10 November 1997 External T.I. 9711175 - FOREIGN AFFILIATES - INVESTMENT BUSINESS

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:

1) Whether sales affiliate carries on investment business.

2) Whether inter-affiliate fee adjusted for purposes of surplus computation if in excess of FMV.

Position:

1) No

2) No

Reasons:

1) Principle purpose of sales and service business generally would not fall into the principal purpose test in the investment business definition in subsection 95(1).

2) While a question of fact, if the computation of the earnings of two foreign affiliates is made in accordance with the tax law of one or more foreign countries, and all of the income of those affiliates has been included in the computation of the earnings of those affiliates, there would generally be no basis for adjustments under subsection 5907(2) of the Regulations where a certain inter-affiliate fee may have been in excess of FMV.

	                      	971117
XXXXXXXXXX                     O. Laurikainen C.A.
(613) 957-2116

Attention: XXXXXXXXXX

November 10, 1997

Dear Sirs:

Re: Foreign Sales Affiliates

This is in response to your letter dated April 28, 1997. You request our views concerning the implications under the Income Tax Act (the "Act") of the following foreign affiliate structure.

1)Canco is a corporation resident in Canada carrying on an active manufacturing business.

2)Usco is a wholly-owned subsidiary of Canco resident in the United States under common law and for the purposes of the Canada - U.S. Income Tax Convention (the "U.S. Convention"). Usco also carries on an active manufacturing business.

3)FSC is a wholly-owned subsidiary of Usco incorporated in Barbados. FSC's business consists solely of marketing and the collection of receivables performed in connection with the sale by Usco of its products to customers residing outside the United States including persons resident in Canada who deal at arm's length with Canco.

4)FSC has International Business Corporation status in Barbados and is ineligible for any tax benefit available under the Canada - Barbados Income Tax Convention (the "Barbados Convention") by virtue of Article XXX(3) thereof. FSC must report its income for U.S. tax purposes and is subject to U.S. Federal and State taxes on 8/23 of its income.

5)FSC receives a commission from Usco for its services which may exceed an arm's length fee. However such fee is acceptable under the Internal Revenue Code of the United States and is therefore deductible in full in computing Usco's income from its active business for U.S. tax purposes.

6)The activities of FSC are subcontracted to a party who deals at arm's length with Canco and who is resident in Barbados. FSC has no employees of its own.

You question whether the income derived by FSC from fees charged to Usco would be included in computing its exempt surplus vis-a-vis Canco. In addition, you request our views whether in these circumstances FSC could be considered to be carrying on business in Canada.

Our Comments

It would appear that your inquiry concerns a factual situation possibly involving a completed transaction. As indicated in paragraph 22 of Information Circular 70-6R3, we are not in a position to deal with factual proposed transactions other than in the form of an advance income tax ruling request where the identity of the parties is known and all the facts surrounding the proposed transactions are presented to us. Issues involving completed transactions should be addressed to the appropriate Taxation Services Office of Revenue Canada. We will nevertheless provide the following general comments.

An "active business" of a foreign affiliate is defined in subsection 95(1) of the Act as "...any business carried on by a foreign affiliate other than

(a) an investment business carried on by a foreign affiliate, or

(b) a business that is deemed by subsection (2) to be a business other than an active business carried on by the affiliate;".

Provided that it can be established that FSC actually carried on the active business of providing marketing and account receivable collection services, it would generally be considered to derive its income from an active business carried on by it. Such activities would generally not fall into the definition of "investment business" in subsection 95(1). Moreover, on the facts presented, there would appear to be no basis for concluding that the business of FSC would be excluded from the definition of "active business" under the provisions of subsection 95(2) of the Act. Therefore the income derived by FSC may qualify as income from an active business notwithstanding that its activities are subcontracted to an arm's length party. However, we note that in computing the "net earnings" under paragraph 5907(1)(f) of the Regulations derived by FSC from such business, income taxes paid both to the United States and Barbados would be deducted.

As the income of FSC and Usco is income from their respective businesses, it would be computed for the purposes of section 5907 of the Regulations in accordance with the rules set down in subparagraph 5907(1)(a)(i). That is, in the case of FSC, if it is required to compute income for tax purposes under Barbados tax law, its earnings for the purposes of paragraph 5907(1)(a) of the Regulations would be the income so computed. Similarly, in the case of Usco, its earnings for the purposes of subparagraph 5907(1)(a)(i) of the Regulations would be its income for tax purposes as computed in accordance with provisions of the Internal Revenue Code of the United States. If neither Barbados nor U.S. Income tax law, provides for an adjustment of the income for tax purposes otherwise computed for reason of the fee paid to FSC by Usco having been excess of the fair market value of the services provided, on the basis of the facts presented, we can see no cause to adjust such income for the purposes of section 5907 of the Regulations.

In order for FSC to qualify as a resident of a designated treaty country under proposed subsection 5907(11.2) of the Regulations, it would be necessary to establish that it is resident there under common law (i.e. its mind, management and control resides in Barbados). Furthermore, it would be necessary to show for the purposes of proposed paragraph 5907(11.2)(c) of the Regulations, that were it not for Article XXX of the Barbados Convention, FSC would be resident in Barbados under Article IV thereof. This would generally only be the case if FSC was in fact liable to tax in Barbados on its worldwide income.

We can provide no comment whether either FSC or Usco would be considered to be carrying on business in Canada and whether or not they would be exempt from tax on the income derived from such business under the income tax conventions Canada has with their respective countries of residence. Such a determination would require full knowledge of all the facts and circumstances that would be available to an auditor in a factual situation. However, we would make one observation. Given that Canco itself carries on an active manufacturing business, it would be expected that it would have an established distribution network in Canada. If that were the case, it would not be unexpected if Usco products were distributed via such network. This would in our view, significantly increase the likelihood that Usco could be found to have a permanent establishment in Canada.

The foregoing comments are given in accordance with the practice referred to in paragraph 22 of information Circular 70-6R3 and are not binding on Revenue Canada.

We hope that you will find the above to be of assistance to you.

Yours truly,

for Director
Reorganizations and International Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch