2015-0617351R3 payments under a German profit transfer agrmt “PTA"

Principal Issues: 1. Are upstream payments under a PTA in the given fact pattern deemed to be dividends under subsection 90(2) and would they be treated accordingly for surplus computation purposes? 2. Are downstream payments under a PTA in the given fact pattern considered capital contributions for purposes of paragraph 53(1)(c) and would they be treated accordingly for purposes of computing “earnings” or “loss” of the relevant foreign affiliate?

Position: 1.Yes.2.Yes.

Reasons: Legislation

Author: XXXXXXXXXX
Section: 90(2); 53(1)(c)

XXXXXXXXXX                                                                                                                                    2015-061735

XXXXXXXXXX, 2016

Dear XXXXXXXXXX:

Re:   XXXXXXXXXX
        Advance Income Tax Ruling

We are writing in reply to your most recent letter (XXXXXXXXXX) in which you requested an advance income tax ruling (“Ruling Letter”) on behalf of the above-referenced taxpayer (“Pubco”).  We acknowledge the additional information you provided through emails and during our telephone conversations.

Pubco’s tax affairs are administered by the XXXXXXXXXX Tax Services Office and it files its tax returns at the XXXXXXXXXX Taxation Centre.

We understand that, to the best of your knowledge and that of Pubco, none of the issues in this Ruling Letter:

(i)   is in an earlier return of Pubco or a related person;

(ii)  is being considered by a Tax Services Office or a Taxation Centre in connection with a tax return already filed by Pubco or a related person;

(iii) is under objection by Pubco or a related person;

(iv)  is before the courts or, if a judgement has been issued, the time limit for appeal has not expired; or

(v)   is the subject of a Ruling previously issued by the Directorate after XXXXXXXXXX.

Rulings issued to Pubco prior to XXXXXXXXXX did not consider the application of subsection 90(2) of the Income Tax Act to the proposed transactions, which is the key issue of this Ruling.

This document is based solely on the Facts and Proposed Transactions described below.  The documentation submitted with your request does not form part of the Facts and Proposed Transactions and any references thereto are provided solely for the convenience of the reader.

Unless otherwise stated, all references to a statute are references to the provisions of the Income Tax Act, R.S.C. 1985 (5th Supp.), c.1, as amended to the date hereof (the “Act”), and every reference herein to a Part, section, subsection, paragraph or subparagraph is a reference to the relevant provisions of the Act.

Our understanding of the Facts, Additional Information, Proposed Transactions and the Purpose of the Proposed Transactions is as follows:

Definitions

In this letter the words and expressions that are defined for the purposes of the Act and the Regulations shall have the same meanings for the purpose hereof, unless otherwise specified herein, and in this letter:

a.    “controlled foreign affiliate” has the meaning assigned by subsection 95(1) of the Act;

b.    “FA1” described in paragraph 4 is XXXXXXXXXX;

c.    “FA2” described in paragraph 5 is XXXXXXXXXX;

d.    “FA3” described in paragraph 6 is XXXXXXXXXX;

e.    “FA4” described in paragraph 7 is XXXXXXXXXX;

f.    “FA5” described in paragraph 9 is XXXXXXXXXX;

g.    “FA5 Subsidiaries” described in paragraph 10 are various subsidiaries of XXXXXXXXXX;

h.    “foreign affiliate” has the meaning assigned by subsection 95(1) of the Act;

i.    “GAAP” means Generally Accepted Accounting Principles;

j.    “GCITA” means the German Corporate Income Tax Act;

k.    “GmbHA” means the GmbH Act;

l.    “GSCA” means the German Stock Corporation Act;

m.    “GTTA” means the German Trade Tax Act;

n.    “KG” described in paragraph 8 is XXXXXXXXXX;

o.    “New FA3” means the company formed on the merger of FA3 and FA4 as described in paragraph 21;

p.    “Organschaft” is the German tax consolidation regime described in paragraphs 15 and 16;

q.    “PTA1” means the profit and loss transfer agreement described in paragraph 11;

r.    "PTA2” means the profit and loss transfer agreement described in paragraph 12;

s.    “Pubco” described in paragraph 1 is XXXXXXXXXX;

t.    “public corporation” has the meaning assigned by subsection 89(1) of the Act;

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

v.    “statutory profit” or “statutory loss” of a corporation for a particular taxation year of the corporation is the profit or loss, as the case may be, of the corporation for that year as determined under German generally accepted accounting principles;

w.    “taxable Canadian corporation” has the meaning assigned by subsection 89(1) of the Act;

x.    “XXXXXXXXXX1” described in paragraph 2 is XXXXXXXXXX; and

y.    “XXXXXXXXXX2” described in paragraph 3 is XXXXXXXXXX.

Facts

1.    Pubco is a taxable Canadian corporation and a public corporation.  Pubco operates a XXXXXXXXXX both directly and indirectly through affiliated corporations, including foreign affiliates, throughout the world.  The business of Pubco is comprised of XXXXXXXXXX.

2.    XXXXXXXXXX1 is a corporation governed by the laws of XXXXXXXXXX.  XXXXXXXXXX1 is a non-resident of Canada and a resident of XXXXXXXXXX for the purposes of the Act and the Canada-XXXXXXXXXX Income Tax Convention.  XXXXXXXXXX1 is an indirect subsidiary, and a foreign affiliate and controlled foreign affiliate, of Pubco.  XXXXXXXXXX1 does not carry on an active business.

3.    XXXXXXXXXX2 is a corporation governed by the laws of XXXXXXXXXX.  XXXXXXXXXX2 is a non-resident of Canada and a resident of XXXXXXXXXX for the purposes of the Act and the Canada-XXXXXXXXXX Income Tax Convention.  XXXXXXXXXX2 is a foreign affiliate and controlled foreign affiliate of Pubco and all its shares are held by XXXXXXXXXX1.  XXXXXXXXXX2 does not carry on an active business.

4.    FA1 is a corporation governed by the laws of XXXXXXXXXX.  FA1 is a non-resident of Canada and a resident of XXXXXXXXXX for the purposes of the Act and the Canada-XXXXXXXXXX Income Tax Convention.  FA1 is a foreign affiliate and controlled foreign affiliate of Pubco and its shares are indirectly held by XXXXXXXXXX2.  FA1 is carrying on an active XXXXXXXXXX business.

5.    FA2 is a corporation governed by the laws of Germany.  FA2 is a non-resident of Canada and a resident of Germany for the purposes of the Act and the Canada-Germany Income Tax Convention.  FA2 is a foreign affiliate and controlled foreign affiliate of Pubco and its shares are indirectly held by FA1.  FA2 does not carry on an active business.

6.    FA3 is a corporation governed by the laws of Germany.  FA3 is a non-resident of Canada and a resident of Germany for the purposes of the Act and the Canada-Germany Income Tax Convention.  FA3 is a foreign affiliate and controlled foreign affiliate of Pubco and all of its shares are held by FA2.  FA3 does not carry on an active business.  The share ownership of FA3 is outlined in the table below:

Holder of       Number             Share capital          % of share          Number of         % of votes
FA3 Shares  of Shares           XXXXXXXXXX        capital                votes

FA2               XXXXXXXXXX  XXXXXXXXXX        XXXXXXXXXX  XXXXXXXXXX  XXXXXXXXXX
Total              XXXXXXXXXX  XXXXXXXXXX        XXXXXXXXXX  XXXXXXXXXX  XXXXXXXXXX

7.    FA4 is a corporation governed by the laws of Germany.  FA4 is a non-resident of Canada and a resident of Germany for the purposes of the Act and the Canada-Germany Income Tax Convention.  FA4 is a foreign affiliate and controlled foreign affiliate of Pubco and all of its shares are held by FA2.  FA4 is carrying on an active XXXXXXXXXX business.

8.    KG is formed under the laws of Germany and is treated as a partnership for purposes of those laws.  FA1 is the general partner but holds no partnership interest in KG.  XXXXXXXXXX2 holds a XXXXXXXXXX% limited partnership interest in KG.

9.    FA5 is a corporation governed by the laws of Germany.  FA5 is a non-resident of Canada and a resident of Germany for the purposes of the Act and of the Canada-Germany Income Tax Convention.  FA5 is a foreign affiliate and controlled foreign affiliate of Pubco.  FA5 is carrying on an active XXXXXXXXXX business.  The share ownership of FA5 is outlined in the table below (according to the articles of association of FA5 each XXXXXXXXXX of share capital participation grants one vote):

Holder of           Number              Share capital           % of share       Number of           % of votes
FA5 Shares       of Shares           XXXXXXXXXX        capital               votes

KG                     XXXXXXXXXX  XXXXXXXXXX        XXXXXXXXXX  XXXXXXXXXX  XXXXXXXXXX
FA2                   XXXXXXXXXX  XXXXXXXXXX        XXXXXXXXXX  XXXXXXXXXX  XXXXXXXXXX
FA3                   XXXXXXXXXX  XXXXXXXXXX        XXXXXXXXXX  XXXXXXXXXX  XXXXXXXXXX
FA4                   XXXXXXXXXX  XXXXXXXXXX        XXXXXXXXXX  XXXXXXXXXX  XXXXXXXXXX
Total                  XXXXXXXXXX  XXXXXXXXXX        XXXXXXXXXX  XXXXXXXXXX  XXXXXXXXXX

10.   FA5 Subsidiaries are direct or indirect subsidiaries of FA5 and are corporations governed by the laws of the relevant foreign countries.  FA5 Subsidiaries are non-residents of Canada and residents of their respective countries of incorporation for the purposes of the Act and of the relevant Income Tax Convention that Canada has with each such country, if any.  FA5 Subsidiaries are foreign affiliates and controlled foreign affiliates of Pubco.  Most of the FA5 Subsidiaries carry on active XXXXXXXXXX businesses.

11.   In XXXXXXXXXX, FA5 and FA3 entered into a profit and loss transfer agreement (“PTA1”) governed by the GSCA.  Under PTA1, FA5 obliged itself to transfer its statutory profits to FA3, while FA3 committed itself to cover any statutory losses of FA5.  PTA1 was concluded, in part, to establish an Organschaft between FA5 and FA3 for the purposes of the GCITA and GTTA.  For each taxation year, FA5, which carried on an active business, computed its taxable income (or loss) under the GCITA and the GTTA and reduced that income (or loss) to nil pursuant to the Organschaft existing between FA5 and FA3.

12.   At the same time, FA3 and FA2 entered into a profit and loss transfer agreement (“PTA2”) governed by the GSCA.  Under PTA2, FA3 obliged itself to transfer its statutory profits to FA2, while FA2 committed itself to cover any statutory losses of FA3.  PTA2 was concluded, in part, to establish an Organschaft between FA3 and FA2 for the purpose of the GCITA and GTTA.  For each taxation year, FA3, which did not carry on an active business, computed its taxable income (or loss) under the GCITA and the GTTA and reduced that income (or loss) to nil pursuant to the Organschaft existing between FA3 and FA2.

13.   At the same time FA4 and FA2 entered into a profit and loss transfer agreement (“PTA3”) governed by the GSCA.  Under PTA3, FA4 obliged itself to transfer its statutory profit to FA2, while FA2 committed itself to cover any statutory losses of FA4.  PTA3 was concluded, in part, to establish an Organschaft between FA4 and FA2 for the purpose of the GCITA and GTTA.  For each taxation year, FA4, which carried on an active business, computed its taxable income (or loss) under the GCITA and the GTTA and reduced that income (or loss) to nil pursuant to the Organschaft existing between FA4 and FA2.

14.   As required by the GSCA, PTA1 provides that adequate compensation payments (“Compensation Payments”) must be made to outside shareholders to compensate them for the loss of potential dividend income that arises by reason of the fact that under PTA1 all the statutory profit of FA5 is transferred to FA3.  Throughout the subsistence of PTA1, KG has received and will continue to receive annual Compensation Payments in the annual amount of XXXXXXXXXX.

Additional information

15.   Germany follows the principle of taxing each corporation individually as a separate legal entity.  However, German tax law provides a tax consolidation regime (Organschaft), which allows consolidated taxation of the taxable income of all companies being part of a German Organschaft group.

16.   Only German resident companies in which the parent company has held directly or indirectly the majority of the voting rights since the beginning of the fiscal year of the subsidiary may be included in an Organschaft (requirement known as “financial integration”).  In addition, to make the Organschaft effective for the purposes of the GCITA and of the GTTA, the parent company and the German subsidiary must enter into a profit and loss transfer agreement (the “PTA”) for a minimum period of XXXXXXXXXX years.

17.   The PTA is a corporate law contract governed by a strict regime outlined in the GSCA which also applies to the PTA’s between GmbH’s.  Under a PTA, and as required under the GSCA, one corporation (“Transferring Entity”) commits itself to transfer its statutory profit to another corporation (“Dominating Entity”) and the Dominating Entity commits to compensate or cover any statutory losses of the Transferring Entity. Consequently, for German GAAP purposes the annual result after the annual profit transfer/loss compensation of the Transferring Entity will always be zero at year-end as long as the PTA is in place. As a result, the Transferring Entity will not be in the position to otherwise distribute an annual profit to its parent/shareholders for the time a PTA is in place (i.e. because the annual statutory income/loss will be zero). Only pre-Organschaft profits brought forward can still be distributed by the company.  For the purposes of the GSCA, parties entering into a PTA do not necessarily have to be a parent and a subsidiary; however, for German tax purposes, in order for tax consolidation to be possible, the parties to a PTA must be a parent and a subsidiary (direct or indirect) to meet the requirement of financial integration.

18.   PTAs are generally concluded in order to implement an Organschaft for German tax purposes. Once an Organschaft is implemented, the taxable income/loss (after adjustment for matters such as book to tax differences and non-deductible items, etc.) of the subsidiary is transferred to the parent.

19.   The GSCA requires a PTA to provide for adequate compensation of outside shareholders with annual payments established in proportion with their shares in the share capital of the Transferring Entity.  The annual amount to be provided as compensation payment must not be less than the amount which could be expected to be distributed as the average dividend for each share based on the past profitability of the corporation and on its prospective profits.

20.   XXXXXXXXXX

Proposed Transactions

The following transactions will be implemented in the order presented:

21.   FA3 will enter into an agreement of merger with FA4 pursuant to which FA4 will merge into FA3, and the merger will qualify as a “foreign merger” as defined in subsection 87(8.1).  In accordance with the German corporate law, the agreement of merger will provide, inter alia, that, upon the effective time of the merger:

a)    FA3 will be the surviving entity upon the merger (“New FA3”);

b)    all rights and property of whatever nature vested in FA4 before its merger into FA3 will be vested in New FA3 immediately after the merger without any further act or deed by New FA3;

c)    any intercompany debt that is outstanding between FA3 and FA4 immediately before the merger will be settled on the merger; and

d)    New FA3 will assume all of the remaining liabilities and other debt obligations of FA4.

22.   FA2 and New FA3 will enter into a share-for-share transfer agreement pursuant to which all the shares of FA5 owned by FA2 will be transferred to New FA3 in consideration for additional shares of New FA3.  Immediately after the transfer, New FA3 will have one class of shares issued and outstanding, and all of these shares will be owned by FA2.

23.   The articles of association of FA5 will be modified to provide for a second class of shares (the “Preferred Shares”), while the shares already issued and outstanding will be renamed and referred to as ordinary shares (the “Ordinary Shares”). All the shares of FA5 currently owned by KG will be converted into Preferred Shares.  The rights, privileges and entitlements of the Preferred Shares shall be described as follows:

a)    The Preferred Shares shall have voting rights;

b)    The Preferred Shares shall carry an annual and cumulative preferential dividend entitlement equal to a fixed amount determined under the articles of association (“Preferred Dividend”). The Preferred Share Dividend is equal to the existing annual Compensation Payment as described in paragraphs 14 and 19 above.  The dividend rights of the holders of the Preferred Shares will be subordinated to all debts incurred by FA5 but have priority over holders of the Ordinary Shares;

c)    During the subsistence of PTA1, the annual Preferred Dividend will be satisfied by the payment of the annual Compensation Payment, which will either reduce FA5’s statutory profit to be transferred to New FA3 or increase FA5’s statutory loss to be covered by New FA3; and

d)    On a liquidation of FA5, the holders of the Preferred Shares will share in the total liquidation proceeds according to their pro rata participation in FA5’s share capital.

24.   Following the changes to the shareholder rights as outlined in paragraphs 21, 22 and 23, the share ownership of FA5 will be as follows:

Holder      Class of            Number      Share         % of           Number of    % of
of FA5      shares              of shares     capital       share          votes            votes
Shares                                                  XXXXX     capital

KG            Preferred         XXXXX       XXXXX       XXXXX       XXXXX        XXXXX
                 Shares
New FA3  Ordinary           XXXXX       XXXXX       XXXXX       XXXXX       XXXXX
                 Shares
Total                                 XXXXX       XXXXX       XXXXX       XXXXX        XXXXX

25.   Further to the transactions described in paragraphs 21, 22 and 23, the PTA3 will be extinguished and the PTA1 between FA5 and New FA3 and the PTA2 between New FA3 and FA2 will remain in existence.  FA5 will remain obliged to transfer its statutory profit computed under German GAAP to New FA3, while New FA3 will be committed to cover any statutory losses of FA5 computed under German GAAP.  In addition, the Organschaft between FA5 and New FA3 for the purpose of the GCITA and GTTA will remain in existence.  Similarly, New FA3 will remain obliged to transfer its statutory profit computed under German GAAP to FA2, while FA2 will be committed to cover any statutory losses of New FA3 computed under German GAAP.  In addition, the Organschaft between FA2 and New FA3 for the purpose of the GCITA and GTTA will remain in existence.

Purpose of the Proposed Transactions

26.   The purpose of the Proposed Transactions is twofold:

a)    To facilitate the repatriation of funds to the ultimate shareholders by consolidating substantially all of the interest in FA5 in a single corporate entity (i.e. New FA3), which would have a XXXXXXXXXX% interest in FA5 and hold XXXXXXXXXX% of the Ordinary Shares; and

b)    To permit the payments made by FA5 to New FA3 under PTA1 and by New FA3 to FA2 under PTA2 to be characterized as dividends pursuant to subsection 90(2) of the Act.

Rulings Given

Provided that the preceding statements constitute a complete and accurate disclosure of all of the relevant Facts, Additional Information, Proposed Transactions and Purpose of the Proposed Transactions, and provided that the Proposed Transactions are completed in the manner described above, our rulings are as follows and will apply to payments made after the Proposed Transactions are completed:

A.    Each payment

i.    made by FA5 to New FA3 in accordance with PTA1 will be deemed to be a dividend pursuant to subsection 90(2); and

ii.   of the fixed amount described in subparagraph 23b) above, made by FA5 to KG will be deemed to be a dividend pursuant to subsection 90(2);

B.    Each payment made by New FA3 to FA2 in accordance with PTA2 will be deemed to be a dividend pursuant to subsection 90(2);

C.    The payments described in Ruling A and B will not be taken into account for purposes of computing the “earnings” or “loss” (as such expressions are defined in Regulation 5907(1)) of FA5, New FA3 and FA2;

D.    For the purposes of the definitions in Regulation 5907(1) of “exempt surplus”, “hybrid surplus” and “taxable surplus”, as the case may be, of FA5 in respect of Pubco, each amount described in Ruling A. that is deemed under Regulation 5901 to have been paid out of the exempt surplus, hybrid surplus or taxable surplus, as the case may be, of FA5 in respect of Pubco will be deducted in computing the respective surplus of FA5 in the manner described in these definitions;

E.    For the purposes of the definitions in Regulation 5907(1) of “exempt surplus”, “hybrid surplus” and “taxable surplus”, as the case may be, of New FA3 in respect of Pubco, each amount described in Ruling A.(i) that is prescribed under Regulation 5900 to have been paid out of the exempt surplus, hybrid surplus or taxable surplus, as the case may be, of FA5 in respect of Pubco will be added in computing the respective surplus of New FA3 in the manner described in these definitions;

F.    For the purposes of the definitions in Regulation 5907(1) of “exempt surplus”, “hybrid surplus” and “taxable surplus”, as the case may be, of New FA3 in respect of Pubco, each amount described in Ruling B. that is deemed under Regulation 5901 to have been paid out of the exempt surplus, hybrid surplus or taxable surplus, as the case may be, of New FA3 in respect of Pubco will be deducted in computing the respective surplus of New FA3 in the manner described in these definitions;

G.    For the purposes of the definitions in Regulation 5907(1) of “exempt surplus”, “hybrid surplus” and “taxable surplus”, as the case may be, of FA2 in respect of Pubco, each amount described in Ruling B. that is prescribed under Regulation 5900 to have been paid out of the exempt surplus, hybrid surplus or taxable surplus, as the case may be, of New FA3 in respect of Pubco will be added in computing the respective surplus of FA2 in the manner described in these definitions;

H.    For purposes of paragraph 53(1)(c) each payment made by New FA3 to FA5 in accordance with PTA1 will be treated as being a contribution of capital and will not be taken into account in computing the “earnings” or “loss” (as such expressions are defined in Regulation 5907(1)), of FA5 or NewFA3; and

I.    For purposes of paragraph 53(1)(c) each payment made by FA2 to New FA3 in accordance with PTA2 will be treated as being a contribution of capital and will not be taken into account for purposes of computing the “earnings” or “loss” (as such expressions are defined in Regulation 5907(1)) of FA2 or New FA3.

The above rulings are given subject to the general limitations and qualifications set out in Information Circular 70-6R6 dated August 29, 2014 and are binding on the Canada Revenue Agency (“CRA”) provided that the Proposed Transactions are completed before XXXXXXXXXX.

These rulings are based on the Act in the present form and do not take into account amendments to the Act which, if enacted into law, could have an effect on the rulings provided herein.

Other Comments

(a)   Each of the above Rulings only apply during the subsistence of PTA1 and PTA 2, the issued shares of FA5 being owned as described in paragraph 24, and the issued shares of FA3 being owned as described in paragraph 22; and

(b)   Nothing in this Ruling Letter shall be construed as implying that the CRA has accepted or otherwise agreed to:

(i)   any surplus balances of foreign affiliates referred to herein;

(ii)  the validity of any agreements or terms and conditions therein;

(iii) any tax consequences relating to the Facts and Proposed Transactions described herein other than those specifically described in the Rulings Given above;

(iv)  the manner in which any income or profits tax paid by FA2, FA3 or FA5 will be treated for purposes of the Act and the Regulations; 

(v)   the application or non-application of subsection 91(4.7) and related provisions; or

(vi)  the characterization for the purposes of the Act of any entity described in the Facts and the Proposed Transactions.

Yours truly,

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

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