Foreign affiliate dumping rules pose challenge to private equity funds

Jun 27, 2019
Jun 27, 2019
0 min. read
Business tax

In response to the 2019 Federal Budget’s changes to the Foreign Affiliate Dumping (FAD) rules, the Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional Accountants (the Joint Committee) commented on the general impact of the FAD rules on foreign-owned private equity funds (PE Funds) investing in Canada. The Joint Committee’s submission highlights the particular challenges that PE Funds must grapple with in applying the FAD rules.

Primer on the FAD rules and ‘More Closely Connected Business’ exception

The purpose of the FAD rules is to prevent perceived base erosion opportunities by imposing adverse tax consequences where, absent Canadian tax considerations, the foreign parent would have made an investment in a foreign affiliate (Subject Affiliate) directly, rather than through a corporation resident in Canada (CRIC). The assumption is that, but for the Canadian tax opportunities, the CRIC would have instead distributed its funds used to make the investment to the foreign parent, for the foreign parent to make the investment directly. Thus, the FAD rules very generally state that where a CRIC that is controlled by a foreign corporation makes a downstream investment in a foreign affiliate, a reduction in cross-border paid-up capital or a deemed dividend subject to withholding tax may result.

Among other exceptions to the FAD rules, the More Closely Connected Business (MCCB) activities exception is intended to carve out situations where the CRIC invested in a foreign affiliate for the CRIC’s own genuine business reasons and not to accommodate the foreign parent’s business or tax purposes. The MCCB exception can apply if the CRIC satisfies a complex test. Key elements of the test include:

  1. The business activities of the Subject Affiliate at the time of the investment are more closely connected to the CRIC’s Canadian business than to the business of the foreign parent;
  2. The CRIC has officers who had principal decision-making authority about the investment in the Subject Affiliate. At the time of the investment, a majority of those officers must have been resident and working either in Canada or in the country of another connected affiliate, the business activities of which are closely connected to the business of the Subject Affiliate; and
  3. At the investment time, it must be reasonable to expect that the performance evaluation and compensation of the CRIC’s officers who have decision-making authority and who are resident in Canada or in the other connected affiliate’s country are more heavily based on the results of the Subject Affiliate than that of the foreign parent’s officers.

As explained by the Joint Committee below, the MCCB exception has been found to be very difficult to apply and thus of limited practical assistance to foreign-owned PE Funds investing abroad through Canada.

MCCB and PE Funds

The main change in the 2019 Federal Budget to the FAD rules is an extension of these rules from CRICs controlled by foreign corporations to CRICs controlled by non-resident persons, which includes both non-resident individuals and trusts. The Joint Committee noted that while the measure is not aimed principally at fact patterns involving CRICs controlled by PE funds, they may be impacted by the proposals.

Beyond the budget changes though, and what is of more general concern, is that the FAD rules, and the MCCB exception in particular, have proven to be a difficult fit for foreign PE Funds investing in CRICs.

For example, the FAD rules assume that the foreign parent controls the CRIC’s business decisions. The rules presuppose that, but for the tax benefits of investing through Canada, the foreign parent would have made the investment in the Subject Affiliate directly, instead of through the CRIC. In other words, the implication is that the foreign parent is making foreign investment decisions through the CRIC for the parent’s own benefit rather than the CRIC’s business goals.

As applied to foreign PE Funds investing in Canada, the typical U.S. PE vehicle with a controlling interest in a CRIC is a partnership, with a U.S. limited liability corporation as the general partner. The limited partners are typically a range of corporate and institutional investors, none of which would individually have control over the PE Fund’s investments. The general partner is normally entitled to vote all the shares of the CRIC owned by the partnership, meaning the CRIC’s foreign investments could fall within the FAD rules because the CRIC is considered to be controlled by the foreign general partner even if the general partner in fact only has a very small economic interest in the arrangement.

However, the degree of control assumed by the FAD rules to be exercised by the foreign parent is not necessarily consistent with how PE Funds operate. In practice, when a foreign PE Fund buys a controlling interest in a CRIC that is not an add-on to an existing business in its portfolio, the newly acquired CRIC is likely the true parent company of any further foreign acquisitions that the CRIC will make. An acquisition by a CRIC of a Subject Affiliate in a similar or complementary business to that of the CRIC’s suggests that the CRIC is the natural investor in the affiliate, not the foreign parent as assumed by the rules. Applying the FAD rules to such a transaction would therefore appear to be outside the policy of the FAD rules because the PE Fund’s tax goals are not the driver of the transaction.

Applying the MCCB exception to prevent the application of the FAD rules is another challenge for PE Funds. Recall that the crux of the MCCB exception is the decision-making authority of the CRIC’s officers. However, determining who the controlling officers are is not a straightforward exercise for PE Funds. The roles and responsibilities of the “deal-makers” in the PE Fund versus the “business people” in the CRIC may vary from deal to deal depending on each individual’s experience, skill, acumen, business networks and knowledge. They may also share a great deal of joint responsibility for critical input in the negotiations, due diligence oversight and consummation of a transaction. These shared duties cannot be easily parsed out and assigned to any specific officer for purposes of identifying the “true” decision-maker and satisfying the narrow MCCB exception.

Joint Committee recommendations

In light of the issues identified, the Joint Committee makes key recommendations to broaden the MCCB exception into a fact-based analysis of whether the Subject Affiliate is more closely connected to the business of the CRIC than to that of the foreign parent. It is also suggested that the MCCB exception be applied with more flexibility to accommodate the more informal decision-making and compensation processes that are common for PE funds.

Takeways for PE Funds

Legislative amendments to the MCCB exception may be warranted to better accommodate the realities of foreign PE Funds. In the meantime, to improve the likelihood of a successful MCCB exception claim, where a CRIC that is owned by a foreign PE Fund makes an investment in foreign affiliates: 

  • The CRIC should fully document its own business reasons for the investment
  • Both the PE Fund and the CRIC should document roles and responsibilities so that a corporate officer of the CRIC who has decision-making authority over the investment in the Subject Affiliate can be clearly identified.
  • A performance and compensation plan for the decision-makers of the CRIC that is more clearly tied to the performance of the foreign affiliate than that of the decision makers in the foreign parent should be developed.

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