XXXXXXXXXX                                                                                                         2013-048235
                                                                                                                                 Judy Ho, CPA, CA
January 27, 2017

Dear XXXXXXXXXX:

Re:  Clause 95(2)(a)(ii)(D)

We are writing in response to your letter wherein you requested our comments regarding whether clause 95(2)(a)(ii)(D) (“Clause D”) of the Income Tax Act (the “Act”) could apply to recharacterize a penalty paid to a foreign affiliate in the hypothetical situation described below.  We apologize for the delay in responding to your request.

Specifically, you have asked for our views on the application of Clause D to the penalty described in paragraph 7 below, in the following hypothetical situation:

1.    A taxable Canadian corporation (“Canco”) owns all of the shares of two non-resident corporations, each of which is a foreign affiliate and a controlled foreign affiliate of Canco (“FA Finco” and “FA Holdco”).

2.    Canco, FA Finco and FA Holdco all have December 31 taxation year ends.

3.    Neither FA Finco nor FA Holdco carries on an active business.

4.    FA Finco makes a loan (the “Loan”) to FA Holdco.

5.    FA Holdco uses the borrowed funds to acquire all shares in FA Opco, which thereby becomes a foreign affiliate and a controlled foreign affiliate of Canco.

6.    The Loan has a ten-year fixed term at the end of which time, the principal balance is to be repaid. The Loan bears interest at market rates payable annually on December 31.  All the terms of the Loan are consistent with those that would have been agreed to between persons dealing with each other at arm’s length.

7.    Prior to the maturity of the Loan, FA Holdco opts to repay a portion of the principal amount and thereby becomes obligated under the Loan agreement to pay a penalty to FA Finco in an amount not exceeding the present value of the interest that would otherwise have been paid or payable by FA Holdco on the portion of the principal that has been repaid.

For the purpose of our analysis, you asked us to assume that all of the requisite conditions for the application of Clause D are met in respect of the interest paid on the Loan.

Our comments

This technical interpretation provides general comments about the provisions of the Act. It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.

In the context of the inquiry, the relevant parts of Clause D read as follows:

      In computing the income from an active business for a taxation year of a particular foreign affiliate of a taxpayer (FA Finco), there shall be included the income derived from amounts that were paid or payable to the particular foreign affiliate (FA Finco) by another foreign affiliate (referred to in this clause as the “second affiliate”) of the taxpayer (FA Holdco) to the extent that the amounts are paid or payable by the second affiliate (FA Holdco), in respect of any particular period in the year, under a legal obligation to pay interest on borrowed money (the Loan) used for the purpose of earning income from property where the property is, throughout the particular period, excluded property of the second affiliate (FA Holdco) that is shares of the capital stock of a corporation (referred to in this clause as the “third affiliate”) (FA Opco) which is, throughout the particular period, a foreign affiliate of the taxpayer, and in respect of each of the second affiliate (FA Holdco) and the third affiliate (FA Opco), for each of their taxation years (each of which is referred to as a “relevant taxation year”) that end in the year, that affiliate (FA Holdco or FA Opco) is subject to income taxation in a country other than Canada in that relevant taxation year.

You observe that in order for the penalty payable by FA Holdco to FA Finco to qualify under Clause D the following four requirements must be met (assuming that the other conditions in Clause D are otherwise met):

-     the penalty received by FA Finco is derived from amounts that are paid or payable by FA Holdco;

-     the penalty received by FA Finco is an amount paid or payable by FA Holdco “under a legal obligation to pay interest on borrowed money”;

-     the penalty received by FA Finco is an amount paid or payable by FA Holdco “in respect of any particular period in the year”; and

-     the borrowed money is used for the purpose of earning income from property that is shares of a foreign affiliate.

You are inquiring, however, whether these conditions could be satisfied in the hypothetical situation described above.

Based on the facts described above, once FA Holdco becomes legally obligated pursuant to the terms of the Loan agreement to pay the penalty to FA Finco, the penalty should be considered to be payable at that time and the first condition should be met.

In order to satisfy the second condition, the amount of the penalty has to be paid, not just be payable. This is so because pursuant to the terms of the Loan agreement, the penalty is paid under a legal obligation to pay a penalty not under a legal obligation to pay interest. In order for the penalty to be recharacterized as interest, paragraph 18(9.1)(e) of the Act must be triggered.  Once the penalty amount is paid, paragraph 18(9.1)(e) (which applies for the purposes of the Act, including the computation of income from property described in the pre-amble to paragraph 95(2)(a)) will in the above circumstances deem the amount of the penalty to have been paid by FA Holdco and received by FA Finco as interest on the Loan.

With respect to the third condition, one issue is whether the phrase “in respect of any particular period in the year” relates to the taxation year of FA Finco or FA Holdco. The beginning of paragraph 95(2)(a) of the Act refers to “a taxation year of a particular affiliate” and then makes further references to “the year” of “the particular foreign affiliate”, prior to the reference to “the year” in Clause D. The particular foreign affiliate in the situation described is FA Finco; therefore, the year referred to above is the taxation year of FA Finco. A taxation year of the “second affiliate” (which is FA Holdco in the situation described) is not introduced in Clause D until subclause IV as a term “relevant taxation year”. Therefore, the grammatical structure of paragraph 95(2)(a) (i.e., the textual interpretation thereof) confirms that the “year” in the phrase “in respect of any particular period in the year” in Clause D is the taxation year of FA Finco.

The other issue with respect to the third condition is whether the penalty which is computed by reference to interest that would have been payable under the Loan agreement in subsequent taxation years is “in respect of any particular period” in the year of FA Finco in which it is paid. The importance of the reference to a particular period is based on the requirement of Clause D that FA Holdco holds shares of a corporation that is a foreign affiliate of Canco throughout that period and that the shares are excluded property of FA Holdco throughout the same period. However, since the penalty payment occurs at a particular time (unlike interest which is accruing on a daily basis over a period of time), the relevant period during which FA Holdco must meet the above requirements for purpose of recharacterizing the penalty payment under Clause D is effectively represented by the time at which the payment is made by FA Holdco and received by FA Finco.

In this context, it should also be noted that paragraph 18(9.1)(f) of the Act is not relevant for the application of Clause D in the situation described. Paragraph 18(9.1)(f) applies only for the purpose of computing income of the payer of a penalty (to determine whether the amount of the penalty is deductible by the payer) and requires that certain conditions must be met for the amount to be deductible. Clause D, however, deals with income of the recipient of the penalty and requires that particular conditions are met only at the time of the income inclusion.

With respect to the last condition, FA Holdco has to be earning income from property and the property has to be, throughout the particular period, shares of the capital stock of a corporation which is, throughout the particular period, a foreign affiliate of the taxpayer. It is indicated in the facts that FA Holdco used the borrowed funds to acquire shares in FA Opco, and FA Opco is a foreign affiliate of Canco. Also, as discussed above, the particular period in respect of FA Holdco is the time in a taxation year of FA Finco at which FA Finco receives the amount of penalty. Therefore, the purpose test (earning income from property that is shares of a foreign affiliate) has to be met in respect of that particular time. As a result, provided that at the time FA Finco receives the amount of penalty, FA Holdco continues to hold the shares of FA Opco that constitute a source of income for FA Holdco, the fourth condition of Clause D would be satisfied.

Lastly, it should also be noted that even though subsection 18(9.1) of the Act could generally defer the deduction by the payer of the penalty of a portion of the amount of such penalty to a future year, subsection 5907(2.7) of the Income Tax Regulations ensures that in the foreign affiliate context, the entire amount of penalty is deducted from the payer’s earnings or loss from an active business in the year in which the amount is paid. Therefore, in the situation described, the possible increase of FA Finco’s surplus balance will be accompanied by the corresponding reduction of FA Holdco’s surplus balance in the year the amount is paid.

Notwithstanding our comment above, in a situation where the surplus balances are increased or decreased inappropriately, consideration will also be given to the application of specific anti-avoidance rules as well as the General Anti-Avoidance Rule in section 245 of the Act.

We trust our comments will be of assistance.

Yours truly,

Vitaliy Anissimov
Section Manager
For Division Director
International Division
Income Tax Rulings Directorate