2015-0592551I7 Excluded property status of partnership interest

Principal Issues: Is the disposition of a partnership interest by a foreign affiliate, on the partnership's dissolution, a disposition of "excluded property"? Can a parent foreign affiliate carry back the losses of its wound-up subsidiary to its prior taxation years?

Position: No, not in this case. No.

Reasons: Immediately before the final distribution of partnership property, the partnership held no excluded property. Subsection 5903(5) of the Regulations does not permit a parent affiliate to apply FAPL of the dissolved subsidiary affiliate to the parent's taxation years prior to the dissolution.

Author: Johns, Jeffrey
Section: 91(1), 95(1) "foreign accrual property income", "excluded property", 5903(1), 5903(5)

                                    March 27, 2018

Attention: XXXXXXXXXX                        HEADQUARTERS
Canada Revenue Agency                        Income Tax Rulings
Compliance Programs Branch                      Directorate 
International and Large Business Directorate        Jeffrey Johns
XXXXXXXXXX                                (416) 954 4020

                                    2015-059255

Whether Partnership Interest Is Excluded Property

Facts

Our understanding of the facts as you presented them to us is as follows:

1.    XXXXXXXXXX (“CANCO1”) and XXXXXXXXXX (“CANCO2”) are two XXXXXXXXXX corporations.  Both CANCO1 and CANCO2 are wholly-owned subsidiaries of XXXXXXXXXX (“Parent”), a corporation resident in Canada.

2.    XXXXXXXXXX was incorporated by CANCO2 in XXXXXXXXXX.  At all times up to the time CANCO2 disposed of all of its shares in XXXXXXXXXX, as described in Fact 10(b), XXXXXXXXXX was a wholly-owned subsidiary of CANCO2 and a foreign affiliate and controlled foreign affiliate of CANCO2.

3.    In XXXXXXXXXX, CANCO2 acquired XXXXXXXXXX% of the shares in the capital of XXXXXXXXXX from Parent for C$XXXXXXXXXX.  At all times up to the time CANCO2 disposed of all of its shares in XXXXXXXXXX, as described in Fact 10(a), it was a wholly-owned subsidiary of CANCO2 and a foreign affiliate and controlled foreign affiliate of CANCO2.

4.    In XXXXXXXXXX, after CANCO2 acquired the shares of XXXXXXXXXX, XXXXXXXXXX (“FORP”) was established in Iceland and registered under the laws of Iceland as a “Sameignarfelag”.  Capital contributions were made to FORP in XXXXXXXXXX of US$XXXXXXXXXX by XXXXXXXXXX and US$XXXXXXXXXX by XXXXXXXXXX for a total of US$XXXXXXXXXX.

5.    FORP has used all capital contributions by the members / partners to provide debt financing, at interest, to affiliated companies within the Parent corporate group.  In turn, the affiliated companies have applied the loan proceeds to active business activities and / or investments that produce / generate active business income.

Throughout the existence of FORP, the majority of its earnings have been interest earned in respect of these loans, and XXXXXXXXXX and XXXXXXXXXX’s respective shares thereof have been recharacterized under subparagraph 95(2)(a)(ii) as active business income.  

6.    For purposes of the Act: 

a.    FORP is considered to be a partnership; and

b.    the capital distributions made from FORP to XXXXXXXXXX and XXXXXXXXXX would be considered to have been paid and received as a reduction of partnership capital from FORP. 

7.    From XXXXXXXXXX to XXXXXXXXXX, FORP made a number of distributions to the partners and a number of reductions of partnership capital.

8.    Immediately prior to the transactions described in Paragraph 9, FORP held loans (the “Loans”) the income from which was recharacterized as income from an active business under subparagraph 95(2)(a)(ii) vis-a-vis XXXXXXXXXX and XXXXXXXXXX.  Immediately before their disposition, the fair market value (“FMV”) of the Loans constituted more than XXXXXXXXXX% of the total FMV of the assets of FORP.

9.    On XXXXXXXXXX:

a.    pursuant to a purchase agreement between XXXXXXXXXX and XXXXXXXXXX, XXXXXXXXXX acquired an additional XXXXXXXXXX% of the partnership interest in FORP from XXXXXXXXXX for US$XXXXXXXXXX;  

b.    FORP disposed of each of the Loans to a non-resident corporation within the Parent’s international corporate group in exchange for cash proceeds; 

c.    FORP distributed US$XXXXXXXXXX to XXXXXXXXXX as a return of capital; and

d.    XXXXXXXXXX made two distributions to CANCO2 (US$XXXXXXXXXX as a dividend and US$XXXXXXXXXX as a return of capital).

10.    On XXXXXXXXXX:

a.    CANCO2 sold its shares of XXXXXXXXXX to XXXXXXXXXX.  XXXXXXXXXX is a corporation not resident in Canada and a wholly-owned controlled foreign affiliate of CANCO1; and
 
b.    CANCO2 sold its shares of XXXXXXXXXX to XXXXXXXXXX, XXXXXXXXXX is a corporation not resident in Canada and a wholly-owned controlled foreign affiliate of Parent.

11.    On XXXXXXXXXX, all remaining assets of FORP, being US$XXXXXXXXXX in cash, were distributed to its members: US$XXXXXXXXXX to XXXXXXXXXX and US$XXXXXXXXXX to XXXXXXXXXX.

12.    On XXXXXXXXXX, FORP was dissolved under Icelandic law.

13.    On XXXXXXXXXX, XXXXXXXXXX resolved to liquidate XXXXXXXXXX and on XXXXXXXXXX, XXXXXXXXXX was dissolved into XXXXXXXXXX.

Taxpayer’s Position

The taxpayer has taken the position that:

a.    at the time it was disposed of, the partnership interest was not excluded property and, therefore, the capital gain or loss from the disposition was included in XXXXXXXXXX’s foreign accrual property income (“FAPI”) in respect of CANCO1; and

b.    as the gain or loss was to be included in XXXXXXXXXX’s FAPI, pursuant to paragraph 95(2)(f.14), it was computed in Canadian currency – therefore, the computation of the ACB of XXXXXXXXXX’s partnership interest in FORP, pursuant to paragraph 95(2)(j) of the Act and subsection 5907(12) of the Regulations, was to be computed in Canadian currency, including each capital contribution and reduction, earnings pick up, and distribution.

Taking this approach, XXXXXXXXXX calculated a foreign accrual property loss (“FAPL”) of C$XXXXXXXXXX for its XXXXXXXXXX taxation year.  The Taxpayer is of the view that this FAPL became a loss of XXXXXXXXXX upon the dissolution of XXXXXXXXXX.  On this basis, CANCO1 has requested that this loss be applied to XXXXXXXXXX’s XXXXXXXXXX and XXXXXXXXXX taxation years.

Proposed position

It has been proposed to CANCO1 that the FORP partnership interest was excluded property at the time of disposition.  Therefore the gain or loss from the disposition of the partnership interest by XXXXXXXXXX should be determined using XXXXXXXXXX’s “calculating currency” pursuant to paragraph 95(2)(f.12) and that any gain or loss should not be included in determining XXXXXXXXXX’s FAPI.  Using this methodology, you have determined that XXXXXXXXXX realized a gain of US$XXXXXXXXXX on the disposition. 

Issue

You have asked for our views on the following question in respect of the disposition by XXXXXXXXXX of its partnership interest in FORP: For purposes of applying the definition, “excluded property” in subsection 95(1), what is the appropriate interpretation of the phrase “at a particular time”? Specifically, at what point in time is the determination of whether the FORP partnership interest qualifies as excluded property to be made?

In addressing your question below, we also provide our views on the method by which a capital gain or loss in this situation would be determined.

In addition, you have also asked for our views on whether any FAPL realized by XXXXXXXXXX can be applied to XXXXXXXXXX’s XXXXXXXXXX and XXXXXXXXXX taxation years.

Analysis

The analysis below is based on the Act as it read at the time of the transactions relevant to your query.

1.    Determination of whether FORP interest is excluded property

A.    Timing of disposition of partnership interest on windup into foreign affiliate

As indicated in Income Tax News No. 38, to determine the status of a foreign entity for Canadian tax purposes, the two-step approach is generally followed:

1. Determine the characteristics of the foreign business association under foreign commercial law;

2. Compare these characteristics with those of recognized categories of business associations under Canadian commercial law in order to classify the foreign business association under one of those categories. 

Under Canadian law, the three essential ingredients to the formation of a valid partnership are: a business, carried on in common, and with a view to profit.  In this case, you have informed us that you have accepted as fact that FORP qualifies as a partnership for purposes of the Act.  In this regard, we note that in Advance Income Tax Ruling #2006-0187681R3, issued in 2007, the Rulings Directorate concluded that the Sameignarfelag discussed in that ruling would qualify as a partnership for purposes of the Act.

The cessation of the existence of a partnership will cause a disposition under the Act of the partner’s interest in the partnership.  The determination of whether or not a partnership ceases to exist will depend on the partnership agreement and the relevant partnership law.  In this case, the Icelandic law under which FORP was established and governed considered FORP officially dissolved on XXXXXXXXXX.

It may be possible to argue that, for purposes of the Act, FORP ceased to exist at a date earlier than the date it was officially dissolved under Icelandic law.  If that were the case, subsection 98(1) of the Act would be applicable.  Subsection 98(1) provides that, notwithstanding that a partnership may cease to exist at law, it is deemed to continue for purposes of the Act until such time as all of the partnership property has been distributed to those entitled by law to receive it.

As subsection 98(1) applies for the purpose of the entire Act, it is applicable in determining the timing of the disposition of a partnership interest by a foreign affiliate.  Therefore, if it were determined that FORP did cease to exist before it was officially dissolved, subsection 98(1) would deem the partnership to cease to exist as of XXXXXXXXXX, the date of the last distribution of FORP’s assets.

In our view, the date of disposition of the FORP partnership interest would either be XXXXXXXXXX, pursuant to the application of subsection 98(1), or XXXXXXXXXX, the formal date of dissolution of FORP.  As described below, our conclusion regarding whether the FORP partnership interest was excluded property at the time it was disposed of will be the same regardless of which of the two dates apply.  As a result, it was not necessary to make a final determination on this issue.

B.    Determination of whether disposition of partnership interest by foreign affiliate is disposition of excluded property

The definition of excluded property includes four categories:

*    paragraph (a) provides that any property used or held by a foreign affiliate principally for the purpose of gaining or producing income from an active business is excluded property;

*    paragraph (b) provides that shares owned by a foreign affiliate of a taxpayer of the capital stock of another foreign affiliate of the taxpayer are excluded property if all or substantially all of the property of the other foreign affiliate is excluded property; 

*    paragraph (c) provides that property all or substantially all of the income from which is (or would be, if there were income from the property) income from an active business (including income deemed to be income from an active business by paragraph 95(2)(a)) is excluded property; and

*    paragraph (c.1) includes certain properties used in hedging agreements.

The excluded property definition also includes paragraphs (d) and (e).  These paragraphs deem, for the purposes of the definitions “foreign affiliate” in subsection 95(1) and “direct equity percentage” in subsection 95(4), a partnership to be a non-resident corporation having capital stock of a single class divided into one class of 100 issued shares and whose partners hold those shares on a pro-rata basis, based on their percentage interest in the FMV of the partnership.  Therefore, a partnership interest qualifies as “excluded property” where the interest (deemed for this purpose to be shares of a corporation) satisfies the conditions of paragraph (b) of the excluded property definition.  In other words, a partnership interest held by a foreign affiliate of a taxpayer will be considered to be excluded property when the partnership would be a foreign affiliate of the taxpayer when the deeming rules in paragraphs (d) and (e) in the definition of “excluded property” are applied and if substantially all of the FMV of the property of the partnership itself satisfies the excluded property definition. (endnote 1) 

As there was not an active business carried on within FORP, in determining whether XXXXXXXXXX’s partnership interest is excluded property, any assets of the partnership would not qualify as excluded property under paragraph (a).  However, any assets held by the partnership on which income was or would be recharacterized as active would qualify as excluded property under paragraph (c).  Therefore, the Loans, while they were held by FORP, would have been excluded property.

C.    Relevant time or period for determining whether partnership interest is excluded property

The preamble of the definition of “excluded property” states that the determination is to be made “a particular time”.  We have not previously commented on the meaning of “a particular time” in determining whether a partnership interest qualifies as excluded property.

However, in external technical interpretation 2014-0536331E5, we looked at the meaning of “a particular time” in the context of determining whether property deemed disposed of under subsection 88(3) would qualify as “excluded property”.

The preamble to subsection 88(3) of the Act makes reference to the “time a taxpayer receives a property” from a foreign affiliate on the liquidation and dissolution of the affiliate.  Where paragraph 88(3)(a) of the Act does not apply, paragraph 88(3)(b) provides that the property of the affiliate is deemed to have been disposed of “at that time” (i.e. the time referred to in the pre-amble) by the affiliate to the taxpayer for proceeds of disposition equal to the distributed property’s fair market value.

The question addressed in 2014-0536331E5 was whether, given that the property is deemed to have been disposed of at the time the taxpayer receives the property, it could qualify as excluded property at that time under paragraph (a) of that definition in subsection 95(1) of the Act.

In response, we stated our view that property that is used or held by a foreign affiliate for the purpose of gaining or producing income from an active business immediately before its distribution on the liquidation and dissolution of the affiliate will be excluded property at the time of the deemed disposition described in paragraph 88(3)(b) of the Act.

As discussed above, in our view, the FORP partnership interest was disposed of by XXXXXXXXXX either on XXXXXXXXXX or XXXXXXXXXX.  If the disposition were on XXXXXXXXXX, immediately before the disposition of the FORP partnership interest (i.e. the time the last property of the partnership was distributed), the partnership held only US$XXXXXXXXXX cash.  The cash would not qualify under paragraph (a) of the excluded property definition, as FORP was not carrying on an active business at that time.  Nor in our view could it be argued that the cash was being used in a continuation of the active business activities undertaken by FORP, as it had never carried on an active business.  Finally, the cash would also not qualify under paragraph (c) of the excluded property definition, as any income from the cash would not be recharacterized under paragraph 95(2)(a).

If the disposition were on XXXXXXXXXX, then immediately before the disposition FORP will not have held property of any kind. As a result, regardless of whether the disposition was on XXXXXXXXXX, the requirement in paragraph (b) of the “excluded property” definition (as altered by paragraphs (d) and (e) of that definition) that all or substantially all of the FMV of the property of FORP be attributable to “excluded property” will not be met.  Therefore, the disposition of the FORP partnership interest by XXXXXXXXXX would not be a disposition of excluded property.

D.    Determination of gain or loss when foreign affiliate disposes of partnership interest – excluded property/non-excluded property

Paragraph 95(2)(f) requires that a foreign affiliate’s capital gain or capital loss from a disposition of property is to be determined as if the affiliate were at all times resident in Canada, i.e. under Part I of the Act using the rules in Subdivision c of Division B.

However, where the disposition is of a partnership interest, paragraph 95(2)(j) provides that the ACB of the partnership interest to the foreign affiliate is to be determined according to the rules in subsection 5907(12) (now 5908(10)) of the Regulations.

Subsection 5907(12) provided, generally, that there would be added to the ACB:

*    profits of the partnership included in the active business income of the foreign affiliate;

*    profits of the partnership included in the FAPI of the foreign affiliate;

*    capital gains of the partnership to the extent they are included in the “exempt earnings” or “taxable earnings” of the foreign affiliate;

*    contributions of capital to the partnership; and 

*    refunds of income taxes paid to a government.

It also provided for the following deductions from ACB:

*    losses of the partnership included in the loss of the foreign affiliate;

*    losses of the partnership included in the computation of the FAPI of the foreign affiliate;

*    capital losses of the partnership to the extent they are included in the “exempt earnings” or “taxable earnings” of the foreign affiliate;

*    distributions of profits or capital to the foreign affiliate;

*    any amount included in the loss of the affiliate for a taxation year ending after 1971 that may reasonably be considered to relate to a loss of the partnership; and

*    amounts of income taxes paid to a government.

Paragraphs 95(2)(f) and (j) apply to a disposition regardless of whether the property qualifies as excluded property or not.  However, the taxable capital gain or allowable capital loss from the disposition will generally only be included in the computation of the foreign affiliate’s FAPI where it is a disposition of property that is not excluded property.  Further, paragraph 95(2)(f.14) requires that any capital gain or loss from a disposition of property that is not excluded property is to be computed using Canadian currency.

In contrast, a capital gain or loss of property that is excluded property is, pursuant to paragraph 95(2)(f.12), to be computed using the foreign affiliate’s “calculating currency” (defined in subsection 95(1)) and any gain or loss will not affect the determination of the foreign affiliate’s FAPI.  However, that amount will be relevant to the determination of the affiliate’s “exempt earnings” or “taxable earnings”, as defined in subjection 5907(1) of the Regulations and affect the amount of a deduction taken under subsection 113(1) in respect of a dividend paid by a foreign affiliate to its Canadian-resident shareholder.

In respect of a disposition of property that is not excluded property, calculating the capital gain or loss in Canadian currency will require that both the proceeds of disposition and each component of the property’s ACB are calculated in Canadian currency.  Where any of these amounts are denominated in a currency other than Canadian, paragraph 261(2)(b) would apply to convert the amount to Canadian currency using the relevant spot rate for the day the amount arose.

In the context of the disposition of a partnership interest that is not excluded property, each of the adjustments to ACB required by subsection 5907(12) (now 5908(10)) of the Regulations would need to be calculated in Canadian currency.  A number of the amounts relevant to an ACB adjustment in respect of a partnership interest that is not excluded property may have been initially calculated in a foreign affiliate’s calculating currency.  For example, the partnership may have previously earned income from an active business or realized capital gains from the disposition of excluded property.  In these circumstances, paragraph 261(2)(b) would apply to convert the amount to Canadian currency using the relevant spot rate for the day the amount arose.

As discussed above, the determination of whether a property disposed of is excluded property is dependent on whether the property qualifies as excluded property at the time of disposition.  This is the case regardless of whether the property may have been excluded property for a period of the time, or even the majority of the time, it was held by the foreign affiliate.  As a result, adjustments to ACB that may be the result of amounts that arose at a time while the property was excluded property will still need to be computed in Canadian currency, and if denominated in another currency, converted to Canadian currency at the relevant spot rate for the day the amount arose.

With respect to the partnership interest in FORP, because it was not excluded property at the time it is disposed of by XXXXXXXXXX, each of the additions and subtractions to XXXXXXXXXX’s ACB in the partnership interest as required by subsection 5907(12) will need to be computed in Canadian currency as of the date they arose.

2.    Carryback of FAPL by XXXXXXXXXX

Subsection 5903(5) of the Regulations provides for the flow-through of FAPLs upon certain foreign mergers or liquidations involving foreign affiliates.  For the relevant taxation years of XXXXXXXXXX and XXXXXXXXXX, paragraph 5903(5) provided that, for the purpose of section 5903, where a subsidiary foreign affiliate is wound up into a parent foreign affiliate, and the surplus entitlement percentage of the taxpayer resident in Canada in each affiliate is not less than XXXXXXXXXX%, then the parent foreign affiliate is “deemed to be the same corporation as, and a continuation of” the subsidiary affiliate.

As CANCO1 held a XXXXXXXXXX% direct interest in XXXXXXXXXX and a XXXXXXXXXX% indirect interest in XXXXXXXXXX, the requirements of paragraph 5903(5)(b) would be met and XXXXXXXXXX would be considered to be the same corporation as, and a continuation of XXXXXXXXXX.

Section 5903 deals only with carrybacks and carryforwards of FAPL.  Subsection 5903(5) applies only for the purpose of section 5903. There are no provisions that would transfer a specific loss realized in a taxation year of a subsidiary to be transferred to its parent.  As well, FAPL is an amount that is computed in respect of a taxation year.

Therefore, subject to meeting the other requirements of section 5903, as a result of the application of paragraph 5903(5)(b), the FAPL of XXXXXXXXXX for its pre-dissolution taxation years will be available to reduce the amount of XXXXXXXXXX’s FAPI for its post-dissolution taxation years.  It would also be possible for XXXXXXXXXX to apply a FAPL for a post-dissolution taxation year to a pre-dissolution taxation year.

However, in our view, the deeming rule does not permit the use of a FAPL of a dissolved subsidiary for a pre-dissolution taxation year to reduce the FAPI of a parent for one of its pre-dissolution years, for the following reasons:

1.    The deliberate addition by Parliament of the phrase “continuation of” makes it clear that the deeming provision was intended to operate in a before/after manner.

2.    The calculation of FAPI is done on an affiliate-by-affiliate basis.  The FAPL of an affiliate for a taxation year may only be used to reduce the amount of that affiliate’s FAPI for another taxation year.  Netting the amount of FAPL for a year of one affiliate against the FAPI of another affiliate is not permitted.  Permitting the use of the subsidiary’s FAPL against the FAPI of the parent for a pre-dissolution taxation year goes against this principle.

3.    Our interpretation is consistent with the application of the equivalent rules that apply in respect of corporations resident in Canada.  Where a windup that is subject to subsection 88(1) (i.e. the wind-up of a 90% or more owned subsidiary into its parent), subsections 88(1.1) and (1.2) apply to determine the effect of the wind-up on the non-capital losses and capital losses of the subsidiary corporation.  Similar to paragraph 5903(5)(b), this rule permits the parent corporation to deduct the losses of its subsidiary in computing its taxable income for any of its taxation years beginning after the commencement of the subsidiary’s winding-up, but does not permit the application of any losses of the subsidiary to the parent’s previous taxation years.  The same treatment also applies in respect of vertical amalgamations, pursuant to subsections 87(2.1) and (2.11). (endnote 2)

As a result, XXXXXXXXXX cannot use XXXXXXXXXX’s FAPL for its last taxation year to reduce the amount of FAPI in its taxation years before XXXXXXXXXX’s dissolution.

As a final point, we note that if our view is incorrect, and paragraph 5903(5)(b) would deem XXXXXXXXXX and XXXXXXXXXX to be the same corporation for all of their pre-wind-up years, that interpretation would require that the FAPI of each corporation for each of their concurrent taxation years be netted against losses of the other for the purposes of determining any FAPL.  Thus XXXXXXXXXX’s loss from the disposition of the FORP partnership interest would need to be netted against XXXXXXXXXX’s FAPI for its concurrent taxation year.  As a result, the FAPL would be reduced and potentially eliminated.

We trust our comments will be of assistance.

Yours truly,

Terry Young, CPA, CA 
Section Manager
for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

ENDNOTES

1 See documents 2008-0288021E5 and 2007-0251651E5
2 Document 9429010.
 

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