5 November 2012 Internal T.I. 2012-0462151I7 - Foreign Tax Credits

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: Whether the deemed disposition of mark-to-market securities gives rise to qualifying income or qualifying losses for the purposes of computing foreign tax credits under section 126 of the Act in respect of foreign withholding tax on dividends from those securities.

Position: No

Reasons: The gains or losses on the deemed disposition of mark-to-market securities will, pursuant to paragraph 126(6)(c), result in tax-exempt income from a separate source that is not qualifying income or qualifying losses for the computation of foreign tax credits. As a result, the qualifying income, being the dividends net of related expenses, will not be affected by any mark-to-market gains or losses.

November 5, 2012

XXXXXXXXXX HEADQUARTERS
Large Case File Manager A. Seidel, CMA
XXXXXXXXXX Tax Services Office (613) 957-2058

Attention: XXXXXXXXXX
2012-046215

Foreign Tax Credits

We are writing in response to your October 22, 2012 e-mail concerning the meaning of “tax-exempt income” in subsection 126(7) of the Income Tax Act (the “Act”) and the application of subsection 126(9) and paragraph 126(6)(c) of the Act.

Background

1. Canco carried on a XXXXXXXXXX business in Canada in its XXXXXXXXXX taxation year. For Canadian income tax purposes, Canco has incurred an overall loss in its XXXXXXXXXX taxation year.

2. Canco held shares of U.S. resident corporations (the “Investments”) in the course of carrying on its XXXXXXXXXX business in Canada in its XXXXXXXXXX taxation year. The U.S. corporations were not foreign affiliates, within the meaning of subsection 95(1) of the Act, of Canco. Canco is required to hold the Investments to support its insurance liabilities and the earning of investment income from its Investments is a key component of the profitability of Canco. Canco received distributions on these Investments and paid foreign non-business income taxes in the U.S. in respect of such distributions.

3. All of the Investments were mark-to-market properties, as defined in subsection 142.2(1) of the Act, to Canco. Consequently, pursuant to subsection 142.5(2), Canco is deemed to have disposed of the Investments immediately before the end of its XXXXXXXXXX taxation year for proceeds equal to their fair market value at that time and to have reacquired the Investments at a cost equal to such proceeds. Subsection 142.5(1) of the Act requires that the gains and losses from both actual and deemed dispositions under subsection 142.5(2), be included or deducted, as the case may be, in computing income for the year. Pursuant to subparagraph 39(1)(a)(ii.2), such dispositions do not give rise to capital gains and losses. In computing income for its XXXXXXXXXX taxation year, Canco incurred a net mark-to-market loss in relation to the Investments. For the purposes of our response, we have made the assumption that the Treaty would deny the U.S. from taxing any of Canco’s gains from the actual disposition of the Investments.

4. For the purposes of section 126, Canco sourced the distributions received on the Investments to the U.S.

Issue

For the purposes of subparagraph 126(1)(b)(i) of the Act, must the net mark-to-market losses on the Investments be deducted in computing the qualifying income from the Investments.

Taxpayer’s View

Canco is of the view that, for the purposes of subparagraph 126(1)(b)(i) of the Act, an amount is included in computing qualifying income where it is sourced to a foreign jurisdiction and is non-business in nature. Canco is therefore of the view that the distributions on the Investments would be qualifying income while the gains and losses arising as a result of the mark-to-market rules in the Act would be included in computing Canco’s Canadian business income and therefore would not be included in computing qualifying income.

Our Comments

In this case, Canco’s Canadian XXXXXXXXXX business would generally constitute a source of income and the distributions received by Canco on the Investments and the net mark-to-market loss in relation to those Investments would be included in the computation of Canco’s income from that source. As the XXXXXXXXXX business is carried on entirely in Canada, the income therefrom would generally be excluded from the computation in subparagraph 126(1)(b)(i) by the mid-amble thereof and, absent paragraph 2 of Article XXIV of the Canada-U.S. Tax Convention (the “Treaty”), no foreign tax credit would be available in respect of U.S. withholding tax on the distributions (absent another source of qualifying income in the U.S.). However, subparagraph 2(a) of Article XXIV of the Treaty provides that “subject to the provisions of the law of Canada regarding the deduction from tax payable in Canada of tax paid in a territory outside Canada … income tax paid or accrued to the United States on profits, income or gains arising in the United States … shall be deducted from any Canadian taxes payable in respect of such profits, income or gains”. Paragraph 3 of Article XXIV provides that profits income or gains … which may be taxed in the other Contracting State in accordance with the Convention … “shall be deemed to arise in that other Contracting State”. Therefore, as a result of Article XXIV of the Treaty a portion of the income from Canco’s Canadian XXXXXXXXXX business must be re-sourced to the U.S. for the purposes of section 126 of the Act. In our view, that portion would be all the income pertaining to the Investments (i.e. the distributions less related expenses and the net mark-to-market loss).

For the purposes of the foreign tax credit computation under section 126, subsection 126(9) of the Act provides rules for the computation of qualifying incomes and qualifying losses for a taxation year from sources in a country. Subparagraph 126(9)(a)(iii) provides that if any income of the taxpayer from the source would be tax-exempt income, that source cannot give rise to qualifying income or a qualifying loss from the particular country. The definition of “tax-exempt income” in subsection 126(7) of the Act provides that income of a taxpayer from a source in a country is considered to be tax- exempt income of the taxpayer where, because of a tax treaty with that country, the taxpayer is entitled to an exemption from all income or profits taxes imposed in that country and to which the treaty applies and no income or profits tax to which the treaty does not apply is imposed in any country other than Canada. In Canco’s case, the distributions on the Investments were subject to U.S. withholding tax in accordance with the Treaty such that the income from the Investments would not be considered to be tax-exempt income. As a result, subject to the “rules of construction” in subsection 126(6), all of the incomes and losses from the Investments would be qualifying income or qualifying losses and be included in the computation in subparagraph 126(1)(b)(i) of the Act.

However, paragraph 126(6)(c) of the Act provides that if any income from a source in a particular country would be tax-exempt income but for the fact that a portion of the income is subject to an income or profits tax imposed by the government of a country other than Canada, such portion as is subject to tax is deemed to be income from a separate source in the particular country. In Canco’s situation, it would have a source of income (the Investments) a portion of which is subject to an income or profits tax (the distributions) and a portion that is not subject to an income or profits tax (the mark-to-market loss). Pursuant to paragraph 126(6)(c), the income arising as a result of the distributions would be considered to be a separate source for purposes of section 126. As a result, it is our view that any mark-to-market gains or losses from the deemed dispositions of the Investments would be from a source that produces only tax-exempt income and would not be included in the qualifying income or qualifying losses of Canco by virtue of subparagraph 126(9)(a)(iii) of the Act. Therefore, Canco would compute its XXXXXXXXXX qualifying income and qualifying losses, and its foreign non-business tax credit, without taking into consideration the XXXXXXXXXX net mark-to-market loss on the Investments.

We trust that these comments are of assistance. If you wish to discuss any of the above, please contact the writer.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Ms. Celine Charbonneau at (613) 952-1361. A copy would be sent to you for delivery to the client.

for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch