2015-0573141R3 Subparagraph 95(2)(a)(i)

Principal Issues: Whether subparagraph 95(2)(a)(i) would apply to recharacterize certain income earned by a foreign affiliate?

Position: Yes

Reasons: Application of the Act.

Author: XXXXXXXXXX
Section: 95(2)(a)(i); 95(1) "investment business"

XXXXXXXXXX

XXXXXXXXXX 2015

XXXXXXXXXX:

Advance Income Tax Ruling
XXXXXXXXXX

We are writing in response to your letters of XXXXXXXXXX and XXXXXXXXXX wherein you requested an advance income tax ruling in respect of the above-noted taxpayer (the “Taxpayer”). We also acknowledge additional e-mails and telephone conversations in this respect. In general terms, you are asking us to rule on the application of the foreign accrual property income (“FAPI”) rules of the Act to certain transactions undertaken by foreign affiliates of the Taxpayer.

You have represented to us that, to the best of your knowledge, none of the issues involved in this ruling request are:

(i) dealt with in a previously filed return of the Taxpayer or of a person related to the Taxpayer;

(ii) being considered by a tax services office or a taxation centre in connection with a previously filed tax return of the Taxpayer or of a person related to the Taxpayer;

(iii) under objection by the Taxpayer or by a person related to the Taxpayer;

(iv) before the courts or, if a judgment has been issued, the time limit for appeal to a higher court has expired; or

(v) the subject of a ruling previously considered by the Income Tax Rulings Directorate in connection with the Taxpayer or a person related to the Taxpayer.

Unless otherwise stated, all references herein to statutory provisions are to the Act, and all references to monetary amounts are to United States dollars.

Definitions

In this letter, the relevant entities will be referred to as follows:

a)    “Canco” means the Taxpayer, i.e. XXXXXXXXXX, as further described in paragraph 2;

b)    “XXXXXXXXXX Group” means the following entities: FA3, FA4, FA5, FA5 Subsidiaries, FA6 and LP;

c)    “FA1” means XXXXXXXXXX, as further described in paragraph 3;

d)    “FA2” means XXXXXXXXXX, as further described in paragraph 4;

e)    “FA3” means XXXXXXXXXX, as further described in paragraph 5;

f)    “FA4” means XXXXXXXXXX, as further described in paragraph 6;

g)    “FA4 Trusts” means, collectively, XXXXXXXXXX and XXXXXXXXXX, as further described in paragraph 7;

h)    “FA5” means XXXXXXXXXX, as further described in paragraph 10;

i)    “FA5 Subsidiaries” means XXXXXXXXXX as further described in paragraph 11;

j)    “FA6” means XXXXXXXXXX, as further described in paragraph 12;

k)    “LP” means XXXXXXXXXX, as further described in paragraph 8;

l)    “LP Trusts” means collectively, XXXXXXXXXX as further described in paragraph 9;

m)    “Parentco” means XXXXXXXXXX, as further described in paragraph 1;

n)    “the FA5 Subsidiary” means the foreign affiliate forming part of the FA5 Subsidiaries that will acquire the FA5 New Portfolio.

In this letter, unless otherwise specified, the following terms have the meaning specified below:

o)    “Act” means the Income Tax Act R.S.C. 1985 c. 1 (5th sup.), as amended to the date hereof. Unless otherwise stated, all terms and conditions used herein that are defined in the Act have the meaning given in such definition;

p)    “CFA” has the meaning given to the expression “controlled foreign affiliate” in subsection 95(1);

q)    XXXXXXXXXX

r)    "CRA" means the Canada Revenue Agency;

s)    XXXXXXXXXX

t)    XXXXXXXXXX

u)    “FA” has the meaning given to the expression “Foreign Affiliate” in subsection 95(1);

v)    “FA5 New Portfolio” means the new portfolio that will be acquired by the FA5 Subsidiary, as described in paragraph 24.

w)    “XXXXXXXXXX

x)    “XXXXXXXXXX;

y)    “Qualifying Interest” has the meaning assigned by paragraph 95(2)(m);

z)    “Regulations” means the Income Tax Regulations C.R.C. 1977 c. 945, as amended to the date hereof;

aa)   “Taxable Canadian Corporation” has the meaning assigned by subsection 248(1);

bb)   “US Tax Treaty” means the Convention between Canada and the United States of America with respect to Taxes on Income and on Capital, (1980) as amended by the Protocols signed June 14, 1983, March 28, 1984, March 17,1995, July 29, 1997 and September 21, 2007;

cc)   XXXXXXXXXX

Facts

1)    Parentco is XXXXXXXXXX.

2)    Canco is a Taxable Canadian Corporation engaged essentially in holding activities. Parentco indirectly (through other Canadian subsidiaries) owns all of the shares of Canco. Canco directly owns all of the shares of FA1.

3)    FA1 is a corporation governed by the XXXXXXXXXX. FA1 is a non-resident of Canada and a resident of the United States for the purposes of the Act and the US Tax Treaty. FA1 is a FA and CFA of Canco in which Canco has a Qualifying Interest. FA1 is a holding corporation. Since XXXXXXXXXX, FA1 has owned XXXXXXXXXX% of the shares of FA2. The remaining XXXXXXXXXX% shares of FA2 are held directly or indirectly by individuals forming part of the senior management of the XXXXXXXXXX Group.

4)    FA2 is a corporation governed by the XXXXXXXXXX. FA2 is a non-resident of Canada and a resident of the United States for the purposes of the Act and the US Tax Treaty. FA2 is a FA and CFA of Canco in which Canco has a Qualifying Interest. FA2 is a holding corporation. FA2 directly owns all of the shares of FA3.

5)    FA3 is a corporation governed by the XXXXXXXXXX. FA3 is a non-resident of Canada and a resident of the United States for the purposes of the Act and the US Tax Treaty. FA3 is a FA and CFA of Canco in which Canco has a Qualifying Interest. FA3 is a holding corporation. FA3 directly owns all of the shares of FA4, FA5 and FA6, as well as a number of other subsidiaries.

6)    FA4 is a corporation governed by the XXXXXXXXXX. FA4 is a non-resident of Canada and a resident of the United States for the purposes of the Act and the US Tax Treaty. FA4 is a FA and CFA of Canco in which Canco has a Qualifying Interest. FA4 has approximately XXXXXXXXXX employees who manage and operate the activities of the XXXXXXXXXX Group. For state tax efficiency, and for legal risk protection, employees of the XXXXXXXXXX Group are housed in FA4. The business of FA4 (as further described in the next section) consists mainly of the acquisition of portfolios of debt receivables across the delinquency spectrum for the purposes, essentially, of the liquidation of these portfolios on a profitable basis through collections. A portfolio may include XXXXXXXXXX accounts. Depending on the type of portfolio a portion, sometimes significant, of the accounts may (at some point in time) be resold while the rest of the accounts are put through the collections process.

FA4 owns:

a) performing loan portfolios that were acquired via FA4 Trusts;

b) a XXXXXXXXXX% limited partnership interest in LP, a XXXXXXXXXX limited partnership formed in XXXXXXXXXX.

7)    The FA4 Trusts were both created under the XXXXXXXXXX, for US regulatory purposes. Under the trust agreement applicable to each of the FA4 Trusts, FA4 is the settlor, the sole beneficiary and the sole administrator of the FA4 Trusts. As the sole trust administrator, FA4 is in charge of the administration and management of the FA4 Trusts and also has the responsibility of ensuring that the FA4 Trusts meet all of their obligations under the terms of their respective trust agreements. The trustee of the FA4 Trusts (XXXXXXXXXX) effectively only has legal title to the FA4 Trusts’ assets (the debt receivables comprising the portfolios).

8)    LP is a XXXXXXXXXX limited partnership formed in XXXXXXXXXX. LP owns loan portfolios held in LP Trusts, to satisfy regulatory requirements applicable to those portfolios.  LP has XXXXXXXXXX employees. All of its activities required to acquire, own and collect portfolios – as described more fully in paragraphs 14 through 19 below – are performed by employees of FA4. Administrative support for legal, finance, accounting and other functions is also provided by employees of FA4. LP employs the equivalent of more than XXXXXXXXXX employees full time, taking into consideration the services provided by the employees of FA4. The compensation for the services performed by FA4’s employees is paid XXXXXXXXXX by LP to FA4 XXXXXXXXXX, or a XXXXXXXXXX.

9)    All LP Trusts were created under the XXXXXXXXXX, for US regulatory purposes. Under the trust agreement applicable to each LP Trust, LP is the settlor, the sole beneficiary and the sole administrator of the LP Trusts. As the sole trust administrator, LP is in charge of the administration and management of the LP Trusts and also has the responsibility of ensuring that the LP Trusts meet all of their obligations under the terms of their respective trust agreements. The trustee of the LP Trusts (XXXXXXXXXX) effectively only has legal title to the LP Trusts’ assets (the debt receivables comprising the portfolios).

10)   FA5 is a corporation governed by the XXXXXXXXXX. FA5 is a non-resident of Canada and a resident of the United States for the purposes of the Act and the US Tax Treaty. FA5 is a FA and CFA of Canco in which Canco has a Qualifying Interest. FA5 is a holding corporation. FA5 owns a XXXXXXXXXX% general partnership interest in LP, and all of the shares of the FA5 Subsidiaries.

11)   The FA5 Subsidiaries are entities governed by the XXXXXXXXXX are non-residents of Canada and residents of the United States for the purposes of the Act and the US Tax Treaty while the remaining FA5 Subsidiaries (all limited liability companies) are non-residents of Canada and residents of the United States for the purposes of the Act. The FA5 Subsidiaries are all FAs and CFAs of Canco in which Canco has a Qualifying Interest.

Over time, the FA5 Subsidiaries have acquired various portfolios for the purpose of execution via collection. The FA5 Subsidiaries have no employees, although FA5, XXXXXXXXXX each pays a percentage of the president’s salary and pay all employment related taxes. Therefore, all activities required to acquire, own and collect portfolios – as described more fully in paragraphs 14 through 19 below – are performed by employees of FA4. Administrative support for legal, finance, accounting and other functions is also provided by employees of FA4. As the FA5 Subsidiaries have no employees, the FA5 Subsidiaries are entirely dependent on the employees and organization of FA4 (LP’s XXXXXXXXXX% partner) to be in a position to carry on the activities that result in income being derived by the FA5 Subsidiaries from debt portfolios and/or structured loans.

12)   FA6 is a limited liability company governed by the XXXXXXXXXX. The activities of FA6 consist of granting loans within the XXXXXXXXXX Group. FA6 is a non-resident of Canada and a resident of the United States for the purposes of the Act. FA6 is a FA and CFA of Canco in which Canco has a Qualifying Interest.

Description of the XXXXXXXXXX Group business

13)   The XXXXXXXXXX Group specializes in the acquisition of debt receivables across the delinquency spectrum and seeks to liquidate them on a profitable basis through collections. The FA5 Subsidiaries, FA4 and LP acquire performing and non-performing portfolios of secured and unsecured debt over several asset classes, including XXXXXXXXXX. None of the FA5 Subsidiaries, FA4 and LP carry on business activities in Canada.

14)   The XXXXXXXXXX Group’s profitability is a function of its ability to (i) XXXXXXXXXX, (ii) XXXXXXXXXX, and (iii) XXXXXXXXXX. In this regard, significant work is involved by FA4’s employees in identifying and diligencing portfolios; XXXXXXXXXX to manage its portfolios and to maximize the profitability of those portfolios. These team members develop XXXXXXXXXX. In the past, the XXXXXXXXXX Group targeted portfolios of up to $XXXXXXXXXX, and in the last XXXXXXXXXX has bid on portfolios of $XXXXXXXXXX. The number of accounts in a given portfolio greatly depends on the asset class and the size of the portfolio.

15)   The bid and offer phase, through to closing of the acquisition of portfolios, when the bid is successful, require significant involvement of the FA4 legal and finance teams to XXXXXXXXXX a significant deployment of resources is required during the acquisition phase.

16)   Once portfolios are acquired by the XXXXXXXXXX Group, FA4’s employees deploy different operational strategies to realize on the portfolios. These strategies range from XXXXXXXXXX or are contracted to external service agents depending on the available servicing expertise for the applicable asset class and geographic markets. XXXXXXXXXX. For certain portfolios, as many as XXXXXXXXXX agencies may be retained by the XXXXXXXXXX Group. In such cases, FA4’s employees manage and monitor the performance of servicers, and establish the direction and operational strategies for realization of the portfolios. For other portfolios, XXXXXXXXXX, the accounts may all be placed with one specialized servicer. FA4 has approximately XXXXXXXXXX employees in Operations that include its XXXXXXXXXX. These employees manage the XXXXXXXXXX Group’s strategic partnerships, attorney and agency relationships and network of master servicers. This includes monitoring the overall performance of the investment, assisting with defining and executing the operational strategy and monitoring performance against the initial underwriting expectation.

17)   The activity of acquiring and collecting receivables is subject to a variety of licensing requirements federally and in several states. Certain FA5 Subsidiaries are licensed in different states; the licensing profile required in respect of a given portfolio will be a key factor in determining in which XXXXXXXXXX Group entity a portfolio will be acquired. Different asset types have different licensing requirements. States vary in terms of licensing by asset type and by owner vs. servicer. Depending on the licensing requirements, the XXXXXXXXXX Group will tend to purchase similar assets in one entity. XXXXXXXXXX Group management generally seeks to limit the aggregate investment in any single entity to $XXXXXXXXXX. As discussed above, certain portfolios, XXXXXXXXXX, have to be purchased in trust structures given the XXXXXXXXXX. 

18)   Portfolios are primarily realized through collections. However, FA4’s employees monitor each portfolio’s performance on a continuous basis. Occasionally, part or all of a purchased portfolio may be sold to maximize overall returns XXXXXXXXXX.

19)   To a lesser extent, the XXXXXXXXXX Group also originates structured loans to unrelated debt buyers in the distressed asset market. Structured financing is provided on a fully collateralized basis over debt receivables that XXXXXXXXXX Group itself would be willing to buy. To extend financing and price the loan effectively to other debt buyers, FA4’s employees employ the same sophisticated analytics and XXXXXXXXXX of the underlying portfolio as if FA4 were buying the portfolio itself. Thus the same effort and expertise goes into analyzing a portfolio for purchase as is required for extending a structured loan to a debt buyer. While the nature of the risk taken on in extending a structured loan is similar to that taken on in acquiring a portfolio, the XXXXXXXXXX Group can enhance its risk profile through structured loans since XXXXXXXXXX (for example, a XXXXXXXXXX Group entity will extend financing for XXXXXXXXXX% of the purchase price resulting in XXXXXXXXXX% less exposure than it would have had if it had acquired the portfolio). In return for a lower risk exposure, the XXXXXXXXXX Group entity will accept less return from the borrower than it would have wanted had it acquired the portfolio. Currently, structured loan activities are carried on by XXXXXXXXXX using FA4’s employees. Given that the expertise and functions that contribute to the structured loan activity, the work process involved and the risk profile are substantially related to the underlying portfolio, as is the case for portfolio acquisitions, the nature of the activity is one and the same as, and forms part of, the same business of acquiring portfolios.

20)   FA4 carries on the business of acquiring and collecting portfolios of debt receivables. The FA5 Subsidiaries and LP carry on the same type of business. Virtually all of the activities of the XXXXXXXXXX Group are, and will continue to be, performed by the employees of FA4.

21)   As at XXXXXXXXXX, FA4 owned portfolios valued at approximately $XXXXXXXXXX, representing approximately XXXXXXXXXX% of the value of all portfolios and structured loans owned by the XXXXXXXXXX Group. As at the same date, LP owned portfolios and structured loans valued at approximately $XXXXXXXXXX, representing approximately XXXXXXXXXX% of the value of all portfolios and structured loans XXXXXXXXXX owned by the XXXXXXXXXX Group.  Portfolios and structured loans owned by the entities in the XXXXXXXXXX Group are principally owned by FA4 and LP.

Transactions

22)   On XXXXXXXXXX, using funding received from FA6, the FA5 Subsidiary acquired from XXXXXXXXXX, an arm’s length person, the FA5 New Portfolio, being a pool of XXXXXXXXXX consisting of XXXXXXXXXX secured loans with an outstanding principal balance of $XXXXXXXXXX.

Additional Information

23)   FA3 owns other U.S. and non-U.S. subsidiaries. Some of these other subsidiaries own XXXXXXXXXX portfolios and carry on a similar business to that carried on by the XXXXXXXXXX Group. In general, these subsidiaries have XXXXXXXXXX employees. Accordingly, most of the activities of these other subsidiaries are, and will continue to be, performed by employees of FA4.

24)   The businesses of the FA5 Subsidiaries, FA4 and LP may be viewed as a single overall business enterprise. Furthermore, FA4 – directly and through LP – and the FA5 Subsidiaries each carry on the business of acquiring and collecting portfolios, and this would be a single business if they were carried on by a single affiliate.

25)   The activities of LP are critical to the profitability of the FA5 New Portfolio. The FA5 Subsidiary would not be able to carry out the income earning activities relating to the FA5 New Portfolio without the activities of LP.

26)   The business carried on by FA4 as a member of LP is an active business (within the meaning of subsection 95(1)) and the business of the FA5 Subsidiary, including its activities related to the FA5 New Portfolio, would be included in that active business if the business of the FA5 Subsidiary were carried on by FA4 as a member of LP.

27)   The FA4 Trusts as well as the LP Trusts are considered bare trusts for Canadian income tax purposes in that the trustee has legal ownership of the property and acts as agent for FA4 and LP with respect to all dealings with the trust assets.

Purpose of the Transactions

28)   The purpose of the transactions described in paragraph 22 is to acquire a new portfolio via one of the FA5 Subsidiaries in order to meet the commercial and practical constraints described in paragraph 17.

Rulings

Provided that:

a)    The above Facts, Transactions, Additional Information and Purpose of the Transactions constitute a complete and accurate disclosure of all of the information relevant to the ruling request;

b)    FA4, FA5 and the FA5 Subsidiary continue to be FAs and CFAs of Canco in which Canco has a Qualifying Interest and continue to be residents of the United States for the purposes of the Act and the US Tax Treaty; and

c)    LP is a partnership for purposes of the Act and its partners continue to be FA4 and FA5, in the proportions presented above;

We rule as follows, in reliance on the above information:

A.    The income earned by the FA5 Subsidiary from the accounts of the FA5 New Portfolio (the “Income”) will be included in computing the income or loss from an active business of the FA5 Subsidiary pursuant to subparagraph 95(2)(a)(i).

B.    The Income will be added to the exempt earnings of the FA5 Subsidiary pursuant to subclause (d)(ii)(A)(I) of the definition “exempt earnings” in subsection 5907(1) of the Regulations.

The above rulings are given subject to the limitations and qualifications set out in Information Circular 70-6R6 dated August 29, 2014, and are binding on the CRA with respect only to the acquisition of the FA5 New Portfolio by the FA5 Subsidiary.

The above rulings are based on the Act and Regulations as they currently exist on the date of this letter, and they do not take into account any proposed amendments to the Act and Regulations. Any such proposed amendments could, if enacted, have a material effect on the rulings provided herein.

Comments

Nothing in this ruling letter should be construed as implying that the CRA has agreed to, reviewed, or made any determination in respect of any other tax consequences relating to the Facts, Transactions and Additional Information described herein other than those specifically described in the rulings given above.

An invoice for our fees in connection with this ruling request will be sent to you under separate cover.

Yours truly,

XXXXXXXXXX
Section Manager
for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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