Foreign Affiliate Dumping and Estates with Non-Resident Beneficiaries

Unless special care is taken, the draft foreign affiliate dumping (FAD) amendments released on July 30, 2019 may create a deemed dividend to a non-resident beneficiary of the estate of the owner of a private company. The amendments are effective for transactions after March 18, 2019.

Suppose that the deceased (Dad) wholly owns a Canadian corporation (Opco). Opco has capitalized a US subsidiary (US FA) with debt and equity totalling $100,000. Dad's will provides a discretionary power to the executor to pass the total value of his property equally to his four children, one of whom is a non-resident (NR son). Assume that the series test in paragraph 212.3(1)(b) and the purpose test in subparagraph 212.3(26)(c)(ii) (both discussed below) are satisfied.

Under proposed section 212.3, the normal tax arising from the deemed disposition on death is supplemented by a deemed dividend from Opco to NR son of $100,000 (the FMV of property transferred by Opco to US FA). This occurs at the dividend time (defined in subsection 212.3(4)), which is one year after Opco capitalized US FA. Both taxes are levied on the same economic value of Opco shares.

Section 212.3 applies for the following reasons:

  • The capitalization of US FA fits the meaning of "investment" in paragraphs 212.3(10)(b) and (c); therefore, an investment has been made by a corporation resident in Canada (CRIC) to an FA (subsection 212.3(1)).
  • Although only the estate controls Opco, proposed subsection 212.3(26) deems NR son to own a certain proportion of Opco. However, since the estate is discretionary and the purpose test is satisfied, NR son will be deemed to own 100 percent of the voting shares of Opco. Thus, NR son is deemed to control Opco when Dad passes away. Therefore, the CRIC is controlled by a non-resident person or a group of non-resident persons not dealing at arm's length.
  • The series test is satisfied (by assumption).

The following defences against this deemed dividend do not seem to be of much relevance:

  • The elective PUC reduction relief contained in section 212.3 is helpful only to the extent that Dad has capitalized Opco with more than nominal capital.
  • Since there was no reorganization, the exception in subsection 212.3(18) is not available. A standard post mortem transaction would not qualify.
  • The general double-taxation relief in subsection 248(28) does not apply because the tax is not levied twice on the same taxpayer: tax on the deemed dividend is levied on NR son and tax on the other income is levied on the estate.

This deemed dividend can be eliminated in several ways, of which the first is likely the most useful:

  • If Opco's investment in US FA is a pertinent loan or indebtedness (PLOI), as defined in subsection 212.3(11), then the FAD amendments will not apply and Opco will be deemed to earn prescribed interest income instead. A PLOI election must be filed for the year in which the debt arises, but it can be late-filed up to three years after the deadline (subsection 212.3(12)).
  • The example assumed that both the series test (in paragraph 212.3(1)(b) and subsection 248(10)) and the purpose test are satisfied. However, either or both of these assumptions might not be true. Consider first the series test. In the example above, the three events (the capitalization of the company, the inclusion of a non-resident in the will, and Dad's death) could be separated by a long period of time and not linked by any grand strategy. Also, the purpose test is not satisfied if the discretionary power was not granted to the executor to avoid the FAD rules.
  • The "more closely connected business activity" exception in subsection 212.3(16) is another possibility. However, in paragraph (a), the executor needs to show that the business activity of US FA is more closely connected to the business activities carried on in Canada by Opco than it is to the business activities carried on by the non-resident person. This might be difficult to show if NR son participates in the decision making of US FA or is involved with US FA.

Henry Shew
Cadesky Tax, Toronto

Canadian Tax Focus
Volume 10, Number 1, February 2020
©2020, Canadian Tax Foundation