2016-0680801I7 Interpretation- subclause 95(2)(a)(ii)(B)(II) Act

Principal Issues: Whether 95(2)(a)(ii)(B)(II) only applies to 40% of the interest paid to a foreign affiliate by a partnership in which another foreign affiliate is a 40% member and a person other than a foreign affiliate is the 60% member.

Position: Yes.

Reasons: Textual, contextual and purposive reading of 95(2)(a)(ii)(B)(II) and the definition of "exempt earnings" in regulation 5907(1).

Author: Meek, John
Section: 95(2)(a)(ii)(B)(II); Regulation 5907(1)

                                                                                                                       August 31, 2017

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                                                                                                                      J. Meek
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Attention: XXXXXXXXXX
                Large File Case Manager                                                             2016-068080

Interpretation of subclause 95(2)(a)(ii)(B)(II) of the Act

This letter is in reply to your referral dated December 14, 2016 (received by email on December 20, 2016 and referred to herein as the “Referral Document”) in which you asked whether we agreed with your views expressed in the Referral Document that, in the following Example, only $4M of the $10M interest paid by MLP to FALuxco would be deemed to be income from an active business under subclause 95(2)(a)(ii)(B)(II) of the Income Tax Act (the “Act”).

Example

A foreign corporation (“FP”) owns 100% of Canco, and Canco owns 100% of two non-resident corporations that are foreign affiliates of Canco (“FA1” and “FALuxco”). FA1 is a 40% member of a partnership (“MLP”) and FP is the 60% member. MLP borrows $200M from FALuxco on which it pays $10M interest to FALuxco in respect of a particular taxation year of FALuxco. MLP has no borrowings from FP. MLP carries on an active business in the U.S., and the proceeds from the FALuxco loan are used in its active business.

In this letter, all references to subclauses, clauses, etc. are references to provisions of the Act, unless otherwise noted.

Taxpayer’s View

The taxpayer takes the view that the phrase “deductible by the partnership in computing that other foreign affiliate’s share of any income or loss of the partnership, for a fiscal period, that is included in computing the amounts prescribed to be that other foreign affiliate’s earnings or loss for a taxation year from an active business” in subclause 95(2)(a)(ii)(B)(II) (the “Expenditure Deductible Condition”) requires solely a determination that, in the Example, the interest amounts be deductible in computing the income of MLP as a whole (i.e., the amount deducted in computing 100% of MLP’s income). The taxpayer appears to suggest that the Expenditure Deductible Condition would only be modified if under the partnership agreement the interest amounts are borne entirely, or not at all, by a particular member of the partnership.

In its submission, and in support of its contention that it was not intended that payments made by a partially-owned partnership be treated different than payments made by a partially-owned foreign affiliate, the taxpayer made reference to a Department of Finance (“Finance”) comfort letter dated June 4, 2009, dealing with a potential amendment to subparagraph 95(2)(a)(i).

Our Comments

For reasons set out more fully in the Analysis below, with respect to the Example, in our view only that portion of the $10M interest that was deducted in computing the active business earnings of FA1 would be recharacterized as income from an active business to FALuxco under subclause 95(2)(a)(ii)(B)(II). It is a question of fact as to what that portion is in any particular case. In the Example, we agree with your view that only 40% of the $10M interest received by FALuxco should be recharacterized as income from an active business (resulting in FALuxco having FAPI of $6M).

In our view, this outcome is consistent with: (i) our understanding that the December 2007 amendment to “old” clause 95(2)(a)(ii)(B) was intended to be a tightening measure; and (ii) the 2013 amendment to the definition of “exempt earnings” in subsection 5907(1) of the Income Tax Regulations (the “Regulations”).

Regarding the taxpayer’s reference to Finance’s June 4, 2009 comfort letter, in our view, that letter is not germane to the issue of the proper interpretation of subclause 95(2)(a)(ii)(B)(II). The issue that Finance was addressing in that letter was the then lack of inclusion of activities performed by a partnership as qualified activities for purposes of meeting the conditions in (now) clause 95(2)(a)(i)(A). Finance was not addressing the amount of income of the particular affiliate that should be deemed to be income from an active business under subparagraph 95(2)(a)(i).

Analysis

We understand from the Referral Document that, as a factual matter (the “Actual Case”), FA1 (referred to as US Holdco 2 in the Referral Document) has both a direct interest in MLP, and also owns shares of another non-resident corporation (herein referred to as FA2 and referred to as US Holdco 1 in the Referral Document) that has a direct interest in MLP. (footnote 1) It is our further understanding that in the Actual Case, Canco has a qualifying interest in each of FA1 and FA2.

In the Actual Case, the interest amounts received by FALuxco from MLP are FAPI to FALuxco except to the extent that subclause 95(2)(a)(ii)(B)(II) deems all or a portion of the amounts to be income from an active business (footnote 2). Such recharacterized income will be the aggregate of the interest paid by MLP that is deductible in computing the income from an active business in respect of each of FA1 and FA2 (each of FA1 and FA2 is “another foreign affiliate” referred to in that subclause). In summary, the interest amounts will be deemed to be income from an active business under subclause 95(2)(a)(ii)(B)(II) only (emphasis added):

“to the extent that those amounts that were paid .. are for expenditures that are deductible by the partnership [MLP] in computing that other foreign affiliate’s [FA1 and FA2] share of any income or loss of the partnership [MLP].. that is included in computing the amounts prescribed to be that other foreign affiliate’s [FA1’s and FA2’s] earnings .. for a taxation year from an active business”.

In our view, the textual reading of subclause 95(2)(a)(ii)(B)(II) requires that the particular expenditure (footnote 3) (or portion thereof (footnote 4)) by the partnership has to meet two separate tests: (i) the expenditure (or portion thereof) has to be deductible in computing the other affiliate’s share of the income of the partnership as determined for purposes of paragraph 96(1)(f); and (ii) the expenditure (or portion thereof) has to be included in computing the amount prescribed to be the other affiliate’s earnings as determined for purposes of paragraph (a) of the “earnings” definition in subsection 5907(1) of the Regulations. This is consistent with our view that, for the purpose of computing the surplus accounts of a particular foreign affiliate such as FA1 and FA2 that carries on an active business in a foreign country as a member of a partnership such as MLP, subsection 5907(1) of the Regulations requires the particular affiliate, and not the partnership, to compute the affiliate’s “earnings” in respect of the affiliate’s active business activities. In the Example, a $4M interest expense deduction would be included in the computation of FA1’s earnings from an active business.

The current version of clause 95(2)(a)(ii)(B) is the result of amendments made in December 2007 and apply to taxation years of a foreign affiliate that begin after 2008. Prior to the December 2007 amendments, the Expenditure Deductible Condition read as follows (emphasis added):

“expenditures … that are or would, if the partnership were a foreign affiliate of the taxpayer, be deductible in the year or a subsequent taxation year by the other affiliate or the partnership in computing the amounts prescribed to be its earnings or loss from an active business”

The December 2007 amendment to “old” clause 95(2)(a)(ii)(B) was part of a large package of proposed amendments to the Act released by Finance on October 2, 2007 and, in our view, that amendment was a tightening measure consistent with the repeal of “old” clause 95(2)(a)(ii)(A)  which had been proposed in Budget 2007 and implemented by the same December 2007 amendments. This is consistent with our understanding that it was the intent of the legislation in “new” subclause 95(2)(a)(ii)(B)(II) to potentially differentiate the tax results to a foreign affiliate with respect to interest paid to it by a partially-owned partnership and interest paid to it by a partially-owned foreign affiliate. It is our understanding that the rationale for this potential difference is that since a partnership is treated as a flow-through for Canadian tax purposes, for the purpose of subclause 95(2)(a)(ii)(B)(II) the interest paid by a partnership should be viewed as interest paid proportionately by each of its members. As such, in the Example, to the extent that a portion of the interest paid to FALuxco by MLP is considered to be paid by a member that is not described in subclause 95(2)(a)(ii)(B)(I), that portion should not be recharacterized as income from an active business since it would not be so recharacterized if it had been paid directly by that member.

In our view, the intention as to the proper interpretation of subclause 95(2)(a)(ii)(B)(II) can best be ascertained by the amendments made in 2013 to the definition of “exempt earnings” in subsection 5907(1) of the Regulations. This definition now reads (as regards clause 95(2)(a)(ii)(B)) as follows (emphasis added):

(d) where the year is the 1976 or any subsequent taxation year of the particular affiliate and the particular affiliate is, throughout the year, resident in a designated treaty country,

 (ii) the particular affiliate’s earnings for the year from an active business to the extent that they derive from

(C) income that is required to be included in computing the particular affiliate’s income or loss from an active business for the year under clause 95(2)(a)(ii)(B) of the Act to the extent that the amounts paid or payable referred to in that clause are for expenditures that are deductible in computing the exempt earnings or exempt loss, for a taxation year, of the other foreign affiliate referred to in that clause,

Pursuant to its coming-into-force clause in Bill C-48, the above reading of clause (d)(ii)(C) of the definition of “exempt earnings” in subsection 5907(1) of the Regulations applies to taxation years of a foreign affiliate that begin after 2008.

With regard to the Actual Case, in our view the amendment made to clause (d)(ii)(C) of the definition of “exempt earnings” in subsection 5907(1) of the Regulations makes it clear that it was intended that subclause 95(2)(a)(ii)(B)(II) be read as requiring a determination of the interest amounts that are deductible in computing that portion of MLP’s income that is included in computing the amounts prescribed to be FA1’s (and FA2’s) earnings as determined for purposes of paragraph (a) of the “earnings” definition in subsection 5907(1) of the Regulations.

In conclusion, in the case of the Example, we agree with your view that only 60% of the $10M interest received by FALuxco should be recharacterized as income from an active business (resulting in FALuxco having FAPI of $6M). We are of this view because only $4M would be deductible in computing that portion of MLP’s income that is included in computing the amounts prescribed to be FA1’s earnings as determined for purposes of paragraph (a) of the “earnings” definition in subsection 5907(1) of the Regulations.

If you have any questions regarding the content of this letter, please contact the undersigned at (613) 670-9000 or John Meek at (416) 954-6038.

Unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. After a 90-day waiting period, a severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. You may request a modification of this 90-day period. The severing process removes all content that is not subject to disclosure, including information that could reveal the identity of the taxpayer. The taxpayer may ask for a version that has been severed using the Privacy Act criteria, which does not remove taxpayer identity. You can request this by e-mailing us at: ITRACCESSG@cra-arc.gc.ca. A copy will be sent to you for delivery to the taxpayer.

Sincerely,

Lori M. Carruthers CPA, CA
Section Manager
for Division Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  We also understand that as a factual matter the MLP units are traded on a public exchange, and those not held by FP, FA1 and FA2 are held by arm’s length persons.
2  The Referral Document makes reference to FALuxco receiving “interest on loans it made indirectly (through Holdco 2) to the partnership”. In such a case, clause 95(2)(a)(ii)(C) would also be relevant to the recharacterization, if any, of the interest income paid to Holdco 2 (referred to herein as FA1) by MLP. The interpretive issues with respect to the Expenditure Deductible Condition in clause 95(2)(a)(ii)(C) are the same as the interpretive issues with respect to subclause 95(2)(a)(ii)(B)(II), and our views expressed herein with respect to the interpretation of the Expenditure Deductible Condition in subclause 95(2)(a)(ii)(B)(II) would be our views with respect to the interpretation of clause 95(2)(a)(ii)(C).
3  The “particular expenditure” being the expenditure (e.g., an interest payment) that gives rise to the income in the recipient affiliate.
4  “Portion” as a result of the words “to the extent” in this subclause.

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