28 November 2005 External T.I. 2004-0073431E5 - Foreign accrual property income

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.

Principal Issues: Meaning of "indirectly" in subparagraph 95(2)(a)(ii) of the Act.

Position: No definitive conclusion. The agreements should set out clearly that one loan is conditional on the deposit and the documentation for the transactions should establish clearly that the flow of income can be directly traced and that the bank involved is acting as a conduit and is in effect receiving an accommodation fee for that service. The payment by the initial payer must, in some manner, be conditional on a payment being made to the ultimate payee or be part of an arrangement to which the initial payer is a party for a payment to be made to the ultimate payee.

Reasons: Previous positions.

XXXXXXXXXX Sylvie Labarre, CA
2004-007343
November 28, 2005

Dear XXXXXXXXXX

Re: Foreign accrual property income

We are writing in response to your letter of April 28, 2004 wherein you requested information concerning subparagraph 95(2)(a)(ii) of the Income Tax Act (the "Act").

1. A corporation resident in Canada (Canco) has a qualifying interest (as defined in paragraph 95(2)(m) of the Act) throughout the year in two foreign affiliates (FA1 and FA2). Canco, FA1 and FA2 are all related to each other throughout the year.

2. FA1 carries on an active business (as defined in subsection 95(1) of the Act) in country A and does not carry on business in Canada.

3. FA1 requires additional financing for its active business. FA2 has additional funds which it is prepared to lend to FA1.

4. Rather than FA2 lending the funds directly to FA1, FA1 and FA2 enter into the following transactions with an arm's length financial institution (Foreign Bank) resident in a country other than Canada:

(a) FA2 deposits funds (the Deposit) with Foreign Bank. Interest is payable by Foreign Bank on the Deposit at an arm's length rate of interest.

(b) FA1 and Foreign Bank enter into a loan agreement whereby Foreign Bank agrees to lend funds (the Loan) to FA1. The loan agreement provides that the principal amount of the Loan shall in no case exceed the amount of the Deposit placed by FA2 with Foreign Bank, and that FA1 is entitled to pre-pay any portion of the principal amount owing under the Loan at any time.

(c) As a condition precedent to advancing funds to FA1 pursuant to the Loan, Foreign Bank requires FA2 to enter into a guarantee agreement (the Guarantee) under which FA2 agrees to: (i) guarantee FA1's obligations under the Loan; and (ii) post the Deposit as collateral in respect of the Guarantee. Under the terms of the Guarantee, FA2 is not entitled to withdraw the Deposit until the maturity date of the Loan (except to the extent FA1 has prepaid any of the principal amount owing under the Loan).

(d) As consideration for the Guarantee, Foreign Bank will pay FA2 a monthly fee (the Guarantee Fee) based on a percentage of the collateral.

(e) Interest is payable by FA1 on the Loan at an arm's length rate of interest, which will exceed the sum of interest payable by Foreign Bank to FA2 on the Deposit.

(f) Foreign Bank is required to pay the interest payments on the Deposit and the Guarantee Fee within two business days of Foreign Bank receiving the corresponding monthly interest payment from FA1 under the Loan. The difference between the interest payments received by Foreign Bank from FA1 under the Loan and the amounts paid by Foreign Bank to FA2 as interest on the Deposit and as a Guarantee Fee will be retained by Foreign Bank as its fee for entering into the transactions.

(g) At all times, Foreign Bank's obligation to pay interest on the Deposit and the Guarantee Fee to FA2 will be contingent upon, and limited to, the amount of interest received by Foreign Bank from FA1 in respect of the Loan (less Foreign Bank's transaction fee).

(h) Foreign Bank is entitled to set off any amounts owing to it by FA1 under the Loan against amounts owing by Foreign Bank to FA2 under the Deposit.

5. FA1 uses the funds from the Loan in its active business. The interest payments made by FA1 in respect of the Loan are deductible in computing FA1's income from an active business under the laws of country A.

6. But for the provisions of subparagraph 95(2)(a)(ii) of the Act, the interest payments received by FA2 on the Deposit and the Guarantee Fee received by FA2 would constitute "income from property" (as defined in subsection 95(1) of the Act) of FA2.

Your question is whether subparagraph 95(2)(a)(ii) of the Act would apply to include the interest payment on the Deposit and the Guarantee Fee received by FA2 in computing FA2's income from an active business. In particular, you ask us whether the interest income on the Deposit and the Guarantee Fee would be considered to be "derived from amounts that were paid or payable, directly or indirectly" to FA2 by FA1.

Our comments

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 70-6R5. However, if the situation relates to a completed transaction a request for the Canada Revenue Agency's views must be made to your local Tax Services Office. We can, however, provide the following general comments.

Paragraph 95(2)(a) of the Act provides that in computing the income from an active business for a taxation year of a particular foreign affiliate of a taxpayer in respect of which the taxpayer has a qualifying interest throughout the year, there shall be included any income of the affiliate from sources in a country other than Canada that would otherwise be income from property of the affiliate to the extent that one of the subparagraph (i) to (iv) applies (taking into account the Legislative Proposals of February 27, 2004, the last part of the sentence would be replaced by "to the extent that one of the subparagraph (i) to (vi) applies"). An amendment to the preamble of paragraph 95(2)(a) is proposed by the Legislative Proposals of February 27, 2004 to broaden the scope of the paragraph to include the foreign affiliates in which the taxpayer does not have a qualifying interest but to which the taxpayer is related throughout the year.

According to your letter, Canco has a qualifying interest in FA2 throughout the year. FA2 receives interest and a Guarantee Fee. Income from property is defined in subsection 95(1) of the Act. The income from property includes, inter alia, its income from an investment business which is also defined in subsection 95(1) of the Act. As stated in the definition of "investment business", income from property includes interest, dividends, rents, royalties or any similar returns or substitutes therefor. In our view, the Guarantee Fee would be such a similar return or substitute. Therefore, the interest income and the Guarantee Fee received by FA2 would otherwise be income from property.

In the particular situation, you ask us to determine whether subparagraph 95(2)(a)(ii) of the Act (as it exists or as amended by the Legislative Proposals of February 27, 2004) applies. Under the Act or under the Legislative Proposals, the conditions of that subparagraph will be met in a taxation year if the income is derived from amounts that were paid or payable, directly or indirectly, to the particular affiliate by a non-resident corporation to which the particular affiliate and the taxpayer are related throughout the year to the extent that those amounts that were paid or payable are expenditures that would, if the non-resident corporation were a foreign affiliate of the taxpayer, be deductible by it in the year or a subsequent year in computing the amounts prescribed to be its earnings or loss from an active business, other than an active business carried on in Canada.

According to your letter, FA1 is a non-resident corporation to which FA2 and Canco are related throughout the year. You also mentioned that the interest payments made by FA1 in respect of the Loan are deductible in computing FA1's income from an active business under the laws of country A.

The last question to resolve is whether the interest and the Guarantee Fee received or receivable by FA2 derived from amounts that were paid or payable indirectly to FA2 by FA1. It is a question of fact whether the income of a foreign affiliate can be said to be derived from amounts that were paid or payable by a related corporation to that foreign affiliate. Subparagraph 95(2)(a)(ii) provides that the payments can be paid or be payable indirectly to the foreign affiliate. This implies that a strong link must be established between the payer of the interest and the payee in a back-to-back loan situation such as yours. The agreements would have to clearly set out that one loan is conditional on the other loan so that the flow of income can be directly traced with the bank simply acting as a conduit and in effect receiving an accommodation fee for its service. In addition, we would expect that the payments would occur more or less at the same time. The fact that the payment made by the initial payer is greater than the payment received by the ultimate payee does not, in and by itself, preclude the application of subparagraph 95(2)(a)(ii) in a particular situation. The fact that the nature of the property income received by the ultimate payee (interest and guarantee fee) is different from the nature of the payment made by the initial payer (interest) is not conclusive in itself.

We have said in the past that 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 if the payment can be traced and shown to be an indirect payment to the other foreign affiliate. However, the application of the provision depends on the particular facts of each case and it is difficult to provide specific guidelines. Certainty with respect to the interpretation of subparagraph 95(2)(a)(ii) could however, be provided through an advance income tax ruling.

We trust the above has been of some assistance and we regret the delay in responding.

Yours truly,

Alain Godin, Manager
for Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Planning Branch