Monthly Archives: July 2010

Chinese Tax

Chinese Tax Developments Re-draw the Map for

Canadian Investors

Canadians doing business in China may have a hard time keeping up with the country’s rapid pace of tax reform. Over the past year, China has introduced a host of changes to its tax laws and administration that aim to increase compliance and eliminate tax avoidance by non-resident investors. A new protocol to the China-Barbados tax treaty could also affect companies investing into China through Barbados by eliminating relief that was previously available to dividends and capital gains. On a brighter note, China has also announced a series of Business Tax exemptions for certain foreign business activities.

Companies with business investments or operations in China may need to review their activities and business structures in light of these reforms. The following recent Chinese tax developments of interest to Canadian investors:

  • Changes to the China-Barbados tax treaty
  • New anti-avoidance rules for non-residents
  • Enterprise Income Tax on representative offices in China
  • New exemptions from China’s Business Tax.

Protocol to the China-Barbados tax treaty

Access to reduced dividend withholding tax rate restricted

Under the protocol to amend the China-Barbados tax treaty signed on February 10, 2010, access to the reduced five-percent withholding tax rate on dividend payments between China and Barbados is only available if a beneficial owner company directly holds at least 25 percent of the dividend payer’s capital. If not, the withholding tax rate under the treaty is 10 percent.

The five-percent withholding tax rate on dividends is still competitive compared with other China treaties. Among popular holding company jurisdictions, only China’s treaties with Luxembourg, Ireland, Singapore and Hong Kong currently provide a five-percent withholding rate on dividends. Each of these treaties also includes a 25-percent ownership test as a condition for the reduced withholding tax rate.

Capital gains exemption narrowed

The China-Barbados protocol restricts the current exemption for capital gains on the disposition of shares in Chinese companies, eliminating one of the advantages of the China-Barbados treaty and bringing it in line with other Chinese treaties. Once the protocol takes effect, China’s capital gains tax will apply to gains realized on the disposition of shares deriving more than 50 percent of their value from immovable property in China. Further, if a Barbados company holds at least 25 percent of a Chinese corporation, any gains realized on the disposition of shares are also taxable in China.

The changes to the China-Barbados treaty eliminate opportunities for foreign shareholders to avoid the Chinese capital gains tax on shares in land-rich Chinese companies and significant interests in Chinese investees.

New anti-avoidance rules for non-residents

The Chinese tax authority recently issued three circulars with guidance that aims to prevent cross-border tax planning that the government perceives as abusive.

Pre-approval of treaty benefits

Starting October 1, 2009, non-residents must request pre-approval to obtain benefits under one of China’s tax treaties on Chinese-source dividends, interest, royalties and capital gains. In a circular dated August 24, 2009, China’s tax authority clarified existing procedures and documentation requirements for non-residents to apply for pre-approval. The process requires extensive disclosure of the non-resident’s operations and group structure.

Intermediate holding companies

In a circular issued on December 10, 2009, China’s tax authority announced plans to eliminate traditional tax planning approaches involving intermediate holding companies. Specifically, the circular targets the “indirect” transfer of an interest in a Chinese company through the transfer of shares in a foreign-incorporated holding company. If the transfer of the intermediate holding company has no commercial purpose, avoids tax liabilities, and is undertaken in an “abusive” manner, the tax authorities can use the substance over form principle to recharacterize the transaction as a sale of the Chinese company and levy capital gains tax accordingly. These changes are retroactive to January 1, 2008.

The December 2009 circular does not define “abusive reorganisation planning”. However, if the shares of the Chinese resident corporation are transferred indirectly and the capital gains tax paid by the ultimate transferor is less than 12.5 percent of the gain, detailed information on the transaction and the parties’ relationship must be submitted to China’s tax authority within 30 days of the transfer. The documentation requirements include questions relating to the substance of the intermediary holding company and its function within the group.

Based on these information requirements, it appears that the Chinese tax authorities may consider the transfer of an intermediate holding company to be abusive where the transfer occurs tax-free and the intermediary company has no assets or activities other than its investment in the Chinese company.

Beneficial ownership of interest, dividends, and royalties

Another new circular sets out guidance on determining whether a non-resident is eligible for beneficial owner status and thus able to claim treaty relief on dividends, interest, and royalties. This circular took effect on October 27, 2009.

The Chinese tax authorities will take a “substance over form” approach in making these determinations. The circular distinguishes a “beneficial owner”, who owns or controls property in substance and “generally” carries on business in substance, from a “conduit company”, which is only registered to satisfy legal requirements but does not manufacture, trade or manage any commercial activities in substance. The circular lists seven factors that constitute unfavourable evidence:

1.      The entity applying for beneficial owner status is liable to distribute all or most (e.g., more than 60 percent) of its income to a resident of a third country within a specified time period (e.g., 12 months).

2.      The entity has no commercial activities other than holding property or shares that generate dividends, interest or royalties.

3.      Where the entity does carry on a business, the assets, number of employees and scale of the business are so small that the business’s size cannot match the revenues earned by the entity.

4.      The entity has little or no control over the property or shares that generate the dividend, interest or royalty income.

5.      The entity pays little or no tax on income earned in the treaty country.

6.      Where the entity seeks treaty benefits for interest income on a loan, the entity has a third-party loan that is similar in amount, interest rate and issuance date.

7.      Where the entity seeks treaty benefits for royalty income from an underlying right regarding patent, franchise or intellectual property, there is a similar underlying right with a third party.

Factors 1 to 4 focus on whether the recipient has substantial activities in its residence country to justify the revenue received. Factor 5 focuses on the amount of tax paid on income earned in the treaty company. Factors 6 and 7 address situations where the loan, patent, franchise or intellectual property is provided via a back-to-back arrangement through an intermediate holding company in a favourable treaty jurisdiction.  

Previously, a non-resident of China generally only had to provide a certificate of tax residency from its state of residence to obtain benefits under one of China’s tax treaties. These new administrative measures require extensive disclosures on the holding company and related tax planning arrangement. The measures reflect the Chinese government’s intention to tighten its enforcement of the taxation of non-residents and strengthen the tax authority’s ability to scrutinize and challenge tax planning strategies that are perceived to be abusive.

If the measures are applied and interpreted strictly, many current investment structures into China may have difficulty sustaining treaty benefits. KPMG in China is aware of cases where non-residents have failed to have their previous treaty entitlements renewed under the new rules.

Canadian companies with Chinese interests should review their holding, financing and intellectual property structures in light of these rules. Structures that do not meet these substance requirements could be restructured to increase the level of activity in the intermediary company (such as by transferring additional functions, assets and resources to the relevant country). Companies intending to set up new structures should account for these substance requirements in their planning. For example, such structures could be set up in countries in which the corporate group has or plans to establish a substantial business operation with its own third-party revenue, employees and physical assets, or substantial head office management functions.

Enterprise Income Tax on representative offices

On February 20, 2010, China’s tax authority announced new rules for calculating China’s Enterprise Income Tax (EIT) and related filing requirements. The EIT applies to non-resident companies that carry on business in China through a “representative office” in China. The changes apply retroactively from January 1, 2010.

Before 2010, Chinese domestic law provided an EIT exemption for representative offices on their market research, marketing communication, and auxiliary activities in China in support of the manufacture and sale of their products. Under the new rules, the relevant tax treaty must be reviewed to determine whether the representative office has a permanent establishment in China. If it does, China has the authority to tax the activities of the representative office. Treaties based on the OECD model treaty typically exclude certain auxiliary activities from their “permanent establishment” definitions; however, the specific treaty should be consulted.

Further, unless a representative office can provide complete and accurate financial records, it must calculate its income tax liability based on the cost-plus method. The new rules raise the mark-up rate to not less than 15 percent (from 10 percent).

Representative offices in China that do not meet the new requirements for exemption should consider the potential benefits of converting the entity to a wholly-foreign-owned corporation.

New exemptions from China’s Business Tax

On September 27, 2009, the Chinese government announced that certain foreign business activities are exempt from China’s Business Tax.

Background

China’s Business Tax is a turnover tax that applies to individuals and entities providing services, transferring intangible assets or selling immovable property in China. The tax rate on the transaction ranges from three to 20 percent depending on the type of transaction. At the end of 2008, the scope of the Business Tax was significantly broadened. Previously, the tax only applied to services that were physically carried out in China. The current regime applies to companies or individuals that either provide or receive services that are located in China

Under the recent changes, Chinese companies and individuals that render services outside China are exempt from Business Tax with respect to construction, cultural and sporting activities. Also exempt are services provided to Chinese recipients outside of China by non-resident individuals and corporations in certain areas, including cultural and sporting services, entertainment, catering, hotels and warehousing services.

Since China’s Business Tax applies to any business services provided to or received by a Chinese resident, the tax can be a significant cost for Canadian companies investing or providing services in China. For example, the tax applies not only to transfers of intangible assets from a foreign entity to a resident of China but also to any future royalties paid by the Chinese resident with respect to the intangible assets, even though the withholding tax also applies to the royalties.

China Business Tax also represents an additional cost for interest payments made by a Chinese borrower to a foreign lender as the five-percent tax is charged in addition to the 10-percent withholding tax. Further, this additional tax is beyond the scope of China’s tax treaties and no treaty protection is available. In effect, for all jurisdictions other than Hong Kong, the effective tax burden on interest payments is now 15 percent (12 percent for Hong Kong).

Further, where a Chinese resident makes service payments to a foreign entity through an intermediate Chinese resident, the Business Tax would apply to both transactions. Foreign entities investing in China should be aware of the potential adverse application of China Business Tax and structure their transactions accordingly.

Since the active business income of foreign affiliates is exempt from Canadian tax, this change does not affect income earned through Chinese subsidiaries of Canadian companies. However, if the Canadian company carries on business in China directly, the change may jeopardize the company’s ability to offset the tax by claiming foreign tax credits for Canadian purposes since the Business Tax is not a tax on income or profit. As a result, Business Tax payments only qualify for an ordinary tax deduction for Canadian purposes, instead of a foreign tax credit or grossed-up deduction under the foreign affiliate rules.

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

International Taxation

Non-residents who conduct business in Canada, earn Canadian income or own taxable Canadian property are required to report and file Canadian income tax returns. Failure to file the required withholding taxes and remittances to CRA can result in severe tax penalties, significant amounts of interest on back taxes, increased accounting and legal costs, and could even tie up proceeds from the sale of Canadian property for extended periods of time.

We have experience in preparing and filing NR4, NR6 and Section 216 tax returns with Canadian tax authorities for non-residents and obtaining Clearance Certificates from CRA.

We have also helped many non-residents obtain favourable results under Voluntary Disclosure rules for waiving CRA penalties.

Recent case

Leave a reply

Are Management fees deductible?

Tax planning to use tax losses in a corporate group structure may be allowed by the Canada Revenue Agency , using management fees as a tool for that planning may not be. As the recent case, Les Entreprises Rejean Goyette Inc. v. Her Majesty the Queen (2009 CCI 351), in which the Tax Court of Canada (TCC) denied the taxpayer’s deduction of inter-corporate management fees because there was no formal management agreement and, therefore, no legal obligation to pay them.

Time to Rework

 

Companies that offer stock option plans to their employees may have to quickly re-evaluate these arrangements following significant changes to the tax treatment of stock options announced in the 2010 federal budget. Many of these changes are effective for stock options exercised after 4:00 pm (EST) on March 4, 2010.

These measures change the tax treatment of stock option cash-outs and eliminate the opportunity to defer tax on the employment benefit resulting from exercising qualifying stock options in public companies and private companies that are non-Canadian controlled private corporations (non-CCPCs). The budget measures also require employers to withhold tax on benefits from employee stock options exercised after 2010.

For employees with underwater stock options, the budget measures may provide some welcome tax relief. This relief may be available for stock option benefits going as far back as 2001.

Background — Tax treatment of stock options

A stock option plan is an arrangement whereby a corporation gives an employee the right (an option) to purchase its shares at a given price. The price may be above or below the market price at the time the option is granted.

When the employee exercises the option to acquire the shares, the difference between the price the employee pays for the shares and their market value is treated as a taxable benefit to the employee.

If certain conditions are met, the employee can claim a deduction of one-half of the taxable benefit. The effect of this deduction is to tax the employment benefit at the same rate as a capital gain.

Generally, public company employees may qualify for the deduction if:

  • The shares are normal common shares (not preferred shares)
  • The exercise price is at least equal to the fair market value of the shares at the time the option was granted
  • The employee deals at arm’s length with the corporation.

 

Before the 2010 federal budget, public company and non-CCPC employees were allowed to postpone the taxation on the benefit on $100,000 per year of qualifying stock options to when the shares were sold instead of when the options were exercised.

Stock options in Canadian controlled private corporations (CCPCs) are treated differently. As long as the employees deal at arm’s length with the corporation, the taxable benefit is reported when the employees sell the stock option shares, rather than when they exercise their options and acquire the shares. The 2010 federal budget does not affect these rules for CCPCs and their employees.

Stock option cash-outs

Some stock option plans have a “stock appreciation right” attached to them. Such plans allow the employee to receive a cash payment equal to the value of the options instead of purchasing the shares. In other words, the employee can “cash out” the options.

Before March 4, 2010, the same tax consequences for the employee resulted from the cash payment as from the issuance of shares — the employment benefit was included in income and the related one-half deduction was available if the required conditions were met. The employer could claim a deduction for the full amount of the cash payment.

The 2010 federal budget proposes to change these rules such that employees who receive a stock option cash-out can only claim the deduction of one-half of the employment benefit if the employer elects to forgo the deduction for the cash payment. If the employer does not make this election, it will be entitled to a corporate tax deduction for the payment but the employees must pay tax on the full value of the employment benefit. This change is effective for all stock options that are cashed out after 4:00 pm (EST) on March 4, 2010, regardless of when the options were issued.

The Department of Finance has not provided any grandfathering relief for stock option cash-out arrangements that were in place before the proposed changes to the rules in the 2010 federal budget. As such, employers and employees will need to reconsider the implications of any cash-out arrangements in place prior to March 4, 2010 before completing the transactions.

Finance has confirmed that an employer’s election to forgo the deduction for the cash payment when an employee cashes out his or her stock option rights can be made separately for each employee. In other words, it does not necessarily have to apply to all the employees in the stock option plan.

Finance has also indicated that the policy reason for not allowing employers to claim a deduction for a stock option cash-out payment is to preserve symmetry in the tax treatment of stock-based compensation. (When an employee exercises stock options and acquires shares, the employer does not get a deduction because it does not pay out cash.) This policy change also achieves more consistency with the U.S. tax treatment of stock options.

Example of new tax treatment of stock option cash-out
The following analysis illustrates the effect of the change by comparing the after-tax cost of stock option cash-outs to employees and employers under the old pre-budget rules and the new post-budget rules.

As the table shows, the employee’s after-tax proceeds of a $100 cash-out payment can remain the same pre- and post-budget at $77 (columns 1 and 2). However, the pre-budget regime caused the CRA to effectively lose a total of $7 in tax revenue per $100 of benefit, rather than receiving $23 in tax revenue from the employee. The reason for this tax revenue difference is the employer’s tax savings of $30 from claiming a deduction for the $100 cash payment to the employee.

Post-budget, the elimination of the employer’s tax deduction results in the CRA receiving $23 per $100 of benefit (when the employer elects to forgo the deduction (column 2)). If the employer does not elect to forgo the deduction (column 3), the CRA receives $16 in tax (compared to $23) but the net after-tax proceeds to the employee fall to $54 because the employee cannot claim the stock option deduction.

Tax Results of Pre- and Post-Budget Employee Cash-Outs 
  Pre-Budget   Post-Budget
  Cash-Out Cash-Out
with Election1		 Cash-Out
No Election
Employer Cash Paid  $100  $100  $100
Tax Savings @ 30% (C)2    30        –    30
Net After-Tax Cost to Employer  $  70  $100  $  70
       
Employee Cash Received  $100  $100  $100
Less Stock Option Deduction    50    50       –
Taxable Income    50    50   100
Tax thereon @ 46% (P)3  (23)  (23)  (46)
Net After-Tax Proceeds to Employee  $  77  $  77  $  54
CRA perspective: Net tax
revenue lost (received) (C –
P)		 $    7 $(23) $(16)
1)       The employee and employer will get the same tax result as the cash-out with election if
the employee acquires the shares instead of taking the cash-out.2)       Assuming a 30% corporate tax rate, $100 deduction equals $30 in tax savings.3)       Assuming a combined federal/provincial top marginal personal tax rate of 46%.

 

The table illustrates that the cash-out without the employer election to forgo the deduction may be the least appealing, even though less tax is paid initially, because the employee is significantly worse off.

If the employer did not elect to forgo the deduction (column 3), the employee would get a better result (from a tax point of view) by acquiring the shares instead of taking the cash-out option. The employee could then sell the shares to achieve the same cash position as the cash-out option with the employer election to forgo the deduction.

Accounting implications of tax changes
In situations where employees holding options to acquire shares under an employee stock option plan are entitled or can choose to receive cash in lieu of shares and they elect to receive those cash payments, these cash-settled grants were generally classified in the financial statements as a liability. 

For Canadian GAAP purposes, transactions settled in equity instruments are generally classified as equity-settled awards and other transactions are classified as liability (cash-settled awards).

For these cash-settled awards, the company may have recorded a future tax asset on the basis that it will receive a deduction when the employee ultimately elects to receive cash payments and the cash payment is made. The proposed budget changes may require the company to review its accounting treatment of its future tax asset.

In addition, as a result of the proposed budget changes, companies may choose to modify the terms of their existing stock option agreements such that their existing liability classified stock option awards are reclassified as equity-settled awards. In these cases, they need to carefully consider the accounting treatment for the change in terms and conditions.

Deferral of stock option taxable benefit

Before the 2010 federal budget, public company employees who exercised stock options could generally defer tax on the related taxable benefit on up to $100,000 of annual qualifying employee stock options until the shares were actually sold. The budget proposes to eliminate this deferral, effective for stock options exercised after 4:00 pm (EST) on March 4, 2010.

As such, employees who exercise stock options after 4:00 pm (EST) on March 4, 2010 will not be able to defer tax on any of their employment benefit.

Employer withholding tax requirements

The budget states that, for benefits arising on the issuance of securities after 2010, employers must withhold tax on a stock option employment benefit from the employee’s pay. The amount of the withholding can be reduced for the 50 percent stock option deduction if the employee qualifies for the deduction. 

As a result, employees who exercise stock options after 2010 will effectively have to pay the tax right away, rather than when they file their tax return for the year.

This tax withholding measure does not apply to options granted before 2011 under a written agreement entered before 4:00 pm (EST) on March 4, 2010, if the agreement includes restrictions on the optioned shares’ disposition.

Background

Before the budget, employers were technically required to withhold tax on the employment benefit at the time of exercise. However, if the employee was not paid any cash, the CRA administratively waived the tax withholding requirement on the benefit for Canadian resident employees.

The budget does not provide details on how the employer will, as a practical matter, withhold the appropriate tax on the employment benefit when the employee does not receive any cash compensation on the exercise of the stock option.

Presumably, the employee will have to provide cash to the employer so that the employer can remit the required employee withholding tax to the CRA. Non-CCPC private companies will unfortunately place their employees in a difficult position where no market in which to sell the shares is available to the employee. Amendments to such plans will likely be necessary.

Employees who exercise stock options will need to keep in mind when considering whether to sell any of the shares that they will effectively need to have funds to pay a tax liability as soon as they exercise their options. 

Underwater stock options

Shares purchased through a stock option plan are usually expected to increase in value. However, some employees who exercised stock options and did not sell the shares right away may have seen the shares’ value fall since the day they exercised their options.

Depending on how much the shares’ value has fallen, employees with these “underwater” stock option shares who deferred the taxable benefit when they exercised their options (as described above) could end up with a deferred tax liability greater than the value of the shares. The budget proposes a special election that the employee can make to ensure that any tax liability on the deferred stock option benefit, when realized, does not exceed the proceeds from the shares’ disposition.

Effectively, the election mechanism converts the taxable employment benefit from the employee’s income into a deemed taxable capital gain. In exchange, the employee pays a special tax equal to the actual proceeds received on the sale of the shares. By making the election, the employee applies the capital loss realized on the disposition of the shares to the deemed taxable capital gain, thereby using allowable capital losses that otherwise must be applied to taxable capital gains.

As such, employees who deferred the taxable benefit on a stock option exercise and who dispose of the shares for proceeds less than the taxable benefit can elect to pay tax equal to the proceeds of disposition instead of paying tax on the taxable benefit. To take advantage of the election, the employee must make the disposition before 2015.

In assessing whether they should take advantage of the special relief, employees should keep in mind that the election reduces the potential for tax relief from using the capital losses otherwise available on the underwater shares against capital gains realized from disposing of other property.

Relief available as far back as 2001
The budget proposes to allow these elections for the previous 10 years (which goes beyond the normal three-year assessment period). Thus, it may be possible for employees to go back as far as 2001 to obtain relief for a deferred employment benefit that was realized on shares that were sold before the March 4, 2010 budget announcement.

To take advantage of this tax relief, employees must make the special election on or before their tax return filing due date for 2010 (generally April 30, 2011). For dispositions after 2010 but before 2015, the deadline for making the election will be the tax filing due date for the year the disposition occurs.

Example of underwater stock option election
The following example illustrates the tax consequences of making the underwater stock option election.

Assume that Mr. X is granted a stock option by his public company employer (Pubco) in 2008, when the fair market value of the Pubco shares equals the exercise price of $1,000. Mr. X exercises the option in 2009, when the fair market value of the shares has increased to $10,000. Thus, Mr. X has a taxable employment benefit of $9,000 in 2009 ($10,000 fair market value minus $1,000 exercise price). Mr. X chooses to defer the $9,000 employment benefit until he disposes of the shares. However, by 2010, the fair market value of the shares has declined to $1,000. Mr. X chooses to dispose of the shares in July 2010.

The following table illustrates the results of Mr. X making the underwater stock option election. This analysis assumes that Mr. X is subject to a combined federal/provincial top marginal tax rate of 46%.

Tax Consequences of Underwater Stock Option Election
   No Election Election
Employment Benefit 2010 $9,000 $9,000
Stock Option Deduction   (4,500)   (9,000)
Deemed Taxable Capital Gain1 –   4,500
Allowable Capital Loss2 –   (4,500)
Taxable Income $4,500 $ –
Tax @ 46%   2,070   –
Special Tax (Proceeds of Disposition)      N/A $1,000
Total Tax $2,070    $1,000
     
1)       Deemed capital gain equals ½ of the lesser of the employment benefit
and the capital loss (both $9,000 in this example).2)       Allowable capital loss realized offsets deemed capital gain.

As the table shows, by making the election, Mr. X will reduce his normal $2,070 tax liability to $1,000. With the election, he claims a $9,000 deduction to remove the entire employment benefit from his income but instead he has to include in his income a deemed taxable capital gain of $4,500 ($9,000 benefit × 50% capital gain inclusion rate). He is then able to use his allowable capital loss of $4,500 ($10,000 cost base of the shares – $1,000 proceeds = $9,000 × 50%) to offset the deemed capital gain of $4,500. Thus, no capital loss remains for carryover.

Making this election completely eliminates Mr. X’s regular tax liability for the employment benefit/capital gain and uses up his capital loss. He is then left with paying the special tax equal to his proceeds of disposition of $1,000. This results in a current tax savings of $1,070 ($2,070 – $1,000).

However, if Mr. X expects to realize capital gains that he could use his allowable capital loss of $4,500 to offset, he may be better off not making the special relief election. In this situation, he would carry over the $4,500 capital loss and apply it against $4,500 in taxable capital gains to realize tax savings of $2,070 ($4,500 × 50%). Doing this would completely offset the $2,070 tax cost of the employment benefit while allowing him to keep the $1,000 proceeds from disposing of his underwater shares.

Generally, to make the special relief election worthwhile, an employee would have to see a significant drop in the value of the stock option shares (e.g., a loss of at least 80 percent of the stock’s value in our example) and not be able to use the related capital losses to reduce tax on other gains.

Also, depending on the exercise price, even if the shares significantly decline in value, an election may not be beneficial if the proceeds of disposition of the stock option shares are high in relation to the taxable employment benefit.

If the shares’ sale proceeds exceed the tax on the deferred taxable benefit, the election is not helpful. 

Non-arm’s length employees’ stock options

The 2010 federal budget proposes to amend the income tax rules to clarify that the disposition of rights under a stock option agreement to a non-arm’s length person results in an employment benefit at the time of disposition (including cash out). Although the government considered that these benefits were taxable in these circumstances under existing tax rules, it also believed that clarification of these rules was warranted.

 

Stock option

Stock option plans are quite often an integral part of an employee’s compensation package to create long term capital use in retirement. Companies implement these plans to attract, reward and retain highly skilled employees.

What is a stock option?

A stock option allows the employee to purchase a certain number of shares at a specified price (‘the option price’) for a specified period of time. Often there is a holding period during which the employee cannot exercise the option. Once this holding period is over, the option is considered ‘vested’ and the employee can exercise the option any time thereafter until the expiry date, if any.

This article will review the different tax rules associated with option plans for Canadian-controlled private corporations (CCPCs) and non-CCPCs i.e. Canadian public corporations.

Taxation of stock options from Canadian public companies

While there are no tax consequences when such stock options are granted, at the time the employee exercises the option they trigger an ‘option benefit’. This benefit is equal to the difference between the market value of the stock and the ‘option price.’ This benefit must be included in the employee’s income from employment in the year in which the option is exercised. The employee can claim a tax deduction equal to one-half of the ‘option benefit’ if the shares are common shares and the exercise price, at the time the options were granted, was equal to the fair market value of the shares.

For example:

  • You have options to acquire 3000 common shares of ABC
    Company at $30 per share (equal to the fair market value of the shares on the date the options were granted).
  • Current market value of ABC’s common shares is $75.
  • All options are vested.
  • If all 3000 shares are exercised, the taxable ‘option benefit’ is $67,500 ($75-$30 = $45 x 3000 shares x 50%).

Taxation of stock options from Canadian controlled private corporations

Employees of CCPCs do not need to include the ‘option benefit’ in income until the year in which the employee disposes the shares. As with non-CCPC shares, the option benefit may be reduced by one-half as long as the exercise price at the time the options were granted was equal to the fair market value of the shares. If it does not meet these criteria, an employee may be able to access another one-half deduction as long as the shares have been held for at least two years at the date of sale.

Deferring the ‘Option Benefit’

The 2000 Federal budget introduced a deferral of the ‘option benefit’ for non-CCPCs until the employee sells the shares, or is deemed to have disposed of the shares on death or on becoming a non-resident of Canada. This deferral applies to options exercised after February 27, 2000, regardless of when the options were issued.

The amount that may be deferred is limited to the benefit arising on $100,000 worth of stock options vested in a particular year. While the $100,000 amount is based on the fair market value of the shares at the time the option is granted, the actual benefit that can be deferred can be much greater.

This can best be illustrated by example:

In January 2000, an employee received 10,000 qualifying shares at an option price of $25 per share equal to the fair market value at the time of grant.

Of the 10,000 options, 5,000 vested in January 2001 and the
remaining 5,000 in January 2002.

On December 1, 2002, all options were exercised. The fair
market value of the shares on that date was $60.

In 2004, the employee sells all 10,000 shares at a fair market value of $65 per share.

2002 Tax Calculation:

Step One – Calculate the number of shares that can be deferred.

The $100,000 maximum deferral is based on the $25 fair market value. Therefore the income benefit that the employee can defer in our example is based on 4,000 shares per vested year ($100,000 / $25).

Step Two – Calculate the income deferral.

(Number of shares * benefit per share)

2001 deferral = $140,0000, (4,000 shares * $35 ($60-$25))

2002 deferral = $140,0000, (4,000 shares * $35 ($60-$25))

Total deferral – $280,000

Step Three – Calculate the income benefit.

2001 income inclusion = $175,000, (5,000 x ($60-$25 = $35))

2002 income inclusion = $175,000, (5,000 x $60-$25=$35))

Total income before deferral – $350,000, less deferral (from Step Two) = $280,000

Total income reported in 2002 = $70,000

Of this $70,000 only 50% is taxable at the employees marginal tax rate.

2004 Tax Calculation

The employee now pays the tax on the $280,000 option benefit that was deferred and the gain on the shares from 2002 to 2004 ($65-$60 x 10,000 shares = $50,000). The total
income reported when the shares are sold is $215,000 ($330,000 x 50%)

Note: If the value of the shares have declined when you eventually sell, you will realize a capital loss but still be liable for the tax on the option benefit.

An employee who receives stock options for a public company and elects to defer the taxable benefit of up to $100,000 per annum (under subsection 7(8) of the Canadian Income Tax Act) until the shares are disposed of must report the taxable benefit (receipt of the stock option) at the time of disposition (on form T1212) and must pay Canadian income tax at that time.

Note: The above article is for information purposes only and should not be construed as offering tax advice. Individuals should consult with their personal tax advisors before taking any action based upon the information in this article.

IFRS Conversion Plan

The Clock is Ticking – Accounting for Taxes in Your IFRS Conversion Plan

International Financial Reporting Standards (IFRS) will replace Canadian generally accepted accounting principles (GAAP) for fiscal years beginning on or after January 1, 2011. Most companies have started their changeover to IFRS. But some companies have delayed their detailed assessment of income taxes in anticipation of a new version of the IFRS for Income Taxes (IAS 12) proposed in the March 31, 2009 exposure draft. 

The March 31, 2009 exposure draft is no longer relevant. After considering comments received in response to the exposure draft, the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) jointly agreed that the project should not proceed in its current form.

With the current proposals not proceeding and deadlines looming, Canadian companies can no longer ignore existing IAS 12. This TaxNewsFlash-Canada highlights differences and also some similarities between Canadian GAAP and IAS 12 that you should consider as part of your company’s conversion plan.

Don’t delay

Little time is available before companies first have to report in IFRS. Within 90 days of January 1, 2011 (by March 31, 2011), companies must issue their 2010 annual Canadian GAAP financial statements, and a scant 45 days after that (by May 15, 2011), they must issue their first 2011 interim IFRS financial statements. The Canadian Securities Administrators has proposed a 30-day extension to the deadline for filing the first interim financial report in the year of adopting IFRS. Given the magnitude of work needed to make a successful changeover to IFRS, this extension may offer only minor relief.

Preparing these interim financial statements and the first-time adoption disclosures in the first quarter of 2011 can be an onerous exercise that is quite different from the usual quarterly financial reporting. With timing this tight, companies that do not start working on their conversion well in advance likely will not have enough time to catch up.

Additionally, as IFRS affects reported pre-tax profits, many IFRS standards affect tax reporting as well. The potential effect of IFRS on an enterprise’s income taxes goes well beyond IAS 12. Tax professionals need to understand the impact of all IFRS adjustments — both on adopting IFRS and on an ongoing basis. Your tax group should begin preparing for the impact of IFRS now to avoid the crises that could arise if the project needs to be completed in a rush.

Differences between IAS 12 and Canadian GAAP

Below is a summary of certain items that are treated differently under IAS 12 and existing Canadian GAAP. Other differences may also exist that will affect an entity’s income tax provision calculation.

Investments in subsidiaries, associates and interests in joint ventures

Similar to Canadian GAAP, IAS 12 requires that deferred tax is not recognized for the excess amount for financial reporting over the tax base of an investment in a subsidiary or a corporate joint venture (i.e., outside basis difference), if certain conditions are met.  Unlike Canadian GAAP, however, IAS 12 requires disclosure of the aggregate amount of temporary differences associated with investments in subsidiaries, branches, associates and interests in joint ventures for which deferred tax liabilities have not been recognized.

Foreign non-monetary assets and liabilities

Under IAS 12, a deferred tax asset or liability is recognized for exchange gains and losses related to foreign non-monetary assets and liabilities that are re-measured in the functional currency using historical exchange rates. By contrast, Canadian GAAP provides that a deferred tax asset or liability is not recognized for temporary differences arising from the difference between the historical exchange rate and the current exchange rate translations of the cost of non-monetary assets and liabilities of integrated foreign operations.

The IFRS treatment will affect Canadian companies with a functional currency that is different from their tax reporting currency.

Initial recognition exception

IFRS also has an exemption from recording deferred income taxes on the initial recognition of an asset or liability. There is no equivalent treatment under Canadian GAAP.

Under IAS 12, a deferred tax liability (asset) is not recognized if it arises from the initial recognition of an asset or liability in a transaction that is not a business combination and affects neither accounting profit nor taxable profit at the time of the transaction. For example, such a transaction could occur where assets are transferred under a tax-free rollover or where an entity is acquired through shares in a transaction that does not constitute a business combination. Further, an entity does not recognize later changes in the unrecognized deferred tax asset or liability as the asset is depreciated, requiring companies to track the piece that is essentially a permanent difference.

Canadian GAAP differs from IAS 12 in this respect. When a transaction is not a business combination and affects neither accounting profit nor taxable profit, an entity would recognize the resulting deferred tax asset/liability and adjust the carrying amount of the asset or liability by the same amount (using simultaneous equation).

Inter-company transfers of assets

An inter-company transfer of assets (such as the sale of inventory or depreciable assets) is a taxable event that establishes a new tax base for those assets in the buyer’s tax jurisdiction. The new tax base of those assets is deductible on the buyer’s tax return as those assets are consumed or sold to an unrelated party.

Under IAS 12, a deferred tax asset or liability is recognized for the difference in tax bases between the buyer and seller on an intra-group transfer of assets and so the deferred tax is computed using the buyer’s tax rate. Under Canadian GAAP, a deferred tax liability or asset is not recognized for the difference in the buyer’s and seller’s tax bases on an intra-group transfer of assets, and any current taxes paid or recovered by the seller are deferred based on the seller’s tax rate.

Distributed vs. non-distributed rate

In some jurisdictions, income taxes are payable at a higher or lower rate if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity. In other jurisdictions, income taxes may be refundable or payable if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity. In these circumstances, IAS 12 requires the use of the tax rate applicable to undistributed profits in measuring deferred taxes. The tax consequences of the distribution are only recognized when a liability to make the distribution is recognized.

In Canada, income taxes generally are not payable at a higher or lower rate depending on the payment of dividends, and so Canadian GAAP does not address any such rate differential. However, Canadian GAAP sets out specific guidance for tax-exempt-type entities (such as real estate investment trusts, mutual fund trusts and specified investment flow-through entities (SIFT). This guidance provides an exemption from recognizing deferred taxes if certain conditions are met (see EIC 107). Additional guidance is provided for SIFTs that will become taxable in 2011 (see EIC 167).

Business combinations

In a business combination, temporary differences arise when the carrying amount of identifiable assets and liabilities acquired is revalued at fair value but the tax bases are not affected by the business combination or are affected by a different amount. For example, when the carrying amount of an identifiable asset is increased to fair value but the tax base of the asset remains at cost to the previous owner, a taxable temporary difference arises. Consistent with current Canadian GAAP, IAS 12 requires companies to recognize a deferred tax liability for these temporary differences and make a corresponding adjustment to goodwill.

Further, in a business combination, the deferred tax position of both the acquirer and acquiree at the date of acquisition is assessed from the point of view of the consolidated group. For example, a previously unrecognized deferred tax asset relating to the acquiree’s or acquirer’s tax losses may be recovered by utilizing the consolidated group’s future profit.

While this treatment is consistent with current Canadian GAAP (in accordance with CICA HB 1581), the accounting for the unrecognized amounts may differ under IAS 12. Under IFRS, where previously unrecognized deferred tax assets (e.g., tax loss carryforwards) of the acquirer are recognized, the acquirer recognizes the deferred tax asset in profit or loss. Under current Canadian GAAP, previously unrecognized deferred tax assets of the acquirer that become recoverable due to a business combination are recognized as a reduction of goodwill, rather than in profit or loss. The future recognition of the deferred tax asset is reported in profit or loss under Canadian GAAP only if the acquirer’s deferred tax asset was not recognized as of the acquisition date.

From the acquiree’s perspective, under IAS 12, if deferred tax assets of the acquiree that were not recognized at the date of acquisition are later realized (by realization or reduction of the valuation allowance), the adjustment is applied to reduce the carrying amount of goodwill related to that acquisition provided that the resulting deferred tax asset is recognized within the measurement period and results from new information about facts and circumstances that existed at the date of acquisition.  If the carrying amount of goodwill is zero, any remaining deferred tax benefits are recognized in profit or loss.  All other acquired deferred tax benefits later realized are recognized in profit or loss.

By contrast, current Canadian GAAP requires the later recognition of the acquiree’s deferred tax assets for temporary differences that existed at acquisition to be recognized first against goodwill, then against other intangible assets before any balance is recognized as a tax recovery in profit or loss.

Uncertain tax positions

Like Canadian GAAP, IAS 12 does not contain specific guidance on the recognition and measurement of uncertain tax positions and practice may vary. Canadian companies adopting IFRS may need to re-measure liabilities recorded in respect of uncertain tax positions that remain unsettled at their IFRS transition date.

Compound instruments

Under IFRS, an entity that issues compound financial instruments, such as convertible debentures, classifies the instrument’s liability component as a liability and the equity component as equity. In some jurisdictions, the tax base of the liability component on initial recognition equals the initial carrying amount of the sum of the liability and equity components, and a taxable temporary difference arises. Under IAS 12, the resulting deferred tax liability is recognized, and the deferred tax expense is charged directly to the carrying amount of the equity component. Later changes in the deferred tax liability are recognized in profit or loss.

By contrast, Canadian GAAP provides that if a compound instrument can be settled tax-free, deferred taxes would not be recorded related to the temporary difference (i.e., the tax base of the liability component is considered equal to its carrying amount, and no temporary difference arises).

Allocation of tax to components of profit or loss or equity

IAS 12 requires the tax effects of items credited or charged directly to equity during the current year also be allocated directly to equity.  IAS 12 also requires subsequent changes in those amounts to be allocated to equity (i.e., full backwards tracing).  Such items may arise from either changes in assessments of recovery of deferred tax assets or changes in tax rates, laws, or other measurement attributes.  One must consider where the initial transaction was recorded as they follow through on changes to the deferred tax liabilities and assets in future years.

In contrast, Canadian GAAP is different from IAS 12 in that it generally requires that subsequent changes in those amounts to be allocated to profit or loss.

Balance sheet classification of deferred tax assets and liabilities

IAS 12 does not permit the deferred tax assets and liabilities to be classified as current.  Essentially, they are presumed to be non-current.  In addition, deferred tax liabilities and assets should be presented separately from current tax liabilities and assets.

On the other hand, Canadian GAAP indicates that the classification of future income tax assets and liabilities is based on the classification of the underlying asset or liability.  Where there is no related asset or liability, the classification is based on the date that the temporary difference is expected to reverse.

Similarities to existing Canadian GAAP

Below is a summary of certain items that will be treated under IAS 12 in a way that is more similar to their accounting treatment under existing Canadian GAAP.

Recognizing deferred tax assets

Under IAS 12, deferred tax assets are recognized to the extent that it is probable that the benefits will be realized. “Probable” is not defined in the standard, however, in practice, the “more likely than not” definition is often used (i.e., same as Canadian GAAP).

Measuring deferred tax assets and liabilities

Similar to Canadian GAAP, IAS 12 requires that deferred taxes are measured based on enacted or substantively enacted tax rates as of the balance sheet date.

Similarly, IAS 12 requires an entity to measure deferred tax liabilities and assets using the tax rate that is consistent with the expected manner of recovery or settlement of the asset or liability.  IAS 12 also indicates that the measurement of deferred taxes shall reflect the tax consequences that would follow from the manner in which the entity expects, at the end of the reporting period, to recover or settle the carrying amount of its assets and liabilities.

Goodwill

A deferred tax liability is not recognized if it arises on the initial recognition of goodwill that is not tax-deductible. However, any temporary difference is recognized after the acquisition if the goodwill is tax-deductible.

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

Luxembourg

Luxembourg Foreign Investment

The Luxembourg government actively encourages foreign investment. There are no formalised legal regimes aimed at foreign investment as such (other than the tax-exempt ‘holding’ companies and collective investment funds ) but on an ad hoc basis the government offers a variety of types of assistance including guarantees, cash, tax incentives, subsidised loans, assistance with development and construction projects etc.

Luxembourg has a wide range of customised investment incentives specifically for new ventures to the principality. This includes the offer of land with favourable conditions at one of the country’s municipal business parks or national industrial parks which are equipped with the infrastructure necessary to support a successful business.

In addition, there are incentives for investment available to Luxembourg and foreign investors alike under the laws of 28th July 1923 and 27th July 1972.

 
Luxembourg Tax Treatment of Offshore Operations.

Offshore companies are taxed as follows :

  • Holding companies formed under the law of 31st July 1929 are exempt from income taxes (the IRC and the Municipal Business Tax on Profits) and from the Fortune Tax. No tax is levied on the transfer of shares, and there are no taxes due on the liquidation of a 1929 Holding Company. No withholding tax is due on dividends payable to a 1929 Holding Company. (NB 1929 holding companies can no longer be formed.)
  • 1929 Holding Companies are subject instead to the capital contribution tax (droit d’apport) of 1% of subscribed capital, either on formation or on a later capital increase, and to the subscription duty (taxe d’abonnement) which amounts to 0.20% of the value of the shares issued by the Holding Company, payable annually in four equal instalments. If shares are quoted, the value is the current market value; if there is no quotation, the paid-in value is used. There are adjustments if dividends are paid out during the year, if profits are written to reserves, or if losses are incurred. Under legislation which came into effect in 2004, in order to satisfy the EU’s ‘harmful tax practices’ initiative:

    A 1929 holding company loses its tax-exempt status if at least 5% of its dividends received relate to foreign participations that are not subject to tax at a rate comparable to the Luxembourg corporate income tax rate. An effective tax rate is considered to be comparable if it is at least 11%, equating to approximately one-half of the current corporate income tax rate that applies to regular resident taxpayers and is in line with the tax rate generally applicable to dividends received from participations that do not qualify for a full exemption.

    Further, the taxable base needs to be determined under a method similar to the methods used in Luxembourg. An auditor or accountant is required to certify annually that the eligibility requirements have been met. A 1929 holding company that loses its tax-exempt status is subject to the normal corporate income tax regime.

    For newly incorporated 1929 holding companies, the amendment applied as from 1 January 2004. For existing 1929 holding companies (i.e. those incorporated under the law applicable before 1 January 2004), the new rules will not apply before they are terminated in 2010.

  • Milliardaire Holding Companies are taxed on the basis of various percentage rates applied to interest paid out and dividends distributed by the company, and on the remuneration and fees paid to directors, auditors and liquidators residing less than six months of the year in Luxembourg. The minimum annual tax liability of a Milliardaire Holding Company is much less than an equivalent 1929 Holding Company would pay. (NB Milliardaire holding companies can no longer be formed.)
  • Financial Holding Companies are taxed on the same basis as 1929 Holding Companies. (NB Financial Holding Companies can no longer be formed.)
  • The replacement for the 1929 holding company, the Family Private Assets Management Company, or SPF is intended to be exempt from corporate income tax, municipal business tax and net-worth tax, and from withholding tax on distributions. These new vehicles are prohibited from commercial activity, and will be limited to private wealth management activity, for example the holding of financial instruments such as shares, bonds and other debt instruments, in addition to cash and other types of bankable asset. If the SPF is used to hold voting rights in other companies, it must ensure that it does not involve itself in the running of those companies, and it is prohibited from providing any kind of service. The SPF’s exemptions can be affected by participation in non-resident, non-listed companies, if those companies are located in a country not subject to a roughly equivalent corporate tax regime.
    A subscription tax at a rate of 0.25% is payable on share capital.
  • SOPARFI companies, which were created under the law of 24th December 1990, are subject to the normal regime of income taxes etc but do receive the benefit of Double Taxation Treaties, and in many circumstances are exempt from taxation on dividends received from or paid to resident and non-resident companies in which they have a significant participation. The EU Parent-Subsidiary Directive also provides some withholding tax exemptions (improved as from 2004), but the SOPARFI benefits are more extensive. The rules are complex; there are conditions; and there are limitations on the deductibility of expenses.
  • The various forms of UCI are all exempt from all Luxembourg taxation, and pay only a small capital duty on start-up, plus an annual tax on net assets which (at the time of writing) varies between 0.01% and 0.06% depending on the type of fund. In June, 2004, the Luxembourg government announced that pension funds would be exempt from the 0.01% ‘subscription’ tax, in order to encourage the transnational pooling of pensions assets.
  • In 2004, Luxembourg introduced the SICAR, which may take one of a number of corporate forms, including that of a limited partnership. A fixed capital duty of Euro 1,250 applies to equity capital injections upon incorporation or thereafter. SICARs that are in corporate form are fully taxable and should in principle, unlike 1929 holding companies, be eligible for benefits under Luxembourg’s tax treaties as well as benefits under EC directives. Investment income and realized gains are not considered taxable income, and realized losses and write-downs are not deductible. All other income and expenses are taxable in the normal way. Distributions are exempt from withholding tax, as are redemptions by nonresident investors, regardless of the amount or holding period. SICARs are exempt from wealth tax, and there is an exemption from VAT for management charges. SICARs are excluded from the benefits of fiscal consolidation. Investors seeking tax transparency will opt for a SICAR in the form of a limited partnership (SeCS). An SeCS is not liable to corporate income tax or net wealth tax, and is exempt from the municipal business tax. Income from the partnership and capital gains realized on units by nonresident partners will not be taxed in Luxembourg.


Luxembourg The EU’s Parent/Subsidiary Directive

Changes to the parent/subsidiary directive in 2004 have reduced the holding requirement to 20% for 2005-06; to 15% for 2007-08; and to 10% for 2009 onward. Under the EU’s Directive on Interest and Royalties, which also came into effect in 2004, both types of payment will be exempt from withholding tax if they are between associated companies (rules as for the participation exemption).

Luxembourg has actually gone even further, meaning that there is no withholding tax on royalties paid to non-resident companies, and Luxembourg holding companies incorporated according to the terms of the law of 1929 are not subject to such withholding tax either. In line with the directive, the laws came into force retrospectively, with effect from January 1st 2004.

Luxembourg Taxation of Foreign and Non-Resident Employees In Luxembourg the taxation of individuals is based entirely on the concept of residence, regardless of nationality.  Generally, individuals are considered to be resident when they maintain a residence in Luxembourg with the intention of remaining other than temporarily. A stay of six months is deemed to be residence. Most types of compensation and benefit paid to employees are taxable; there are no special privileges or exemptions for expatriate workers.Non-residents are liable to pay Luxembourg taxes only on certain types of income arising in Luxembourg or from Luxembourg sources. These types of income are very precisely defined in Luxembourg legislation. Nationals of countries with which Luxembourg has double taxation treaty also need to be aware that the relevant treaty may well affect their tax treatment. The main types of taxable income for non-residents are: 

  1. income from trade or business carried on in Luxembourg or arising there;
  2. income from dependent services (ie employment income) performed or arising in Luxembourg;
  3. pension income resulting from former activity in Luxembourg;
  4. investment income arising or paid from Luxembourg;
  5. income from leasing of goods etc situated in Luxembourg or exploited by a Luxembourg entity;
  6. capital gains on the sale of property or substantial participations in Luxembourg companies.

Each of these categories is further defined in considerable detail in the legislation.

Luxembourg eventually signed up to the compromise on the European Savings Tax Directive reached in January, 2003, and has imposing a withholding tax on non-residents’ investment returns, like Switzerland, as from July, 2005 (initially at a rate of 15%, rising to 20% in 2008, and 35% in 2011).

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

 

US structures

 

US structures

US entities doing business overseas can use a variety of structures. Some of the most important are listed below with notes about their taxation characteristics:

Controlled Foreign Corporation

The foreign subsidiary of a US corporation or a foreign company owned by US shareholders is typically a Controlled Foreign Corporation (CFC).

A CFC means any foreign corporation if on any day during the foreign corporation’s taxable year US shareholders own more than 50% of:

  • The total combined voting power of all voting stock, or
  • The total value of all the stock.

A foreign corporation is any corporation not created or organized in the United States. A US shareholder is a US person that owns 10% or more of the voting power of all classes of stock entitled to vote of the foreign corporation. A US person is a citizen or resident of the United States, a domestic partnership or corporation, or any estate or trust unless its income from sources outside the US (other than income that is effectively connected with a US trade or business) is not includable in gross income under US tax law.

In determining whether a US person is a US shareholder, the US person will be considered to own stock that it owns:

  • Directly;
  • Indirectly through foreign entities; or
  • Constructively under certain rules that attribute stock ownership from one entity to another.

A US shareholder includes actual distributions from a CFC in taxable income, plus under Subpart F of the Tax Code certain types of undistributed income of a CFC, including:

  • Passive investment income;
  • Income from the purchase of goods from, or sale to, certain related entities;
  • Income from the performance of services for or on behalf of certain related entities;
  • Certain types of shipping and oil-related income;
  • Insurance income from insuring risk located outside the CFC’s country of incorporation;
  • Income from bad conduct activities, such as participation in an international boycott, payment of illegal bribes and kickbacks, and income from a foreign country during any period that country is “tainted” under IRC 901(j); and
  • In addition, the US shareholders of a CFC are required to include in income their share of the CFC’s increase in earnings invested in US property.

The Subpart F rules are extremely complex, and professional advice is absolutely necessary in interpreting them.

Foreign Sales Corporation

Under legislation dating from 1984, which was eventually declared unacceptable by the World Trade Organization after a complaint from the European Union, the US Internal Revenue Code authorized the establishment of foreign sales corporations (FSCs), being corporate entities in foreign jurisdictions through which US manufacturing companies could channel exports. 15% of the revenue concerned was exempted from corporation tax, meaning (at 35% tax) that companies kept 5.25% more of their revenue.  

The FSC rules generally replaced the domestic international sales corporation (DISC) rules. IC-DISCs exist, however, for small domestic taxpayers.  

Possessions Corporations

Possessions corporations may operate to obtain the benefits of section 936 in all US possessions including the US Virgin Islands. However, the overwhelming majority of possessions corporations are operating in Puerto Rico.

Possessions corporations must have:

  • Filed a valid Form 5712, Election To Be Treated as a Possessions Corporation Under Section 936 (an election cannot normally be revoked for the first ten years);
  • Derived 80% or more of their gross income from sources in a US possession during the applicable period immediately before the tax year ended, and
  • Derived 75% or more of their gross income from the active conduct of a trade or business in a US possession during the applicable period immediately before the tax year ended. In 1976 the amount was 50%. This amount increased over the years to 75%.

The ‘applicable period’ is generally the shorter of 36 months or the period when the corporation actively conducted a trade or business in the US possession.

A domestic international sales corporation (DISC) or a former DISC, or a corporation that owns stock in a DISC, former DISC, foreign sales corporation (FSC), or a former FSC is ineligible for Section 936 relief.

A possessions corporation is allowed a credit against its US tax liability equal to the portion of its tax that is attributable to:

  • The taxable income from non-US sources from the active conduct of a US trade or business within a US possession, and
  • The qualified possession source investment income.

The credit is not allowed against environmental tax, tax on accumulated earnings, personal holding company tax, additional tax for recovery of foreign expropriation losses, tax increase on early disposition of investment credit property, tax on certain capital gains of S corporations or recapture of low income housing credit.

A possessions corporation may elect either the cost sharing or profit split method of computing taxable income with respect to a certain possession product

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

Tax Forecast

 

Corporate Income Tax Forecast Methodology

 The corporate income tax forecast is produced by:

  • Forecasting total annual corporate tax liability.
  • Forecasting annual liability by payment type – advance payments, final payments, delinquent payments and refunds.
  • Convert the annual tax liability forecast by payment types into a quarterly collections forecast.

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.

Corporate Liability Model

The corporate income tax model is similar in nature to the personal models. However, the transition from collections to liability is far more complex. A specific corporate tax year may start any time during the same calendar year. Many corporations use calendar year or fiscal year as their tax year, but not all. As a result, collections and refunds for a given tax year are spread over several years The differing tax years also means that payments are received on multiple tax years simultaneously. For example, an average of 72 percent of advanced payments received during a calendar year belongs to that tax year. The remaining 28 percent belong to the prior tax year.. In essence collections are split by tax year and then shifted back in time to create a liability data set.

This produces a monthly liability variable for each payment type. The monthly data are then converted to annual data prior to forecasting each payment type. The main driver behind the total liability model is corporate profits.

Collections Model

The spreading equations take the annual liability forecasts by payment type and convert them into monthly collections forecasts. The steps involved in this process are laid out below:

  • Annual forecasted liability by payment type is spread equally over the months of the year.
  • The liability series for all payment types except refunds is split into two pieces based on when collections for a given tax year’s liability occur. (The reverse of the process used to convert collections to liability).
  • The forecasts are then shifted forward in time to account for the time between when the liability is incurred and collections occur.
  • Historical seasonally patterns are applied to the forecasts using X-11 determined seasonal factors.
  • Monthly forecasts are summed to get quarterly collections forecasts.

Forecaster Judgement

The raw collections forecasts must be adjusted to account for tax law changes that are not included in the liability models. This includes recent legislation and policy actions such as adding more tax auditors at the Department of Revenue. Kicker credits that have yet to be taken are also reflected in this manner.

In addition, recent collections trends must be taken into consideration. If there is reason to believe that collections patterns will vary from historical patterns, then the forecast can be adjusted accordingly outside of the forecasting models. Both of these items can have significant impacts on the final revenue forecast.