News of Note

CRA finds that compliance with the arm’s length standard does not oust the FAPI base erosion rules

A Canadian public company received and paid for R&D work done for its benefit by direct and indirect wholly-owned U.S. subsidiaries. It unsuccessfully argued that the fee income to these subsidiaries was not foreign accrual property income to it under s. 95(2)(b)(i)(A) because the fees paid by it satisfied the arm’s length standard in s. 247(2). The Rulings Directorate stated:

Paragraph 95(2)(b), as well as the other FAPI base erosion rules under paragraphs 95(2)(a.1) to (a.4), were enacted before the current transfer pricing rules … [and] we see no inconsistency and no operational conflict in the combined application of these two sets of rules … .

They also noted that there were issues to address in determining whether and to what extent the Canadian company would be entitled to a foreign accrual tax deduction for U.S. taxes of the subsidiaries, but that it was premature to address those issues given the stage of the file.

Neal Armstrong. Summaries of 1 February 2018 Internal T.I. 2016-0671921I7 under s. 95(2)(b)(i)(A), s. 95(3)(b), s. 95(3)(d) and Reg. 5907(1.3).

CRA expands on the distinction between recognized and incidental product sales re the 90% business income (a.k.a. business revenue) test for an excluded share

Under the split income proposals, dividends or gains from “excluded shares” are excluded from the tax on split income. Subpara. (a)(i) of the excluded share definition requires that less than 90% of the corporation’s "business income" be from the provision of services, and para. (c) requires that "all or substantially all of the income" of the corporation be not derived directly or indirectly from related businesses.

CRA has now provided to STEP Canada its official responses to the questions posed to it at the May 2018 STEP Roundtable. In its response to Q.5 on the above definition, CRA confirmed its previous oral response that references to “business income” and “income” are to gross income rather than net income.

It also expanded (as compared to its oral response) on its views on when it will regard product sales as “real” for purposes of the 90% business income test, stating:

Where a corporation has income from the provision of both services and non-services (including a service business that also involves a sale of property such as a business carried on by plumbers, mechanics or other contractors that sell replacement parts or building materials), the income from the provision of services and non-services should be computed separately and the non- service income should generally be taken into account in determining whether shares of a corporation are excluded shares of an individual unless such income can reasonably be considered to be necessary but incidental to the provision of the services (for instance as would be the case in an office cleaning service if it billed separately for the cleaning supplies used).

The distinction between the plumber who sells a replacement toilet and an office cleaning service that purports to charge separately for its cleaning supplies may indicate that CRA will ignore separate product charges when they are contrived.

Neal Armstrong. Summary of 29 May 2018 STEP Roundtable, Q.5 under s. 120.4(1) – excluded share.

CRA releases its English and French-language interpretations on the valuation of professionals’ WIP

In early May, we published, translated and summarized a May 1, 2018 letter of the Rulings Directorate to the APFF respecting the measurement of the work-in-progress of the listed types of professionals, CRA indicated inter alia that:

  • If the professionals choose to follow the direct cost rather than absorption costing method in determining the cost of their WIP, they will not be required to include the costs of fixed overheads such as rent.
  • The cost of their WIP will include payroll costs including benefits but will not include any value of partner time.
  • For most professionals, the lower of cost and FMV will be cost determined on this basis. However, in the case of personal injury lawyers and others earning income on a contingency fee basis, their WIP will generally be valued under s. 10(4)(a) at “the amount that can reasonably be expected to become receivable in respect thereof after the end of the year,” i.e., nil.

CRA has now released that APFF letter as well as an English version (also dated May 1, 2018) of what is essentially the same letter. We have retained our own translation of the APFF letter, as the English letter might also be a translation.

Neal Armstrong. Summaries of 1 May 2018 letter to APFF, 2017-0709101E5 F, essentially repeated in 1 May 2018 External T.I. 2018-0743031E5, under s. 10(5)(a) and s. 10(4)(a).

Leekes Ltd. – Court of Appeal of England and Wales finds that the ability of successor to apply predecessor losses to income from the same trade did not extend to profits from an enlarged trade

A British taxpayer (Leekes) carrying on a retail trade through four stores acquired, for nominal consideration, all the shares of another company (Coles) carrying on a similar retail trade through three stores, and then effectively wound-up Coles so as to carry on the operations of the three former Coles’ stores directly. At issue was whether a provision - which provided that Leekes (viewed as the successor to the Coles’ trade) could deduct any amount for which the predecessor (Coles) would have been entitled to relief if it had continued to carry on the trade - permitted Leekes to deduct its losses from continuing to carry on the three former Coles’ stores from its profits from operating its four “old” stores.

In finding that such relief was unavailable, Henderson LJ stated:

[T]he words "the trade" can only refer to the trade previously carried on by Coles. They cannot refer to the enlarged trade carried on by Leekes, because that trade had never been carried on by Coles, and Coles cannot therefore be deemed to have continued to carry it on. … [I]t is necessary to ascribe a deemed continuity to the former trade of Coles, although it now forms part of the merged business carried on by Leekes, and relief may only be obtained if and to the extent that Leekes then derives trading income from the former Coles trade.

ITA s. 111(5)(a)(ii) provides a somewhat generous test for carrying forward losses from a streamed business and deducting them from profits from a similar business as described in s. 111(5)(a)(II)(B). In most circumstances, an expanded business would qualify as a similar business, so that it would be unnecessary to address any relevance of the distinction drawn in the above case between the core of the business that is a continuation of that which was previously carried on, and the expanded component of that business (that had been a separate person's business).

Neal Armstrong. Summary of Leekes Ltd v HM Revenue & Customs, [2018] EWCA Civ 1185 under s. 111(5)(a)(ii).

Income Tax Severed Letters 18 July 2018

This morning's release of three severed letters from the Income Tax Rulings Directorate is now available for your viewing.

Patterson Dental – Tax Court of Canada finds that a zero-rating for epinephrine did not include a drug containing epinephrine

The taxpayer did not charge GST on its sales of anesthetic solutions containing epinephrine to dentists on the basis that it was making a supply of a drug that was “epinephrine.” However, the epinephrine had no anesthetic effect and instead acted as a vasopressor to prolong the duration of the local anesthetic.

Favreau J found that the zero-rating in Sched. VI, Pt. I, s. 2(e) was not available in part based on a distinction drawn by him between “drugs which have epinephrine as their sole active ingredient” and “those that have epinephrine combined with another active ingredient, such as the anesthetics in issue.” He also was influenced by Finance’s Technical Notes, which indicated that the drugs intended to be covered by s. 2(e) were “designed to serve as an emergency relief for patients suffering from major death threatening conditions.”

Neal Armstrong. Summary of Patterson Dental Canada Inc. v. The Queen, 2018 TCC 131 under ETA Sched. VI, Pt. I, s. 2(e).

J.B. – Court of Quebec finds that an unsigned layperson’s agreement qualified as a written separation agreement

Dortélus J found that a separation agreement drafted by the taxpayer’s husband in mangled English and which she did not sign nonetheless qualified as a “written separation agreement” for purposes of the Quebec equivalent of s. 160(4) given that she agreed with its basic terms and he thereafter complied with their agreement that he would transfer a ½ interest in some real estate to her in satisfaction of her claims for support. The husband also was found to be living “separate and apart” from her at the time, as also required by s. 160(4), even though he was spending some time in her basement to help ease the shock of the transition with their children.

Consequently, his tax debt did not flow through to her as the transferred property was deemed to have a nil value.

Neal Armstrong. Summary of J.B. v. Agence du revenu du Québec, 2018 QCCQ 4200 under s. 160(4).

Rocco Gagliese Productions – Tax Court of Canada finds that royalties generated by a CCPC from writing TV-episode music were active business income

A company which earned royalties from the daily activities of its sole shareholder and employee in writing and producing music for TV episodes was found to be earning income from an active business and not earning income from a specified investment business. D’Arcy J stated:

The principal purpose of the Appellant’s business was to earn income from Mr. Gagliese’s daily activities of originating and recording music tracks for individual television episodes. As Mr. Gagliese testified, if you take away his daily writing activities, the Appellant earned little or no income.

Neal Armstrong. Summaries of Rocco Gagliese Productions Inc. v. The Queen, 2018 TCC 136 under s. 125(7) – specified investment business, and s. 129(4) – income or loss - para. (b).

Aitchison Professional Corporation – Tax Court of Canada finds that s. 160 does not catch the transfer of valuable services to a non-arm’s length person

At a time that a lawyer (“James”) owed $2.1 million in taxes, he transferred his law practice to a professional corporation and thereafter worked for it as an unpaid volunteer or employee. His two daughters (also lawyers) worked for the corporation at market salaries and in the first three years received over $1 million in dividends as a result of “an improbable share structure and a complete disregard for dividend rights.”

In finding that James had not transferred “property” to the corporation for s. 160 purposes by virtue of choosing not to negotiate a salary for his valuable professional services, Graham J stated:

The right to negotiate is a right that everyone possesses and that is enforceable against no one. It is not “property”. If an employee negotiates a poor contract, the potential salary that he or she leaves on the table is not “property” that he or she has transferred to his or her employer. It is simply a lost opportunity.

He added:

This case demonstrates that there is clearly a gap in section 160 … [but s]imply amending section 160 to cause it to cover the non-arm’s length provision of services may have undesired consequences. …

If a tax debtor spent all of his or her free time caring for his or her aging parents, would the Minister assess the parents for the fair market value of that care?

Neal Armstrong. Summary of Aitchison Professional Corporation v. The Queen, 2018 TCC 131 under s. 160(1).

Six further full-text translations of CRA interpretations are available

The table below provides descriptors and links for six Interpretation released in June 2013, as fully translated by us.

These (and the other full-text translations covering all French-language Interpretations released in the last 5 years by the Income Tax Rulings Directorate) are subject to the usual (3 working weeks per month) paywall.

Bundle Date Translated severed letter Summaries under Summary descriptor
2013-06-26 9 May 2013 External T.I. 2012-0435401E5 F - Server as a PE in a province Income Tax Regulations - Regulation 400 - Subsection 400(2) server (including leased server) in a province at disposal of the business and used in that business is PE
18 June 2013 External T.I. 2012-0433261E5 F - 55(5)(f) and Surplus Stripping Income Tax Act - Section 84 - Subsection 84(2) partial conversion of retained earnings to capital dividends through deliberate failure to make s. 55(5)(f) designation was abusive stripping
Income Tax Act - Section 245 - Subsection 245(4) deliberate engaging of s. 55(2) to convert annual taxable dividends into annual capital gains permitting annual capital dividends would engage s. 245(2)
20 February 2013 External T.I. 2012-0469811E5 F - Interest deductibility Income Tax Act - Section 18 - Subsection 18(2) interest subject to s. 18(2) must be calculated on a lot-by-lot basis
2013-06-19 29 April 2013 External T.I. 2013-0476131E5 F - Régime d'assurance-collective Income Tax Act - Section 6 - Subsection 6(4) general description of the s.6(4) exception to s. 6(1)(a)(i)
Income Tax Act - Section 6 - Subsection 6(1) - Paragraph 6(1)(e.1) overview of interrelationship between ss. 6(1)(a)(i), 6(1)(e.1) and 6(4)
7 May 2013 External T.I. 2013-0481321E5 F - Logement sécurisé - travail de nature temporaire Income Tax Act - Section 6 - Subsection 6(6) - Paragraph 6(6)(a) - Subpargraph 6(6)(a)(i) payment of rents by a foreign employer at a secure compound in another country could qualify except for after when employment ceased
10 May 2013 External T.I. 2012-0449651E5 F - SENC - revenu d'entreprise exploitée activement Income Tax Act - 101-110 - Section 110.6 - Subsection 110.6(1) - Qualified Small Business Corporation Share assets used by an LP in its active business are used by its partner in an active business
Income Tax Act - Section 129 - Subsection 129(6) Norco followed