2008 Ruling 2007-0248961R3 - Thin Capitalization

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 undistributed partnership income reduces the retained earnings computed for purposes of clause 18(4)(a)(ii)(A) of the Act.

Position: No.

Reasons: Does not fit into the "retained earnings of any other corporation" exclusion in that clause.

XXXXXXXXXX 								2007-024896

XXXXXXXXXX , 2008

Dear XXXXXXXXXX :

Re: XXXXXXXXXX
XXXXXXXXXX
Advance Income Tax Ruling Request

This is in response to your XXXXXXXXXX request, and your XXXXXXXXXX amended request, for an advance income tax ruling on behalf of the above. We acknowledge receipt of the additional information provided to us on XXXXXXXXXX .

Unless otherwise stated, all statutory references herein are to the Income Tax Act, R.S.C. 1985, c.1, (5th Supplement) (the "Act"), as amended to the date of this advance income tax ruling. All references herein to amounts and values expressed in terms of money are stated in Canadian dollars.

The rulings given herein are based solely on the facts, proposed transactions and the purpose of the proposed transactions described below. Facts and proposed transactions described in the documents submitted with your request that are not set out below do not form part of the facts and proposed transactions on which this ruling is based and any reference to these documents is provided solely for the convenience of the reader.

Our understanding of the facts, proposed transactions and the purpose of the proposed transactions is as follows:

Definitions

(a) "Parent" means XXXXXXXXXX .;

(b) "Subco" means XXXXXXXXXX .;

(c) "Canco" means XXXXXXXXXX .;

(d) "ULC" means XXXXXXXXXX .;

(e) "Partnership" means XXXXXXXXXX ;

(f) "General Partner" means XXXXXXXXXX .;

(g) "CRA" means the Canada Revenue Agency;

(h) "CBCA" means the Canada Business Corporations Act;

(i) "Exchange" means the XXXXXXXXXX ;

(j) "Foreign Country" means United States of America;

(k) "GAAP" means Canadian generally accepted accounting principles;

(l) "Province" means XXXXXXXXXX ;

(m) "ULC Province" means XXXXXXXXXX ;

(n) "Treaty" means the Canada-United States Tax Convention (1980);

(o) "First Loan" means ULC's loan payable to Subco as described in paragraph 7;

(p) "Second Loan" means Canco's loan payable to the Partnership as described in paragraph 8;

(q) "New Loan" means Parent's loan to Canco as described in paragraph 12;

(r) "Final Loan" means Subco's proposed loan to ULC as described in paragraph 16;

(s) "New Preferred Shares" means the new class of preferred shares of Canco described in paragraph 11;

(t) "Canadian partnership" has the meaning assigned by subsection 102(1) of the Act;

(u) "fiscal period" has the meaning assigned by subsection 249.1(1) of the Act;

(v) "non-capital loss" has the meaning assigned by subsection 111(8) of the Act;

(w) "paid-up capital" has the meaning assigned by subsection 89(1) of the Act;

(x) "private corporation" has the meaning assigned by subsection 89(1) of the Act;

(y) "taxable Canadian corporation" has the meaning assigned by subsection 89(1) of the Act;

(z) "taxable dividend" has the meaning assigned by subsection 89(1) of the Act; and

(aa) "taxation year" has the meaning assigned by subsection 249(1) of the Act.

Facts

1. Parent was incorporated under the laws of the Foreign Country. Parent's shares trade on the Exchange. Parent is resident in the Foreign Country for the purposes of the Act, the Foreign Country's domestic income tax law and the Treaty.

2. Subco was incorporated under the laws of the Foreign Country. Subco is resident in the Foreign Country for the purposes of the Act, the Foreign Country's domestic income tax law and the Treaty. Subco is a wholly-owned subsidiary of Parent.

3. ULC is a private corporation and a taxable Canadian corporation incorporated under the laws of the ULC Province. ULC's tax affairs are administered by the XXXXXXXXXX Tax Services Office and it files its tax returns at the XXXXXXXXXX Taxation Centre under Business Number XXXXXXXXXX . ULC has a floating taxation year that ends on the day that is the XXXXXXXXXX . Subco owns all of the issued and outstanding shares of ULC.

4. The General Partner is a private corporation and a taxable Canadian corporation incorporated under the CBCA. The General Partner's tax affairs are administered by the XXXXXXXXXX Tax Services Office and it files its tax returns at the XXXXXXXXXX Taxation Centre under Business Number XXXXXXXXXX . The General Partner has a floating taxation year that ends on the day that is the XXXXXXXXXX . Subco owns all of the issued and outstanding shares of the General Partner.

5. The Partnership is a Canadian partnership formed under the laws of the Province. The General Partner is the sole general partner of the Partnership and ULC is the sole limited partner of the Partnership. The General Partner has a XXXXXXXXXX % interest in the Partnership and ULC holds the remaining XXXXXXXXXX % interest in the Partnership. Subject to the request for a change in fiscal period described in paragraph 10 below, the Partnership's fiscal period ends on the last day of XXXXXXXXXX .

6. Canco is a private corporation and a taxable Canadian corporation incorporated under the CBCA. Canco's tax affairs are administered by the XXXXXXXXXX Tax Services Office and it files its tax returns at the XXXXXXXXXX Taxation Centre under Business Number XXXXXXXXXX . Prior to XXXXXXXXXX , Canco had two classes of shares issued and outstanding. All of the issued and outstanding common shares of Canco are owned by the Partnership. Subco owns all of the issued and outstanding preferred shares of Canco. The preferred shares have no redemption rights, a cumulative dividend entitlement of XXXXXXXXXX % of the issue price per annum and a liquidation entitlement equal to their aggregate issue price. The voting rights attached to the preferred shares represent more than XXXXXXXXXX % of the voting rights attached to all the issued and outstanding shares of Canco. Canco has a floating taxation year that ends on the day that is the XXXXXXXXXX . Canco holds the shares of numerous subsidiaries and related entities.

7. The First Loan is a loan payable by ULC to Subco. The principal amount outstanding on the First Loan is $XXXXXXXXXX . Interest is payable on the principal amount outstanding at a rate of XXXXXXXXXX % per annum.

8. The Second Loan represents a number of loans payable by Canco to the Partnership. On XXXXXXXXXX , the total principal amounts outstanding under the Second Loan totaled approximately $XXXXXXXXXX . Interest is payable at various rates on the principal amounts outstanding under the Second Loan and these principal amounts each have a different maturity date.

9. On XXXXXXXXXX , the contributed surplus attributable to ULC's common shares was nil and the paid-up capital in respect of its common shares was approximately $XXXXXXXXXX .

Completed Transactions

10. On XXXXXXXXXX , the Partnership requested the concurrence of the Minister of National Revenue to change its fiscal period year-end from the last day of XXXXXXXXXX to the day that is the XXXXXXXXXX such that the Partnership's fiscal year commencing on XXXXXXXXXX would end on XXXXXXXXXX . Provided the request is granted, the Partnership's taxation year will thereafter coincide with the taxation year of ULC and the General Partner.

11. On XXXXXXXXXX , the articles of incorporation of Canco were amended to authorize the issuance of the New Preferred Shares. The New Preferred Shares will be accounted for as a liability under GAAP. The New Preferred Shares have the following attributes:

• Non-voting;
• Entitled to cumulative annual dividends computed as a fixed percentage of their redemption amount;
• Dividends payable in cash or, at the option of Canco, by issuing additional New Preferred Shares;
• Priority dividend entitlement over all of the authorized common shares of Canco but subordinate dividend entitlement to all of the other authorized preferred shares of Canco;
• Redeemable by Canco at any time prior to their maturity date;
• Not retractable by the holder until the maturity date unless Canco fails to pay any of the cumulative annual dividends within XXXXXXXXXX days of their due date; and
• Transferable without restriction.

12. On XXXXXXXXXX , Parent made the New Loan to Canco. The New Loan was a non-interest-bearing loan with a principal amount of approximately $XXXXXXXXXX .

13. On XXXXXXXXXX , Canco used the proceeds of the New Loan to distribute $XXXXXXXXXX of its accumulated retained earnings to the Partnership.

14. On XXXXXXXXXX , the Partnership used the $XXXXXXXXXX to subscribe for New Preferred Shares having an aggregate redemption amount equal to the amount paid for such shares.

15. On XXXXXXXXXX , Canco used the $XXXXXXXXXX share subscription proceeds received from the Partnership to repay the New Loan.

Proposed Transactions

16. Subco will make the Final Loan to ULC. The Final Loan will be an interest-bearing loan with a principal amount of approximately $XXXXXXXXXX .

17. ULC will use the Final Loan proceeds to return approximately $XXXXXXXXXX of the paid-up capital attributable to the common shares of ULC held by Subco.

Purposes of the Completed and Proposed Transactions

18. The purpose of Canco's dividend to the Partnership, as described in paragraph 13, was to increase ULC's retained earnings as described in clause 18(4)(a)(ii)(A) to fully or partially offset the proposed clause 18(4)(a)(ii)(C) reduction in the paid-up capital of the ULC common shares.

19. The purpose of the Final Loan is to increase ULC's interest expense for taxation years commencing after XXXXXXXXXX . The principal amount of the Second Loan exceeds the principal amount of the First Loan such that the interest income allocated to ULC by the Partnership has exceeded the interest expense incurred by ULC for taxation years that ended after XXXXXXXXXX . For the taxation year ended XXXXXXXXXX , ULC's net income for income tax purposes, consisting primarily of this net interest income earned through the Partnership, was reduced to nil by ULC's deduction of its non-capital losses available from prior taxation years. ULC's non-capital losses were reduced to nil in its taxation year ended XXXXXXXXXX . For taxation years ending after XXXXXXXXXX , the interest payable on the First Loan and the Final Loan will substantially offset the interest income allocated to ULC by the Partnership.

Additional Information

20. Pursuant to GAAP, the consolidated retained earnings of ULC include its share of the net income of the Partnership that was included in its income pursuant to section 96 of the Act and its share of the retained earnings of Canco and any of its subsidiaries in which Canco has a significant influence. ULC's cumulative share of the Partnership's undistributed income for the fiscal periods ending XXXXXXXXXX will be approximately $XXXXXXXXXX such that ULC's consolidated GAAP retained earnings as at XXXXXXXXXX would include this amount. For the purposes of Clause 18(4)(a)(ii)(A) of the Act, the retained earnings of ULC must exclude any retained earnings "to the extent that those earnings include retained earnings of any other corporation", being Canco and its subsidiaries. However, clause 18(4)(a)(ii)(A) will not apply to exclude the earnings of the Partnership as these earnings would not be "retained earnings of any other corporation".

21. For the purposes of subsection 18(4) of the Act, the proposed reduction in the paid-up capital of the ULC common shares, as described in paragraph 17 above, and the proposed increase in the consolidated retained earnings of ULC, as a result of the dividend described in paragraph 13 above, will not result in a change in the proportion computed pursuant to paragraphs 18(4)(a) and (b).

Ruling

Provided that the preceding statements constitute a complete and accurate disclosure of all of the relevant facts, proposed transactions and the purpose of the proposed transactions, and provided further that the proposed transactions are completed in the manner described above, our ruling is as follows:

A. In computing ULC's retained earnings for the purpose of clause 18(4)(a)(ii)(A), subsection 248(24) will not apply to exclude its share of the net income of the Partnership that was included in its income pursuant to section 96 of the Act whether or not the Partnership has distributed such income to ULC.

This ruling is given subject to the limitations and qualifications set out in Information Circular 70-6R5, issued by the CRA on May 17, 2002, and is binding on the CRA provided that the proposed transactions are completed before XXXXXXXXXX .

Except as expressly stated, this advance income tax ruling does not imply acceptance, approval or confirmation of any other income tax implications of the facts or proposed transactions described herein. For greater certainty, the CRA has not:

(a) made any determination as to whether paragraph 20(1)(c) of the Act applies to the interest paid or payable by Canco to the Partnership on the Second Loan or to the interest to be paid by ULC to Subco on the Final Loan;

(b) made any determination as to whether subsection 18(4) of the Act applies to any interest paid or payable to Subco by ULC;

(c) made any determination as to whether section 18.2 of the Act applies to any interest paid or payable by Canco or ULC;

(d) reviewed or made a determination of the paid-up capital of ULC's common shares;

(e) reviewed or made a determination of the undistributed earnings of the Partnership;

(f) made a determination as to whether GAAP would require ULC to account for its investments using the cost method, the equity method or the consolidation method of accounting; or

(g) received concurrence, from the Minister of National Revenue, that the Partnership can change its fiscal period year-end as described in paragraph 10 above.

The above-noted ruling is based on the Act in its present form and does not take into account any proposed amendments, which, if enacted, could have an effect on the ruling provided herein.

Yours truly,

XXXXXXXXXX
for Director
International & Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch