2009 Ruling 2008-0287701R3 - Foreign Affiliate Issues

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: (1) Will the group compensation payments be considered deductible in computing the Foreign Target's income from active business (to the extent the income is otherwise considered income from active business)? (2) Is FA6 resident in a designated treaty country for the purposes of Part LIX of the Regulations? (3) Will the amount included in Foreign Target's taxable profits for reserves previously claimed in accordance with XXXXXXXXXX tax law be included in Foreign Target's "earnings" from an active business? (4) Will FA6 be "resident" and "subject to taxation" in XXXXXXXXXX for the purpose of clause 95(2)(a)(ii)(D)? (5) If so, and assuming the other conditions of clause 95(2)(a)(ii)(D) are met, will the interest paid or payable by FA6 to FA5 on Loan 2 be included in computing FA5's income from active business?

Position: (1) Yes, but will not be included in exempt earnings. (2) No. (3) No. (4) Yes. (5) Yes, but will not be included in exempt earnings.

Reasons: (1) Application of clause 95(2)(a)(ii)(B). (2) In order to be resident in a designated treaty country for the purposes of Part LIX of the Regulations subsection 5907(11.2) of the Regulations requires that the foreign affiliate be resident in the same country under the Income Tax Act and under the relevant treaty. (3) No, amounts are notional amounts that are unrelated to the actual income of Foreign Target for the taxation year from an active business and thus will not be taken into account when computing Foreign Target`s prescribed earnings from an active business. (4) Yes, to be resident in XXXXXXXXXX and subject to taxation clause 95(2)(a)(ii)(D) requires only common law residency (as opposed to the requirements 5907(11.2) of the Regulations). (5) Plain reading of clause 95(2)(a)(ii)(D).

XXXXXXXXXX 2008-028770

XXXXXXXXXX , 2009

Dear XXXXXXXXXX :

Re: XXXXXXXXXX
Business Number XXXXXXXXXX

This is in reply to your letter of XXXXXXXXXX in which you requested an advance income tax ruling on behalf of the above-named taxpayer (the "Taxpayer"). We also acknowledge our subsequent correspondence (XXXXXXXXXX ).

We understand that, to the best of your knowledge and that of the Taxpayer, none of the issues involved in the ruling request is:

(i) in an earlier return of the Taxpayer or a related person;
(ii) being considered by a tax services office or taxation centre in connection with a previously filed tax return of the Taxpayer or a related person;
(iii) under objection by the Taxpayer or a related person;
(iv) before the courts, or if a judgment has been issued, the time limit for appeal to a higher court has not expired; or
(v) the subject of a ruling previously issued by the Rulings Directorate.

This document is based solely on the facts and proposed transactions described below. The documentation submitted with your request does not form part of the facts and proposed transactions and any references thereto are provided solely for the convenience of the reader.

Unless otherwise stated, all references to a statute are to the Income Tax Act (Canada), R.S.C. 1985, c.1 (5th Supp.), as amended to the date of this letter, (the "Act"), and all terms and conditions used herein that are defined in the Act have the meaning given in such definition unless otherwise indicated.

Definitions

In this letter, the following terms have the meanings specified:

"Cancol" is XXXXXXXXXX ;

"Canco2" is XXXXXXXXXX ;

"FAl" is XXXXXXXXXX ;

"FA2" is XXXXXXXXXX .;

"FA3" is XXXXXXXXXX .;

"FA4" is XXXXXXXXXX .;

"FA5" is XXXXXXXXXX .;

"FA6" is XXXXXXXXXX .;

"Foreign Parent" is XXXXXXXXXX .;

"Foreign Target" is XXXXXXXXXX ;

"NR1" is XXXXXXXXXX ;

"Proposed Transactions" means the transactions described in the paragraphs hereof which appear under the heading "Proposed Transactions"; and

"Regulations" means the Income Tax Regulations, C.R.C. 1977, c. 945, as amended.

Facts

1. Foreign Parent is a widely-held foreign corporation that operates a XXXXXXXXXX . Foreign Parent is incorporated under the laws of XXXXXXXXXX and is a non-resident of Canada and a resident of XXXXXXXXXX for the purposes of the Act and for the purposes of the Canada-XXXXXXXXXX Tax Convention.

2. NR1, an indirect wholly owned subsidiary of Foreign Parent, is a corporation governed by the laws of the XXXXXXXXXX . NR1 is a non-resident of Canada and a resident of the XXXXXXXXXX for the purposes of the Act and for the purposes of the Canada-XXXXXXXXXX Income Tax Convention (the "XXXXXXXXXX Treaty").

3. Cancol is a corporation incorporated under the laws of XXXXXXXXXX , and is a private corporation and a taxable Canadian corporation for the purposes of the Act. Cancol has both Canadian and foreign direct and indirect holdings and operations. NR1, through another foreign corporation, indirectly owns all the shares of Cancol.

4. Canco2 is a corporation incorporated under the laws of XXXXXXXXXX , and is a private corporation and a taxable Canadian corporation for the purposes of the Act. Canco2 is primarily an investment holding company, which also provides XXXXXXXXXX services to related parties. Canco2 is a wholly-owned subsidiary of Cancol.

5. Canco2 files its corporate tax returns at the XXXXXXXXXX Taxation Center which are administered by the XXXXXXXXXX Tax Service Office.

6. FAl is a corporation governed by the laws of the XXXXXXXXXX . FAl is a non-resident of Canada and a resident of the XXXXXXXXXX for the purposes of the Act and the XXXXXXXXXX Treaty. Canco2 directly owns XXXXXXXXXX % of the common shares of FAl while NR1 directly owns XXXXXXXXXX % of the convertible preferred shares of FAl. FAl is a foreign affiliate of Canco2 in which Canco2 has a qualifying interest. FAl is also a controlled foreign affiliate of Canco2.

7. FA2 is a corporation governed by the laws of one of the states of the United States of America. FA2 is a holding company with minimal operating activities. FA2 is the United States holding company for Foreign Parent's U.S. operations and certain XXXXXXXXXX operating subsidiaries. FA2 is a non-resident of Canada and a resident of the United States for the purposes of the Act and the Canada-United States Tax Convention (the "U.S. Treaty"). FAl directly owns XXXXXXXXXX % of the Class B common shares of FA2 while Foreign Parent directly owns XXXXXXXXXX % of the Class A common shares and XXXXXXXXXX % of the preferred shares of FA2. FA2 is a foreign affiliate of Canco2 in which Canco2 has a qualifying interest. FA2 is also a controlled foreign affiliate of Canco2.

8. Foreign Target operates XXXXXXXXXX . Foreign Target is incorporated under XXXXXXXXXX law and is a non-resident of Canada and a resident of XXXXXXXXXX for the purposes of the Act and for the purposes of the Canada-XXXXXXXXXX Income Tax Convention.

9. FA2 incorporated a subsidiary corporation, FA3, under the laws of the State of XXXXXXXXXX and subscribed to its common shares for a nominal amount. FA3 is a non-resident of Canada and a resident of the United States for the purposes of the Act and the U.S. Treaty. FA3 is a foreign affiliate of Canco2 in which Canco2 has a qualifying interest and a controlled foreign affiliate of Canco2.

10. FA3 incorporated a subsidiary corporation, FA4, under the laws of the State of XXXXXXXXXX and subscribed to its common shares for a nominal amount. FA4 is a non-resident of Canada and a resident of the United States for the purposes of the Act and the U.S. Treaty. FA4 is a foreign affiliate of Canco2 in which Canco2 has a qualifying interest and is a controlled foreign affiliate of Canco2.

Proposed Transactions

11. FA2 incorporated another subsidiary corporation ("FA5") under the laws of the State of XXXXXXXXXX and subscribed to its common shares for a nominal amount. FA5 is a non-resident of Canada and a resident of the United States for the purposes of the Act and the U.S. Treaty. FA5 is a foreign affiliate of Canco2 in which Canco2 has a qualifying interest and a controlled foreign affiliate of Canco2.

12. FA5 incorporated a subsidiary corporation ("FA6") under the laws of the State of XXXXXXXXXX and subscribed to its common shares for a nominal amount. FA6 is a non-resident of Canada. Its central control and management (including meetings of its board of directors) and all of its activities are located in XXXXXXXXXX . However, FA6 is a resident of the United States for the purposes of the U.S. Treaty and is not a resident of XXXXXXXXXX for the purposes of the Canada-XXXXXXXXXX Income Tax Convention. FA6 is a foreign affiliate of Canco2 in which Canco2 has a qualifying interest and a controlled foreign affiliate of Canco2.

12.1 FA2, FA3, FA4, FA5 and FA6 report on a consolidated basis for U.S. tax purposes.

13. FA6 established a branch in XXXXXXXXXX . The business purpose of the branch is to carry out material activities relating to the acquisition and ownership of the shares of Foreign Target and to provide management and other services to group companies. The branch employs approximately XXXXXXXXXX individuals, some of whom will have senior levels of responsibility. These individuals and functions are expected to remain in XXXXXXXXXX for the foreseeable future.

14. The branch has separate premises distinct from those occupied by other XXXXXXXXXX members of the group.

15. Foreign Parent and certain of its foreign subsidiaries borrowed approximately XXXXXXXXXX through a syndicated loan facility. Foreign Parent and its subsidiaries used the proceeds from this loan to:

(a) subscribe to newly-issued common shares of FA2 for fair market value consideration of XXXXXXXXXX ;

(b) make a loan to FA2 amounting to the U.S. dollar equivalent of XXXXXXXXXX , which will bear interest at an arm's length rate;

(c) indirectly through one or more foreign subsidiaries, acquire newly-issued common shares of FA3 for fair market value consideration of the U.S. dollar equivalent of XXXXXXXXXX ; and,

(d) finance acquisition costs.

16. FA2 subscribed to newly-issued common shares of FA3 for fair market value consideration amounting to the U.S. dollar equivalent of XXXXXXXXXX .

17. FA3 subscribed to newly-issued common shares of FA4 for fair market value consideration amounting to the U.S. dollar equivalent of XXXXXXXXXX .

18. FA2 subscribed to newly-issued common shares of FA5 for fair market value consideration amounting to the U.S. dollar equivalent of XXXXXXXXXX .

19. FA5 subscribed to newly-issued common shares of FA6 for fair market value consideration amounting to the U.S. dollar equivalent of XXXXXXXXXX .

20. FA4 used the proceeds from its issuance of share capital to FA3 to make a loan to FA5 amounting to XXXXXXXXXX ("Loan 1"). The floating interest rate on Loan 1 will correspond to XXXXXXXXXX plus XXXXXXXXXX %. Initially, the interest rate is expected to be approximately XXXXXXXXXX %. The interest is payable on XXXXXXXXXX , and is thereafter payable on each successive XXXXXXXXXX and XXXXXXXXXX .

21. FA5 used the proceeds from its borrowing from FA4 to make a loan to FA6 (to be allocated by FA6 to its XXXXXXXXXX branch) amounting to the XXXXXXXXXX ("Loan 2"). The floating interest rate on Loan 2 is set at a rate equal to XXXXXXXXXX plus XXXXXXXXXX %. The interest rate on Loan 2 is currently lower than the interest rate on Loan 1 made by FA4 to FA5.

22. FA5 subscribed to newly-issued common shares of FA6 for fair market value consideration amounting to the U.S. dollar equivalent of XXXXXXXXXX .

23. For XXXXXXXXXX branch capitalization purposes, FA6 allocated the XXXXXXXXXX to its XXXXXXXXXX Branch.

24. FA6, through its XXXXXXXXXX branch, used the proceeds from Loan 2 and from the issuance of its share capital to FA5 to acquire XXXXXXXXXX % of the shares of the Foreign Target for approximately XXXXXXXXXX .

24.1 The financing received by FA6, which originated from Foreign Parent, was provided indirectly in the manner described above so that FA2 could obtain interest deductions in the United States while FA6 could obtain an interest deduction in XXXXXXXXXX , in respect of its XXXXXXXXXX Branch, and thereby reduce the cost of the acquisition of Foreign Target.

25. To manage various currency exposures, certain entities including FA5 entered into principal and interest rate swaps with the Foreign Parent.

26. Following its acquisition, Foreign Target will continue as a XXXXXXXXXX incorporated entity, with its central control and management located in XXXXXXXXXX .

27. For XXXXXXXXXX tax purposes, it is expected that FA6 (in respect of its XXXXXXXXXX branch) should be permitted to deduct the interest paid or payable by it on Loan 2. Under the XXXXXXXXXX group taxation regime, a profitable member of the group is entitled to make a Group Contribution Payment ("GCP") to a loss-making member of the group. As such, it is expected that Foreign Target will make a GCP to FA6. For XXXXXXXXXX tax purposes, the GCP will reduce Foreign Target's taxable profits and increase FA6's taxable profits in the same amount. Under XXXXXXXXXX tax rules, any GCP to be made by Foreign Target cannot exceed what would be the taxable profits of Foreign Target before any such GCP.

27.1 For XXXXXXXXXX tax purposes FA6 will be required to compute its income and pay any tax owing in respect of its XXXXXXXXXX branch.

28. The funds received by FA6 from Foreign Target by way of GCP will be used by FA6 to pay interest to FA5 on Loan 2. The interest income received by FA5 on Loan 2 will be used by FA5 to pay interest to FA4 on Loan 1. If the interest rate on Loan 2 is not enough for FA5 to service the interest on Loan1 to FA4, FA2 will provide FA5 the amounts required to pay interest to FA4 (either through a loan or an equity injection).

29. FA6 must (through its XXXXXXXXXX branch) directly own at least XXXXXXXXXX % of the shares of Foreign Target for the whole taxation year of FA6 and the Foreign Target in order for Foreign Target to be able to make GCP to FA6 for that year. Thus, Foreign Target will not be able to make a GCP to FA6 for the period beginning at the acquisition date and ending XXXXXXXXXX (the "Stub Period"). Consequently, FA6's XXXXXXXXXX branch should incur a loss for the Stub Period. In addition, it is expected that, for the first XXXXXXXXXX years following the acquisition, the XXXXXXXXXX taxable profits of Foreign Target will not be sufficient to cover FA6's interest expenses.

30. The decision to make a GCP is discretionary.

31. Foreign Target's income from an active business will be earned only in XXXXXXXXXX as Foreign Target does not have a permanent establishment in any other foreign country. Eligible dividends and capital gains expected to be earned by Foreign Target will be exempted from tax in XXXXXXXXXX by reason of the XXXXXXXXXX participation exemption and, consequently, should not form part of its taxable profits.

32. Under XXXXXXXXXX tax rules, in any given year; a taxpayer can elect to deduct a reserve to a maximum of approximately XXXXXXXXXX % of its taxable profits for the year. The reserve must be reversed into taxable profits within XXXXXXXXXX years after the year for which it was deducted. This reserve is added to taxable profits and is therefore relevant to the GCP determination. Foreign Target has claimed this reserve in prior years but will cease to claim the reserve commencing in the taxation year immediately following the Stub Period.

33. FA2 has not reported any foreign accrual property income ("FAPI") in it returns since it has been a foreign affiliate of Canco2.

34. Currently there is no intent that any significant foreign accrual property losses ("FAPL") arising from the Proposed Transactions will be carried back to previous taxation years or used in the foreseeable future.

Purpose of the Proposed Transactions

The Proposed Transactions are implemented to facilitate the acquisition of XXXXXXXXXX % of the shares of Foreign Target from the XXXXXXXXXX . That acquisition took place in XXXXXXXXXX .

Rulings

Provided that the preceding statements constitute a complete and accurate disclosure of all of the relevant facts, proposed transactions and purposes of the proposed transactions, and provided that the terms are as described above, we rule as follows:

A. in computing the income or loss from an active business for a taxation year of FA6 in relation to Canco2, for each relevant year, there shall be included pursuant to clause 95(2)(a)(ii)(B) any income or loss derived by FA6 from a GCP paid to FA6 by Foreign Target to the extent that the GCP is deductible by Foreign Target to FA6 in computing the amounts prescribed to be its earnings or loss for a taxation year from an active business other than an active business carried on in Canada. For these purposes, the GCP that is paid will be considered deductible in a taxation year in computing the amount prescribed to be its earnings or loss from an active business, other than an active business carried on in Canada, to the extent that, before taking into account any such payment, Foreign Target has an amount of "exempt earnings" for that year from an active business, other than an active business carried on in Canada, as defined in subsection 5907(1) of the Regulations which equals or exceeds the amount of any such payment;

B. any income of FA6 described in Ruling A, above, will be included in the "taxable earnings" of FA6 in relation to Canco2, as described in paragraph (b) of the definition thereof in subsection 5907(1) of the Regulations; and

C. provided FA6 is resident in XXXXXXXXXX under common law principles, for the purposes of clause 95(2)(a)(ii)(D), FA6 will be "resident" and "subject to income taxation" in XXXXXXXXXX and provided all the other relevant conditions of clause 95(2)(a)(ii)(D) are met, the interest paid or payable by FA6 to FA5 on Loan 2 will be included in computing the income or loss from an active business of FA5. Any such income will be included in computing the amount prescribed to be the "taxable earnings" of FA5 as defined in subsection 5907(1) of the Regulations.

The above advance income tax rulings, are based on the Act and Regulations in their present form and do not take into account any proposed amendments thereto, are given subject to the general limitations and qualifications set out in Information Circular 70-6R5 Advance Income Tax Rulings, dated May 17, 2002, and are binding on the Canada Revenue Agency.

Comments

1. It is our view that neither the deduction taken in respect of the reserve referred to paragraph 32 above in computing taxable profits of Foreign Target for XXXXXXXXXX Tax purposes nor the addition of an amount in respect thereof when such a reserve is reversed and taken into income affect the amount prescribed to be Foreign Target's earnings from an active business for the purposes of ruling A above; and

2. If FA2 is able to use the FAPL created by the proposed transactions to eliminate past or future FAPI the application of the general anti-avoidance rule may be considered.

3. Nothing in this ruling should be construed as implying that the Canada Revenue Agency has agreed to, reviewed or has made any determination in respect of:

(a) the determination of the fair market value or adjusted cost base of any property referred to herein; or

(b) any tax consequences relating to the facts and proposed transactions described herein other than those specifically described in the rulings given above.

Yours truly,

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