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: (a) Whether paragraph 95(2)(b) can apply in respect of R&D services provided to Canco by its CFA, notwithstanding that these services have been rendered under terms and conditions aligned with the arm’s length principle applicable for the purposes of subsection 247(2)?
(b) Whether R&D services are eligible to paragraphs 95(3)(b) or (d) exceptions?
Position: (a) Yes. (b) No.
Reasons: (a) Interpretation of the Act. (b) Interpretation of the Act and previous positions.
February 1, 2018
Income Tax Rulings
Interaction of 95(2)(b) & 247(2)
This is in reply to your correspondence of October 20, 2016, wherein you requested our views with respect to interpretative issues involving the application of paragraph 95(2)(b) and subsection 247(2), and the application of exceptions provided by subsection 95(3). Further to the initial request, we acknowledge the additional information provided to us through e-mails, and in the course of various telephone conversations. We apologize for the delay in responding.
Unless otherwise stated, all references herein to statutory provisions are references to provisions of the Income Tax Act (the “Act”) and to the Income Tax Regulations (the “Regulations”).
We understand the relevant facts of the situation submitted to be as follows:
1. XXXXXXXXXX (“Canco” or “Taxpayer”) is a public corporation that is a taxable Canadian corporation, as these terms are defined in subsection 89(1). Canco’s relevant taxation year under review ends on XXXXXXXXXX.
2. A valid election under subsection 261(3) was made by Canco resulting in the United States Dollar (“USD”) being its elected functional currency, within the meaning assigned by subsection 261(1), for its taxation year ended on XXXXXXXXXX.
3. Canco owns all of the issued and outstanding shares of XXXXXXXXXX (“CFA1”), which is a non-resident corporation incorporated in the United States (“U.S.”) and subject to tax therein.
4. CFA1 owns all of the issued and outstanding shares of XXXXXXXXXX (“CFA2”), of XXXXXXXXXX (“CFA3”), and of XXXXXXXXXX (“CFA4”), which are non-resident corporations incorporated in the U.S. and subject to tax therein.
5. Each of CFA1’s, CFA2’s, CFA3’s and CFA4’s relevant taxation year ends on XXXXXXXXXX.
6. CFA1, CFA2, CFA3 and CFA4 are foreign affiliates (“FAs”) and controlled foreign affiliates (“CFAs”) of Canco, as these terms are defined in subsection 95(1).
7. During their XXXXXXXXXX taxation year, CFA1, CFA2, CFA3 and CFA4 performed research and development services (“R&D Services”), totalling approximately USD $XXXXXXXXXX in connection with XXXXXXXXXX held by Canco.
8. The R&D Services costs of approximately USD $XXXXXXXXXX were deducted by Canco in computing its income from a business carried on in Canada for its taxation year ending on XXXXXXXXXX.
9. The R&D Services were provided to Canco by non-arm’s length non-resident corporations under terms and conditions that would have been made between persons dealing at arm’s length, in accordance with the arm’s length principle developed in the Transfer Pricing Guidelines published by the Organisation for Economic Co-operation and Development (“OECD”).
10. CFA1 is the parent of a group of corporations (“US Consolidated Group”) which is considered for U.S. federal tax purposes to be an affiliated group of corporations under the provisions of the Internal Revenue Code. This group also includes CFA2, CFA3 and CFA4.
11. CFA1 filed an amended annual consolidated U.S. federal income tax return for the US Consolidated Group’s taxation year ending on XXXXXXXXXX. In this amended return, an amount of nearly USD $XXXXXXXXXX of “credit for increasing research activities” was deducted against the U.S. federal income tax otherwise payable, resulting in an amount of approximately USD $XXXXXXXXXX of tax being payable by CFA1 for that year.
12. CFA1, CFA2, CFA3 and CFA4 only provide research and development services to Canco. Therefore, the total of the USD $XXXXXXXXXX of “credit for increasing research activities” claimed is attributable to the R&D Services provided to Canco in its taxation year that ended on XXXXXXXXXX.
13. In their taxation year ending on XXXXXXXXXX, CFA1, CFA2, CFA3 and CFA4 collectively earned net income of approximately USD $XXXXXXXXXX in respect of the R&D Services provided to Canco.
14. The audit division of the XXXXXXXXXX Tax Services Office of the Canada Revenue Agency (“CRA”) identified the following positions in order to support the reassessment of Canco’s taxation year ending on XXXXXXXXXX:
a. the net income earned by CFA1, CFA2, CFA3 and CFA4 in respect of the R&D Services provided to Canco is subject to paragraph 95(2)(b);
b. the amount of foreign accrual property income (“FAPI”), as defined under subsection 95(1), of CFA1, CFA2, CFA3 and CFA4, for their taxation years ending on XXXXXXXXXX, is approximately USD $XXXXXXXXXX, USD $XXXXXXXXXX, USD $XXXXXXXXXX, and USD $XXXXXXXXXX, respectively;
c. since the amount of U.S. tax credits deducted against U.S. federal income tax exceeds the amount of such tax that may reasonably be regarded as applicable to the net income in respect of the R&D Services provided to Canco, the portion of the U.S federal income tax applicable to the FAPI of CFA1, CFA2, CFA3 and CFA4 included in Canco’s income under subsection 91(1) is XXXXXXXXXX; and
d. alternatively, since CFA2, CFA3 and CFA4 each applied net operating losses from prior years or losses from other business in the calculation of the US Consolidated Group’s taxable income, these losses reduce the taxable income attributable to CFA2, CFA3 and CFA4 to XXXXXXXXXX and the portion of the U.S. federal income tax applicable to the FAPI of CFA2, CFA3 and CFA4 included in Canco’s income under subsection 91(1) is XXXXXXXXXX.
Our understanding of the facts is based on the information provided in your request for an opinion, including a document summarizing the facts and providing the Taxpayer’s comments dated July 12, 2016, the other documents attached to the request, additional information received by e-mails dated January 6 and March 14, 2017, and various conversations involving XXXXXXXXXX. Also, the Taxpayer provided further documents and representations that were sent to us by e-mail on December 16, 2016 and May 31, 2017. Note that all the facts pertaining to this particular situation are not fully repeated herein and one should refer to the above noted documents for additional details, where necessary.
In this context, you asked for our views with regard to the following issues:
(a) whether paragraph 95(2)(b) can apply in respect of the R&D Services provided to Canco, notwithstanding that these services have been rendered under terms and conditions aligned with the arm’s length principle applicable for the purpose of subsection 247(2); and
(b) whether either of the exceptions in paragraphs 95(3)(b) or (d) would apply.
You did not request that we specifically comment as to whether the conditions of application of paragraph 95(2)(b) were met in the context of the situation submitted. In this respect, we have assumed that these conditions are met and that paragraph 95(2)(b) would be applicable to the situation submitted, subject to our comments hereafter in respect of the above mentioned issues.
95(2)(b) & 247(2)
With respect to the first issue, we are of the view that paragraph 95(2)(b) applies in respect of the R&D Services provided to Canco, notwithstanding that these services have been rendered under terms and conditions aligned with the arm’s length principle applicable for purposes of subsection 247(2). In this respect, no specific provision of the Act mandates a way for these provisions to interact and the fact that there might be legitimate reasons for services to be rendered to a taxpayer by its CFA is not relevant in determining whether paragraph 95(2)(b) should apply. Each of paragraph 95(2)(b) and subsection 247(2) are aimed at preventing the erosion of the Canadian tax base, but they apply from different perspectives and their application is guided by their own tax policies, as established by the Department of Finance Canada (“DOFC”).
In this context, we are of the view that it is not appropriate to consider that the transfer pricing regime always provides for a comprehensive solution in respect of preventing the erosion of the Canadian tax base. Paragraph 95(2)(b), as well as the other FAPI base erosion rules under paragraphs 95(2)(a.1) to (a.4), were enacted before the current transfer pricing rules, which were introduced in 1998. As such, we see no inconsistency and no operational conflict in the combined application of these two sets of rules to the situation submitted. In addition, our interpretation is also supported by the following statement made by the Advisory Panel on Canada’s System of International Taxation in its final report entitled “Enhancing Canada's International Tax Advantage”, issued in December 2008:
“The Panel heard that the base erosion rules are unnecessary in light of Canada’s transfer pricing rules. In the Panel’s view, transfer pricing rules pose administrative challenges. Well-designed and properly focused base erosion rules complement the transfer pricing rules and provide certainty about the types of income that should be subject to Canadian tax, without adversely affecting the global competitiveness of Canadian businesses.” (par. 4.122)
The arguments raised by the Taxpayer in order for paragraph 95(2)(b) not to be applied in respect of the situation submitted are essentially driven by tax policy considerations. In this respect, we note that the CRA’s mandate includes, among other things, supporting the administration and interpretation of the Act as guided by our understanding of the relevant tax policy. Any tax policy concern should be addressed to the DOFC for its consideration. In this case, we understand that the Taxpayer has made submissions to the Honourable Bill Morneau, Minister of Finance, and met with senior DOFC officials. We further understand that the Minister of Finance provided a written response setting out the relevant Canadian tax policy in this regard.
The Taxpayer also raised an argument to the effect that a broad interpretation of the FAPI base erosion rules might result in a contravention of the arm’s length principle developed in the OECD Transfer Pricing Guidelines. In this regard, we note that such base erosion rules are common features of “controlled foreign corporations” regimes worldwide, and that they are generally not limited in their application under income tax conventions. In this respect, Article XXIX(2)(a) of the Canada-U.S. Tax Convention specifically provides that the convention shall generally not affect the taxation by Canada of its residents.
Exceptions of 95(3)(b) & (d)
Regarding the second issue mentioned above, although we haven’t reviewed the relevant legal documentation that governs the interaction of the parties, we are of the view that no exception in paragraphs 95(3)(b) or (d) applies to allow the R&D Services provided to Canco not to be considered “services” for the purposes of paragraph 95(2)(b). It is our understanding that the Taxpayer’s argument is to the effect that the R&D Services provided to Canco should be considered to be services performed in connection with the sale of goods under the terms of paragraph 95(3)(b), or, alternatively, be part of the manufacturing or processing of property, and as such subject to the exception provided in paragraph 95(2)(d).
Concerning the scope of paragraph 95(3)(b), it has been our longstanding position that the phrase “services performed in connection with the (...) sale of goods” is limited to services that are directly related to the sales function (in this respect, see for example documents 9729770, 2002-0123755 and 2013-0497361I7). It is our view that the structure of the phrase refers to activities that are immediately linked or related to the process of selling goods and transferring ownership in the goods from the seller to the purchaser, requiring that the services be directly performed in the actual sale or negotiation process. Thus, we are of the general view that the exception of paragraph 95(3)(b) does not extend to research and development services such as the R&D Services, as these types of services would generally not be immediately linked or related to the process of selling goods and transferring ownership in the goods from the seller to the purchaser.
In regard to the exception provided in paragraph 95(3)(d), it is our general view that, for the purposes of that provision, research and development services such as the R&D Services would not qualify as manufacturing or processing activities. We note that for purposes of the manufacturing and processing profits deductions set out in subsection 125.1(1), the expression qualifying activities (as defined in section 5202 of the Regulations) includes scientific research and experimental development (as defined in section 2900 of the Regulations) carried on in Canada. This specific inclusion in that definition supports the interpretation that the expression “manufacturing or processing” for purposes of subsection 125.1(1) would not have otherwise included such type of activities. We further note that no such extended meaning applies for the purposes of paragraph 95(3)(d).
In its representations, the Taxpayer did not elaborate specifically on various other requirements that have to be met for the exception of paragraph 95(3)(d) to apply to the situation under review, including the “taxpayer’s specifications” and the “taxpayer ownership” requirements. In such circumstances, and considering the interpretation of the expression “manufacturing or processing” discussed above, we feel it is not necessary to expand further on our comments concerning paragraph 95(3)(d) in order to support our conclusion that this exception should not apply to the R&D Services.
In dealing with the situation submitted, we identified various issues in respect of the determination of the foreign accrual tax (“FAT”), within the meaning assigned by subsection 95(1), applicable to amounts included under subsection 91(1) in computing Canco’s income for its taxation year ended on XXXXXXXXXX, as well as various FA surplus computation issues. These issues were discussed between the CRA’s stakeholders and, it is our understanding, were generally brought to the attention of the Taxpayer. However, we further understand that the Taxpayer was reluctant to provide additional information and representations on these issues prior to any conclusion being reached by the CRA as to whether the R&D Services provided to Canco give rise to FAPI inclusions in Canco’s income. In these circumstances, we are not in a position to offer conclusive comments on these issues, but we are nevertheless inclined to share general comments and identify facts that would have to be clarified in order to apply the relevant rules given the conclusion that the R&D Services provided to Canco do give rise to amounts included under subsection 91(1) in computing Canco’s income.
The deduction in respect of foreign taxes that might be available under subsection 91(4) is generally determined with reference to the FAT applicable to an amount included under subsection 91(1) in computing a taxpayer’s income for a taxation year of the taxpayer in respect of a particular FA of the taxpayer, and the relevant tax factor, within the meaning assigned by subsection 95(1). In the context of the situation submitted, the amount of foreign tax paid by CFA1 may only give rise to FAT to the extent it can reasonably be regarded as applicable to the FAPI inclusions in Canco’s income in respect of CFA1. For there to be FAT attributable to the FAPI inclusions in Canco’s income in respect of CFA2, CFA3 and CFA4, it would have to be an amount prescribed as such under paragraph 5907(1.3)(a) of the Regulations for the purposes of paragraph (b) of the FAT definition. As such, numerous requirements would have to be met, including that “tax sharing payments” were made.
In addition, if any amount is prescribed as FAT under paragraph 5907(1.3)(a) of the Regulations, the net operating losses from prior years and losses from other businesses used by members of the US Consolidated Group would have to be reviewed in order to assess whether the “FAT Denial Rule” of subsection 5907(1.4) of the Regulations applies. In this respect, the nature of the loss, the year it was incurred, and whether that year precedes an acquisition of control by Canco, by example, would be part of the facts that would have to be confirmed. Also, information would be required in respect of the functioning of the U.S. research and development credit regime in order to determine whether any amount can be deducted in that respect in the determination of any amount of FAT.
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. A severed copy will also be distributed to the commercial tax publishers, following a 90-day waiting period (unless advised otherwise to extend this waiting period), 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 e-mailed to: ITRACCESSG@cra-arc.gc.ca. In such cases, a copy will be sent to you for delivery to the Taxpayer.
We hope this information is of assistance to you and thank you for your enquiry.
Acting Section Manager
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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