21 October 2013 Internal T.I. 2013-0496841I7 - Application of clause 95(2)(a)(ii)(D) ITA

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 clause 95(2)(a)(ii)(D) ITA applies to the interest paid or payable by one foreign affiliate of a taxpayer to another of its foreign affiliate?

Position: No.

Reasons: Conditions set out in subclauses 95(2)(a)(ii)(D)(I) and (II) are not met as there is no money borrowed and no property acquired.

Sylvain Grégoire
Montérégie Rive-Sud TSO 2013-049684
3250 Lapinière Blvd. Hugo Gravel, LL.B., D. Brossard, QC J4Z 3T8 Fisc.

October 21, 2013

Subject: Clause 95(2)(a)(ii)(D) ITA

This is in response to your e-mail dated July 11, 2013 wherein you inquired whether clause 95(2)(a)(ii)(D) of the Income Tax Act, 1985 R.S.C., c. 1 (5th suppl.), as amended (the "ITA") was applicable to the particular situation described below.

Facts and assumptions

Our understanding of the relevant facts is as follows:

Initial Structure

1. At all relevant times, XXXXXXXXXX ("Canco") was a corporation resident in Canada for the purposes of the application of the ITA;

2. Canco owned 100 % of the interest in XXXXXXXXXX ("NR1"), a limited liability company formed under the laws of XXXXXXXXXX. At all relevant times NR1 was a corporation not resident in Canada for the purposes of the ITA and resident in the United States;

3. Canco owned 99,99%, and NR1 the remaining 0,01 %, of XXXXXXXXXX ("NR2"), a co-operative formed under the laws of XXXXXXXXXX. At all relevant times, NR2 was a corporation not resident in Canada for the purposes of the ITA and resident in XXXXXXXXXX;

4. NR2 owned 100 % of the interest in XXXXXXXXXX ("NR3"), a XXXXXXXXXX formed under the laws of XXXXXXXXXX. At all relevant times, NR3 was a corporation not resident in Canada for the purposes of the ITA and resident in XXXXXXXXXX;

5. NR3 owned 100 % of the interest in ("NR4"), an S.R.L. formed under the laws of XXXXXXXXXX. At all relevant times, NR4 was a corporation not resident in Canada for the purposes of the ITA and resident in XXXXXXXXXX;

Transactions

6. Canco lent US$ XXXXXXXXXX (the "Loan") to NR3. NR3 commingled the proceeds of the Loan with other funds in order to permit the acquisition of shares of XXXXXXXXXX ("NR5"), a XXXXXXXXXX formed under the laws of XXXXXXXXXX. At all relevant times, NR5 was a corporation not resident in Canada for the purposes of the ITA and resident in XXXXXXXXXX;

7. NR5 owned 100% of the shares of XXXXXXXXXX ("NR6"), an XXXXXXXXXX formed under the laws of XXXXXXXXXX. At all relevant times, NR6 was a corporation not resident in Canada for the purposes of the ITA and resident in XXXXXXXXXX. NR6 carried on an active business in XXXXXXXXXX.

8. NR5 was liquidated into NR3. All the shares of NR6, previously held by NR5, were then held by NR3;

9. NR3 sold NR6's shares to Canco in settlement of the Loan;

10. Canco then transferred the NR6's shares to NR1 in consideration for new units in NR1;

11. NR4 acquired NR6's shares from NR1 for fair market value consideration of US$ XXXXXXXXXX, satisfied by the issuance of an interest bearing note in the same amount ("Note1");

12. NR2 acquired Note1 from NR1 by issuing an interest bearing note in the amount of US$ XXXXXXXXXX ("Note2") to NR1;

13. NR2 transferred Note1 to NR3 as a contribution of capital;

14. At all relevant times, NR1, NR2, NR3, NR4, NR5 and NR6 were foreign affiliates and controlled foreign affiliates in respect of which Canco had a qualifying interest.

Final Structure

15. After the transactions had been implemented, the structure was the same as the initial structure except that NR6's shares were owned by NR4, Note2 was owed by NR2 to NR1 and Note1 was owed by NR4 to NR3.

Issue

The only issue raised in your request is whether 95(2)(a)(ii)(D) ITA applies to the interest paid by NR2 to NR1 on Note2, such that the amount of the interest, which would otherwise be included in NR1's income from property and therefore included in its foreign accrual property income ("FAPI"), would instead be included in its income from an active business for its XXXXXXXXXX and XXXXXXXXXX taxation year.

Our comments

General

If certain conditions are met, income that would otherwise be included in a foreign affiliate's income from property, is to be included in its income from an active business pursuant to, inter alia, clause 95(2)(a)(ii)(D) ITA. With respect to the relevant taxation years, this clause reads as follows:

(2) Determination of certain components of foreign accrual property income — For the purposes of this subdivision,

(a) [Income related to active business activities, etc.] — 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

(ii) the income or loss is derived from amounts that were paid or payable, directly or indirectly, to the particular foreign affiliate or a partnership of which the particular foreign affiliate was a member

(D) by another foreign affiliate (referred to in this clause as the "second affiliate") of the taxpayer — in respect of which the taxpayer has a qualifying interest throughout the year — to the extent that the amounts are paid or payable by the second affiliate, in respect of any particular period in the year,

(I) under a legal obligation to pay interest on borrowed money used for the purpose of earning income from property, or

(II) on an amount payable for property acquired for the purpose of gaining or producing income from property (Our emphasis)

Subclauses 95(2)(a)(ii)(D)(I) and (II) ITA set out two alternative conditions precedent to the application of clause 95(2)(a)(ii)(D) ITA. Pursuant to these provisions, the affiliate being referred to as the second affiliate must either pay an amount to the first affiliate (I) under a legal obligation to pay interest on borrowed money used for the purpose of earning income from property; or (II) on an amount payable for property acquired for the purpose of gaining or producing income from property.

Application of subclause 95(2)(a)(ii)(D)(I) ITA

As previously mentioned, provided certain other conditions are met, clause 95(2)(a)(ii)(D) ITA should apply if the amounts paid by the second affiliate to the particular affiliate are paid pursuant to a legal obligation to pay interest on borrowed money, as prescribed by subclause 95(2)(a)(ii)(D)(I) ITA.

In the situation described above, NR2 acquired a note owed by NR4 to NR1 from NR1 in consideration for the issuance of another note to NR1 in the same amount.

The expression borrowed money has been interpreted, inter alia, by the Supreme Court of Canada in Minister of National Revenue v. T.E. McCool Limited, 49 D.T.C. 700, a case dealing with interest deductibility under the equivalent (at that time) of subparagraph 20(1)(c)(i) ITA. This case is relevant with respect to the present issue as subclause 95(2)(a)(ii)(D)(I) ITA uses a wording similar to the one used in subparagraph 20(1)(c)(i) ITA. In its reasons for judgement, Estey, J. stated that:

Terms such as "borrowed capital", "borrowed money" in tax legislation have been interpreted to mean capital or money borrowed with a relationship of lender and borrower between the parties. Inland Revenue Commissioners v. Port of London Authority, [1923] A.C. 507; Inland Revenue Commissioners v. Rowntree & Co. Ltd., [1948] 1 All E.R. 482; Dupuis Fréres Ltd. v. Minister of Customs and Excise, [1927] Ex. C.R. 207, [1917-2] CTC 726 [[1917-27] CTC 326]. It is necessary in determining whether that relationship exists to ascertain the true nature and character of the transaction. In this case the promissory note arises out of an exchange in which, as already detailed, the purchase price was paid by assuming outstanding obligations, a small payment of cash, allotment of capital stock and the execution and delivering of this promissory note. Under such circumstances it cannot be held that the relationship of lender and borrower in respect to this note exists between the respondent company and the payee of the note. (Our emphasis)

In its reasons for judgment, Kellock, J., in the same case mentioned the following:

This claim was disallowed by the Minister and the company's appeal was dismissed by the learned trial judge, on the ground that in order to qualify under the statute the taxpayer would have to be in the position of a borrower and some other person would have to be a lender, while in fact there was no such relationship as between the company and McCool. I agree with the learned trial judge that the company cannot bring itself within the language used in section 5(1)(b). To employ the language of Viscount Finlay in Commissioners of Inland Revenue v. Port of London Authority, [1923] A.C. 507 at 514, in order to enable the statute to apply, "there must be a real loan and a real borrowing." Here there is nothing more than unpaid purchase money secured by a promissory note which, in my opinion, is insufficient. It is not sufficient to say that if the company had borrowed the amount of the note and paid McCool it would have been entitled to the deduction. However that may be, that was not done and the statute does not apply. This appeal should also be dismissed. (Our emphasis)

Further to the decision in T.E. McCool, the SCC reasoning has been constantly followed by the courts. For example, in Penn Ventilator v. The Queen, 2002 D.T.C. 1498, Lamarre-Proulx, J.T.C.C. basing her reasoning on T.E. McCool stated that:

[63] In view of the decision of the Supreme Court of Canada in M.N.R. v. T.E. McCool Limited (supra ) having found that a promissory note was not borrowed money, subparagraph 20(1)(c )(i) cannot apply. (Our emphasis)

As such, given the findings of the Supreme Court in T.E. McCool, it is unlikely that the condition set out in subclause 95(2)(a)(ii)(D)(I) ITA is met as no lender-borrower relationship has been created between NR1 and NR2. As a consequence, the interest paid or payable by NR2 to NR1 was not paid or payable on borrowed money.

Application of subclause 95(2)(a)(ii)(D)(II) ITA

Alternatively, if the condition discussed in the preceding section is not met, and provided certain other conditions are met, clause 95(2)(a)(ii)(D) ITA should apply if the amounts paid by the second affiliate to the particular affiliate are with respect to an amount payable for property acquired for the purpose of earning income from property, which property must be excluded property of the second affiliate that is shares of another foreign affiliate in which the taxpayer has a qualifying interest, as prescribed by subclause 95(2)(a)(ii)(D)(II) ITA.

In the situation described above, NR2 acquired Note1 in consideration for the issuance of Note2. This acquisition of property does not meet the requirement set out in subclause 95(2)(a)(ii)(D)(II) ITA as the property acquired was not shares of another foreign affiliate. Further to this, NR2 contributed Note1 to the capital of NR3. The concept of property acquired has been discussed, inter alia, in document 5-9798, Deductibility of Interest, June 12, 1990, where it was said that:

A shareholder who transfers borrowed funds to a corporation as contributed surplus would not directly acquire any property. Therefore, in accordance with the above-quoted comments, the interest expense would not be deductible.

Therefore, given NR2 did not acquire any property upon the contribution of Note1 to the capital of NR3, the condition set out in subclause 95(2)(a)(ii)(D)(II) ITA is not met.

Conclusion

Given that neither the condition set out in subclause 95(2)(a)(ii)(D)(I) ITA nor the condition set out in subclause 95(2)(a)(ii)(D)(II) ITA are met, clause 95(2)(a)(ii)(D) ITA does not apply to include the interest paid or payable by NR2 to NR1 on Note2 in NR1's income from an active business. Therefore the amount of those interest should be included in NR1's income from property and consequently constitutes FAPI for NR1.
We trust these comments are of assistance.

Guy Goulet, CPA, CA, M. Fisc.
Manager
for Director
International & Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch