5 August 1986 Income Tax Severed Letter 95-1511 F

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.

This is in reply to your letter of April 25, 1986 in which you request two technical interpretations with respect to the computation of foreign accrual tax pursuant to paragraph 95(1)(c) of the Income Tax Act (the "Act"). Both interpretations relate to the computation of foreign accrual tax in the context of the U.S. Internal Revenue Code (the "Code") but could have implications with respect to other foreign jurisdictions.

Long Term Capital Gains

If in a taxation year a U.S. corporation has a long term capital gain, subsection 1201(a) of the Code provides an alternative tax calculation which generally results in the U.S. corporation paying a tax equal to 28% of the capital gain. Although the U.S. effective tax rate on the capital gain is quite similar to the Canadian rate of approximately 25% of such gains, the mechanics of the U.S. calculation are quite different.

If a U.S. controlled foreign affiliate of a Canadian taxpayer realizes a capital gain on the disposition of property that does not constitute excluded property, one half of the capital gain is generally included in the foreign accrual property income ("FAPI") of the U.S. subsidiary pursuant to paragraph 95(1)(b)(ii) of the Act. Subsection 91(1) requires the FAPI to be included in the taxable income of the Canadian shareholder. Subsection 91(4) of the Act allows the Canadian taxpayer a deduction equal to the portion of the foreign accrual tax applicable to the FAPI multiplied by the relevant tax factor (currently 2.174 for corporations). Although the mechanics of the provisions are somewhat complex, their clear intention is to ensure that FAPI is not subject to additional Canadian tax if the effective rate of foreign tax on the FBI amount in the case of corporations, at least 46%. Since only one-half of a capital gain is included in FAPI, this result should hold provided that the effective rate of foreign tax on the entire capital gain is not less than 23%.

In the case of a capital gain realized by a U.S. subsidiary, the desired result is achieved if paragraph 95(1)(c) of the Act is interpreted such that U.S. tax equal to 23% of the capital gain is regarded as applicable to the amount included in FAPI with the remaining U.S. tax (i.e. 5% of the capital gain) relating to the exempt portion of the capital gain. In your view, this interpretation is appropriate in view of the clear intention of the FAPI provisions of the Act.

We concur with your interpretation of the computation of foreign accrual tax with respect to foreign taxes paid on a capital gain as set out above.

Loss Carrybacks

The definition of FAPI found in paragraph 95(1)(b) of the Act provides for the deduction of FAPI and non-FAPI losses of the controlled foreign affiliate for the particular taxation year, and for the five immediately preceding taxation years, in determining the net FAPI for a particular taxation year. There is no provision to allow for the carryback of a loss incurred by the controlled foreign affiliate in a subsequent taxation year to reduce the FAPI of a preceding taxation year. The definition of FAPI was introduced into the Act at a time when Canadian corporations were allowed to carry forward non-capital losses for a period of five years and to carry back non-capital losses and net capital losses one year. The FAPI definition has not been amended to reflect the liberalization of the loss carryover provisions introduced for the 1983 and subsequent taxation years.

You are concerned with the situation where a U.S. controlled foreign affiliate of a Canadian taxpayer realizes a capital gain in a taxation year which is included in its FAPI for that year, pays U.S. tax in respect of the amount included in FAPI, in a subsequent year realizes a loss and, by virtue of a carryback of that loss pursuant to the provisions of the Code, receives a refund of all U.S. tax paid for the taxation year in which the FAPI income arose. In your view, the portion of the U.S. tax originally paid in respect of the earlier year that reasonably related to the amount included in FAPI (probably 23% of the capital gain), represents foreign accrual tax notwithstanding the subsequent refund of the tax by virtue of the loss carryback. You are of this view for the following reasons:

1. At the end of the first taxation year of the Canadian shareholder the controlled foreign affiliate had incurred a liability for U.S. tax under the Code and that tax was ultimately paid by the U.S. affiliate;

2. The U.S. tax clearly related to the amount included in FAPI; and

3. This interpretation is consistent with the general scheme of the FAPI provisions which is to allow FAPI to be reduced by losses incurred by the same controlled foreign affiliate in taxation years falling into the Canadian statutory periods for carryovers of losses.

We do not concur with your interpretation with respect to the computation of foreign accrual tax when taxes paid to a foreign jurisdiction are refunded because of a loss carried back. If at the time of the determination of the foreign accrual tax, no taxes have been paid because of a refund, it is our opinion that there is no foreign accrual tax. Therefore the Canadian shareholder's return for the taxation year in which the FAPI was incurred should be re-assessed on the basis that there is no deduction pursuant to the provisions of subsection 91(4) of the Act for that year. While this position in some cases may appear to create inappropriate results, the problem appears to result from the fact that the rules with respect to the computation of FAPI income do not provide for the carrying back of losses, and not from the interpretation of paragraph 95(1)(c) of the Act.

In any case whether or not there is foreign accrual tax is a question of fact, and even though refunded taxes are not considered to be foreign accrual tax, it may be possible depending upon the situation to establish that taxes paid in another year may reasonably be considered to relate to the FAPI income in question. In this regard it should be noted that to qualify as foreign accrual tax, the taxes do not have to be paid in the taxation year in which the FAPI income to which they relate is incurred. They can be deducted pursuant to the provisions of subsection 91(4) of the Act in the year that they are paid provided they are paid within 5 years of the year in which the FAPI income to which they relate was incurred.

We trust that this information will be of assistance to you.