24 November 2008 External T.I. 2007-0228301E5 - FAPI & Capital Dividend Account

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: Whether FAPI of a foreign affiliate of a corporation can be added to the corporation's capital dividend account when the FAPI was derived from capital gains of the foreign affiliate?

Position: No

Reasons: FAPI is income from property.

									2007-022830
XXXXXXXXXX 								S.E.  Thomson
(613) 957-2122
November 24, 2008

Dear XXXXXXXXXX :

Re: Foreign Accrual Property Income and Capital Dividend Account

This is in reply to your email dated March 19, 2007, and subsequent emails, in which you ask for our views on whether a portion of the foreign accrual property income ("FAPI") of a foreign affiliate of a taxpayer, as defined in subsection 95(1) 1 , can be added to the taxpayer's capital dividend account ("CDA"), as computed in subsection 89(1).

More specifically, your client is a Canadian-controlled private corporation ("Canco"), as that term is defined in subsection 125(7). Canco owns shares of a controlled foreign affiliate ("Forco"), as that term is defined in subsection 95(1). For simplicity, we will assume that Canco owns 100% of the shares of Forco.

Forco has realized a capital gain from the disposition of property other than excluded property, as that term is defined in subsection 95(1). Fifty percent the gain is added to Forco's FAPI vis-à-vis Canco. You have concluded that the remaining 50% of the capital gain, i.e. the non-taxable portion, should be added to Canco's CDA for the following reasons:

• FAPI comprises property income, income from a business other that an active business, and taxable capital gains, and the elements of FAPI retain their nature in the hands of Canco;
• the purpose of the rules in sections 91 to 95 is to tax Canco on very specific items earned by foreign affiliates, but having done so, Canco should be entitled to the same benefits that would accrue to Canco, had Canco earned the items directly; and
• under the proposed foreign investment entity regime, capital gains realized by the non-resident entity are considered to be capital gains of Canco, and are added to Canco's CDA.

Further, you say there is no agreement as to where on the corporate tax return (the "T2") Canco should report the FAPI.

OUR COMMENTS

We do not agree with your conclusion for the following reasons.

Subsection 2(1) provides that an income tax shall be paid on the taxable income of every person resident in Canada at any time in the year. Subsection 2(2) provides that the taxable income of a taxpayer is the taxpayer's income for the year, plus or minus amounts permitted by Division C. Section 3 provides the rules by which the taxpayer determines its income for the purposes of Part I. Specifically, paragraph 3(a) instructs the taxpayer to determine the total of all amount each of which is its income from a source, such as the taxpayer's income from each office, employment, business and property, but expressly carves out taxable capital gains from the disposition of property. Subsection 4(1) provides that the income or loss from each source is to be computed independently from income or loss from other sources.

Subdivision b provides the rules under which a taxpayer computes its income from a business or property. Paragraph 12(1)(k) is in subdivision b. It provides that the taxpayer must take into income the amounts required by subdivision i to be included in income in respect of a dividend paid by a corporation not resident in Canada, or in respect of a share of a foreign affiliate of the taxpayer.

Section 90 and subsection 91(1) are in subdivision i. Section 90 provides that the taxpayer must include in income dividends received from a corporation not resident in Canada. Subsection 91(1) provides that the taxpayer must include in income a percentage of a controlled foreign affiliate's FAPI in respect of each share of the controlled foreign affiliate, as income from the share. Therefore, as a result of the interaction of all of the above provisions, we conclude that dividends and FAPI are both "income from property" to Canco. The fact that the dividends were paid out of, or that the FAPI results from, capital gains from the disposition of capital property by Forco does not alter this conclusion.

The CDA of a corporation resident in Canada is computed in subsection 89(1). Specifically, paragraph (a) of the computation includes the corporation's capital gain from a disposition of property, less the taxable capital gain on that disposition. This has the effect of including the non-taxable portion of the capital gain in the CDA. The computation does not include any portion of a capital gain realized by a foreign affiliate of the corporation.

Under proposed subsection 94.2(4), a taxpayer resident in Canada is required to include in or deduct from income an amount computed using the "mark-to-market" formula, as defined in proposed subsection 94.2(1). The amount is considered to be income from property, unless proposed subsection 94.2(20) applies. If proposed subsection 94.2(20) applies, the taxpayer is deemed to have a capital gain or capital loss from the disposition of capital property. Proposed subsection 94.2(20) applies if the interest in the non-resident entity is capital property to Canco, and if all or substantially all of the mark-to-market formula can be attributed to capital gains or losses, or increases or decreases in the fair market value of capital property. The FAPI rules do not contain a similar rule that would recharacterize the subsection 91(1) income inclusion as a capital gain.

To summarize, it is our view that capital gains realized by Forco and included in Forco's FAPI vis-à-vis Canco are not added to Canco's capital dividend account. The question of whether this is appropriate in policy terms should be addressed to the Department of Finance.

Finally, we note that FAPI should be reported on line 217 of T2 Schedule 1 Net Income (Loss) For Income Tax Purposes.

We trust that we have been of some assistance.

Yours truly,

Olli Laurikainen, C.A.

For Director
International & Trusts Division
Income Tax Rulings Directorate
ENDNOTES

1 Unless otherwise stated, statutory references in this letter are to the Income Tax Act, R.S.C. 1985 (5th Suppl.) c. 1, as amended to the date hereof.