26 June 1991 Internal T.I. 901189 F - Computation of Active Business Income of a Foreign Affiliate

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.

Dear Sirs:

This is in reply to your letter dated January 22, 1990 wherein you request our opinion with respect to the following:

Assumptions

1.     A Canadian-controlled private corporation ("Canco") carries on a consulting active business in Canada and in other countries.

2.     Canco is the sole shareholder of a corporation ("Insurco") incorporated under the laws of a foreign jurisdiction and registered to carry on an insurance business in such jurisdiction.  The mind and management of Insurco is exercised in that jurisdiction.

3.     Canco intends to pay insurance premiums to Insurco in order to cover its professional liability risks as well as its Canadian and foreign subsidiaries' risks.  Canco will claim a deduction of the amount of the premiums paid in the computation of its income under Part I of the Income Tax Act (the "Act").

Before we consider your specific queries, we wish to point out that to be deductible in computing income, paragraph 18(1)(a) of the Act provides that an outlay or expense must be made or incurred by the taxpayer for the purpose of gaining or producing income from a business or property.  It appears that the part of the insurance premiums paid by Canco that relates to the liability risk of its Canadian and foreign subsidiaries would be in respect of the business carried on by such subsidiaries and would not be deductible by Canco. In these circumstances we would anticipate that the premiums paid on behalf of the Canadian or foreign subsidiaries by Canco would give rise to a receivable from the subsidiaries.

Queries

1.     By virtue of paragraph 95(2)(b) of the Act the income of a controlled foreign affiliate of a taxpayer from services is deemed to be income from a business other than an active business if the amount paid in consideration therefore is deductible in computing the income from a business carried on in Canada by any person in relation to which the affiliate is a controlled foreign affiliate.

Pursuant to subsection 95(3) of the Act "services" is defined as including the insurance of Canadian risks for purposes of paragraph 95(2)(b) of the Act.

Does Revenue Canada consider that the term "services" also includes the insurance of non-Canadian risks for purposes of paragraph 95(2)(b) of the Act?

2.     If the answer to question one is no:

a)        What are the criteria used to segregate Canadian non- Canadian risks?

b)        Where a lump-sum premium covers Canadian risks as well as non-Canadian risks, what method is used to separate income from Canadian and non-Canadian risks?

c)        On what basis would the general expenses (such as salaries, rent, bank charges, telephone, etc.) of Insurco be allocated against income relating to Canadian risks and non-Canadian risks?

3.     Pursuant to subparagraph 95(2)(a)(i) of the Act income of a foreign affiliate from sources in a country other than Canada that pertains to or is incidental to an active business carried on in a country other than Canada is considered to be income from an active business.  Assuming that Insurco's premium income is from an active business, would the income generated by the temporary investment of excess funds be considered, if it pertains to or is incidental to Insurco's premium income, as income from an active business of Insurco and not income from services?

Your Opinion

1.     You believe that since subsection 95(3) of the Act specifically refers to the term "Canadian" the term services should be interpreted as not including the insurance of non-Canadian risks for purposes of subparagraph 95(2)(b)(1) of the Act.  Your position is in accordance with the rule of statutory interpretation "expressio unius exclusio alterius" to the effect that the express mention of one item implies the exclusion of other items of the same class not mentioned.

2.      

a)        The Act does not provide rules to define the meaning of Canadian risk.  While the place of residence of the person insured can be held as an element of decision, the use of the word "Canadian" denotes a strong relation to the geographical aspect of the question.  Since it often happens that projects generating the risk are located in foreign countries, it should be reasonable to assume that the insurance of personal liability with respect to a project undertaken outside Canada would be considered as the insurance of a non-Canadian risk.

b)     To establish the part of a lump-sum premium that relates to Canadian risks, you believe it would be reasonable to adopt a method based on the value of the contracts undertaken in Canada and elsewhere.  You also believe that any other reasonable method could be used such as a method based on gross revenue and salaries of the payor corporation.

  c)     To determine the net income from Canadian risks and non Canadian risks you believe the expenses should be attributed to each type of income on a reasonable basis.  The method followed by the taxpayer to segregate Canadian risk income from non-Canadian risk income should generally be used for the expenses.

3.     With respect to the incidental income generated by the insurance business, you believe it would qualify as income from an active business and should not be considered as service income as defined by subsection 95(3) of the Act.  Incidental income generated by the income derived from the insurance of non-Canadian risks would certainly not be considered as service income.

Our Opinion

With regard to your queries 1, 2(a) and 2(b) our response is as follows:

If the part of the premium that is paid by Canco on behalf of any of its Canadian or foreign subsidiaries is deductible in computing the income of any such subsidiary from a business carried on in Canada, then paragraph 95(2)(b) of the Act will provide that that part of the premium will be income of Insurco from a business other than an active business.

Although every case will have to be decided on its own facts, there could be circumstances where a premium that relates to a project outside Canada is deductible in computing income from a business carried on in Canada.  In our opinion, premiums relating to the insurance of such risks would, in such case, be income from services for the purposes of paragraph 95(2)(b) of the Act.

In response to your question 2(c) it is our opinion that if a particular expense incurred by Insurco specifically relates to premiums which were deductible by Canco, its Canadian or foreign subsidiaries in computing income from a business carried on in Canada then it would be deductible by Insurco fully.  For expenses not so identifiable a reasonable allocation is acceptable provided it is consistently followed.

In regard to your question 3 this Department is aware that reliance has been placed on the provisions of subsection 138(2) of the Act by certain taxpayers when evaluating their tax position as it would be affected by the provisions of subparagraph 95(2)(b)(i) and subsection 95(3) of the Act.  The argument submitted is that, because the preamble to subsection 138(2) of the Act reads "Notwithstanding any other provision of this Act", the income of an insurer (including a foreign affiliate) from carrying on an insurance business is the amount of its income for the year from carrying on that insurance business in Canada.  Consequently, as long as a foreign affiliate was factually carrying on an insurance business, subsection 138(2) of the Act would override the rules in subparagraph 95(2)(b)(i) and subsection 95(3) of the Act and there would not be any income inclusion under the foreign accrual property income ("FAPI") rules since the business would not be carried on in Canada and would be active.

We do not believe that this result was intended by Parliament and is therefore not consistent with the scheme of the Act when the Act is considered as a whole.  We would note that the July, 1990 Draft Legislation released by the Department of Finance proposes to amend subsection 138(2) of the Act so that it will only apply to residents of Canada that carry on a life insurance business (effective for the 1990 and subsequent taxation years).  Consequently, any conflict between subsection 138(2) of the Act and the FAPI rules, if one indeed currently exists, will be removed.

We further note that paragraph 95(2)(b) of the Act is being amended to clarify that, in computing the income from an active business of a controlled foreign affiliate, investment income is to be excluded to the extent that it pertains to or is incident to a business that is treated by that paragraph as not being an active business.  This amendment also provides that where a controlled foreign affiliate of a taxpayer provides certain services, the provision of such services will be treated as a separate business and any income pertaining to or incident to that business will be income from a business other than an active business and will therefore be FAPI.

Notwithstanding the foregoing, It is this Department's current position that even if an Insurco's business was active, which based on the limited facts available we do not concede, and assuming the existence of "excess funds", income generated by those excess funds would be FAPI pursuant to subparagraph 95(1)(b)(i) of the Act and not active business income pursuant to 95(2)(a)(i) of the Act in the circumstances described below.

In our view, an investment of a portion of capital in excess of the cyclical needs of a business would not generate active business income in the context of the FAPI rules.  If it is established (by actuarial methods or otherwise) that the funds invested by a captive foreign affiliate insurance company were not necessary to provide for the settlement of potential future insurance claims, we would consider these funds not to be "at risk" in the business.  In other words, if it is shown that part of the funds used to make investments could be withdrawn from a foreign affiliate Insurco and not cause a decidedly destabilizing effect on the business, the income from such funds would not pertain to or be incident to the business of the company.  In our view, as stated above, such income would be FAPI pursuant to subparagraph 95(1)(b)(i) of the Act and not active business income pursuant to 95(2)(a)(i) of the Act.

We trust the foregoing is of assistance.

Yours truly,

for DirectorReorganizations and Non-Resident DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch