2017-0694231I7 Subsection 247(2), surplus, and FAPI

Principal Issues: Where, as a result of a transfer pricing adjustment made under subsection 247(2) with respect to a transaction between a taxpayer that is a corporation resident in Canada and its directly held wholly owned controlled foreign affiliate for the sale of goods or provision of services, an amount is included in computing the taxpayer’s income, (1) whether subsection 247(2) could apply to reduce the surplus or FAPI of the foreign affiliate in respect of the taxpayer, and (2) whether there would be an increase in the taxpayer’s adjusted cost base in the shares of the foreign affiliate as a result of the application of paragraph 53(1)(c).

Position: (1) No. (2) No.

Reasons: (1) A reduction of surplus or FAPI of the foreign affiliate in the situation described is not a type of transfer pricing adjustment contemplated by subsection 247(2). (2) A conferral of benefit resulting from an incorrect transfer price cannot be considered a contribution of capital for purposes of paragraph 53(1)(c).

Author: Tu, Grace
Section: 247; definition of "earnings" under 5907(1); 5907(2); 95(2)(f); 53(1)(c)

                                                                                                                       October 27, 2017

Chantal Tubie                                                                                                 HEADQUARTERS
International Tax Division, ILBD                                                                     Income Tax Rulings
International Advisory Services Section (East)                                               Directorate
344 Slater Street, 6th Floor, Minto Place                                                        Grace Tu 
Ottawa ON  K1A 0L5
                                                                                                                        2017-069423

Applicability of subsection 247(2) in the computation of exempt surplus or foreign accrual property income of a controlled foreign affiliate
 

Dear Ms. Tubie,

This memo is in reply to your request for a technical interpretation dated March 21, 2017 regarding certain potential consequences of the application of subsection 247(2) of the Income Tax Act (the “Act”) to transactions between a corporation resident in Canada (“Canco”) and its directly held wholly owned controlled foreign affiliate (“CFA”).

Unless otherwise noted, all statutory references herein are references to the Act.

Your specific questions are as follows:

Where, as a result of a transfer pricing adjustment made under subsection 247(2) with respect to a transaction between Canco and CFA for the sale of goods or provision of services, an amount is included in computing Canco’s income:

(1)   whether subsection 247(2) could also apply to reduce the exempt surplus or foreign accrual property income (“FAPI”) of CFA in respect of Canco; and

(2)   whether there would be an increase in Canco’s adjusted cost base (“ACB”) in the shares of CFA as a result of the application of paragraph 53(1)(c).

Our Comments

Would subsection 247(2) apply to reduce CFA’s exempt surplus or FAPI in respect of Canco?

A transfer pricing adjustment can be made by the Minister under subsection 247(2) when a taxpayer and a non-resident person with whom the taxpayer does not deal at arm’s length are participants in a transaction (or a series of transactions) and the terms or conditions made or imposed in respect of the transaction (or the series) between any of the participants in the transaction (or series) differ from those that would have been made between persons dealing at arm’s length. Where such terms or conditions do differ, any amounts otherwise determined for the purposes of the Act in respect of the taxpayer are adjusted to reflect arm’s length terms and conditions.

While it has been suggested that the “in respect of the taxpayer” language in subsection 247(2) might extend to the foreign affiliate’s surplus and FAPI amounts that are computed in respect of the taxpayer, we do not believe that subsection 247(2) is intended to have such a two-sided effect. Of particular concern would be that to interpret subsection 247(2) as having such a two-sided effect could give inconsistent results as compared to where a foreign affiliate computes its surplus and FAPI in respect of a related Canadian corporation and not in respect of the taxpayer with whom the foreign affiliate is transacting. Thus, it is our view that in order for subsection 247(2) to apply in the computation of a foreign affiliate’s surplus and FAPI, the foreign affiliate itself must be the taxpayer to which subsection 247(2) is applied. Since, in this scenario, CFA is transacting with a Canadian resident (Canco), CFA cannot be a taxpayer to which subsection 247(2) is applied. As such, in these circumstances, subsection 247(2) cannot be applied independently to CFA to adjust CFA’s surplus or FAPI in respect of Canco. In this regard, it is worth noting, for greater certainty, that the legal terms and conditions of any such cross-border transactions can only be altered to the extent that subsection 247(2) does so, unless the transactions are subject to rectification. Rectification is beyond the scope of this memo.

The surplus of CFA could conceivably be adjusted where CFA’s “earnings” are computed pursuant to subparagraph (a)(i) or (a)(ii) of the definition of “earnings” under subsection 5907(1) of the Income Tax Regulations (the “Regulations”) and the relevant foreign tax law makes its own transfer pricing adjustment, whether by way of a corresponding adjustment or otherwise. Although such a possibility is generally beyond the scope of this memo, we would point out that, in such a case, consideration would have to be given to whether subsection 5907(2) of the Regulations could reverse that foreign tax law adjustment and to the possible impact of any accompanying transfer of assets to effect a so-called “repatriation” payment.

Could the benefit conferred by Canco to CFA be considered a contribution of capital for purposes of paragraph 53(1)(c)?

Where transfer prices differ from arm’s length terms, it can generally be considered that a benefit is conferred on the person overcharging or underpaying for goods or services. However, there is no general rule in the Act that deems such a conferral of benefit to be a contribution of capital. In this regard, it is notable that paragraph 212.3(10)(b) has specific language to achieve such a result, but that rule is only applicable in the foreign affiliate dumping context.  On this basis, it is our view that the benefit conferred in the situation described cannot be considered a capital contribution by Canco to CFA for purposes of paragraph 53(1)(c).

For your information 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. A severed copy will also be distributed to the commercial tax publishers, following a 90-day waiting period (unless advised otherwise), for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca.

We trust our comments will be of assistance, and thank you for your enquiry.

Yours truly,

Dave Beaulne, CPA, CA
Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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