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: i) Where a corresponding adjustment under foreign tax law results in a reassessment of taxable income and income taxes payable of a foreign affiliate by a foreign tax authority, would there be a re-computation of earnings and net earnings of the foreign affiliate for the relevant taxation years under subparagraph 5907(1)(a)(i) of the Regulations? ii) Also, would the income retained but not included in computing the earnings of the foreign affiliate as a result of the corresponding adjustment result in an addition to the earnings of the foreign affiliate under paragraph 5907(2)(f) of the Regulations for the relevant taxation years?
Position: In the factual circumstances provided, i) yes and ii) yes.
Reasons: i) The corresponding adjustment and the resulting reassessment by the foreign tax authority changes the amount of income or profit from active business of the foreign affiliate computed in accordance with the foreign tax law and the income taxes paid by the foreign affiliate in respect of that income or profit for the reassessed taxation years. ii) The income realized and retained by the foreign affiliate, but excluded from its income for foreign income tax purposes as a result of the corresponding adjustment by the foreign tax authority, would be "revenue, income, or profit" derived by the foreign affiliate for purposes of paragraph 5907(2)(f) of the Regulations.
2019 International Fiscal Association Conference
Question 10 - Foreign Affiliate Earnings and Foreign Transfer Pricing Adjustments
Parent, a corporation formed and resident in Canada, is the parent company of a global business operation. Parent wholly owns a corporation formed and resident in Canada (“Canco”) and a corporation formed and resident in Country A (“CFA”), a designated treaty country as defined in subsection 5907(11) of the Income Tax Regulations (the “Regulations”).
Parent and CFA entered into an agreement whereby CFA provided services to certain companies directly or indirectly held by Parent (the “CFA Service Agreement”). The income earned by CFA was income from an active business carried on in Country A and not foreign accrual property income (“FAPI”) as defined in subsection 95(1) of the Income Tax Act (the “Act”). Parent also entered into an agreement with Canco whereby Canco provided services to certain companies directly or indirectly held by Parent (the “Canco Service Agreement”).
The Canada Revenue Agency (“CRA”) subsequently issued tax reassessments to Canco for certain taxation years, including in the income of Canco under the Canco Service Agreement a portion of the fees received by CFA under the CFA Service Agreement.
Canco and CFA submitted a request to the Competent Authorities of Canada and Country A under the Mutual Agreement Procedure (“MAP”) of the Canada-Country A Tax Treaty for relief from double-taxation with respect to the reassessed taxation years. The adjustments under the MAP Settlement resulted in reassessments by the Country A tax authority to reduce CFA’s income in each relevant taxation year and in a repayment to CFA of the amount of Country A income taxes that were paid but were not due in light of the adjustments under the MAP Settlement. Moreover, pursuant to the MAP Settlement, it was agreed that no secondary adjustment would be made to the income of Canco or CFA. CFA did not and will not make any payment to Canco in respect of the addition to the income of Canco for Canadian tax purposes pursuant to the reassessments.
Under Country A law, transfer pricing adjustments and corresponding reassessments by the Country A tax authority do not alter the legal right of CFA to the income it earned pursuant to the CFA Service Agreement and do not result in a recharacterization of the nature of the income earned by CFA. Moreover, Country A accounting standards do not require any restatement of CFA’s original financial statements with respect to the relevant taxation years in connection with the adjustment to CFA’s income under Country A’s tax law.
As a result of the reassessment of the taxable income of CFA in Country A and the corresponding refund of income taxes payable of CFA, would there be:
i. a re-computation of earnings and net earnings of CFA for the relevant taxation years under subsection 5907(1) of the Regulations?
ii. an addition to the earnings of CFA under paragraph 5907(2)(f) of the Regulations for the relevant taxation years of the amount of the income retained but excluded from its income for Country A income tax purposes?
Under subparagraph 5907(1)(a)(i) of the definition of “earnings” in the Regulations, the starting point for computing a foreign affiliate’s earnings from an active business is its income or profit computed in accordance with the income tax laws of the country in which it is resident. Likewise, under paragraph 5907(1)(a) of the definition of “net earnings” in the Regulations, a foreign affiliate’s net earnings from an active business is computed based on the portion of any income or profits tax paid by the foreign affiliate to the government of a country for the year that can reasonably be regarded as tax in respect of those earnings.
In the specific circumstances described above, the corresponding adjustment under the MAP Settlement and the resulting reassessment by the Country A tax authority changes both the amount of income or profit from active business of CFA computed in accordance with Country A tax law and the amount of income taxes paid by CFA to the government of Country A in respect of that income or profit for the particular year. As a result, in our view:
i. The “earnings” of CFA, under subparagraph 5907(1)(a)(i), will be reduced by the income adjustment under the MAP Settlement and Country A reassessment pertaining to each taxation year reassessed, to reflect its income or profit from an active business as computed in accordance with the income tax law of Country A for each of its reassessed taxation years.
Upon receipt of the Country A reassessment reducing income to reflect the adjustment under the MAP Settlement, the “net earnings” of CFA, under subsection 5907(1), will be increased by an amount equal to the amount of income taxes that were paid for each such taxation year to the government of Country A but not payable in light of the MAP Settlement and Country A reassessment pertaining to that taxation year.
Moreover, given that the character and receipt of income of CFA pursuant to the CFA Service Agreement remains unaltered by the MAP Settlement, the taxation and corporate laws of Country A and the accounting practice of Country A, it is our view that:
ii. The amount of the adjustment under the MAP Settlement and Country A reassessment that is excluded from the computation of income or profit from an active business pursuant to the income tax law of Country A for each of the reassessed taxation years will be added to the earnings of CFA for each such taxation year pursuant to paragraph 5907(2)(f) of the Regulations given that the amount of the adjustment under the MAP Settlement and Country A reassessment constitutes the “revenue, income or profit” of CFA for purposes of paragraph 5907(2)(f).
Generally, given that there are a multitude of factors that need to be considered in determining the impact of transfer pricing adjustments on the computation of earnings including, amongst others, foreign tax law, the specific terms of relevant legal agreements, mutual agreement procedure settlements, advance pricing agreements and the character of income under Canadian tax law, the CRA will only consider the consequences of any particular scenario upon a request in the context of an advance income tax ruling request involving proposed transactions.
May 15, 2019
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