Corporate Tax- Canada
The 2007 federal Budget, announced on March 19 2007, included certain proposed amendments to the concept of a 'prescribed stock exchange' for the purposes of the Income Tax Act (Canada). These changes were largely instigated by perceived problems with Section 116 of the act.
Although amending the definition of 'prescribed stock exchange' does not address the principal concerns with Section 116, the amendments do have some significant effects.
Barriers to Foreign Investment in Canada
The principal goal of any tax policy is to raise revenue. However, a tax policy should aim to achieve this goal with the smallest impact on the general growth of the nation's economy. International competitiveness is an important aspect of this balance. Without a competitive tax policy for cross-border investment, a country risks alienating its domestic businesses and investment opportunities from foreign markets. In the case of Canada, a competitive tax policy is of utmost importance for attracting investment from the United States. With the increasing globalization of capital markets, the importance of being able to attract investment from other significant foreign markets will only increase.
For several years, Canadian companies and US institutional investors have voiced complaints about certain aspects of the Canadian income tax system that negatively affect investment by non-residents in Canadian companies. These complaints often target the withholding and reporting procedures contained in Section 116 of the act.
Section 116 requires that a purchaser withhold 25% from the purchase price whenever it purchases shares in a Canadian corporation that is a 'taxable Canadian property' from a non-resident of Canada and remit this amount to the Canada Revenue Agency (CRA). This withholding obligation can be avoided by applying for and receiving a certificate of compliance from the CRA. However, even if the transaction does not result in a gain, or if the transaction is exempt from Canadian tax by operation of a tax treaty, a compliance certificate is still necessary if the withholding tax is to be avoided.
The procedure for acquiring a compliance certificate is onerous and presents a significant deterrent to foreign investment. Further, the CRA has often been criticized for improperly using this procedure as an audit vehicle. The CRA will generally require significant documentation to accompany the application, which could include:
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supporting documents;
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the share purchase agreement;
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the original agreement under which the shares were purchased in order to establish cost base;
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evidence from the home jurisdiction tax authority establishing residence there; and
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personal information of the partners if the non-resident vendor is a partnership.
Even after the CRA has received the correct documentation, the processing time can last several months. Delays of this magnitude can pose a significant risk to foreign investment firms which dispose of shares for other marketable securities whose value may fluctuate significantly during the processing period.
The various concerns with Section 116 can generally be split into two complaints: (i) the compliance certificate procedure is too onerous; and (ii) the provision applies to many transactions that do not warrant such scrutiny.
Prescribed Stock Exchange
Shares of a corporation listed on a prescribed stock exchange are generally not taxable Canadian property under the act and are described as "excluded property" for purposes of Section 116. Listing on such an exchange can offer a non-resident the ability to liquidate its share position in the Canadian corporation without being subject to the withholding and reporting provisions of Section 116. Not surprisingly, Canadian corporations looking to raise capital from foreign investors have been influenced by this fact when determining where to list their shares. Some corporations have been forced to list on a second prescribed exchange just to ensure that their non-resident investors are not subject to Section 116 on disposition of the shares.
The concept of a prescribed stock exchange is not only relevant for Section 116. Shares listed on a prescribed stock exchange are also eligible for investment by tax-deferred plans (eg, registered retirement saving plans, registered retirement income funds and deferred profit-sharing plans) and are qualified securities for the purposes of securities lending arrangements.
The definition of a 'prescribed stock exchange' is contained in Sections 3200 and 3201 of the regulations to the act. These sections list several exchanges in Canada and around the world that qualify and define the term 'prescribed stock exchange' for the entire act.
Budget Amendments
In the supplementary information to the notice of ways and means to amend the act, the Department of Finance admitted that the use of the term 'prescribed stock exchange' for all the various provisions that use the term may not be necessary or warranted:
"[D]ifferent tax policy objectives underlie the various references to this concept in the Income Tax Act. For example, the [registered retirement saving plan] rules are meant to ensure that retirement savings are held in relatively liquid and well-governed markets. This requires stringent criteria such as an assurance that the exchange is properly governed and that non-arm's-length dealings are adequately monitored. On the other hand, the use of this concept in the securities lending rules is simply an indirect way of ensuring that a security is listed and traded in a public market.
Because different tax policy goals are currently served by the same concept, with the result that all of the tax consequences discussed above flow from prescription, the most stringent tests have to be applied to every candidate exchange even if a less strict test would satisfy the purpose for which prescription is sought. This can delay the accommodation of a new exchange and may cause unnecessary difficulties for Canadian businesses and investors."
The amendments propose to replace the term 'prescribed stock exchange' wherever it is used in the act with one of three different terms, as applicable:
The term 'designated stock exchange' will be used for the purposes of establishing qualified investments for deferred plans such as registered retirement saving plans and will cover those stock exchanges currently listed as a prescribed stock exchange. An individual stock exchange will become a designated stock exchange only if it receives approval from the minister. These amendments will not alter the application of these rules.
Further, this term will initially replace the term 'prescribed stock exchange' wherever it is currently used within the act, except as discussed below.
The term 'recognized stock exchange' will replace a prescribed stock exchange in the definition of 'excluded property' in Section 116(6) of the act. This term will not represent a specific list of exchanges as is currently the case with the current definition of 'prescribed stock exchange'. Rather, a recognized stock exchange will refer to any stock exchange that is located in Canada or in another country that is a member of the Organization for Economic Cooperation and Development and that has a tax treaty with Canada. This category will also include those stock exchanges listed as designated stock exchanges.
The term 'stock exchange' will be used for the securities lending rules in Section 260 of the act and will include all stock exchanges. This will not be a defined term, but instead will rely on the common and legal meanings of the term.
Impact of Amendments
While an amendment to the act is unlikely to address the issues surrounding the administration of the compliance certificate procedure adequately, certain amendments could reasonably reduce the scope of that provision. By replacing the term 'prescribed stock exchange' in Section 116 with the broader term of 'recognized stock exchange', the government proposes to shield certain dispositions from the onerous provisions of Section 116. Dispositions of shares listed on exchanges that were not a prescribed stock exchange, but are now caught within the ambit of the new definition of a 'recognized stock exchange', will no longer need to comply with Section 116. The most significant trading forums that would appear to be included in the definition of a 'recognized stock exchange' that were not previously considered to be prescribed stock exchanges are:
Further clarification may be required as to which trading forums will be considered a stock exchange for purposes of the act, such as the Over-the-Counter Bulletin Board. This amendment does not adequately deal with all the problems to foreign investment caused by Section 116, but it does remove one particular issue that was significant for corporations listed, or considering listing, on the AIM, the NYSE Arca or the CNQ.
While the principal motivation behind this amendment was to deal with Section 116, the amendment significantly broadens the application of the securities lending rules in Section 260 of the act. These rules principally facilitate short-selling securities transactions that would otherwise create taxable dispositions under the act. By including in the definition of 'qualified securities' any share listed on a stock exchange, these rules will apply to any publicly listed security.
Comment
While the creation of the new term 'recognized stock exchange' corrects an overly restrictive definition of a prescribed stock exchange for purposes of Section 116, the Budget did not correct the most significant problems with the scope of Section 116. As a result, this provision will still act as a significant barrier to foreign investors. However, allowing dispositions of shares listed on the AIM, the NYSE Arca or the CNQ to occur without having to comply with the requirements of Section 116 is a positive step in reducing the application of that provision in circumstances that do not warrant the scrutiny of a Section 116 review. Consequently, Canadian corporations intending to list only on the AIM, the NYSE Arca or CNQ have become much friendlier investments for foreign investors.
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