CRA finds that the fresh-start rule re a change of an active to an investment business is inapplicable where there also is a “fundamental change” to that business

A wholly-owned foreign affiliate (FA 1) of the taxpayer had carried on a business of distributing a product that had been manufactured by another foreign affiliate of the taxpayer (Producer FA). FA 1 held the trademark and other intellectual property (IP) relating to the product, and provided a royalty-free licence to Producer FA (and another FA providing distribution services) for their use of such IP in connection with the product.

However, on the “Change-in-Business Date,” a new, wholly-owned foreign affiliate (FA 2) of the taxpayer became the distributor of the product and began making royalty payments to FA 1 for its use of the IP. As these royalties were the only income stream for FA 1 after that date, FA 1 now carried on an investment business.

Whether the fresh start rules in s. 95(2)(k.1) applied, so that the taxpayer could rely on Reg. 5907(2.9) and those rules to increase the exempt surplus of FA 1 on account of a gain realized on a deemed disposition of the IP for its FMV, turned on whether such investment business of FA 1 was to be regarded as the business that it had carried on (as an active business) prior to the Change-in-Business Date.

In rejecting this proposition, the Directorate stated:

[W]hile retaining the elements of a business, they can be so materially altered that in effect the changes give rise to a new type or new field of business. … [W]hile after the Change-in-Business Date FA 1 continued to hold the Original IP as its main asset, it no longer used it in a distribution business, but rather it used it in its new licensing business instead.

… [I]t would be reasonable to conclude that … FA 1 had a fundamental change in its business - it ceased carrying on its distribution business and entered into a new field of business, which is not of the same kind and type as, and not a continuation of, the business it carried on before the Change-in-Business Date. This change to the business operations of FA 1 … would go beyond the change in nature of a business from active to passive contemplated in paragraph 95(2)(k).

The effect of this interpretation is to render it highly uncertain when s. 95(2)(k.1) applies.

Neal Armstrong. Summary of 10 February 2023 Internal T.I. 2019-0816681I7 under s. 95(2)(k).