News of Note

CRA commented on an example of the reduction to the small business deduction that may arise under the “specified corporate income” (SCI) rules. Mr. A owned 50% of a real estate management company (Hco), which derived substantially all of its income from providing services to a corporation owned by Mrs. A with a real estate business. Hco was 50% owned by an unrelated third party, and was not associated with Wco.

CRA noted that, absent an election under s. 125(3.2), the total active business income (ABI) derived by Hco from Wco would be excluded under s. 125(1)(a)(i)(B) from its income eligible for the SBD, notwithstanding that Hco and Wco were described as dealing with each other at arm’s length. This was because (applying the two conditions in s. (a)(i)(A) of the SCI definition): Mrs. W, who had an interest in Wco, did not deal at arm’s length with a shareholder of Hco (Mr. A); and it was not the case that substantially all of Hco’s ABI was from the provision of services (or property) to persons (other than Wco) with which Hco dealt at arm’s length.

However, the ABI otherwise carved out under the SCI definition could be restored under s. 125(1)(a)(ii.1) to the extent that Wco assigned all or a portion of its business limit to Hco under s. 125(3.2).

Neal Armstrong. Summary of 20 October 2022 External T.I. 2020-0869681E5 under s. 125(7) - “specified corporate income” - s. (a)(i).

The taxpayer (“KQI”), which was a Canadian operating subsidiary in a group ultimately controlled by a Finnish parent, used funds that had been borrowed by a Canadian holding company in the group and advanced to KQI as an interest-bearing loan and share subscription proceeds to purchase, for a cash purchase price of $394 million, cumulative preferred shares of “Kone USA” (a group company with an active business) from the non-resident affiliated company (“Kone BV”) to which such shares had recently been issued as a stock dividend. At the same time, KQI agreed to resell such preferred shares at pre-agreed higher prices, to Kone BV in three and five years’ time, which in fact occurred. The gain arising under this resale was deemed under s. 93 to be dividends coming out of exempt surplus of Kone USA. The funds so received by Kone BV were used indirectly to fund purchases by the Kone group of targets with complementary businesses.

The ARQ sought to impute interest income to KQI under TA s. 127.6, the Quebec equivalent of ITA s. 17(1), on the basis that the above “repo” transaction was a sham that should instead be characterized as an interest-free loan by KQI to Kone BV or, alternatively, that the repo transaction represented an abusive avoidance of such s. 17 equivalent for Quebec GAAR purposes.

In rejecting the sham argument, Fournier JCQ noted that although the parties had agreed to treat the repo transaction as a secured loan by KQI to Kone BV for U.S. tax purposes, such characterization under the US “substance over form” tax doctrine did not detract from the “actual legal obligations agreed to between the parties in Canada and Quebec.”

In rejecting the application of the Quebec GAAR, he found that the required element of abuse of the s. 17-equivalent rule had not been established. He noted that such rule “contemplated blocking the exporting of income and preventing Canadian corporations from using their capital outside Canada by means of loans or advance not bearing a reasonable rate of interest and which remains unpaid for more than one year,” whereas here, no such loan or advance had occurred and KQI had “instead acquired from Kone BV the shares of Kone USA, which it had agreed to hold for a certain passage of time and to then resell them.”

Neal Armstrong. Summary of Kone Inc. v. ARQ, No. 500-80-028109-149 (Court of Quebec, 22 December 2022) under s. 245(4).

S. 90(8)(b) provides one of the exceptions to the application of the upstream loan rule in s. 90(6), namely, for indebtedness that arose in the ordinary course of the creditor’s business (suggested to be, generally, trade accounts receivable rather than loans) or a loans made in the ordinary course of the creditor’s ordinary business of lending money, if bona fide arrangements were made, at the time the indebtedness arose or the loan was made, for repayment within a reasonable time.

The August 9, 2022 proposals would narrow the second, moneylending business, exception, while leaving the trade receivables exception intact. In particular, the proposed amendment would provide that if, at any time during which the upstream loan is outstanding, less than 90% of the aggregate outstanding amount of the loans of the business is owing by borrowers that deal at arm’s length with the lender/creditor, the money-lending business exception would not apply to the loan. (There is a similar narrowing of s. 15(2.3).)

Where there is intended reliance on the moneylending business exception, there will need to be a calculation of the percentage representing the moneylending to entities within the group, during all of the time in which the loan is outstanding – which could create difficulties if inter alia loan balances vary on a daily basis.

This amendment applies not only to loans made after 2022, but also to any portion of a particular loan made before 2023 that remains outstanding on January 1, 2023 as if that portion were a separate loan that was made on January 1, 2023 – so that taxpayers may be required to take remedial action in respect of pre-existing upstream loans.

Neal Armstrong. Summary of Audrey Dubois, “Upstream Loans: Limitation on the Scope of the Moneylending Business Exception,” International Tax Highlights, Vol. 1, No. 2 November 2022, p. 9 under s. 90(8)(b).

CRA ruled on a post-mortem portfolio under which:

• some of the preferred shares of the subject portfolio company (Holdco) were redeemed in its hand in order to generate the recovery of Holdco’s ERDTOH and NERDTOH and a capital loss to be carried back to the deceased’s terminal year pursuant to s. 164(6)
• the estate transferred, to a “Newco” formed by it, preferred shares of Holdco in consideration for a demand note ("Note 2") of Newco and a Newco common share (apparently, its only issued and outstanding share), electing under s. 85(1).
• after a period of at least one year following such transfer, Newco may progressively repay the note at the rate of 1/3 of its principal per year, with such repayments funded through Holdco redeeming preferred shares.
• after the expiry of a specified period of years, Newco will be wound up.

Neal Armstrong. Summary of 2021 Ruling 2021-0877011R3 under s. 84(2).