2016-0642091C6 IFA 2016 Q.5: Upstream loans: 90(7) and 90(9)

Principal Issues: How the CRA intends to apply the back-to-back loan rule in subsection 90(7) under two scenarios.

Position: The back-to-back loan rule would not generally be applied in the first scenario and would generally be applied in the second.

Reasons: A TCP approach leads to different results depending on the facts.

Author: Grégoire, Sylvain
Section: 90(7); 90(9) and 90(11)

2016 International Fiscal Association Conference
CRA Roundtable

Question 5 – Upstream loans – Subsections 90(7) and 90(9)

Part A

Assume the following hypothetical facts:

a)    Canco, a corporation resident in Canada, directly owns all the shares of FA1, a foreign affiliate of Canco.

b)    FA1 owns all the shares of FA2, another foreign affiliate of Canco.

c)    FA2 generates excess liquidity in its active business and loans $10M to FA1.

d)    FA1 immediately uses the funds to make a $10M loan to Canco.

e)    The shares of FA1 held by Canco have a $4M adjusted cost base.

f)    At the lending time, FA1 has an exempt deficit of $20M and FA2 has exempt surplus of $100M.

g)    The loans are not repaid within two years.

Part B

The facts are the same as in Part A except that FA2’s source of funds is a borrowing of $10M from an arm’s length financial institution (the “Bank”) and it does not have any excess liquidity.

Can the CRA tell us how it would apply the back-to-back loan rule in subsection 90(7) in these two scenarios?

CRA Response

Part A

This scenario illustrates what may be perceived by some as a deficiency in the upstream loan rules, based on the apparent policy intent of subsection 90(11) as it relates to the so-called “reserve” deduction under subsection 90(9). For example, if FA2 had loaned directly to Canco, Canco would not be able to access enough of FA2’s surplus to eliminate the deficit in FA1 and, thus, Canco would not be entitled to a full deduction under subsection 90(9) notwithstanding that the foreign affiliate group as a whole has sufficient net surplus. However, if it were FA1 that had made the loan, subsection 90(11) would apply to bring up all of FA2’s surplus to create a sufficiently large exempt surplus balance to fully cover the upstream loan.

This scenario appears to represent an attempt at planning around the problem of a direct FA2 loan to Canco, but the back-to-back loan rule in subsection 90(7) seems to defeat such planning. However, given the overall context and purpose of the upstream loan rules, as informed by the more specific intent of subsections 90(7) and (11), the CRA would not generally apply the back-to-back loan rule in such a scenario, absent the presence of abusive tax avoidance. Rather, subsection 90(6) would be applied only to the loan made by FA1 to Canco, with the result that subsection 90(11) would apply and the entire exempt surplus balance of FA2 would be included in the “reserve” determination in subsection 90(9).

Part B

The fact that subsection 90(7) applies for the purposes of all of subsections 90(6) to (15), i.e. it also applies to itself, means that it is meant to apply iteratively. Thus, in this particular scenario, it is the CRA’s view that it would generally be appropriate to successively apply subsection 90(7) to these loans. Thus, first, the loan made by the Bank to FA2 and the loan made by FA2 to FA1 would be deemed not to have been made and, instead, a direct loan would be deemed to have been made by the Bank to FA1. Secondly, the notional loan from the Bank to FA1 and the loan from FA1 to Canco would be deemed not to have been made and, instead, a direct loan would be deemed to have been made by the Bank to Canco. Therefore, as a result of the double application of subsection 90(7), the Bank would be deemed to have made a $10M loan directly to Canco and the three actual loans would be deemed not to have been made. Assuming the Bank is not a foreign affiliate of Canco, this would mean that subsection 90(6) would generally not apply in this type of scenario.

We find support for this position in the overall context of the upstream loan rules and their focus on synthetic distributions: there does not appear to be a net flow of surplus out from FA1 nor FA2 in this scenario. However, if as part of this type of arrangement there were cash flowing back, directly or indirectly, to the Bank from FA2 or another entity within Canco’s foreign affiliate group, the CRA may, depending on the circumstances, seek to apply the general anti-avoidance rule based on the guidance provided in the Department of Finance Explanatory Notes relating to the enactment of these rules, in particular the comments in respect of uses of back-to-back loan arrangements to frustrate the intent of subsection 90(7).

Sylvain Grégoire
Dave Beaulne
2016-064209
May 26, 2016

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