Regulation 5907

Table of Contents

Subsection 5907(1)

Paragraph 5907(1)(l)

Administrative Policy

5 June 1996 T.I. 961803 (C.T.O. "Income or Profits Tax for Foreign Affiliate Rules")

"Income or profits tax" for purposes of the definition of "underlying foreign tax" could include Canadian income tax paid by a foreign affiliate in respect of its taxable earnings.

Earnings

Administrative Policy

14 March 2014 Internal T.I. 2013-0499141I7 - IRC 338(h)(10), "earnings" and safe income

"notional" deduction arising from Code s. 338(h)(10) step-up excluded

After the Directorate found (at para. 232) that the earnings amounts of "US-Opco" foreign affiliates should be calculated similarly to what would have been calculated if the U.S. tax basis of their assets had not been stepped up under IRC 338(h)(10), so that where US-Opco goodwill, for which no actual expenditure had been, had been amortized, the amortization taken on the stepped-up tax basis under IRC 338(h)(10) should be added to the earnings amount pursuant to Reg. 5907(2)(f), the Directorate noted that, in the alternative, the amortization amount should not be considered in computing the earnings amount determined under s. (a)(i) of Reg. 5907(1) –"earnings" (apparently on the basis "that ‘notional' income or deductions are simply excluded from the earnings amount" (para. 15)].)

See more detailed summary under Reg. 5907(2)(f).

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 55 - Subsection 55(2) goodwill gains which accrued prior to purchase of FA and which were included under s. 55(5)(d) did not contributed to gain on Canco shares 286
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(1) - Exempt Earnings no carve out for goodwill gains 132
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(2) - Paragraph 5907(2)(f) "notional" deduction arising from Code s. 338(h)(10) step-up of non-purchased goodwill reversed under Reg. 5907(2)(f) rather than (b) 433

5 September 2013 External T.I. 2011-0431031E5 - Guatemala's taxes

tax imposed on revenue rather than income

A Guatemalan tax on gross revenue was imposed at a rate (for 2013) of 5% up to a low threshold (appx. Cdn. $3,925) and 6% above under the same "Guatemalan Income Tax Law" which allowed the taxpayer to annually choose whether to pay tax on its gross revenue or to pay tax on its net income or profit. In a taxation year where a foreign affiliate that carries on its active business only in Guatemala has chosen to pay the Guatemalan tax on gross revenue, its "earnings" will be determined under s. (a)(iii) rather than (a)(i) of the definition of "earnings" in Reg. 5907(1), since this revenue tax did not require the affiliate to compute its income or profit.

20 May 2011 Roundtable, 2011-0404501C6 - computation of surplus

LLC earnings

A US LLC wholly owned by a US corporation, which has not checked the box to be treated as a corporation for US tax purposes, nevertheless has "earnings" under subparagraph (a)(i) of the s. 5907(1) definition. To fall under that subparagraph, it is sufficient that the LLC's earnings are required to be calculated under US law in order to compute the owning corporation's taxes rather than its own taxes. However, CRA also stated:

If the CRA encounters a Canadian corporation that has attempted to inflate the surplus balances of a foreign affiliate that is a US limited liability company by computing its "earnings" in accordance with the Act and ignoring discretionary deductions, the CRA may challenge the taxpayer's filing position as if none of these positions existed. The result may be that U.S. limited liability company does not qualify as a "foreign affiliate" as defined in subsection 95(1) of the Act.

5 December 2003 External T.I. 2002-0165195 - Debt Forgiveness in Foreign Affiliates

Where a debt owing by a controlled foreign affiliate to its Canadian parent had financed the acquisition of shares of a U.S. subsidiary in order to earn dividends that were deemed active business income under s. 95(2)(a)(ii), the forgiveness of that debt would not give rise to an inclusion under paragraph (a) or (b) of the definition of earnings.

8 July 1998 T.I. 980712

A U.S. incorporated company (USco) which is a wholly-owned subsidiary of a corporation resident in Canada (Canco) is deemed to be a non-resident of Canada under s. 250(5) but is not resident under common law principles in a designated treaty country. Just prior to the end of its taxation year, USco becomes a common-law resident in the U.S. and is so resident there at the end of its taxation year. If USco during the taxation year carried on an active business through a permanent establishment in the U.S., its net earnings from that active business in the U.S. for the year would be included in the exempt surplus of USco with respect to Canco.

80 C.R. - Q.17

Since under the income tax laws of the U.S. and the U.K. a payment made by one Canadian foreign affiliate to another in connection with group consolidation or group relief are not taken into account in computing the profits or loss of either company, such payments would not affect their surplus accounts.

Articles

Arda Minassian, Kara Ann Selby, "Computation of Surplus Accounts", 2002 Conference Report, (CTF), c. 43

Business in multiple countries (p. 43:6)

If a foreign affiliate carries on a business in multiple countries, the earnings definition may not adequately resolve the appropriate tax system to use in computing earnings. Assume that a Canadian corporate taxpayer purchased FA 1 in 1972. FA 1 carries on an active business, is a resident of country A, and is required by law to file income tax returns there. In that same year, FA 1 purchased a foreign resource property in country B. By virtue of the active business income generated from that resource property, FA 1 is considered to carry on a business in country B and is required to file income tax returns there as well....A technical reading of the earnings definition requires FA 1 to compute its income from its active business for the year in accordance with the income tax law of country A, but this result is not logical.

S. 95(2)(a) income (p. 45:7)

"Income from property" is a defined term in the Act. Therefore, income from property deemed to be income from an acive business by virtue of paragraph 95(2)(a) would be computed generally by following the rules in Part I of the Act. Difficulties may arise when applying Canadian rules to foreign affiliates under other tax regimes. [After discussing captive insurance company example:] The real difficulty is in computing the income under Canadian rules, because certain amounts, such as the claims and premium reserves, may be difficult to determine.

Paragraph (a)

Administrative Policy

27 October 2017 Internal T.I. 2017-0694231I7 - Subsection 247(2), surplus, and FAPI

surplus could be adjusted by transfer-pricing adjustment

The Directorate considered that where there was a s. 247(2) transfer pricing adjustment to increase Canco’s income as a result of having undercharged for goods or services provided to a non-resident subsidiary (CFA), s. 247(2) could not also be applied to reduce the exempt surplus or foreign accrual property income of CFA in respect of Canco. The Directorate went on to state:

The surplus of CFA could conceivably be adjusted where CFA’s “earnings” are computed pursuant to subparagraph (a)(i) or (a)(ii) of the definition of “earnings” under [Reg.] 5907(1) … and the relevant foreign tax law makes its own transfer pricing adjustment, whether by way of a corresponding adjustment or otherwise. …[C]onsideration would have to be given to whether subsection 5907(2) … could reverse that foreign tax law adjustment ... .

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 247 - New - Subsection 247(2) s. 247(2) transfer pricing adjustment for sales undercharges to a CFA does not decrease the ES of the CFA 157
Tax Topics - Income Tax Act - Section 53 - Subsection 53(1) - Paragraph 53(1)(c) sale of goods at undervalue to sub does not imply a contribution of capital 168
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(2) effect on surplus balances of foreign transfer-pricing adjustment might be reversed under Reg. 5907(2) 145

Subparagraph (a)(i)

Administrative Policy

24 August 2016 External T.I. 2015-0592921E5 - Computation of Earnings of a Foreign Affiliate

a Singapore company recognizing earnings from a foreign branch only on a remittance basis could not measure its “earnings” under Singapore rules

Singco, a Singapore resident which is wholly-owned by Canco, carries on an active business through permanent establishment in each of a designated treaty country and one which is not (“Branch 1” and “Branch 2”, in countries A and B, respectively.) Under the income tax law for country A (but not for country B,) Singco is required to compute its income from its active business activities carried on through the branch for each taxation year. The profits of Branch 1 and Branch 2 are not subject to the income tax law of Singapore until such time as those profits are remitted to Singapore, which does not occur until a taxation year subsequent to when they arose. How would the “earnings” be computed? CRA responded:

[S]ince the income or profit of Branch 1 and Branch 2 for a taxation year is remitted to Singapore in a taxation year subsequent to the taxation year in which it is earned, the income tax law of Singapore would not require that that income or profit be computed in accordance with Singapore income tax law for the particular taxation year. Therefore, subparagraph (a)(i) of the definition of “earnings” would not apply in computing the earnings of Singco from its branches.

CRA went on to note that the “earnings” of Branches 1 and 2 would instead be computed under s. (a)(ii) and (iii), respectively, and also noted that:

unlike Branch 1, the “net earnings” derived by Singco for the year from the “earnings” from its active business carried on through Branch 2 in country B will not be included in its “exempt earnings” for the taxation year as country B is not a “designated treaty country”. Rather, they would be included in Singco’s “taxable earnings” for the taxation year.

Locations of other summaries Wordcount
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(1) - Earnings - Paragraph (a) - Subparagraph (a)(iii) branch earnings in non-designated country not computed under Singapore tax law until repatriated were computed under ITA rules 93

Articles

Michael Black, "Cross-Border Consolidation and the Foreign Affiliate Rules", Canadian Tax Journal (2017) 65:1, 173-89

CCCTB proposal in European Commission draft EU directive package of October 2016 (pp.175-6)

[I]ncluded in that package is a proposal to revamp the way that companies are taxed by adopting a common consolidated corporate tax base (CCCTB)….

1. Companies that are tax-resident in the European Union and EU-located branches of third-country companies would have one common set of rules for computing taxable income….

2. Companies within the same group would consolidate their individual results. On consolidation, transactions carried out between group members would be eliminated in order to compute consolidated taxable income. Under the proposed definition of a group, a common EU parent is not required.

3. The group's consolidated taxable income would be allocated among the individual group members on the basis of a set formula. The proposed formula gives equal weight to three factors: sales, labour, and assets. The labour factor is further divided and gives equal weight to two factors: payroll and number of employees….

Potential for negative ACB gains to arise if earnings for surplus purposes are determined on an apportionment basis (p. 178)

If earnings are computed as the amount determined by the apportionment formula, the surplus balance of the foreign affiliate may no longer mirror the cash available for distribution….

Potential surplus shifting with jettisoning of transfer pricing controls (p. 180)

Another potential concern may be the lack of transfer-pricing controls within the European Union after the implementation of the CCCTB….Without transfer-pricing controls, inappropriate surplus movements could result….

Subparagraph (a)(iii)

Administrative Policy

26 April 2017 IFA Roundtable Q. 9, 2017-0691201C6 - Computation of Earnings for LLCs

CRA’s new position, that LLCs generally must compute their income under ITA rather than Code rules, need not be applied for surplus calculations for pre-2016 years

At the November 30, 2016 CTF Annual Conference, CRA has changed its 2009 view, and now considered that where a foreign affiliate is a disregarded U.S. LLC with a single-member regarded U.S. corporation, its earnings should be computed under Canadian income tax law under Reg. 5907(1) – earnings - s. (a)(iii), rather than under the Code under s. (a)(i), effective for taxation years ending after August 19, 2011. Will CRA provide transitional relief? CRA responded:

[I]f a taxpayer uses the 2009 Position to calculate the earnings of a foreign affiliate that is a disregarded U.S. LLC for the LLC’s taxation years ended on or before November 29, 2016 (i.e. on or before the day the 2016 Position was announced), the CRA is prepared to accept that calculation, provided that the taxpayer and all taxpayers related to the taxpayer use the 2009 Position to calculate the earnings of all of their foreign affiliates that are disregarded U.S. LLCs for all taxation years of these LLCs that ended on or before November 29, 2016. …

T]he earnings of a disregarded U.S. LLC for any taxation year that ends after November 29, 2016, should be computed in accordance with the 2016 Position.

24 August 2016 External T.I. 2015-0592921E5 - Computation of Earnings of a Foreign Affiliate

branch earnings in non-designated country not computed under Singapore tax law until repatriated were computed under ITA rules

A Singapore company was not required under Singapore income tax law to compute its income from its active business activities carried on through the branches in each of a designated treaty country and one which was not until a subsequent taxation year when their profits were remitted to Singapore. Accordingly, the branch earnings were to be determined under the income tax law of the designated treaty county (under (a)(ii) of the “earnings” definition in Reg. 5907(1)), or under modified Canadian tax rules (under (a)(iii) of that definition), as the case may be.

Locations of other summaries Wordcount
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(1) - Earnings - Paragraph (a) - Subparagraph (a)(i) a Singapore company recognizing earnings from a foreign branch only on a remittance basis could not measure its “earnings” under Singapore rules 286

29 November 2016 CTF Roundtable Q. 11, 2016-0669761C6 - Computation of Earnings for LLCs

LLCs to compute their income under ITA rather than Code rules

At the 2011 IFA Roundtable, Q.9, CRA indicated that a disregarded U.S. LLC that is a foreign affiliate and has a single member which is a regarded U.S. corporation should compute its “earnings” in accordance with Reg. 5907(1) – earnings - s. (a)(i). (a) Has this changed following the enactment in 2013 of Reg. 5907(2.03) requiring an affiliate, in computing its “earnings” in accordance with Canadian tax law, to claim maximum discretionary deductions? b) Would the answer change if the LLC had one or more members which were not regarded U.S. resident corporations? CRA responded:

(a) [A]s a result of the context provided by subsection 5907(2.03)…[t]he CRA is now of the view that the “earnings” from a U.S. active business of a U.S.-resident, single member LLC that is disregarded for U.S. tax purposes and that is a foreign affiliate of a corporation resident in Canada should be computed in accordance with subparagraph (a)(iii) of the Earnings Definition. The change in the CRA’s position is effective for the first taxation year of the LLC for which subsection 5907(2.03) has effect, that year being the LLC’s first taxation year ending after August 19, 2011.

The CRA recognizes that subsection 5907(2.03) does not contemplate a scenario where the “earnings” of a foreign affiliate are computed under subparagraph (a)(i) of the Earnings Definition in one taxation year and under subparagraph (a)(iii) of the Earnings Definition the next taxation year. However, for the purposes of such a transition, the CRA is prepared to accept that paragraph 5907(2.03)(b) applies under this scenario and that the deductions claimed in preceding taxation years in computing the LLC’s “earnings” under subparagraph (a)(i) of the Earnings Definition were “deductions…actually claimed under the Act”.

(b) If [a U.S. LLC with two or more members] carries on an active business in the U.S and is required for U.S. tax purposes to compute its income to determine the partners’ distributive shares, it is the CRA’s view that the LLC must compute its “earnings” under subparagraph (a)(i) of the Earnings Definition in accordance with the income tax laws of the U.S.

Articles

Paul Barnicke, Melanie Huynh, "Earnings of Disregarded US LLC", Canadian Tax Highlights, Vol. 25, No. 2, February 2017, p. 5

Change in treatment of disregarded LLCs in 29 November 2016 CTF Roundtable Q. 11 (p. 5)

[R]etroactive to all FA taxation years ending after August 19, 2011, a disregarded US LLC must apply the regulation 5907(l)(a)(iii) method. The CRA [in 2016-0669761C6] also said that if a taxpayer was switching methods, the CRA would accept deductions claimed under US tax law as deductions claimed under the Act….

Treatment where previous Code deduction was less than maximum ITA deduction (pp. 5-6)

[I]t is therefore unclear whether – if the Act provided for a larger deduction than US tax law did for the years in question—the shortfall leads to a retroactive downward adjustment to the earnings computed under regulation 5907(l)(a)(iii): regulation 5907(2.03)(b) deems maximum deductions to have been claimed in prior taxation years….

Adverse effect of retroactive surplus adjustments (p. 6)

[A] taxpayer must switch to Canadian tax law retroactive to 2011; for this reason, if the taxpayer paid dividends out of what was previously thought to be exempt surplus, it may discover that it has an unjust shortfall of surplus when it recomputes earnings for post-2010 taxation years….

Timing/entity differences between ITA and Code (p. 6)

[U]sing Canadian tax law may trigger early recognition of income or gain for surplus purposes but without corresponding US tax: subsequent US tax will be paid by a different FA and is ignored in the computing of the first FA's surplus. For example, if under US rules an LLC rolls its asset to a related FA and US tax law is used to compute its earnings, no income or gain is recognized for the purposes of the LLC's surplus; when the related FA sells the asset, the related FA recognizes the deferred income or gain and pays tax thereon, for both its US tax and surplus purposes.

Taxable surplus

Articles

Michael Black, "Cross-Border Consolidation and the Foreign Affiliate Rules", Canadian Tax Journal (2017) 65:1, 173-89

CCCTB proposal in European Commission draft EU directive package of October 2016 (pp.175-6)

[I]ncluded in that package is a proposal to revamp the way that companies are taxed by adopting a common consolidated corporate tax base (CCCTB)….

1. Companies that are tax-resident in the European Union and EU-located branches of third-country companies would have one common set of rules for computing taxable income….

2. Companies within the same group would consolidate their individual results. On consolidation, transactions carried out between group members would be eliminated in order to compute consolidated taxable income. Under the proposed definition of a group, a common EU parent is not required.

3. The group's consolidated taxable income would be allocated among the individual group members on the basis of a set formula. The proposed formula gives equal weight to three factors: sales, labour, and assets. The labour factor is further divided and gives equal weight to two factors: payroll and number of employees….

Potential for shifting of surplus (due to disproportionate underlying tax) where earnings for surplus purposes are determined on a pre-apportionment basis but taxes reflect CCCTB (p. 180)

[i]t may be more appropriate to determine the earnings as the pre-consolidated before-tax income computed in accordance with the CCCTB. Under this approach, taxes determined in accordance with the CCCTB could still shift surplus inappropriately from one foreign affiliate to another….

Exempt Earnings

Administrative Policy

14 March 2014 Internal T.I. 2013-0499141I7 - IRC 338(h)(10), "earnings" and safe income

no carve out for goodwill gains

An indirect wholly-owned foreign affiliate ("FA") of Canco made an arm's length purchase of all the shares of "US Holdco," whose wholly-owned subsidiaries ("US-Opcos") had accrued gains inherent in the appreciated assets of their active businesses including capital property, depreciable property and intangible property such as goodwill. The US-Opcos each carried on an active business in the United States.

In finding that the exempt earnings of the US-Opcos included gains that had accrued prior to the US-Opcos becoming foreign affiliates of Canco on the intangible property disposed of by the US-Opcos, the Directorate noted that, unlike capital gains, neither "net earnings" nor "earnings" has "a carve-out rule for gains on account of income that accrued prior to the US-Opcos becoming foreign affiliates of Canco" (para. 32).

See more detailed summary under Reg. 5907(2)(f).

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 55 - Subsection 55(2) goodwill gains which accrued prior to purchase of FA and which were included under s. 55(5)(d) did not contributed to gain on Canco shares 286
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(1) - Earnings "notional" deduction arising from Code s. 338(h)(10) step-up excluded 129
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(2) - Paragraph 5907(2)(f) "notional" deduction arising from Code s. 338(h)(10) step-up of non-purchased goodwill reversed under Reg. 5907(2)(f) rather than (b) 433

10 March 2011 External T.I. 2008-0302851E5 - Application of subsection 96(1) to capital gains

allocation of exempt portion of partnership gain

Where Canco owns all the shares of two foreign affiliates (FA1 and FA2) which, in turn, each hold a 50% interest in a partnership, the exempt portion of a capital gain realized by the partnership will be included in the exempt earnings of FA1 and FA2, notwithstanding that s. 96(1) is silent with respect to each partner's share of that capital gain. Each of FA1 and FA2 will be considered to have been allocated a share of the capital gain in proportion to its respective interest in the partnership.

Paragraph (d)

Administrative Policy

24 May 2018 External T.I. 2017-0710641E5 - Interest Charge Domestic International Sales Corp

CMC of FA must be in the DTC and it must be liable to tax therein (albeit, may be conditionally exempted)

Exempt earnings of a foreign affiliate include its net earnings from an active business carried on in a designated treaty country if it is resident in that country. Reg. 5907(11.2)(a) provides that it is deemed to not be resident in that country unless it is resident there for purposes of the relevant Treaty.

CRA confirmed its position that:

[W]here a person’s worldwide income is subject to a particular Contracting State’s full taxing jurisdiction but that Contracting State’s domestic law does not levy tax on the person’s taxable income … we will generally accept that the person is a resident of that Contracting State unless the arrangement is abusive … [e.g., it] is placed within the taxing jurisdiction of the particular Contracting State in order to gain treaty benefits in a manner that does not create any material economic nexus to that Contracting State… .

CRA then confirmed that an “Interest Charge Domestic International Sales Corporation,” so qualified, i.e., a U.S. subsidiary of a Canco that earned profit on an exempted basis on the sale of goods manufactured by another U.S. subsidiary for export. CRA’s reasons suggest that it also considered it necessary that the central management and control of the exempted corporation be in the U.S.

Locations of other summaries Wordcount
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(11.2) U.S. IC-DISC is “resident” of the U.S. for Treaty purposes as the U.S. asserts its jurisdiction to tax and grants benefits only on continued meeting of conditions 379
Tax Topics - Income Tax Act - Section 250 - Subsection 250(5) whether a corp resident in the U.S. for Treaty purposes is deemed to be resident there for ITA purposes 38

Subparagraph (d)(ii)

Clause (d)(ii)(A)

Subclause (d)(ii)(A)(I)

Administrative Policy

2015 Ruling 2015-0573141R3 - Subparagraph 95(2)(a)(i)

US sub, by servicing both its own debt portfolios and that of a U.S. sister, generated exempt earnings to the sister

A Canadian corporation has a U.S. business of purchasing and collecting defaulted or other higher risk debts which, for risk management and state licensing reasons, it carries on through multiple U.S. subsidiaries. However, at least in the case of the “FA5 Subsidiaries,” all the work is done by the (apparently numerous) employees of their sister, FA4. CRA ruled that s. 95(2)(a)(i) deemed the income of one of the FA5 Subsidiaries to be active business income, and an addition to its exempt surplus under Reg. 5907(1) – exempt earnings – s. (d)(ii)(A)(I). Here, FA4 also held distressed debt portfolios of its own, albeit partly through a subsidiary LP – and one of the conditions for the CRA ruling was that LP qualified as a partnership for ITA purposes. CRA also stipulated that both corporatations be U.S. residents for Treaty purposes.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 95 - Subsection 95(2) - Paragraph 95(2)(a) - Subparagraph 95(2)(a)(i) US sub servicing the collection of both its own debt portfolios and that of a U.S. sister was a good mothership to the sister 323

Exempt Surplus

Administrative Policy

23 June 1993 T.I. (Tax Window, No. 32, p. 13, ¶2608)

Where a foreign corporation with a December year-end pays a dividend in June and then becomes a foreign affiliate of a Canadian corporation in October, the dividend so paid will not be deducted from exempt or taxable surplus of the foreign corporation in relation to the Canadian corporation because it will not be a "whole dividend" as defined in Regulation 5907(1)(n), i.e., the dividend was paid prior to the Canadian corporation acquiring shares of the foreign affiliate.

15 January 1992 Memorandum (Tax Window, No. 15, p. 1, ¶1675)

Where a Canadian subsidiary owns shares in its U.S. parent, a taxable dividend paid to the parent will not be included in the exempt surplus of the parent under Regulation 5907(1)(d)(vii).

Net Earnings

Administrative Policy

21 April 2015 Internal T.I. 2014-0560811I7 - FACL carryback – Surplus & PAS election

surplus pools are not to be retroactively adjusted for a FACL carryback

In 2010, CFA paid the "2010 Dividend" to its 100% parent ("Canco"). On audit, CRA identified that CFA had realized a capital gain (giving rise to foreign accrual property income). Canco designated a portion of a foreign accrual capital loss arising from a disposition in 2011 to be carried back to 2010. Must CFA's surplus pools be retroactively adjusted for the 2011-FACL carryback?

CRA responded:

…(b) of the definition of "net earnings" in subsection 5907(1) of the Regulations is clear… . It generally provides…that for surplus purposes an amount of FAPI is to be determined without reference to variable F.1 of the FAPI definition, i.e. without regard to any loss carryback. A loss in respect of FAPI is, correspondingly, accounted for under paragraph (b) of the definition of "net loss" in subsection 5907(1)… and is taken into account only in the taxation year of the affiliate in which the loss is incurred.

See summaries under Reg. 5901(2)(b) and Reg. 5903.1(1).

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 220 - Subsection 220(3.2) no relief for late-filed Reg. 5901(2)(b) election 50
Tax Topics - Income Tax Regulations - Regulation 5901 - Subsection 5901(2) - Paragraph 5901(2)(b) no relief for late-filed Reg. 5901(2)(b) election 164
Tax Topics - Income Tax Regulations - Regulation 5903.1 - Subsection 5903.1(1) FACL carryback from transitional year 140
Tax Topics - Income Tax Regulations - Regulation 600 no relief for late-filed Reg. 5901(2)(b) election 50

15 January 1992 Memorandum (Tax Window, No. 15, p. 2, ¶1676)

The U.K. ACT is not an "income or profits tax", although the normal corporate tax payable by a foreign affiliate, before any deduction in respect of any ACT paid by the affiliate, is such a tax.

Paragraph (a)

Administrative Policy

15 May 2019 IFA Roundtable Q. 10, 2019-0798781C6 - Foreign Affiliate Earnings and Foreign Transfer Pricing Adjustments

MAP Settlement reduced net earnings when foreign country reassessed to implement income reduction
This comments on 2017-0729431R3.

CRA had assessed a Canadian subsidiary (Canco) in a Canadian multinational group under s. 247(2) on the basis that the fees earned by a CFA (resident in Country A) of Canco’s Canadian parent from management services were too high from a transfer-pricing perspective and the fees earned by Canco itself from providing management services to group companies were too low. After negotiations between the competent authorities, it was agreed (under the “MAP Settlement”) that the income of CFA (which was from an active business) would be reduced by assessment by the Country A taxing authority, thereby generating income tax refunds for the affected years, and that there would be no adjustment to the actual fees charged by CFA (to which it was entitled under the Country A domestic law) and that there also would be no secondary adjustments.

CRA in its discussion indicated that, as a result:

  • The “earnings” of CFA, under Reg. 5907(1)(a)(i), were reduced by the income adjustment under the MAP Settlement as reassessed by Country A.
  • Upon receipt of such Country A reassessments reducing CFA’s income to reflect the MAP Settlement adjustments, the “net earnings” of CFA, under Reg. 5907(1), were increased by the amount of income taxes that had been paid to Country A but, in fact, were not payable after giving effect to the MAP Settlement and consequential Country A reassessment.
  • The amount of the MAP Settlement adjustment (reassessed by Country A) that was excluded from the computation of income or profit from an active business pursuant to the income tax law of Country A for each of the reassessed taxation years was added to the earnings of CFA pursuant to Reg. 5907(2)(f) given that the amount of such adjustment constituted “revenue, income or profit” of CFA for purposes of Reg. 5907(2)(f).
Locations of other summaries Wordcount
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(2) - Paragraph 5907(2)(j) MAP settlement resulted in reduction in "earnings" - (a)(i) under Reg. 5907(1) but in increase under Reg. 5907(2)(j) 474

2018 Ruling 2017-0729431R3 - Transfer Pricing Adjustment and Earnings

MAP downward adjustment to foreign income taxes increased net earnings

CRA assessed a Canadian subsidiary (Canco 1) in a Canadian multinational group under s. 247(2) on the basis that the fees earned by a sister company (Forco 1) resident in Country A from a customer were too high from a transfer-pricing perspective and the fees earned by Canco 1 under a services contract as part of the same business arrangements were correlatively too low. After negotiations between the competent authorities for Canada and Country A, it was agreed that Canco 1 would not appeal this assessment, and the income of Forco 1 (which was from an active business) would be reduced by assessment by the Country A taxing authority, thereby generating income tax refunds for those years. It was agreed that there would be no adjustment to the actual fees charged to the (apparently arm’s length) customer(s) and that there would be no secondary adjustments.

CRA ruled that these downward adjustments to the business income of Forco 1 reduced its (exempt) earnings as determined under s. (a)(i) of the definition of “earnings” in Reg. 5907(1), i.e., its earnings as computed in accordance with the Country A income tax law – but that such adjustments were to be added to its earnings pursuant to Reg. 5907(2)(f).

CRA also ruled that upon receipt of the Country A reassessment reflecting such downward income adjustments for the relevant years, the “net earnings” of Forco 1 for those years as defined in Reg. 5907(1)(a) would be increased by the amount of income taxes that had been correspondingly overpaid.

Locations of other summaries Wordcount
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(2) - Paragraph 5907(2)(f) fictional transfer pricing adjustments did not affect the exempt surplus calculation (other than for the foreign taxes adjustment) 511
Tax Topics - Income Tax Act - Section 247 - New - Subsection 247(2) CRA agreed under MAP to fictional transfer pricing adjustments re NR sister charging NR customer too much and Canco charging too little 190

Underlying Foreign Tax

Administrative Policy

30 October 2014 External T.I. 2013-0488881E5 - Upstream Loan

notional UFT disproportionate election

The disproportionate election under s. (b) of the UFT definition is treated as being applicable for a s. 90(9)(a) notional dividend received by Canco. See detailed summary of Scenario 2 under s. 90(9).

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 248 - Subsection 248(28) no double inclusion following FA creditor wind-up 54
Tax Topics - Income Tax Act - Section 40 - Subsection 40(3) notional s. 40(3) gain does not generate surplus 59
Tax Topics - Income Tax Act - Section 90 - Subsection 90(6) no double inclusion following FA creditor wind-up or for 2nd loan in series 105
Tax Topics - Income Tax Act - Section 90 - Subsection 90(9) notional election and double taxation issues 1108
Tax Topics - Income Tax Regulations - Regulation 5901 - Subsection 5901(1.1) notional Reg. 5901(1.1) election 24
Tax Topics - Income Tax Regulations - Regulation 5901 - Subsection 5901(2) - Paragraph 5901(2)(a) 90-day rule unavailable 22
Tax Topics - Income Tax Regulations - Regulation 5901 - Subsection 5901(2) - Paragraph 5901(2)(b) notional Reg. 5901(2)(b) election 25

27 November 1998 T.I. 982283

The tax paid by a U.S. C.-Corp (which is a foreign affiliate of the Canadian taxpayer) in respect of its share of the investment income earned by a U.S. LLC will qualify as underlying foreign tax at such time as the income in respect of which the tax was paid is distributed (i.e., a dividend is paid) to it by the LLC.

88 C.R. - Q.12

Foreign tax paid in respect of a capital gain may reasonably be regarded as having been paid in respect of taxable earnings to the extent that such foreign tax is required to eliminate the Canadian income tax which otherwise would be payable under the FAPI rules or through the repatriation of the taxable surplus resulting from the gain.

Underlying Foreign Tax Applicable

Administrative Policy

3 April 2013 External T.I. 2012-0460671E5 - Disproportionate UFT election

In Year 1, FA2, which has no exempt surplus, and taxable surplus and underlying foreign tax of $200 and $25, respectively, pays a $100 dividend to its immediate wholly-owning parent, FA1. In Year 2, FA1, which has no ES, TS or UFT, pays a $100 dividend to Canco. Accordingly, the TS of FA2 and FA1 change to $100 each and their UFT balances change to $12.50 each.

CRA stated that "the relevant return of income under Part I of the Act in which Canco should file a disproportionate UFT claim in respect of the FA2 dividend is its return for Year 1 [not Year 2]," and after referring to 901185 [immediately below], CRA then stated:

We continue to be of the view that the "return of income under Part I of the Act in respect of the whole dividend" referred to in paragraph (b) of the definition of "underlying foreign tax.., in which any claim must be made, is the return of Canco that includes the time when the whole dividend which is the subject of the claim is paid. However, if Canco had not filed a disproportionate UFT claim in respect of the FA2 dividend in its return for Year 1…CRA.. is prepared, in limited circumstances, to accept a disproportionate UFT claim from Canco in respect of the FA2 dividend in its return for Year 2 (i.e., in Canco's return for the year that includes the time it received the FA1 dividend).

Where FA2 at all relevant times was a wholly-owned subsidairy of FA1 with one class of shares, this limitation is that Canco's Year 2 claim "be limited to the maximum amount which could have been claimed by Canco in respect of the FA2 dividend in its return for Year 1."

9 August 1991 T.I. 901185

In Year 1, FA2, which has no exempt surplus, and taxable surplus and underlying foreign tax of $1,000 and $100, respectively, pays a $100 dividend to its immediate wholly-owning parent, FA1. In Year 2, FA1, which has no ES, TS or UFT, pays a $100 dividend to Canco. Accordingly, the TS of FA2 and FA1 change to $900 and $100, and their UFT balances change to $90 and $10, respectively.

The Directorate indicated that a "claim" can be made by Canco pursuant to 5907(1)(m)(ii) [now, para. (b) of the definition of "underlying foreign tax applicable" in Reg. 5907(1)] with respect to the $100 dividend paid from FA2 to FA1 in year 1 in its Part I tax return for year 1

...as there is nothing in 5907(1)(m)(ii) that would restrict its application to dividends from top tier affiliates. The amount of the "claim" could be up to a maximum of the total underlying foreign tax account of FA2 (subject to the amount of the dividend and the balances in exempt and taxable surplus).

The Directorate noted that if the additional claim in Year 1 was for $51, the increased UFT of $61 would permit a full s. 113(1)(b) deduction in respect of the dividend paid to Canco in Year 2 based on a relevant tax factor of 100/38. The Directorate went on to state:

…because the computation of "underlying foreign tax" pursuant to paragraph 5907(1)(1) of the Regulations is "at a particular time", it is our view that the two dividends could be paid in the same taxation year of Canco (i.e. one from FA2 to FA1 and then another from FA1 to Canco) with the same result being achieved. The underlying foreign tax of FA2 could be utilized to increase the deduction available to Canco pursuant to paragraph 113(1)(b) of the Act by making a disproportionate claim on Canco's Part I return. This would be accomplished by notifying the Department by letter attached to Canco's Part I return identifying the dividend from FA2 to FAl and the amount of the disproportionate "claim" pursuant to subparagraph 5907(1)(m)(ii) of the Regulations for that dividend.

Subsection 5907(1.1)

Administrative Policy

22 November 1991 Memorandum (Tax Window, No. 13, p. 9, ¶1608)

Provided that the primary and secondary affiliates are going concerns and the intercompany account has been charged with a number of offsetting items, the secondary affiliate will be considered to have paid the primary affiliate for the taxes where their amount has been booked to the intercompany account.

Subsection 5907(1.3)

Administrative Policy

8 April 2004 Internal T.I. 2003-0037291I7 - US LLC and Regulation 5907(1.3)

A wholly-owned US C-corp subsidiary (US Holdco) of a taxable Canadian corporation wholly-owned two LLCs (US LLC1 and US LLC2), which earned only foreign accrual property income, with their income being included in that of US Holdco for Code purposes. Under a tax sharing agreement, each group member paid its respective tax costs as if it had filed a separate return, with the amount of this hypothetical tax distributed accordingly - e.g. should an LLC be in a loss position, that LLC would receive compensatory payments from the other group members that represented the hypothetical ‘tax refund.

After finding that the compensatory payments were foreign accrual tax under s. (a)(ii) of the FAT definition in s. 95(1) to the extent that the LLC earnings were distributed to US Holdco, CRA went on to find that the payments were not deemed to be FAT under Reg. 5907(1.3)(a) as the LLCs had no liabilities for US tax in the first place (being flow-through entities), so that:

[A]ny compensatory payment made by US LLC1 or US LLC2 under the tax sharing agreement cannot reasonably be regarded as being in respect of income or profits tax that would otherwise have been payable by either US LLC1 or US LLC2.

Reg. 5907(1.3)(b) also did not apply as here there was not a group loss system such as obtained in the UK.

Paragraph 5907(1.3)(a)

Administrative Policy

1 February 2018 Internal T.I. 2016-0671921I7 - R&D Services - 95(2)(b) vs 247(2) & 95(3)(b), (d)

overview of FAT rules re consolidated US return with R&D credit

Four U.S.-resident controlled foreign affiliates of a Canadian public corporation (“Canco”), namely, CFA1 (wholly-owned by Canco), and CFA2, CFA3 and CFA4 (wholly-owned by CFA1) performed, as their only activity, research and development services (“R&D Services”) for the benefit of Canco, and with the fees paid therefor by Canco being their only revenue. CFA1 filed an amended annual consolidated U.S. federal income tax return for the “US Consolidated Group”, including CFA2, CFA3 and CFA4 in which a significant amount as a “credit for increasing research activities” was deducted against the U.S. federal income tax otherwise payable.

The Directorate found that s. 95(2)(b) applied to the R&D Services provided to Canco so as to result in a foreign accrual property income inclusion to Canco. Although it was not asked to comment on this issue at this stage, the Directorate made some general comments on the foreign accrual tax deduction, including:

[T]he amount of foreign tax paid by CFA1 may only give rise to FAT to the extent it can reasonably be regarded as applicable to the FAPI inclusions in Canco’s income in respect of CFA1. For there to be FAT attributable to the FAPI inclusions in Canco’s income in respect of CFA2, CFA3 and CFA4, it would have to be an amount prescribed as such under paragraph 5907(1.3)(a) of the Regulations for the purposes of paragraph (b) of the FAT definition. As such, numerous requirements would have to be met, including that “tax sharing payments” were made.

In addition, if any amount is prescribed as FAT under paragraph 5907(1.3)(a) of the Regulations, the net operating losses from prior years and losses from other businesses used by members of the US Consolidated Group would have to be reviewed in order to assess whether the “FAT Denial Rule” of subsection 5907(1.4) of the Regulations applies. In this respect, the nature of the loss, the year it was incurred, and whether that year precedes an acquisition of control by Canco, by example, would be part of the facts that would have to be confirmed. Also, information would be required in respect of the functioning of the U.S. research and development credit regime in order to determine whether any amount can be deducted in that respect in the determination of any amount of FAT.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 95 - Subsection 95(2) - Paragraph 95(2)(b) - Subparagraph 95(2)(b)(i) - Clause 95(2)(b)(i)(A) provision of services for fee by CFA to Canco on arm’s length terms did not oust s. 95(2)(b)(i)(A) 163
Tax Topics - Income Tax Act - Section 95 - Subsection 95(3) - Paragraph 95(3)(d) R&D services of CFAs not part of M&P process 180
Tax Topics - Income Tax Act - Section 95 - Subsection 95(3) - Paragraph 95(3)(b) R&D services of CFAs not immediately related to the sale of goods by Canco 203

Articles

Michael Black, "Cross-Border Consolidation and the Foreign Affiliate Rules", Canadian Tax Journal (2017) 65:1, 173-89

CCCTB proposal in European Commission draft EU directive package of October 2016 (pp.175-6)

[I]ncluded in that package is a proposal to revamp the way that companies are taxed by adopting a common consolidated corporate tax base (CCCTB)….

1. Companies that are tax-resident in the European Union and EU-located branches of third-country companies would have one common set of rules for computing taxable income….

2. Companies within the same group would consolidate their individual results. On consolidation, transactions carried out between group members would be eliminated in order to compute consolidated taxable income. Under the proposed definition of a group, a common EU parent is not required.

3. The group's consolidated taxable income would be allocated among the individual group members on the basis of a set formula. The proposed formula gives equal weight to three factors: sales, labour, and assets. The labour factor is further divided and gives equal weight to two factors: payroll and number of employees….

Difficulties under CCCTB in satisfying same country and consolidated determination tests (p. 187)

[T]wo key conditions in regulation 5907(1.3)(a) appear to conflict with the CCCTB:

1. Regulation 5907(1.3)(a) requires that each of the corporations must be resident in the same country. If EU FA 1 and EU FA 2 are resident in different EU countries, any compensation payment would not meet the conditions in regulation 5907(1.3)(a) and would not be prescribed to be FAT.

2. Regulation 5907(1.3)(a) requires that the foreign affiliates "determine their liabilities for income or profits tax payable to the government of that country for a taxation year on a consolidated or combined basis." The mechanics of the CCCTB proposals do not meet this condition because under the CCCTB, the EU foreign affiliates do not determine their liability for tax on a consolidated basis; instead, each foreign affiliate determines its liability for tax on an individual entity basis. As discussed above, the taxable income of the group is consolidated; however, each entity's liability for taxes is based on its allocated share of that income multiplied by the tax rate in the local jurisdiction.

Subsection 5907(1.5)

Administrative Policy

6 February 2015 External T.I. 2014-0542281E5 - Foreign affiliate - prescribed foreign accrual tax

both 5907(1.4) and (1.5) apply on year-by-year basis

Under the income tax law of "Country X" FA2, its sister, FA3 and FA1, which is the parent of FA2 and FA2 and the wholly-owned subsidiary of Canco, determine their income tax on a consolidated basis, so that FA1 (which has no income or loss for any year) pays such tax on behalf of FA2 and FA3 (with FA1, the "Group"). In year 1, FA2 earns $100 of FAPI, FA3 has a $100 active business loss and FA2 makes the "Payment" of $40 to FA1. The Payment may reasonably be regarded as in respect of the income tax otherwise payable by FA2 (at a 40% rate) respecting FAPI had there been no consolidation.

In year 2, FA2 has no FAPI or other income and FA3 has a foreign accrual property loss ("FAPL") of $100. Would the portion of the Payment otherwise prescribed by Reg. 5907(1.3) to be foreign accrual tax ("FAT") be reduced to nil by Reg. 5907(1.4)?

CRA stated that this determination:

must be made based on the income and losses of the members of the Group for year 1 and, if applicable, preceding taxation years. Accordingly, the FAPL realized by FA3 in year 2 would not be relevant to the analysis. In year 1, it is reasonable to consider that the Payment made by FA2 is in respect of the active business loss of FA3. Therefore…[Reg.] 5907(1.4)… applies to reduce the amount otherwise prescribed by subsection 5907(1.3)…to be the FAT applicable to the amount included in income by Canco to nil. Our view would be the same regardless of the year in which the Payment in respect of year 1 is made by FA2.

Suppose that in year 2, FA2 had no income (as before) but FA3 had active business income of $100, so that Reg. 5907(1.5) would prescribe in year 2 an amount equal to the Payment to be FAT applicable to the amount included under s. 91(1) in the income of Canco in year 1. In finding that the deduction under s. 91(4) would not be available to Canco in year 1, CRA stated:

[T]he operation of subsection 5907(1.5)… will cause the deduction under subsection 91(4) of the Act to become available to Canco in year 2.

Subsection 5907(1.6)

Articles

Adam Freiheit, "Reinstated Foreign Accrual Tax and the Multi-Period Perspective", Canadian Tax Journal, (2015) 63:2, 521-42, p. 521.

General reduction under Reg. 5907(1.4) (p. 523)

[R]egulation 5907(1.3) can prescribe the particular FA's tax compensation payments to other members of the group to be FAT….

[R]egulation 5907(1.4) reduces the amount otherwise prescribed to be FAT pursuant to regulation 5907(1.3) to the extent that the amount "can reasonably be considered to be in respect of" a loss or capital loss of another corporation, where that loss or capital loss would not be a FAPL of a CFA of a relevant person or partnership in respect of the taxpayer….

Purpose of Reg. 5907(1.4) (p. 524)

The-[Finance] explanatory notes to regulation (1.4) clarify its purpose merely by stating that any resulting FAT denial is "consistent with the fact that... active business losses and capital losses resulting from the disposition of excluded property of a foreign affiliate are not included in the computation of a FAPL." This can be interpreted to mean that, just as a stand-alone FA cannot use active business losses to reduce FAPI, so too an FA should not be able to generate FAT by compensating a separate entity for its active business losses. Regulation 5907(1.4) blocks a taxpayer from increasing FAT deductions on the reassignment of active business losses within a consolidated group.

One-shot reinstatement only when full notional loss deduction (pp. 524-5)

[I]f regulation 5907(l.5) reinstates FAT, it does so all at once—with prescribed FAT in the taxpayer's taxation year that includes the last day of the FA's designated taxation year. Thus, if the [Finance] explanatory notes example is modified so that FA 3 earns active business income of $299 in 2006 and $1 in 2007, the FAT is still reinstated only in 2007, with no FAT deductionin2006.

FAT deduction under s. 91(4) (in e.g. 2007) in respect of year (e.g. 2004) of FAPI inclusion (p. 527)

[C]anco, pursuant to Finance's approach, is viewed as having a FAT reduction in 2004 and therefore a net FAPI income inclusion for that year. Canco's deduction in respect of reinstated FAT, however, is delayed until 2007. A taxpayer may be prevented from carrying back a loss resulting from reinstated FAT to the FAPI year….

Imaginary nature of deduction/application of local rules (pp. 527-8)

[U]nder regulation 5907(1.6), 2007 is a designated taxation year of FA 2, because the 2004 losses of the members of the consolidated group could "reasonably be considered" to have been fully deducted in computing US taxable income in that year. The local deductions in this context are hypothetical. Regulation 5907(1.6)(a) requires a taxpayer to ignore all FAPI earned by the members of the consolidated group, whereas, in reality, FA 3's losses are applied against FA2's FAPI in 2004, and no losses are available for carryover….

In evaluating the hypothetical carryover, the FAT reinstatement regulations only authorize the assumption that no FAPI is earned by the relevant affiliates. All other local prerequisites for loss carryovers must be applied, regardless whether they resemble those under the Act….

[A] taxpayer cannot be certain of its intended deduction for reinstated FAT until it resolves its income and losses under local rules for each period that might have losses that can be carried back to a relevant year.

No reinstatement if FAPI earner ceases to be FA (p. 528)

…FAT reinstatement is seemingly possible only if the FA that has earned the relevant FAPI remains an FA of the taxpayer. The requisite relationships may be lost if, for example, the taxpayer transfers the FA to a parent or sister company.

Tainting effect of Losscos joining group (p. 529)

The hypothetical carryover under the FAT reinstatement regulations does not seem to ignore losses of entities that join the consolidated group, even while ignoring the income of such entities. Regulation 5907(1.6)(a) authorizes only one assumption in analyzing the carryover: that FAPI is ignored. The hypothetical deductions are arguably prevented if income in periods following the FAPI year is actually offset by losses of entities that are newly formed, or acquired… .

Requirement to utilize capital losses? (p. 529)

[R]egulation 5907(1.6) appears to require that all "losses" from the FA years ending in the FAPI year be fully deducted. "All losses" presumably includes capital losses, FAPLs, and FACLs realized by the group companies. [fn 29: While FAPLs realized by members of a consolidated group would not of themselves cause regulation 5907(1.4) to reduce FAT, this provision can nonetheless apply when there are FAPLs in a group if other members of the group realize active business losses in the year.]…

Several local taxation periods ending in FAPI year (p. 530)

[A] taxpayer is eligible for FAT reinstatement only if losses for all taxation years ending in the FAPI year are hypothetically deducted against non-FAPI income. The FAPI year is a taxation year of the Canadian taxpayer. The relevant FAs might have several local taxation periods ending in this FAPI year. There could be situations where losses in some of the periods ending in the FAPI year did not "cause" the relevant FAT denial….

Blocking effect of FAPLs (p. 530)

[T]he losses in question must be fully deducted against any income on the assumption that the relevant foreign corporations have no FAPI. Thus, a taxpayer could arguably fail to get FAT reinstated even if the members of the group have active business income that would offset the FAPI-year losses, if those members also have FAPLs in the relevant years.

In the example illustrated by table 3, FA 1 has a FAPL of $200 in 2006. Seemingly, no 2004 losses can be deducted hypothetically against FA 3's 2006 active business income because, this income can be viewed as being already offset by FA l's FAPL in that year….

Reinstatement by deducting FAPI-year losses against passive income earned by non-FAs (p. 532)

The members of the consolidated group might include non-FAs, which by definition cannot earn FAPI. [fn 30: FAPI is defined in subsection 95(1) only relative to FAs of a taxpayer. To illustrate, an FA ("US Sub 2") of a Canadian taxpayer ("Canco") might be a member of a consolidated group that includes non-FAs if Canco is wholly owned by a US parent ("USP"); USP directly owns all the common shares of US Sub I and US Sub 2; USP, US Sub 1, and US Sub 2 form a consolidated group; and Canco owns only all of the special shares of US Sub 2.] As a result, one could arguably achieve reinstatement by deducting FAPI-year losses against passive income earned by non-FAs, even if that income would have been FAPI had the non-resident entities been FAs of the taxpayer….

Deduction against 50% of non-excluded property capital gains (p. 532)

The FAT reinstatement regulations seemingly permit losses to be used against other kinds of non-active business income, such as passive income earned by FAs for local purposes that is excluded in computing FAPI. For example…assuming that "income" for the purposes of regulation 5907(1.6)(a) can include capital gains, one should arguably be able to deduct FAPI-year losses against 50 percent of an FA's gains on the disposition of non-excluded property because the FA would still have such gains even assuming that it had no FAPI.

No reinstatement when no FAPI-year losses (p. 533)

…FA 1 compensates FA 2 in year 2 for the use of its active business losses realized in year 1. FA 2 later earns active business income in year 6. The FAT in respect of FA 1 otherwise prescribed by regulation 5907(1.3) is arguably reduced under regulation 5907(1.4), by the amount of FA l's compensation payment to FA 2, since FA 2 is not being compensated for a FAPL. However, this FAT seemingly cannot be reinstated, despite the active business income earned in year 6, because regulations 5907(1.5) and (1.6) trigger such reinstatement only when FAPI-year losses are hypothetically carried over, and in this example there are no FAPI-year losses whatsoever.

Initial multi-year perspective (pp. 537-8)

The CRA had applied [in 901876] a multi-period perspective in an even earlier head office memorandum [than in9719055 and 2002-013420117]...in interpreting the FAT definition and regulation 5907(1.3). ... FA 1 and FA 2 are FAs of a Canadian taxpayer; FA 1 is the head company of a consolidated group that includes FA 2. … The CRA accepted that FA 2's compensation payment in year 1 could constitute FAT in respect of its FAPI in year 2 if the consolidated group could hypothetically carry back the active business loss from year 2 to offset its active business income in year 1….

Multi-year perspective where local differences (p. 542)

Many provisions in the Act and regulations require a taxpayer to determine whether income or profits taxes can "reasonably be considered" to have been paid "in respect of" income from a specific source. Where a taxpayer has different sources of income for local purposes in various years, the challenge is to determine in what respects a multi-period perspective can be adopted in determining what the taxes reasonably relate to….

For some time, the CRA has respected a multi-period perspective in analyzing some of these broad provisions. … In implementing regulations 5907(1.5) and (1.6), Parliament codified an application of the multi-period perspective – but only in the context of FAT denial rules applicable to consolidated groups. The FAT reinstatement regulations were intended to permit FAT deductions when active business losses causing FAT denial are hypothetically deducted against active business income earned in subsequent years.

It is not clear whether the legislature, in enacting the FAT reinstatement regulations, sought to change how the multi-period perspective was already being applied. Parliament may have merely been clarifying how to apply the multi-period perspective in more difficult, multiple company scenarios.

Subsection 5907(2)

Administrative Policy

27 October 2017 Internal T.I. 2017-0694231I7 - Subsection 247(2), surplus, and FAPI

effect on surplus balances of foreign transfer-pricing adjustment might be reversed under Reg. 5907(2)

The Directorate considered that where there was a s. 247(2) transfer pricing adjustment to increase Canco’s income as a result of having undercharged for goods or services provided to a non-resident subsidiary (CFA), s. 247(2) could not also be applied to reduce the exempt surplus or foreign accrual property income of CFA in respect of Canco. The Directorate went on to state:

The surplus of CFA could conceivably be adjusted where CFA’s “earnings” are computed pursuant to subparagraph (a)(i) or (a)(ii) of the definition of “earnings” under [Reg.] 5907(1) … and the relevant foreign tax law makes its own transfer pricing adjustment, whether by way of a corresponding adjustment or otherwise. …[C]onsideration would have to be given to whether subsection 5907(2) … could reverse that foreign tax law adjustment and to the possible impact of any accompanying transfer of assets to effect a so-called “repatriation” payment.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 247 - New - Subsection 247(2) s. 247(2) transfer pricing adjustment for sales undercharges to a CFA does not decrease the ES of the CFA 157
Tax Topics - Income Tax Act - Section 53 - Subsection 53(1) - Paragraph 53(1)(c) sale of goods at undervalue to sub does not imply a contribution of capital 168
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(1) - Earnings - Paragraph (a) surplus could be adjusted by transfer-pricing adjustment 128

Paragraph 5907(2)(f)

Administrative Policy

2019 Ruling 2018-0762581R3 - Foreign Affiliate Reorganization

Reg. 5907(2)(f) does not apply where inventory is transferred on a foreign rollover basis
Background

The Taxpayer, a Canadian-resident corporation, wholly-owns CFA1 and CFA2, each of which carries on an active business in Foreign Country. In order to combine CFA1 and CFA2 on a foreign rollover basis without losing loss-carryforwards of CFA1:

  • The Taxpayer will transfer all the shares of CFA2 to CFA1 in exchange for CFA2 shares with an equivalent FMV.
  • CFA2 will distribute a dividend to CFA1 equal to its retained earnings, which will remain unpaid to the extent of insufficient cash.
  • CFA2 will transfer its entire business to CFA1 by transferring all of its capital and non-capital property (which have a net accrued gain) and assigning substantially all of its liabilities (including any unpaid dividend liability, if any), excepting any assets and liabilities that cannot be transferred (e.g., tax refunds and/or taxes payable) at book value in exchange for a CFA1 promissory note (the “CFA1 Note”) equal to the book value of the assets transferred minus the amount assumed liabilities (the “Proposed Business Transfer”).
  • Pursuant to a shareholders’ resolution, CFA2 will then be liquidated into CFA1 and will distribute its remaining assets to CFA1 and assign any residual liability to CFA1. As a result of the distribution of the CFA1 Note to CFA1, which will result in the CFA1 Note being extinguished.
Rulings

No amount of revenue, income or profit will be required to be added to the earnings of CFA2, pursuant to Reg. 5907(2)(f) in respect of the Proposed Business Transfer of CFA2’s non-capital property. In its summary, CRA stated:

Since the transfer of the non-capital assets is done on a rollover basis under the relevant foreign income tax law, the conditions of paragraph 5907(2)(f) are not met.

Reg. 5907(5.1) will apply to the disposition by CFA2 of its capital property to CFA1 pursuant to the Proposed Business Transfer (with the summary stating):

No gain or loss is recognized on the transfer of the capital assets under the relevant foreign income tax law, and the other conditions … in subsection 5907(5.1) … are met.

Locations of other summaries Wordcount
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(2.1) Reg. 5907(5.1) applicable to pre-wind-up transfer on a foreign tax law rollover basis 147
Tax Topics - Income Tax Act - Section 15 - Subsection 15(1) no s. 15(1) application to sale of assets of CFA2 to CFA1 at NBV preliminarily to wind-up 76

2018 Ruling 2017-0729431R3 - Transfer Pricing Adjustment and Earnings

fictional transfer pricing adjustments did not affect the exempt surplus calculation (other than for the foreign taxes adjustment)
Background and MAP agreement

Canco 1, which was an in direct wholly-owned subsidiary of ACo (a Canadian public corporation), was reassessed by CRA under s. 247(2) on the basis that it was undercharging for services rendered by it to counterparties and, by implication, permitting Forco 1 (an indirect wholly-owned subsidiary of ACo resident in Country A) to earn higher fees from counterparties than should have been the case from a transfer-pricing perspective. Under a “MAP Settlement” negotiated between the competent authorities for Canada and Country A, it was agreed that

  • there would be a downward adjustment for Country A taxation purposes in the fee amounts that Forco 1 was treated as earning (the “MAP Adjustment”),
  • there was no required adjustment to the amount of such fees earned for commercial purposes
  • no secondary adjustment would be made in respect of the MAP Adjustment to the income of Canco 1 or Forco 1 or to create a loan or other obligation between them
  • Canco 1 waived its rights to appeal respecting the matter

As a consequence of the MAP Adjustment, Forco 1 expects to receive an income tax refund (the “Country A Repayment”) from Country A.

Proposed transactions and additional information

Forco 1 will declare and pay a dividend to ACo. It will not make any election under Reg. 5901(2) to reorder its surplus distributions. Its surplus balances before the above adjustments were nil as a result of earning and fully distributing its active business earnings.

Forco 1 estimates that it will have a net loss from an active business for each of various taxation years. The amount of the Country A Repayment will be added to Forco 1’s distributable reserves/retained earnings for financial accounting purposes.

Rulings

The earnings of Forco 1, as determined under s. (a)(i) of the definition of “earnings” in Reg. 5907(1) equals its income from an active business as computed in accordance with the Country A income tax law, which reflects the MAP Adjustments. However, such adjustments are added to the earnings of Forco 1 pursuant to Reg. 5907(2)(f). In this regard, the CRA summary states:

i) The corresponding adjustment and the resulting reassessment by the foreign tax authority changes the income or profit from active business of the foreign affiliate computed in accordance with the foreign tax law and the income taxes paid by the foreign affiliate in respect of that income or profit. ii) The money realized and retained by the foreign affiliate, but excluded from its income for foreign income tax purposes as a result of the corresponding adjustment by the foreign tax authority, would be "revenue, income, or profit" derived by the foreign affiliate for purposes of paragraph 5907(2)(f) of the Regulations.

Upon receipt of the Country A reassessment reflecting such adjustments reducing its income, the “net earnings” of Forco 1 for those years as defined in Reg. 5907(1)(a) will be increased by the amount of income taxes that were correspondingly overpaid. Conversely, the payment of Country A income taxes owing as a result of Country A reassessment increasing income, its “net earnings” will be decreased by the amount of such income taxes paid for such taxation year.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 247 - New - Subsection 247(2) CRA agreed under MAP to fictional transfer pricing adjustments re NR sister charging NR customer too much and Canco charging too little 190
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(1) - Net Earnings - Paragraph (a) MAP downward adjustment to foreign income taxes increased net earnings 247

6 May 2014 May CALU Roundtable, 2014-0523341C6 - CALU - Insurance Death Benefit received by FA

life insurance policy unlikely to pertain to CFA's active business

Mr. X, a Canadian resident, owns 100% of Canco which owns 100% of the shares (having a low ACB) of Foreignco, which is required by the income tax law in its country of residence to compute its income from its active business carried on therein. The proceeds of a life insurance policy (previously acquired by Foreignco) received by it upon the death of Mr. X are exempt under the local tax law and also would be exempt if received in Canada. Into which surplus account will they go? After stating that it is "conceivable" that "in very rare cases" the proceeds might be viewed as income pertaining or incident to the active business, CRA went on to state:

[T]here are no facts provided as to why a life insurance policy was acquired by Foreignco on the life of Mr. X and therefore no basis to conclude the policy was related to Foreignco's active business. If that is the case, the life insurance proceeds would not be added to "earnings" from an active business of Foreignco under paragraph 5907(2)(f) of the Regulations. … As no amount is included in the computation of income under the provisions of the Act, no amount could be included as FAPI. Therefore, the life insurance proceeds received by Foreignco would not be included in its taxable surplus pool. Accordingly, the life insurance proceeds … would form part of Foreignco's pre-acquisition surplus pool.

If no exempt, hybrid, or taxable surplus is available any dividend paid by Foreignco will be determined to be paid out of Foreignco's pre-acquisition surplus and a capital gain will be triggered by virtue of subsection 40(3)… .

14 March 2014 Internal T.I. 2013-0499141I7 - IRC 338(h)(10), "earnings" and safe income

"notional" deduction arising from Code s. 338(h)(10) step-up of non-purchased goodwill reversed under Reg. 5907(2)(f) rather than (b)

An indirect wholly-owned foreign affiliate ("FA") of Canco made an arm's length purchase of all the shares of "US Holdco," whose wholly-owned subsidiaries ("US-Opcos") had accrued gains inherent in the appreciated assets of their active businesses including capital property, depreciable property and intangible property such as goodwill. The US-Opcos each carried on an active business in the United States.

FA and the common parent of the selling consolidated group filed a joint election under s. 338(h)(10) of the Code (the "IRC") with respect to FA's acquisition of the US Holdco shares, so that the US-Opcos recognized gain as if they had sold all their assets at FMV and they were treated as having purchased all of their assets for an amount equal to the purchase price of the shares of US Holdco. The US-Opcos thereafter disposed of a portion of their assets including depreciable and intangible property.

The Directorate found that the US-Opcos' earnings amounts should be calculated similarly to what would have been calculated if no IRC 338(h)(10) election had been made. In particular:

  1. Where a depreciable or intangible property had been fully depreciated/amortized, respectively, the depreciation or amortization taken in excess of the actual expenditure as the result of the stepped-up tax basis under IRC 338(h)(10) election, should be added to the earnings amount pursuant to Reg. 5907(2)(b).
  2. Where an intangible property having no actual expenditure (i.e., goodwill) had been amortized, the amortization taken on the stepped-up tax basis under IRC 338(h)(10) should be added to the earnings amount pursuant to Reg. 5907(2)(f) (or in the alternative should not be considered in computing the earnings amount determined under s. (a)(i) of Reg. 5907(1) –"earnings" [apparently on the basis "that ‘notional' income or deductions are simply excluded from the earnings amount" (para. 15)].) (Conversely, such amortization would not "be in respect of an ‘expenditure made' and, therefore, could not result in an add back pursuant to paragraph 5907(2)(b)" (para. 23))
  3. To the extent the disposition of intangible property resulted in income from an active business, the increase in tax basis as the result of the IRC 338(h)(10) election (net of any accumulated amortization taken thereon), of intangible property disposed of other than goodwill may be added to the earnings amount pursuant to Reg. 5907(2)(b) and the net stepped-up tax basis under IRC 338(h)(10) of the goodwill disposed of should be added to the earnings amount under Reg. 5907(2)(f) (or, in the alternative, should not be considered in computing the earnings amount determined under s. (a)(i) of the "earnings" definition) – without duplication of the adjustments in 1 and 2.

See also summary under s. 55(2).

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 55 - Subsection 55(2) goodwill gains which accrued prior to purchase of FA and which were included under s. 55(5)(d) did not contributed to gain on Canco shares 286
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(1) - Earnings "notional" deduction arising from Code s. 338(h)(10) step-up excluded 129
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(1) - Exempt Earnings no carve out for goodwill gains 132

5 December 2003 External T.I. 2002-0165195 - Debt Forgiveness in Foreign Affiliates

forgiveness gain did not relate to active business items

The U.S. subsidiary ("CFA1") of Canco has non-interest bearing loans payable by it to Canco. The proceeds of those loans had been used by CFA1 to acquire shares of U.S. subsidiaries of CFA1 in order for CFA1 to earn dividends that were deemed active business income pursuant to s. 95(2)(a)(ii). The forgiveness of those loans would not result in an adjustment to "earnings" under Regulation 5907(2)(f) because this provision only applies to revenue, income or profit derived from an active business carried on by a foreign affiliate. However, the forgiveness would be considered to be a contribution of capital which could be added to the ACB of the shares of CFA1 held by Canco pursuant to s. 53(1)(c).

Paragraph 5907(2)(j)

Administrative Policy

15 May 2019 IFA Roundtable Q. 10, 2019-0798781C6 - Foreign Affiliate Earnings and Foreign Transfer Pricing Adjustments

MAP settlement resulted in reduction in "earnings" - (a)(i) under Reg. 5907(1) but in increase under Reg. 5907(2)(j)
This comments on 2017-0729431R3.

Parent (a Canadian-resident parent of a multinational group) and CFA (resident in a designated treaty country, Country A, and earning active business income) entered into the “CFA Service Agreement” for the provision by CFA of services to group companies and Parent also entered into the “Canco Service Agreement”) with Canco for Canco’s provision of services to group companies. CRA subsequently reassessed Canco for certain taxation years to include in its income under the Canco Service Agreement a portion of the fees received by CFA under the CFA Service Agreement.

Adjustments under the MAP Settlement between the two competent authorities result in Country A’s tax authority reassessing CFA in each relevant taxation year and in a repayment to CFA of the amount of Country A income taxes that were paid but were not due. The MAP Settlement provided that no secondary adjustment would be made to the income of Canco or CFA, and none will in fact be made.

Under Country A law, transfer pricing adjustments and corresponding reassessments by the Country A tax authority do not alter the legal right of CFA to the income it earned, nor do they result in any restatement of CFA’s income in its original financial statements.

Would there be a resulting:

i. a re-computation of earnings and net earnings of CFA under Reg. 5907(1); and

ii. an addition to the earnings of CFA under Reg. 5907(2)(f) for the amount of the income retained but excluded from its income for Country A income tax purposes?

CRA responded:

i. The “earnings” of CFA, under subparagraph 5907(1)(a)(i), will be reduced by the income adjustment under the MAP Settlement and Country A reassessment pertaining to each taxation year reassessed, to reflect its income or profit from an active business as computed in accordance with the income tax law of Country A for each of its reassessed taxation years.

Upon receipt of the Country A reassessment reducing income to reflect the adjustment under the MAP Settlement, the “net earnings” of CFA, under subsection 5907(1), will be increased by an amount equal to the amount of income taxes that were paid for each such taxation year to the government of Country A but not payable in light of the MAP Settlement and Country A reassessment pertaining to that taxation year.

ii. The amount of the adjustment under the MAP Settlement and Country A reassessment that is excluded from the computation of income or profit from an active business pursuant to the income tax law of Country A for each of the reassessed taxation years will be added to the earnings of CFA for each such taxation year pursuant to paragraph 5907(2)(f) of the Regulations given that the amount of the adjustment under the MAP Settlement and Country A reassessment constitutes the “revenue, income or profit” of CFA for purposes of paragraph 5907(2)(f).

Locations of other summaries Wordcount
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(1) - Net Earnings - Paragraph (a) MAP Settlement reduced net earnings when foreign country reassessed to implement income reduction 298

26 May 2016 IFA Roundtable Q. 8, 2016-0642041C6 - s. 95(2)(a)(ii)(B) and borrowing to return capital

interest used to fund return of capital that had been used in an active buisness deductible under Reg. 5907(2)(j)

Where FA1 borrows $350,000 from a sister (FA3) to make a capital distribution to its Canadian shareholder (Canco) on its Class A common shares, which had previously been issued by it to Canco solely to use the subscription proceeds of $800,000 to finance FA1’s active business, CRA would accept that the interest on the $350,000 loan would be received as deemed active business income by FA3 under s. 95(2)(a)(ii)(B). CRA indicated that this result would obtain even if FA1 had issued shares of another class (its Class B common shares) to Canco, to finance the $200,000 acquisition of shares (of FA2) which were not excluded property, at the same time as it issued the Class A common shares.

In the situation where FA1 was required to compute its income (pursuant to Reg. 5907(1) – earnings – (a)(iii)) under Part I of the Act, CRA indicated that the interest was deductible under s. 20(1)(c) “because the borrowed funds replaced capital that…had been used by FA1 for the purpose of earning income from an active business,” whereas in the situation where the earnings were computed pursuant to (a)(i) or (iii) of the earnings definition under local tax law and the interest was non-deductible under such law, CRA simply stated that the interest would be deductible under Reg. 5907(2)(j).

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 95 - Subsection 95(2) - Paragraph 95(2)(a) - Subparagraph 95(2)(a)(ii) - Clause 95(2)(a)(ii)(B) tracing approach to determining whether interest on money borrowed to return capital is considered for s. 95(2)(a)(ii)(B) to be deductible in computing exempt earnings 470

28 May 2015 IFA Roundtable Q. 11, 2015-0581571C6 - IFA 2015 Q11: Application of clause 95(2)(a)(ii)(B)

interest on borrowing to distribute accumulated profits

"Borrower FA," which exclusively carries on an active business, borrows money from "Lender FA" to pay a dividend in an amount not exceeding its accumulated profits used in its business. Assuming the other s. 95(2)(a)(ii)(B) conditions are met, is the interest deductible by Borrower FA in computing the amount prescribed to be its earnings or loss from an active business, so that it will be included in the active business income of Lender FA? In responding affirmatively, CRA stated:

If the interest expense is not deductible by Borrower FA in any taxation year under the relevant foreign country's income tax law, it will nevertheless be deductible…pursuant to paragraph 5907(2)(j)… because it will be considered to have been made or incurred by Borrower FA for the purpose of gaining or producing earnings from an active business carried on by it as determined under subparagraphs (a)(i) or (ii) of the definition of "earnings" in subsection 5907(1)… .

See summary under s. 95(2)(a)(ii)(B).

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 95 - Subsection 95(2) - Paragraph 95(2)(a) - Subparagraph 95(2)(a)(ii) - Clause 95(2)(a)(ii)(B) interest on borrowing to distribute accumulated profits 238

6 March 1995 Memorandum 941221 (C.T.O. "Adjustments in the Computation of Exempt Surplus")

Interest paid on overdue taxes must be deducted under Regulation 5907(2)(j) in computing the earnings of a foreign affiliate.

93 C.M.TC - Q. 2

Discussion of treatment of interest paid by one U.S. foreign affiliate to another where only part of the interest paid is deductible under s. 163(j) of the Internal Revenue Code.

20 May 1993 T.I. (Tax Window, No. 31, p. 3, ¶2509)

Where funds are lent by FA1 to a second foreign affiliate (FA2) which carries on business in the U.S., and due to the application of the excess interest rule in s. 163(j) of the IRC, FA2 is unable to claim a current deduction for the interest paid to FA1, Regulation 5907(2)(j)(i) will not be applicable in computing the earnings of FA2 for the year the interest is paid because s. 163(j) only defers the deduction. However, the Regulation would apply if FA2 is sold prior to claiming the deduction for the interest paid to FA1 or if the interest deduction were applied to passive income.

22 November 1991 Memorandum (Tax Window, No. 13, p. 9, ¶1608)

In the absence of persuasive evidence, charitable donations, political donations and penalties will not be considered to be deductible.

Finance

16 May 2018 IFA Finance Roundtable, Q.6

interest denied under U.S. hybrid rule would be deductible

After indicating that, in the context of s. 95(2)(a)(ii), interest paid by and to a foreign affiliate whose deductibility was denied under Code s. 163(j) could nonetheless access the benefit of recharacterization as active business income under the s. 95(2)(a)(ii) rule if such interest was allowed to be carried forward indefinitely, Finance went on to indicate that interest which is permanently denied, under say the hybrid rule, should also not create difficulties under s. 95(2)(a)(ii) by virtue of Reg. 5907(2)(j).

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 95 - Subsection 95(2) - Paragraph 95(2)(a) - Subparagraph 95(2)(a)(ii) - Clause 95(2)(a)(ii)(B) the expanded U.S. earnings stripping rule should not adversely affect the operation of s. 95(2)(a)(ii) 146

Articles

Arda Minassian, Kara Ann Selby, "Computation of Surplus Accounts", 2002 Conference Report, (CTF), c. 43

The underlying principle of the regulation 5907(2) adjustments is to determine the amount of assets available to repatriate surplus. Permanent non-deductible expenses, such as the disallowed portion of meals and entertainment, illustrate this principle....

The deduction of amounts in excess of the actual expense artificially reduces earnings, and the taxpayer will want to increase exempt surplus by the additional amount. For example, Thailand and Singapore provide deductions in excess of actual expenses. Thailand offers tax relief for certain manufacturing companies in the form of a second deduction of its utility expenses, while Singapore allows certain capital assets to be depreciated to 150 percent of their original cost.

Subsection 5907(2.01)

Administrative Policy

22 April 2015 External T.I. 2014-0550451E5 - Interpretation of paragraph 5907(2.01) of the Regulations.

"consideration received" includes assumed liabilities

Does "consideration received" in Reg. 5907(2.01)(a) include any liabilities assumed by a foreign affiliate (the "Receiving Affiliate") on a transfer of property to it by another foreign affiliate (the "Disposing Affiliate") of the taxpayer? After citing Daishowa-Marubeni International Ltd. v The Queen, 2013 SCC 29, for the proposition that "'consideration received' by a taxpayer in respect of a particular disposition of assets includes the amount of any liabilities of the taxpayer that are assumed by a purchaser as part of the purchase of the disposed assets," CRA concluded:

[T]he assumption by the Receiving FA of liabilities of the Disposing FA on a transfer of property to it, is "consideration received" by the Disposing FA for the property transferred… . Accordingly, any such transfer of property by a Disposing FA would not meet the test in paragraph 5907(2.01)(a)… .

Subsection 5907(2.02)

Articles

Gwendolyn Watson, "The Foreign Affiliate Surplus Reclassification Rule", Canadian Tax Journal (Canadian Tax Foundation) (2019) 67:4, 1233-66

Example of what the 1992 Auditor General’s Report had in mind as conversion of taxable surplus into exempt surplus (pp. 1242-1243)

Suppose that FA 1 is a holding corporation whose only assets are shares of FA 2. FA 2 is resident in, and carries on an active business in, a low-tax jurisdiction that is not a designated treaty country. As a result, the income of FA 2 gives rise to taxable surplus, and since FA 2 operates in a low-tax jurisdiction, it is assumed that FA 2 has no underlying foreign tax. The shares of FA 2 have a large accrued capital gain, and it is assumed that these shares are excluded property to FA 1 on the basis that all or substantially all of FA 2's assets are excluded property, being operating assets used or held by FA 2 principally for the purpose of gaining or producing income from its active business. If FA 2 paid a dividend to FA 1, and FA 1 paid a dividend to Canco, the dividends would be prescribed to be paid out of the taxable surplus of FA 2 and FA 1, respectively. Canco would be required to include the dividend received from FA 1 in income and would not be entitled to claim a deduction under section 113 since there is no underlying foreign tax applicable to the taxable surplus divi­dend prescribed to be paid by FA 1.

However, notwithstanding the specific anti-avoidance rules described in the previous section, FA 1 could generate exempt surplus if it sold the shares of FA 2 to FA 3, or FA 2 could generate exempt surplus if it sold its active business assets to FA 3. In the case of a sale of shares by FA 1, provided that FA 1 did not receive share con­sideration from FA 3 on the sale, former paragraph 95(2)(c) would not apply, so that FA 1 would realize a capital gain on the disposition of the shares of FA 2; further, since the FA 2 shares are excluded property, this gain would not give rise to FAPI. The capital gain realized by FA 1 would be recharacterized as a dividend to the extent of FA 2's taxable surplus pursuant to the automatic election in former subsec­tions 93(1) and (I.I). However, any capital gain in excess of the taxable surplus of FA 2 would remain a capital gain; the non-taxable portion of the gain would be added to FA 1 's exempt surplus, and the taxable portion of the gain would be added to FA l's taxable surplus. Former regulations 5907(2)(f) and (5.1) would not apply to suppress these surplus additions since FA 1 is a holding corporation that does not hold the shares of FA 2 as part of an active business. Further, FA 3 would acquire the FA 2 shares with a cost equal to their fair market value, and FA 2 would continue to own assets with accrued gains that could give rise to exempt and taxable surplus when those assets were disposed of in the future. In the case of a sale of assets by FA 2, the rollover rules and former subsections 93(1) and (1.1) would not be relevant and the surplus suppression rules would not apply, provided that the income and capital gains realized by FA 2 on the sale were taxable in its home jurisdiction, albeit at a low rate of tax.

In either of these situations, FA 1 or FA 2 would be able to generate exempt sur­plus with no adverse Canadian tax implications under the FAPI rules, and under the ordering rule in former regulation 5901(1), this surplus could then be repatriated to Canco on a tax-free basis.

Requirement for a disposition “to” a designated person or partnership (pp. 1254-1255)

[R]egulation 5907(2.02) is confined to dispositions of property “to" certain persons or partnerships, and the phrase "disposition to" been interpreted by the courts to effectively mean dispositions by means of a transfer of property by one person to another. [Fn. 60: See, for example, Anderson et al. v. MNR, 74 DTC 1103 (TRB); rev'd on other grounds, sub nom. The Queen v. Huestis, 75 DTC 5042 (FCTD); further appeals dismissed, The Queen v. Huestis, 7 5 DTC 5393 (FCA), and sub nom. Stevenson Construction Co. Ltd. et al. v. The Queen, 77 DTC 5044 (SCC). See also Devon Canada Corporation v. The Queen, 2018 TCC 170. These cases considered the issue in the context of property that ceased to exist under the doctrine of merger in connection with the transfer. As illustrated in the Devon Canada case, the question of whether there is an acquisition of property by the transferee in this circumstance is a separate question from whether there has been a disposition of the property.] Arguably, this would exclude, for example, a deemed disposition and reacquisition of shares arising under the negative adjusted cost base rule in subsection 40(3).

Exclusion of exempt surplus items that are not in exempt earnings (pp. 1255-1256)

…[S]ince regulation 5907 (2.02) focuses on exempt earnings and exempt loss, the other items that are reflected in exempt surplus or exempt deficit are outside the scope of this rule. For 2011 and later periods, these items include

■ exempt surplus dividends received ( or deemed to have been received) from another foreign affiliate;

■ tax refunds or credits received by a shareholder affiliate in respect of exempt surplus dividends received from another foreign affiliate;

■ taxable dividends received by an affiliate from a corporation resident in Can­ada that would be deductible under section 112 if the dividend were instead received by the Canadian taxpayer in respect of which the affiliate is a foreign affiliate;

■ certain amounts in respect of tax payments or tax losses in a consolidated group added under regulation 5907(1.02), (1.1), or (1.2); and

■ certain adjustments under regulation 5905, such as those required under the fill-the-hole rule in regulation 5905(7.2).

Inclusion in exempt earnings of taxable gain already recognized in Canada or abroad (p. 1257)

…[E]xempt earnings include

■ the taxable portion of capital gains from dispositions of capital property used in active business operations that, if the dispositions are internal, have been recognized under foreign tax laws as required by regulation 5907(5 .l); and

■ the non-taxable portion of capital gains where the taxable portion of the cap­ital gain has been included in FAPI, either because the property was not excluded property or, if it was excluded property, because the disposition was subject to one of the rollover rules.

There is no apparent reason from a policy perspective why any of the foregoing should be subject to potential recharacterization under regulation 5907(2.02) given that the taxable portion of the gain has been properly recognized under foreign or Canadian tax rules, as applicable.

Carve-out for money (p. 1258)

…in response to concerns regarding the scope of the version of regulation 5907(2.02) in the 2011 proposals, the Department of Finance added the carve-out for money in regulation 5907(2.02):

A particular concern was expressed in respect of transfers of money in the context of interest payments that are recharacterized as active business income under paragraph 95(2)(a)-income that should normally result in exempt surplus. The application of the surplus reclassification rule to interest payments was not intended.

This exception makes sense from a policy perspective in that inter-affiliate interest payments have the effect of simply moving active business income, and thus exempt earnings, from one foreign affiliate to another and do not generate any additional exempt earnings from the perspective of the particular Canadian taxpayer.

Meaning of deduction from exempt loss (p. 1259)

Regulation 5907(2.02) also potentially applies when a disposition of property gives rise to an amount that is deducted in computing exempt loss. …

… Presumably the word "deduction" was intended to capture positive amounts that, when netted with negative amounts arising in the same year, result in an overall loss that is included in exempt loss. For example, if a foreign affiliate carries on an active business in a designated treaty country that has a loss for a particular year, but subsumed in that loss is an income gain in respect of an internal disposition of property, presumably regulation 5907(2.02) is intended to apply to that income gain.

Assumed tax benefit (p. 1260)

[O]ne is to assume that the increase in exempt earnings (or the decrease in exempt loss) arising from the disposition of property is a tax benefit. This assumed tax benefit was pre­sumably added to counter the argument that the mere addition to exempt earnings (or decrease in exempt loss) is outside the scope of the rule …

Implied surplus conversion object (p. 1263)

[I]t is clear that the mischief that is the intended target of regulation 5907(2.01) is a situation where a foreign affiliate has a balance of low-taxed taxable surplus and disposes of excluded property to generate exempt earnings ( or decrease exempt loss), without the imposition of Canadian income tax, in order to take advantage of the ordering rule and distribute the resulting exempt surplus in lieu of the low-taxed taxable surplus, thereby minimizing Canadian income taxes on the distribution. In light of this, and consistent with the approach adopted by the court in Lehigh Cement, in assessing whether there is a tax benefit, the approach that accords with the purpose of the regulation is a comparison between the tax treatment of a foreign affiliate distribution from a surplus perspec­tive following the disposition of property versus the tax treatment of a distribution if no such disposition of property occurred. If there is a tax benefit arising from the generation and distribution of exempt surplus (factoring in the tax consequences should the disposition of property give rise to FAPI), as compared with a distribution of existing low-taxed taxable surplus, and the purpose test (discussed below) is satisfied, the rule applies to reclassify the new exempt surplus back to the type of surplus that existed prior to the disposition.

…[O]ne would expect that Canadian tax avoidance is a necessary prerequisite to its application and that an increase in exempt earnings (or a decrease in exempt loss) is not enough on its own to engage the rule. A more reasonable interpretation is that the legislative drafters were merely ensur­ing that the rule could apply to dispositions of property that give rise to an increase in exempt earnings (or a decrease in exempt loss) where the exempt surplus balance is not distributed but rather is itself relied on in lieu of low-taxed taxable surplus.

Potential indifference to surplus in bump transaction (p. 1264)

[W]hen effecting a bump transaction, the Canadian taxpayer will often be indifferent as between rely­ing on the bump and relying on the tax-free surplus balance, and may in fact prefer to rely on the bump in order to avoid the time and effort required to ensure that the foreign affiliate surplus balances are accurate and up to date.75 Therefore, purely from a bump perspective, one would expect that there would be limited circum­stances where regulation 5907 (2 .02) could apply.

Primary purpose of the disposition (p. 1264)

Since the disposition is a transaction for the purposes of the avoidance transaction definition, it is clear from the text of this definition that in all cases one is testing the purpose of the disposition, and not the purpose of a series that may include the disposition.

… [A]s noted by the court in Lehigh Cement, the focus of the analysis should nonetheless be the purpose that is the specific target of the anti-avoidance rule under consideration (in this case, regulation 5907(2.02)) and not some other tax-avoidance purpose.

Conclusion (p. 1266)

… On the basis of the legislative history leading up to Bill C-48, it is clear that regulation 5907(2.02) is one of several rules designed to target a specific form of tax avoidance, namely, foreign affiliate surplus-stripping transactions, which involve a disposition of excluded property by a foreign affiliate for the purpose of converting, on a tax-free basis, low-taxed taxable surplus into exempt surplus that can then be repatriated, or otherwise relied on, to minimize Canadian income taxes. A textual, contextual, and purposive interpretation of regu­lation 5907(2.02) supports the view that the rule should apply only in these limited circumstances.

Words and Phrases
disposition to

Paul Barnicke, Melanie Huynh, "Exempt Earnings Anti-Avoidance", Canadian Tax Highlights, (Canadian Tax Foundation), Vol. 23, No. 12, December 2015, p. 5

Application of rule to non-rollover reorgs, cf. fresh start rule (p. 5)

The main target of this anti-avoidance rule may be intercompany excluded-property transfers, but its application can be much broader. It may be possible to consider in this light (1) an FA that pays a dividend in kind; (2) a non-QLAD (qualifying liquidation and dissolution) subsection 88(3) liquidation; and (3) an FA-to-FA liquidation or merger that is not structured as a rollover. One should also ask whether the asset-packaging rule in regulation 5907(2.01) may, in the right circumstances, be caught by regulation 5907(2.02), because, for example, surplus maximization is a stronger motivation than any conditions that were stipulated by the third-party purchaser. Moreover, on the basis of Finance's technical notes, regulation 5907(2.02) may also apply to exempt earnings generated from a deemed disposition of active business assets under the fresh start rules in paragraphs 95(2)(k) and (k.l). However, it is questionable whether the FA's deemed disposition and reacquisition of its asset is considered a disposition of the asset by the FA to itself; a disposition to a person is a precondition of regulation 5907(2.02).

Jenny Li, "The Interaction of the Fresh Start and Surplus Reclassification Rules", International Tax, Wolters Kluwer CCH, April 2014, No. 75, p. 8.

Two conditions under Reg. 5907(2.02) (p. 9)

[T]he "surplus reclassification rule". [fn 5: Regulation 5907(2.02).]…rule reclassifies an amount of exempt earnings as taxable earnings if the following two conditions are met:

  • Condition 1: The amount is an increase in exempt earnings (or a decrease in exempt losses) that arises from a disposition of property (other than money) to a "designated person or partnership". [fn 7: …defined in Regulation 5907(1)]
  • Condition 2: The disposition is a transaction that is an "avoidance transaction as defined in section 245… .
Example of FA of Canco ("USSub") switching to s. 95(2)(a)(ii) licensing business (p.9)

In 2014, USSub decides to change its business from producing and selling its energy food bars to licensing its "secret" recipe. The primary licensee of the secret recipe will be a company related to USSub. Under subparagraph 95(2)(a)(ii) of the Tax Act, the future income of USSub will be deemed to be active business income and thus classified as exempt surplus. This strategy shift is in response to business and economic conditions in the United States. This strategy shift will cause USSub's business to change from an active to a passive business. [fn 8: USSub's business will be an "investment business" as defined in subsection 95(1) because, among other reasons, its business of licensing property will be principally carried on with non-arm's length persons.]

Boosting of USSub exempt surplus under fresh start rule (p.9)

Under the fresh start rules [in ss. 95(2)(k) and (k.1)], USSub will be deemed to have disposed of and reacquired its assets used in the business at their fair market value at December 31, 2013. A potentially large amount of exempt surplus could be created when the fictional tax reset button is pushed. The assets will be stepped-up to fair market value and subsequently amortized, thereby reducing the exempt surplus of USSub.

Should the surplus reclassification rule re-characterize this exempt surplus as taxable surplus in these circumstances?

Application of Reg. 5907(2.02) 1st condition (disposition "to") (p.10)

Has an increase in exempt earnings arisen from a disposition of property to a "designated person or partnership"? ...[T]he fresh start rules do not explicitly deem USSub to have disposed of its property to any person in particular. Rather, the rules only provide that there is a deemed disposition and a deemed re-reacquisition of such property… .

[T]he Technical notes…stated that: …any exempt earnings that are otherwise created by these rules are subject to the new anti-avoidance rule in subsection 5907(2.02)….

Clearly, the government intended a deemed disposition and reacquisition under the fresh start rules to be within the ambit of regulation 5907(2.02). Whether this position is correct is unclear… .

Application of Reg. 5907(2.02) 2nd condition ("avoidance transaction") (p.10)

What about the primary purpose?...USSub clearly changes its business for bona fide business reasons and not to obtain a tax benefit (e.g., to generate exempt surplus). In some cases, this may not be so clear… .

[E]ven if a possible tax benefit is realized, the intent of USSub was not to accelerate or create exempt surplus in order to repatriate cash to Canada…The absence of excess cash that cannot be repatriated due to a lack of exempt surplus in USSub could support the position that the transaction (i.e., the change in business) was not undertaken to realize a tax benefit.…

Subsection 5907(2.03)

Administrative Policy

22 January 2013 External T.I. 2012-0460121E5 - Computation of "earnings" of a foreign affiliate

no double deduction on switch to Canadian computation

In taxation year X, the tax regime in Forland changes so that FA ceases to be required under the income tax law of Forland to compute its income or profit from its active business, and instead becomes subject to a flat rate of tax based on its gross revenue, so that FA commences to be required under (a)(iii) of the definition of "earnings" in Reg. 5907(1) to compute its income under Canadian principles. CRA was asked whether FA would be required to deduct, in taxation year X and subsequent taxation years, amounts that it had previously deducted in computing its earnings in taxation years preceding taxation year X for which its calculation of earnings had been made in accordance with the income tax law of Forland. For example, if the cost of a depreciable capital property used by FA in its active business had already been fully depreciated under Forco's income tax laws in the prior years, would the cost of the same asset be required to be claimed again in computing the earnings under Canadian principles in taxation year X pursuant to proposed Reg. 5907(2.03), having regard to the requirement therein that such earnings be computed as if FA had "claimed all deductions that it could have claimed under the Act, up to the maximum amount deductible in computing [FA's] income."

In responding, CRA stated that in applying proposed Reg. 5907(2.03) in respect of the particular taxation year:

any deduction claimed by the affiliate in computing its earnings or loss from that business, in any taxation year of the affiliate that began on or before the commencement of the particular taxation year and for which the earnings or loss from that business had been determined under subparagraph (a)(i) or (ii) of the definition "earnings" in subsection 5907(1) of the Regulations, would be considered to have been actually claimed under the Act and to be within the maximum amount deductible.

Articles

Michael W. Colborne, "Regulation 5907(2.03) and Offshore Metal Streams", Resource Sector Taxation, Volume IX, No. 2, 2013, p. 647.

Description of offshore metal streams transactions (pp. 647-8)

While a detailed description of offshore metal streams transactions is beyond the scope of this article, a brief description of the typical, or base-case, "offshore" transaction is warranted. The usual situation involves a Canadian parent company that owns a foreign affiliate ("Mineco"), which has a mineral project under development in a foreign country. Mineco enters into an off-take contract for the sale of metal at spot prices with another foreign affiliate ("Saleco") of the Canadian parent, which is resident in a low or no-tax jurisdiction. Saleco in turn enters into a metal stream agreement with an arm's length third party, under which Saleco agrees to sell a metal to the third party under certain terms and conditions. One of the terms is that the third party is required to advance money to Saleco as a deposit, which deposit is reduced and applied as part payment for metal to be delivered by Saleco (the amount of deposit so applied is the difference between the spot price that day and a specific fixed amount for each unit of metal).

This structure is intended to allow the upfront deposit to escape foreign taxation in the country in which Mineco operates because Mineco does not receive the upfront deposit as proceeds from the metal sale. Instead, the upfront amount will usually find its way from Saleco by way of equity or debt investment by the Canadian parent.

Treatment before Reg. 5907(2.03) (p. 648)

Absent subsection 5907(2.03) of the Regulations, provided Saleco is resident in, say the Cayman Islands, it would compute its earnings from an active business using Canadian rules by reason of subparagraph (a)(iii) of the definition of "earnings." Assuming typical terms to the metal stream agreement, in computing earnings, Saleco would be required to include the amount of the upfront deposit in income under paragraph 12(1)(a) and would be entitled to claim a reasonable reserve in respect of that amount for goods to be delivered after the end of the year pursuant to paragraph 20(1)(m). However, Saleco would not claim the deduction under paragraph 20(1)(m) so as to allow it to add the entire amount of the deposit to its earnings from an active business. Thus, the deposit could be distributed by Saleco to the Canadian parent by way of dividend in accordance with the usual rules in Part LIX of the Regulations. This would allow the Canadian parent to invest the money downstream in Mineco, which for foreign tax reasons is often much more desirable than having Saleco make the investment in Mineco.

Effect of Reg. 5907(2.03) (p. 648)

Regulation 5907(2.03) curtails this result because it requires Saleco to claim the maximum amount of a reserve under paragraph 29(1)(m) of the Act in computing Saleco's earnings. Thus, Saleco cannot distribute the cash on hand to its Canadian parent by way of dividend. If it has none of the balances described in subsection 90(9) of the Act (typically not), then it is unlikely that Saleco will be able to loan the money upstream unless it was certain it could be repaid within the two-year period required by paragraph 90(8)(a) of the Act.

Subsection 5907(2.1)

Administrative Policy

8 October 2010 Roundtable, 2010-0373661C6 F - Calcul de surplus et NIIF

IFRS statements can only be used if prepared in accordance with local laws

Could the financial statements prepared in accordance with IFRS by a subsidiary of a Canadian public corporation be used with respect to the election under ITR subsection 5907(2.1)? CRA responded:

[T]he financial statements of a foreign affiliate prepared under IFRS could only be used for the purposes of ITR subsection 5907(2.1) ITR if they were financial statements prepared in accordance with the laws of the country in which the corporation resides.

2019 Ruling 2018-0762581R3 - Foreign Affiliate Reorganization

Reg. 5907(5.1) applicable to pre-wind-up transfer on a foreign tax law rollover basis

In order to wind-up CFA2 into CFA1 (which is directly held by Canco), CFA2 will first distribute its retained earnings and then sell its assets at their book value (i.e., for less than their FMV) in exchange for a promissory note of CFA1 and the assumption of liabilities, with that note then being extinguished as a result of its assignment to CFA1 on the formal liquidation of CFA2. The asset transfers by CFA2 to CFA1 will occur on a rollover basis under the foreign tax law.

CRA ruled that Reg. 5907(5.1) will apply to the disposition by CFA2 of its capital property to CFA1 pursuant to the Proposed Business Transfer. In its summary, CRA stated:

No gain or loss is recognized on the transfer of the capital assets under the relevant foreign income tax law, and the other conditions provided in subsection 5907(5.1) of the Regulations are met.

Locations of other summaries Wordcount
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(2) - Paragraph 5907(2)(f) Reg. 5907(2)(f) does not apply where inventory is transferred on a foreign rollover basis 333
Tax Topics - Income Tax Act - Section 15 - Subsection 15(1) no s. 15(1) application to sale of assets of CFA2 to CFA1 at NBV preliminarily to wind-up 76

Articles

Albert Baker, David Bunn, "FAs and the Repeal of the ECP Regime", Canadian Tax Highlights, Vol. 24, No. 9, September 2016, p. 4

Repeal of ECP regime will affect the consequences of the election (p. 4)

Assume for instance that a US business is acquired by an FA of a Canadian taxpayer in an asset deal and that goodwill is a significant portion of the acquisition. Because goodwill is amortized for US tax purposes on a straightline basis over 15 years but is generally carried at historical cost for the purposes of financial statements, the benefit of following accounting rules rather than tax rules may be significant if there has been no impairment. At the same time, the opposite could be true if a significant impairment was recognized for accounting purposes in a subsequent year before the purchased goodwill was the subject of an equivalent amount of amortization for tax purposes.

An election under regulation 5907(2.1) has retroactive effect and can never be revoked: therefore, the decision whether to make an election requires careful consideration. The repeal of the ECP regime not only will have an impact on a taxpayer that is deciding whether to make an election under regulation 5907(2.1), but also may have an impact on a taxpayer that already made an election at a time when purchased goodwill was not a relevant consideration.

Paul Dhesi, Korinna Fehrmann, "Integration Across Borders", Canadian Tax Journal, (2015) 63:4, 1049-72

Advantage of book depreciation election (p.1071)

[A]n election is available under regulation 5907(2.1) to use book depreciation rather than tax depreciation deducted under foreign tax law in computing income from an active business in respect of the foreign affiliate. Particularly in the case of jurisdictions where accelerated depreciation deductions are permitted, a foreign affiliate's ability to pay dividends from exempt surplus may be decreased as a result of this reduction in taxable income and thus earnings….

This is relevant for the determination of a foreign affiliate's tax-free surplus balance as well since the computation does not make adjustments for temporal differences, including depreciation….

Subsection 5907(2.6)

Administrative Policy

1 March 1991 Memorandum (Tax Window, No. 2, p. 18, ¶1185)

The election cannot be filed late.

Subsection 5907(2.7)

Administrative Policy

27 January 2017 External T.I. 2013-0482351E5 - Clause 95(2)(a)(ii)(D)

loan prepayment penalty fully deducted from surplus when paid

CRA indicated that where a loan from one controlled foreign affiliate (FA Finco) of Canco to a second CFA of Canco (FA Holdco) meets the conditions in s. 95(2)(a)(ii)(D), a prepayment penalty paid by FA Holdco to FA Finco also can be recharacterized as active business income by s. 95(2)(a)(ii)(D) if the penalty is first recharacterized as interest under s. 18(9.1)(e). CRA then stated:

[E]ven though subsection 18(9.1)… generally defer the deduction by the payer of the penalty of a portion of the amount of such penalty to a future year, [Reg.] 5907(2.7)…ensures that…the entire amount of penalty is deducted from the payer’s earnings or loss from an active business in the year in which the amount is paid. Therefore…the possible increase of FA Finco’s surplus balance will be accompanied by the corresponding reduction of FA Holdco’s surplus balance in the year the amount is paid.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 95 - Subsection 95(2) - Paragraph 95(2)(a) - Subparagraph 95(2)(a)(ii) - Clause 95(2)(a)(ii)(D) s. 95(2)(a)(ii)(D) can recharacterize a loan prepayment penalty as active business income 434
Tax Topics - Income Tax Act - Section 18 - Subsection 18(9.1) s. 18(9.1) applied where loan prepayment penalty was equal to PV of interest thereon 174

25 April 1995 T.I. 942987 (C.T.O. "6363-1 Foreign Affiliates Deemed ABI")

Where one U.S. subsidiary ("B") of a Canadian corporation lends money on an interest-bearing basis to a second U.S. subsidiary ("C") of the Canadian corporation and the interest is added to the cost of C's inventory for U.S. tax purposes, Regulation 5907(2.7) will require the interest to be deducted by C in computing its earnings from an active business in the year the interest first becomes paid or payable. When the inventory is sold, the earnings of C from an active business will be adjusted upwards.

Subsection 5907(5)

Articles

Philippe Montillaud, Grant J. Russell, "Foreign Accrual Tax and Flow-through Entities", International Tax Planning, Volume XVIII, No. 4, 2013, p. 1280

Application of s. 93(2.01) stop-loss rule to DLAD capital loss (p. 1282)

Regulation 5907(5) requires that capital gains and losses for surplus purposes are to be calculated in accordance with the rules in subsection 95(2) of the Act, which rules obviously include paragraph 95(2)(e). The reference to subsection 93(4) in the Regulation's definition of "hybrid surplus," however, makes clear that recourse should also be had to other relevant rules in the Act, including the stop loss rule in subsection 93(2). Subsection 93(2), in combination with newly introduced subsection 93(2.01), provides that any loss realized by a Canadian resident corporation or a foreign affiliate of the corporation on the disposition of a share of a foreign affiliate must be reduced by the total of any "exempt dividends" received or deemed to have been received on the share by the corporation or affiliate prior to the disposition. Accordingly, where a shareholder affiliate's capital loss on a DLAD is otherwise recognized for the purpose of calculating an affiliate's hybrid surplus, the loss is nevertheless reduced under subsections 93(2) and (2.01) by the amount of any exempt dividends previously paid on the shares of the disposing affiliate. An "exempt dividend" is defined in subsection 93(3) and generally refers to a dividend that is deductible from a Canadian-resident corporation's income under section 113 of the Act.

Example showing reduction of DLAD capital loss by exempt dividend (p. 1282)

Consider the following example:

  • FA1 owns all the shares of FA2, which shares have an adjusted cost base of $100.
  • FA2 has only one asset ("Asset"), which Asset has an adjusted cost base and fair market value of $100; the Asset is not an "excluded property" within the meaning assigned under subsection 95(1).
  • FA2 has $100 of exempt surplus.
  • FA2 distributes the Asset by way of an exempt dividend to FA1.
  • FA2 is then liquidated on a DLAD.

Save for subclause 95(2)(e)(iv)(A)(II)1, FA1 would realize a capital loss on the disposition of FA2's shares equal to their cost basis of $100. This loss is recognized for hybrid surplus purposes, but is nevertheless deemed nil because of the $100 exempt dividend paid prior to the DLAD. Accordingly, no amount in respect of the loss is included in FA1's hybrid surplus calculation.

Subsection 5907(5.1)

Subsection 5907(6)

Administrative Policy

10 October 2014 APFF Roundtable Q. 24, 2014-0538181C6 F - 2014 APFF Roundtable, Q. 24 - Surplus accounts calculation

criteria for determining whether use by FA of Cdn$ presents fair picture of surpluses

Reg. 5907(6) was amended for taxation years commencing after 18 December 2009 to eliminate a prohibition against maintaining surplus accounts of a foreign affiliate in Canadian dollars. (a) What are the criteria which CRA applies to determine if it is reasonable to maintain the surplus accounts in Canadian dollars or a foreign currency other than the currency of the affiliate's residence, or to change the currency? (b) For surplus accounts of foreign affiliates calculated in the foreign currency of a particular country before the amendments, does CRA accept that the balance as at December 18, 2009 is converted to Canadian currency at the exchange rate on that date and that the surplus accounts are then maintained in Canadian currency? CRA responded (TaxInterpretations translation):

(a) As indicated in response to question 7 at the Corporate Management Tax Conference Roundtable of the Canadian Tax Foundation in 1992, there is no hard and fast rule for determining what, in a particular situation, is considered reasonable respecting the choice of a currency in which the surplus accounts of a foreign affiliate are to be maintained for purposes of ITR subsection 5907(6). Those comments remain relelvant notwithstanding the amendments…[which] essentially…had the effect of adding the possibility of using Canadian currency, to the extent it is reasonable to do so.

…A number of criteria may apply in determining if it is reasonable to use the Canadian dollar…such as…the principal currency in which the corporation maintains its books and registers for purposes of presenting its financial results, the currency generally used in conducting its commercial transactions in the country in which it carries on business, and the currency which it uses for taxation purposes in the country of its residence. If an examination of these criteria, as well as others considered to be appropriate, permits a determination that use of the Canadian dollar presents a fair picture ["image juste"] of the surplus account balances of the foreign affiliate, we will consider that such use is reasonable in the circumstances.

(b) Provided that the use of the Canadian dollar is reasonable in the circumstances and that there is no retroactive tax planning involved, we will accept that the surplus account balances of a foreign affiliate for its taxation years terminating before the entry into force of the amendments effected by the 2012 Act [on 26 June 2013] are to be converted into Canadian dollars using the "relevant spot rate," as that expression is defined in subsection 261(1), at the first day of the first taxation year of the foreign affiliate commencing after 18 December 2009… . Generally, we would not consider that retroactive tax planning is involved if the taxpayer advised us in writing well in advance of the time of the preparation of the accounts for the purposes of a determination… .

Brian Darling, "Revenue Canada Perspectives" in Income Tax and Goods and Services Tax Considerations in Corporate Financing, 1992 Corporate Management Tax Conference Report (Canadian Tax Foundation, 1993), 5

1-20, question 7, at 5:13:

[w]hat is reasonable in the circumstances can be determined on a case-by-case basis. There are no hard-and-fast rules. In our view, the use of a particular currency in presenting an affiliate's financial statements or for denominating shares or loans does not, by itself, constitute a reasonable basis for using that currency as the "calculating currency." Where a particular currency has become a generally accepted currency for conducting business in a country, such currency may be considered "reasonable in the circumstances," notwithstanding that some other currency is the official currency of that country. As well, the currency that is used for income tax purposes in the foreign jurisdiction would normally be considered "reasonable in the circumstances."

Subsection 5907(10)

Administrative Policy

The Queen v. Old HW-GW Ltd., 93 DTC 5199 (FCA)

Because Puerto Rico was a country distinct from the United States for purposes of paragraphs (b) and (c) of Regulation 5907(10), it followed given that Puerto Rico was excluded from the listed countries in Regulation 5907(11), that it was a country for purposes of paragraph (a). The subsequent references in paragraphs (b) and (c) were to "that" country or "such" country. Accordingly, a Puerto Rican tax incentive which was designed to promote sales in the continental U.S. was an "export incentive".

Subsection 5907(11)

Administrative Policy

1 May 2009 CLHIA Roundtable Q. 4, 2009-0316641C6 - CLHIA Round Table Question #4 - TIEAs

In order for income from an active business carried on by a foreign affiliate to qualify as 'exempt earnings', the affiliate must be resident in a designated treaty country under common law and the active business must be carried on by it in a designated treaty country. Accordingly, if the central management and control of a foreign affiliate is in Country A (a non-treaty country) and it carries on business only in Country B (also a non-treaty country), it would be necessary for Canada to have a TIEA with both countries. Conversely, if the foreign affiliate was incorporated in Country A but not resident there under common law definitions, and was resident in Country B at common law and also carried its entire business on in Country B, it would only be necessary for a TIEA to be entered into with Country B.

7 June 1991 T.I. (Tax Window, No. 4, p. 31, ¶1285)

St. Vincent includes the Grenadine Islands of the Bequia, Mustique, Canouan, Mayreau, Union Island and associated islets which are under the jurisdiction of the St. Vincent government.

Articles

Nathan Boidman, "Canada's Two-Faced TIEAs - Netherlands Antilles Trumps Bermuda", Tax Notes International, Vol. 55, No. 12, September 21, 2009, p. 1023.

Subsection 5907(11.2)

Administrative Policy

24 May 2018 External T.I. 2017-0710641E5 - Interest Charge Domestic International Sales Corp

U.S. IC-DISC is “resident” of the U.S. for Treaty purposes as the U.S. asserts its jurisdiction to tax and grants benefits only on continued meeting of conditions

A Canadian resident public corporation (“Canco”) indirectly owns all of the issued and outstanding shares of a U.S. resident subchapter C corporation (“USco”), which exports products manufactured in the U.S. Canco incorporates a wholly-owned subchapter C corporation (“Newco”), whose central management and control is in the U.S. Newco elects to be treated as an “Interest Charge Domestic International Sales Corporation” (“IC-DISC”) under the Internal Revenue Code (the “Code”) and would meet all the statutory requirements related to minimum capital, holding qualified export assets, and earning qualified export income to qualify as such in the year it elects to be treated as an IC-DISC and in subsequent years.

Newco would operate either as a buy-sell IC-DISC (purchasing the goods from USco at a discount ) or a commission IC-DISC (acting as a commissioned selling agent of USco). Would the active business earnings of Newco qualify as earnings of a “resident” of the U.S., viewed as a designated treaty country? CRA first indicated:

[W]here a person’s worldwide income is subject to a particular Contracting State’s full taxing jurisdiction but that Contracting State’s domestic law does not levy tax on the person’s taxable income … we will generally accept that the person is a resident of that Contracting State unless the arrangement is abusive … [e.g., it] is placed within the taxing jurisdiction of the particular Contracting State in order to gain treaty benefits in a manner that does not create any material economic nexus to that Contracting State… .

CRA then stated:

[T]he U.S. asserts its jurisdiction to tax an IC-DISC on its worldwide income based on its place of incorporation. The U.S. then exercises its discretion to grant the benefits of the IC-DISC tax regime only up to certain limits, provided an IC-DISC continues to meet specified conditions for the tax exemption.

…Newco, an entity tht is managed and controlled in the U.S. would be regarded as being “liable to tax” in the U.S. and thus a resident of the U.S. under the Treaty. Newco would therefore be considered a resident of a designated treaty country as defined in subsection 5907(11) ... and would not be considered not to be resident in a designated treaty country pursuant to paragraph 5907(11.2)(a) ... .

Locations of other summaries Wordcount
Tax Topics - Income Tax Regulations - Regulation 5907 - Subsection 5907(1) - Exempt Earnings - Paragraph (d) CMC of FA must be in the DTC and it must be liable to tax therein (albeit, may be conditionally exempted) 214
Tax Topics - Income Tax Act - Section 250 - Subsection 250(5) whether a corp resident in the U.S. for Treaty purposes is deemed to be resident there for ITA purposes 38

2013 Ruling 2013-0477871R3 - 5900(1)(a) and dividends from foreign affiliate

dividends from Malaysian offshore company

Background

A non-resident subsidiary (ForeignHoldco) of a taxable Canadian corporation (Parent) made a non-interest-bearing loan (the Loan) to parent following a liquidation and dissolution (to which Reg. 5907(7) applied) of a Labuan subsidiary of ForeignHoldco (LabuanOpco). LabuanOpco was incorporated under the Offshore Companies Act 1990 (Malaysia) and was resident in Malaysia. Rather than being subject to income tax under the Malaysian Income Tax Act 1967, it was required under the Labuan Offshore Business Activity Tax Act 1990 (Malaysia) to pay 3% of its net income (except for a year in which it elected to pay a flat tax of MYR 20,000), on the basis that such income was from an offshore business activity carried on in a foreign currency in or from Labuan. Such activity was an active business for the purposes of Reg. 5906(1)(a). Immediately prior to the dividends paid to ForeignHoldco in connection with or prior to the liquidation of LabuanOpco, the total of all of the net earnings of LabuanOpco for its preceding years from the active business carried on by it in Malaysia, net of any prior dividends, was equal to or exceeded the amount of those dividends.

Proposed transactions

In order for Parent to settle the Loan:

  1. ForeignHoldco will declare a dividend equal to the amount outstanding on the Loan at that time, to be paid by the issuance of a non-interest bearing promissory note payable on demand.
  2. The promissory note will be transferred by Parent to ForeignHoldco in payment of the outstanding amount of the Loan.
Ruling

: For the purposes of applying the surplus rules to the proposed dividend to Parent, the amount of ForeignHoldco's surplus balances:

in respect of Parent will be determined on the basis that each of the dividends received by ForeignHoldco from LabuanOpco were prescribed by paragraph 5900(1)(a) of the Regulations to have been paid out of LabuanOpco's exempt surplus in respect of Parent.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 90 - Subsection 90(14) repayment by set-off against dividend 87

10 November 1997 T.I. 971117

A Barbados corporation that had International Business Corporation status in Barbados and that was ineligible for any tax benefit under the Canada-Barbados Income Tax Convention by virtue of Article XXX(3) thereof would qualify as a resident of a designated treaty country under Regulation 5907(11.2) if it was, in fact, liable to tax in Barbados on its worldwide income.

1997 A.P.F.F. Round Table , Q. 3.5, No. 9M19020

"Under the IBC Act, a corporation that is not incorporated under the laws of Barbados in which it has a branch that qualifies as an IBC, is liable for Barbados tax only with respect to the income attributable to its Barbados branch. The Department is of the view that such a corporation would not be a resident of Barbados for purposes of the tax convention because it is not liable for tax on its world income."

27 October 1997 T.I. 970470

A foreign affiliate ("USCO") that was incorporated in the U.S. but operates in Mexico through a branch and has its central management and control in Mexico will not have its earnings derived from its active business included in its exempt surplus as it will not qualify as resident in Mexico under Regulation 5907(11.2).

17 February 1997 T.I. 961753

The ten-year tax holiday for Barbados Enclave Enterprises would not, by itself, disqualify them from being considered as being resident in Barbados.

Locations of other summaries Wordcount
Tax Topics - Treaties - Income Tax Conventions - Article 4 61

8 March 1996 T.I. 960067

A foreign affiliate incorporated in Barbados and licensed under the Exempt Insurance Act, 1983 will not be considered to be "liable to taxation" in Barbados given that its main and, most likely, source of income will effectively be exempt from taxation in Barbados for a guaranteed period of 30 years with the exception of amounts, which although expressed as an income tax, in substance represent an annual licence fee of Bds. $5,000.

Locations of other summaries Wordcount
Tax Topics - Treaties - Income Tax Conventions - Article 4 69

1996 Corporate Management Tax Conference Round Table, Q. 3

Because the term "resident in a designated treaty country" is not defined, a company must be resident in a designated treaty country under Canadian common law principles in addition to not being deemed not to be a resident of that country under Regulation 5907(11.2).

Paragraph 5907(11.2)(b)

Articles

Tina Korovilas, Drew Morier, "Non-Corporate Vehicles in the Foreign Affiliate Context", 2018 Conference Report (Canadian Tax Foundation), 20:1 – 114

LLCs can generate exempt earnings (pp. 20:10-11)

[T]he fundamental requirement—established in paragraph (d) of the “exempt earnings” definition in regulation 5907(1)—is that the FA be resident in a designated treaty country (DTC)….

[I]n the case of a treaty country, DTC residence for surplus purposes will exist only where the FA is resident in the country for both common-law and tax treaty purposes.

[F]iscally transparent entities, such as LLCs, are generally not considered treaty residents. However, such entities are accommodated by the residence rules applicable for FA surplus purposes. Under regulation 5907(11.2)(b), an FA will qualify as a treaty resident of a country if it would be resident in that country if treated as a body corporate for the purpose of income taxation in that country. An LLC, if it were treated as a body corporate for US income tax purposes, would be a resident in the United States under the Canada-US treaty. Thus, an LLC may qualify as a DTC resident for FA surplus purposes provided that it is resident in the United States under common-law principles.

Locations of other summaries Wordcount
Tax Topics - Income Tax Act - Section 96 122
Tax Topics - Income Tax Act - 101-110 - Section 104 - Subsection 104(1) 111
Tax Topics - General Concepts - Ownership 245
Tax Topics - Income Tax Act - Section 90 - Subsection 90(1) 99
Tax Topics - Income Tax Act - Section 93.1 - Subsection 93.1(2) - Paragraph 93.1(2)(a) 120
Tax Topics - Income Tax Act - Section 93.1 - Subsection 93.1(2) - Paragraph 93.1(2)(d) - Subparagraph 93.1(2)(d)(i) 80
Tax Topics - Income Tax Regulations - Regulation 5901 - Subsection 5901(2) - Paragraph 5901(2)(b) 91
Tax Topics - Income Tax Act - Section 93 - Subsection 93(1.3) 168
Tax Topics - Income Tax Act - Section 95 - Subsection 95(1) - Excluded Property - Paragraph (e) 155
Tax Topics - Income Tax Act - Section 95 - Subsection 95(1) - Excluded Property - Paragraph (a) 368
Tax Topics - Income Tax Act - Section 95 - Subsection 95(1) - Excluded Property - Paragraph (c) 290
Tax Topics - Income Tax Act - Section 95 - Subsection 95(2) - Paragraph 95(2)(y) 64
Tax Topics - Income Tax Act - Section 95 - Subsection 95(2) - Paragraph. 95(2)(z) 332
Tax Topics - Income Tax Act - Section 95 - Subsection 95(2) - Paragraph 95(2)(a) - Subparagraph 95(2)(a)(ii) - Clause 95(2)(a)(ii)(B) - Subclause 95(2)(a)(ii)(B)(II) 169
Tax Topics - Income Tax Act - Section 95 - Subsection 95(2) - Paragraph 95(2)(a) - Subparagraph 95(2)(a)(ii) - Clause 95(2)(a)(ii)(D) 688
Tax Topics - Income Tax Act - Section 94 - Subsection 94(1) - Exempt Foreign Trust - Paragraph (h) - Subparagraph (h)(ii) - Clause (h)(ii)(C) 615

Subsection 5907(13)

Administrative Policy

3 October 2000 External T.I. 1999-001556 -

In a situation where a foreign affiliate continues into Canada, the Agency indicated that although s. 128.1(1)(b) "may deem certain dispositions to have occurred, generally no income or profits tax would actually have been paid by the affiliate in respect of such deemed disposition. As a result, no amount of notional tax (in respect of such deemed dispositions) would be included in the 'underlying foreign tax' of the affiliate and hence would not be reflected in the 'taxable earnings' or 'taxable surplus' of the affiliate for purposes of paragraph 5907(13)(a) of the Regulations".

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