8 May 2002 External T.I. 2002-0122335 - Indirect payment through a trust

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: Whether interest is paid "indirectly" from one foreign affiliate to another foreign affiliate for the purposes of subparagraph 95(2)(a)(ii)(B) where a trust is interposed.

Position: No.

Reasons: The phrase "amounts that were paid ... indirectly ... to the particular affiliate" requires that a payment by the payor affiliate to some intermediary person be conditional on, or part of an arrangement for, an equal payment being made to the recipient affiliate. (Also see E9605735 and E9517445)

XXXXXXXXXX 2002-012233

May 8, 2002

Dear XXXXXXXXXX:

Re: Subparagraph 95(2)(a)(ii) of the Income Tax Act (the "Act")

We are writing in reply to your facsimile letter of February 5, 2002 wherein you requested our opinion regarding the application of subparagraph 95(2)(a)(ii) of the Act (all further statutory references in this letter are to the Act) in a situation where a controlled foreign affiliate of a Canadian corporation pays interest to a trust which, in turn, distributes that same amount to its sole beneficiary, being another controlled foreign affiliate of the same Canadian corporation.

The situation in your letter may be briefly described as follows:

1. Canco, a Canadian resident corporation, owns 100% of the shares of both Payor Affiliate and Beneficiary Affiliate, each of which is a corporation resident in "Country X", being a designated treaty country (per subsection 5907(11) of the Regulations to the Act and each of which is not resident in Canada.

2. Beneficiary Affiliate is the sole beneficiary of "Trust", which is a trust that is resident in Country X and is not resident in Canada.

3. The only asset of the Trust is a mortgage granted by Payor Affiliate which bears a market interest rate.

4. All of the assets of Payor Affiliate are used by it in carrying on an active business in Country X and the interest it pays on the mortgage is deductible in computing its earnings from an active business.

5. The Trust is subject to tax by Country X on its worldwide income. However, the Trust will allocate all of its income to Beneficiary Affiliate in order to reduce its income to nil.

6. You ask us to assume that paragraph 94(1)(d) of the Act will not apply to this hypothetical situation on the assumption that the provision will be revised in proposed amendments dealing with "Non-resident Trusts and Foreign Investment Entities".

Your question is whether the distribution to the Beneficiary Affiliate by the Trust of an amount equal to the interest received by the Trust from the Payor Affiliate will be considered a payment made indirectly to the Beneficiary Affiliate by the Payor Affiliate so that the amount will be included in the income from an active business of the Beneficiary Affiliate pursuant to paragraph 95(2)(a) of the Act.

Your request appears to relate to a proposed transaction or a completed transaction. Confirmation of the income tax consequences of proposed transactions involving specific taxpayers will only be provided in response to a request for an advance income tax ruling. To make such a request the advance income tax ruling must be submitted in accordance with the guidelines set out in Information Circular 70-6R4 ("IC-70-6R4") dated January 29, 2001. However, if the situation relates to a completed transaction a request for the Canada Customs and Revenue Agency's views must be made to your local Tax Services Office. We can, however, provide the following general comments.

The words in subparagraph 95(2)(a)(ii) of the Act that you rely on are

"amounts that were paid or payable, directly or indirectly, to the particular affiliate ... by another foreign affiliate of the taxpayer"

or, to rephrase the above for your situation,

"amounts that were paid ... indirectly ... to the particular affiliate ... by another foreign affiliate".

Dictionary meanings of "indirect" and "indirectly" include:

indirect

adj.

Diverging from a direct course; roundabout.

Not proceeding straight to the point or object.

indirectly

adv.

In an indirect manner; not in a straight line or course; not in express terms; obliquely; not by direct means; hence, unfairly; wrongly.

We consider that the word "indirectly", when used with the preposition "to" in relation to an activity, requires a relation or link between the activity initiated and the ultimate object of that activity. Moreover, in the context of an "indirect payment" referred to in clause 95(2)(a)(ii)(B) of the Act, we consider that the payment made by the initial payor must, in some manner, be conditional on an equal payment being made to the ultimate payee or be part of an arrangement to which the initial payor is a party for an equal payment to be made to the ultimate payee.

In the past, we have stated that certain "back-to-back" loan situations may qualify as an indirect payment but the payment "would have to be able to be directly traced". In Document 9605735 (August 7, 1996), to which you referred, we stated:

For example, subparagraph 95(2)(a)(ii) will apply in a back to back loan situation where the agreements set out clearly that one loan is conditional on the other loan or deposit, and the documentation for the transactions establish clearly that the flow of income can be directly traced and that the bank or third party involved in a back to back loan is acting as a conduit and is in effect receiving an accommodation fee for that service.

In addition, the time lag between the two payments in a back to back loan situation (that is, the payment to the bank or third party by the related non-resident corporation (the "first payment") and the payment by the bank or third party to the particular foreign affiliate (the "second payment")) would have to be reasonable in order for the amounts to be directly traceable. The fact that the second payment may be made shortly before the first payment would not necessarily mean that the income could not be recharacterized as active business income under subparagraph 95(2)(a)(ii) of the Act if it were evident by the documentation for the transactions and the short time lapse between the payments that the transactions were all part of one back to back loan arrangement.

As well, in Document 9517445 (February 1, 1996), we stated:

At the 1995 Canadian Tax Foundation Conference, a representative of the Department of Finance stated that the words "directly or indirectly" were meant to deal with back to back loans and certain fronting arrangements involving insurance. He added that, "The object of subparagraph 95(2)(a)(ii) is to keep the active business income of certain affiliated or related groups of corporations whole where there are payments amongst its members."

In our view, where an arm's-length intermediary is involved in a payment flow, an amount would be considered to be paid or payable directly or indirectly by another qualified foreign affiliate to a particular foreign affiliate where the payment can be traced and shown to be a payment made directly or indirectly to a particular foreign affiliate that was deductible by the other foreign affiliate in computing its earnings or loss from an active business.

In the trust situation you have described, the making of the payment by Payor Affiliate to the Trust is not conditional or dependent on any arrangement by the Trust to make a payment of the same amount to the Beneficiary Affiliate. Instead, an independent decision is being made by the trustees of the Trust to distribute to the Beneficiary Affiliate, as the sole beneficiary of the Trust at the time of the distribution, an amount equal to the amount received by the Trust from the Payor Affiliate. Accordingly, we do not consider that the interest paid by Payor Affiliate to the Trust in a particular year of the Trust and distributed by the Trust to Beneficiary Affiliate in the same year will be deemed to be income of Beneficiary Affiliate from an active business carried on by it pursuant to paragraph 95(2)(a) of the Act.

Our comments are provided in accordance with the practice outlined in paragraph 22 of IC-70-6R4.

Yours truly,

for Director
International and Trust Division
Income Tax Rulings Directorate
Policy and Legislation Branch