13 January 2014 External T.I. 2013-0474431E5 - Application of 95(2)(b)(ii)

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: 1. If Canco seconds employees to a foreign affiliate of Canco in consideration for a fee equal to its cost (i.e. the employees' remuneration) plus a 25% mark-up, will the service business income of the foreign affiliate be recharacterized as FAPI pursuant to subparagraph 95(2)(b)(ii) of the Act as a result of the services provided by the seconded employees from Canco?
2. If Canco does not charge a 25% mark-up on the seconded employees' salaries, would the result be different?

Position: 1. Yes but only to the extent the services are performed by Canco. 2. Yes

Reasons: 1. Due to the wording of subparagraph 95(2)(b)(ii) of the Act, the phrase "to the extent that" limits the recharacterization to only the portion of the foreign affiliate's income that is attributable to the services provided on behalf of the foreign affiliate by Canco's employees.
2. Where no mark-up is charged on the seconded employees' salaries, Canco would not be seen as providing services to the foreign affiliate. Rather, the seconded employees would be seen as providing services on behalf of the foreign affiliate as opposed to Canco.

XXXXXXXXXX
2013-047443
Henry Leung
(613) 957-2129

January 13, 2014

Dear XXXXXXXXXX:

Re: Application of subparagraph 95(2)(b)(ii) of the Income Tax Act (the "Act")

This is in response to your e-mail dated February 1, 2013 where you described the following hypothetical situation.

Canco is a Canadian resident corporation that owns all of the shares of Foreign Affiliate, a corporation resident in a foreign country with which Canada has an income tax convention. Foreign Affiliate is engaged in the business of providing services to arm's length persons solely in the foreign country. The arm's length persons are not "foreign affiliates", within the meaning of the definition in subsection 95(1), of Canco.

Of the services provided by Foreign Affiliate to its arm's length customers during a particular period of time, 95% are performed by employees of Foreign Affiliate. These employees are also resident in the same foreign country as Foreign Affiliate. The remaining 5% of the services provided by Foreign Affiliate during the particular period are performed by employees of Canco who have been seconded to Foreign Affiliate. These seconded employees who have all relocated to the country where Foreign Affiliate is resident, do not bring any special skills to the business compared to the employees of Foreign Affiliate. None of the seconded employees is a person described in clause 95(2)(b)(ii)(A) or (B).

Canco pays the salaries of the employees seconded to Foreign Affiliate and charges Foreign Affiliate a fee equal to the cost of the remuneration plus a 25% mark-up.

You ask the following questions:

1. What, if any, portion of the service business income of Foreign Affiliate will be recharacterized as foreign accrual property income (FAPI) pursuant to subparagraph 95(2)(b)(ii) of the Act as a result of the seconded employees' performance of services for Foreign Affiliate?

2. Would it make a difference if Canco did not charge a 25% mark-up on the cost of the seconded employees' remuneration?

Our Comments:

95(2)(b) of the Income Tax Act ("Act") reads as follows:

(b) [services deemed not active business] – the provision by a foreign affiliate of a taxpayer, of services or of an undertaking to provide services
(i) …
(ii) is deemed to be a separate business, other than an active business, carried on by the affiliate, and any income from that business or that pertains to or is incident to that business is deemed to be income from a business other than an active business, to the extent that the services are, or are to be, performed by
(A) any taxpayer of whom the affiliate is a foreign affiliate,
(B) another taxpayer who does not deal at arm's length with
(I) the affiliate, or
(II) any taxpayer of whom the affiliate is a foreign affiliate,
(C) a partnership any member of which is a person described in clause (A) or (B), or
(D) a partnership in which any person or partnership described in any of clauses (A) to (C) has, directly or indirectly, a partnership interest;

With respect to the first question, subparagraph 95(2)(b)(ii) applies to this situation since the services provided by Foreign Affiliate to its customers are being performed in part by Canco. Here, Canco is reimbursed for the remuneration of the seconded employees and also receives a mark-up (profit). It is our view that where a mark-up or profit element is charged by the taxpayer (Canco), that factor is indicative of the fact that Canco is providing services in the course of its business to and on behalf of Foreign Affiliate.

However, the phrase "to the extent that" used in subparagraph 95(2)(b)(ii) of the Act in our view limits the application of that provision to recharacterize only the portion of the income from services provided by Foreign Affiliate that can reasonably be considered to be attributable to services performed by Canco. While it is a question of fact to what extent service business income of Foreign Affiliate is reasonably attributable to the services provided by Canco in a particular case, it may be arguable that if all the employees have comparable skills, then since 5% of the services provided by Foreign Affiliate during a particular period of time are performed by the seconded employees of Canco, only 5% of the income earned by Foreign Affiliate in respect of the services provided during that period of time will be recharacterized as FAPI pursuant to subparagraph 95(2)(b)(ii) of the Act.

If on the other hand, as described in the second question, Canco is simply reimbursed for the cost of remuneration paid to the Canco employees that are seconded to Foreign Affiliate, provided the reimbursement represents arm's length compensation to Canco, it is our position that Canco would not be seen as performing the services that Foreign Affiliate provides to its customers. Rather, a seconded employee would be seen as providing services on behalf of Foreign Affiliate only. In other words the activities of the employees would not be seen as comprising part of the business activities of Canco. Accordingly, if Canco was only reimbursed for the cost of the remuneration of the seconded employees with no mark-up element, provided the reimbursement represents arm's length compensation to Canco, it is our view that subparagraph 95(2)(b)(ii) will not apply to recharacterize the income of Foreign Affiliate.

Subsection 247(2)

The Canada Revenue Agency routinely reviews transactions of this nature and in particular whether a fee charged by a Canadian corporation to its foreign affiliate for the services of seconded employees is equal to an arm's length amount. A discussion of how to determine an arm's length fee is beyond the scope of this letter. However, in a case where subsection 247(2) of the Act would apply to impute a profit element in respect of a fee for the services provided by employees of a taxpayer seconded to a foreign affiliate of the taxpayer that is in the business of providing services, it would in our view follow that the taxpayer provided services through such employees and paragraph 95(2)(b)(ii) applies.

We trust these comments to be of assistance.

Yours truly,

Olli Laurikainen, CPA, CA
For Director
International Division
Income Tax Rulings Directorate