5 December 2005 External T.I. 2005-0155331E5 - XXXXXXXXXX 2006 Meeting - Q & A's

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: Questions & Answers provided by Wayne Adams at 2006 XXXXXXXXXX Meeting
Limited partnerships and thin capitalization
Various questions re 95(6)
Reverse hybrids and treaty

Position: See body of memo

Reasons: See body of memo

On October 24, 2006, Wayne Adams, Director General of the Income Tax Rulings Directorate, Canada Revenue Agency, attended the XXXXXXXXXX meeting and responded to the following questions:

1. Application of the thin-capitalization rules in subsection 18(4) to a foreign owned and controlled private equity fund (the "Fund")

Facts/Assumption

1. The Fund is a limited partnership (LP); all of the investors in the Fund are non Canadian; none of the investors in the Fund owns more than a 10% interest in the LP; the general partner is non Canadian and has operational control of the fund.

2. The Fund intends to acquire 100% of the shares of a Canadian corporation ("Target").

3. The Fund will leverage 100% of its 'equity' in the form of an interest bearing loan to a Canadian acquisition company ("Holdco").

4. Holdco will acquire 100% of the shares of Target and will amalgamate immediately after the closing to form Amalco.

5. Assume that there is no 'capital' for purposes of the subparagraph 18(4)(a)(ii) of the Act in Amalco.

Questions/Comments

A. Will CRA attempt to apply subsection 18(4) to deny the interest deduction in Amalco?

CRA Response

Where a partnership with non-resident partners has lent money to a corporation resident in Canada, subsection 96(1) does not apply to deem the partnership to be a separate person for purposes of the thin capitalization rules. Consequently, the determination of whether there are any "specified shareholders" for purposes of the thin capitalization rules is made at the partner, rather than the partnership, level.

If each partner of the partnership has an interest of less than 10% in the partnership and all the partners deal at arm's length with each other for purposes of subsection 251(1), no partner would own the requisite shares of the capital stock of the debtor corporation necessary to be a "specified shareholder". The thin capitalization rules would not apply and the CRA would not deny any interest deduction. Alternatively, if all of the partners of a partnership do not deal with each other at arm's length for purposes of subsection 251(1), each partner would be a specified shareholder. The thin capitalization rules would apply and the CRA would deny such portion of the interest deduction as determined by subsection 18(4).

B. Does the answer to 1) change depending on the ownership of the limited partnership units in the Fund (for example, if any limited partners would be considered a specified non-resident shareholder if they made loans directly to Amalco)?

CRA Response

If a non-resident person ("Non-Resident") is a specified shareholder of a corporation by virtue of his or her direct shareholdings and is also a partner in a partnership that has made a loan to the corporation, the outstanding debt to specified non-residents for thin capitalization purposes would be the total of any loans to the corporation made outside the partnership by the Non-Resident and the share of the loans made by the partnership allocable to the partnership interest of the Non-Resident.

2. Subsection 95(6)___________________________________________________

A. Canco, a taxable Canadian corporation, directly owns shares of a foreign affiliate corporation ("Foreign Opco") and subsequently transfers those shares to a foreign holding corporation ("Foreign Holdco"). At the May 9, 2005 International Fiscal Association Conference ("2005 IFA Conference") CRA officials indicated that if those shares were transferred to Foreign Holdco for the principal purpose of "mixing" low-tax and high-tax foreign earnings from a non-designated treaty country, paragraph 95(6)(b) would apply. Assuming this position has not changed, would the timing of setting up a mixer structure (i.e. originally versus at a later time) be relevant in determining whether paragraph 95(6)(b) applies? If the timing is relevant, how do you rationalize this interpretation in light of the Supreme Court of Canada's decision in Singleton (i.e. the legal relationships of the underlying transaction must be examined as opposed to how or when the transaction was structured)?

CRA Response

As we noted at the 2005 Canadian Tax Foundation conference, the CRA continues to be of the view that subsection 95(6) is a broadly worded anti-avoidance rule. Since the 2004 CTF Conference, the CRA has been preparing some examples of certain structures where it considers that paragraph 95(6)(b) will apply, and of structures where it considers that paragraph 95(6)(b) will not apply. The CRA intends to publish the examples in an Income Tax Technical News at some future date. Completion of the ITTN has been postponed pending the outcome of the Univar Canada Ltd case that was heard in the Tax Court of Canada in May 2005. However, some of the draft examples were discussed during the CRA roundtable at the May 2005 IFA Conference in Toronto.

All potential subsection 95(6) reassessments will be referred to Head Office for review by representatives of the Income Tax Rulings Directorate, the Tax Avoidance and Special Audits Division, and the International Tax Directorate.

In answer to your first question, in our view it is not relevant when the mixer structure is set up. If the principal purpose for the acquisition of the Foreign Holdco shares is to permit a person to avoid, reduce or defer the payment of tax under the Act, paragraph 95(6)(b) will apply.

B. In a follow up question at the IFA conference, CRA suggested that paragraph 95(6)(b) may apply if the mixer corporation was established principally to reduce foreign withholding tax on dividends paid from lower-tier affiliates. This interpretation appears extremely broad and contrary to the words of paragraph 95(6)(b), which require the principal purpose of the acquisition of shares to be the avoidance or reduction of Canadian tax, not foreign tax. Can you comment?

CRA Response

In our view, foreign tax considerations are not relevant in determining the principal purpose of the acquisition for paragraph 95(6)(b). The argument that a foreign tax benefit was the primary purpose for a transaction was raised in RMM Canadian Enterprises Inc. and Equilease Corporation v. HMTQ (97 DTC 302). The judgment contained the following relevant passage:

".. I am not prepared to say that because a U.S. tax saving that is greater than the Canadian tax saving is envisaged or achieved by a Canadian tax avoidance scheme this in itself takes the transaction outside the ambit of section 245. A particular transaction the purpose of which is the avoidance of Canadian tax may well have international fiscal implications. Section 245 operates within the context of Canadian tax law and it is within that context that the primary purpose is to be determined. The appellant's position appears to be that where an avoidance transaction in Canada results in greater inroads being made against the U.S. fisc that against the Canadian fisc the primary purpose cannot be the avoidance of Canadian tax. I do not accept that."

We consider the above passage instructive in interpreting paragraph 95(6)(b).

C. Canco owns 100% of a foreign affiliate, Foreign Opco. Canco transfers its shares in Foreign Opco to a foreign holding corporation ("Foreign Holdco") for fair market value consideration consisting of common shares of Foreign Holdco. The principal purpose of establishing Foreign Holdco is to defer the recognition of Canadian tax on a capital gain realized by Canco on the eventual disposition of shares of the foreign affiliate. No arm's length sale is contemplated at the time so subsection 85.1(4) does not apply to prevent the application of the rollover provided by subsection 85.1(3) specifically to facilitate such transactions. Please advise whether the CRA would seek to apply paragraph 95(6)(b).

CRA Response

The principal purpose of establishing Foreign Holdco is to defer Canadian tax payable by Canco on the eventual disposition of the shares of Foreign Opco. Therefore the requisites for the application of paragraph 95(6)(b) are met.

D. Canco and USco are 100% owned subsidiaries of a foreign corporation ("Foreignco"). Canco acquires shares of USco which have a preferential dividend entitlement but also have up-side potential in certain circumstances (i.e. certain "common share"-like features). Please comment on whether paragraph 95(6)(b) would apply in a situation where Canco acquires shares with characteristics of both preferred and common shares. Does it make a difference whether Canco borrows to acquire shares of USco or uses excess cash?

CRA Response

If the principal purpose for the acquisition of the USco shares by Canco is to allow a person avoid, reduce or defer the payment of tax under the Act, paragraph 95(6)(b) will apply. We generally would accept that the acquisition of common shares in a corporation engaged in an active business would be made principally to earn a return in the form of dividends and growth in the value of the shares. If Canco acquired shares other than common shares of USco, the facts and circumstances would need to be examined to assess whether the principal purpose of the acquisition was to avoid, reduce or defer taxes otherwise payable by either Canco or Foreignco.

E. Due to time constraints associated with a foreign acquisition, Canco simply lends money to a newly incorporated foreign subsidiary ("Acquisitionco") in order to acquire shares of a foreign corporation ("Foreignco"). Once there is sufficient time to implement normal tax planning measures, the debt is contributed to a foreign affiliate of Canco located in a favourable tax jurisdiction. Subsequent interest payments made by Acquisitionco are received by the new affiliate and included in exempt surplus. Would the CRA seek to apply paragraph 95(6)(b) to the above situation.

CRA Response

We are of the view that acquisition of the shares of the affiliate of Canco in the favourable jurisdiction is carried out principally to allow Canco to convert its taxable interest income stream into an exempt dividend stream. Accordingly paragraph 95(6)(b) would be applied.

3. Partnerships

A. Please advise whether or not the CRA has completed its review with respect to the eligibility for treaty benefits of synthetic NRO partnerships (i.e., partnerships of U.S. corporations that have "checked the box" to be treated as a corporation for U.S. tax purposes).

CRA Response

The CRA has not completed its review. Officials of the Department of Finance and the CRA will be going to Washington towards the end of the month to meet with their American counterparts on the Fifth Protocol to the Canada-United States Income Tax Convention. The treatment of partnerships formed in Canada and that have "checked the box" for U.S. tax purposes is one of the topics for discussion with the United States.