News of Note

Finance has issued a comfort letter respecting umbrella corporation interests where there is no tax avoidance purpose

Following some discussions and consultations with the funds industry and their advisors, the Department recently issued a comfort letter. The comfort letter provides an exception from the tracking interest rules if it cannot reasonably be considered that one of the purposes for the creation or issuance of a tracking interest in an umbrella corporation or for the acquisition of the interest by a taxpayer is to avoid the corporation being a CFA for the year. Thus, if the purpose is commercial rather than tax-related, there can be an exception from the tracking interest rules.

Neal Armstrong. Summary of 15 May 2019 IFA Finance Roundtable – “Tracking Interest Rules & Umbrella Corporations” under s. 95(8).

Finance is looking into the circular interactions between draft s. 247(1.1) and other parts of the Act

At the 15 May 2015 IFA Finance Roundtable, Ted Cook indicated that the purpose of s. 247(1.1) was to resolve ambiguity as to the ordering of the respective operations of Parts I and XVI.1 – for example, where a management fee paid by a Canadian taxpayer to a non-arm’s-length non-resident was found to be inappropriate, that could trigger s. 247, but the fee could also trigger s. 18(1)(a) on the grounds that the fee was not paid for the purpose of earning business income. Accordingly, s. 247(1.1) establishes that the operation of the transfer rules occurs as the first step. Finance considers that this is a sensible approach, as s. 247 adjusts the tax base, and the tax base should be set before other types of adjustments are applied.

Finance has heard the tax community’s concerns about circular interactions between s. 247 and other parts of the Act, and is looking into this issue.

An example (provided by Stephanie Smith) of the interaction of Part XVI.1 and a Part I provision (s. 18(4)), occurs where Canco is paying interest at 5% on a $100 million debt owing to a non-arm’s-length non-resident shareholder where an appropriate arm’s-length interest rate would have been 3%, resulting in the disallowance of $2 million of interest expense under s. 247(2). The next step is to turn to Part I. If Canco had $60 million in equity, meaning its debt-equity ratio was about 1/10 higher than the 1.5:1 ratio in s. 18(4), approximately 1/10, or $300,000, of the interest deduction then would be denied under s. 18(4).

She indicated that Finance would not normally expect an upward adjustment under Part XVI.1 to have tax consequences to a Canadian corporation under s. 85.

Neal Armstrong. Summary of 15 May 2019 IFA Finance Roundtable – “Proposed s. 247(1.1)” under s. 247(1.1).

CRA finds that interest was deductible on a note indirectly issued to satisfy a dividend

Opco wishes to distribute its accumulated profits of $500,000 to its parent (Holdco) without using cash and so as to generate an interest deduction. It declares and satisfies a $500,000 dividend through the issuance of preferred shares that have a redemption amount and paid-up capital of $500,000 – and then immediately redeems the preferred shares through its issuance to Holdco of a $500,000 promissory note bearing interest at a reasonable rate.

Before concluding that the interest was deductible under s. 20(1)(c)(ii), CRA referenced its position in Folio S3-F6-C1, para. 1.65 that “where a note is issued to purchase and cancel (or otherwise redeem) shares, interest expense may be deductible under subparagraph 20(1)(c)(ii),” and then stated:

In a situation such as described above where there is a capitalization of a portion of a corporation's accumulated profits as stated capital of the preferred shares of the capital stock of the corporation, the CRA is of the view that the "capital" attributable to the preferred shares for the purpose of applying the "fill the hole" concept … generally corresponds to the paid-up capital of the shares. The purpose test in subparagraph 20(1)(c)(ii) would generally be met since the Note replaces the capital that was used by Opco for eligible purposes.

Neal Armstrong. Summary of 26 May 2016 External T.I. 2014-0527251E5 F under s. 20(1)(c)(ii).

CRA indicates that it generally denies a s. 113(1) deduction where Canco has failed to prepare surplus accounts – which failure also will preclude a late-filed Reg. 5901(2)(b) election

Canco does not prepare detailed calculations of its various surplus and underlying tax balances in respect of a wholly-owned subsidiary (FA) from which it received a dividend, and claims a full s. 113(1) deduction for that dividend (without knowing how much is a deduction under s. 113(1)(a) rather than, say, s. 113(1)(d).)

CRA indicated that if a complete surplus computation is not provided to it, its current general practice is to deny the s. 113(1) deduction. Furthermore, an unsupported s. 113(1) claim could be subject inter alia to ss. 152(4), 163(2), 163(2.2) or 239(1), depending on the circumstances. (This seems to be misaligned with the jurisprudence. An assessment is of a particular dollar amount of tax, and it does not matter what route was reached to get to that figure – see, e.g., Consumers’ Gas. Furthermore (to draw an analogy with surplus account records), expense deductions may be accepted in circumstances falling well short of full supporting documentation – see, e.g., Staltari, Weinberger, Samra, Savoidakis, Sidhu.)

A related question: Would CRA accept the late-filing by Canco of an election under Regs. 5901(2.1) and (2.2) in order for the dividend to be completely sheltered by the s. 113 (e.g., if it later discovered that it had hybrid or taxable surplus)?

CRA indicated that relying on surplus balances unsubstantiated by a detailed computation would generally not meet the condition in Reg. 5901(2.1)(b) of having demonstrated making reasonable efforts respecting this predicament before the filing-due date.

In addition to the situation submitted not satisfying that test, it also would be the CRA view that it would not be “just and equitable” (per Reg. 5901(2.2)) to permit the filing of a late election where Canco did not make detailed calculations of its relevant surplus accounts because of its assumption that the late election, and related ACB deduction, would result in no income inclusion.

Neal Armstrong. Summaries of 15 May 2019 IFA Roundtable, Q.9 under s. 113(1)(a) and Reg. 5901(2.2).

Income Tax Severed Letters 22 May 2019

This morning's release of four severed letters from the Income Tax Rulings Directorate is now available for your viewing.

CRA indicates that the Art. XXIX-A(3) Canada-US LOB clause exclusion would be unavailable to income derived by a Canadian subsidiary from an offshore connected-business FA

Canco (which is purely a holding company for a foreign affiliate carrying on business in a third country) pays a dividend to USco, which is owned by individuals resident in a non-treaty country but which is engaged in the active conduct of a trade or business in the U.S. FA is in the same business as USco and its activities are all connected to USco’s business. Would Art. XXIX-A(3) of the Canada-US Treaty be available respecting such dividend, so that it would be subject to the Treaty-reduced rate of 5%?

No. CRA indicated that of the three tests set out in Art. XXIX A(3), the connected test would not be satisfied, i.e., the dividend income would not be considered to be derived in Canada in connection with, or incidental to, the USco trade or business (including any such income derived directly or indirectly by USco through one or more other Canadian residents).

CRA went on to indicate that to the extent that this denial is not considered appropriate in the circumstances, the taxpayer may request special relief through the CRA competent authority under Art. XXIX-A(6).

Neal Armstrong. Summary of 15 May 2019 IFA Roundtable, Q.8 under Treaties – Income Tax Conventions - Art. 29A.

CRA indicates that a s. 15(1)-relevant s. 246(1)(a) benefit generally will not subject a non-resident to Part I tax

In the case of a non-resident indirectly receiving a benefit, the focus usually is more on the potential imposition of Part XIII tax under s. 246(1)(b) than of Part I tax under s. 246(1)(a).

When asked about the latter provision, CRA indicated that generally a non-resident’s Part I tax liability, including from any s. 246(1)(a) benefit, is based on the non-resident’s taxable income earned in Canada under s. 2(3) and Division D (ss. 115-116). To the extent that only s. 15(1) is relevant in the analysis of the s. 246(1)(a) benefit being conferred, such a benefit generally would not be considered taxable income earned in Canada, as it would generally not be included under s. 2(3) (which references only employment in Canada, carrying on business in Canada and dispositions of taxable Canadian property) or Division D.

CRA went on to indicate that even if the benefit amount were not taxable income earned in Canada, it could still be relevant for certain purposes in computing the non-resident’s income as provided in s. 250.1(1)(b).

Neal Armstrong. Summary of 15 May 2019 IFA Roundtable, Q.7 under s. 246(1)(a).

CRA indicates that non-resident partners of a partnership that has disposed of TCP must file Part I returns even if a s. 116 certificate indicates that all Part I tax is paid

One of the exceptions to the s. 150 requirement for a non-resident to file a Canadian tax return is the exception for an “excluded disposition” in s. 150(5). Where a s. 116 certificate is issued respecting a disposition of taxable Canadian property (that is not treaty-protected property) by a partnership with numerous non-resident partners, and all Canadian taxes owing on the resulting taxable capital gain have been paid, is no Part I tax considered to be payable by the non-residents for the purposes of s. 150(5)(b), such that the disposition will be an “excluded disposition”?

CRA indicated that non-resident taxpayers are required under s. 150 to file a Canadian tax return if inter alia Part 1 “tax is payable” for the year, being the amount payable before deducting any amounts paid on account of tax, such as instalments or withholding. This interpretation applies to “tax is payable” in ss. 150(1), 150(1.1), and (respecting the definition of “excluded disposition”) 150(5)(b). Therefore, even if a s. 116 certificate has been issued indicating that all Part 1 tax has been paid, there would be no excluded disposition.

Neal Armstrong. Summary of 15 May 2019 IFA Roundtable, Q.6 under s. 150(5)(b).

CRA indicates that a functional currency reporter realizes capital gains or losses from FX fluctuations when it receives a Cdn$ tax refund for an earlier functional currency year

Canco, which for all relevant years has filed its returns in U.S. dollars as its functional currency, becomes entitled to a Canadian dollar refund as a result of filing an amended return for an earlier such year (2012). The amount thereof, if it were converted to USD using the exchange rate as of the date of the refund, is greater than the USD amount that would be determined by converting the overpayment to USD using the exchange rate(s) that were initially used in determining Canco’s income tax payable for its 2012 taxation year.

CRA indicated that such FX fluctuation gives rise to a s. 39(1) gain that is included in computing Canco’s income, given that Canco, which in the first place, is required by s. 261(5)(a) to computing its Canadian tax results in the elected currency, must then, when determining the amount of the payment, convert to Canadian dollars, as per s. 261(11).

This made sense to it, stating that a functional currency reporter’s foreign-exchange risk arising from an overpayment of Canadian income tax is comparable to a Canadian resident’s foreign-exchange risk arising from the overpayment of tax to a foreign jurisdiction: s, 39 applies in either case.

Neal Armstrong. Summary of 15 May 2019 IFA Roundtable, Q.5 under s. 261(11).

CRA indicates that unpaid simple interest that is deemed to be a loan by s. 78(1)(b)(ii) generally is not outstanding debts to specified non-residents

The thin cap rules apply to “outstanding debts to specified non-residents”, whose definition specifies that there is deductible interest paid or payable on them. Where the Canadian debtor and the non-resident creditor make an s. 78(1)(b)(ii) agreement to deem the amount of simple interest owing by the one to the other to be a loan, CRA generally considers that the amount of the deemed loan would not be an outstanding debt to a specified non-resident for the purposes of ss. 18(4) and (5) until the compound interest is paid and thereby becomes deductible under s. 20(1)(d).

Neal Armstrong. Summary of 15 May 2019 IFA Roundtable, Q.4 under s. 18(5) - outstanding debts to specified non-residents - s. (a)(ii).