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 “fresh start” rules applied on the facts at issue and the consequences of their application.
Position: The “fresh start” rules did not apply on the business restructuring.
Reasons: The requirements in paragraph 95(2)(k) were not satisfied because the foreign affiliate commenced carrying on a new business when the business model changed.
Marian Young HEADQUARTERS
Senior Technical Specialist Income Tax Rulings Directorate
International Technical Issues Section Ina Eroff
International Tax Division, ILBD
Cc: Sandy Alexandra
Regional Program Advisor
ILBD, XXXXXXXXXX
Cc: Quinnie WONG
International Tax Auditor
XXXXXXXXXX
2019-081668
February 10, 2023
Re: “Fresh Start” Rules
This is in reply to your email XXXXXXXXXX regarding the application of paragraphs 95(2)(k) and (k.1) (referred herein as “fresh start” rules) of the Income Tax Act, R.S.C. 1985 (5th Supp.), c.1, as amended, (the “Act”) to the taxation years ended XXXXXXXXXX (“FA 1”), a wholly-owned foreign affiliate of XXXXXXXXXX (“Taxpayer”). As explained in more detail below and in summary, in our view, the provisions in paragraph 95(2)(k.1) do not apply to the facts at issue because the conditions in paragraph 95(2)(k) are not satisfied. Specifically, in our view, FA 1 was not carrying on the same business before and after its business model changed from an “active business” to an “investment business” (as defined in subsection 95(1)).
Unless otherwise stated, every statutory reference herein is a reference to the relevant provision of the Act and all terms used herein that are defined in the Act have the meaning given in such definition unless otherwise indicated.
Facts:
1. Taxpayer is a corporation incorporated under the laws of XXXXXXXXXX.
2. FA 1 is a wholly-owned subsidiary of Taxpayer, and is resident in XXXXXXXXXX for purposes of the Act.
3. XXXXXXXXXX Producer FA and XXXXXXXXXX Distributor FA are wholly-owned subsidiaries of Taxpayer and are incorporated in, and for purposes of the Act are resident in, XXXXXXXXXX.
4. In XXXXXXXXXX, Taxpayer developed XXXXXXXXXX (together with related trademarks, referred herein as the “Original IP”) for certain XXXXXXXXXX (the “Product”) and transferred the ownership of the Original IP to FA 1 for XXXXXXXXXX.
5. Until XXXXXXXXXX (the “Change-in-Business Date”) the business of FA 1 was structured as follows:
(a) Pursuant to the Manufacturing Agreement entered into between XXXXXXXXXX Producer FA and FA 1, XXXXXXXXXX Producer FA was acting as a contract manufacturer, producing and packaging the Product in XXXXXXXXXX for FA 1 in accordance with FA 1’s specifications. For that purpose, FA 1 granted to XXXXXXXXXX Producer FA a non-exclusive, royalty-free license to use the Original IP in the manufacturing of the Product.
(b) Pursuant to the Manufacturing Agreement, FA 1 was acquiring from XXXXXXXXXX Producer FA the finished Product in agreed quantities and for an agreed price. For that purpose, FA 1 had to provide annual and quarterly forecasts of the anticipated volume requirements. The functions of FA 1 also included certain quality controls, inspections and testing.
(c) Pursuant to the Distribution Agreement entered into between FA 1 and XXXXXXXXXX Distributor FA, FA 1 appointed XXXXXXXXXX Distributor FA as its exclusive wholesale purchaser of the Product and agreed to sell it the Product on agreed terms and for an agreed price. XXXXXXXXXX Distributor FA was also granted a limited, non-exclusive, royalty-free license to use the Original IP for the purpose of marketing the Product.
(d) XXXXXXXXXX Distributor FA would take possession of the product from XXXXXXXXXX Producer FA and distribute the Product in XXXXXXXXXX FA 1 provided guidelines and approvals relating to advertising and promotional programs and label and package designs.
(e) Income of FA 1 from the resale of the Product was included in computing its earnings from an active business carried on in a designated treaty country.
6. Thus, prior to the Change-in-Business Date, the business of FA 1 was a distribution business where it distributed the Product. Its main source of income was the sale of the finished Product which was manufactured specifically for FA 1, in accordance with its specifications, by XXXXXXXXXX Producer FA. FA 1 was acquiring the Product from XXXXXXXXXX Producer FA and selling it to XXXXXXXXXX Distributor FA who marketed and distributed it in XXXXXXXXXX Pursuant to the Distribution Agreement, FA 1 retained some control over the distribution process by providing guidelines and approvals relating to advertising and promotional programs, as well as label and package designs. Prior to the Change-in-Business Date, FA 1 was not earning any royalty income. The non-exclusive licences granted to XXXXXXXXXX Producer FA and XXXXXXXXXX Distributor FA were royalty-free.
7. In XXXXXXXXXX, Taxpayer formed a new wholly-owned foreign affiliate in XXXXXXXXXX (“FA 2”). It was established as a “new innovator” – all future XXXXXXXXXX of the Product were to be developed and tested by FA 2. FA 2 is resident in XXXXXXXXXX for purposes of the Act.
8. Since the Change-in-Business Date, FA 2 replaced FA 1 in the distribution chain and FA 1 ceased to carry on the business of distributing the Product. FA 2 began making royalty payments to FA 1 for the use of the Original IP, which was the only income stream after the Change-in-Business Date for FA 1 in its taxation year ended XXXXXXXXXX (referred hereafter as the “specified taxation year”).
9. After the Change-in-Business Date, the business carried on by FA 1 is an “investment business” (as defined in subsection 95(1)). (footnote 1) Specifically, the principal purpose of FA 1’s business after the Change-in-Business Date is to earn royalties and the business is conducted principally with persons with whom FA 1 does not deal at arm’s length, such that the exceptions in the definition “investment business” do not apply.
10. At all relevant times, each of Taxpayer, FA 1 and FA 2 had a XXXXXXXXXX taxation year end.
11. Taxpayer relied on subsection 5907(2.9) of the Income Tax Regulations (the “Regulations”) and paragraphs 95(2)(k) and (k.1) to increase the “exempt earnings” and “exempt surplus” of FA 1 for its taxation year ended XXXXXXXXXX on account of the accrued gain (approximately $XXXXXXXXXX) it asserts was realized on a deemed disposition and reacquisition of the Original IP for its fair market value.
You are requesting our opinion on the application of paragraphs 95(2)(k) and (k.1) in this factual scenario.
Response:
Paragraph 95(2)(k) contains conditions for the application of paragraph 95(2)(k.1). The reference to “the business” in clause 95(2)(k)(ii)(A) means that in order for the “fresh start” rules to apply, the business carried on by FA 1 after and before the Change-in-Business Date should be the same business, the nature of which changed from an active business to an “investment business” (i.e., “passive”). When applying paragraph 95(2)(k) to the above Facts, in our view, one is required to first identify the particular business that was carried on by FA 1 in the specified taxation year that is an investment business, and then determine whether that particular business was carried on by FA 1 in the immediately preceding taxation year.
In that respect, October 24, 2012 Department of Finance Technical Notes to paragraphs 95(2)(k) and (k.1) (which replaced old paragraph 95(2)(k)) expressly state:
“… the amendments ensure that the fresh start rules are no longer triggered if the operator begins to carry on the particular business in the specified taxation year, i.e. where it did not carry on the particular business in the preceding taxation year. In other words, there has to be a transition, whether by way of the business changing its nature or by the non-resident corporation becoming a foreign affiliate of the taxpayer, in order for the fresh start rules to apply.”
In order to determine whether the same business continues after its nature changes, in our view, considerations similar to the “same” business requirement in subsection 111(5) would apply. Paragraph 14 of Interpretation Bulletin IT-302R3 “Losses of a Corporation—The Effect that Acquisitions of Control, Amalgamations, and Windings-up have on Their Deductibility—After January 15, 1987”, dated February 28, 1994 (archived), provides guidance on some of the factors to be considered in determining whether the same business is being carried on pre and post acquisition of control for the purposes of subsection 111(5). As noted in paragraph 14 of IT-302R3, these factors include, among others, the nature of the business, the nature of income-producing asset and the extent to which the original business constitutes a substantial portion of the activities of the corporation in the allocation of time and financial resources.
For additional comments on determining whether a corporation is carrying on the same business, IT-302R3 refers to Interpretation Bulletin IT-206R “Separate Businesses”, dated October 29, 1979 (archived). Paragraph 4 of IT-206R states that where one business operation succeeds another and the succeeding business operation is not of the same kind as the former, the two operations will be viewed as different businesses at the different times and no other factors will operate to change that view. Paragraph 5 of IT-206R further provides that when determining whether business operations are of the same kind, the principal factor to be considered is the type of business that a taxpayer is in.
As described in the Facts, prior to the Change-in-Business Date, the business of FA 1 was a distribution business. After the Change-in-Business Date, the only source of income of FA 1 is royalties paid by FA 2. FA 1 has no more functions in respect of the manufacturing, acquiring, marketing and distributing of the Product. Its original distribution business ceased completely and does not constitute any part of the current business activities of FA 1.
The Facts at issue are analogous to the facts considered by the Tax Appeal Board in Island Motor Transport Limited v. MNR, 33 Tax A.B.C. 365. In that case, the taxpayer attempted to deduct business losses it had incurred while carrying on the business of a bus system operator from its rental income after it had leased its franchise and real property to another entity. The Tax Appeal Board concluded that holding a franchise and operating it were two separate things. It denied the taxpayer the deduction in respect of the business losses on the basis that the taxpayer entered in a new field of business, a new activity completely different from its former one, when it ceased to operate as a carrier of passengers and became nothing more than a receiver of rents.
Island Motor Transport Limited stands for the proposition that while retaining the elements of a business, they can be so materially altered that in effect the changes give rise to a new type or new field of business. By analogy, while after the Change-in-Business Date FA 1 continued to hold the Original IP as its main asset, it no longer used it in a distribution business, but rather it used it in its new licensing business instead.
Based on the Facts as described above, in our view, it would be reasonable to conclude that on the Change-in-Business Date, FA 1 had a fundamental change in its business - it ceased carrying on its distribution business and entered into a new field of business, which is not of the same kind and type as, and not a continuation of, the business it carried on before the Change-in-Business Date. This change to the business operations of FA 1, as described in the Facts, would go beyond the change in nature of a business from active to passive contemplated in paragraph 95(2)(k). Based on our understanding of the Facts, in our view, the “fresh start” rules in paragraph 95(2)(k.1) would not apply, and as such no amount with respect to the $XXXXXXXXXX accrued gain referred to above would be included in computing the earnings of FA 1 under subsection 5907(2.9) of the Regulations. (footnote 2)
Our conclusion above is based on our understanding of the Facts as described above. If it were determined that the above facts were incomplete, the above conclusion could warrant re-examination.
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. After a 90-day waiting period, a severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. You may request an extension of this 90-day period. The severing process removes all content that is not subject to disclosure, including information that could reveal the identity of the taxpayer. The taxpayer may ask for a version that has been severed using the Privacy Act criteria, which does not remove taxpayer identity. You can request this by e-mailing us at: ITRACCESSG@cra-arc.gc.ca. A copy will be sent to you for delivery to the taxpayer.
Yours truly,
John Meek
Acting Section Manager
For Division Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
FOOTNOTES
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 Notwithstanding being income from property as a result of being income from an “investment business”, the royalty payments received by FA 1 from FA 2 in the specified taxation year and in subsequent taxation years would be included in computing FA 1’s active business income under clause 95(2)(a)(ii)(B).
2 Furthermore, in computing FA 1’s active business income after the Change-in-Business Date, such income would not be reduced by any amount in respect of the $XXXXXXXXXX accrued gain referred to above.
All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5
© His Majesty the King in Right of Canada, 2023
Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistributer de l'information, sous quelque forme ou par quelque moyen que ce soit, de facon électronique, méchanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.
© Sa Majesté le Roi du Chef du Canada, 2023
Email this Content