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 subsection 258(4) applies in the particular situation described in the letter so as to deny the application of subsection 258(3) of the Act?
Position: Question of fact but likely yes.
Reasons: Based on a textual, contextual and purposive analysis of subsections 258(3) and (4), and examination of the facts of the particular situation.
International and Large Business Case Manager Income Tax Rulings Directorate
XXXXXXXXXX Vicky Liu
2020-085685
Subject: Application of subsections 258(3) and 258(4)
We are writing in response to your letter dated July 7, 2020, in which you requested our comments concerning your questions in respect of the application of subsections 258(3) and 258(4) in the situation described in your letter. We apologize for the delay in our response.
Our understanding of the situation is as follows:
1. XXXXXXXXXX is a Canadian corporation and a wholly-owned subsidiary of XXXXXXXXXX. XXXXXXXXXX is a Canadian insurance corporation and the ultimate parent of the corporate group. XXXXXXXXXX is a “specified financial institution” as defined in subsection 248(1) by virtue of being controlled by XXXXXXXXXX.
2. In 2010, XXXXXXXXXX subscribed for 9,350,000 mandatory redeemable preferred shares of Luxco 1 (“MRPS”) for $935,000,000 USD. Luxco 1 then used the proceeds of issue to make loans to XXXXXXXXXX US foreign affiliates for the corporate group’s US operations. Luxco 1 was a corporation formed under the laws of Luxembourg and was a direct wholly-owned subsidiary of XXXXXXXXXX.
3. In 2012, XXXXXXXXXX acquired the MRPS and the common shares of Luxco 1 from its parent corporation XXXXXXXXXX pursuant to a section 85 rollover.
4. August 26, 2015, XXXXXXXXXX subscribed for an additional 200,000,000 common shares of XXXXXXXXXX for $200,000,000 USD.
5. August 27, 2015, XXXXXXXXXX subscribed for 2,000,000 Class B MRPS of Luxco 1 worth $200,000,000 USD. The 9,350,000 MRPS previously held were reclassified as Class A MRPS.
6. August 28, 2015, Luxco 1 loaned XXXXXXXXXX, $200,000,000 USD. XXXXXXXXXX issued a promissory note to Luxco 1 for the same amount. XXXXXXXXXX was a wholly-owned subsidiary of US Ops Holdco, a sister corporation of XXXXXXXXXX and a 100% indirectly-owned subsidiary of XXXXXXXXXX. Both XXXXXXXXXX and US Ops Holdco are US residents and controlled foreign affiliates of XXXXXXXXXX.
7. In 2015, XXXXXXXXXX utilized the loan proceeds to acquire the following US based XXXXXXXXXX, which carried on the business of property/real estate management in the US.
XXXXXXXXXX
8. It is agreed that the MRPS (Class A and B) are “term preferred shares” as defined in subsection 248(1). The general attributes of the MRPS (Class A and B) are as follows:
a) The Company has a mandatory redemption duty at the end of thirteen years (or sooner) from the date of issuance of the MRPS assuming that the MRPS are neither converted nor redeemed by the holder;
b) the Company shall redeem all Shares then in issue upon expiry of a thirteen (13) years period from the date on which the relevant Shares are issued;
c) the MRPS shall carry full voting rights;
d) the MRPS are redeemable before the maturity date (i.e., thirteen years or sooner) at the option of the Company or the holder with prior notice. The redemption price includes: the par value, all and any accrued and unpaid dividends, the premium account and the reserve account;
e) all or a portion of the MRPS are convertible at any time into a fixed value of ordinary shares at the option of the holder equal to the value of the respective MRPS par value, accrued and unpaid dividends, attached Shares Premium Account and attached Reserve Account;
f) The shareholder owning Ordinary Shares will be exclusively entitled to any and all rights attached to the share premium paid for the subscription of Ordinary Shares;
g) the rights of the MRPS holders to receive redemption proceeds are subordinated to other debt obligations by Luxco1 but senior to ordinary shares;
h) Class A MRPS shall be entitled to an annual cumulative dividend rate of 5.72%; and
i) Class B MRPS shall be entitled to an annual cumulative dividend rate of 5.675%.
9. Luxco 1 paid a $56,750,000 USD dividend to XXXXXXXXXX for year ending December 31, 2015. Dividends to XXXXXXXXXX are paid out of Luxco 1’s exempt surplus. XXXXXXXXXX claimed a corresponding paragraph 113(1)(a) deduction with respect to the $56,750,000 USD of dividends received from Luxco 1.
10. In 2016, XXXXXXXXXX acquired US Ops Holdco 1 from its parent corporation XXXXXXXXXX. After the acquisition, both US Ops Holdco and XXXXXXXXXX were wholly-owned subsidiaries of XXXXXXXXXX.
11. Luxco 1 paid dividends of $70,840,000 USD, $70,800,000 USD and $58,684,855 USD to XXXXXXXXXX for years ending December 31, 2016, 2017 and 2018 respectively. XXXXXXXXXX claimed a corresponding paragraph 113(1)(a) deduction with respect to those dividends received from Luxco 1.
12. The dividend payments made by Luxco to XXXXXXXXXX were considered as interest expense of Luxco 1 for domestic tax purposes in Luxembourg.
13. The purpose of the transfer by XXXXXXXXXX of Luxco 1 to XXXXXXXXXX in 2012, as explained by the taxpayer, was to allow the corporate group to consolidate financing structures for its US operations and centralize existing internal loans to other companies within the US operations under XXXXXXXXXX. Going forward, XXXXXXXXXX was to be used as a primary entity within the corporate group to provide financing to the corporate group’s US operations.
14. The activities of XXXXXXXXXX as stated by the taxpayer are limited to providing a guarantee to US Ops Holdco and holding the shares of US Ops Holdco and Luxco 1. Its income is limited to a guarantee fee and dividends earned from these subsidiaries. It does not engage in any active conduct of purchasing, investing, trading in, or disposing of shares of related or arm’s length parties. XXXXXXXXXX assets consist of mostly cash and loan/advances to foreign related corporations. The guarantee provided by XXXXXXXXXX to US Ops Holdco is further guaranteed by XXXXXXXXXX.
15. On September 28, 2018, XXXXXXXXXX converted both the Class A MRPS and Class B MRPS of Luxco 1 to three convertible non-interest bearing loans (“NIB”) and recorded them as Loans to Subsidiary in the financial statements of XXXXXXXXXX.
You requested our comments on the meaning of “not in the ordinary course of the business” in the context of paragraph 258(4)(a) and, in particular, whether the exception under paragraph 258(4)(a) applies to the dividends received by XXXXXXXXXX on the Class B MRPS regarding the method of financing employed by XXXXXXXXXX through XXXXXXXXXX and Luxco 1 to acquire the US based entities of XXXXXXXXXX.
In the past, the CRA and the Tax Court of Canada have considered the meaning of the phrase “not in the ordinary course of the business” in the context of subsection 112(2.1). Subsection 112(2.1) applies to deny a subsection 112(1) deduction to a dividend received by a dividend recipient if the dividend recipient is a specified financial institution and the dividend was paid on a term preferred share that the dividend recipient acquired in its ordinary course of business. Subsection 258(3) is equivalent to subsection 112(2.1) but in the foreign context, which addresses the same issue as subsection 112(2.1) where the share acquired by a specified financial institution is a share of a foreign affiliate. Paragraph 258(4)(a) provides an exception to the application of subsection 258(3) if the share was not acquired in the ordinary course of the business of the specified financial institution. We are of the view that the following comments in respect to subsection 112(2.1) also apply to subsection 258(3).
At the 1984 Canadian Tax Foundation Round Table, our Directorate had stated the following position at Question 62:
“We understand that the major reason for the exclusion from the application of subsection 112(2.1) for shares “not acquired in the ordinary course of business” of the holder was to minimize the possibility of dividends on “in-house” shares being denied a deduction under subsection 112(1) by virtue of subsection 112(2.1).
Factors that have been considered in establishing whether particular shares were not acquired in the ordinary course of business are as follows:
1. the nature of the holder's activities;
2. the number and frequency of such share acquisitions by the holder;
3. whether the funds involved represent the initial capitalization of a new subsidiary or the provision of additional operating capital to a subsidiary, both of which would normally indicate permanent capitalization;
4. the terms of the shares acquired and their status as “term preferred shares” otherwise than by virtue of control of the issuer by specified financial institutions; and
5. whether the shares were acquired as consideration on the sale of a business or part of a business where the holder's business has not previously included such transactions.”
In responding to Question 15 of the 1986 Canadian Tax Foundation Round Table, our Directorate stated the following concerning the meaning of “acquired in the ordinary course of business”:
“It is a question of fact whether or not a term preferred share has been acquired by a specified financial institution in the ordinary course of its business ...
Where a specified financial institution invests in term preferred shares of a related corporation, the shares will generally be considered to have been acquired in the ordinary course of business...”
Our Directorate has also confirmed in technical interpretation 9608455 that the reference in subsection 112(2.1) to a share “not acquired in the ordinary course of business” imposes a requirement to distinguish between shares acquired in functional subsidiaries and shares acquired in connection with the commercial lending activities of the shareholder. More specifically, in technical interpretation 9203965 our Directorate stated:
“. . . it is our view that where a corporation acquires shares of a wholly-owned subsidiary and the proceeds from the issue constitute permanent capital of the subsidiary such shares would not generally be considered to have been acquired in the ordinary course of the parent corporation's business…”
In Canada v. Loblaw Financial, 2121 SCC 51, the Supreme Court of Canada affirmed that there is a distinction between capitalization and the conduct of a business and held that a parent corporation does not conduct business with its controlled foreign affiliate when it provides capital and exercises corporate oversight.
The meaning of the phrase “ordinary course of the business” in subsection 112(2.1) of the Act was addressed in Société d'Investissement Desjardins v. M.N.R., 91 DTC 393 (“Société d'Investissement Desjardins”). In that case, Tremblay T.C.J. concluded at paragraph 94 that, “Parliament clearly wanted to make a distinction between specified financial institutions for which the acquisition of term preferred shares was a regular operation and those for which such a transaction was an exception.”
As stated earlier, the determination of whether shares were acquired in the ordinary course of business is a question of fact that has to be determined by examining all the facts in the circumstances. The CRA and the courts have attempted to clarify the meaning of “carry on a business” in various contexts. In order to constitute “carrying on” a business, it normally requires some continuity, frequency and regularity of the commercial activities. It is arguable that the acquisition of the Class B MRPS is not considered part of the ordinary course of business carried on by XXXXXXXXXX, but rather the acquisition may be considered an isolated and special transaction that is not part of a course of conduct that involves repeated dealings of a similar nature. On the other hand, we do realize that our Directorate provided the view, in technical interpretation 2001-0079985, that even though the acquisition of preferred shares is an isolated event, it does not preclude that it is “in the course of”. Given that the wording of the provisions is not without ambiguity, the purposive and contextual part of the analysis become more important.
Subsection 258(3) was enacted to prevent a specified financial institution, a category that generally includes conventional financial institutions and corporations related to or controlled by such institutions, from conducting an “ordinary course” business of providing financing to customers, by substituting loans with share investments, to obtain a tax advantage. Thus, it is arguable that the type of transactions at issue (i.e. hybrid cross-border debt within the same corporate group) are not the transactions that subsection 258(3) was specifically enacted to address.
In Citibank Canada v. R, 2002 DTC 6876, the court considered whether certain shares should be considered “term preferred shares” for the purposes of subsection 112(2.1) and made the following comments about the purpose of the rules:
“In my analysis, Parliament intended to tax arrangements which were, in substance, debt arrangements. Hence, the question is whether the present arrangement is, at its core, a debt financing arrangement or a capital investment by Citibank in the issuers of the shares…”
Therefore, it is also important to consider whether the arrangement in the current case, at its core, more closely resembles a debt financing arrangement or a capital investment. According to the facts provided above, there are arguments for both type of arrangements. Therefore, it would be difficult to conclude with certainty. However, we are more inclined to conclude that the arrangement more closely resembles a capital investment. In Charter Industries Ltd v MNR, 75 DTC 270, the court was of the view that the advances the appellant company provided to its subsidiary were capital in nature, considering that the appellant company was not in the business of lending money to the general public or to any disinterested third parties and the purpose of the advances was to provide the necessary capital to its subsidiary to prevent it from becoming insolvent. In the present case, XXXXXXXXXX is not in the business of lending money to the general public or to any disinterested third parties and the loans it made were limited to its foreign related corporations. All of the proceeds from the issue of the Class A and Class B MRPS were used by Luxco 1 to make loans to XXXXXXXXXX US foreign affiliates for their US operations. In particular, the funds from the Class B MRPS subscription were used by XXXXXXXXXX, an indirectly wholly-owned subsidiary of XXXXXXXXXX, to acquire the US XXXXXXXXXX entities which carries on an active business in the US. This supports the view that the share acquisition of the Class B MRPS by XXXXXXXXXX represents a capitalization of a subsidiary. Such transaction has long been acknowledged by the CRA to be outside the “ordinary course of business” test: see, for example, ruling 2010-0375111R3 and technical interpretations 9608455 and 9203965.
In summary, based on a textual, contextual and purposive analysis of subsections 258(3) and (4), we are of the opinion that it is difficult to support the view that the Class B MRPS were acquired in the ordinary course of the business carried on by XXXXXXXXXX. Thus, the exception under paragraph 258(4)(a) would likely apply.
We trust that the foregoing will be of assistance to you.
Yours truly,
Angelina Argento
Manager
for Division Director
International Tax Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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