2015-0610561C6 2015 CTF Q.9 - s. 95(2)(a)(ii)(D)(IV)(2)

Principal Issues: In circumstances where the Second Affiliate and Third Affiliate are fiscally-transparent under the tax laws of a foreign jurisdiction, can sub-subclause 95(2)(a)(ii)(D)(IV)(2) be interpreted such that the condition will be met with respect to the Third Affiliate where, due to the interest expense incurred by the second affiliate as well as other expenses of that second affiliate, less than all or substantially all of the income earned by the Third Affiliate would be ultimately included in the income of the ultimate non-transparent member or shareholder?

Position: Yes

Reasons: In our view, the requirement in sub-subclause 95(2)(a)(ii)(D)(IV)(2) that the shareholders or members of the Third Affiliate are subject to income taxation “on all or substantially all of the income” of that affiliate does not mean the Second Affiliate cannot incur expenses. Rather, it means that the requirement will not be met where, generally, more than 10% of the income of the Third Affiliate is ultimately not subject to income taxation in a country other than Canada (e.g., a 20% shareholder or member is tax-exempt or otherwise not subject to income taxation in the foreign jurisdiction on the relevant income.

Author: Chang, Jack Yu-Fan
Section: 95(2)(a)(ii)(D)(IV)(2)

2015 Canadian Tax Foundation Conference
CRA Roundtable

Question 9 – Sub-subclause 95(2)(a)(ii)(D)(IV)(2): Fiscally Transparent Entities

One of the exceptions from treating interest income earned by a foreign affiliate of a Canadian taxpayer as FAPI is found in clause 95(2)(a)(ii)(D) of the ITA. In general terms, this provision applies when the interest is payable to the foreign affiliate by another foreign affiliate of the taxpayer (the “Second Affiliate”) on amounts borrowed by the Second Affiliate to acquire shares of another corporation (the “Third Affiliate”) where the acquired shares constitute excluded property and a number of other conditions are met.  One of those conditions is that both the Second Affiliate and the Third Affiliate must be subject to taxation in a country other than Canada or their direct or indirect members or shareholders must be subject to taxation in a country other than Canada in respect of all or substantially all of the particular affiliate’s income for the relevant taxation year. This latter provision is to enable limited liability companies and other similar fiscally transparent entities to meet the conditions. 

However, an issue arises where both the Second Affiliate and the Third Affiliate are fiscally transparent. Due to the interest expense incurred by the Second Affiliate as well as other expenses that the Second Affiliate may incur, it is possible that less than 90% of the income earned by the Third Affiliate will be included in the income of the ultimate non-transparent member.

Can the CRA confirm that it will interpret sub-subclause 95(2)(a)(ii)(D)(IV)(2) such that the condition will be met with respect to the Third Affiliate provided that all or substantially all of the Third Affiliate’s net income is included in the income of Second Affiliate and the Second Affiliate meets the requirements of sub-subclause 95(2)(a)(ii)(D)(IV)(2)?

CRA Response

In general, for the purpose of sub-subclause 95(2)(a)(ii)(D)(IV)(2) of the Act, it is our view that “subject to income taxation” means that the income is included in the computation of the taxable income in the relevant country. Where the Second Affiliate and Third Affiliate are fiscally transparent, the shareholders or members of the Second Affiliate would still be considered to be subject to income taxation on the income earned by the Third Affiliate notwithstanding that the Second Affiliate incurred interest expense on the loan used to acquire the shares of the Third Affiliate.

In our view, the requirement in sub-subclause 95(2)(a)(ii)(D)(IV)(2) that the shareholders or members of the Third Affiliate are subject to income taxation “on all or substantially all of the income” of that affiliate does not mean that the Second Affiliate cannot incur deductible expenses.  Rather, it means that the requirement will not be met where, generally, more than 10% of the income of the Third Affiliate is ultimately not subject to income taxation in a country other than Canada (e.g., a 20% shareholder or member is tax-exempt or otherwise not subject to income taxation in the foreign jurisdiction on the relevant income).

Therefore, provided that the requirements in sub-subclause 95(2)(a)(ii)(D)(IV)(2) are otherwise satisfied, the fact that the Second Affiliate has incurred interest or other expenses will not cause the requirements of sub-subclause 95(2)(a)(ii)(D)(IV)(2) not to be met.

Jack Chang
2015-061056
November 24, 2015

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