News of Note

DEML Investments – Tax Court of Canada finds that the generation of a capital loss on a partnership interest representing a successful investment was a GAAR abuse

In early 2008, the sale of petroleum and natural gas (PNG) rights by an arm’s length vendor (Transglobe) to the parent (Direct Energy) of the taxpayer (DEML) was structured on the basis that Transglobe transferred 99% and 1% of the PNG rights, at a nominal s. 85(1) elected amount, to two wholly-owned Newcos (137 and 138, respectively), which then transferred the rights on an s. 97(2) rollover basis to a newly-formed partnership (DERP2). Direct Enery then acquired the shares of 137 and 138 for $51 million and $0.5 million, respectively.

A year later, Direct Energy transferred the shares of 137 to DEML on an s. 85(1) rollover basis, with 137 then distributing its partnership interest in DERP2 to DEML on its winding up, with the ACB of that partnership interest being bumped under s. 88(1)(d).

DERP2 then distributed its resource properties to DEML as a return of capital, thereby increasing the COGPE balance of DEML and reducing the ACB of DEML’s partnership interest by the FMV of the rights (higher than the value a year earlier) – but with these items effectively being approximately reversed at the partnership year end as a result of DERP2’s proceeds of the distribution of the PNG rights being allocated to its partners.

After then reseeding DERP2 with a small resource property that was of interest to a third-party purchaser, DEML sold its partnership interest to that purchaser, thereby realizing a capital loss. In confirming CRA’s GAAR assessment to deny the capital loss, Russell J stated:

Here the substantial Capital Loss was claimed where there was no economic loss or impoverishment, thus per Triad Gestco breaching the OSP [object, spirit and purpose] of the Act’s capital loss provisions, including paragraph 39(1)(b). …

As the purpose of the capital loss provisions is to recognize real losses, there is clear abuse where artificial losses are deducted. That is even more so when those losses are based on non-capital CRP [Canadian resource property], that will also be deducted through CCOGPE pools at a 100% inclusion rate thus creating a double deduction.

Similarly, regarding the use of the s. 88(1)(d) bump to effectively create most of the quantum of the loss, he stated:

[I]t seems incomprehensible that an artificial loss would signal misuse of capital loss provisions of the Act without equally indicating misuse of the very “bump” provisions of the Act used to achieve the artificial loss through the “bumping” of an ACB.

Neal Armstrong. Summary of DEML Investments Limited v. The King, 2024 TCC 27 under s. 245(4).

CRA discusses the different treatment of losses under Pt. XIV, and Art. X(6) of the Canada-US Treaty

The Directorate confirmed the position in 9408985 that in light of the branch profits limitation under Ar. X(6) of the Canada-US Treaty of 10% of cumulative untaxed "earnings," a two-step process should be followed under which branch tax is first computed in accordance with Part XIV, then the upper limit is computed under Art. X(6) which, if applicable, reduces the branch tax computed under the first step.

Regarding the effect on “earnings” under Art. X(6) where a non-resident corporation applied a loss carryback to reduce its taxable income earned in Canada in the prior year, the Directorate noted that, in contrast to the Part XIV rules, the Art. X(6) earnings for a particular year are not reduced by the carryback of losses to that year from a subsequent year, so that such loss only reduces the cumulative earnings for Art. X(6) purposes in the loss year. Furthermore, although Art. X(6)(b) contemplates the deduction of Part I federal, and provincial income tax in computing earnings, when there is a loss carryback to a prior year which reduces such taxes for that year, the impact of such tax reduction on earnings for Art. X(6) purposes should be to reduce the loss for the current year rather than to increase earnings for the prior year.

The Directorate further stated:

[T]he amount of Allowance for Investment Property in Canada claimed in the prior year and that is being added back to the branch tax base under paragraph 219(1)(g) should not be added back in the same manner in computing “earnings” under Article X(6). Instead, the amount of Allowance for Investment Property in Canada for the current year, calculated under Regulation 808, would be deducted in the “earnings” calculation in accordance with subparagraph (c) of Article X(6).

Neal Armstrong. Summary of 21 October 2021 Internal T.I. 2020-0872281I7 under Treaties – Income Tax Conventions – Art. 10.

We have translated 6 more CRA interpretations

We have translated 6 further CRA interpretations issued in April of 2002. Their descriptors and links appear below.

These are additions to our set of 2,768 full-text translations of French-language Technical Interpretation and Roundtable items (plus some ruling letters) of the Income Tax Rulings Directorate, which covers all of the last 22 years of releases of such items by the Directorate. These translations are subject to our paywall (applicable after the 5th of each month).

Bundle Date Translated severed letter Summaries under Summary descriptor
2002-03-29 4 April 2002 External T.I. 2001-0103525 F - Identical Property Income Tax Act - Section 54 - Superficial Loss - Paragraph (i) right to convert Class A shares into Class B shares would cause the loss on disposing of Class B shares, followed immediately by acquiring Class A shares, to be a denied superficial loss
18 April 2002 Internal T.I. 2001-0105007 F - RECOMPENSE POUR UN SAUVETAGE MARITIME Income Tax Act - Section 3 - Paragraph 3(a) salvage received by crew members was not an exempt windfall
Income Tax Act - Section 5 - Subsection 5(1) salvage received by employed crew members likely employment income
5 April 2002 External T.I. 2002-0122055 F - BIEND D'UN REER DONNES EN GARANTIE Income Tax Act - Section 146 - Subsection 146(12) where property used as security, s. 146(12) rather than s. 146(10) applies to a depositary RRSP
Income Tax Act - Section 146 - Subsection 146(10) s. 146(10) rather than s. 146(12) applies to a non-depositary RRSP where its property is used as security
Income Tax Act - Section 146 - Subsection 146(7) s. 146(7) can reverse only the current year’s inclusion under s. 146(10)
12 April 2002 External T.I. 2002-0122495 F - PRIME PAYEE SUR OBLIGATION Income Tax Act - Section 54 - Adjusted Cost Base premium on bond acquired as capital property produces a capital loss at maturity
Income Tax Act - Section 9 - Capital Gain vs. Profit - Debt/ receivables short holding time to maturity does not preclude a bond from being capital property
Income Tax Regulations - Regulation 7000 - Subsection 7000(1) - Paragraph 7000(1)(b) determination of Reg. 7000(1)(b) proportions made on a taxpayer-specific basis
11 April 2002 External T.I. 2002-0125675 F - REER DECOUVERT BANCAIRE Income Tax Act - Section 146 - Subsection 146(4) - Paragraph 146(4)(a) bank overdraft due to admin fee charge to RRSP could constitute money borrowed from the trust
Income Tax Act - Section 146 - Subsection 146(10) overdraft in RRSP bank account due to admin fee charge could represent the use of trust property as loan security
21 March 2002 External T.I. 2001-0115265 F - 89(1)(c.1)(i)&(c.2)(i) Capital Div. Acc. Income Tax Act - Section 89 - Subsection 89(1) - Capital Dividend Account under revised rules, CDA from goodwill disposition can only be accessed in the following year

CRA finds that capital for purposes of determining a Canadian Treaty-reduced dividend withholding rate of 5% references stated capital

An Israeli company held 100,000 preferred shares of Canco with an FMV and stated capital of $1,000,000 and $100, respectively, whereas the other five shareholders held 1,000 common shares with an FMV and stated capital of $1,000 and $100, respectively. Article 10(2)(a) of the of the Canada-Israel Treaty provided for a reduced withholding rate of 5% on dividends paid by a company resident in Canada to a resident of Israel where “the beneficial owner of the dividends is a company (other than a partnership) which holds directly at least 25 per cent of the capital of the company paying the dividends.”

After referring to para. 15 of the 2014 OECD commentary to Article 10, which stated inter alia that “[a]s a general rule … the term “capital” … should be understood as it is understood in company law," CRA found that the 25%-of-capital test should be applied on the basis of the shares’ stated capital, so that this test was not satisfied by the preferred shares.

Neal Armstrong. Summary of 14 December 2023 External T.I. 2019-0820291E5 under Treaties – Income Tax Conventions – Art. 10.

CRA provides favourable rulings on the s. 212.1(4) exception and on the s. 15(1.5) demerger rules

The Taxpayer (a Canadian public corporation with a widely-dispersed shareholder base) and Pubco (a corporation, governed by the laws of (foreign) Country 2 and dealing at arm’s length with the Taxpayer) engaged in transactions to permit the Taxpayer, with funding provided by Pubco, to acquire Target (a public limited company governed by the laws of (foreign) Country 1) so that: the Taxpayer will retain Target’s Canadian, Country 1, and certain other international businesses; Pubco will acquire 100% of Target’s businesses in Country 3 and Country 4; and the Taxpayer and Pubco will initially jointly own Target’s business in Country 2 and Country 5 branch business and subsequently sell them to an arm’s length party.

Somewhat curiously, the Target structure was acquired by a Bidco owned exclusively by the Taxpayer but funded in significant part (perhaps as to ½) by Pubco. Shortly after the acquisition by Bidco, there was a transfer of most of the Target holdings to a “JV Co” initially owned by the Taxpayer but with Pubco being transferred ½ of the shares of JV Co in consideration for the Bidco cash funding it had earlier provided. Shortly thereafter, a foreign holding company (Country 1 Subco) for the Canadian corporate structure (Canco 1 and its Canadian subsidiary) that had been retained in the structure still "beneath" the Taxpayer transferred its shares of Canco 1 to the Taxpayer. The “Purposes” of the transactions stated inter alia that:

The purpose of structuring the funding of the Acquisition in a manner that Pubco would not acquire any equity interest in Bidco was to comply with various anti-trust and regulatory requirements. As a consequence, the conditions of subsection 212.1(4) were satisfied and Pubco did not control Country 1 Subco immediately before the disposition of the shares of Canco 1.

Partly in reliance on this statement, CRA ruled that s. 212.1(4) would not apply to this transfer of the Canco 1 shares such that s. 212.1(1.1)(a) would not deem a dividend to be paid by Canco 1 to Country 1 Subco.

Well beneath JV Co was a foreign opco with “keeper” and “non-keeper” businesses (as referred to above), whose assets were excluded property. CRA gave detailed and favourable rulings on the application of the s. 15(1.5) demerger rules to a division of that opco between a Demergerco 2 and Demergerco 1 (which was to be sold).

Neal Armstrong. Summaries of 2021 Ruling 2020-0875391R3 under s. 212.1(4) and s. 15(1.5).

CRA confirms that an agent not acting in relation to a trust has no trust reporting obligations

Regarding whether the new trust-reporting rules apply to an arrangement under which a person can reasonably be considered to act as agent for one or more other persons with respect to all dealings with certain property, without the arrangement being a trust, CRA indicated that ss. 104(1) and 150(1.3) do not apply to an arrangement if it is not a trust, and that the determination of whether an arrangement is a trust is not something on which it generally comments as this is the responsibility of the parties, and then stated:

To the extent that a given arrangement is not a trust and does not give rise to the creation of a trust under the applicable private law, and is not otherwise deemed to be a trust for the purposes of the Act, it will not be an arrangement described in subsections 104(1) and 150(1.3). Accordingly, the arrangement will not be a trust for the purposes of section 150.

These comments generally support the proposition that a general partner holding limited partnership property as agent for the partners does not in this regard have trust reporting obligations. Note that, in the common law provinces, the GP cannot hold the partnership property as trustee for the partnership, which is not an entity, it cannot hold such property as bare trustee for the limited partners as it rather than they have the discretion as to such property’s use, and it is, vis-à-vis the limited partners, the one with the entitlement to exercise control and other ownership rights over the partnership property by virtue of the limited partnership law (see Hudson’s Bay v. OMERS, Kucor and Lehndorff) rather than by virtue of trust law.

Neal Armstrong. Summary of 27 February 2024 External T.I. 2024-1006681E5 under s. 150(1.3).

Income Tax Severed Letters 28 February 2024

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

Yao – Tax Court of Canada finds that the denial of the CCB benefit to refugee claimants was not contrary to the Charter

Bocock J held that he was bound by the decision in Almadhoun (2018 FCA 112) that, as a matter of statutory interpretation of s. 122.6 – eligible individual - s. (e)(ii) of the Canada child benefit (the “CCB”) provisions, the CCB was not available to refugee claimants. He also found that the exclusion of refugee claimants from the CCB was not contrary to s. 7 or 15 of the Charter. Regarding s. 7 (security of the person), Bocock J noted the finding in Carter (2015 SCC 5) that security of the person is engaged by “state interference with an individual’s physical or psychological integrity, including any state action that causes physical or serious psychological suffering” and found that “[w]hile the mental health of the [refugees before him] was impacted, this does not constitute a ‘serious and profound effect’ … .”

Regarding s. 15(1) (discrimination), he was bound by the finding in Toussaint (2011 FCA 213) that immigration status is not an analogous ground, and he indicated that “[r]efugee claimant status is conceptually a subset of immigration status.”

The denial of the CCB to refugees claimants also, in its impact, did not create a distinction on the basis of race or sex. He noted in this regard that “racialized people” already received the CCB in a greater proportion than their representation within the Canadian population, and that there was “insufficient evidence that excluding refugee claimants from the CCB disproportionately affects racialized women receiving the benefit.”

Neal Armstrong. Summaries of Yao v. The King, 2024 TCC 19 under s. 122.6 – eligible individual - s. (e)(ii), Charter, s. 7(1), s. 15(1).

We have translated 6 more CRA interpretations

We have translated 6 further CRA interpretations released during April of 2002. Their descriptors and links appear below.

These are additions to our set of 2,762 full-text translations of French-language Technical Interpretation and Roundtable items (plus some ruling letters) of the Income Tax Rulings Directorate, which covers all of the last 21 3/4 years of releases of such items by the Directorate. These translations are subject to our paywall (applicable after the 5th of each month).

Bundle Date Translated severed letter Summaries under Summary descriptor
2002-04-12 26 April 2002 Internal T.I. 2002-0129707 F - FRAIS D'OUVERTURE DE COMPTE Income Tax Act - Section 20 - Subsection 20(1) - Paragraph 20(1)(bb) admin fee for shares that generate only capital gains cannot be deducted under s. 20(1)(bb)
Income Tax Act - Section 18 - Subsection 18(1) - Paragraph 18(1)(b) - Capital Expenditure v. Expense - Oversight or Investment Management admin fee on becoming a holder of shares that were not a source of property income was a non-deductible capital expenditure and ACB addition
Income Tax Act - Section 54 - Adjusted Cost Base admin fee for shares that generate only capital gains is an ACB addition
7 March 2002 Internal T.I. 2001-0114957 F - Fiducie de nouveaux arrivants Income Tax Act - Section 94 - Subsection 94(1) - Non-Resident Time s. 94(1)(b)(i)(A)(III) allowed a newcomer to defer FAPI recognition from non-resident trusts for 60 months
4 February 2002 Internal T.I. 2002-0118937 F - Calcul du paragraphe 86.1(3) de la Loi Income Tax Act - Section 86.1 - Subsection 86.1(3) numerical example of operation of s. 86.1(3)
12 February 2002 Internal T.I. 2002-0119057 F - Perte du décédé et intérêt Income Tax Act - Section 161 - Subsection 161(7) - Paragraph 161(7)(b) - Subparagraph 161(7)(b)(ii) “subsequent taxation year” here and in s. 161(7)(a)(iv.2) refers to the first taxation year of the estate
25 April 2002 Internal T.I. 2002-0131937 F - FRAIS D'EMPRUNT-EVALUATION ARPENTAGE Income Tax Act - Section 20 - Subsection 20(1) - Paragraph 20(1)(e) - Subparagraph 20(1)(e)(ii) cost of appraisal fee required by mortgage lender was deductible
2 May 2002 Internal T.I. 2002-0132877 F - DÉDUCTIBILITÉ DES INTÉRÊTS Income Tax Act - Section 20 - Subsection 20(1) - Paragraph 20(1)(c) - Subparagraph 20(1)(c)(i) interest on borrowed money to acquire common shares generally deductible

Arrangements to use a ULC to generate an interest deduction in Canada and the US, or a non-inclusion in the US, need to be examined under the hybrid mismatch rules

In considering the application of the hybrid mismatch arrangements to cross-border arrangements involving the generation of an interest deduction to a Canadian unlimited liability company (ULC), one should be mindful of the currently-drafted rules in Bill C-59 (the “first package”) and a potential “second package” to implement other proposals contained in the (BEPS) OECD Action 2 Report.

In Example 1, a US C corporation (“US Parent”) wholly owns a Canadian ULC (“Cansub”) that is disregarded in the U.S. and to which it made an interest-bearing loan. The interest payments are deductible in Canada by Cansub.

Although there is a deduction in Canada but no recognition of income in the United States, resulting in a deduction/non-inclusion (D/NI) mismatch, this structure may not represent a hybrid financial instrument under the first package given inter alia that the D/NI mismatch arises primarily because of the difference between the countries in their tax treatment of Cansub (as opaque or disregarded) and not because of a difference in the tax treatment of the financial instrument as such and that the OECD Action 2 Report states that “[a] payment cannot be attributed to the terms of the instrument where the mismatch is solely attributable to the status of the taxpayer or the circumstances in which the instrument is held.”

Regarding the second package, the BEPS Action 2 Report relevantly provides that no mismatch will arise to the extent that the payer’s deduction is set off against “dual-inclusion income,” being an item included in income under the laws of both the payer and payee jurisdictions. Interest expense might be disallowed in Canada to the extent that Cansub was in a net loss position. A deeming rule might be introduced to deem the interest payment to be a dividend paid to US Parent, which would be subjected to a 25% withholding tax rate based on the anti-hybrid rule in Art. IV(7)(b) of the Treaty.

In a variation of Example 1, the loan to Cansub is made by a US C-corp. subsidiary of US Parent (US Sub) out of its own funds rather than by US Parent.

As in Example 1, it is arguable that the first package will not apply.

Respecting the second potential package, although Cansub would be a “hybrid payer” (its interest payments are deductible in Canada and also generate a duplicate deduction for the US investor, viz., US Parent, in the US), the BEPS “deductible payments rule” does not apply if a deduction can be offset against an amount that will be included in income in both jurisdictions, so that if the interest expense can be offset against income of Cansub (which is taxed in both jurisdictions), the rule may not apply – but may apply if Cansub is in a loss position.

Example 3 is the same as Example 2, except that Cansub receives the loan from a third party rather than US Parent. There is a double interest deduction: by Cansub in Canada; and by US Parent in the US.

If this was not a structured arrangement (which would entail it being reasonably considered that a portion of the economic benefit arising from the D/NI mismatch is reflected in the pricing of the transaction giving rise to a D/NI mismatch, or the transaction or series was otherwise designed to give rise to the D/NI mismatch), then it would not be considered a hybrid financial instrument arrangement and would not be caught by the first package.

Regarding the potential second package, there is a BEPS scoping rule, which denies a deduction in the payer jurisdiction (Canada) only where the parties are in the same control group or are part of a structured arrangement – so that if this loan is not a structured arrangement, the interest deduction may not be disallowed in Canada.

Neal Armstrong. Summary of Simon Townsend and Silvia Wang, “Can the Hybrid Mismatch Rules Affect Canadian ULCs?”, International Tax Highlights, Vol. 3, No. 1, February 2024, p. 5 under s. 18.4(10).

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