27 June 2008 External T.I. 2007-0247551E5 - FAPI and Part XIII Tax

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Various issues regarding foreign affiliate status, FAPI recognition, cost base adjustment of partnership interest and withholding tax on interest.

Position: See letter for details.

Reasons: See letter for details.

XXXXXXXXXX 2007-024755
S. Leung, CA

Attention: XXXXXXXXXX

June 27, 2008

Dear Sir or Madam:

Re: Foreign Affiliates and Partnership

We are writing in reply to your letter of July 31, 2007 in which you requested our interpretation of certain provisions of the Income Tax Act (the "Act"), the Income Tax Regulations (the "Regulations") and the Canada-United States Income Tax Convention (the "Convention") as they apply to a foreign partnership as described in the hypothetical facts below.

1. A taxable Canadian corporation ("Canco") owns all the shares in the capital stock of two corporations each of which is not resident in Canada at common law ("CFA1" and "CFA2", respectively).

2. Each of CFA1 and CFA2 is a person resident in the U.S. for the purposes of the Convention and at common law.

3. Each of CFA1 and CFA2 is a foreign affiliate ("FA") and a controlled foreign affiliate ("CFA") of Canco.

4. CFA1 and CFA2 are the only members of a partnership ("FP") that carries on an active business in the U.S. and does not carry on business in Canada for the purposes of the Act.

5. FP owns shares of a taxable Canadian corporation ("Holdco") and does not own any taxable Canadian property ("TCP") other than the shares of Holdco. It also owns all the shares in the capital stock of a corporation ("NRco") that is resident in the U.S. for the purposes of the Convention.

6. NRco owns investment property and does not carry on business in Canada or own any TCP.

7. Periodically, NRco pays cash dividends to FP ("Foreign Dividends"). Periodically, FP distributes such Foreign Dividends to CFA1 and CFA2.

8. Periodically, Holdco pays cash dividends to FP ("Canadian Dividends"). Periodically, FP distributes such Canadian Dividends to CFA1 and CFA2.

9. Periodically, Canco borrows money from FP under a debt obligation that bears interest at a reasonable market rate ("Interest").

10. Each taxation year or fiscal period, as the case may be, of each of Canco, CFA1, CFA2, FP, NRco and Holdco ends on the same date (i.e., December 31).

11. Under the applicable law governing FP, (a) it is not a limited partnership; (b) it is not a legal person; (c) as it is not a legal person, each member is considered to have some form of proprietary interest in the property of the partnership; and (d) each member is jointly and severally liable with the other member for the debts of the partnership.

You seek our views on the following issues:

(i) Is NRco a FA and a CFA of Canco?

(ii) Are the Foreign Dividends excluded from the foreign accrual property income ("FAPI") of CFA1 and CFA2 by virtue of item A(b) of the definition of FAPI?

(iii) Are the Canadian Dividends excluded from the FAPI of CFA1 and CFA2 by virtue of item A(c) of the definition of FAPI?

(iv) Do the Foreign Dividends and the Canadian Dividends (collectively, the "Dividends") increase the adjusted cost base ("ACB") to each of CFA1 and CFA2 of its partnership interest in FP under subparagraph 5907(12)(a)(ii) of the Regulations?

(v) Is the rate of Part XIII withholding tax applicable to payments of Interest by Canco to FP reduced to 10% by virtue of Article XI(2) of the Convention?

(vi) Is the Part XIII withholding tax paid by FP on payments of Interest foreign accrual tax ("FAT") paid by CFA1 and CFA2?

Our Comments

The situation outlined in your letter appears to relate to an actual situation involving identifiable taxpayers. Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5 Advance Income Tax Rulings, dated May 17, 2002. Where the transactions have already been completed and the tax return in respect of the transactions filed, the applicable Tax Services Office should be consulted with respect to the income tax liabilities of such taxpayers. However, we can offer the following general comments.

It is a question of fact whether FP is a partnership for Canadian income tax purposes. If FP is formed under the Delaware Revised Uniform Partnership Act ("DRUPA"), it has been the long-standing position of Canada Revenue Agency ("CRA") that a partnership formed under DRUPA is a partnership for Canadian income tax purposes. In the comments below, it is assumed that FP is a partnership for Canadian income tax purposes.

(i) Is NRco a FA and a CFA of Canco?

In order to determine whether NRco is a FA of Canco, one would first need to ascertain the purpose of such determination. For the purposes of the foreign affiliate rules under section 113 of the Act and the regulations prescribed thereto, as well as for the purposes of any other provisions of the Act referred to in the pre-amble of subsection 93.1(1) of the Act, that latter subsection would apply and NRco would be considered to be a FA and a CFA of Canco as the shares of NRco would be deemed to be owned by CFA1 and CFA2 in proportion to the fair market value of their respective partnership interest in FP.

However, where the determination of the foreign affiliate status of NRco is for the purposes other than those mentioned above, subsection 93.1(1) of the Act would not apply as the conditions set out therein are not met. This is so where, for example, the purpose of the determination of the foreign affiliate status of NRco is to determine whether section 91 of the Act applies to Canco with respect to the FAPI of NRco. In such case, subsection 96(1) of the Act would apply and the income of CFA1 and CFA2 as partners of FP would be computed as if FP were a separate person resident in Canada and each FP activity (including the ownership of property) were carried on by FP as a separate person. As a result, the shares of NRco would be considered to be owned by FP as a separate person resident in Canada and NRco would be a FA and a CFA of FP, not of Canco.

Consequently, any FAPI of NRco would be included in the income of FP by virtue of subsection 91(1) of the Act and would be treated as FAPI of CFA1 and CFA2 vis-a-vis their partnership interest in FP and such FAPI of CFA1 and CFA2 would be included in the income of Canco by virtue of subsection 91(1) of the Act. Such income inclusions in these entities would respectively increase the cost base of the shares of NRco owned by FP by virtue of paragraphs 53(1)(d) and 92(1)(a) of the Act, the cost base to CFA1 and CFA2 of their respective partnership interest in FP by virtue of paragraph 95(2)(j) of the Act and subparagraph 5907(12)(a)(ii) of the Regulations, and the cost base to Canco of the shares of CFA1 and CFA2 by virtue of paragraphs 53(1)(d) and 92(1)(a) of the Act.

(ii) Are the Foreign Dividends paid by NRco to FP excluded from the FAPI of CFA1 and CFA2 by virtue of item A(b) of the definition of FAPI?

Pursuant to paragraph (b) of the description of "A" in the definition of FAPI in subsection 95(1) of the Act, a dividend received by a FA of a taxpayer from another FA of the taxpayer is excluded from the computation of FAPI. In this case since NRco is not a FA of Canco for the purpose of computing the FAPI of CFA1 and CFA2 vis-à-vis Canco, the Foreign Dividends received by CFA1 and CFA2 from NRco through FP would not be excluded from the computation of the FAPI of CFA1 and CFA2 by virtue of item A(b) of the definition of FAPI.

However, after taking into account the proposed amendment to subsection 5900(3) of the Regulations, since in computing the income of CFA1 and CFA2 FP is treated as if it were a separate person resident in Canada, subsection 91(5) of the Act would apply to permit a deduction by FP of the Foreign Dividends received by FP with the result that, with respect to such Foreign Dividends, there is no net income from property that would be included in the value of "A" in the definition of FAPI with respect to CFA1 and CFA2. 1

Also, there would not be any deduction under "H" of the definition of FAPI with respect to the Foreign Dividends because in order to have a deduction under "H", such dividends have to be included in the value of "A" in the definition of FAPI in respect of CFA1 and CFA2 and have to be deemed by paragraph 93.1(2)(a) of the Act to have been received by CFA1 and CFA2 for the purposes of sections 93 and 113 of the Act. There is no amount to be included in the value of "A" in the definition of FAPI that is deemed to have been received by CFA1 and CFA2 under paragraph 93.1(2)(a) because of the application of subparagraph 93.1(2)(d)(ii) of the Act. The latter subparagraph states that, notwithstanding paragraphs 93.1(2)(a) to (c), the amount included in the affiliate's income in respect of the dividend referred to in paragraph 93.1(2)(a) shall not exceed the amount that would be included in its income pursuant to subsection 96(1) in respect of the dividend received by a partnership if the value for "H" in the definition of FAPI were nil and the Act were read without reference to subsection 93.1(2). As the amount in respect of the Foreign Dividends that would be included in the income of CFA1 and CFA2 pursuant to subsection 96(1) is nil (i.e., there is no net dividend income to CFA1 and CFA2 with respect to the Foreign Dividends after the subsection 91(5) deduction by FP), the second condition in the description of "H" in the definition of FAPI in subsection 95(1) of the Act is not met.

It is also noteworthy that since there is no amount to be included in the income of CFA1 and CFA2 in respect of the dividend referred to in paragraph 93.1(2)(a) of the Act (i.e., for the purposes of section 113 and the regulations made for the purposes of that section), no amount would be included in the computation of taxable surplus of CFA1 and CFA2 with respect to the Foreign Dividends.

The Foreign Dividends received by FP from NRco would reduce the ACB to FP of the shares of NRco by virtue of subparagraph 53(2)(b)(i) and paragraph 92(1)(b) of the Act.

(iii) Are the Canadian Dividends paid by Holdco to FP excluded from the FAPI of CFA1 and CFA2 by virtue of item A(c) of the definition of FAPI?

Pursuant to paragraph (c) of the description of "A" in the definition of FAPI in subsection 95(1) of the Act, a taxable dividend received by a FA of a taxpayer would be excluded from the computation of FAPI of that affiliate to the extent that the amount thereof would, if the dividend were received by the taxpayer, be deductible by the taxpayer under section 112 of the Act. It is our view that the Canadian Dividends received by CFA1 and CFA2 from Holdco through FP would meet the above condition and would be excluded from the computation of FAPI of CFA1 and CFA2 by virtue of that paragraph.

(iv) Do the Dividends increase the ACB to CFA1 and CFA2 of their respective partnership interest in FP under subparagraph 5907(12)(a)(ii) of the Regulations?

Subparagraph 5907(12)(a)(ii) of the Regulations operates to add to the ACB to a FA of a taxpayer of a partnership interest where the affiliate is a partner of the partnership by "the affiliate's incomes as described by the description of "A" in the definition "foreign accrual property income" in subsection 95(1) of the Act for a taxation year ending after 1971 and before that time that can reasonably be considered to relate to profits of the partnership."

With respect to the Foreign Dividends received by CFA1 and CFA2 from NRco through FP, as noted in (ii) above, the net income of CFA1 and CFA2 with respect to such dividends after the subsection 91(5) deduction claimed by FP is nil. Hence, the value of the description of "A" in the definition of FAPI in subsection 95(1) of the Act with respect to such dividends in respect of CFA1 and CFA2 is nil. As a result, subparagraph 5907(12)(a)(ii) of the Regulations would not apply to add to the ACB to CFA1 and CFA2 of their respective partnership interest in FP with respect to the Foreign Dividends received by CFA1 and CFA2 through FP. This is logical because as noted in (i) above, the ACB to CFA1 and CFA2 of the partnership interest in FP has already been increased by virtue of paragraph 95(2)(j) of the Act and subparagraph 5907(12)(a)(ii) of the Regulations.

The amounts of the Canadian Dividends that are excluded from computing the FAPI of CFA1 and CFA2 under item A(c) of the definition of FAPI would also not be added to the ACB to CFA1 and CFA2 of their respective partnership interest in FP because such Canadian Dividends cannot be considered, under subparagraph 5907(12)(a)(ii) of the Regulations, to be the income of CFA1 and CFA2 described in the description of "A" in the definition of FAPI in subsection 95(1) of the Act. Therefore, in the case at hand, the Canadian Dividends received by CFA1 and CFA2 from Holdco through FP would not be considered to be the property income of CFA1 and CFA2 described in the description of "A" in the definition of FAPI that can reasonably be considered to relate to profits of FP.

You state that the amount in the description of "A" in the definition of FAPI would include the Dividends notwithstanding that these dividends are excluded because of the exceptions contained in the description of "A" in that definition. In this regard, you claim that the phrase "as if there were not included in the affiliate's income any amount described in any of paragraphs (a) to (d) of the description of A" used in the description of "D" of the definition of FAPI provides support to the interpretation you propose. We do not agree. The description of "D" in the definition of FAPI in subsection 95(1) of the Act simply states that in computing the FA's losses certain amounts (namely, those referred to in any of paragraphs (a) to (d) of the description of "A" of that definition) that were normally included in computing the affiliate's property income are excluded. In our view, although the words used in the description of "D" with respect to those items listed in paragraphs (a) to (d) of the description of "A" in the definition of FAPI are different from those used in the description of "A", the principle and the purpose is the same; that is, in determining the affiliate's income or losses from property for the purposes of computing FAPI, none of the amounts referred to in paragraphs (a) to (d) of the description of "A" would be taken into account.

However, as we fail to see in policy terms why the Canadian Dividends in this case should not be added to the ACB to CFA1 and CFA2 of their respective partnership interest in FP, we will inform the Department of Finance of this deficiency.

(v) Is the rate of Part XIII withholding tax applicable to payments of Interest by Canco to FP reduced to 10% by virtue of Article XI(2) of the Convention?

It is our view that subsection 96(1) of the Act would not apply in this regard and the CRA would look through the partnership to the partners who are the beneficial owners of the Interest with respect to the application of Article XI(2) of the Convention. Provided that CFA1 and CFA2 are beneficial owners of the Interest and the Limitation on Benefits Article contained in the proposed 5th Protocol of the Convention does not apply to deny treaty benefits to CFA1 and CFA2, the reduced treaty rate of 10% would be available, taking into account the application of paragraph 10(6)(a) of the Income Tax Application Rules and paragraph 212(13.1)(b) of the Act. It should be noted that the withholding rate would be further reduced in the future under the proposed 5th Protocol of the Convention.

(vi) Is the Part XIII withholding tax paid by FP on payments of Interest FAT paid by CFA1 and CFA2?

The Part XIII withholding tax meets the definition of FAT as it is considered to be paid by CFA1 and CFA2 through FP which is a flow-through entity (that is, not a separate person under subsection 96(1) of the Act as that subsection would not apply with respect to the tax liability of the partners).

As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, the opinions expressed in this letter are not rulings and are consequently not binding on the CRA.

Yours truly,

Olli Laurikainen, CA
Section Manager
for Division Director
International and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
ENDNOTES

1 It should be noted that under subsection 96(1) of the Act, income of the partnership vis-à-vis a partner is to be computed in respect of each particular source. In principle, income from a source is to be computed on a net basis (i.e., income net of expenses with respect to that source). The policy of the CRA regarding subparagraph 93.1(2)(d)(i) of the Act with respect to whether it is the gross amount of the dividend that would be deductible under subsection 113(1) is an administrative one reflecting the intention of the Department of Finance with respect to the interpretation of that subparagraph and it only applies to the interpretation of that subparagraph.