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.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
Principal Issues:
Whether inflationary adjustments made to income under Mexican tax law are included in the determination of a foreign affiliate’s earnings amount under subsection 5907(1) of the Regulations.
Position: No
Reasons:
Such adjustments are purely notional and do not involve a payment or a receipt by a foreign affiliate. Moreover they have arguably little to do with the foreign affiliate's active business.
970900
XXXXXXXXXX O. Laurikainen
(613) 957-2116
Attention: XXXXXXXXXX
March 2, 1998
Dear Sirs:
Re: Foreign Affiliates - Impact of Inflationary Adjustments on Surplus Accounts
This is in reply to your letters wherein you request our comment concerning the computation of the surplus accounts of a foreign affiliate under section 5907 of the Regulations to the Act (the "Regulations") where the foreign affiliate is resident in and/or carries on an active business in Mexico.
Our understanding of the issue is as follows. In these circumstances, either subparagraph (a)(i) or (ii) of the definition of "earnings" in subsection 5907(1) of the Regulations applies. Such "earnings" of the affiliate from an active business are defined to be its income or profit from its active business determined under Mexican tax law. Under Mexican tax law, a taxpayer is required compute inflationary adjustments in respect of its monetary assets and liabilities on a monthly basis. The adjustments are computed to determine the effects of inflation on the value of such items. Mexican tax legislation provides that an inflationary adjustment in respect of monetary asset accounts is to be deducted in computing the taxpayer's interest income, while on the other hand an inflationary adjustment in respect of monetary liability accounts is applied to reduce the amount that would otherwise be deductible in respect of interest expense. The inflationary adjustment may exceed the revenue or expense account being adjusted. In such case the excess is nevertheless taken into consideration in computing income for Mexican tax purposes. For example, in a case where a foreign affiliate only has one debt and such debt is interest free, an inflationary adjustment in respect of the debt would be included in income.
You request our view as to the implications of the above inflationary adjustments on the computation of the surplus accounts of a foreign affiliate.
The objective underlying section 5907 of the Regulations is to determine the amount that is representative of the earnings of the affiliate for the year that could be paid by way of dividend to its shareholders. It is our view that the broad wording of the provisions of section 5907 of the Regulations must be read with this objective in mind.
The amount determined under the definition of "earnings" in subsection 5907(1) of the Regulations, is the income or profit of a foreign affiliate from an active business carried on by it, computed in accordance with the income tax law of the relevant country. Notwithstanding that the amount must be computed in accordance with the tax laws of a foreign country, it is our view that notional income inclusions and deductions computed under the foreign tax law which are not attributable to actual income or losses from the active business and which do not affect the amount that is available for payment of dividends from earnings of the foreign affiliate's active business activities are excluded from the calculation. An amount computed under Mexican tax law to be an inflationary adjustment, is not an element of a foreign affiliate's actual income from an active business nor is it an amount that impacts the number of Mexican Pesos available for distribution by the foreign affiliate by way of dividend. Therefore, it is our view that such notional amounts would not be included or deducted in the determination of a foreign affiliate's "earnings" as defined under subsection 5907(1) of the Regulations.
In any case, the Mexican inflationary adjustments do not represent actual revenues or outlays of the current period nor do they represent an accrual of anticipated future revenues and outlays. Therefore even if they were to be included or deducted in computing the "earnings" of a foreign affiliate as defined under subsection 5907(1) of the Regulations, adjustments in respect thereof would be required to be made under the provisions of subsection 5907(2) of the Regulations as follows.
The inflationary adjustment in respect of monetary assets which is deducted against interest revenue in our view results in understatement of interest revenue. The full amount of the adjustment is an amount of revenue which "is not otherwise required to be included in computing the earnings amount..." for the purposes of paragraph 5907(2)(f) of the Regulations to the Act and should be added in computing the adjusted earnings amount. That is to say that, if the adjustment exceeds interest revenue, the notional deduction taken in respect of the excess, would in our view also qualify for add back under paragraph 5907(1)(f) of the Regulations. Similarly, an inflationary adjustment in respect of monetary liabilities, results in an expense of a foreign affiliate to be non-deductible in computing its earnings. Such disallowed expense represents an "expense not otherwise permitted to be deducted in computing the earnings amount of the affiliate" for the purposes of subparagraph 5907(2)(j)(i) of the Regulations and would be deducted in computing the adjusted earnings amount. Moreover, should the amount of the inflationary adjustment in respect of monetary liabilities exceed the foreign affiliate's interest expense otherwise determined, the excess would also be required to be deducted under paragraph 5907(2)(j) of the Regulations.
We recognize that an argument could be raised to the effect that the excess would under Mexican tax law be considered a revenue item. However, we would take the position that the effect of including such excess as additional income would be no different than, or could be considered as, denial of a deduction in respect of another outlay or expense made by the affiliate for the purpose of earning income. Such amount would in our view be deducted in computing adjusted earnings under subparagraph 5907(2)(j)(i) of the Regulations.
As indicated earlier however, it is unnecessary to look to the provisions of subparagraph 5907(2) of the Regulations in this case, as the inflationary amounts would not in our view enter into the computation of "earnings" for the purposes of subsection 5907(1) of the Regulations.
We trust the above is of assistance to you.
Yours truly,
for Director
Reorganizations and International Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch]
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