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: Various questions on the application of the FIE legislation - 1), 2) and 3) basic computations; 4) dispositions; 5) choice of methods; 6) and 7) foreign exchange
Position: See body of letter
Reasons: See body of letter
October 3, 2007
Mina Ally HEADQUARTERS
Toronto North Call Site Income Tax Rulings
Corporate Services Directorate
S. E. Thomson
(613) 957-2122
2006-019910
Various Questions on Proposed Foreign Investment Entity Legislation
Dear Mina:
This is in response to your email to Bruce Bachelder of the Business Programs Section on July 31, 2006 regarding several questions you have on the proposed Foreign Investment Entity ("FIE") legislation. We are responding to your questions in the order you have presented them. As you may know, the FIE proposals were re-released on June 13, 2007, effective for taxation years that begin after 2006, except where the taxpayer elects to apply them to taxation years that begin after 2002. For simplicity, we will assume that the taxpayer does not elect to apply the FIE legislation prior to 2007. Note that we have reworded some of your questions, and where you refer to the date January 1, 2003, we have changed it to January 1, 2007. We will also assume that the taxpayer's interest is not nor has ever been an interest in a tracking entity (as defined in subsection 94.2(1)) or an interest in an insurance policy, each of which has special rules. Additionally, we will assume that the participating interest is capital property to the taxpayer. All references to provisions of the Income Tax Act in this memo are references to the draft legislation released on June 13, 2007 unless otherwise noted.
1. Under the Imputed Income Method, a taxpayer must include in income an amount determined by multiplying the designated cost to the taxpayer of the participating interest by a rate of interest. You would like to know if the interest rate is applied to the designated cost of the participating interest, or to the fair market value of the participating interest on January 1, 2007.
The Imputed Income Method is set out in section 94.1. The charging provision under the Imputed Income Method is in subsection 94.1(4). Subsection 94.1(4) reads as follows:
94.1(4) If subsection (3) or 94.2(9) applies to a taxpayer resident in Canada for a taxation year of the taxpayer in respect of a participating interest and subsections 94.2(3) and 94.3(3) do not apply to the taxpayer for the taxation year in respect of the participating interest, then this subsection applies to the taxpayer for the taxation year in respect of the participating interest and there shall be included (as income from property from a property that is the participating interest) in computing the taxpayer's income for that taxation year the total of all amounts each of which is the amount, in respect of each month in that taxation year, at the end of which month the taxpayer holds the participating interest, determined by the formula
A × B
where
A is the designated cost, to the taxpayer of the participating interest, at the end of the month; and
B is the quotient obtained when the rate of interest prescribed, in respect of amounts required by this Act to be paid by the Minister, for the quarterly period that includes that month is divided by 12.
In other words, the interest rate described in variable B is applied to the designated cost described in variable A at the end of each month. The term "designated cost" is defined in subsection 94.1(1), as the formula A + B + C + D + E + F - G. Note that variable D of the designated cost formula includes the gain accrued prior to the commencement of the application of the new FIE rules and variable G includes the loss accrued prior to that date.
2. If the interest rate in question 1 is applied to the fair market value of the participating interest, does the taxpayer also have to report gains and losses realized by the foreign investment entity in the period? (Assume that the taxpayer has not disposed of the participating interest in the year.)
As noted in 1 above, under the Imputed Income Method in section 94.1, the interest rate is applied to the designated cost, as defined. Under the Imputed Income Method, the taxpayer includes in income an amount computed by multiplying the designated cost by a rate of interest. Under the Imputed Income Method, the taxpayer does not include in income gains and losses realized by the foreign investment entity in the period.
Under the Mark-to-Market Method in section 94.2, the taxpayer includes in or deducts from income an amount determined by the mark-to-market formula. The charging provision for the Mark-to-Market Method is in subsection 94.2(4), and the "mark-to-market formula" is defined in subsection 94.2(1). In simple terms, under the Mark-to-Market Method, the taxpayer includes in or deducts from his income the change in the fair market value of the participating interest in the year.
Under the Accrual Method in section 94.3, the taxpayer includes in income the amount determined by the formula in subsection 94.3(4). In simple terms, the taxpayer includes in his income his share of the income of the non-resident entity in the year.
3. Is the monthly interest under the Imputed Income Method applied to the designated cost at the beginning of each month?
No, as noted in 1 above, under the Imputed Income Method, the interest rate is multiplied by the designated cost to the taxpayer of the participating interest at the end of each month. The product is included in the taxpayer's income for the taxation year as income from property that is the participating interest. This income inclusion is added to the designated cost to the taxpayer of the participating interest in the following year, by virtue of variable B of the definition of "designated cost" in subsection 94.1(1).
4. When the taxpayer sells the participating interest, is the capital gain or loss computed as the proceeds of disposition less the adjusted cost base, or as the proceeds of disposition less the designated cost.
The tax treatment of dispositions under the FIE legislation depends on which method is effective at the time of disposition, and whether another method has previously applied. For simplicity, we will assume that only one of the methods has ever applied to the particular participating interest.
For all 3 methods, dispositions of participating interests are deemed to occur in the order in which they were acquired, by virtue of paragraph 94.1(2)(u) (note that subsection 94.1(2) applies for all 3 methods). In very general terms, the tax treatment of dispositions under the 3 methods is as follows:
Imputed Income Method
A disposition of a participating interest that is capital property to the taxpayer and to which the Imputed Income Method applies will result in a capital gain or capital loss as computed under existing sections 39 and 40. The proceeds of disposition will be computed in accordance with existing section 54, and the adjusted cost base to the taxpayer of the participating interest will be computed in accordance with paragraphs 53(1)(m) and 53(2)(w). Paragraph 53(1)(m) includes in the adjusted cost base of the participating interest to the taxpayer all amounts previously included in the taxpayer's income under subsection 94.1(4) in respect of the participating interest. If a disposition of the participating interest results in a capital loss because prior subsection 94.1(4) income inclusions exceeded the taxpayer's economic gain, subsection 94.1(5) provides a mechanism to convert part of the capital loss to a deduction from income.
Mark-to-Market Method
In the Mark-to-Market Method, the proceeds of disposition and the cost of the participating interest constitute variables A and E in the mark-to-market formula as defined in subsection 94.2(1). In effect, the tax effect of the disposition is captured in the mark-to-market formula. The "proceeds of disposition" of the participating interest is defined in subsection 94.2(1) for purposes of section 94.2. If the participating interest is disposed of in a year subsequent to the year in which the participating interest is acquired, the cost of the participating interest is not relevant. That is, in subsequent years, under the mark-to-market formula, variable F (fair market value at the beginning of the year) is relevant, and variable E is not relevant.
Also included in the mark-to-market formula in the year of disposition is variable D, which is the taxpayer's deferral amount in respect of the participating interest, if the taxpayer has not previously elected to include the deferral amount in the mark-to-market formula. The "deferral amount" is defined in subsection 94.2(1), and is essentially one-half of the accrued gain or loss to the taxpayer of the participating interest before the Mark-to-Market Method became effective. Note that subsection 94.2(18) applies if the disposition results in a "superficial loss" (as that term is generally defined in section 54) because of the recognition of a negative deferral amount.
In addition, on a disposition of the participating interest, the taxpayer must include in or deduct from his income the positive or negative reconciliation amount by virtue of subsection 94.2(21). The term "reconciliation amount" is defined in subsection 94.2(1). In effect, subsection 94.2(21) ensures that the taxpayer recognizes his economic gain or loss from the participating interest, to the extent it has not already been captured by the mark-to-market formula.
Subparagraph 39(1)(a)(ii.3) provides that a taxpayer's capital gain does not include gains from the disposition of property in respect of which subsection 94.2(3) applies and subsection 94.2(20) does not apply. Therefore, if a taxpayer disposes of a participating interest to which the Mark-to-Market Method applies, he will not have a capital gain unless both subsections 94.2(3) and 94.2(20) apply. If both subsections 94.2(3) and 94.2(20) apply, paragraph 94.2(4)(b) deems the taxpayer to have a capital gain or loss from the disposition of the participating interest in each year that the Mark-to-Market Method applies.
Subsection 94.2(13) applies when the taxpayer disposes (other than certain deemed dispositions) of the participating interest in a year when the Mark-to-Market Method applies. If subsection 94.2(13) applies, the cost of the participating interest (other than for section 94.2 itself) will be equal to the fair market value of the participating interest immediately before the time of disposition.
Paragraph 52(1)(d) provides that amounts included in the taxpayer's income under subsection 94.2(4) (i.e. under the Mark-to-Market Method) are not included in computing the adjusted cost base of the participating interest to the taxpayer. As noted in the Explanatory Notes to subsection 52(1), section 94.2 contains its own rules for making adjustments to the cost of property in respect of income or gains recognized under subsection 94.2(4).
Accrual Method
By virtue of paragraph 94.3(3)(d), the Accrual Method applies only if the participating interest is capital property to the taxpayer. When the taxpayer disposes of the participating interest, the capital gain or capital loss is determined in accordance with existing sections 39 and 40. The "proceeds of disposition" of the participating interest is defined in subsection 94.2(1) (note that the definitions in subsections 94.1(1) and 94.2(1) apply in section 94.3). The "adjusted cost base" of the participating interest is determined in accordance with subsection 94.3(5) and paragraphs 53(1)(m.1) and 53(2)(w).
5. If the taxpayer uses the Imputed Income Method in year 1 with respect to a participating interest, can the taxpayer use the Mark-to-Market Method or the Accrual Method in subsequent years for that participating interest?
If the conditions in subsection 94.1(3) apply, the taxpayer must use the Imputed Income Method, unless the conditions in subsections 94.2(3) (i.e. the Mark-to-Market Method) or 94.3(3) (i.e. the Accrual Method) apply. Both subsections 94.2(3) and 94.3(3) will apply only if the conditions in subsection 94.1(3) first apply. Therefore, in order to get to the Mark-to-Market Method or the Accrual Method, the conditions under the Imputed Income Method must be met. That is, the Imputed Income Method is the default method.
If the taxpayer elects to use the Mark-to-Market Method, by virtue of clause 94.2(3)(b)(iii)(B), the taxpayer must make the election for the first taxation year to which the conditions in subsection 94.1(3) apply. Similarly, if the taxpayer elects to use the Accrual Method, by virtue of subparagraph 94.3(3)(b)(ii), he must make the election for the first taxation year to which the conditions in subsection 94.1(3) apply. If the taxpayer uses the Imputed Income Method in year 1 in respect of a participating interest, he cannot elect to use the Mark-to-Market Method or Accrual Method in subsequent years for that participating interest or identical interests.
6. If the participating interest held by the taxpayer at January 1, 2007 is in a foreign currency, should it be converted to Canadian dollars for purposes of the reporting under FIE legislation? If yes, how should the resulting foreign exchange gain or loss be treated?
Under the Imputed Income Method in section 94.1, a taxpayer must include in income an amount determined by multiplying the designated cost to the taxpayer of the participating interest by a rate of interest. The term "designated cost" is defined in subsection 94.1(1) to be the formula A + B + C + D + E + F - G. Each component of these variables should be converted to Canadian dollars. For example, the cost amount in Variable A should be converted to Canadian dollars at the exchange rate in effect when the cost amount arose. Note that Variable B (previous inclusions under the Imputed Income Method) will already be in Canadian dollars. Once all the variables in the designated cost formula are converted to Canadian dollars, the monthly interest rate is applied to the designated cost. The result will be in Canadian dollars, and is included in income of the taxpayer as income from property under subsection 94.1(4).
Under the Mark-to-Market Method in section 94.2, the taxpayer includes in or deducts from income an amount determined by the mark-to-market formula. The mark-to-market formula is defined in subsection 94.2(1) to be the formula (A + B + C + D) - (E + F + G). Each component of these variables should be converted to Canadian dollars. For example, the proceeds of disposition in Variable A should be converted to Canadian dollars at the exchange rate in effect at the time of the disposition.
Once all the variables in the mark-to-market formula are converted to Canadian dollars, the result will be income or loss from property under paragraph 94.2(4)(a), or will be deemed to be a capital gain or loss under 94.2(4)(b).
Under the Accrual Method in section 94.3, the taxpayer includes in income the amount determined by the formula in subsection 94.3(4), A - B - C - D. Variable A is the taxpayer's "income allocation" as defined in subsection 94.3(1). In general terms, the "income allocation" is the taxpayer's share of the non-resident entity's income for the taxation year computed as if the non-resident entity had been a taxpayer resident in Canada throughout its existence. That is, the income of the non-resident entity is to be computed in Canadian dollars.
7. How will the foreign exchange gains or losses be treated in subsequent years?
The conversion methods described in the preceding paragraph will apply each year that the taxpayer holds the participating interest in a non-resident entity. As the Canadian dollar amounts will include the effects of foreign exchange fluctuations, there is no need to compute any other foreign exchange gains or losses.
We trust that we have been of assistance.
Yours truly,
Olli Laurikainen, Manager
For Director
International & Trusts Division
Income Tax Rulings Directorate
cc:
- Bruce Bachelder, Business Programs Section, Taxpayer Service & Debt Management Branch
- Linda Smith - International & Large Business Directorate
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