4 June 2002 External T.I. 2001-0114255 - Taxation year of a foreign affiliate

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

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: Where U.S. Treasury Regulation §1.1502-76(b)(1)(ii) applies, for purposes of computing the exempt surplus of a foreign affiliate, does the "taxation year of the subject affiliate in which it last became a foreign affiliate" mean the year ending on the day of the acquisition, or the year commencing on the day subsequent to the acquisition?

Position: The year commencing on the day subsequent to the acquisition, plus any transactions from the previous day after the acquisition

Reasons: Only the earnings and loss of the foreign affiliate subsequent to the acquisition is considered in the computation of exempt surplus.

XXXXXXXXXX 		2002-011425
S. E. Thomson
June 4, 2002

Dear XXXXXXXXXX:

Re: Taxation year of a foreign affiliate

This is in reply to your letter of December 5, 2001, in which you ask for our technical interpretation of the application of the phrase "taxation year of the subject affiliate in which it last became a foreign affiliate" in subsection 5907(1) of the Income Tax Regulations (the "Regulations").

In the hypothetical scenario you have outlined, a Canadian corporation ("Canco") owns all of the shares of a U.S. resident corporation ("Holdco"), which, in turn, owns all of the shares of a second U.S. resident corporation ("FA1"). All three corporations have a December 31st year-end. On May 31st, Holdco acquires all of the shares of a U.S. resident corporation ("FA2"), which in turns owns all of the shares of another U.S. resident corporation ("FA3"). FA2 and FA3 also had a December 31st year-end prior to the acquisition. FA2 and FA3 carry on an active business in the United States.

For U.S. tax purposes, Holdco and FA1 file a consolidated tax return as members of a group. Prior to the acquisition on May 31st, FA2 and FA3 were included in the consolidated tax return of another group (the "old group"). After the acquisition, FA2 and FA3 will be included in the consolidated filing of Holdco and FA1.

U.S. Treasury Regulation §1.1502-76(b)(1)(ii)(A)(1) (the "end-of-day rule") states that when a corporation becomes or ceases to be a member of a group that files a consolidated return, it becomes or ceases to be a member at the end of the day on which its status as a member has changed, and its tax year ends for all Federal income tax purposes at the end of that day.

The income or loss of FA2 and FA3 for their taxation years ended at the end of the day on May 31st would be included in the consolidated filing of the old group, and the income or loss of their taxation years commencing on June 1st will be included in their consolidated filing with FA1 and Holdco.

However, Treas. Reg. §1.1502-76(b)(1)(ii)(B) (the "next-day rule") states that if, on the day of the corporation's change in status as a member, a transaction occurs that is properly allocable (considering all of the factors) to the portion of the corporation's day after the event giving rise to the change, the corporation must treat the transaction as occurring at the beginning of the day following the day of the change.

You have asked us for our opinion, given these two regulations, on the calculation of exempt surplus or deficit in Part LIX of the Income Tax Act (the "Act") in the above scenario. The term "exempt surplus" in subsection 5907(1) of the Regulations, is computed at a particular time "in respect of the period beginning with ... the first day of the taxation year of the subject affiliate in which it last became a foreign affiliate of the corporation, ... and ending with the particular time...".

If we consider that the end-of-day rule applies, since FA2 and FA3 became foreign affiliates of Canco in the taxation year ending May 31st, the first day of that taxation year is the previous January 1st. Therefore, exempt surplus of FA2 and FA3 in respect of Canco, would be computed for the period commencing the previous January 1st. If FA2 and FA3 had been foreign affiliates of another Canadian corporation during the period January 1st through May 31st, this interpretation would result in the exclusion of the earnings or loss of FA2 and FA3 for the year ended May 31st from their exempt surplus vis-à-vis the other Canadian corporation. This would be anomalous because it is the old group that would be responsible for the U.S. tax liability associated with the earnings of FA2 and FA3 for that taxation year.

However, if we consider that the next-day rule applies, FA2 and FA3 become foreign affiliates of Canco in the taxation year commencing June 1st, and exempt surplus would be computed commencing on that day.

OUR COMMENTS

Although you have asked for our technical interpretation on a hypothetical situation, it appears that your request involves a transaction or series of transactions contemplated by specific taxpayers. In order to obtain confirmation as you have requested, your request should be resubmitted as a request for an advance income tax ruling. Although we cannot comment directly on your situation, we can offer the following general comments on the relevant provisions of the Act. Please note that these comments are not binding on the Canada Customs and Revenue Agency.

The term "taxation year" of a foreign affiliate referred to in subsection 5907(1) of the Regulations is defined in subsection 95(1) of the Act to be, inter alia, the period for which the accounts of the foreign affiliate have been ordinarily made up. As noted in paragraph 4 of Information Circular 77-9R Books, Records & Other Requirements For Taxpayers Having Foreign Affiliates, the financial statements of the foreign affiliate are those that have been accepted by taxation authorities in the foreign jurisdiction (if required).

A rule which deems a change in status to occur at a particular time, such as the "end-of-the day rule", is useful in eliminating the administrative task of attempting to allocate normal everyday transactions carried out by a corporation to a pre and post-acquisition period by providing that a year-end occurs at the end of the day, and that results of operations for such year pertain to the period while the vendor held the shares of the corporation. However, the "next-day rule" demonstrates that, in substance, the new taxation year effectively begins at the moment the shares are acquired by providing that a transaction properly allocable... is to be treated as occurring at the beginning of the day following the date of change. To put it another way, since, in this case, material transactions taking place after the change in control on May 31st are included in computing the income for the period beginning June 1st, the taxation year in which the corporation became a foreign affiliate arguably begins on the acquisition.

Paragraph (b) of Treas. Reg. §1.1502-76 states that, in general, a consolidated return must include the common parent's items of income for the entire consolidated year, and each subsidiary's items for the portion of the year for which it is a member. Since the group comprising Holdco, FA1, FA2 and FA3 is responsible for U.S. taxes only for the taxation years beginning on June 1st and subsequent, and since the income of FA2 and FA3 for that year would generally include material transactions occurring on the previous day but after the acquisition, in our view, the taxation year in which FA2 and FA3 last became foreign affiliates of Canco would commence on June 1st for purposes of the computation of exempt surplus or deficit.

We trust that our comments have been helpful.

Yours truly,

Olli Laurikainen
for Director
International & Trusts Division
Income Tax Rulings Directorate