The Basics of Offshore Tax Planning For Canadian Corporations – Part 6

Using an Offshore Subsidiary to Finance Other Foreign Affiliates

In situations where substantial amounts of capital are needed to finance the active business operations of Canco’s foreign affiliates (“Forcos”), Canadian tax laws provide an incentive for Canco to form a financing affiliate (“Finco”) in an appropriate jurisdiction, which will permit little or no income tax to be paid on the interest that Finco earns.

This incentive is the fact that, as long as the interest received by Finco is deductible against the active business income earned by Forco in a foreign jurisdiction, that interest income will be deemed to be active business income, rather than FAPI, in Finco’s hands [1]. This will be the case even if Finco is relatively passive.

The use of this strategy will only make sense if there are Forcos operating in foreign jurisdictions that levy significant taxes on its profits. The objective would be to reduce those profits that are taxable in the foreign jurisdiction by the interest paid to Finco.

The required capital would generally be supplied by Canco to Finco via a share subscription. If Canco has to incur interest costs to obtain the required capital, it should be able to deduct such interest costs in computing its income [2].
The tricky part of such arrangements is generally ensuring that the interest paid by Forco to Finco is deductible by Forco in its country of residence, and ensuring that little, if any, in the way of withholding tax is payable by Finco on the interest.

If Forco is resident in the US, the earnings stripping provisions of the Internal Revenue Code, potential for debt to be characterized as stock[3], and limitation of benefits provisions in tax treaties will all create many challenges that require high-level US tax advice.

At one time, it was possible for Canadian based companies to use a subsidiary formed as a US LLC as a Finco, and utilize the Canada-US Tax Convention to obtain a reduce US tax rate on interest. However, subsequent changes to US law [4], as well as the treaty [5], now mean that such planning is a thing of the past.

In the next article in this series, I will discuss some issues in relation to offshore tax planning with Forco, and the optimal ownership structures to use.

In accordance with Circular 230 Disclosure
[1] Paragraph 95(2)(a)(ii)
[2] Paragraph 20(1)(c)-this type of arrangement is often called “double dip” financing because Canco deducts the interest, and no Canadian tax is paid on Finco’s interest received from Forco.
[3] See Laidlaw Transportation Inc. v. Commissioner, 75 TCM 2598 (1998) for a notorious example of a plan by a major Canadian-based company that went awry when it came to the treatment in the US of interest paid to an offshore financing affiliate.
[4] Specifically, Regulations dealing with hybrid and reverse hybrid entities issued under Code Sec. 894(c).
[5] Article IV(7)

Mr. Atlas is a Toronto-based Chartered Accountant who practices as an independent consultant on a wide-range of international and domestic tax issues. Most of his practice consists of advising accounting and law firms on high-level tax issues. Prior to forming an independent tax practice in 1991, was Partner in charge of tax practice of major independent accounting firm in Toronto. Advises clients worldwide. Author of leading book, Canadian Taxation of Non-Residents, considered one of the few Canadian tax professionals, outside of the big accounting and law firms, who is an expert on high-level international tax matters.

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