17 September 2003 External T.I. 2003-0037685 - non-arm's length acquisition

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:

1. Whether paragraph 13(7)(e) of the Act applies to a disposition of property from a US sister company to a Canadian sister company.

2. Whether the half-year rule exception in subsection 1100(2.2) of the Regulations applies to the Canadian company when they acquire the property from the US company.

Position: 1. Question of fact.

2. Question of fact.

Reasons:

1. Paragraph 13(7)(e) of the Act only applies where the property acquired by the Canadian company is "capital property of the transferor".

2. The property is generally not "depreciable property" of the transferor, by virtue of subsection 1102(3) of the Regulations, such that the requirements in paragraph 1100(2.2)(f) of the Regulations are not satisfied and the exception to the half-year rule does not apply.

2003-003768
XXXXXXXXXX A. Seidel
(613) 957-2058
September 17, 2003

Dear XXXXXXXXXX:

Re: Non-arm's Length Acquisitions

This is further to our telephone conversation (Seidel/XXXXXXXXXX) of September 8, 2003, your letter dated April 24, 2003 and our letter dated June 30, 2003, concerning the non-arm's length acquisition of computer "applications software". Please note that this letter replaces our earlier response of June 30, 2003.

You describe a situation where a non-resident corporation has developed applications software the cost of which the non-resident corporation has expensed in computing income. The non-resident has owned the software for more than a year and licenses its use to arm's length parties. The software is situated outside of Canada. You query whether paragraph 13(7)(e) of the Income Tax Act (the "Act") or subsection 1100(2.2) of the Income Tax Regulations (the "Regulations") would apply if a Canadian sister corporation acquired the applications software at its fair market value, packages it with some of its own computer software and licenses its use to arm's length parties.

The particular circumstances in your letter on which you have asked for our views appear to be a factual situation involving a specific taxpayer. As explained in Information Circular 70-6R5, it is not this Directorate's practice to comment on transactions involving specific taxpayers other than in the form of an advance income tax ruling. To the extent that you require confirmation of the tax consequences of proposed transactions, you should be requesting an advance income tax ruling. However, we would point out that advance income tax rulings are not provided in respect of transactions that are substantially completed. The tax consequences of completed transactions can only be determined after a review of all of the relevant facts and documentation, which is the responsibility of the Verification and Enforcement Division of the local tax services office.

Although we cannot provide any specific comments with respect to the situation described in your letter, the following general comments may be of assistance.

In general, where a taxpayer resident in Canada has acquired a property for use in the taxpayer's business, the nature, purpose and anticipated life of the property will be considered in determining whether the acquisition cost should be written off in the year the property is acquired or, because of its enduring nature, the acquisition cost of the property should be capitalized.

The proper classification of applications software is discussed in Interpretation Bulletin IT-283R2 ("IT-283R2"). Paragraph 10 of IT-283R2 states that "computer software" includes a right or license to use computer software and that "software" is considered to be of an "enduring nature" where its useful life is anticipated to last beyond one year. "Applications software" that is a capital property and a depreciable asset is included in Class 12 of Schedule II of the Regulations.

Paragraph 13(7)(e) of the Act applies to, among other things, and "notwithstanding any other provision of this Act", a non-arm's length acquisition of a depreciable property of a prescribed class provided "the property was a capital property of the transferor".

"Capital property" is defined in section 54 of the Act to include any depreciable property of the taxpayer and any property (other than depreciable property) any gain or loss from the disposition of which would, if the property were disposed of, be a capital gain or a capital loss, as the case may be, of the taxpayer.

"Depreciable property" is defined in subsection 13(21) of the Act to include property acquired by the taxpayer in respect of which the taxpayer has been allowed, or would, if the taxpayer owned the property at the end of the year and the Act were read without reference to subsection (26), be entitled to, a deduction under paragraph 20(1)(a) of the Act in computing income for that year or a preceding taxation year.

Subsection 1102(3) of the Regulations applies where a taxpayer is a non-resident person and provides that the classes of property described in Part XI and in Schedule II of the Regulations shall, except for the purpose of determining the foreign accrual property income of the taxpayer for the purposes of subdivision i of Division B of Part I of the Act, be deemed not to include property that is situated outside Canada. Therefore, any property situated outside of Canada is not "depreciable property" of the taxpayer.

Where applications software is developed and situated outside of Canada prior to its acquisition by a Canadian sister corporation, such applications software would not be "depreciable property" of the transferor. The applications software would be "depreciable property" of the transferee where all of the criteria discussed in IT-283R2 are satisfied.

Whether or not the applications software would be a "capital property" of the transferor is a question of fact that can only be determined by a review of all of the facts relevant to a particular situation. Even though a non-resident transferor may have been allowed to expense the cost of developing the applications software, there may be situations where the disposition of the applications software gives rise to a capital gain or capital loss such that the software would be considered to be a capital property of the transferor. In such situations, the capital cost of the applications software to the Canadian sister corporation would be determined under subparagraph 13(7)(e)(ii) of the Act.

Where the applications software is not a capital property of the transferor, the rules in paragraph 13(7)(e) of the Act will not apply to the transferee. The general rule pertaining to non-arm's length acquisitions of property, such as section 69 of the Act, would, nevertheless, apply to the acquisition of the applications software by the Canadian sister corporation.

Subsection 1100(2.2) of the Regulations provides an exception to the "half-year rule" applicable to depreciable property acquired in a taxation year in certain situations. One of those situations is where a property of a class in Schedule II of the Regulations is acquired by a taxpayer from a person with whom the taxpayer was not dealing at arm's length at the time the property was acquired, the property was depreciable property of the person from whom it was acquired and the property was owned by the transferor for a period of at least one year. The rules in section 1100 of the Regulations determine the deduction allowed, "for the purposes of paragraphs 8(1)(j) and (p) and 20(1)(a) of the Act", in computing a taxpayer's income under Part I of the Act. Where the applications software is not, by virtue of subsection 1102(3) of the Regulations, depreciable property of the transferor, all of the conditions enumerated in subsection 1100(2.2) of the Regulations would not be satisfied. The half-year rule in subsection 1100(2) of the Regulations would therefore apply to the acquisition of the applications software by the Canadian sister corporation.

Yours truly,

John Oulton, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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