2014-0536581I7 Foreign affiliate fresh start rules

Principal Issues: 1) Whether the fresh start rules apply when a non-resident corporation becomes a foreign affiliate of a taxpayer notwithstanding that business activities of the corporation do not change. 2) Whether paragraph 138(11.91)(e) can give rise to an eligible capital expenditure.

Position: 1) Yes 2) Yes

Reasons: 1) All the requirements of 95(2)(k) are met. 2) Consistent with longstanding view in context of paragraph 149(10)(b).

Author: Laurikainen, Olli
Section: 95(2)(k), 95(2)(k.1), 138(11.91)(e), 14(5)

                                                                                                                                                      July 31, 2014

      XXXXXXXXXX TSO                                                                                                                HEADQUARTERS
                                                                                                                                                      Olli Laurikainen

                                                                                                                                                       2014-053658

      Paragraphs 95(2)(k) and (k.1)

This is in response to your e-mail of June 18, 2014, requesting our view whether paragraphs 95(2)(k) and (k.1) of the Income Tax Act (the “Act”) apply in a particular fact pattern.

Paragraphs 95(2)(k) and (k.1) of the Act provide rules for computing the income of a foreign affiliate (“FA”) of a taxpayer resident in Canada from a business for the first and subsequent years in which the business is carried on by the FA.  Paragraphs 95(2)(k) and (k.1) of the Act apply in circumstances where, subject to paragraph 95(2)(a), the income from the business is included in computing the foreign accrual property income (“FAPI”) of the FA. These so called “fresh start” rules ensure that income and losses accruing in prior periods do not enter into the calculation of the income from the business in the particular and subsequent taxation years.  This is done, in part, by deeming a disposition of property used or held in a business of a FA for proceeds equal to fair market value and deeming a reacquisition of the property at a cost equal to that same fair market value.

Our understanding of the facts is as follows.

1.    Canco is a corporation resident in Canada.

2.    On XXXXXXXXXX, Canco acquired the shares of FA1 from an arm’s length non-resident person for $XXXXXXXXXX.

3.    As a result of the acquisition described in paragraph 2 above, FA1, FA2 and FA3 became foreign affiliates of Canco.   Canco has a “qualifying interest” within the meaning of that term in paragraph 95(2)(m) of the Act in FA1, FA2 and FA3.

4.    At the time of the acquisition, the assets of FA1 consisted of:
-     assets used in an active business with a fair market value of $XXXXXXXXXX, and
-     shares of FA2 with a value of $XXXXXXXXXX.

5.    At the time of the acquisition, the assets of FA2 consisted of:
-     intellectual property with a value of $XXXXXXXXXX and cost of $XXXXXXXXXX, and
- shares of FA3 with a value of $XXXXXXXXXX.

6.    FA2 carries on an “investment business”, as defined in subsection 95(1) of the Act, comprised of licensing certain intellectual property solely to XXXXXXXXXX persons, FA3 and an arm’s length person resident in Canada.  The taxation year of FA2 ends on XXXXXXXXXX.  In the taxation year of FA2 ending immediately preceding the acquisition of the shares of FA1 by Canco, the business of FA2 was not, at any time, part of a “taxable Canadian business” as that term is defined in subsection 95(1) of the Act.

7.    FA3 carries on an active business and deducts the license fee paid to FA2 in computing the amount prescribed to be its earnings or loss for a taxation year from an active business (other than an active business carried on in Canada).

8.    In computing the FAPI of FA2 for its first taxation year immediately following the acquisition, Canco excluded the license fees paid by FA3 on the grounds that they are included in FA2’s active business income pursuant to clause 95(2)(a)(ii)(B) of the Act.   In addition, in computing the FAPI derived from the remainder of the license fees received by FA2 a deduction under paragraph 20(1)(b) of the Act was taken based on the premise that FA2 had made an eligible capital expenditure (“ECE”), as defined in subsection 14(5) of the Act, of $XXXXXXXXXX in respect of the intellectual property at the beginning of the taxation year of FA2 in which it became a foreign affiliate of Canco.

You request our view on whether the provisions of paragraphs 95(2)(k) and (k.1) of the Act apply to cause FA2 to be considered to have made an ECE equal to the FMV of the intellectual property so as to increase the deductions available under paragraph 20(1)(b) of the Act in computing its FAPI.

Our Comments

In our view the requisites of paragraph 95(2)(k) of the Act are satisfied in the above case such that paragraph 95(2)(k.1) of the Act applies to FA2.  This view is consistent with the Department of Finance Technical Notes on paragraph 95(2)(k) and (k.1) which read in part as follows:  “…there has to be a transition, whether by way of the business changing its nature or by the non-resident corporation becoming a foreign affiliate of the taxpayer, in order for the fresh start rules to apply”.   Therefore, as a result of the operation of subparagraph 95(2)(k.1)(iii) and paragraph 138(11.91)(e) of the Act, FA2 is deemed to have disposed of its intellectual property immediately before the beginning of its taxation year ending XXXXXXXXXX for $XXXXXXXXXX and to have reacquired it at the beginning of that taxation year for $XXXXXXXXXX.

The operation of paragraph 95(2)(k.1) of the Act is conditional upon the prerequisites described in paragraph 95(2)(k) having been satisfied.  The prerequisites set out in subparagraph 95(2)(k)(i) must be satisfied in FA2’s taxation year ending XXXXXXXXXX while those set out in subparagraph 95(2)(k)(ii) of the Act must be satisfied in FA2’s immediately preceding year.  In the above scenario there is only ambiguity in whether all the conditions in clauses 95(2)(k)(ii)(A), (B) and (C) of the Act have been met in the taxation year of FA2 ending before the acquisition of the shares of FA1 by Canco.  We will discuss them below in reverse order.

In respect of the relevant taxation year clause 95(2)(k)(ii)(C) is to be read pursuant to S.C. 2013, c.34, subsec. 70(19) as follows:

(C) the business was not described in subclause (i)(C)(I) or (IV), or the activities were not described in subclause (i)(C)(III);

Therefore, to make sense of clause 95(2)(k)(ii)(C), we need to refer to clause 95(2)(k)(i)(C), which for the relevant year is to be read pursuant to S.C. 2013, c.34, subsec. 70(19), without reference to sub-clause (II), as follows:

(C) the business is
(I) an investment business,
(II),
(III) a business whose activities include activities deemed by any of paragraphs (a.1) to (b) to be a separate business, other than an active business, carried on by the affiliate, or
(IV) a business the income from which is included by paragraph (l) in computing the affiliate's income from property for the specified taxation year, and

In our case the business of FA2 is an investment business in FA2’s taxation year ending XXXXXXXXXX and its activities included activities that are deemed by paragraph 95(2)(a.3) of the Act to be a separate business, other than an active business, carried on by FA2.  However, in its immediately preceding taxation year, the definition of “investment business” in subsection 95(1) of the Act did not apply to FA2 with reference to Canco because that definition only applies with reference to a “a foreign affiliate of a taxpayer”.  Similarly, paragraph 95(2)(a.3) had no application to FA2 with reference to Canco in that year.  Accordingly, it is our view that the prerequisite in clause 95(2)(k)(ii)(C) is satisfied.

The prerequisite in clause 95(2)(k)(ii)(B) would be satisfied in FA2’s taxation year ending before the acquisition because, as indicated in fact 5 above, FA2 did not carry on a “taxable Canadian business” in that year.

The other clause of subparagraph 95(2)(k)(ii) that may be somewhat in question is clause (A).  It reads as follows:

 (A) the affiliate or partnership carried on the business, or the activities so deemed to be a separate business, as the case may be   

Applying the analysis above regarding clause (C) to clause (A), one might argue that “the affiliate”…did not carry on the business or activities in its taxation year ended before the acquisition because at that time FA2 was not a “foreign affiliate” as that term is defined in subsection 95(1), of Canco.  However, we observe that if FA2 were a member of a partnership that carried on the business or activities, the prerequisite in clause (A) would clearly be satisfied.  This is so because unlike the definition of “foreign affiliate”, there is no definition of partnership in the Act that makes reference to who the partners are.  Since it would appear that the legislator contemplated the same outcome under paragraph 95(2)(k) regardless of whether the business was carried by a foreign affiliate directly or, indirectly through a partnership, we believe that the words of clause 95(2)(k)(ii)(A), read in context,  can be interpreted in a manner so as to conclude that the condition therein was satisfied in FA2’s taxation year ending before the acquisition.

In sum, it is our view that all the conditions in paragraph 95(2)(k) of the Act for the operation of paragraph 95(2)(k.1) to FA2 are satisfied in the above scenario.   

Eligible Capital Property

The operation of clause 95(2)(k.1)(iii)(D) of the Act triggers the application of paragraph 138(11.91)(e) to the property of FA2.  The latter provision provides that FA2 is deemed to have disposed of each property owned by it for proceeds equal to its fair market value and to have required it at a cost equal to that fair market value.  The wording of paragraph 138(11.91)(e) of the Act does not mesh well with the definition of ECE in subsection 14(5) of the Act which contemplates an “…outlay or expense made or incurred by the taxpayer, as a result of a transaction…”.  However, it is our view that the wording of paragraph 138(11.91)(e) of the Act is sufficient to cause FA2 to be considered to have made an ECE at the relevant time in an amount equal to the fair market value of its intellectual property.  This view is consistent with the position taken in the context of other similar provisions of the Act (e.g. see our document E 9319777).  

Computation of Income

Under the facts set out above, the income from the entire licensing business of FA2 should generally be computed taking into account all of FA2’s licensing revenue.  In computing such business income, FA2 would claim its deductions, including a deduction under paragraph 20(1)(b) in respect of the ECE.  The business income, net of deductions would only then be allocated between the portion derived from the payments from FA3 that is re-characterized by paragraph 95(2)(a)(ii) as active business income and the portion derived from the license fees paid by the arm’s length person resident in Canada, which remains as FAPI.  Furthermore, in the XXXXXXXXXX taxation year of FA2, the portion of the income that can reasonably be considered to have accrued from XXXXXXXXXX to XXXXXXXXXX when FA2 was not yet a foreign affiliate of Canco would be deducted under paragraph 95(2)(f.1) of the Act.

Business Requirement in Subparagraph 95(2)(k)(i)

You asked us to comment on the possible policy rationale for the operation of paragraph 95(2)(k.1) of the Act having been restricted by subparagraph 95(2)(k)(i) to property used by a FA in a business.  In other words, why would the cost of property used to earn income from property not be similarly bumped when a foreign corporation becomes an FA.  Since Canadian tax policy falls into the responsibility of the Department of Finance, we are not in position to opine on why the legislator chose to limit the application of these rules such that they do not apply to property held by a FA that is used by it to earn income from property. However, it is our understanding that the fresh start rules were first enacted at the same time as certain provisions such as the “investment business” definition in subsection 95(1), and paragraphs 95(2)(a.1), (a.2) and (a.3) of the Act, all of which caused income of a FA that would otherwise have been income from an active business to be FAPI.  Therefore, it seems the original fresh start rules were likely directed specifically at the computation of income from a business of a FA.  It is possible that the Department of Finance has simply not turned its mind to property of a FA that is used to earn income from property.

While it is a question of fact whether the income from a property of a taxpayer is income from a business or income from property for the purposes of the Act, we would note that the threshold amount of activity that is required to cause any corporation (including a FA) to be considered to be carrying on business is extremely low.  Therefore, if a taxpayer were to take the position that the income of a FA is income from a business (e.g. in the case of FA2’s licensing income) it would be generally be difficult for the CRA to challenge the taxpayer’s position.  For guidance on this issue we would refer you to the decisions in The Queen v. Canada Trustco Mortgage Company, F.C.T.D., 1999 and Canadian Marconi Company v. The Queen, S.C.C., 1986.

For Director
International Division
Income Tax Rulings Directorate
Legislative Policy & Regulatory Affairs Branch

cc Mark Turnbull

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