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 it is mandatory to claim the maximum deduction available under paragraph 20(1)(c) when computing the foreign accrual property income/loss of a foreign affiliate.
Reasons: Reg. 5907(2.03) is not applicable to the computation of foreign accrual property income/loss. Paragraph 20(1)(c), which is applicable in computing income/loss from property of a foreign affiliate pursuant to paragraph 95(2)(f), is discretionary in nature.
June 5, 2018
Re: Interest expense of a foreign affiliate holding company
We are writing in response to your email of December 14, 2017 in which you requested our views on the computation of foreign accrual property income (“FAPI”), as defined in subsection 95(1) of the Income Tax Act (the “Act”), in a hypothetical situation where interest is paid by a controlled foreign affiliate of a Canadian resident corporation to an arm’s length party.
Unless otherwise stated, every statutory reference herein is a reference to the relevant provision of the Act and its Regulations, and all terms used herein that are defined in the Act and its Regulations have the meaning given in such definition unless otherwise indicated.
You presented the following hypothetical scenario to illustrate your questions:
1) Canco is a corporation resident in and formed under the laws of Canada.
2) FA1 is a wholly owned subsidiary of Canco that is formed in and resident of a designated treaty country (“DTC”) as defined in Regulation 5907(11).
3) FA1 is solely a holding company for FA2 (as described below) and does not carry on an active business.
4) FA1 borrows $100 from an arm’s length party (which you have described as a “Bank”) at an interest rate of 10%/annum and uses the proceeds of the loan to acquire all the shares of FA2, which are excluded property as defined in subsection 95(1). FA1 pays interest to the Bank in accordance with arm’s length terms and conditions on the loan.
5) The Bank is not a foreign affiliate of Canco nor of any other person with whom Canco does not deal at arm’s length.
6) Canco and FA1 did not have any ownership in FA2 prior to the acquisition of FA2’s shares by FA1.
7) FA2 is a wholly owned subsidiary of FA1 that is formed in and resident of a DTC. FA2 carries on an active business in a DTC.
8) In a year subsequent to the acquisition of FA2, FA2 pays an exempt surplus dividend of $75 to FA1. FA1 uses $10 from the dividend to pay interest to the Bank.
9) FA1 pays an exempt surplus dividend of $65 to Canco, and Canco claims a deduction of $65 in respect of the dividend under paragraph 113(1)(a).
You have asked us to comment on whether the interest paid by FA1 to the Bank is deductible in computing the FAPI of FA1 for the year, and if so and assuming there were no other amounts to be included in the computation of FAPI, whether the deduction would result in a net loss in respect of FAPI (otherwise referred to as a foreign accrual property loss (“FAPL”)). You have also enquired whether Canco is required to deduct the interest expense in computing FA1’s FAPI/FAPL (assuming all the requirements of paragraph 20(1)(c) were otherwise met) or whether Canco may choose to forgo the interest deduction in computing the FAPI/FAPL in respect of FA1.
This technical interpretation provides general comments about the provisions of the Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of a particular transaction proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.
Paragraph 95(2)(f) requires that FA1’s income/loss from property, which is included in the determination of FAPI/FAPL, be computed as if FA1 were a resident in Canada. Consequently, FA1 would compute its FAPI/FAPL in accordance with the provisions of the Act, adjusted as required pursuant to paragraph 95(2)(f.11) and other provisions as addressed below. In the hypothetical situation, paragraph 95(2)(f.11) would not have any impact on the computation of FA1’s FAPI/FAPL. Therefore, the interest deductibility provision in paragraph 20(1)(c) would apply to provide an interest deduction in the computation of FA1’s FAPI/FAPL, provided that all the conditions of that paragraph were met. Further, based on your representation that the Bank is not a foreign affiliate of Canco nor of a person not dealing at arm’s length with Canco, the amount of FA1’s interest deductible in computing its income/loss from property would not be deemed to be nil as otherwise would be required by the mid-amble of factor A in the subsection 95(1) definition of FAPI because clause 95(2)(a)(ii)(D) would not apply to the interest paid or payable by FA1 to the Bank. Therefore, if FA1 does not have any other amounts to be included in the computation of FAPI, the interest deduction for the interest paid or payable to the Bank would result in a FAPL in respect of FA1.
However, unless a specific provision of the Act or its Regulations otherwise apply, as addressed further below, it is our view that Canco is not required to deduct the interest expense paid or payable by FA1 to the Bank when computing FAPI of FA1, since paragraph 20(1)(c) is a discretionary deduction, the preamble of which provides that an amount “may be deducted”. However, if Canco does not deduct an amount of interest in computing FA1’s FAPI/FAPL for the year in which that interest is paid or payable, that interest may not be deducted in computing FA1’s FAPI/FAPL for any subsequent year.
Regulation 5907(2.03) was introduced to prevent taxpayers from purposely inflating a surplus balance or minimizing a deficit balance by requiring that the earnings or loss of a foreign affiliate be computed on the basis that maximum allowable deductions under the Act had been claimed. However, Regulation 5907(2.03) only applies to the computation of certain earnings or loss from an active business, specifically in the computation of earnings under subparagraph (a)(iii) and paragraph (b) of the “earnings” definition in Regulation 5907(1) and paragraph (b) of the “loss” definition in Regulation 5907(1). Since FA1 does not carry on an active business or earn income that is deemed to be from an active business, the definition of “earnings” and the definition of “loss” in Regulation 5907(1) are not applicable to FA1. Therefore, in our view Regulation 5907(2.03) would not apply to require that Canco deduct the interest expense paid or payable by FA1 to the Bank in computing FA1’s income/loss from property.
Regulation 5907(2.7), which otherwise requires a foreign affiliate to claim deductions in the earliest year in which an amount is paid or payable and deems the affiliate to be carrying on an active business, also would not apply to FA1 as the Bank is not a foreign affiliate of Canco.
Therefore, in our view FA1 would not be required to deduct its interest expense in the hypothetical situation presented. However, a review of all the relevant facts and circumstances in a particular situation should be done to determine the non-arm’s length and foreign affiliate status amongst the entities involved, as well as to consider whether subsection 245(2) or a more specific anti-avoidance provision could apply to a particular situation.
We trust this information is of assistance to you.
Ann Kippen, CPA, CA
For Division Director
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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