7 August 1991 Income Tax Severed Letter - Foreign Accrual Property Income Rules

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.

Subject: XXX

This is in reply to your memoranda dated XXX regarding XXX

Facts

A brief summary of relevant facts, as we understand them, is as follows:

• 1. XXX
• 2. XXX
• 3. XXX
• 4. XXX
• 5. XXX
• 6. XXX
• 7. XXX
• 8. XXX
• 9. XXX

Issues

• 1. XXX
• 2. XXX

Commentary and Recommendations

XXX

Assuming the existence of excess funds can be established the remainder of our commentary concern issue #2.

The fact that the XXX business is active itself is not relevant in addressing issue #2. However, the first question which must be answered is: If there are excess funds does the management of the funds constitute a separate activity for income tax purposes from that of the XXX business. If not, then the income from such funds will pertain to or be incident to an active business and will not be FAPI, pursuant to 95(2)(a)(i).

The existing jurisprudence on this issue and analogous situations in the context of sections 125 and 129 is not conclusive. For instance, in Ensite Ltd. v. R. [[1986] 2 C.T.C. 459] (86 DTC 6521) interest earned on funds deposited by the Canadian taxpayer in a foreign bank as security for foreign currency loans was considered ineligible for foreign investment income treatment. The Court held that the threshold of the relevant test is met when the withdrawal of the funds would "have a decidedly destabilizing effect on corporate operations themselves." The funds were needed to meet certain recurring claims from the business and were therefore "inseparable" or vitally associated with the business. Consequently income on such funds was considered active in the context of subsection 129(4.2).

In Supreme Theatres Ltd. v. R. [[1981] C.T.C. 190] (81 DTC 5136) the Court concluded, in considering the meaning of the words "pertaining to or incidental to an active business" in subparagraph 95(2)(a)(i), that the word incidental is probably used in its "separable" sense otherwise it would have been unnecessary to have provided such a description in the statute. It could therefore be argued that any income derived from the investment of undistributed earnings in excess of that required by an active business of a foreign affiliate is still income which is incidental (albeit "separable") to an active business and is, therefore not FAPI even if the investment activity is not sufficient to constitute an active business in its own right. That is, one might conclude that income from any redundant or "excess capital" investment would always be active business income and this would render paragraph 95(2)(a)(i) meaningless.

However, it is the Department's current position that even if an XXX business is active, and assuming the existence of "excess funds", income generated by those excess funds would be FAPI pursuant to subparagraph 95(2)(a)(i) of the Act in the circumstances described below.

In our view, an investment of a portion of capital in excess of the cyclical needs of a business would not generate active business income in the context of the FAPI rules. XXX

XXX. In our view, as stated above, such income would be FAPI pursuant to 95(1)(b)(i) of the Act and not active business income pursuant to 95(2)(a)(i) of the Act. This position is reflected in paragraph 9 of IT-73R3 wherein the Department stated that investment of a portion of capital in excess of the cyclical needs of a business should not be active business income.

We note that in Ben Barbary v. M.N.R. [[1989] 1 C.T.C. 2364] (89 DTC 242) the taxpayer argued that the mortgagee interest was income from an "active business" because it was income from property that was "incident to" or "pertained to" an active business carried on by the taxpayer within the meaning of 129(4.1)(b).

The facts in Ben Barbary were that the corporate taxpayer held land and the assets of certain business being operated thereon. In 1992, the taxpayer sold a portion of the land together with certain of the business assets and took back a mortgage and a promissory note.

However, the Court stated that while the evidence indicated that the mortgage and promissory note were important to and used in the business retained by the taxpayer (a restaurant business) ... "The truth of that statement does not assist the Appellant, however, because the mortgage and promissory note, regarded as property, were not incident to and did not pertain to the Appellant's restaurant business. The mortgage and promissory note were no more connected with the restaurant than any other income producing investment which the appellant might have purchased with redundant capital if it thereafter used the income from such investment to support the operation of the restaurant.

The fact that a corporation, carrying on an active business and holding certain property (i.e. investments) unrelated to the business, uses the income from property in connection with the operation of the active business does not mean that the property is "incident to or pertains to" the active business." XXX

The second question in issue #2(a) is:

XXX

First, because of Canadian Marconi v. R. [[1986] 2 C.T.C. 465] (86 DTC 6526) the Department would have to address the rebuttable presumption (the "presumption") that, in the case of a corporation, income received or generated by an activity carried out in pursuit of its stated objects is presumed to be income from a business.

In the Marconi case the Court held that the funds from the sale of a division which were invested in short term securities pending the purchase of another business constituted active business income for the purpose of the manufacturing and processing deduction. In that case the Court also referred to Interpretation Bulletin IT-73R3 paragraph 2 where the Department conceded the existence of the presumption. In IT-73R3 paragraph 1, the Department further stated that "once income is established as being derived from a business source, any appreciable activity expended in the actual income generating process of that business (other than usual "housekeeping" functions such as banking and record-keeping), characterizes that income as income from an active business".

As discussed in more detail below, it is our opinion that the presumption in Marconi does not apply in the context of the FAPI rules regarding foreign affiliates. It is furthermore our view that the commentary in IT-73R3 referred to above does not preclude the recognition of FAPI in cases such as XXX

Regarding the case at hand as well as FAPI cases in general, we refer to a legal opinion dated July 18, 1990 by Darlene Patrick of the Tax Litigation Section of the Department of Justice regarding XXX (copy attached).

XXX

As a consequence, paragraphs 95(1)(b) and 95(2)(a) were enacted to defined the types of income that Parliament intended should be taxed currently as FAPI.

Specifically a distinction was made between FAPI and non-FAPI income as follows:

Source of Income
FAPI

Active business
No

Non-active business which is incidental
to an active business
No

Property which is incidental to an active business No

Non-active business which is not incidental to an active business Yes

Property which is not incidental to an active business Yes

XXX This approach is supported by the following reasoning by the court in Ensite (referred to above):

"the rebuttable presumption that corporate income is income from a business (see: Canadian marconi Co. v. R., released concurrently herewith) is of no application here as it would tend to collapse the distinction between active business income and other sources of income which Parliament clearly intended to preserve in its amendment of s. 129(4) of the Act."

In the Ben Barbary case (referred to above) the Court stated:

"any rebuttable presumption arising from an object clause set out in a corporate charter will not apply if the taxpayer is a private corporation and the issue is whether income from a particular source is "active business income" or "investment income". If my understanding of the Ensite case is correct, the object clauses in the Appellant's corporate charter are irrelevant in deciding the appeal herein."

XXX

XXX

Conclusion

XXX XXX