25 September 1981 Income Tax Severed Letter 6-1834C

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.

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This is in reply to your memorandum of March 13, 1981 requesting an interpretation of subparagraph 95(1)(a)(iii) in the following situation:

• 1. A United Kingdom company (UKCO) owns 100% of the voting shares of a Canadian company (Canco) and 100% of the voting shares of a Bermudian company (Bermco).
• 2. Canco owns 100% of all the non-voting preferred shares of Bermco.
• 3. Canco does not own any voting share of either Bermco or UKCO.

In these circumstances it is our view that Bermco is not a controlled foreign affiliate of Canco.

However, subsections 15(1), 56(2), 245(2) and 214(3) could be considered if the consideration paid by Canco for the non-voting preferred shares exceeds the fair market value thereof. For example, the fair market value of the non-voting preferred shares issued by Canco by Bermco could be greatly reduced if they are not redeemable at the option of the holder.

The taxation of a benefit in the hands of UKCO could also be considered if the FVM of the preferred shares issued to Canco is reduced as a result of transactions made by Bermco such as

• a) a sale of property to UKCO at less than FMV
• b) an acquisition of property from UKCO for more than FMV; or
• c) an interest free loan to UKCO.

Similarly, a benefit would be conferred in every taxation year in which Canco has an outstanding balance receivable on an interest free loan to UKCO. An argument could be made that the same principle would apply if the preferred shares issued to Canco by Bermco are not, before any dividend is paid to UKCO, entitled to cumulative dividends at a reasonable rate which in our view should be approximately equal to the commercial rate of interest that would be charged on a promissory note by an arms length lender in similar circumstances.

Canadian Taxation of Foreign Accural Property Income (FAPI)

Subdivision 1 of Division B of Part I of Income Tax Act Sections 90 to 95 inclusive, Part 5900 of the Income Tax Regulations.

Introduction

Prior to 1972, dividends received by Canadian corporations from non-resident corporations in which the Canadian corporation owed at least 25% of the voting shares were deductible in computing taxable income, regardless of the particular place of residence of the non-resident corporation and the type of income it earned. This then was a simple, uncomplicated, practical and easily administrable exemption method of dealing with foreign source income of Canadian-based multi-national. Hovever, this treatment of dividends made it possible for Canadian corporations to avoid Canadian taxes on all income earned outside Canada through non-resident subsidiaries, whether or not the subsidiaries were resident in tax havens and whether or not the income was passive income.

To counter tax haven abuse and to tax passive income on accrual basis, as well as to stimulate other countries to negotiate tax treaties with Canada, effective 1972 the rules relating to the taxation of dividends from foreign subsidiaries and affiliates were substantially altered. With a transitional period of four years, the new rules came into force fully in 1976. These new rules replaced the relatively simple exemption method described above with a complicated combination exemption and credit method of dealing with foreign source income of Canadian-based multi-national.

Overview of the General System (October 1984)

Although many of the specific rules which came into force in 1976 have been revised, the basic structure of the foreign affiliate system has been maintained.

In general the system (summarized in exhibits 1 and 2) is as follows:

• • A non-resident corporation qualifies as a "foreign affiliate" if the Canadian shareholder owns at least 10% of any class of shares either directly or indirectly.
• "Controlled foreign affiliate", at any time, of a taxpayer resident in Canada means a foreign affiliate of the taxpayer that was, at that time, controlled, directly or indirectly in any manner whatever, by
• (i) the taxpayer,
• (ii) the taxpayer and not more than four other persons resident in Canada, or

(ii1) a related group of which the taxpayer was a member.

• • Dividends paid from business earnings by a foreign affiliate to a Canadian corporate shareholder may be out of either "exempt surplus" or "taxable surplus". Exempt surplus generally includes after-tax business income earned in listed countries (countries, including the Federative Republic of Brazil, with which Canada at the time of listing either had an Income Tax Treaty or was in the process of negotiating one). Taxable surplus includes after-tax business income earned after the affiliate's 1975 year in non-listed countries. As a special transitional measure, exempt surplus also includes all after-tax business income (whether earned in listed or non-listed countries) for the years 1972-75 inclusive. Taxable surplus also includes FAPI net of foreign taxes paid whether or not the FAPI is earned in a listed or non-listed country.
• • Dividends received out of exempt surplus by a Canadian corporate shareholder are not subject to tax in Canada. Dividends received out of taxable surplus are subject to tax, but deductions are available. These deductions are approximately equal to the aggregate of (1) the underlying foreign tax applicable to the earnings being distributed, and (2) double any foreign withholding taxes applicable to the dividends. The net effect of these provisions is that Canadian tax will not be payable on dividends out of taxable surplus if the total foreign tax burden is at least 46% (the basic Canadian corporate tax rate).
• • Dividends paid by a foreign affiliate exceeding its exempt and taxable surplus accounts are considered to come out of "pre-acquisition surplus", a notional account for which no actual computations are made. Amounts received out of pre-acquisition surplus are not subject to tax in the hands of a Canadian corporate shareholder, provided the amount of such dividends, net of any foreign withholding tax, does not exceed the tax cost of the shares on which the dividends were paid. The result is a deemed capital gain equal to the excess when they exceed that tax cost.
• • With respect to passive income earned by a foreign affiliate, which is also a "controlled foreign affiliate", Canadian shareholders (individuals as well as corporations) must include in income on an annual basis their pro rata share of such income, whether or not the income is distributed by the affiliate as dividend payments. FAPI is calculated in accordance with the provisions of the Canadian Income Tax Act and not the laws of the foreign country.
• • The FAPI attribution rules are applicable to the 1976 and subsequent years of controlled foreign affiliates, and apply to controlled affiliates in listed as well as non-listed countries.
• • A controlled foreign affiliate with $5,000 or less of passive income in a taxation year is exempted from the FAPI attribution rules in that taxation year.
• • FAPI generally includes income from property and non-active businesses, as well as one-half of capital gains accruing after an affiliate's 1975 year (less one-half of capital losses accruing after the same date). Capital gains relevant to FAPI do not include gains realized by a controlled foreign affiliate on the disposition of excluded property (defined in Exhibit 3). FAPI specifically excludes any interaffiliate dividends, as well as income received from another foreign affiliate provided the amount was deductible in computing foreign business earnings of the payor affiliate.
• • The various foreign affiliate rules generally do not apply to Canadian shareholders who are individuals, with the important exception that the FAPI attribution rules do apply.
• • There is an appropriate deduction from FAPI for foreign taxes paid that may reasonably be regarded as applicable to the FAPI. The effect being that FAPI is only taxed in Canada to the extent foreign taxes on that income are less than Canadian taxes would be on that income.
• • Where FAPI has been included in a taxpayer's income there are appropriate provisions in the Act to ensure the taxpayer is not taxed again when he realizes that income in the form of dividends or on the disposition of his shares in the foreign affiliate.

The Main Problem

The main problem with the system is the complexity of the rules implementing it. This complexity creates problems with the interpretation and application of the rules. However, this complexity is unavoidable. If the Canadian rules are to tax (subject to foreign tax credits) FAPI on the accrual basis but only when realized and the receipt in Canada of taxable surplus and to provide exemptions for the receipt in Canada of net earnings from an active business of a foreign affiliate resident in listed countries, those rules to the extent possible had to be compatible with the laws of the various foreign countries in which foreign affiliates could be found.

In many cases it would be impractical if not impossible to write rules which would give the desired result in call cases, even if only one foreign country's laws had to be considered. Therefore, in order to cover as many situations as possible many of the Canadian rules require that a reasonable approach be taken. This of course precludes the setting of hard and fast rules. Each case has to be taken on its own merits, thus adding to the administrative workload.

Cooperation Necessary to Try to Make the System Work

In some circumstances the rules do not work to produce the desired results. In the past, Revenue Canada and the Department of Finance and the professional and corporate tax community have worked together to find workable solutions to technical problems as they arose. The results of this joint effort are reflected in the recent amendments to Income Tax Act and the proposed amendments to the Income Tax Regulations. However, all the technical problems are not resolved and it will be necessary, in the future, that these groups continue to try to keep the system working.