News of Note

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

A US corporate REIT that is a qualifying person under the Canada-US Treaty owns US LLC 1, which owns US LLC 2 which, like US LLC 1, is disregarded for US purposes, and is a s. 216 taxpayer. Interest on an unsecured loan from LLC 1 to LLC 2 is now subject to Part XIII tax as a result of the introduction of s. 212(13.2)(b). CRA confirmed that no Treaty relief would be available under Art. XI given that LLC 1 does not qualify as a Treaty resident from the Canadian perspective and given that Art. IV(6) could not apply because the interest is disregarded for US purposes.

CRA further agreed that two alternative modifications to this structure would generate an exemption for the interest under Art. XI of the Treaty.

In Scenario 1, the REIT forms a taxable REIT subsidiary (TRS) that is a US resident and a qualifying person for Treaty purposes, and TRS and LLC 1 form US LP in which they have respective interests of 0.1% and 99.9%, respectively, and the loan to LLC 2 is made by US LP rather than LLC 1.

CRA indicated that TRS would be entitled to the Treaty benefit respecting its share of the interest income received by US LP and that the REIT would get the benefit of Art. IV(6) respecting its share of such interest income given inter alia that the U.S. income tax treatment of the interest received by US LP and indirectly allocated to REIT is the same as the U.S. income tax treatment that would apply had the REIT derived the amount directly from US LP.

Scenario 2 is similar to Scenario 1 except that TRS, which is held by the REIT, subscribes for a 0.1% membership interest in LLC 2 so that for US purposes, LLC 2 is a partnership between it and the REIT and, as in the base case, the loan is made by LLC 1 to LLC 2. CRA indicated that, again, Art. IV(6) would apply given inter alia that the U.S. income tax treatment of interest income to REIT is the same as the U.S. income tax treatment would be had REIT received the interest income directly from LLC 2.

Neal Armstrong. Summary of 17 May 2023 IFA Roundtable, Q.6 under Treaties – Income Tax Conventions – Art. 4.

The non-capital losses of $90M, and other tax attributes (the “Tax Attributes”) of the taxpayer, were effectively sold to arm’s length investors pursuant to transactions under which:

• The existing shareholders of the taxpayer exchanged their shares for shares of a “Newco” under a Plan of Arrangement
• A venture capital company facilitator (Matco) entered into an “Investment Agreement” with the taxpayer and Newco pursuant to which Matco (principally in consideration for $3M in cash) acquired a debenture of the taxpayer that was convertible into shares representing 79% of its equity shares but only 35% of its voting shares.
• The taxpayer then transferred its assets (including the proceeds of issuing the debenture) and its liabilities to Newco.
• Matco then identified a mutual fund management company which wanted to effect a public offering of shares of the taxpayer and use the proceeds (of $100M) for a new bond trading business to be carried on in the taxpayer – a transaction which then proceeded.

Rowe J indicated that s. 111(5) addresses where “the identity of those behind the corporation has changed” and “functions so that the tax benefits associated with those losses will not benefit a new shareholder base carrying on a new business.”

In finding that the transactions (which he described, at para. 6, as “narrowly circumventing the text of s. 111(5)”) did not accord with the rationale of s. 111(5), so that the use of the tax attributes had been properly denied under s. 245(2), Rowe J stated:

[T]he appellant was gutted of any vestiges from its prior corporate “life” and became an empty vessel with Tax Attributes. …

Moreover, the shareholder base of the taxpayer underwent a fundamental shift throughout the transactions … .

Matco achieved the functional equivalent of … an acquisition of [de jure] control through the Investment Agreement, while circumventing s. 111(5), because it used separate transactions to dismember the rights and benefits that would normally flow from being a controlling shareholder.

Use of the Tax Attributes was properly denied pursuant to s. 245(2).

Neal Armstrong. Summaries of Deans Knight Income Corp. v. Canada, 2023 SCC 16 under s. 245(4), s. 111(5), s. 248(10) and s. 256(5.1).

Regarding whether USco (a US C-Corp and a “qualifying person” for purposes of the Canada-US Treaty) would be considered to be carrying on business in Canada by virtue only of some of its employees being Canadian residents who worked from their homes for two or three days a week and, if so, whether USco would be considered to be earning income through a permanent establishment (PE) in Canada, CRA indicated:

• Internal support activities such as those of an accountant or an HR professional providing services only to USco would generally not constitute USco carrying on business in Canada.
• However, where a Canadian resident employee worked from home as part of a team providing consulting services, the Canadian physical location of that individual might inform where the services were performed, with it also being relevant if the clients were resident in Canada.
• If such a Canadian resident employee acted in a product development role, this might engage s. 253(a), which references “creating or improving, in whole or in part, anything in Canada”.
• S. 253(b) might also be engaged, which was described as generally including “actively seeking and attempting to obtain customers in Canada, beyond ‘a mere invitation to treat’ or advertisement.”
• The employee’s home office would not constitute a “fixed place of business” through which the business of USco was partly or wholly carried on under the PE Article assuming that such office was not rented by USco or was otherwise at its disposal.
• Regarding Art. V(5), “if a contract entered into by a Canadian employee requires approval by the U.S. office to be binding, such contract would not necessarily be viewed as entered into in Canada, provided the approval by the U.S. office is not merely a formality.”

Neal Armstrong. Summaries of 17 May 2023 IFA Roundtable, Q.5 under s. 115(1)(a)(ii), s. 253(a), s. 253(b) and Treaties – Income Tax Conventions – Art. V.