Canada Amends Tax and Regulatory Legislation to Permit Foreign Bank Branches

On June 28, 1999, the Canadian Government announced the coming into force of Bill C-67, An Act to amend the Bank Act, the Winding-up and Restructuring Act and other Acts relating to financial institutions and to make consequential amendments to other Acts ("Bill C-67"), which will permit foreign banks to establish specialized, commercially focused branches in Canada.

As Secretary of State (International Financial Institutions) Jim Peterson stated, "[t]his legislation will give foreign banks greater flexibility in structuring their Canadian operations and will remove unnecessary regulatory obstacles to more effective competition from foreign banks." The new rules bring Canada’s foreign bank entry policies in line with practices in other major industrial countries.

This article has four parts. Part A presents an overview of the branching rules. A description of the tax aspects of the branching regime is found in Part B. Part C describes other foreign bank issues addressed in Bill C-67. Part D sets out the range of foreign bank entry options that are now available. Appendix I reproduces the Government’s chart summary of the legislation

Bill C-67 adds a new Part to the Bank Act ("Act"), Part XII.1 – "Authorized Foreign Banks."

Foreign banks have a choice of two vehicles to branch into Canada: a "full-service branch" or a "lending branch." Foreign banks with ministerial orders authorizing them to establish branches in Canada will be listed in a new Schedule III to the Act.

A foreign bank that currently carries on business in Canada through a Schedule II bank subsidiary may either maintain the Schedule II bank subsidiary and establish a full-service branch, or "convert" the Schedule II bank subsidiary to either a full-service or a lending branch.

Foreign banks may not maintain both a Schedule II bank subsidiary and a lending branch, except during a "conversion" period while the bank subsidiary is being "converted" to a lending branch.

Thus, a foreign bank with a Schedule II bank subsidiary may operate a full-service branch and also make other financial services investments permitted under the Act. A foreign bank may continue to hold permitted investments through its Schedule II bank subsidiary or otherwise with a Government consent. Similarly, a foreign bank that establishes a full-service branch in Canada will be permitted to hold a Schedule II bank subsidiary and other permitted Canadian investments.

If a foreign bank establishes a lending branch in Canada, it will not be permitted to hold a full-service branch, a Schedule II bank subsidiary or any other retail deposit-taking institutions, but it may hold other permitted Canadian investments.

The approval process for a foreign bank wishing to establish a branch (de novo or by conversion of a Schedule II bank subsidiary) is similar to that for the incorporation of any Canadian bank. The process includes the publication of a notice of intention to make the application for four consecutive weeks in the official government publication, the Canada Gazette, and in a newspaper of general circulation at the place where the branch plans to locate its principal office.

The Minister of Finance ("Minister") makes an order under new subsection 524(1) authorizing the foreign bank to establish a branch to carry on business in Canada. The order is in the Minister’s discretion and may be subject to any terms and conditions that the Minister considers appropriate. An order concerning a lending branch is subject to restrictions pursuant to subsection 524(2). ¹ Once the Minister makes an order authorizing the foreign bank to establish a branch, the foreign bank becomes an "authorized foreign bank" listed in Schedule III to the Act.

The Superintendent of Financial Institutions ("Superintendent") then makes an order under section 534 approving the commencing and carrying on of business in Canada by the foreign bank through its branch within a year of the Minister’s order.

The scope of the information requirements for a foreign bank branch application is described in a Guide to Foreign Bank Branching prepared by the Office of the Superintendent of Financial Institutions ("OSFI").

The Government announced non-statutory entry criteria for foreign bank branch applicants. Generally, the applicant will be expected to:

• have a minimum consolidated asset base of CAD$5 billion, if the application is for a full-service branch;
• have a proven track record in international banking;
• demonstrate favourable financial performance over the five-year period prior to the application (i.e., be well-capitalized, based on Bank for International Settlements standards);
• have a controlling parent that is widely held in its home jurisdiction, subject to limited exceptions;
• have a five-year business plan detailing the branch’s proposed business in Canada; and
• undertake to keep OSFI informed of significant developments that could adversely affect the applicant’s soundness and reputation globally, significant news releases and, as required, copies of financial accounts.
• In addition, the applicant must meet statutory requirements. The Minister may not issue an order permitting the establishment of a branch unless he/she is satisfied that:
• the authorized foreign bank will be capable of making a "contribution to the Canadian financial system"; and
• if the applicant is from a non-World Trade Organization ("WTO") member country, treatment as favourable for banks to which the Act applies exists or will be provided in the jurisdiction in which the authorized foreign bank principally carries on business, either directly or through a subsidiary (reciprocity).

Furthermore, the Minister must be of the opinion, after consultation with the Superintendent, that the applicant:

• is a bank in its jurisdiction of incorporation, incorporated and regulated in a manner acceptable to the Superintendent; and
• its principal activity ² is the provision of services that will be permitted by the Act to a bank in Canada. ³
• The Minister will also have the discretion to take into consideration "all matters that the Minister considers relevant" having particular regard to:
• the nature and sufficiency of the financial resources of the foreign bank as a source of continuing financial support for the carrying on of its business in Canada;
• the soundness and feasibility of the plans of the foreign bank for the future conduct and development of its business in Canada;
• the business record and past performance of the foreign bank;
• whether the business in Canada of the authorized foreign bank will be carried on responsibly by persons who meet certain "fit and proper" criteria; and
• the best interests of the financial system in Canada.

Before the Superintendent will make an order pursuant to section 534 approving the commencement and carrying on of business in Canada by an authorized foreign bank, the bank must have deposited with an "approved" Canadian financial institution unencumbered assets of a type to be approved by the Superintendent, the total value of which is:

• CAD$100,000, for a lending branch; and
• CAD$10 million, or any greater amount (representing five percent of branch liabilities) that the Superintendent specifies, for a full-service branch.

Both a full-service branch and a lending branch may engage in consumer and commercial financing and other financial services activities permitted to Canadian banks, subject to exceptions noted below. Branches face the same restrictions on their business and powers as Schedule I and II banks, such as restrictions on insurance distribution and automobile leasing.

An advantage that a branch has over a Schedule II subsidiary is that a branch’s lending limits are based on the aggregate capitalization of the authorized foreign bank, whereas the lending limits of a bank subsidiary separately capitalized in Canada are based on the subsidiary’s capitalization, not its parent’s. Prudent person investment and loan portfolio guidelines apply to all branches, just as they apply to Schedule I and II banks.

The key disadvantage that a foreign bank branch has compared to a Schedule II bank subsidiary are restrictions on its sources of funding, which are described below. Foreign banks may wish to establish or maintain a Schedule II bank subsidiary if the branch funding restrictions are considered to be too onerous.

A full-service branch faces some limitations on its sources of funds. It may borrow through the acceptance of wholesale deposits (i.e., CAD$150,000 and over), but may not accept retail deposits (below CAD$150,000), subject to a one percent de minimus exception and certain other exceptions that will be prescribed by regulation. A full-service branch may guarantee securities and accept bills of exchange.

Until Canadian provincial governments revise their securities and other legislation or the Canadian Government revises the definition of "bank" in the Act to include foreign bank branches, full-service branches will face significant impediments to their participation in capital and securities markets. At present, provincial securities legislation provides important exemptions for Canadian banks listed in Schedules I or II of the Act, but not branches in Schedule III. Unlike Canadian banks, branches are not exempt from the definition of "underwriter" when participating in the issue of certain types of indebtedness (bonds, debentures, etc.) and are not exempt from the requirement to register as "advisers," a widely defined category. Branches’ trades are not exempt from registration requirements when they purchase as principals, not underwriters. Bonds, debentures and other indebtedness of, or guaranteed by, a branch are not exempt securities for the purpose of registration requirements. When a branch purchases as principal, its trades are not exempt from prospectus requirements.

It is anticipated that provinces will amend their legislation so that branches will be treated in the same manner as to Canadian banks or, if the provinces do not act, the federal Government will consider further amendments to the Act later in 1999 to put branches on the same footing as domestic banks.

A full-service branch will not be eligible for membership in the Canada Deposit Insurance Corporation ("CDIC"), but will eligible for membership in the Canadian Payments Association ("CPA"). A full-service branch will have access to a designated clearing and settlement system, as defined in the Payment Clearing and Settlement Act, subject to the approval of the Bank of Canada.

An authorized foreign bank that establishes a full-service branch in Canada (which cannot be a CDIC member) could hold a Schedule II foreign bank subsidiary that is a member of CDIC. It is interesting to compare this to the as-yet-unproclaimed 1997 addition of subsection 413(2) to the Act, which would prohibit a bank that opts out of CDIC membership from being affiliated with a member of CDIC, such as a trust company. Since Canada’s retail deposit-taking Schedule I banks cannot operate their wholesale banking operations through an entity separate from their retail bank operations, those Canadian banks do not enjoy the same flexibility as foreign banks.

A lending branch has much more restrictive borrowing powers than a full-service branch. It may not accept retail or wholesale deposits, or borrow in Canada or elsewhere (except from other "financial institutions" other than a foreign bank). Moreover, it may not borrow or guarantee securities and accept bills of exchange, unless the underlying security is not to be subsequently sold or traded. A lending branch may accept deposit liabilities and borrow, and guarantee securities and accept bills of exchange from prescribed classes of financial institutions by means of financial instruments that can be sold or traded with those financial institutions in accordance with as yet to be released regulations. This limitation will effectively deny lending branches broad access to the Canadian commercial paper and bankers’ acceptance markets, a significant limitation.

A lending branch may borrow from a "financial institution," which is Canadian bank, trust, loan or insurance company, securities dealer, cooperative credit society or association, or a "foreign institution." A "foreign institution" is an entity incorporated or formed outside Canada that engages in financial services activities. A lending branch may also borrow from a foreign bank "designated" under subsection 521(1.07) of the Act. A lending branch may not borrow from a "non-bank affiliate of a foreign bank" or from a foreign commercial finance company, unless that company’s presence in Canada is through a branch rather than a subsidiary or it is "designated."

Since the borrowing restrictions only apply to a lending branch, it may be possible that a loan to a Canadian resident could be booked at the foreign bank’s head office or a non-Canadian branch, subject to withholding taxes on interest payments in certain circumstances. The application of the borrowing restrictions to lending branches will require careful study by a foreign bank considering a lending branch and further elaboration by regulation.

Since a lending branch may not accept deposits, it is not eligible for membership in the CDIC. A lending branch also is not eligible to join the CPA, but may have access to a designated clearing and settlement system, subject to the approval of the Bank of Canada.

The corporate governance rules that apply to Schedule I and II banks, such as the requirement to have a Canadian board of directors, do not apply to branches. The authorized foreign bank must appoint a "principal officer" for the branch, who must be ordinarily resident in Canada. Moreover, the related party or self-dealing rules that apply to Canadian banks do not apply to a branch, except in respect of its dealings with federally regulated financial institution subsidiaries. These rules provide significant advantages for branches.

While a Schedule II bank subsidiary is subject to all consumer protection regulations under the Act, a branch will only be subject to certain consumer and disclosure-related regulations. Full-service branches must comply with federal regulations respecting consumer complaint-handling, cost of borrowing, and disclosure of charges and interest. They must post notices, both in their offices and in advertisements, indicating that deposits are not insured by CDIC. Because lending branches do not take deposits from the public, regulations respecting the disclosure of charges and disclosure of interest do not apply to them. Lending branches are required to post notices in their offices that they do not accept deposits from the public and that they are not CDIC members. Tied selling restrictions apply to both types of branches.

In addition, lending branches must disclose that they do not take deposits and that they are not members of the CDIC. Full-service branches must also disclose that they are not CDIC members.

Since a foreign bank may have both a Schedule II bank subsidiary that takes retail deposits and a full-service branch that does not take retail deposits, restrictions on shared premises are imposed. An authorized foreign bank may not carry on business on premises shared with those of a CDIC-member institution affiliated with the foreign bank where the public has access to the premises. A bank subsidiary and a branch may share premises where "back-room" operations are conducted. Where a bank subsidiary and a branch carry on business in adjacent premises, public notice that the businesses are separate and distinct is required.

All Schedule III foreign bank branches enjoy reduced regulatory burdens compared to Schedule I or II banks. While Schedule II bank subsidiaries and full-service branches are subject to annual examinations by OSFI, lending branches are examined only "periodically."

Authorized foreign banks may establish a financial year end in respect of their business in Canada on any one of March 31, June 30, September 30 or December 31.

While a Schedule II bank subsidiary is subject to the full reporting requirements of all banks in Canada, a full-service branch enjoys a somewhat reduced level of reporting. Reporting requirements for a lending branch are lighter still.

An authorized foreign bank must file with the Superintendent in respect of its business in Canada an annual return on its condition and affairs at the end of each financial year showing, among other things, its assets and liabilities and its income and expenditures. All branches are required to appoint external auditors to report on their annual returns.

As with a Canadian bank, the Superintendent has broad remedial powers over branches. The Superintendent may:

• issue "directions of compliance" where an authorized foreign bank is committing, or is about to commit, an "unsafe or unsound practice" in relation to its business in Canada;
• issue an asset maintenance order to protect the rights of depositors or creditors of an authorized foreign bank;
• in certain circumstances, take control of the assets of the authorized foreign bank for a period of time; and
• request that the Attorney General of Canada apply for a winding-up order under the Winding-up and Restructuring Act.

A foreign bank that now holds a Schedule II bank subsidiary may choose to "convert" that bank subsidiary to either a full-service or a lending branch. Where the foreign bank applies to establish a lending branch, with ministerial approval (on the recommendation of the Superintendent) the bank may continue to hold its investment in the Schedule II bank subsidiary or a federal trust and loan company, provided that the bank subsidiary or trust and loan company has received ministerial approval for voluntary liquidation.

Where the foreign bank is in the process of liquidating its bank subsidiary and/or trust company subsidiary and wishes to establish a full-service branch, the CAD$10 million capital equivalency deposit for a full-service branch may be waived with ministerial approval (on the recommendation of the Superintendent), but the branch will be required to maintain a deposit equal to 5 percent of the branch’s liabilities.

The transition period for conversion is two years, but may be extended by ministerial order for a period not to exceed seven years in total. At the time of application for conversion, an authorized foreign bank must present a detailed plan for the disposition of its deposit-taking subsidiaries’ assets and liabilities, including plans to transfer those assets and liabilities to the branch.

If a foreign bank elects to liquidate its Schedule II bank, or federal trust or loan company subsidiary, it will be required to ensure that, before a ministerial approval is granted, all depositors have moved their accounts if the foreign bank chooses to operate in Canada through a lending branch, or all retail depositors have moved their accounts if the bank establishes a full-service branch. Wholesale depositors in a full-service branch will lose their existing deposit insurance coverage.

The tax aspects of a "conversion" to a branch are discussed in Part B, below.

If an authorized foreign bank discontinues its business in Canada, it may apply for the release of its assets on deposit in Canada.

An authorized foreign bank will not be permitted to obtain a release of its assets by the Superintendent unless it provides for the discharge of, or transfers all or substantially all of, its liabilities in respect of its business in Canada. Those liabilities may only be transferred to another foreign bank’s branch in Canada, to a Canadian bank or to a federal trust or loan company. Where a branch is in liquidation, however, the court having jurisdiction under the Winding-up and Restructuring Act may order the release of the assets to the liquidator.

OSFI will have the power to intervene in the operation and affairs of a branch in certain cases. In prescribed circumstances, the Superintendent may take control of the assets (a defined term – essentially the branch assets) of an authorized foreign bank. The period of control is limited, but may result in a request by the Superintendent that the Attorney-General of Canada apply to the Court for an order placing the branch in liquidation under the Winding-up and Restructuring Act. As is the case with all Canadian financial institutions, the Bankruptcy and Insolvency Act will not apply to authorized foreign banks.

A new Part II of the Winding-up and Restructuring Act is added to deal with the winding up of branches. The basic thrust of the amendments is to create a separate asset group comprised of the branch assets of the authorized foreign bank, which should include the shares of the authorized foreign bank in any of its Canadian subsidiaries. As in any winding-up, the court would appoint a liquidator. New Part II of the Winding-up and Restructuring Act in combination with the amendments to the Act also provides a scheme of priorities for distributions out of the liquidation. The scheme is identical to that which applies on the insolvency of a bank, except that it is restricted to claims relating to the authorized foreign bank’s business in Canada. In the event of a surplus after the payment of these claims (with interest), the surplus may be returned by the court-appointed liquidator to the authorized foreign bank, provided that the court approves. In the alternative, instead of liquidating the branch assets and distributing them, the Superintendent may authorize the court-appointed liquidator to turn over the branch assets to the liquidator of the authorized foreign bank in its home jurisdiction. This step would also require the approval of the court.

Like Schedule I and II banks, foreign bank branches are subject to the sunset provisions in the Act. Many specific provisions of the Act have been amended to attempt to provide branches with the same powers and restrictions as Canadian banks. As with other foreign bank activities in Canada, the Investment Canada Act will not apply to the establishment in Canada of a foreign bank branch.

As a consequence of the proposed amendments to the Act permitting foreign banks to carry on business in Canada through branch offices, certain changes to the Income Tax Act (Canada) (the "ITA") were announced with the intention that these new Canadian branches of foreign banks would be in a comparable tax position to Canadian resident banks. These changes are to be effective on and after June 28, 1999, the date that the foreign bank entry legislation came into force.

The following commentary is based on the Notice of Ways and Means Motion ("N of W&MM") released on February 11, 1999 and a May 11, 1999 press release describing special transitional tax rules for foreign banks converting existing subsidiaries in Canada to branches. Legislation to implement the rules has not been tabled as of the date of this publication.

The proposed amendments are applicable to an "authorized foreign bank" as that term is defined in section 2 of the Act.

The determination of the amount of allowable interest expense deduction will be based on the assumption that 95 percent of the value of the assets used in the year in connection with the Canadian branch business is funded with indebtedness. No specific commentary is provided as to whether "value" is to be based on fair market or some other criterion, nor as to whether the interest expense is to be determined on a daily or some other basis.

Subject to the 95 percent limitation, the interest expense deduction is to be based on the total of

1. the actual interest cost of third party debt ("direct debt") incurred by the authorized foreign branch in connection with its business carried on in Canada, and
2. a notional interest expense calculated by applying a prescribed rate to the balance of the assumed funding ("allocated debt"), being the difference between the 95 percent limit and the amount of direct debt.

The proposed amendments to the ITA will deem an authorized foreign bank to be a person resident in Canada for the purposes of Part XIII of the ITA. The intent is to treat authorized foreign banks and Canadian domestic banks equally with respect to Part XIII and, as a consequence, that Part will apply to interest and other payments made to or by the branch.

Subject to certain exemptions and as may be reduced by an applicable tax treaty, paragraph 212(1)(b) in Part XIII of the ITA imposes a 25 percent tax on every amount that a person resident in Canada pays or credits to a non-resident person as, on account or in lieu of payment of, or in satisfaction of interest. One of the typical exemptions available to banks relates to certain interest payments to a non-resident on non-Canadian currency deposits with an institution that is a prescribed financial institution. For this purpose, a "prescribed financial institution" is defined to include a corporation that is a member of the CPA. Under the proposed legislation, full-service branches of foreign banks will be members of the CPA, but lending branches will not be eligible to be CPA members.

It appears that a lending branch will be at a disadvantage compared to a full-service branch or a bank subsidiary in obtaining funding from an arm’s length non-resident lender. The lending branch is restricted in its ability to receive deposits and will not be a member of the CPA. Accordingly, the withholding tax exemption describe above that is typically available to banks will not be available to the lending branch. The other typical withholding exemption that might be available is more restrictive. It relates to interest paid to an arm’s length non-resident if under the terms of the obligation the Canadian borrower is not obliged to repay more than 25 percent of the principal amount of the obligation within five years of the date of issuance of the obligation.

The MacKay Report recommended that withholding taxes should be removed for interest on all arm’s length borrowings, regardless of the term of the borrowing. In the Policy Paper, the Government acknowledged the MacKay recommendation to extend the current withholding tax exemption to all interest payments to non-resident arm’s length lenders. The Government noted that this change would increase choice and lower prices for Canadian borrowers. At present, Canada is negotiating a protocol with the United States to amend the current Canada-United States Tax Convention. It is understood that the rate of withholding tax on interest is one item being addressed in the negotiations.

The proposed amendments also apply a tax to an arbitrary portion (15 percent) of the interest expense on the allocated debt based on the rate of withholding tax that would ordinarily apply between Canada and the country of residence of the authorized foreign bank. This in essence is a tax on a notional interest expense. Based on the limited description of the tax contained in the N of W&MM, this appears to be similar to the branch level interest tax ("BLIT") levied in the US on similarly allocated interest expense of foreign branches operating in the US. It is interesting to note that Revenue Canada has expressed the view that BLIT is not a creditable tax for Canadian purposes on the basis that it is not an income or profits tax. With this in mind, it would be prudent for authorized foreign banks to assess the ability to claim foreign tax credits in respect of this tax in their home jurisdiction.

Notwithstanding that a proposal for the BLIT was included in the N of W&MM, it is understood that the Government might be prepared to abandon the BLIT, in whole or in part, if it can reach an agreement with the governments of certain countries that their equivalent to a BLIT (if it exists) would not be applicable to branches of Canadian banks operating in those countries. If a country does not have a BLIT, we understand that it is not intended to have the BLIT apply to Canadian branches of banks that are resident in that country.

Canadian banks are subject to large corporations tax and tax on the capital of financial institutions under Part I.3 and Part VI, respectively, of the ITA. Both of these capital taxes are imposed on the bank’s taxable capital employed in Canada. In very general terms, taxable capital employed in Canada of a bank is largely based on the total of the bank’s long-term debt, capital stock, retained earnings, contributed and other surpluses, and reserves not deducted in computing income under Part I of the ITA.

For the purposes of calculating the Part I.3 and Part VI capital tax base, the proposed amendments specify that an authorized foreign bank has capital equal to 10 percent of the "risk-weighted assets" of the Canadian branch, which will be defined with regard to the risk-weighted asset requirements used by the OSFI.

Based on 1997 published financial statements, the five largest Canadian domestic banks reported total capital ratios ranging from 9.7 percent to 10.4 percent. On this basis, the proposal to estimate an authorized foreign bank’s capital based on 10 percent of risk-weighted assets appears to be comparable to the capital of Canadian domestic banks. The Policy Paper states that the Canadian Government will discuss the competitive disadvantages that capital taxes impose on banks with provincial governments.

Part XIV of the ITA imposes a 25 percent tax on every non-resident corporation carrying on business in Canada at any time in the year. The tax is generally imposed on the branch’s net after-tax income less an investment allowance. The investment allowance is calculated based on certain qualified investments and gives recognition to the fact that earnings have not been repatriated to the foreign home office. As such, branch tax is a surrogate for the amount of non-resident withholding tax that would apply to dividends paid by a Canadian subsidiary to its foreign parent.

Under the current provisions of the ITA, one of the exempt entities specified in subsection 219(2) is a bank. The proposed amendments to the ITA specify that Part XIV tax will apply to an authorized foreign bank. No details, however, have been provided at this time about how the calculation is to be completed.

Certain of Canada’s international tax treaties, including the Canada-US and the Canada-UK treaties, exempt the first CAD$500,000 of branch profits from tax in the source country. This exemption is only available to branch operations and is not applicable to dividends paid by a Canadian bank subsidiary to its foreign parent.

Subject to the general limitations imposed under section 126 of the ITA, the proposed amendments to the ITA will permit an authorized foreign bank to claim a foreign tax credit, in respect of withholding tax paid to the government of a country, other than its country of residence, on income from a business carried on by the authorized foreign bank in Canada.

The existing Canadian tax rules calculate separate foreign tax credits for "non-business income tax" and "business income tax" paid to a foreign jurisdiction. Because of the nature of a branch operation, the foreign tax credit available to a Canadian branch of an authorized foreign bank would only apply in respect of non-business income tax. Since the Act generally precludes a Canadian bank subsidiary of a foreign bank from carrying on business outside of Canada, the application of the foreign tax credit rules for branches and subsidiaries should be comparable.

Various provisions of the ITA are in place to ensure that transactions between non-arm’s length parties are effected at fair market values. Since a Canadian branch of a foreign bank and its home office are not separate legal entities, the proposed amendments contain provisions that are intended to ensure that transfers of assets between the Canadian branch and its home office are taxed in a manner similar to other non-arm’s length transactions. The N of W&MM contains specific proposals applicable to situations both where the Canadian branch acquires property from its home office and where property is sold to its home office. In both cases, the transfers are deemed to take place at fair market values.

While the N of W&MM does not specifically mention the application to authorized foreign banks of the existing loss deferral rules that apply to transfers between non-arm’s length parties, the related commentary indicates that these rules will be applicable.

The provisions in subsections 18(4) to (8) of the ITA ("the thin capitalization rules") are intended to prevent a non-resident from forming a thinly capitalized corporation in Canada. In the absence of these rules, a non-resident investor could finance a Canadian investment with a disproportionate amount of debt, thereby reducing business income that would otherwise be taxed at full corporate rates, while extracting interest payments that would be subject to lower rates of withholding tax.

If applicable, the thin capitalization rules disallow a portion of the interest expense otherwise deductible. The disallowance is based on a formula calculation that limits the amount of interest-bearing outstanding debts to a specified non-resident shareholder on which deductible interest expense can be calculated to a ratio of 3:1 of such debt to equity.

In circumstances where an authorized foreign bank has made loans to a Canadian resident corporation in which the foreign bank is a specified non-resident shareholder, the proposed amendments will exclude from the definition "outstanding debts to specified non-residents" any debt that would otherwise be included, provided the interest payable to the authorized foreign bank in respect of that amount is included in computing the bank’s income from a business carried on in Canada.

It appears that the practical effect of this amendment is to allow any permitted investment in Canada of an authorized foreign bank to borrow funds from the Canadian branch of that authorized foreign bank and avoid the application of the thin capitalization rules.

The thin capitalization rules apply to corporations resident in Canada and do not apply to branches of non-resident companies. As a consequence of these amendments, a Canadian branch of an authorized foreign bank can obtain a disproportionate amount of its interest bearing funding from its home office or other branches without the application of the thin capitalization rules, whereas a permitted investment in Canada of a foreign bank could not.

The ITA contains a number of special rollover provisions to permit a taxpayer to transfer assets to a Canadian taxable corporation on a tax-deferred basis. Consideration received for the transferred assets typically requires that the transferor receive consideration that, at least in part, consists of shares of the transferee Canadian taxable corporation. The tax basis of these shares reflects the deferral of the gain that will be realized on a subsequent disposition of the shares.

The existing rollover provisions in the ITA permit a non-resident to transfer a Canadian branch operation to an incorporated Canadian entity on a tax-deferred basis. The existing rollover provisions, however, do not apply to defer a gain on the transfer of assets, or a banking business as a whole, of a foreign bank subsidiary to a branch. The N of W&MM proposals, as originally released, did not indicate that comparable provisions were being considered to permit a tax-deferred transfer to a branch. In the absence of such provisions, the conversion of a Canadian bank subsidiary into a branch operation could result in the realization of gains. Furthermore, to the extent a Canadian bank subsidiary has loss carryovers, these losses could not be transferred to a branch operation under the existing legislation.

In recognition that a foreign bank subsidiary that chooses to restructure itself as a branch operation under Bill C-67 could face significant tax issues and might, therefore, be discouraged from pursuing the branching option the Secretary of State (International Financial Institutions) Jim Peterson announced proposals on May 11, 1999 to allow special transitional tax rules for foreign banks that establish specialized, commercially focused branches in Canada.

The proposed measures will allow for a deferral of the recognition of a subsidiary’s tax liability in respect of certain assets by allowing the foreign bank to elect, on a property-by-property basis, to transfer property from its subsidiary to its new Canadian branch on a tax-deferred basis. Eligible properties will be those that are eligible for transfer under section 85 of the ITA. The branch will inherit any accrued gain on a property transferred from the subsidiary and will be subject to tax on the accrued gain when the branch disposes of the property or ceases to use it in its Canadian banking business.

A foreign bank subsidiary will also be permitted to transfer all or part of its retained earnings on a tax-deferred basis to a Canadian branch office. This transitional measure will defer the application of non-resident withholding tax that would otherwise apply to the distribution of retained earnings to the foreign parent on wind-up of the subsidiary into the foreign parent. For purposes of Part XIV branch tax, the transferred amount will be treated as having been claimed by the foreign bank as its investment allowance for a notional year preceding the branch’s first year of operation in Canada. The deferral of branch tax would be maintained only so long as the branch continues to use the earnings in the Canadian business of the foreign bank.

A final transitional measure will permit a foreign bank subsidiary that is wound-up into its foreign parent to transfer its tax losses to the Canadian branch office. The Canadian branch office will be treated as having incurred losses equal to the losses of the wound-up subsidiary in the year in which the subsidiary incurred the losses.

The transitional rules will apply to foreign banks that carried on a banking business in Canada through a federally regulated bank or trust company on the day that Bill C-67 was introduced in Parliament (February 11, 1999). Furthermore, the transitional relief measures will only be available for a limited period of time. The foreign bank will have to establish that it has complied with certain guidelines issued by the Superintendent on or before December 31, 2000 and that it has completed the transaction in respect of which relief is sought on or before the earlier of (i) the day that is 6 months after the day that the Superintendent makes an order permitting the foreign bank to carry on business in Canada, and (ii) December 31, 2002.

A Canadian branch of a foreign bank will be permitted to accept tax payments on behalf of the Receiver General of Canada in the same manner as Canadian resident banks, provided that it is not a lending branch.

While no published comment has been made, it is our understanding that the Department of Finance is considering appropriate adjustments to the foreign property definition as it applies to deferred income plans and registered pension plans to ensure that deposits in foreign bank branches are not deemed foreign property. This adjustment would be relevant for purposes of Part XI of the ITA. In general terms, Part XI applies to certain tax-exempt entities and imposes a tax at the end of each month at the rate of 1 per cent of the amount by which more than the allowable portion of the entity’s investments (20 per cent) are in foreign property.

The N of W&MM does not specifically address the tax treatment to be given to transactions conducted between branches of an authorized foreign bank.

For example, one branch of a bank may execute a transaction that creates an interest rate or currency exposure for the bank while another branch executes an offsetting transaction that has the effect of crystallizing a net profit on the combined transactions. The net profit may be shared through a notional transaction between the two branches. The transaction is notional because it arises from a single party transacting with itself.

The proper tax characterization of such inter-branch transactions can be controversial. A clear statement that inter-branch transaction generally would be recognized for Canadian tax purposes (subject all the normal Canadian tax limitations) would have provided welcome clarification.

In addition, consideration may need to be given to the application of various tax treaties. It is not always entirely clear where a branch of a foreign bank is resident for purposes of an income tax treaty. This may raise interesting issues in assessing the tax treaty that will be relevant for determining the available treaty benefits, if any.

Bill C-67 contains a number of amendments to the Act and other federal legislation that impact on foreign bank entry into Canada, some of which are highlighted here. Other significant "technical" amendments are also noted.

Provisions in the Act have been deleted or revised to reflect Canada’s commitments as a member of the WTO under the December, 1997 WTO Financial Services Agreement. WTO member foreign banks with Schedule II bank subsidiaries in Canada will not be restricted in the number of offices that the subsidiary may have in Canada. No non-WTO member Schedule II foreign bank subsidiary may have any branch office in Canada, other than its head office and one other branch office, without an approval of the Minister.

Similarly, Bill C-67 provides that WTO member authorized foreign banks may have branch offices in Canada other than its principal office and one branch office without the requirement for ministerial approval. Non-WTO country authorized foreign banks, however, may not have a branch office in Canada, other than its principal office and one branch office, without approval of the Minister.

Bill C-67 makes several amendments to "Part XII – Foreign Banks." Several important changes are proposed to the key definitions in section 507.

The subsection 507(1) definition of an "entity associated with a foreign bank" ("EAFB") has been modified. An entity will now be an EAFB if:

• the entity controls, or is controlled by, the foreign bank (instead of, as previously, if the foreign bank has a "substantial investment" in the entity);
• the entity and the foreign bank are controlled by the same person (instead of, as previously, if the person who has a substantial investment in the foreign bank controls the entity); or
• two or more persons who are acting in concert in relation to the entity and in relation to the foreign bank will, if they were one person, control the entity and the foreign bank (instead of, as previously, if two or more persons who are acting in concert in relation to the entity and in relation to the foreign bank will, if they were one person, control the entity and have a substantial investment in the foreign bank).
• These changes to the definition of an EAFB will reduce the scope of the application of the investment restrictions in section 518 that apply to a foreign bank.

The definition of a "non-bank affiliate of a foreign bank" ("NBAFB") will also be modified. A NBAFB will include a Canadian entity, other than a bank,

• in which a foreign bank or an EAFB has a substantial investment (instead of, as previously, an entity in which a foreign bank has a substantial investment); or
• that is controlled by a foreign bank or an EAFB (instead of, as previously, an entity that is controlled by an entity in which a foreign bank or an EAFB has a substantial investment).

This amendment also reduces the scope of the range of Canadian entities that must meet certain disclosure requirements concerning their borrowings in Canada. Moreover, these amendments likely reduce the range of Canadian entities for which foreign banks will be required to obtain section 521 consent orders before they can hold shares or ownership interests in Canadian financial service providers. It should be noted that an authorized foreign bank with a branch in Canada will continue to be required to obtain section 518 or 521 consent orders with respect to its permitted investments in Canada.

Section 518 of the Act sets limits on the kinds of Canadian investments that a foreign bank and any EAFB may have if the foreign bank itself or an EAFB owns shares in a Schedule II foreign bank subsidiary. Formerly, subsection 518(1) set out the basic rule that a foreign bank and any EAFB could not acquire or hold a substantial investment in any Canadian entity other than the foreign bank subsidiary, and could not acquire or hold a substantial investment in any other Canadian entity with the exception of a federally incorporated trust, loan or insurance company, or a federally or provincially incorporated securities dealer.

Amendments to this subsection revise the basic rule so that a foreign bank and any EAFB shall not acquire control of, or acquire or hold a substantial investment in, any Canadian bank other than the foreign bank subsidiary, and shall not acquire control of, or acquire or hold a substantial investment in, any other Canadian entity with the exception of the permitted investments noted above and, in addition, a provincial trust or insurance company, a cooperative credit association to which the federal Cooperative Credit Associations Act applies, or a provincial cooperative credit society.

To make or hold investments in Canadian entities or to carry on a financial services business in Canada, a foreign bank formerly required a section 521 consent order from the Canadian cabinet. Now, an order of the Minister only is required. This change levels the playing field for all market entrants.

A section 521 consent order will continue to be required for a foreign bank to acquire or hold all or substantially all of the assets of another foreign bank’s branch in Canada or to acquire control of a Canadian financial services entity. A section 521 consent order, however, will not be required if the foreign bank acquires assets of another foreign bank branch through its Schedule II bank subsidiary or its branch.

A "technical" amendment has been made to the control or approval requirements in subsection 468(3) of the Act to address an oversight relating to the 1997 amendments to the Act. A new subparagraph 468(3)(c)(ii) has been added to confirm that ministerial approval is required where a multi-activity subsidiary (a paragraph 468(1)(n) subsidiary) engages in one or more of certain activities that otherwise would require ministerial approval.

Amendments are proposed to the Office of the Superintendent of Financial Institutions Act that will permit the Minister, with Cabinet approval, to enter into agreements with provinces concerning:

• the administration, application and enforcement of provincial trust and insurance legislation;
• the authorization of the Superintendent to exercise the powers, duties and functions on behalf of a provincial authority concerning provincial trust and insurance companies; and
• to make federal trust and insurance legislation and regulations applicable to provincial trust and insurance companies and to limit the application of provincial legislation to those entities.

This amendment confirms authority for existing agreements with some provinces, and may anticipate OSFI assuming prudential regulatory authority for all Canadian financial institutions, possibly as a trade-off for "national" regulation of market conduct issues by the provinces (as advocated by most Canadian securities administrators).

A provision is added to all federally financial institutions legislation to permit the Governor in Council to make regulations prohibiting or restricting the disclosure of prescribed supervisory information. For example, regulations could prevent a financial institution seeking a competitive advantage by advertising that it has been given an excellent rating by the regulator or by disclosing contents of an examination letter.

• minimum CAD$10 million capitalization required (may be reduced to CAD$5 million);
• a foreign bank may not have both a Schedule II foreign bank subsidiary and a lending branch;
• full bank powers, including retail deposit-taking;
• disadvantages: lending limits restricted by the capitalization of the bank subsidiary, full corporate governance requirements, related party rules; and
• CDIC membership: must be a member of CDIC (if 1997 amendments to the Act are proclaimed, may opt out of CDIC membership if it does not take retail deposits).

• CAD$5 billion in worldwide assets, widely held, regulated as a bank and supervised in home jurisdiction in line with internationally recognized standards (the threshold amount is not statutory);
• same powers as Canadian banks, except no retail deposit-taking (under CAD$150,000), which may be an unattractive borrowing restriction;
• lending restrictions based on the aggregate capitalization of the foreign bank;
• minimum capital equivalency deposit of the greater of CAD$10 million (may be reduced to CAD$5 million) or 5 percent of branch liabilities;
• CDIC: not a member because no retail deposits permitted;
• CPA: may be a member;
• access to designated clearing and settlement systems, subject to Bank of Canada approval;
• ongoing supervision and annual examination by OSFI, but some reduction in reporting requirements; must appoint external auditors to conduct an annual audit;
• the Superintendent requires information-sharing arrangements with foreign supervisors and the foreign bank parent to assess the whole foreign bank regularly;
• a foreign bank may not have both a full-service branch and a lending branch; a foreign bank could have both a full-service branch and a Schedule II foreign bank subsidiary with separate premises, in which case disclosure requirements apply;
• an authorized foreign bank may have other permitted investments, but requires a section 521 consent order for same;
• related party rules will not apply, except to federally regulated financial institution subsidiaries; will not be subject to corporate governance requirements;
• a branch will be taxed as a bank;
• branches will be subject to federal consumer protection requirements; and
• in the case of insolvency, the Canadian branch will be liquidated as if it were a separate entity.

• no minimum world-wide asset size requirement, but must be widely held, regulated as a bank and supervised in home jurisdiction in line with internationally recognized standards;
• same powers as Canadian banks, except no retail or wholesale deposit-taking;
• disadvantage: significant restrictions on borrowing powers on a global basis;
• lending restrictions based on the aggregate capitalization of the foreign bank;
• capital equivalency deposit of CAD$100,000;
• CDIC: may not be a member because no retail deposits permitted;
• CPA: may not be a member;
• access to designated clearing and settlement systems, subject to Bank of Canada approval;
• light reporting requirements with the Superintendent having the power to examine as necessary; will have to appoint an external auditor to conduct an annual audit;
• if a foreign bank has a lending branch, it may not have a Schedule II bank or other deposit-taking subsidiary or a full-service branch as well;
• a lending branch may have permitted investments pursuant to a section 521 consent order;
• related party rules will not apply except in respect of federally regulated financial institution subsidiaries; will not be subject to corporate governance requirements;
• a branch will be taxed as a bank;
• branches will be subject to federal consumer protection requirements; and
• in the case of insolvency, the Canadian branch will be liquidated as if it were a separate entity.

• as revised, this section sets limits on the kinds of Canadian investments that a foreign bank and any EAFB may have, if the foreign bank or an EAFB owns shares in a foreign bank subsidiary; and
• where a foreign bank owns a bank subsidiary, a ministerial order is required where the foreign bank or an EAFB seeks to acquire control of, or acquire a substantial investment in, a Canadian entity.

• a "near bank," a regulated foreign bank or an authorized foreign bank may hold permitted investments in Canada pursuant to a section 521 consent order; and
• the Department of Finance’s February 1997 news release on foreign bank branching and its September 1997 Foreign Bank Entry Policy Consultation Paper stated the Government’s "interim policy" during the review period was that regulated foreign banks carrying on activities in Canada without being regulated could continue to do so, but could not take deposits and must maintain Canadian assets below CAD$200 million. The Government’s foreign bank branching news release states the regulated foreign banks that have already established or seek to establish unregulated operations in Canada would continue to be subject to the interim policy pending the on-going review of financial sector regulation generally.

• highly restricted range of activities that can be conducted in Canada through a representative office (RO);
• ROs are designed to promote services of the foreign bank outside Canada and cannot do banking business in Canada. There is a clear physical and operational distinction between a RO and any other presence of the foreign bank in Canada;
• a RO is subject to annual reporting and fee requirements; and
• the Superintendent will examine the operations of the RO and the conduct of its office personnel to ensure compliance.

• the current operation of one regulated foreign bank in Canada provides an example of the manner in which a foreign bank may conduct operations in Canada and avoid the regulatory net. Section 508 prohibits a foreign bank from directly or indirectly undertaking any banking business in Canada. A section 521 consent order provides an exemption to this prohibition in specified circumstances;
• the regulated foreign bank successfully argued it is not undertaking banking business in Canada because its operations are based from its foreign head office. Canadian customers obtain its lending services directly through mail or telemarketing;
• as a policy, OSFI does not consider the ways in which that bank solicits its Canadian business to be carrying on a banking business in Canada, merely into Canada and, therefore, permits it to operate from its foreign head office; and
• will OSFI’s policy continue now that foreign banks will have the option to branch in Canada?