5 December 2003 External T.I. 2002-0165195 - Debt Forgiveness in Foreign Affiliates

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.

PRINCIPLE ISSUES: (1) Whether debt forgiveness rules apply on settlement of loans in foreign affiliate context; (2) Whether paragraph 95(2)(i) applies to foreign exchange gains or losses arising from settlement of debt in circumstances described?

Position: (1) Yes; (2) Yes.

Reasons: (1) Paragraph 95(2)(g.1); (2) Paragraph 95(2)(i).

									Suzanie Chua
XXXXXXXXXX 								(613) 957 2115
									2002-016519
December 5, 2003

Dear XXXXXXXXXX:

Re: Debt Forgiveness in Foreign Affiliates

We refer to your letter regarding the above matter and write in response to your queries raised. The hypothetical situation you have described is as follows:

1. Canco is a corporation resident in Canada that has subsidiaries in the US and the UK. Canco has a US subsidiary ("CFA1") that qualifies as a "controlled foreign affiliate" of Canco under the definition of that term in subsection 95(1) and subsection 17(15) of the Income Tax Act (the "Act").

2. CFA1 has US dollar non-interest bearing loans payable to Canco (the "CFA1 debt"). The CFA1 debt was used by CFA1 to (i) acquire shares of CFA1's US subsidiaries that are also "controlled foreign affiliates" as defined in subsections 95(1) and 17(15) of the Act, of Canco, (ii) finance the operations of CFA1's US subsidiaries, and (iii) finance CFA1's own expenses associated with the activities described in (i) and (ii).

3. All of the US subsidiaries of CFA1 carry on active business and earn no other type of income.

4. All of the US controlled foreign affiliates of Canco are residents of the US and would be considered US residents pursuant to the Canada-US Income Tax Convention.

5. CFA1 does not carry on active business. No part of the CFA1 debt was used by CFA1 to earn foreign accrual property income ("FAPI") and all of the debt was used to earn dividends from subsidiaries and interest income that was deemed active business income pursuant to subparagraph 95(2)(a)(ii).

6. The CFA1 debt is on account of capital i.e. any gain or loss on settlement thereof will be a capital gain or loss in the hands of Canco and/or CFA1 as the case may be.

The questions you raised can be summarized as follows:

(a) Whether the forgiveness of the CFA1 debt would affect the computation of CFA1's FAPI;

(b) Whether the forgiveness of the CFA1 debt gives rise to an addition to any surplus account of CFA1 vis-a-vis Canco for the purpose of section 5907 of the Regulations; and

(c) Whether the settlement of the CFA1 debt will give rise to a foreign exchange gain or loss that would be included in the computation of the FAPI of CFA1?

Our Comments

Written confirmation of the tax implications inherent in real transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5. However, we are prepared to provide you with the following general comments.

With respect to question (a), as stated in the Department of Finance ("Finance") Technical Notes February 1995, the intent of paragraph 95(2)(g.1) of the Income Tax Act (the "Act") is to apply the debt forgiveness rules in section 80 for purpose of computing FAPI, with respect to obligations settled or extinguished that relate to "FAPI" as that term is defined in subsection 95(1) of the Act. Paragraph 95(2)(g.1) is only applicable for purposes of calculating FAPI and does not apply to the calculation of CFA1's business or property income for other purposes of Subdivision i of Division B, Part I of the Act. Subsection 80(1), as modified by subparagraph 95(2)(g.1)(i), reads:

"commercial debt obligation" issued by a debtor means a debt obligation issued by the debtor

(a) where interest was paid or payable by the debtor in respect of it pursuant to a legal obligation, or

(b) if interest had been paid or payable by the debtor in respect of it pursuant to a legal obligation,

an amount in respect of interest was or would have been deductible in computing the debtor's foreign accrual property income (within the meaning assigned by subsection 95(1))".

If a portion of the debt had been used to earn FAPI, and the remainder to earn active business income, we are of the view that the whole debt would be a "commercial debt obligation", not just the portion that related to the earning of FAPI. In answer to your question (a), if any amount in respect of interest on the CFA1 debt would have been deductible in computing CFA1's FAPI had interest been paid or payable thereon, the income inclusion attributable to the forgiveness of the whole debt would be brought into the computation of FAPI. However, based on the above hypothetical facts, the forgiveness of the CFA1 debt does not affect the computation of FAPI because all of the debt was used to earn dividends from subsidiaries and interest income that was deemed active business income pursuant to subparagraph 95(2)(a)(ii) (i.e. items of income not included in the FAPI computation). Accordingly, the CFA1 debt would not be a "commercial debt obligation" for the purposes of computing FAPI and there would be no impact arising on the forgiveness of the CFA1 debt on the computation of FAPI.

With respect to your question (b), paragraph (a) of the definition of "earnings" in subsection 5907(1) of the Regulations deals with income from an active business carried on by a foreign affiliate and CFA1, as you indicated, did not carry on an active business. Moreover we are of the view that paragraph (b) of that definition does not apply in these circumstances. There is nothing in the "exempt earnings" or "taxable earnings" definitions that would pick up forgiveness of a commercial debt obligation that did not relate to FAPI. Furthermore, the adjustment to "earnings" in paragraph 5907(2)(f) would not be available because this provision applies to revenue, income or profit derived from an active business carried on by a foreign affiliate. Therefore, while such income may be computed for a foreign affiliate, there appears to be nothing in the Regulations that would allow it into exempt or taxable surplus.

However, a contribution of capital the amount of which can be added to the adjusted cost base of the shares of CFA1 held by Canco, pursuant to paragraph 53(1)(c) occurs when the CFA1 debt is absolutely forgiven by Canco. If dividends were paid out by CFA1 that exceeded the exempt surplus and taxable surplus of CFA1 vis-à-vis Canco (i.e. as a result of the debt forgiveness not having been included in those amounts), such dividend would constitute a dividend from CFA1's pre-acquisition surplus. While such dividends would be deductible by Canco pursuant to paragraph 113(1)(d) of the Act, they would also be offset against the adjusted cost base of the shares of CFA1 held by Canco pursuant to paragraph 92(2)(c) of the Act.

Finally, with respect to your question (c), paragraph 95(2)(i) of the Act states that gains or losses of a foreign affiliate from the settlement or extinguishment of a debt that related at all times to the acquisition of excluded property shall be deemed to be gains or losses from the disposition of excluded property. On the hypothetical facts, CFA1 used all of the borrowed money to acquire shares and debt that were excluded property and to pay expenses associated with such acquisitions. On this basis, it appears that the borrowed money "related at all times" to the acquisition of excluded property for the purposes of paragraph 95(2)(i). By operation of subparagraph 95(2)(f)(ii), a capital gain or loss on the settlement of the CFA1 debt would be calculated using the "calculating currency" as that term is defined therein, of CFA1. If the debt was denominated in the calculating currency of the affiliate, i.e. US dollars in your example, no foreign exchange gain or loss would arise. On the other hand, if a debt interest in respect of which was deductible in computing FAPI were forgiven, by virtue of paragraph 80(2)(k), any currency gain or loss would not be included in the "forgiven amount". In that case, paragraph 95(2)(i) of the Act would not apply. Accordingly, the taxable capital gain or allowable capital loss would be computed pursuant to subsection 39(2) and subparagraph 95(2)(f)(i) of the Act using the Canadian dollar as the calculating currency and would be included in the computation of CFA1's FAPI. With respect to the computation of surpluses and deficits of CFA1, subsections (5) and (6) of Regulation 5907 would require that amount and the tax-free portion to be converted into the currency that would be, in CFA1's case, US dollars.

Prior to the CFA1 debt forgiveness, to the extent an amount owing in respect of the CFA1 debt was not used in the manner described in subsection 17(8), subsection 17(1) would apply.

We trust that the foregoing will be of assistance to you.

Yours truly

Olli Laurikainen
Section Manager
for Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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