25 November 2021 CTF Roundtable - Official Responses

Presented by: [1] Yves Moreno, A/Director, International Division, Income Tax Rulings Directorate, CRA; and

Stéphane Prud'Homme, Director, Reorganizations Division, Income Tax Rulings Directorate, CRA

Unless otherwise stated, all statutory references in this document are to the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (the Act), as amended to the date hereof.

Q.1: Indemnities and Subsection 87(4)

Pursuant to subsection 87(4), shareholders of a predecessor corporation only receive rollover treatment where they receive no consideration for the disposition of those shares on the amalgamation, other than shares of the capital stock of the new corporation. In the context of certain corporate transactions, using a triangular amalgamation pursuant to subsection 87(9) is common (e.g., where a public corporation acquires the shares of a private corporation or where the target corporation has many shareholders). In these transactions, the parties may provide indemnities to one another for representations, warranties and potential liabilities that exist at the time of closing.

Where such indemnities are provided, are the requirements of subsection 87(4) still satisfied?

For example, imagine an M&A transaction where a taxable Canadian corporation (Parent) enters into an agreement to acquire the shares of another taxable Canadian corporation (Target). The parties agree to carry out the transaction by way of a triangular amalgamation whereby Parent creates a newly formed wholly-owned subsidiary and it proposes to amalgamate with Target pursuant to subsection 87(9). Pursuant to the agreement, each shareholder of Target would dispose of his/her/its shares of Target in exchange for a certain number of shares of Parent.

1. If the shareholders of Target provide indemnities to Parent for any representations, warranties, etc. which indemnities will be settled with a cash payment to Parent, do subsections 87(2) and 87(4) continue to apply?
2. Assume that as part of the transaction, certain of the Parent shares that were issuable to the Target shareholders as part of the transaction are instead placed in escrow during the indemnity period. If no indemnity claim arises, the shares will be released from escrow to the Target shareholders. If an indemnity claim is made by Parent, the parties agree that Parent can repurchase such shares from escrow for $1 and cancel them (note that the number of shares cancelled would have a value equal to the amount of the indemnity claim). Would the CRA ascribe the value of the indemnity claim that is satisfied as an amount “paid by the corporation” for purposes of paragraph 84(3)(a), such that a deemed dividend may arise if the amount paid is in excess of the paid up capital of such shares?
3. If Parent provides indemnities to the Target shareholders for any representations, warranties, etc. in the form of cash payment to Target shareholders, would this be consideration other than shares of Parent for purposes of subsection 87(4)?
4. If, instead, Parent provides indemnities to the Target shareholders for any representations, warranties, etc. in the form of a subsequent issuance of additional shares of Parent to Target shareholders, would this continue to be in accordance with the provisions of section 87(4)?

CRA Response

How a payment is treated from a tax point of view depends mostly on the legal nature of the payment. The main question to be asked is whether a payment to settle indemnities for representations, warranties, etc., in a M&A type of transaction can be considered as payment for the settlement of such indemnities or proceeds of disposition of shares being disposed of in such transaction. This cannot be answered here as it is a mixed question of fact and law. Where the representations and warranties are bona fide representations and warranties that are usually encountered in M&A transactions, the payment of indemnities to settle such representations and warranties is normally made quite some time after the transaction itself and would normally not be considered to form part of the proceeds of disposition of the property that is the subject of the M&A transaction. As such, and depending on specific facts and circumstances, such payment would normally not be viewed as proceeds of disposition of shares of a predecessor corporation in the context of a triangular amalgamation to which subsection 87(9) applies. The specific answers to the questions are as follows:

1. If the settlement for cash is made by the shareholders of Target to Parent, we do not see why the condition in paragraph 87(1)(a) would not be respected in this situation. Even if the cash payment was made by the corporation that results from the amalgamation (the “new corporation”) to Parent, we would presume that such payment is made quite some time after the amalgamation, once it is established whether all representations and warranties have been respected or satisfied, and, therefore, would not be made on the amalgamation or be part of the amalgamation. In that situation, we do not see how the condition in paragraph 87(1)(a) would not be met since all property of the predecessor corporations have become property of the new corporation by virtue of the amalgamation.

The question of whether Parent could benefit from the application of subsection 87(4) is only relevant where Parent owns shares of a predecessor corporation that have an ACB lower than FMV. However, as discussed above, the payment of an indemnity quite some time after the amalgamation regarding bona fide representations and warranties would normally not be considered to be consideration received for the disposition of shares of a predecessor corporation, depending on specific facts and circumstances.

2. It looks like the share consideration to be received by a shareholder of a predecessor corporation may be reduced by a repurchase by Parent of shares issued as consideration for shares of a predecessor corporation for $1 and the value of the shares repurchase would correspond to the indemnity claim made by the Parent. For example, let’s say that Parent had issued $10M of its shares to the shareholders of the Target. The indemnity claim amounts to $1M. Parent repurchases $1M worth of shares held by the Target shareholders for $1. In this situation, the reduction in value of the shares held by the Target shareholders is made as consideration for the settlement of the indemnity claim. Therefore, the amount considered to be paid for the repurchased shares under subsection 84(3) should be equal to the amount of settlement for the indemnity claim. The Target shareholders are viewed as having received $1M for the repurchase of the shares and having made a payment of $1M to Parent to settle the indemnity claim.

3. As discussed above, cash payments made by Parent to Target shareholders to settle indemnity claims would normally not be viewed as consideration received by the Target shareholders for the disposition of shares of a predecessor corporation, depending on facts and circumstances.

4. As discussed above, if Parent issues additional shares to the Target shareholders to settle indemnity claims, such shares issuance would normally not be viewed as consideration for the disposition of shares of a predecessor corporation, depending on facts and circumstances. In such situation, the value of the shares issued by Parent to the Target shareholders would represent an amount paid to such shareholders to settle the indemnity claim and taxed accordingly.

Q.2: Subsection 15(2) Shareholder Loans and TOSI

Assume a taxpayer (X) has an amount included in his or her income under subsection 15(2) in respect of a shareholder loan for a taxation year. The amount is also “split income” that is subject to tax under subsection 120.4(2) (TOSI). In computing X's net income, X is entitled to a deduction under paragraph 20(1)(ww) for the income subject to TOSI and this amount will be equal to the amount included in X's income under subsection 15(2). In a subsequent taxation year, X repays the shareholder loan. Does claiming the paragraph 20(1)(ww) deduction preclude X from subsequently claiming the paragraph 20(1)(j) deduction when the loan is repaid?

CRA Response

Paragraph 20(1)(j) provides:

(j) such part of any loan or indebtedness repaid by the taxpayer in the year as was by virtue of subsection 15(2) included in computing the taxpayer’s income for a preceding taxation year (except to the extent that the amount of the loan or indebtedness was deductible from the taxpayer’s income for the purpose of computing the taxpayer’s taxable income for that preceding taxation year), if it is established by subsequent events or otherwise that the repayment was not made as part of a series of loans or other transactions and repayments; [Emphasis added]

As provided in our answer to question 32 of the CPAC Provincial Roundtable (CRA document no. 2021-090510), paragraph 20(1)(ww) provides a deduction in computing income, whereas the bracketed phrase contained in paragraph 20(1)(j) only applies to deductions in computing taxable income. Consequently, the fact that X claimed the paragraph 20(1)(ww) deduction should not, in and of itself, preclude X from subsequently claiming the paragraph 20(1)(j) deduction when the loan is repaid.

Q.3: Section 86.1

Consider the following situation:

US Pubco is a corporation incorporated under the laws of the United States (U.S.) and its common shares are listed and traded on a U.S. Stock Exchange. A Canadian resident individual (the Taxpayer) owns common shares of US Pubco. Under a Canadian butterfly transaction, US Pubco wants to package one of its businesses into a new corporation incorporated under the laws of the U.S. (US Pubco Spinco).

US Pubco owns all of the issued and common shares of US Pubco Spinco and intends to spin out all of its common shares of US Pubco Spinco to its common shareholders pursuant to an exchange offer (the Exchange Transaction). Under the terms of the Exchange Transaction, US Pubco will offer its common shareholders the option to exchange their US Pubco common shares for its US Pubco Spinco common shares on a pro rata basis.

The Exchange Transaction does not contemplate a distribution by US Pubco of its US Pubco Spinco common shares to its shareholders as a dividend in kind. The disposition by the Taxpayer of the common shares of US Pubco is an essential condition for the receipt of the shares of US Pubco Spinco, such that the Taxpayer cannot simultaneously own both common shares of US Pubco and common shares of US Pubco Spinco.

Will the Taxpayer who exercises the Exchange Transaction benefit from the provisions of section 86.1?

CRA Response

Paragraph 86.1(1)(a) applies in respect of a distribution by a corporation that qualifies as an “eligible distribution” under subsection 86.1(2). Where applicable, that paragraph provides that “the amount of an eligible distribution received by a taxpayer shall not be included in computing the income of the taxpayer”. Where property is received by a shareholder in consideration for the disposition of a share of the corporation, section 86.1 does not adjust the income inclusion or the deduction of the loss resulting from the disposition of the share. On that basis, paragraph 86.1(1)(a) is not applicable to the Taxpayer in respect of the Exchange Transaction.

Accordingly, the surrender by the Taxpayer of their common shares of US Pubco as consideration for the receipt of common shares of US Pubco Spinco does not constitute an “eligible distribution” contemplated by section 86.1.

Q.4: Liable to Tax and Territorial Taxation

In order to qualify for the benefits under an income tax convention agreed upon by the Government of Canada and the government of a foreign jurisdiction (a Tax Treaty), a person must generally be considered a resident of a “Contracting State” for the purposes of the relevant Tax Treaty. Treaty residence of a taxpayer’s foreign affiliate is also generally relevant in the context of the computation of the foreign affiliate’s surplus accounts in respect of the taxpayer to support the claim by that taxpayer of certain deductions under subsection 113(1). Generally, a person must be “liable to tax” in a “Contracting State” by virtue of a criterion referred to in the residence article of the relevant Tax Treaty in order to be considered a resident of that foreign jurisdiction for the purposes of the treaty.

It has been the long-standing position of the CRA that, to be considered “liable to tax” for the purposes of the residence article of a Tax Treaty, a person must be subject to the most comprehensive form of taxation as exists in the relevant foreign jurisdiction. This generally refers to full tax liability on worldwide income.

When it comes to applying the concept of “liable to tax” in the context where the foreign jurisdiction taxes on a territorial basis, the CRA has stated the following in the past: “In order to qualify as a resident [of a] contracting state which has territorial tax system, a taxpayer will generally have to be subject to as comprehensive a tax liability as is imposed by the particular state.” (See CRA document no. 9822230)

Can the CRA provide additional guidance in respect of that determination?

CRA Response

It should generally be recognized that in determining the residence status of a person for the purposes of a Tax Treaty, each situation should be decided on its own particular facts. That determination should be done keeping in mind the intention of the Contracting States to the Tax Treaty.

That determination turns on whether a person can be considered to be “liable to tax” in a foreign jurisdiction by reason of its “domicile, residence, place of management or any other criterion of a similar nature”, as generally stated under the relevant provision of the Tax Treaty. Additional interpretative issues arise in respect of jurisdictions that have a remittance and/or territorial tax system, as the status of residence may not be relevant in order to determine the extent to which a person is “liable to tax” under the tax law of those jurisdictions.

The resolution of such interpretative issues requires a textual, contextual and purposive analysis of the relevant provisions of the applicable Tax Treaty, in light of the applicable foreign tax legislation, as well as secondary authoritative sources, including for example the Organization for Economic Cooperation and Development relevant Model Tax Convention and its Commentary.

The CRA recently had to consider the issue in respect of a particular corporation established under the law of Singapore, where a form of territorial tax system applies. That system relies on “source-based taxation” in respect of income from a source in that jurisdiction and on “remittance-based taxation” for foreign-source income. In that particular case, the corporation was considered to be a resident of Singapore for the purposes of the Canada-Singapore Tax Treaty, provided that its central management and control was at all relevant times exercised in that jurisdiction.

As mentioned above, it should be noted that the determination of the treaty residence of a person is to be determined on a case-by-case basis. Taxpayers may wish to request an advance income tax ruling from the Income Tax Rulings Directorate if they are contemplating transactions involving foreign entities whose residency under the particular treaty may be unclear.

Q.5: Corporate Attribution in a Tiered Corporate Structure

Scenario

An individual transfers $100 to a trust. The trust uses the $100 to subscribe for shares of Holdco. Holdco is a holding company. Holdco then uses the $100 to subscribe for shares of Subco. Subco is an investment company. Subco uses the $100 to acquire investments. The beneficiaries of the trust include minor children who are “designated persons” in respect of the individual, as defined in subsection 74.5(5). The trust agreement prohibits any distribution (income or capital) from the trust to minors. The individual is not a beneficiary of the trust nor a shareholder of either Holdco or Subco. Subco is not a small business corporation.

Assuming that subsection 74.4(2) does not apply to the transfer of the $100 to Holdco in light of subsection 74.4(4), will subsection 74.4(2) or subsection 74.5(6) apply to the transfer of the $100 to Subco?

CRA Response

Subsection 74.4(2) - Overview

Subsection 74.4(2) is a corporate attribution rule with broad application. It applies to a direct or indirect transfer or loan of property by an individual to a corporation, by means of a trust or by any other means whatever, where it can reasonably be considered that one of the main purposes of the transfer or loan is to reduce the income of the individual and to benefit, either directly or indirectly, though a trust or by any other means whatever, a designated person in respect of that individual.

Subsection 74.5(5) defines a “designated person” to include, inter alia, a child (under the age of 18 years old) of the individual that makes the transfer or the loan to the corporation. In the scenario above, an individual has indirectly transferred property ($100 cash) to Subco, through a trust and Holdco.

The question of whether it is reasonable to consider that one of the main purposes of this transfer of property is to reduce the income of the individual and to benefit, either directly or indirectly, his or her minor children (the Purpose Test) is a question of fact which must be resolved in light of all the circumstances and particulars of each case. We do not have any facts relating to the purposes of the transfer and we are therefore unable to conclude on the Purpose Test in this scenario.

Subsection 74.4(4) – Exception to the Purpose Test

Subsection 74.4(4), which provides an exception to the Purpose Test in subsection 74.4(2), does not apply in this situation for the reasons set out below.

Subsection 74.4(4) was introduced to ensure that, in certain estate planning circumstances, subsection 74.4(2) will not apply with respect to a designated person in respect of an individual where the individual loans or transfers property to a corporation, and:

(a) the only interest that the designated person has in the corporation is a beneficial interest in the shares of the corporation which are held through a trust,

(b) the terms of the trust provide that the person may not receive or otherwise obtain the use of any income or capital of the trust while the person is a designated person in respect of the individual, and

(c) the designated person has not received or otherwise obtained the use of any of the income or capital of the trust, and no deduction has been made by the trust in computing its income under subsection 104(6) or (12) in respect of amounts paid or payable to, or included in the income of, that person while being a designated person in respect of the individual.

When interpreting the condition in paragraph 74.4(4)(a) above, for purposes of answering this question, “the corporation” refers to Subco. The minor children in respect of the individual have a beneficial interest in the trust that only owns the shares of Holdco. The trust does not own any shares of Subco. Therefore, this condition is not met, and subsection 74.4(4) does not apply to prevent the application of subsection 74.4(2) to the indirect transfer of property by the individual to Subco.

Subsection 74.4(2) – Requirements for Application in a Particular Taxation Year Accordingly, to the extent that the Purpose Test is met, subsection 74.4(2) will apply to the individual in a taxation year that includes a period after the transfer throughout which all of the following three conditions are met:

• the individual was a resident in Canada;
• the corporation was not a small business corporation (defined in subsection 248(1)); and
• the person is a designated person in respect of the individual and would have been a specified shareholder of the corporation if the definition “specified shareholder” in subsection 248(1) were read without reference to paragraphs (a) and (d) of that definition and if the reference therein to “any other corporation that is related to the corporation” were read as a reference to “any other corporation (other than a small business corporation) that is related to the corporation”.

The scenario states that Subco is not a small business corporation.

For purposes of our response, we have assumed that Holdco is not a small business corporation and that the individual is a Canadian resident.

With respect to whether the minor children of the individual (i.e., the designated persons) are specified shareholders of Subco, the relevant portion of the modified definition of “specified shareholder” states:

specified shareholder of a corporation in a taxation year means a taxpayer who owns, directly or indirectly, at any time in the year, not less than 10% of the issued shares of any class of the capital stock of the corporation or of any other corporation (other than a small business corporation) that is related to the corporation and, for the purposes of this definition,

(b) each beneficiary of a trust shall be deemed to own that proportion of all such shares owned by the trust at that time that the fair market value at that time of the beneficial interest of the beneficiary in the trust is of the fair market value at that time of all beneficial interests in the trust, […]

and

(e) notwithstanding paragraph (b), where a beneficiary’s share of the income or capital of the trust depends on the exercise by any person of, or the failure by any person to exercise, any discretionary power, the beneficiary shall be deemed to own each share of the capital stock of a corporation owned at that time by the trust.

We would have to review the relevant trust documents to conclude on whether paragraph (e) of the definition of “specified shareholder” is met in this case because there is no mention of the trust being discretionary in the scenario. Assuming the children’s shares of the income or capital of the trust depend on the trustee’s exercise, or failure to exercise, any discretionary power, paragraph (e) of the definition of “specified shareholder” would be met, even if the children are not entitled to any income or capital of the trust while they are minors. In such a case, paragraph (e) of the definition of “specified shareholder” would deem the minor children to own the shares of Holdco, a corporation related to Subco. Therefore, the minor children who are designated persons in respect of the individual, would also be specified shareholders of Subco.

Subsection 74.5(6)

In light of the comments made above, it is not necessary for us to consider the application of the anti-avoidance provision to subsection 74.4(2) in subsection 74.5(6), dealing with back-to-back loans and transfers.

Q.6: Subsection 143.4(1) and the “right to reduce”

In CRA Document No. 2016-0628741I7, the CRA appears to have taken the position that where, in a particular year, a debtor and its creditors enter into a plan of arrangement pursuant to which interest will be forgiven and the plan is not implemented until a subsequent year, subsection 143.4 would apply in the year the plan was approved by the creditors. We say “appears” because certain specifics have been redacted. The CRA stated:

A “right to reduce” is defined in subsection 143.4(1) as follows: “right to reduce” means a right to reduce or eliminate an amount in respect of an expenditure at any time, including, for greater certainty, a right to reduce that is contingent upon the occurrence of an event, or in any other way contingent, if it is reasonable to conclude, having regard to all the circumstances, that the right will become exercisable.

Notwithstanding that the Taxpayer’s right to reduce the Interest Debt is contingent upon a series of conditions that are set out in the Plan, including the Conditions Precedent, it may still fall under the definition of a “right to reduce” in subsection 143.4(1) “if it is reasonable to conclude, having regard to all the circumstances, that the right will become exercisable.” Since there is no definition in the Act of the term “exercisable,” we refer to the ordinary meaning of this term. According to Merriam-Webster’s online dictionary, the verb to “exercise” includes the following meanings:

1 a: to make effective in action: use b: to bring to bear: exert c: to implement the terms of (as an option)

Also, according to this online dictionary, the suffix “able” means:

• fit for or worthy of being
• likely to or capable of
• having a certain quality

Based on the foregoing definitions, a right that is “exercisable” may be interpreted as a right that is “capable of being made effective in action,” “capable of being brought to bear” or “capable of being implemented.” Thus, a right may be considered a “right to reduce,” if it is reasonable to conclude, having regard to all the circumstances, that the right will become “capable of being made effective in action” or “capable of being implemented.”

[…]

It is our view, based on the information provided, that the Taxpayer’s right to reduce the Interest Debt is contingent upon a series of conditions that are set out in the Plan, including the Conditions Precedent, and that it falls within the definition of a “right to reduce” in subsection 143.4(1) because it is reasonable to conclude, having regard to all the circumstances, that the right will become exercisable. Thus, subsection 143.4(4) would apply in XXXXXXXXXX and this will result in an income inclusion for that year pursuant to paragraph 12(1)(x). Any income inclusion pursuant to paragraph 12(1)(x) should be offset by losses generated by the unclaimed interest expense relating to the XXXXXXXXXX to XXXXXXXXXX taxation years.

Assume that CCAA procedures commence in a particular year (Year 1), creditors approve the plan the following year (Year 2) and the plan is implemented in a subsequent year (Year 3). At what stage of the process will a “right to reduce” arise for purposes of section 143.4? We suggest that prior to the plan being (at the very least) approved by the creditors, it would not be reasonable to conclude, having regard to all the circumstances, that any right to reduce an amount would become exercisable, but seek CRA’s confirmation given the broad and somewhat vague wording of the definition.

CRA Response

You have asked us to consider when the “right to reduce” arises for purposes of section 143.4 when interest is forgiven under a plan of arrangement from proceedings under the Companies’ Creditors Arrangement Act (the CCAA).

Under subsection 143.4(1), a “right to reduce” an amount in respect of an expenditure includes, for greater certainty, a right to reduce that is contingent upon the occurrence of an event, or any other way contingent, if it is reasonable to conclude, having regard to all the circumstances, that the right will become exercisable.

In general, when a right to reduce arises under subsection 143.4(1) will require a determination of when the legal right, albeit contingent, arises and whether it is reasonable to conclude that the right will be exercisable. This determination will depend on a review of all of the facts and circumstances. In the case of interest that is forgiven under a CCAA proceeding, this will include a review of the plan of arrangement and terms of the contingencies contained therein and an assessment of whether that right of a debtor to pay interest for less than the full amount to settle the obligation will be exercisable in the circumstances. In our view, this review and assessment should be done in the context of a ruling request when all of the circumstances surrounding the CCAA proceeding are available.

We are prepared to consider this issue in the context of a request for an advance income tax ruling as described in Information Circular IC 70-6R11, Advance Income Tax Rulings and Technical Interpretations.

Q.7: Sub-funds and the Tracking Interest Rules in Subsections 95(8) to (12)

Assume that a taxpayer owns shares of a non-resident umbrella corporation contemplated by the tracking interest rules in subsections 95(8) to (12). The umbrella corporation is a foreign affiliate, the shares are a tracking interest in respect of the umbrella corporation and the shares held by the taxpayer are shares of a tracked class. Accordingly, subsection 95(11) applies.

Please confirm that the separate corporation contemplated by subsection 95(11) is deemed to own only the properties of the sub-fund and the notional shareholders are the holders of the shares.

Is the result the same if the taxpayer owns shares tracking two sub-funds? Are there two “separate corporations”, or is there only one “separate corporation” deemed to own the properties of the two sub-funds and the notional shareholders are the holders of the two classes of shares of the umbrella corporation?

CRA Response

For purposes of this response, a number of assumptions are made to make the question more detailed.

This answer assumes that the issued and outstanding share capital of the non-resident umbrella corporation (the Umbrella Corporation) is formed of Class A shares, Class B shares, and Class C shares. It also assumes that, under the relevant laws of Country X, the assets and liabilities and activities of Umbrella Corporation are segregated into various “sub-funds”, being “Sub-fund A”, “Sub-fund B”, and “Sub-fund C”. The properties segregated in Sub-fund A are not the same as the properties segregated in Sub-fund B, and the same applies to Sub-fund C. The Class A shares of Umbrella Corporation derive their value and income solely from the net assets and activities of Sub-fund A. Similarly, the Class B and Class C shares respectively derive their value and income solely from the net assets and activities of Sub-fund B and Sub-fund C.

A taxpayer resident in Canada (the Taxpayer) owns 90% of the Class A shares of Umbrella Corporation. Although Umbrella Corporation is, for purposes of the Act, a foreign affiliate of the Taxpayer, it is not a controlled foreign affiliate of the Taxpayer.

Consistent with the base scenario in the question, the Class A shares of Umbrella Corporation are, for purposes of applying subsections 95(8) to (12), a “tracking interest” in respect of Umbrella Corporation and, for purposes of applying subsection 95(11), are a “tracking class.” Accordingly, subsection 95(11) applies. This is similarly true with respect to the Class B shares of Umbrella Corporation for purposes of the second question.

In light of these detailed facts, the first question is whether, in respect of the Class A shares held by the Taxpayer, the separate corporation contemplated by subsection 95(11) is deemed to own only the properties of Sub-fund A and the notional shareholders of that separate corporation are the holders of the Class A shares of Umbrella Corporation.

If, in addition to the Class A shares of Umbrella Corporation, the Taxpayer also owns 10% of the Class B shares of Umbrella Corporation, the second question is whether there is still only one “separate corporation” that is deemed to own the properties of two related sub-funds and whether the notional shareholders of that one separate corporation are the holders of the Class A and Class B shares of Umbrella Corporation.

With respect to the first question, the properties and activities of Sub-fund A are the ones that can reasonably be said to determine the fair market value of the Class A shares. On that basis, “the” tracked property and activities referred to in paragraphs 95(8)(a), 95(10)(b), 95(11)(a) and “the” tracked properties and activities in subparagraph 95(11)(e)(ii) are the properties and activities of Sub-fund A (although only subparagraph 95(11)(e)(ii) refers to “properties”, this response will refer to “the tracked properties and activities”).

Therefore, the properties and activities of Sub-fund A are deemed to be the properties and activities of a non-resident corporation in which the Taxpayer is deemed to own shares for purposes of determining the amounts to be included or deducted by the taxpayer under subsection 91(1) and (4) or of applying section 233.4 taking into account the various presumptions in subsection 95(11).

The answer to the first question is that the separate corporation contemplated by subsection 95(11) is deemed to own only the properties of Sub-fund A and the notional shareholders of that separate corporation are the holders of the Class A shares of Umbrella Corporation.

With respect to the second question, where the Taxpayer also owns 10% of the Class B shares, the premise that the properties and activities of Sub-fund A are the ones that can reasonably be said to determine the fair market value of the Class A shares remains the same. On that basis, “the” tracked properties and activities referred to in paragraphs 95(8)(a), 95(10)(b), 95(11)(a) and “the” tracked properties and activities in subparagraph 95(11)(e)(ii) remain the properties and activities of Sub-fund A. Therefore, the properties and activities of Sub-fund A are still deemed to be the properties and activities of a non-resident corporation in which the Taxpayer is deemed to own shares of for purposes of determining the amounts to be included or deducted by the Taxpayer under subsection 91(1) and (4) or of applying section 233.4 taking into account the various presumptions in subsection 95(11).

In addition, the properties and activities of Sub-fund B are the ones that can reasonably be said to determine the fair market value of the Class B shares. On that basis, “the” tracked properties and activities referred to in paragraphs 95(8)(a), 95(10)(b), 95(11)(a) and “the” tracked properties and activities in subparagraph 95(11)(e)(ii) are the properties and activities of Sub-fund B.

Therefore, the properties and activities of Sub-fund B are deemed to be the properties and activities of another non-resident corporation in which the Taxpayer is deemed to own shares for purposes of determining the amounts to be included or deducted by the taxpayer under subsection 91(1) and (4) or of applying section 233.4 taking into account the various presumptions in subsection 95(11).

The answer to the second question is that there are two separate notional corporations. On the one hand, the tracked properties and activities of Sub-fund A are, under paragraph 95(11)(a), deemed to be the properties and activities of a non-resident corporation and, under paragraph 95(11)(e), the notional shareholders of that separate corporation are the holders of the Class A shares of Umbrella Corporation. On the other hand, the tracked properties and activities of Sub-fund B are, under paragraph 95(11)(a), deemed to be the properties and activities of another nonresident corporation and, under paragraph 95(11)(e), the notional shareholders of this other corporation are the holders of the Class B shares of Umbrella Corporation.

Finally, although this variation is not part of the question, should a taxpayer hold two classes of shares of a foreign affiliate and both classes derive their value from the same properties and activities, such properties and activities are deemed under paragraph 95(11)(a) to be owned by a single non-resident corporation. The interest of that taxpayer in that separate corporation would be determined under paragraph 95(11)(e) taking into account both classes of shares according to subparagraph 95(11)(e)(ii).

In the interest of completeness, we note that the Department of Finance announced in a Comfort Letter to the Investment Funds Institute of Canada dated March 25, 2019 that a recommendation will be made to introduce changes that would be effective for taxation years of foreign affiliates beginning after February 26, 2018 in respect of portfolio investments described in that letter.

Q.8: Loan from a FA to a Partnership held by two FAs

Assume CanParent has a number of wholly owned foreign affiliates (FAs), including FA1, FA2 and FA3. FA1 and FA2 are the sole members of a partnership (P). P borrows under an interest-bearing loan from FA3 to buy all of the issued shares of FA4 (the shares of FA4 are excluded property). Subsection 93.1(4) deems P to be a non-resident corporation for the purpose of applying clause 95(2)(a)(ii)(D). As a result, for the purposes of subdivision i of the Act, the interest paid by P to FA3 will be included in computing the income or loss from an active business of FA3. Technically, it seems possible that subsection 15(2) could apply as it is not clear that the exceptions in subsection 15(2.1) or 15(2.2) are met. However, this would appear to undermine the purpose of the foreign affiliate rules and subsection 93.1(4). Can CRA comment on whether it believes subsection 15(2) would apply in this situation?

CRA Response

Policy concerns regarding provisions of the Income Tax Act, such as the ones expressed in this question, should be brought to the attention of the Department of Finance. We have informed the Department of Finance about these policy concerns.

Q.9: Work-Space-In-The-Home Expenses

An employee is only entitled to deduct certain expenses under section 8 where the employee’s employer has prepared a Form T2200, Declaration of Conditions of Employment. The employer’s responsibility is to determine if the conditions of employment necessary to entitle the employee to deduct the expenses have been met.

In respect of the work from home (WFH) expenses allowed under subsection 8(13), no deduction is permitted except to the extent that the work space is either (i) the place where the individual principally performs the duties of office or employment or (ii) used exclusively for earning income from office or employment and is used on a regular or continuous basis for meeting customers or other persons in the ordinary course of performing duties of office or employment.

Due to COVID-related stay-at-home orders, many employees now work from home. Understandably, the CRA implemented the T2200-S form, and allowed flexibility in how employees deducted the WFH expenses.

Post-COVID, combinations of conducting some work at the employer’s office and some work from home are expected. Tracking whether or not an employee is required to work principally from home may be difficult.

Can the CRA provide guidance to employers as to how they should determine if an individual is required to principally perform their duties away from the office of the employer?

CRA Response

Generally, a salaried employee may deduct home office expenses under subparagraph 8(1)(i)(iii) if the conditions in that subparagraph, and those in subsections 8(10) and (13) are satisfied.

Subparagraph 8(1)(i)(iii) allows for the deduction of work-space-in-the-home expenses (i.e., supplies consumed directly in the performance of the duties of employment), where an employee was required by contract of employment to supply and pay for those expenses, the expenses are reasonable, and the employee was not provided a reimbursement by their employer for these expenses.

It is the general position of the CRA that when an employee and employer have entered into a formal work arrangement, the employee is “required by contract of employment” to provide a work space in their home and pay for some additional costs associated with providing this work space. While the actual agreement can take many different forms (for example, a verbal agreement, an e-mail from the employer confirming the agreement, or a formal written agreement initiated by either the employee or the employer), what is critical is that the details of the work arrangement are agreed to and clearly understood by both the employee and the employer.

Subparagraph 8(13)(a)(i) provides that expenses which are otherwise deductible under subparagraph 8(1)(i)(iii) cannot be deducted as work-space-in-the-home expenses unless the work space is the place where the employee principally (i.e., more than 50%) performs their duties of employment.

Where the conditions in subparagraph 8(1)(i)(iii) are met by an employee, subsection 8(10) further requires that Form T2200, Declaration of Conditions of Employment, be completed and signed by their employer to certify the conditions of employment. However, a signed Form T2200 does not provide an employee with any assurance that the expenses incurred are deductible, since the Act contains other criteria that the employee must satisfy.

With regard to the completion of Form T2200, Question 10 asks that an employer approximate the percentage of the employee’s duties of employment that were performed at a work space in their home. An employer is not asked to certify whether this work space was the place where the employee principally (i.e., more than 50%) performed their duties of employment.

As the nature of work arrangements and the manner in which they are documented will differ by employer, an employer should use the method which best aligns with their practices and procedures to collect the information needed to respond to Question 10 on Form T2200.

Q.10: Regulation 100(4)(a) and Payroll Deductions and Remittances

Due to the pandemic, remote work arrangements are becoming increasingly popular and may remain permanent even after the pandemic ends. Pursuant to paragraph 100(4)(a) of the Income Tax Regulations (the Regulations) and the T4001 Employer's Guide, Payroll Deductions and Remittances, where an employee is not required to report for work at any establishment of the employer, the employee is deemed to report for work at the establishment from which the employee’s salary and wages are paid. That establishment normally means the location of the payroll department or payroll records.

Please clarify how this guidance applies to a company with a centralized payroll department, where all employees across the country are managed by a single payroll department situated in Ontario. For example, let's say there is an employee, Mr. Y, who lives in PEI and used to physically work at the PEI office location. Mr. Y does not have any authority to contract. Post-pandemic, Mr. Y's entire team switches to 100% remote work and Mr. Y is no longer required to report to the office in PEI, although the team still continues to serve the same Atlantic region as it did previously. The company continues to have a permanent establishment in PEI. Based on the above guidance, it appears that Mr. Y's province of employment will now be Ontario, resulting in a mismatch with his province of residence.

The T4001 Guidance provides that where an employee's province of employment differs from his or her province of residence such that there is too much or too little tax withheld, the employee is able to request a Letter of Authority or use Form TD1 to ask the payroll department to adjust the withholding accordingly. However, this results in a burden to the employee and a large administrative burden to the company's payroll department if numerous employees request such adjustments. Further, a change in province of employment may result in other unintended changes, such as group insurance premiums sales taxes. Although Mr. Y continues to live in PEI and the nature of his work has not changed, by virtue of Mr. Y becoming a remote worker, employer-paid premiums would be subject to 8% Ontario sales tax (previously 0% in PEI).

Given the trend of remote working, will the CRA consider a change to its position so that Mr. Y's province of employment will be PEI?

CRA Response

On the one hand, pursuant to subsection 102(1) of the Regulations, if an employee reports for work at an establishment of the employer in a province, the employee will be considered as reporting for work at this establishment, regardless of where payroll is processed. On the other hand, if an employee is not required to report for work at any establishment of the employer and works exclusively remotely, the employee is deemed to report for work at the establishment from which the remuneration is paid, as provided in paragraph 100(4)(a) of the Regulations.

In the given situation, from the moment it is clear that Mr. Y will no longer be required to report for work at the establishment of his employer in PEI, he will be deemed to report for work at the employer’s establishment in Ontario, as per paragraph 100(4)(a) of the Regulations.

The CRA will continue to monitor trends relating to remote working arrangements.

Q.11: Subsection 261(21), Loan to FA and Excluded Property

In response to question 4 of the 2017 IFA tax conference, the CRA commented on the application of subsections 261(20) and (21) (published in CRA document no. 2017-0691211C6). In the scenario discussed, the following were the relevant assumed facts:

1. Parent is a Canadian-resident corporation and the parent corporation of a multinational group. Parent computes its Canadian tax results in Canadian dollars.
2. Cansub is a Canadian-resident corporation and a wholly-owned subsidiary of Parent. Cansub has made a functional currency election to use the USD as its functional currency for Canadian income tax purposes.
3. FA is a corporation resident in the U.S. and a wholly-owned subsidiary of Cansub. FA carries on an active business in the U.S. and uses USD as its “calculating currency” for purposes of the Canadian foreign affiliate rules.
4. FA makes an upstream loan to Parent (FA-Parent Loan) denominated in USD. Parent enters into a third party hedging arrangement in order to hedge its foreign exchange exposure on the FA-Parent Loan.
5. The FA-Parent Loan is not an “excluded property” (as defined in subsection 95(1)) of FA.
6. Parent realizes a foreign exchange loss on the repayment of the FA-Parent Loan, and an offsetting foreign exchange gain on the settlement of the Hedge.

In its response, the CRA indicated that subsection 261(21) applies in respect of a “specified transaction”, which in this scenario was the FA-Parent Loan. Further, the CRA’s analysis was that subsection 261(6.1) provides that, for the purposes of determining FA’s foreign accrual property income (FAPI) (as defined in subsection 95(1)) in respect of Cansub, FA is deemed to have elected to determine its Canadian tax results in USD, and FA’s Canadian tax results are its FAPI in respect of Cansub, and any amount relevant to that determination. Based on the loan giving rise to FAPI and the context of subsection 261(6.1), subsection 261(21) applied to the upstream loan.

If the facts were changed such that the “specified transaction” was instead a loan from Parent to FA (Parent-FA Loan) and that the gain or loss that is derived from the settlement of this loan was deemed, pursuant to paragraph 95(2)(i), to be a gain or loss from the disposition of an excluded property of FA (not giving rise to FAPI), does the CRA agree that subsection 261(21) should not apply in respect of the Parent-FA Loan?

CRA Response

Subsection 261(20) states that subsection 261(21) applies in determining a taxpayer's income, gain or loss for a taxation year in respect of a transaction (a specified transaction) if:

a) the specified transaction was entered into, directly or indirectly, at any time by the taxpayer and a related corporation (paragraph 261(20)(a));

b) the taxpayer and the related corporation had different tax reporting currencies at any time during the period (the accrual period) in which the income, gain or loss accrued (paragraph 261(20)(b)); and

c) in the absence of subsections 261(20) and (21), it would be reasonable to consider that a fluctuation at any time in the accrual period in the value of the taxpayer’s tax reporting currency relative to the value of the related corporation’s tax reporting currency increased the taxpayer’s loss in respect of the specified transaction, reduced the taxpayer’s income or gain in respect of the specified transaction, or caused the taxpayer to have a loss, instead of income or a gain, in respect of the specified transaction (paragraph 261(20)(c)).

If subsection 261(21) applies, each fluctuation in value referred to above is deemed not to have occurred, notwithstanding any other provision of the Act.

Having regard to the hypothetical scenario described in the question, pursuant to the condition in paragraph 261(20)(b), it must be determined whether Parent and FA have different tax reporting currencies at any time during the period in which Parent’s foreign exchange loss in respect of the Parent-FA Loan accrued.

On the one hand, since Parent did not make a functional currency election under subsection 261(3), subsection 261(2) provides that its tax reporting currency is the Canadian dollar.

On the other hand, contrary to the scenario discussed in response to question 4 of the CRA round table at the 2017 IFA tax conference, in this question, the amount of any foreign exchange gain or loss realized by FA that would be derived from the settlement of the Parent-FA Loan would be deemed to be a gain or loss from the disposition of an excluded property and, as such, would not constitute an amount that enters in the determination of FA’s FAPI in respect of Cansub.

Given that no FAPI results from the Parent-FA Loan and considering that FA does not have Canadian tax results for the taxation years in which the accrual period occurs, we are of the view that FA would not have a “tax reporting currency”, as that term is defined under subsection 261(1), during the accrual period.

Therefore, for the purposes of paragraph 261(20)(b), Parent and FA do not have different tax reporting currencies during the accrual period. Since the condition set out in paragraph 261(20)(b) is not satisfied in the scenario described above, subsection 261(21) does not apply to deny the foreign exchange loss realized by Parent from the settlement of the Parent-FA Loan.

This response turns on the specific facts and assumptions outlined above. We recommend that an advance income tax ruling be requested to confirm the application of the relevant provisions where other circumstances exist.

Q.12: Remissions and Fees - Advance Income Tax Rulings and Pre-ruling Consultations

The fees charged by the CRA for providing an advance income tax ruling or a supplemental ruling (a Ruling), and a consultation in advance of a Ruling (a Pre-ruling Consultation), are governed by the Service Fees Act[2] .

In accordance with section 7 of the Service Fees Act, a reduction of a fee (a remission) is required where the CRA considers that a service standard has not been met.

A. Can the CRA describe how a remission will be determined with respect to the fees charged for Rulings and Pre-ruling Consultations?

B. Can the CRA confirm whether the hourly rate charged for Rulings and Pre-ruling Consultations is expected to change?

CRA Response (A)

The objective of the Income Tax Rulings Directorate (the Directorate) is to issue a Ruling or complete a Pre-ruling Consultation within a specified, agreed-upon time period.

The service standard for a Ruling is 90 business days commencing with the receipt of all information required from the client as outlined in Appendix A – Ruling Request Checklist of Information Circular IC 70-6R11, Advance Income Tax Rulings and Technical Interpretations[3] (IC 70-6). The service standard for a Pre-ruling Consultation is to complete a teleconference within 15 business days from the date the Directorate confirms to the client that the request complies with IC 70-6 and has been accepted.

In some cases, achieving these service targets may not be possible. Where the service target date needs to be adjusted, the Directorate will inform the client in advance and establish an alternate, mutually agreed upon service target date.

Remission of the service fee will be granted when the Ruling is issued, or the Pre-ruling Consultation is completed, subsequent to its service target date, as set out in Appendix H – Remissions of IC 70-6.

The remission will be calculated on an incremental basis as a percentage discount on the hourly rate applicable to the hours worked subsequent to the service target date and will be processed as a reduction to the client invoice.

Remission of the service fee, where appropriate, will apply to Rulings or Pre-ruling Consultations received by the Directorate after April 1, 2021. Additional information regarding remissions can be found in Appendix H - Remissions of IC 70-6.

CRA Response (B)

It has always been the CRA’s practice to recover the costs associated with the provision of Rulings and Pre-ruling Consultations from those who request the service. The CRA will be increasing the existing fee for Rulings and Pre-ruling Consultations in order to reflect the current costs of delivering these services.

When the fee structure was last updated in 2000, the fee was set at $100 for each of the first 10 hours spent processing a Ruling or a Pre-ruling Consultation request, and $155 for each subsequent hour. Since 2019, the hourly rate has been subject to annual increases in accordance with the Consumer Price Index (the CPI) as required by section 17 of the Service Fees Act. As a result, the current hourly rate for a Ruling or a Pre-ruling Consultation is $104.04 for the first 10 hours, and $161.26 for each subsequent hour.

Over the next two years, the Directorate will be phasing in a fee increase for Rulings and Pre-ruling Consultations. Beginning April 1, 2022, the new single-tier, hourly rate will be $221.24. This hourly rate will increase to $281.22 on April 1, 2023. The hourly rate does not include applicable taxes and will continue to be adjusted annually in accordance with the CPI.

Information in respect of the amendment to the fee structure for Rulings and Pre-ruling Consultations was published in the Canada Gazette, Part II, on July 21, 2021 as SOR/2021-173.[4]

Q.13: Income Tax Rulings Directorate - Internal Evaluation and Service Enhancements

We understand that the Income Tax Rulings Directorate recently underwent an internal evaluation process.

Can you provide us with some information about the results?

CRA Response

The recent internal evaluation of our directorate was undertaken to assess how well the program has been achieving expected outcomes, and to identify potential options for improvement. As part of this process, the CRA’s Audit, Evaluation, and Risk Branch interviewed employees, tax industry representatives, officials from similar programs in other jurisdictions, and our clients (perhaps including some participants at this event today). Their report was published on Canada.ca in June, including two recommendations for us to better meet our goals.

We would like to thank everyone who responded to requests from the evaluation team for input, as the results were informative and will help us enhance our program.

The evaluation results showed that while clients are generally quite satisfied with our staff and the quality of the interpretive positions we issue, the timeliness of our products can be a concern. This is a concern for us as well, as it may lead to situations where opinions are not requested because of the amount of time that would be involved. To address this, the directorate is reviewing its service model and priorities for options to reduce the turnaround time for advance income tax rulings and technical interpretations. We will have more information for you about this when the process is more advanced.

It was also recommended that we change our performance measurement practices to enhance transparency and better capture client expectations. To respond to this, we are taking steps to make our service results for the rulings and interpretations we deliver to you more visible. Starting with this year’s outcomes, we will make our service standard results accessible through the CRA’s Information Circular IC70 6R, “Advance Income Tax Rulings and Technical Interpretations”. This means that starting next year, when you consult that Information Circular, you can see both our current service offering, and how often we met our service targets when we issued advance income tax rulings and technical interpretations to members of the public the previous year.

We will also be reintroducing the use of post-engagement surveys when we issue advance income tax rulings and technical interpretations, to help us stay abreast of emerging service needs. We plan to begin this practice next spring, but will defer our start date if we hear from clients that they would prefer to not receive these requests while they are still dealing with the impacts of the pandemic on their work.

Q.14: Failure to properly file a T1135 and Section 233.4

Generally, under section 233.3, every taxpayer owning “specified foreign property” with a total cost amount greater than $100,000 is required to file a Form T1135 in respect of each of its taxation years in which the $100,000 total is exceeded.

The definition of “specified foreign property” in subsection 233.3(1) includes, under paragraphs (c) and (g), a share of the capital stock of, or indebtedness owed by, a non-resident corporation. However, a share of the capital stock or indebtedness of a non-resident corporation that is a foreign affiliate of the taxpayer for the purposes of section 233.4 is excluded from the definition of “specified foreign property” under paragraph (k) of that definition. Therefore, a taxpayer is not required to report a share or indebtedness of an entity that is a foreign affiliate for purposes of section 233.4 on a T1135.

Subsection 233.4(2) has special rules for determining whether a non-resident corporation is a foreign affiliate of the taxpayer for purposes of section 233.4. Those rules narrow the definition of “foreign affiliate” such that an entity that is a foreign affiliate for other purposes of the ITA may not be a “foreign affiliate” for purposes of section 233.4.

Example

1. Canadian parent (Parent) owns 100% of the shares of Canadian subsidiary (Cansub).
2. Cansub owns 100% of the shares of a non-resident corporation (NRco).
3. NRco is a “foreign affiliate” of both Parent and Cansub under the definition of “foreign affiliate” that applies generally for the purposes of the ITA. However, under the restricted definition of “foreign affiliate” that applies for purposes of section 233.4, NRco is only a foreign affiliate of Cansub.

As the restricted definition of “foreign affiliate” in section 233.4 applies for purposes of the exception to the definition of “specified foreign property” referred to above, if Parent held indebtedness owing by NRco, it would have to report that indebtedness on a T1135 while if the same indebtedness were held by Cansub, it would not have to report the indebtedness on a T1135.

The instructions on the T1135 form advise taxpayers not to include shares of the capital stock or indebtedness of a “foreign affiliate”. The T1135 form does not indicate that the term “foreign affiliate” for the purposes of the T1135 has a different, much narrower meaning, than that term has for other purposes of the ITA. The instructions include the following under the heading “What property do you have to report?”:

Specified foreign property does not include:

• a share of the capital stock or indebtedness of a foreign affiliate;

Under the heading “Tables”, we find the following specific instructions for the table where we are to report “indebtedness owed by non-residents”:

Report all amounts owed to you by a non-resident person (other than a foreign affiliate corporation)…

As a result, a taxpayer looking at the T1135 form is led to believe that the broad definition of “foreign affiliate” that applies for the purposes of the Act also applies for the purposes of the T1135. In such case, the taxpayer may conclude that the CRA does not require a particular indebtedness held by the taxpayer to be reported on the T1135 even though the statute calls for its inclusion or they may simply be unaware of the separate definition of “foreign affiliate” because the T1135 form makes no mention of it.

Where a taxpayer has failed to file a T1135 or has failed to include an amount on the T1135 because the taxpayer relied on the wording of the T1135 (which does not reflect the more narrow exclusion for foreign affiliates) will the CRA pursue the taxpayer for penalties in respect of the failure?

CRA Response

The Act imposes an obligation on all Canadian resident taxpayers to file Form T1135, Foreign Income Verification Statement, if at any time during the year, the total cost amount of all specified foreign property to the taxpayer was more than $100,000 (Canadian).

The term “specified foreign property” is defined in subsection 233.3(1) with certain exceptions including a share of the capital stock or indebtedness of a non-resident corporation or an interest in or indebtedness of a non-resident trust that is a foreign affiliate of the person or partnership for the purpose of section 233.4.

Section 233.3 does not exclude from reporting on Form T1135 investments in all foreign affiliates, but only the investments in non-resident corporations or non-resident trusts that are foreign affiliates for the purpose of section 233.4. The instructions on Form T1135 do not specifically refer to the definition of “foreign affiliate” as modified by section 233.4. We recognise that there may be circumstances where this could lead to some misinterpretation or confusion by a taxpayer and may result in their failure to file Form T1135 or disclose the foreign affiliate as required by the Act.

Taxpayers who may have been assessed penalties (such as those provided by subsections 162(5), 162(7), 162(10), 162(10.1) and 163(2.4)) as the result of late or incorrectly filing of Form T1135 and are of the view that the late or incorrect filing was the result of the form’s lack of clarity regarding transactions with foreign affiliates, may make an application for relief of interest (such as the interest applicable under subsection 161(11)) and penalties under the CRA’s fairness provisions. Subsection 220(3.1) provides the Minister with the discretion to waive or cancel all or any portion of any penalties and interest otherwise payable under the Act. All the relevant facts and circumstances of a taxpayer’s situation will be reviewed and each request will be decided on its individual merits. For more information on existing taxpayer relief provisions, including the administrative guidelines that the CRA applies when considering requests for relief and the types of circumstances that may qualify, please consult Information Circular, IC07-1R1, Taxpayer Relief Provisions.

Under Canada’s self-assessment system, the CRA encourages taxpayers to come forward and voluntarily correct their tax affairs by either submitting taxpayer requested adjustments to correct past filing errors or through application to the Voluntary Disclosures Program (VDP), should the taxpayer meet the program’s eligibility criteria.

Q.15: “Current Use” Approach and Clauses 95(2)(a)(ii)(B) and (D)

Where one foreign affiliate (FA Finco) of a taxpayer makes a loan to another foreign affiliate of the taxpayer, clauses 95(2)(a)(ii)(B) and (D) are often the provisions relied upon to deem interest income earned by FA Finco to be income from an active business.

Please describe how the current use approach, developed by the courts in the context of interpreting subparagraph 20(1)(c)(i), would apply in the following examples.

Example 1

FA Finco lends money to FA Acquireco LLC, which uses the money to purchase all of the shares of FA Target LLC from an arm’s length vendor. FA Target LLC merges into FA Acquireco LLC (the survivor) which is then renamed FA Mergeco LLC. After the merger, FA Mergeco LLC only earns income from carrying on an active business.

The shares of FA Acquireco LLC and FA Target LLC are excluded property and all of the properties of FA Acquireco LLC and FA Target LLC are excluded property. FA Acquireco LLC, FA Target LLC and FA Mergeco LLC are Delaware limited liability companies that have not elected to be taxed as corporations for U.S. tax purposes. FA Holdco is a corporation formed in Delaware that is taxed as a corporation for U.S. tax purposes.

Example 2

FA Finco lends money to FA Holdco, which uses the money to purchase all of the shares of FA Target from an arm’s length vendor. Shares of FA Target are not excluded property (more than 10% of the fair market value of its assets are not excluded property). A few days after the acquisition of FA Target, FA Target and FA Opco merge and become FA Mergeco. On the merger, FA Holdco receives shares of FA Mergeco, replacing its shares of FA Target and FA Opco. After the merger, all or substantially all of the properties of FA Mergeco are excluded property.

CRA Response

In dealing with interest deductibility under paragraph 20(1)(c), courts have held, among other things, that in determining whether borrowed money is used for the purpose of earning income from a business or property, it is the current use of the money, and not the original use, that is relevant. Furthermore, a link must be established between the money that was borrowed and its current use. This is known as the current use approach. It is CRA’s longstanding position that the current use approach applied in the context of paragraph 20(1)(c) could also be relevant in the application of clauses 95(2)(a)(ii)(B) and 95(2)(a)(ii)(D).

The following describes how the current use approach would be applied in the examples provided in the question, in the context of clauses 95(2)(a)(ii)(B) and (D).

Example 1

After the merger of FA Acquireco LLC and FA Target LLC, interest will be paid or payable by FA Mergeco LLC to FA Finco. In order to qualify for active business income recharacterization under clause 95(2)(a)(ii)(B) after the merger, one of the conditions is that the interest be deductible by FA Mergeco LLC in computing its earnings or loss for a taxation year from an active business (other than an active business carried on in Canada).

Since FA Mergeco LLC is a disregarded entity for U.S. tax purposes, pursuant to subparagraph (a)(iii) of the definition of “earnings” in subsection 5907(1) of the Income Tax Regulations, its earnings from an active business is the amount that would be the income from the active business for the year as computed under Part I of the Act if the business were carried on in Canada and FA Mergeco LLC were resident in Canada. As a result, paragraph 20(1)(c) is relevant in determining whether interest is deductible in computing the earnings from an active business of FA Mergeco LLC.

After the merger, if the proceeds of the loan can be linked to a current eligible use (such as the property of FA Mergeco LLC which are used in an active business carried on by FA Mergeco LLC), the interest should be deductible in computing the earnings from an active business of FA Mergeco LLC, and the interest income recharacterized as income from an active business of FA Finco subject to all other requirements being satisfied.

Example 2

One of the conditions in clause 95(2)(a)(ii)(D) requires that the money borrowed by FA Holdco from FA Finco be used for the purpose of earning income from property that are shares of a foreign affiliate of the taxpayer in respect of which the taxpayer has a qualifying interest and is excluded property of FA Holdco. Generally, the use of money borrowed for purposes of clause 95(2)(a)(ii)(D), is to be determined based on the principles that apply for purposes of paragraph 20(1)(c).

Prior to the merger, FA Holdco used borrowed money to purchase shares of FA Target. As a result of the merger, FA Holdco receives shares of FA Mergeco replacing shares of FA Target. A reasonable argument could be made that, for purposes of clause 95(2)(a)(ii)(D), the current use of the borrowed money is linked to the shares of FA Mergeco. To the extent that there is a reasonable expectation that FA Holdco receives dividends on the shares of FA Mergeco, that the shares of FA Mergeco are excluded property at all relevant times, and that FA Mergeco is a foreign affiliate of the taxpayer in respect of which the taxpayer has a qualifying interest at all relevant times, the “use” and “purpose” test described in subclauses 95(2)(a)(ii)(D)(I) and (III) should be met after the merger, and the interest income recharacterized as income from an active business of FA Finco subject to all other requirements being satisfied.

Q.16: Convertible Debentures and Part XIII Withholding Tax

In 2010, the Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional Accountants of Canada (Joint Committee) made a submission concerning the potential application of Part XIII withholding tax in the context of convertible debentures issued by Canadian resident issuers. In May 2013,[5] the CRA indicated that the analysis was substantially advanced but that there was a need to consult with the Department of Finance on the tax policy issues. In November 2013,[6] the CRA gave a general update but indicated that it could not provide additional certainty concerning the application of Part XIII tax given “the very broad range of situations in which convertible debentures can be issued”. In addition the CRA indicated that “[t]heir terms and conditions can be complex due to the wide variety of products available in the marketplace, and the particular circumstances and the terms and conditions of the debentures may differ from one situation to another.”

Given your experience over the last eight years, can the CRA now provide any further guidance regarding withholding tax in the context of convertible debentures?

CRA Response

In November 2013, the CRA also indicated that the Income Tax Rulings Directorate (ITRD) continued to encourage issuers and/or holders of convertible debts to request advance income tax rulings (rulings) if they have concerns about the application of Part XIII to convertible debts in the context of proposed transactions. Provided that a ruling request is received prior to the issuance of the convertible debts, the ITRD will examine the request and the rulings would generally apply prospectively to future regular periodic interest payments, conversions or sales of convertible debts.

However, since November 2013, the ITRD has received only one additional ruling request concerning the application of Part XIII tax to convertible debentures.

ITRD’s Rulings Letters

In November 2013, the CRA provided information concerning a favourable ruling letter[7] (Letter 1). On June 24, 2014, in a letter[8] of amendments to Letter 1, the ITRD provided two additional rulings and an opinion in respect of the proposed transactions described in Letter 1 (as amended by the letter of amendments).

The additional rulings given provided that:

• For the purposes of paragraph 212(1)(b), any amount deemed to be a payment of interest on a convertible note under subsection 214(7) as a result of a conversion of the convertible note into common shares as described in the relevant proposed transactions, will not be “participating debt interest” within the meaning of the definition in subsection 212(3).
• Any amount deemed to be a payment of interest on a convertible note under subsection 214(7) as a result of a conversion of the convertible note into common shares as described in the relevant proposed transactions, will not be subject to Part XIII withholding tax under paragraph 212(1)(b), provided that PUBCO (i.e. the issuer of the convertible note) deals at arm’s length with ACO (i.e. a non-resident person) at the time of the conversion.

The opinion provided that in the event of a disposition of a convertible note by ACO to a person resident in Canada (other than the issuer) for proceeds of disposition payable in cash, any amount deemed to be a payment of interest on a convertible note under subsection 214(7) would not in general constitute “participating debt interest” within the meaning of the definition in subsection 212(3).

The ITRD issued similar rulings in another rulings letter.[9] Moreover, the rulings given are applicable to the payment of make-whole amounts as described in the proposed transactions.

The ITRD continues to encourage issuers and/or holders of convertible debts to request advance income tax rulings if they have concerns about the application of Part XIII to convertible debts in the context of proposed transactions.

Subsection 214(7) Excess

In response to Q.12 at the CRA Round Table at the May 2009 IFA Seminar,[10] the CRA said that where there is a conversion of a traditional convertible debenture (as described in the response) by its original holder for common shares of the capital stock of the issuer, there would generally be no excess under subsection 214(7).

In its 2010 letter of submissions, the Joint Committee stated that the conversion premium realized on conversion or sale of a convertible debenture would constitute an excess (the amount by which the price for which the obligation was assigned or otherwise transferred exceeds the price for which the obligation was issued) under subsection 214(7).

The CRA has to review its administrative position (i.e. no excess) concerning the application of subsection 214(7) to the conversion of convertible debentures in light of new information available, including the Federal Court of Appeal decision in Agnico-Eagle Mines Limited, 2016 FCA 130. However, we were unable to complete our review in time to provide comments at this round table because of time constraints. When the analysis will be completed, the CRA will share its views with the CTF. Any change of position would be applicable on a prospective basis only.

Definition of “Participating Debt Interest”

The CRA’s view is still that the deemed payment of interest on standard convertible debentures under subsection 214(7) that arises because of a transfer or assignment of standard convertible debentures by a non-resident person to a person resident in Canada (including the issuer of the debenture), does not generally constitute “participating debt interest” (as defined in subsection 212(3)).