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 the income earned by one foreign affiliate on property that is earmarked for future development of another foreign affiliate's active business can be included in income from active business under paragraph 95(2)(a).
Position: No.
Reasons: It is our view that the investment activities of the first foreign affiliate are not "directly related" to the active business activity of the other foreign affiliate for purposes of 95(2)(a)(i)(A). Also, the income from property, if earned by the other foreign affiliate, would not be included in its income from an active business as the income is not income that "pertains to or is incident to" the active business of that other foreign affiliate for purposes of 95(2)(a)(i)(B).
September 30, 2013
XXXXXXXXXX HEADQUARTERS
Large File Case Manager Income Tax Rulings
XXXXXXXXXX Directorate
XXXXXXXXXX T.S.O.
2012-043966
Subparagraph 95(2)(a)(i) income characterization
This is in reply to your memorandum of March 9, 2012, in which you requested our views on the application of subparagraph 95(2)(a)(i) to income from property otherwise earned by a foreign affiliate of a particular taxpayer.
DEFINITIONS
In this letter, the following terms have the meanings specified below. Unless otherwise noted, all legislative references are to the Act.
(a) "Act" means the Income Tax Act, R.S.C. 1985 (5th Supp.) c.1, as amended to the date of this letter.
(b) "Canco" means XXXXXXXXXX, a Canadian corporation pursuant to the meaning at subsection 89(1).
(c) "Predecessor" means XXXXXXXXXX, a corporate predecessor of Canco that was a Canadian corporation pursuant to the meaning at subsection 89(1).
(d) "FA1" means XXXXXXXXXX, a controlled foreign affiliate of Canco that is resident in XXXXXXXXXX for purposes of the Act and the XXXXXXXXXX.
(e) "FA2" means XXXXXXXXXX, previously known as XXXXXXXXXX, a controlled foreign affiliate of Canco that is resident in XXXXXXXXXX for purposes of the Act and the XXXXXXXXXX.
(f) "FA3" means XXXXXXXXXX, a controlled foreign affiliate of Canco, incorporated in XXXXXXXXXX and a resident of XXXXXXXXXX both under the Act and under the XXXXXXXXXX.
(g) "project" is used to refer to XXXXXXXXXX activities.
BACKGROUND
We have been asked to provide our views in respect of the application of paragraph 95(2)(a) to income earned through controlled foreign affiliates of Canco and Predecessor during their XXXXXXXXXX and subsequent taxation years.
As outlined in the taxpayer's representations, the long-term business strategy of Canco has been to invest a substantial portion of profits from its XXXXXXXXXX towards the construction and development of its next generation of projects, including the XXXXXXXXXX (the "newer projects"). In this regard, the management of Canco has stated that a significant portion of cash generated from the XXXXXXXXXX in XXXXXXXXXX, which is owned and operated by FA1, was "earmarked" and destined for future investment in Canco's projects.
During the years in question, a portion of the investment income earned within FA1 on its "earmarked" property was earned from investments it had arranged in order to remain in accordance with certain XXXXXXXXXX contracts with the XXXXXXXXXX government. In its submissions, the representatives of Canco have described the XXXXXXXXXX regime as a foreign investment contract system for investment into XXXXXXXXXX through which an investor receives various commercial benefits, XXXXXXXXXX.
Also, under its business strategy and during the years in question, Canco and Predecessor each used a XXXXXXXXXX controlled foreign affiliate as a principal global finance and treasury centre with the Canco group of companies. In Canco's case this was FA2, and in Predecessor's case this was FA3. During this period, FA2 and FA3 conducted typical treasury centre activities, including hedging of production value with arm's length parties, taking deposits of working capital from related affiliates, investing pooled amounts with arm's length parties, and lending to various operating foreign affiliates to finance their project activities including project construction and development.
In addition to the treasury program being operated through FA2 and FA3, and despite the overarching implications of the XXXXXXXXXX contracts, Canco oversaw a complex program of dividend payments from FA1 to its shareholder outside of XXXXXXXXXX, with subsequent reinvestment of the resulting funds back into XXXXXXXXXX corporations, so that the funds would be used for investment in the future development of Canco's XXXXXXXXXX operations within XXXXXXXXXX. It should be noted that these FA1 dividends do not appear to have been subjected to the additional withholding tax outlined under the XXXXXXXXXX contract, presumably through arrangements in relation to the subsequent reinvestment of these funds back into XXXXXXXXXX within a timely period.
As a result of their respective activities during the years in question, FA1, FA2 and FA3 earned investment income on property which was "earmarked" for the development of the XXXXXXXXXX projects of Canco's multinational group in future years. More specifically, FA1, FA2, and FA3 earned current investment income on funds that had been or were being accumulated mainly for future investment in the development of newer XXXXXXXXXX projects operated by Canco's other foreign affiliates.
In consideration of these facts, you have asked whether paragraph 95(2)(a) would apply during the years in question to otherwise include the income from property earned within FA1, FA2, and FA3 into the computation of income from an active business of the particular foreign affiliate. You have asked for our views notwithstanding the fact that, prior to XXXXXXXXXX, Canco computed its income or loss from an active business through the application of subparagraph 95(2)(a)(i) in accordance with a method that was accepted by CRA Audit over 9 years ago, and in contemplation of a previous version of that subparagraph. Under this arrangement, Canco used budgeted expenditures for the subsequent year as a proxy for current "working capital", such that investment income earned on such working capital would be treated as amounts of income from active business under subparagraph 95(2)(a)(i). You are seeking our views in respect of the XXXXXXXXXX and subsequent taxation years because Canco and Audit are now revisiting their prior arrangement.
ISSUES
In order for income from property to be considered income from active business under subparagraph 95(2)(a)(i), the conditions of both clauses 95(2)(a)(i)(A) and (B) must be met. The relevant portions of subparagraph 95(2)(a)(i) read as follows:
"For the purposes of this subdivision,
(a) in computing the income or loss from an active business for a taxation year of a particular foreign affiliate of a taxpayer in respect of which the taxpayer has a qualifying interest throughout the year or that is a controlled foreign affiliate of the taxpayer throughout the year, there shall be included any income or loss of the particular foreign affiliate for the year from sources in a country other than Canada that would otherwise be income or loss from property of the particular foreign affiliate for the year to the extent that
(i) the income or loss
(A) is derived by the particular foreign affiliate from activities that can reasonably be considered to be directly related to active business activities carried on in a country other than Canada by
(I) another foreign affiliate of the taxpayer in respect of which the taxpayer has a qualifying interest throughout the year
and
(B) would be included in computing the amount prescribed to be the earnings or loss, from an active business carried on in a country other than Canada, of
(I) that other foreign affiliate referred to in subclause (A)(I) if the income were earned by it
"
In consideration of this legislation, we understand that Canco has held, at all relevant times, a qualifying interest in FA1, FA2, FA3, and in any of the foreign affiliates of Canco that were carrying on activities to which Canco has suggested the activities of FA1, FA2 or FA3 were directly related. As such, for purposes of this analysis, it is assumed that the requirement in subclause 95(2)(a)(i)(A)(I) have been met during the relevant period.
Similarly, for purposes of applying subparagraph 95(2)(a)(i), we understand that the relevant activities of FA1, FA2, FA3, and the relevant active business activities of the foreign affiliates of Canco to which the activities of FA1, FA2 and FA3 are suggested to be directly related, were carried on in a country other than Canada. Further, for the purposes of this analysis, we have assumed that any relevant foreign affiliate, other than FA1, FA2, and F3, i.e., the "other foreign affiliate" referred to in subclause 95(2)(a)(i)(A)(I), is considered to carry on an active business at all times during the taxation years in question.
Despite these facts and assumptions, it remains to be determined whether the income from property in FA1, FA2 and FA3 is derived from activities "that can reasonably be considered to be directly related to active business activities" of another foreign affiliate, as required in clause 95(2)(a)(i)(A), and whether the requirements of clause 95(2)(a)(i)(B) have been met.
When considering whether property is held in the course of carrying on an active business, both Audit and Canco have recognized the significance of the decision in Ensite Ltd v. The Queen. (endnote 1) In Ensite, the Supreme Court of Canada ("SCC") considered whether interest earned by a Canadian resident corporation on foreign currency deposits that were held outside of Canada qualified as "foreign investment income" within the meaning of subsection 129(4).
Drawing on this decision, the CRA has developed its views in respect of whether property was used or held by a corporation in the course of carrying on a business, as summarized in Interpretation Bulletin IT-73R6, The Small Business Deduction. In light of Ensite, paragraph 6 of IT-73R6 states that:
"...the holding or using of property must be linked to some definite obligation or liability of the business and that a business purpose test for the use of the property was not sufficient. The property had to be employed and risked in the business to fulfil a requirement which had to be met in order to do business. In this context, risk means more than a remote risk. If the withdrawal of the property would have a decidedly destabilizing effect on the corporate operations, the property would generally be considered to be used in the course of carrying on a business. In other words, the property has to be an integral part of the financing of the business or necessary to the overall business operations in order for income from the property to be part of the income of the corporation
from an active business."
Despite these comments, there remains disagreement between Audit and Canco in respect of the application of the principles from Ensite in determining if income from property should be included in income from an active business for purposes of subparagraph 95(2)(a)(i).
Overall, through their submissions and arguments, Canco seeks to broaden the extent of its prior arrangement with Audit and expand the methodology of determining amounts of property income which qualify for relief under subparagraph 95(2)(a)(i). In Audit's opinion, Canco's proposed methodology is not in accordance with the present version of subparagraph 95(2)(a)(i).
For purposes of subparagraph 95(2)(a)(i), Canco advocates for the use of a consolidated view of their entire corporate group. In Canco's opinion, the operations of all of its foreign affiliates conducting its corporate group's projects should be seen as being the same type and kind of business, and that they should all be viewed as part of a single integrated global business. Further, Canco argues that where a single business is carried on through multiple foreign affiliates that it would be reasonable to consider the activities of the two foreign affiliates to be directly related.
In support of this view, Canco refers to the following excerpt from the Department of Finance's 1995 Explanatory Notes on subparagraph 95(2)(a)(i):
"Subparagraph 95(2)(a)(i) is directed at cases where the business activities of a single foreign active business are conducted in more than one related corporation. It also deals with the situation where income of one foreign corporation is derived from assets that are at risk in a foreign active business carried on by a related foreign corporation. Assets will be considered to be at risk in a business where the permanent removal of such assets would have a destabilizing effect on the business."
Whereas Finance provided a series of examples within the Explanatory Notes, including one example involving a treasury centre structure (endnote 2) similar to the structure adopted by Canco, Canco argues that it would be inappropriate to regard these examples as the only situations in which 95(2)(a)(i) should be applied. Rather, Canco suggests that the provision is sufficiently broad to apply in many other scenarios beyond those described by the Explanatory Note examples, wherever the activities of a foreign active business are carried on through multiple foreign affiliates.
As a more specific argument, it is Canco's position that the requirement in clause 95(2)(a)(i)(A) is met on the basis that the investment activities within FA1, FA2 and FA3 were "directly related" to the project development activities, i.e., active business activities, of the related foreign affiliates. In particular, Canco points to the earmarking of invested funds within FA1, FA2 and FA3, i.e., earmarked in the current year for expenditure in future years on project developments within related foreign affiliates, together with a limited accounting of project development expenditures in subsequent years, suggesting that the investment funds within FA1, FA2 and FA3 were ultimately spent as initially designated. Under their argument, the income from property generated on funds that are currently placed in temporary investments within one foreign affiliate, and earmarked for future use in the active business activities of another foreign affiliate, should qualify under 95(2)(a)(i)(A) on the basis that those funds are ultimately used, at some time in the future, in the active business activities of another foreign affiliate. Despite their suggestion, and noting that the determination of income or loss from an active business under paragraph 95(2)(a) is for a particular taxation year, Canco is largely silent on how such a "prospective" approach to the application 95(2)(a)(i)(A) could be administered on an ongoing basis in any given year; i.e., how the current characterization of funds could be supported by future use of those funds, before the funds are actually used.
In applying clause 95(2)(a)(i)(B), it is Canco's opinion that the earmarked investment funds within FA1, FA2 and FA3 should be seen as working capital of the related foreign affiliates that are developing the newer projects, where those funds had been held within the respective related foreign affiliates themselves. More specifically, Canco suggests that in their circumstances, the investment funds would be viewed as "at risk" in the active business activities of those affiliates if the funds were held within those affiliates. Canco would consider it inappropriate to extend a general principle from Ensite that would deny the consideration of investment income from funds set aside, or earmarked, for future capital expenditures in an active business as incidental to, or pertaining to, that active business, such that the income must constitute property income. More specifically, Canco believes that such a view would constitute a misapplication of the comments delivered from the Tax Court of Canada in McCutcheon Farms v. MNR, in which Justice Sarchuk stated that:
"
income from the investment of surplus funds, held for future business needs or future capital expansion does not pertain and is not incident to the business any more than it is income from the business." (endnote 3)
If a principle is found to exist such that funds set aside for future capital expansion cannot be treated as incident to or pertaining to that active business, Canco suggests that such a principle does not apply to FA1's investment income earmarked for the development of its own newer project, as the future development expenditures should not be seen as an expansion of business. In support of this opinion, Canco again raises the suggestion that the business of its affiliates should be seen as part of a single business carried on by its multinational corporate group. In light of their view, it is Canco's opinion that the development of both newer projects and additional future projects are a continuation of Canco's existing business, with a normal life cycle that involves closing down existing projects and developing newer projects. Canco argues that XXXXXXXXXX, the development of new projects is required to sustain its business, and that the development of new projects does not amount to an expansion of business in the sense contemplated by cases such as McCutcheon Farms, and Transport Lacte Inc v. MNR. (endnote 4) Canco distinguishes itself from these two cases chiefly on the basis of XXXXXXXXXX scope of its corporate group operations, as opposed to the small, closely-held businesses and the nature of the capital purchases considered in those earlier decisions, i.e., purchase of additional farmland, or purchase of an additional milk route.
Canco further argues that even if the various businesses in question are the separate active businesses of the respective foreign affiliates that are developing their newer projects, and not Canco's business as a whole, any capital expenditures toward the development of those newer projects should not be seen as an expansion of those affiliates' businesses. In Canco's opinion, the business of those affiliates is the development of those newer projects and that it would be strained to say that funds set aside for such development were not employed or at risk in the business.
To support its position that the earmarked funds were employed or at risk in the active business of the affiliates developing the newer projects, Canco has attempted to demonstrate that:
- the XXXXXXXXXX contracts required the use of the funds as planned;
- the funds were eventually spent as planned;
- earmarked and accumulating funds were small in comparison to the total expected capital cost of the newer projects; and
- the removal of the earmarked funds would have a destabilizing effect on the affiliates' operations in respect of one of the newer projects, in particular, since without access to those funds the affiliates would be unable to meet lenders' co-funding conditions for project financing, leaving insufficient funds to bring the project to completion.
Overall, Canco currently wishes to broaden the prior audit arrangement and expand the methodology of determining amounts of property income which qualify for relief under subparagraph 95(2)(a)(i). Canco now wishes to use this methodology for all of its foreign affiliates. In addition to applying it to all its foreign affiliates, it is Canco's position that the methodology should be expanded to include budgeted expenditures for a period longer than one year. In Canco's opinion this is appropriate since the Canco corporate group now undertakes larger projects over longer periods of time.
In its submission, Audit has raised the general position that income of a foreign affiliate from property that is currently earmarked for the future use in development of newer projects and other activities of related foreign affiliates does not meet the requirements of subparagraph 95(2)(a)(i), and is therefore not deemed to be income from active business.
On the suggestion that the activities of Canco and its affiliates should be seen as parts of a single business carried on by its multinational corporate group, it is Audit's position that there is no statutory basis for adopting a theory of corporate consolidation.
Audit notes that clause 95(2)(a)(i)(A) requires that the activities of the particular affiliate, i.e., those generating income that would otherwise be FAPI, must be "reasonably considered to be directly related to" the active business activities of the other affiliate. It is Audit's opinion that this requirement has not been met. In support of this position, Audit argues that when the word "related" is qualified by "directly" in a statute, the extent of relatedness is significantly circumscribed.
Audit also argues that the earning of investment income by one affiliate, and the development of a project by another affiliate, are unrelated activities. Once the particular affiliate has cash that is not being used in its active business, commercial reality would dictate that the cash would be used to earn interest, regardless of whether the cash was intended to be used in the other affiliate.
It is also Audit's position that the requirements of clause 95(2)(a)(i)(B)(I) are not met. Specifically, it is Audit's opinion that if the income was earned directly by the related foreign affiliates, it could not be said that the earmarked funds were employed or at risk in the active business of the affiliates in satisfaction of the Ensite principles. It is Audit's further opinion that if the related foreign affiliates that were developing the newer projects had directly held the earmarked funds that were set aside for future expansion, the income earned on those funds would still be income from property.
Finally, Audit argues that an acceptance of Canco's position would result in the avoidance of the Foreign Accrual Property Income ("FAPI") regime any time a tenuous connection existed between the interest income earned by one affiliate, and the current or future active business of another affiliate. Such avoidance would not be within the intentions of Finance when they drafted this legislation.
95(2)(a)(i) - Corporate Consolidation
Canco has suggested that the activities of the two foreign affiliates considered in 95(2)(a)(i)(A) should be regarded as being directly related to each other where the operations of the foreign affiliates are carried out within a corporate group, and viewed as part of a single integrated global business. In this regard, and as outlined by Audit, we would agree that there is no statutory basis for adopting a general theory of corporate consolidation when applying subparagraph 95(2)(a)(i) to any given factual scenario.
The Department of Finance has indicated, in their February 1995 Explanatory Notes, that subparagraph 95(2)(a) is "directed at cases where the business activities of a single foreign active business are conducted in more than one related corporation." In our view, while these words could be subject to different interpretation, they are not inconsistent with Audit's approach. In any event, there is no explicit indication in the legislation that an approach to consider the activities of the entire foreign affiliated group is intended.
Further, we note that groups of related corporations are not unknown to the Act. Generally, where a number of corporations are to be examined together as a group, it is reasonable to find clear language in the Act indicating that such consideration is to be expected. The definition of "affiliated group of persons" in subsection 251.1(3) is one of many such examples found within the Act. In contrast, the language of subparagraph 95(2)(a)(i) is quite clear that the two entities being examined are two particular foreign affiliates, without reference to a larger group. For instance, clause 95(2)(a)(i)(A) refers to "the particular foreign affiliate" and subclause 95(2)(a)(i)(B)(I) uses the words "that other foreign affiliate referred to in subclause (A)(I)."
For these reasons, we are of the view that for the purpose of 95(2)(a)(i), the extent to which the activities of one foreign affiliate should be contemplated when considering the treatment of income from property earned by another foreign affiliate is limited to that outlined in the provision itself, and not in contemplation of an overall consolidated view of a corporate group.
Canco has argued that the income from property generated on funds that are currently placed in temporary investments within one foreign affiliate should qualify under 95(2)(a)(i)(A) as income resulting from activities that are "directly related" to the active business activities of the other foreign affiliate on the basis that the invested funds are ultimately used, at some time in the future, in the active business activities of the other foreign affiliate. In support of this argument, Canco has gone to significant lengths to describe the extent of its subsequent capital expenditures in its newer projects.
Despite this suggestion, it is apparent that the limited accounting offered by Canco is selective, providing little to no information on additional sources of cash within the Canco group in each successive year. For example, the XXXXXXXXXX indicate an overall increase in cash and equivalents within the corporate group over that period, which could reasonably be attributed to a combination of its operating, financing and investing activities. However, the project expenditure summaries provided by Canco are not comprehensive as to the source of the underlying funds actually used in the active business activities of the related foreign affiliates in those subsequent years.
In respect of the words "directly related to", as used in 95(2)(a)(i)(A), it is our opinion that this must be interpreted to mean a more circumscribed amount of connection than would otherwise be indicated by the phrases "related to" or "in relation to." The use of the word "directly" describes a relationship that is of immediate closeness or causality. For instance, such requisite level of relatedness can be examined through the use of a "but for" test, i.e. "but for" the activities in question the income or loss would not have been generated. This is similar to asking if one amount of income or expense is earned or incurred on account of the other.
Support for this view is found in the February 1995 Explanatory Notes, which suggest that the link inferred by the words "directly related to" would not be found merely on the basis that the activities of the two foreign affiliates contemplated under 95(2)(a)(i) are similar. These Explanatory Notes suggest that a more immediate closeness was intended by the drafters. For instance, in describing the connection that is required under 95(2)(a)(i), Finance stated that:
"The activities resulting in the income from property must be dependent upon and would not have taken place but for the active business activities taking place."
As such, it is our opinion that Canco has not demonstrated that the income from property earned within FA1, FA2, or FA3 is dependent upon the occurrence of the active business activities of the related foreign affiliates. The earmarking of investment property for use in future years in the active business activities of related foreign affiliates does not support the conclusion that the income from property would not have otherwise have been generated but for the active business activities taking place. As such, in our view, the investment activities of Canco should not be considered to be directly related to the active business activities of the other foreign affiliates for purposes of 95(2)(a)(i)(A).
95(2)(a)(i)(B) Whether the income from property would otherwise be viewed as "pertaining to" or "incident to" the active business of the other foreign affiliate
Where the test under 95(2)(a)(i)(A) is satisfied, clause 95(2)(a)(i)(B) would still require that the income from property be included in the active business income of the other foreign affiliate referred to in subclause (A)(I), if it had otherwise been earned by that other foreign affiliate.
"Active business" is negatively defined in subsection 95(1) for the purposes of division B, subdivision i of the Act, and excludes from its definition "business carried on by the foreign affiliate other than an investment business carried on by the foreign affiliate." In a similar manner, 95(1) defines "income from an active business" to include a foreign affiliate's income for the year that pertains to or is incident to that active business, excluding the foreign affiliate's income from property for the taxation year and certain other exceptions.
The Income Tax Rulings Directorate has previously considered the meaning of the term "pertains to or incident to" for purposes of applying subparagraph 95(2)(a)(i) of the Act, (endnote 5) and in particular, recognized the interpretive approach outlined by the courts in Atlas Industries Ltd. v. MNR. (endnote 6) In Atlas Industries, Christie, A.C.J.T.C. stated that:
"Giving the words "incident to or pertains to an active business" their grammatical and ordinary sense, and bearing in mind their context, there must I think be a financial relationship of dependence of some substance between the property and the active business before the exclusion in paragraph 129(4.1)(b) comes into play. The operations of the business ought to have some reliance on the property in the sense that recourse is had to it regularly or from time to time or that it exists as a back-up asset to be called on in support of those operations when the need arises. This I regard to be the basic approach to paragraph 129(4.1)(b). Whether income-producing property has crossed the dividing line into the paragraph will depend on the facts of each case." (endnote 7)
The approach outlined by the Courts in Atlas Industries was cited with approval in McCutcheon Farms, (endnote 8) and in our longstanding view, should be considered when considering the phrase "that pertains to or is incident to" an active business for purposes of applying 95(2)(a)(i).
Further, as acknowledged in the submissions from both Audit and Canco, Ensite has been recognized as a seminal case for purposes of determining whether property is held by a company in the course of carrying on a business. Briefly put, Ensite supports the precedent that for property to be considered part of an active business, and for the income from said property to be considered income from the active business, "withdrawal of the property must have a decidedly destabilizing effect on the corporate operations'." This phrase was adopted by Wilson J. in Ensite from March Shipping. (endnote 9) Under this premise, if the property fulfills a mandatory precondition to carrying on the business, the test is met. The test is also met where the property is vitally associated with the business, and is required to meet the recurring expenses of the business. Neither property that is not mandatory, but is held for sound business purposes, nor property held to achieve collateral purposes, such as the future replacement of existing capital assets or purchase of new capital assets, satisfy the test.
Relying on these Ensite principles, the Tax Court of Canada has, in multiple instances, rejected arguments that funds held and invested in a business, but not truly employed and at risk in the business, could be considered part of a taxpayer's active business, even if the funds were meant to fund future capital expenditures or to expand the taxpayer's business operations. (endnote 10) We are of the view that neither the decision in Ensite, the subsequent Tax Court cases applying the resulting Ensite principles, nor anything within the text of paragraph 95(2)(a) to support the establishment of different principles based on a company's size or the scope of its operations.
One premise from Ensite, that funds held for the future expansion of business, or the future replacement of capital assets, are not to be considered as being currently used in an active business, is made all the more clear upon a reading of the example case provided by Wilson J. at paragraph 14 of the Supreme Court's judgment: Bank Line Ltd v. Commissioner of Inland Revenue. (endnote 11) In Bank Line Ltd, the taxpayer owned and operated a fleet of several dozen ships, with plans for future replacements of ships, or to add to the fleet, using funds generated from its business. The taxpayer amassed funds that were not required for its current expenses, which were invested in short-term deposits and government securities. The taxpayer had claimed that the income from those investments was "trading income" of the company as "funds employed in its trade, inasmuch as they represented, principally, money set aside for the replacement of the fleet as and when ships became obsolete without which the trade of the [taxpayer company] could not continue." (endnote 12) While it was accepted by the Court that portions of the funds had in fact been used to expand the fleet, the Court held that such income constituted "trading receipts" only when they arose from capital which, in the relevant accounting periods, had been actively employed in the trade in question, and was in a real and practical sense at risk in the ordinary course of that trade. Funds set aside and intended for a future use or future expansion of the business could not be said to be so actively employed.
Financial detriment caused by the withdrawal of funds is not, in upon itself, enough to be considered to have a "decidedly destabilizing effect on the corporate operations" as contemplated in Ensite through consideration of March Shipping. (endnote 13) For further context, we note that the situation in March Shipping involved a taxpayer that took prepayment for services delivered to its shipping company customers, and from these prepayments subtracted an amount which was in excess of its operating expenses, placing the excess in short-term, interest bearing deposits. In coming to a conclusion that the investment of the funds was an ancillary activity, the Court considered the possible of alternatives available to the taxpayer as follows:
"The Company could have refrained from investing the funds (thereby not earning the interest); or used its own or borrowed funds rather than requiring agency deposits (thereby increasing operating expenses). There is no evidence that either of these courses of action would have affected the basic operations of the Company in any way except by less revenue or greater expense." (endnote 14)
Considering these principles, it is our opinion that even if the activities could be considered to be linked to a particular related foreign affiliate under clause 95(2)(a)(i)(A), the income from those activities would not meet the hypothetical requirement in clause (B), such that the income would be included in the other affiliate's income from an active business. This is because, at Canco's own admission, the amounts on deposit were for the purpose of future capital expenditure, future business expansion and future development of the Canco corporate group business, and not for expenses incidental to or pertaining to the carrying on the other foreign affiliates' active business. As discussed above, the Courts have rejected the argument that funds make up part of an active business if they are intended to pay for the future growth of the business, regardless of their eventual expenditure as intended. Although Canco's suggestion that such a view results from a misapplication of passing comments of the Tax Court Justice in McCutcheon Farms, we would argue that these comments, in fact, form part of the judgement itself, and should not be discounted as obiter dictum.
To the extent that the use of the earmarked funds in Canco related to something other than an expansion of business, we are not of the view that removal of the earmarked funds would be decidedly destabilizing, as envisioned by the Supreme Court in Ensite. In fact, by their own account, Canco's representatives describe these funds, at least in part, as "not immediately required" for XXXXXXXXXX projects, and that such funds "were generally placed on deposit" for future use. (endnote 15)
According to Audit and Canco, the amount of funds earmarked for use in the newer projects and future development is approximately USD $XXXXXXXXXX. Canco has argued that the removal of these funds would have had a destabilizing and adverse effect on the ability of the affiliates to see the newer projects to fruition, since it would jeopardize Canco's ability to access additional financing. Canco has described its industry as one that requires extensive capital in order to advance its projects, and has indicated that a significant portion of the capital required for these projects is generally expected to be generated by the Canco group, itself. In light of these factors, Canco has suggested that the removal of the funds accumulated in FA1, FA2, and FA3 would require the corporate group to internally source, or to borrow from other sources, the additional funding required for its projects. However, through its submissions, Canco has not represented that they are otherwise incapable of raising the required capital, either internally or through additional borrowings or capitalization, if and as required. In addition, the very fact that the funds were earmarked for the capital development of projects of other foreign affiliates, and were not required by any lenders of Canco or its affiliates to be transferred into that other foreign affiliate, or even to be located in the same jurisdiction as the other foreign affiliate, leads one to believe that the earmarked funds could be obtained from any corporation within the Canco group, including those in Canada.
As such, in line with the arguments raised by Audit, it is also our opinion that the loss of the investment funds held within FA1, FA2 and FA3 could not be said to cause a decidedly destabilizing effect on the corporate operations as envisioned in the Ensite case. Rather, it would be reasonable to expect that the operations of Canco and its affiliates could continue despite the removal of these investment funds, albeit at some inconvenience and potentially at lower profitability over a longer period of time. Again, while there may be arguments to suggest that the accumulation of investment assets within a corporate group may serve a sound business purpose to facilitate the funding of newer projects and future expansion within the group, such purpose is not, in itself, sufficient to satisfy the Ensite test.
Arguably, if Canco and its affiliates had been required to maintain the investment funds in order to fulfill a mandatory precondition to carrying on business, the Ensite test would be met. In this regard, when the Courts have determined that a use of property was in satisfaction of a mandatory precondition to trade, the mandatory preconditions have typically been legal in nature. For example, the companies in Ensite, Liverpool and London and Globe Insurance Co v. Bennett were each required, by the governments in the countries in which they were doing business, to have and invest funds in certain ways as a precondition to being in their respective businesses. (endnote 16)
While it may be true that Canco is required to fulfil certain conditions imposed XXXXXXXXXX under that government's XXXXXXXXXX regime, XXXXXXXXXX, the resulting requirements do not appear to be a precondition to carrying on business as contemplated in Ensite. Instead, the XXXXXXXXXX regime appears to be a system in which specific investment activity is performed in exchange for commercial XXXXXXXXXX benefits. Canco does not describe the imposition of these XXXXXXXXXX contracts as a precondition to its newer projects. Based on the submissions from Canco, it would appear that the intent behind maintaining the earmarked funds in FA1 is not to comply with a contractual requirement, but rather to defer XXXXXXXXXX imposed by the XXXXXXXXXX contract. XXXXXXXXXX. (endnote 17) While it may serve a sound business purpose for Canco to enter into a XXXXXXXXXX contract, the conditions imposed by the XXXXXXXXXX regime also fall short of the type of preconditions outlined in Ensite.
CONCLUSION
Based on the above, we generally agree with Audit that the requirements contained in subparagraph 95(2)(a)(i) have not been met in the case at hand, and that the income from property within FA1, FA2, and FA3 should not be included in computing the income from an active business income of the respective foreign affiliate during the years in question. We do not view the situation described by Canco as satisfying either clause 95(2)(a)(i)(A) or (B) for the reasons outlined above.
Please note that we have not considered, and have not been provided with, information in respect of income of the taxpayers involved which may be excluded from the definition of "income from property" by virtue of subparagraph (a)(i) of the definition of "investment business" and the definition of "foreign bank" in subsection 95(1). As such, nothing in this document should be construed as our position concerning the definitions of "investment business" or "foreign bank" in respect of the taxpayers involved.
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the CRA's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be made by you to Mrs. Celine Charbonneau at (613) 957-2137. In such cases, a copy will be sent to you for delivery to the taxpayer.
We hope these comments are of assistance.
Yours truly,
Robert A. Demeter, CPA, CGA
Section Manager
for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
ENDNOTES
1 Ensite Ltd v The Queen, [1986] 2 S.C.R. 509, 1986 CanLII 41 (SCC) [Ensite].
2 In particular, refer to Example 7 in the 1995 Explanatory Notes to subparagraph 95(2)(a)(i).
3 McCutcheon Farms v. MNR, 88 DTC 1208 (TCC) [McCutcheon Farms].
4 Transport Lacte Inc v. MNR, 89 DTC 606 [Transport Lacte Inc].
5 See IT Rulings Documents XXXXXXXXXX and E 2008-0272371
6 Atlas Industries Ltd. V. MNR, 86 DTC 1756 (TCC).
7 ibid.
8 McCutcheon Farms v. MNR, 91 DTC 5047
9 Wilson J. in Ensite quoting from March Shipping Ltd v. MNR, 77 DTC 371 (TRB) [March Shipping].
10 Sanilit Ltd v. MNR, 87 DTC 450 at 457; McCutcheon Farms, supra note 2 at 1214; Transport Lacte Inc, supra note 3 at 610; Muir Cap & Regalia Ltd v. MNR, 91 DTC 533 at 536; Balmoral Investments Ltd v. The Queen, 97 DTC 802 at 808.
11 (1974), 49 TC 307 (Scot. Ct. of Session) [Bank Line Ltd].
12 Bank Line Ltd, ibid, at paragraph 11 of the court reporter's summary of the case stated.
13 Wilson J. in Ensite quoting from March Shipping Ltd v. MNR, 77 DTC 371 (TRB)
14 March Shipping Ltd v. MNR, 77 DTC 371 (TRB)
15 Canco's submission at page XXXXXXXXXX.
16 Liverpool and London and Globe Insurance Co v. Bennett, [1913] AC 610 (HL) (referenced in Ensite); but see Owen v. Sassoon (1951), 32 TC 101 (Eng HCJ), in which contractual preconditions requiring certain capital holdings in order to be an underwriter for Lloyd's.
17 XXXXXXXXXX.
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