19 April 2006 Internal T.I. 2004-0080731I7 - attribution of FAPI of a 94(1)(c) trust

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: 1. Does 75(2) apply in a particular fact situation?

2. If 75(2) applies to attribute an amount of FAPI to the settlor of a trust to which 94(1)(c) applies, is the income to be attributed computed under 91 or 94(1)(c)(i)(C)?

3. If the CFA of the trust incurs a loss, can the loss be used to reduce the amount attributed to the settlor in the previous year (assuming the March 16, 2001 amendments to Regulation 5903 are promulgated in the same form as proposed)?

Position: 1. Yes
2. Section 91

3. Provided that 75(2) applies in the loss year, the amount of the deductible loss can be applied by the taxpayer to whom the income was attributed in the previous year.

Reasons: 1. A Canadian resident who is a capital beneficiary of the trust contributed the common shares of the CFA to the 94(1)(c) trust. Although the trustees took steps to avoid the attribution of 75(2) in years following the initial year, the application of 95(6) would result in the continued attribution of the trust's FAPI to the Canadian resident.

2. The income or loss from property, or taxable capital gains or allowable capital losses from the disposition of property are to be computed in accordance with Division B of Part I of the Act; thus section 91 is the appropriate taxing provision for the contributor. The calculation under 94(1)(c)(i)(C) is not appropriate because 94(1)(c)(i)(C) is a component of the trust's total taxable income and does not necessarily reflect the net income from any particular property.

3. If 75(2) does not apply to the loss year, there is no authority for any taxpayer other than the Trust to claim the Trust's "deductible loss".

							April 19, 2006

	Compliance Programs Branch		Income Tax Rulings Directorate
	International Tax Directorate		Annemarie Humenuk

	Attention: Linda Smith
							2004-008073

XXXXXXXXXX

This is in response to your email of June 9, 2004, concerning the application of subsection 75(2) to property held by a trust that is deemed to be resident in Canada under paragraph 94(1)(c). We apologize for the delay in our response.

All statutory references in this memorandum are references to the provisions of the Income Tax Act, R.S.C. 1985 (5th supp.) c. 1, as amended (the "Act").

In the situation you describe, a non-resident trust, the XXXXXXXXXX, (referred to in this memorandum as the "Trust") that is deemed to be resident in Canada under paragraph 94(1)(c) has directly and indirectly acquired shares of XXXXXXXXXX., a non-resident corporation, from an individual who is a resident of Canada (referred to in this memorandum as "Canadian Resident") and the terms of the Trust are such that subsection 75(2) applies to attribute any income earned by the Trust on those shares, or property substituted for those shares, to the Canadian Resident. The non-resident corporation (referred to in this memorandum as "CFA") is a controlled foreign affiliate of the Trust as that term is defined in subsection 95(1). The CFA realized income in 2002 and a loss in the following year, 2003.

In determining the amount to be included in the Canadian Resident's income under subsection 75(2) for each year, you ask whether the income inclusion should be computed under section 91 as it is for ordinary residents of Canada holding shares of a controlled foreign affiliate, or under subparagraph 94(1)(c)(i) as it is for a trust that is deemed to be resident in Canada under paragraph 94(1)(c) holding shares of a controlled foreign affiliate. Since, in the situation you describe, the Trust has no amounts computed under any of clauses 94(1)(c)(i)(A), (B), (D) or (E) for either 2002 or 2003, you ask whether the amount to be included in the Canadian Resident's income from the property held by the Trust under the conditions described in subsection 75(2) will be the same as it would have been had he owned the shares of the CFA directly with the same degree of ownership and control as the trustees of the Trust. Finally, you ask how the loss realized by the CFA in the second taxation year affects the computation of the amount attributed to the Canadian Resident under subsection 75(2) in the first taxation year.

Before addressing issues relating to the computation of the amount to be attributed to the Canadian Resident under subsection 75(2) in respect of the CFA of the Trust, we offer the following comments with respect to the representation dated November 7, 2005 from the Trust's representative which was forwarded to us by Nerissa Fu. The Trust's representative acknowledges that subsection 75(2) applies to the income earned on the property held in the XXXXXXXXXX but states that it does not apply to any of the income earned on the property held by the Trust. The relevant periods identified by the representative in determining whether subsection 75(2) could apply to any income earned by the Trust are:

• the period before the reorganization of the CFA when the Trust held 100% of the common shares of CFA (XXXXXXXXXX, 2001 to XXXXXXXXXX, 2003); and
• the period after the reorganization of CFA when the trust held 100% of newly issued common shares of CFA and 100% of the preferred shares of CFA (XXXXXXXXXX, 2003 to the present time).

The Trust's representative argues that the conditions described in subsection 75(2) are not met with respect to the common shares of CFA that were transferred to the Trust by the Canadian Resident because the Canadian Resident does not have an absolute right of reversion which was stated to be a requirement for the application of subsection 75(2) in the case of Fraser v MNR (91 DTC 5123). Since the Canadian Resident's entitlement to a return of the corpus of the Trust's property depends on the exercise of discretion by the trustees of the Trust, the Trust's representative argues that the common shares of the CFA could not revert to the Canadian Resident during the period before the corporate reorganization. With respect to the period of time following the corporate reorganization, the Trust's representative argues that, in the event subsection 75(2) had applied to the income earned on the common shares of the CFA initially transferred to the Trust and to any income earned on any property that is substituted property as defined in subsection 248(5) for the original common shares, it is only the preferred shares of the CFA that are property substituted for the original common shares since the newly issued common shares of the CFA were acquired by the Trust with arm's length debt. Although the Trust's representative seems to acknowledge that the preferred shares would be substituted property for the common shares originally issued by the CFA if subsection 75(2) had applied to those common shares, he argues that there would be no amount to attribute to the Canadian Resident after XXXXXXXXXX, 2003 (after the corporate reorganization) in any event because the Trust's participating percentage of the preferred shares of the CFA is 0% (because the preferred shares have no current dividend entitlement) and no other income was earned in respect of the preferred shares following the reorganization. As a result, the Trust's representative concludes that no amount is attributable to the Canadian Resident before or after XXXXXXXXXX, 2003.

Our position that subsection 75(2) will apply when the property held by the trust may revert to the contributor by reason of that contributor being a capital beneficiary of the trust remains unchanged. The Fraser case dealt with the application of subsection 75(2) to property held in a commercial investment vehicle and the comments of the court in that case are not applicable to the situation under review. Notwithstanding that the Trust acquired the new common shares with borrowed funds, it is clear that the Trust held 100% of the equity in the CFA before and after the reorganization. Thus, in our view a respectable argument can be made that, after the reorganization, paragraph 95(6)(b) applies to deem the Trust's "participating percentage" of the preferred shares of the CFA to be 100% for the purpose of computing the amount to be attributed to the Canadian Resident. As you know, all potential reassessments involving subsection 95(6) will be referred to Head Office for review by representatives of the Income Tax Rulings Directorate, the Tax Avoidance and Special Audits Division, and the International Tax Directorate.

With respect to the computation of the amount to be attributed to a taxpayer under subsection 75(2), it is our view that the income or loss from property, or taxable capital gains or allowable capital losses from the disposition of property are to be computed in accordance with Division B of Part I of the Act, including any deemed disposition. When subsection 75(2) applies to attribute the income from any of the shares of a controlled foreign affiliate held by a trust resident in Canada (including a trust that is deemed to be resident in Canada), the amount to be attributed to the taxpayer is the amount of any dividends received on the shares and any amount determined under section 91 in respect of those shares. Thus, in this case where no dividends were paid on any of the shares of the CFA, the amount to be attributed to the Canadian Resident is the amount of FAPI as determined under section 91. Note that the amount to be included in the Canadian Resident's income under section 91 in this case is the same as the amount that would be computed under clause 94(1)(c)(i)(C) as part of the trust's taxable income if subsection 75(2) had not applied. Likewise, even if the Trust had received dividends from the CFA, the portion of the Trust's taxable income as computed under subparagraph 94(1)(c)(i) which is derived from the shares of the CFA would be the same as the amount included in the Canadian Resident's income under paragraph 12(1)(k) and section 91 from the shares of the CFA since the dividends would have been included in the Trust's income under clause 94(1)(c)(i)(B). The computation of taxable income under subparagraph 94(1)(c)(i) is not the appropriate calculation for the amount to be attributed to a taxpayer under subsection 75(2) because subsection 75(2) attributes the income from the particular properties transferred to the trust and not the whole of the trust's taxable income.

The Trust, on the other hand, is only required to include the amount in income by which its taxable income as computed under subparagraph 94(1)(c)(i) exceeds the income attributed to the Canadian Resident under subsection 75(2). Provided that the Trust has no income other than the income from the property held on any of the conditions described in subsection 75(2), the Trust's taxable income as computed under subparagraph 94(1)(c)(i) should reasonably be expected to be nil.

You asked how the loss realized by the CFA in the second year affects the computation of the amount attributed to the Canadian Resident under subsection 75(2) in the first taxation year. As you are aware, there is a proposal to amend section 5903 of the Regulations to allow a deductible loss of a particular controlled foreign affiliate of a taxpayer as computed under section 5903 of the Regulations to be applied to reduce the amount of FAPI included in the taxpayer's income for one or more of the three preceding years or any of the seven subsequent years. Provided that the amendment to the Regulation is enacted in substantially the same form as that released by the Department of Finance on March 16, 2001, a taxpayer will be able to claim such portion of the deductible loss of the controlled foreign affiliate of that taxpayer as is determined by section 5903 of the Regulations to reduce the amount included in income as FAPI in any of the three previous years immediately preceding the loss year as well as in any seven of the years subsequent to the loss year.

When a controlled foreign affiliate of a trust realizes a loss in a particular taxation year and that trust holds property under one of the conditions described in subsection 75(2), the issue arises as to which taxpayer, the trust or the person to whom the income was attributed, is entitled to claim the deductible loss and what mechanism ensures that the amount of deductible loss available for any other taxation year is reduced appropriately. A deductible loss, as computed under the proposed amendment to section 5903 of the Regulations, will be deductible by the trust to the extent that it reduces the computation of FAPI included in the trust's income for another year, except to the extent that such income was attributed to the person who transferred the shares to the trust under subsection 75(2). Where that income was attributed to another taxpayer, the taxpayer who has included an amount of FAPI from a particular controlled foreign affiliate in that other taxation year by reason of the application of subsection 75(2) may claim such portion of the deductible loss as determined by section 5903 of the Regulations in order to reduce the amount included in income in that other taxation year, provided that the conditions in subsection 75(2) are met in respect of the loss year, as explained below. Under the proposed amendments to section 5903 of the Regulations, the amount so claimed will reduce the amount of deductible loss available to be claimed by either the trust or the taxpayer in any other taxation year.

Note that if subsection 75(2) does not apply to attribute any amount to the Canadian Resident after reorganization of the CFA on XXXXXXXXXX, 2003, as the Trust's representatives argue, the 2003 deductible loss of the CFA would not be available to the Canadian Resident to reduce the amount included in his income in 2002 even if the draft proposals are enacted in substantially the same form as that released by the Department of Finance on March 16, 2001. This is because the deductible loss of the CFA for a particular year would only be deductible by the Canadian Resident if subsection 75(2) applies to attribute the deductible loss to the Canadian Resident.

Other Comments

Please note that the statement in document 2004-007193 in which we said "It is possible for the formula to compute to a negative amount, therefore, the 94(1)(c)(i)(B) amount can be a loss." is incorrect. Pursuant to section 257 of the Act, where an amount computed by a formula results in a negative amount, the amount is deemed to be nil unless otherwise provided by the provision in question. Nevertheless, where subsection 75(2) applies to attribute the income of a trust that is subject to paragraph 94(1)(c) to the settlor or other contributor, the amount of any loss from the trust's property that would otherwise be included in the calculation of the amount to be included in the trust's taxable income under clause 94(1)(c)(i)(B) would be attributable to that settlor or other contributor and would be determined in accordance with Division B of Part I of the Act.

We note that the Canadian Resident transferred his property to the CFA in 2001 and then transferred the shares of the CFA to the Trust in 2001. As he was resident in Canada at this time, you may want to verify the capital gains reported by him as a result of these transfers.

While the draft legislation on the Taxation of Non-Resident Trusts and Foreign Investment Entities released by the Department of Finance in July 2005 proposes to change the computation of the Trust's income under section 94 for taxation years that begin after 2002, these proposals are expected to have no effect on the amount to be attributed to the Canadian Resident under subsection 75(2) in the situation described in this memorandum.

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. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

T. Murphy
Section Manager
for Division Director
International & Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch