23 December 2016 Comfort Letter

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Dear Mr. XXXXX,

SUBJECT: Foreign accrual property income resulting from the application of paragraph 95(2)(b) of the Income Tax Act to inter-affiliate payments for services

I am writing you in response to your correspondence to the Tax Legislation Division, and your various related communications, concerning your request for an amendment to the Income Tax Act (the "Act") to ensure that paragraph 95(2)(b) of the Act does not apply to certain services fees paid by one foreign affiliate of XXXXX ("XXXXX") to another foreign affiliate of XXXXX.

Paragraph 95(2)(b) is one of the "base erosion"rules in the Act. Your request relates, in particular, to subclause 95(2)(b)(i)(B)(I). That subclause provides that, if a particular foreign affiliate of a taxpayer provides services to another foreign affiliate of the taxpayer, then, to the extent that amounts paid by the other foreign affiliate in consideration for the services are deductible in computing its foreign accrual property income ("FAPI") (as defined in subsection 95(1) of the Act), these amounts are deemed to be income of the particular foreign affiliate from a business other than an active business – and are therefore included in the particular foreign affiliate's FAPI.

The issue that you have raised arises from the application of subclause 95(2)(b)(i)(B)(I) in the following factual situation, described in your letter. XXXXX, a corporation resident in Canada, and its subsidiaries establish and invest in certain investment funds. In structuring such investments, a non-resident holding corporation ("Holdco") is formed to acquire shares of a non-resident operating company ("Opco") that carries on an active business (as defined in subsection 95(1) of the Act). XXXXX (or a controlled foreign affiliate of XXXXX) and a group of arm's length investors contribute capital to Holdco to fund the acquisition of Opco. A wholly-owned, non-resident subsidiary corporation of XXXXX ("Manager") provides asset management and investment advisory services in respect of Opco in consideration for a management fee. Holdco, rather than Opco, pays the management fee to Manager because (among other reasons) Holdco is not the sole shareholder of Opco and Opco's other shareholders are unwilling to bear the fee.

In the investment structure described above, Holdco, Opco and Manager are all "foreign affiliates" of XXXXX (as defined in subsection 95(1)). You note that, since Holdco does not carry on an active business (its sole activity being the holding of shares of Opco), the services fees paid by Holdco to Manager are deductible in computing Holdco's FAPI, resulting in a foreign accrual property loss ("FAPL"). Accordingly, subclause 95(2)(b)(i)(B)(I) applies with the result that the services income is included in Manager's FAPI.

You have submitted to us that this result is inappropriate in policy terms. In this regard, you note that neither Opco nor Holdco earns FAPI. In addition, Manager's services are provided in respect of Opco, a subsidiazy of Holdco that carries on an active business and the shares of which are "excluded property" of Holdco (as defined in subsection 95(1)); if the services fees were paid by Opco out of its active business income, instead of by Holdco, paragraph 95(2)(b) would not apply.

Our Comments:

We agree that, in policy terms, paragraph 95(2)(b) ought not to apply to cause the services fees received by Manager from Holdco to be FAPI in the circumstances described above.

We are therefore prepared to recommend to the Minister of Finance that the Act be amended to provide that, effective for taxation years of foreign affiliates ending after 2016, subclause 95(2)(b)(i)(B)(I) does not apply in respect of income of a foreign affiliate (''FA1") of a taxpayer from the provision of services, to the extent that conditions generally analogous to those in clause 95(2)(a)(ii)(D) are satisfied, including in particular the following conditions:

  • The income derives from amounts paid or payable by another foreign affiliate (''FA2") of the taxpayer in consideration for the services;
  • The amounts paid or payable are for expenditures incurred by FA2 for the purpose of gaining or producing income from property;
  • The property is shares of another foreign affiliate ("FA3") that are "excluded property" of FA2 (as defined in subsection 95(1)); and
  • The Canadian taxpayer has a "qualifying interest" (as defined in paragraph 95(2)(m) of the Act) in FA1, FA2 and FA3.

We will also recommend that, to the extent that subclause 95(2)(b)(i)(B)(I) does not apply in respect of FA1's income from services because of the above recommended amendment, any FAPL of FA2 otherwise resulting from its corresponding expenditures for those services be eliminated.

While we cannot offer any assurance that either the Minister of Finance or Parliament will agree with our recommendations in respect of this matter, we hope that this statement of our intentions is helpful.

Yours sincerely,

Brian Emewein
General Director – Legislation
Tax Policy Branch