18 December 2012 Internal T.I. 2012-0461651I7 - Foreign Tax Credits - s. 126 vs. s. 110.5

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. Was there an abuse under the actual facts of using a loss-consolidation structure and section 110.5 of the Act?
2. If the loss-consolidation structure was successful in utilizing the foreign tax credits as planned, would there have been any abuse of the foreign tax credit provisions?

Position: 1. No
2. Maybe - although unlikely in this case.

Reasons: 1. The loss-consolidation structure used by the taxpayer to shift income between the parent and the subsidiaries is acceptable since it followed the steps of a typical loss-consolidation structure which CRA has held was acceptable. The use of section 110.5 is not offensive since the provision was enacted to prevent the wastage of foreign tax credits by converting foreign tax credits that would otherwise be wasted into non-capital losses.
2. If the loss-consolidation structure was successful in generating sufficient income to utilize the foreign tax credits, there may have been a need to consider whether additional credits specifically prohibited by paragraph (b) in 110.5 were obtained and if so, whether such result is appropriate given the purpose of those credits; and whether it would have been appropriate to allow a conversion of expiring foreign tax credits of one corporation to be turned into non-capital losses of another corporation. Since the loss-consolidation structure was not successful in this case, there is no need to consider this matter further.

December 18, 2012

XXXXXXXXXX TSO HEADQUARTERS
Income Tax Rulings Directorate
Henry Leung
(613) 957-2129

2012-046165
Attention: XXXXXXXXXX

Permissibility of Loss-Consolidation Strategies to prevent the expiry of Foreign Tax Credits

This is in response to your memorandum of June 14, 2012 regarding the potential abuse of foreign tax credits provided under sections 126 and 110.5 of the Income Tax Act.

Facts

Your enquiry relates to the following facts:

In XXXXXXXXXX, XXXXXXXXXX (Canco) incurred approximately $XXXXXXXXXX Cdn of tax deductible currency losses on hedging instruments due to the strengthening of the U.S. dollar. Canco projected that for XXXXXXXXXX, it would incur an overall hedging loss of $XXXXXXXXXX Cdn and have a net hedging tax loss of $XXXXXXXXXX. Since Canco's foreign XXXXXXXXXX were required to pay foreign taxes on their XXXXXXXXXX profits locally, Canco projected it would lose the ability to claim up to $XXXXXXXXXX Cdn of foreign tax credits (FTCs) in XXXXXXXXXX should the projections prove accurate.

As a result, Canco devised a plan (Project Shift), as described below, to transfer $XXXXXXXXXX of taxable income from profitable subsidiaries of Canco to itself. The intended effect of Project Shift would be to allow Canco to claim the FTCs and cause losses in the subsidiaries which will allow them to carry-back those losses to prior years.

Project Shift involved the following transactions:

• XXXXXXXXXX profitable subsidiaries were involved (XXXXXXXXXX), all of which were Canadian corporations.
• Canco made a demand, interest-bearing loan to each of the subsidiaries. The principal amounts of all the loans made totalled approximately $XXXXXXXXXX. Canco did not require any external funding in order to make these loans.Each of the subsidiaries used the borrowed funds to invest in preferred (Class A and Class B preferred shares) and common shares of new wholly-owned subsidiaries (Newcos), all incorporated in the Province of XXXXXXXXXX.
• Each of the Newcos then lent the proceeds to Canco on a demand, non-interest bearing basis.

After the income from the subsidiaries were transferred (via interest payments), the structure was unwound on or before XXXXXXXXXX through the following steps:

• Each Newco reduced the stated capital of its Class B preferred shares to a nominal amount (without making any distribution or payment in respect thereof). The amount by which the stated capital was reduced was added to that Newco's contributed surplus under relevant accounting rules and corporate law. This was done to allow the dividends on its preferred shares to be paid in compliance with the solvency test under the applicable corporate law.
• Each Newco demanded and received re-payment of an amount of the non-interest bearing loans made to Canco equal to the sum of all declared dividends on its preferred shares and the total redemption/retraction amount of its Class A preferred shares, which each of the Newcos paid out.
• The profitable subsidiaries in turn, used all the amounts received from the Newcos to pay Canco all the accrued interest on the loan made by Canco to each of the subsidiaries (earning a small profit (based on a XXXXXXXXXX-basis point spread between the interest rate paid on the loans received from Canco and the dividend rate on the preferred shares) and to partially repay the loans to Canco to the extent of any remaining funds.
• Canco then subscribed for a small number of common and Class B preferred shares of each Newco at their respective fair market values. Each Newco then demanded repayment of the remainder of the non-interest bearing loan owing to that Newco from Canco, which Canco repaid.
• Canco then contributed to the capital of each Newco the funds each Newco required to redeem/retract all of Newco's Class B preferred shares. The amounts of the capital contributions were added to the contributed surplus of each Newco as permitted by GAAP.
• Each Newco then reduced its contributed surplus by the total of all amounts that was previously deducted from its Class B Preferred Shares stated capital and added to the contributed surplus. This reduction was added back to the Class B Preferred Shares stated capital so that the stated capital of the Class B Preferred Shares equalled the aggregate redemption/retraction amount of the outstanding shares of that class. Each of the Newcos then redeemed its Class B Preferred Shares in full. The amounts received by each of the profitable subsidiaries were then used to repay the remainder of the loans it owed to Canco.
• Each of the profitable subsidiaries then sold the common shares of its respective Newco to Canco for an amount equal to the fair market value (a nominal amount). Canco then wound-up each Newco.

The effect of the transactions undertaken resulted in the subsidiaries receiving dividends tax free by virtue of subsection 112(1) of the Act. At the same time, the subsidiaries were able to deduct the interest on the loans paid to Canco against their income from other sources pursuant to paragraph 20(1)(c). This is so since the money borrowed by the subsidiaries from Canco was used to acquire the shares of the respective Newcos which were held by the subsidiaries for the purpose of producing income from property. The interest payments received by Canco with respect to the loans increased the taxable income of Canco by $XXXXXXXXXX.

The fluctuation in the relative value of the Canadian/U.S. currencies was greater than anticipated resulting in a $XXXXXXXXXX hedging loss for fiscal XXXXXXXXXX. The hedging loss exceeded the income that was transferred into Canco via Project Shift, which necessitated Canco making a section 110.5 election in XXXXXXXXXX to generate enough taxable income to enable it to claim foreign tax credits in respect of all the foreign taxes that would otherwise be wasted.

You request our views on:

a) Whether there was any abuse under the actual facts of using a loss-consolidation structure and section 110.5 of the Act?
b) Had Project Shift been successful in utilizing the foreign tax credits, would there then have been an abuse of the foreign tax credit provisions under the Act?

Our Comments

a)

One of the concerns that you highlighted focusses on the concern that Canco implemented Project Shift to allocate income from profitable subsidiaries to Canco in order to allow Canco to generate income to fully utilize its foreign tax credits. Moreover, it was pointed out that that Project Shift does not have any restrictions or limits to taxable income to utilize foreign tax credits while section 110.5 does.

As you have noted, it has been CRA's position in the past that loss-consolidation structures between related corporations are acceptable. CRA has taken the position that an acceptable loss-consolidation structure usually involves the following steps:

• Parent is the lossco;
• Parent obtains a daylight loan;
• ACo is a wholly owned subsidiary of Parent and is the profitco;
• Parent makes an interest-bearing loan to ACo (ACo Loan);
• ACo uses the borrowed money to subscribe for Newco preferred shares;
• Newco then makes an interest-free loan to Parent; and
• Parent repays the daylight loan.

While the example above illustrates Parent as the lossco and ACo as the profitco, it should be noted that in standard loss-consolidation structures, Parent can be a profitco or lossco and any entity in the group can undertake the borrowing, as long as all the participants are related. Foreign entities are not involved in standard intra-group loss consolidations. Furthermore, these steps must be legally effective, and documented and duly authorized with no corporate or regulatory impediments. The transactions must also be in full technical compliance with relevant provisions of the Act, including paragraph 20(1)(c) where interest expense deductions are claimed and subsections 112(1) – (2.4) if relying on inter-corporate dividend deductions. The purpose of such strategies is generally to effectively allow all the non-capital losses to be utilized, which would be similar to the situation they would be in had the lossco and profitco in the related group been amalgamated. Since we would normally allow for such losses to be utilized under an amalgamation, two entities who choose not to amalgamate for business reasons, should not be disadvantaged, and thus this is why the policy behind such structures are permitted and not subject to GAAR. As noted in the Explanatory Notes to subsection 245(4) issued on June 30, 1998, if properly undertaken, GAAR, generally, was not considered to apply to loss consolidation as:

There are explicit exceptions intended to apply with respect to transactions that would allow losses, deductions or credits earned by one corporation to be claimed by related Canadian corporations. In fact, the scheme of the Act as a whole, and the expressed object and spirit of the corporate loss limitation rules, clearly permit such transactions between related corporations where these transactions are otherwise legally effective and comply with the letter and spirit of these exceptions. Therefore, even if these transactions may appear to be primarily tax-motivated, they ordinarily do not fall within the scope of section 245.

Project Shift, as undertaken by Canco, is a typical loss-consolidation structure that the CRA finds acceptable based on the facts described above. Canco did not use a daylight loan to source its funding of the loans it made to each of the profitable subsidiaries, as Canco was able to make such loans using its own internal sources of funds. Canco was the lossco in this case, as it had a $XXXXXXXXXX loss for tax purposes on its XXXXXXXXXX tax return. Moreover, the steps in Project Shift were in full technical compliance with paragraph 20(1)(c) and subsection 112(1) of the Act. By undertaking Project Shift, Canco shifted income from the profitable subsidiaries to Canco as planned, and as discussed above, such a structure is acceptable and not offensive to the extent it leads to the utilization of non-capital losses. We provide no comment on the transactions described above which affected the corporate capital accounts of the various parties as we have not been provided with full details of the various amounts etc.

While Canco hoped that the transfer of the income from the profitable subsidiaries to Canco would have been enough to generate sufficient taxable income to utilize its foreign tax credits, the hedging loss that actually occurred was greater than that projected and exceeded the income that was transferred from the profitable subsidiaries to Canco. Accordingly, Canco needed to make a section 110.5 election in XXXXXXXXXX to generate more taxable income to claim the foreign tax credits.

It is important to note that section 110.5 of the Act is a permissive provision as opposed to a mandatory provision. The object and purpose of section 110.5 of the Act is described in the Technical Notes released by the Department of Finance:

Section 126 of the Act permits a taxpayer to claim a foreign tax credit. The credit is equal to the lesser of the foreign tax paid on the taxpayer's foreign source income and the Canadian tax that would otherwise be payable on that income. Where a taxpayer incurs a loss in a taxation year the amount of Canadian tax otherwise payable on foreign source income may be reduced. This would occur wherever the loss reduces the taxpayer's total income to an amount that is less than his foreign source income. In those circumstances, the Canadian tax otherwise payable may be less than the foreign tax paid on such income and, as a result, the amount that may be claimed as a foreign tax credit would have been reduced as a result of the deduction of the loss in computing income. This reduction is generally referred to as the foreign tax credit wastage attributable to the loss. New section 110.5 permits a corporation in such circumstances to increase its taxable income in order to avoid this wastage of the foreign tax credit. The amount added to taxable income is also added to the corporation's non-capital loss which may be carried over to other taxation years. The provision does not enable a corporation to add amounts to taxable income in order to produce tax against which the investment tax credit and other tax credits may be claimed.

Section 110.5 of the Act was enacted to provide a corporation with the option of generating additional income so that more foreign tax credits can be utilized under subsections 126(1) and 126(2) in order to avoid wasting foreign tax credits that might otherwise expire. While the effect of adding an amount to taxable income under section 110.5 is to convert into a non-capital loss for the year foreign taxes paid that might otherwise not be creditable against Canadian taxes payable in the year or any other year, the object and purpose of section 110.5 cannot be considered to have been abused or misused for the sole reason that another plan to achieve the same goal had failed because the actual loss incurred by Canco was greater than it had anticipated. Furthermore, it is important to note that Project Shift did not provide Canco with any additional tax credits that are specifically prohibited by paragraph (b) of section 110.5 of the Act. Thus, there was no misuse or abuse of section 110.5 of the Act by undertaking the Project Shift arrangement.

b)

If Project Shift had been successful, Canco could have utilized all the foreign tax credits under section 126 without the need to make a section 110.5 election. If Canco was also able to claim additional credits as prohibited by paragraph (b) of section 110.5, as a result of increasing its taxable income under Project Shift, then one could argue that section 110.5 may have been abused or misused. However, based on the reasoning discussed in the June 30, 1998 Explanatory Notes to subsection 245(4) quoted above, if the credits claimed would have been available to the amalgamated corporation resulting from an amalgamation of Canco and the profitable subsidiaries, it would in our view be difficult to establish an abuse.

Since Project Shift did not manage to create positive taxable income in Canco, and a section 110.5 election was filed there is no need for further analysis in this regard. The outcome produced was consistent with the text and purpose of section 110.5.

We trust these comments are of assistance.

Olli Laurikainen, C.A.
Section Manager
For Division Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch