26 May 1998 External T.I. 9805415 - INVESTMENT IN A NON-RESIDENT ENTITY

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 GAAR applies to a transaction under which a taxpayer acquires shares of a non-resident corporation that invests in a Canadian resident mutual fund and the taxpayer gives the shares to his grand-daughter.

Position:

Sections 94.1 and 74.1 could require the taxpayer to report deemed income on the shares of the non-resident corporation. In such case, GAAR would have no application.

Reasons:

On the basis of the facts submitted by the taxpayer, the investment would be a share of a non-resident entity that would reasonably be considered to derive its value primarily from portfolio investments in trusts, funds or entities. Therefore, if one of the main purposes of the acquisition or holding of the investment was to reduce significantly the Canadian taxes otherwise payable, section 94.1 would apply. Income deemed to be earned under section 94.1 by the grand-daughter would be attributed back to the taxpayer under 74.1 as income from property.

		980541
XXXXXXXXXX 	N. Mondou, M.Fisc.
(613) 957-8961

May 26, 1998

Dear Sir:

Re: Open-ended Mutual Funds

This is in reply to your letter dated February 13, 1998, in which you requested our views with respect to the application of the General Anti-Avoidance Rule (“GAAR”) to the purchase of shares of a non-resident company.

More particularly, the situation you describe is as follows. A taxpayer will purchase shares of an open-ended mutual fund company, i.e. a company the shares of which are retractable upon request. This company will be resident of Bermuda and will not be listed on a stock exchange. The Bermudian company will invest its capital in units of a mutual fund trust that resides in Canada. The taxpayer will gift the shares of the Bermudian company to his grand-daughter, who is currently under 18. The shares will be held by her mother in trust for her. The purpose of the gift is to provide for future education expenses of the child.

Every year, the Bermudian company will redeem shares held by the grandchild in an amount sufficient to trigger approximately $8,000 of capital gains. No tax will be payable by the grandchild as her tax payable will be off-set by the basic personal tax credit amount. The redemption price of the shares will be immediately reinvested in shares of the Bermudian company.

The reason for the existence of the Bermudian company is to avoid the management fees in the range of 6% that would be otherwise charged by the mutual fund trust on the redemption of its units.

You wish to know if GAAR would apply in such a situation.

Our comments

The situation outlined in your letter involves an actual fact situation. To the extent that it relates to a past transaction you should contact the appropriate tax services office, since the review of such transactions falls within their responsibility. If it relates to a proposed transaction, assurance as to the tax consequences of actual proposed transactions will only be given in the context of an advance income tax ruling. The procedures for requesting an advance income tax ruling are outlined in Information Circular 70-6R3 dated December 30, 1996, issued by Revenue Canada. However, we offer the following general comments.

Section 94.1 of the Income Tax Act (the “Act”) requires the investor to report a minimum annual income from their investment in an“offshore investment fund property”. An “offshore investment fund property” includes property that meets the following tests:

a) it is a share of a “non-resident entity”. In this respect, “non-resident entity” includes a corporation that is not resident in Canada. It does not include controlled foreign affiliates however;

b) the underlying assets of the non-resident entity are primarily portfolio investments listed in paragraph 94.1(1)(b) of the Act. This would include investments in trusts, funds or entities. As stated in Question 19 of the 1986 Round Table, the Department gives a very broad meaning to the term “portfolio investments”; and

c) one of the main reasons for acquiring or holding the share in the non-resident entity is to provide a benefit from the underlying portfolio investment assets of the entity while deferring or reducing significantly the tax that would be payable if these investments were owned directly.

In this respect, the Act requires the following factors to be taken into consideration:

a) the nature, organization and operation of any non-resident entity and the form of, and the terms and conditions governing, the investor’s interest in, or connection with, any non-resident entity;

b) the extent to which any income, profits and gains that may reasonably be considered to be earned or accrued, whether directly or indirectly, for the benefit of any non-resident entity are subject to an income or profits tax that is significantly less than the income tax that would be applicable to such income, profits and gains if they were earned directly by the investor; and

c) the extent to which the income, profits and gains of any non-resident entity for any fiscal period are distributed in that or the immediately following fiscal period.

It is our view that if, in the circumstances you describe, the distributions made by the Bermudian company are not at least equal to and of the same nature as the income earned on the portfolio investments it holds, so that there is a significant reduction of the Canadian taxes that would be otherwise payable by the grandchild if she held the portfolio investments directly, section 94.1 of the Act could apply. In such a case, one of the main reasons for the creation of a corporation resident in a tax haven would be viewed as being the reduction of taxes.

The application of section 94.1 of the Act would result in the grandchild being required to report income determined on the basis of the “designated cost” of her interest in the offshore investment fund property multiplied by the prescribed rate for the period. This amount would be reduced however by the income she would earn from the fund for the year (excluding capital gains). The income reported by the grandchild will be added to the adjusted cost base of her shares of Bermudian company as provided under paragraph 53(1)(m) of the Act.

Furthermore, the income to be reported each year under section 94.1 of the Act being income from a source that is the investment in the offshore investment fund property, it would be attributed back to the grandfather under subsection 74.1(2) of the Act until the year the grand-daughter turns 18.

Finally, when section 94.1 of the Act applies to a transaction, GAAR does not apply.

We trust that these comments are of assistance.

Yours truly,

P. Spice
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch
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