2018-0772971I7 Interaction between sections 94, 17, 247

Principal Issues: 1. Whether paragraph 94(2)(a) applies to the facts provided. 2. Whether the application of section 17 will change the application of section 94. 3. Whether the application of section 247 will change the application of section 94. 4. Would our views change if instead of a non-interest bearing loan services were provided for less than fair market value consideration.

Position: 1. Yes. 2. No. 3. No. 4. No.

Reasons: See analysis below.

Author: Campbell, Katie
Section: 94, 247, 17

                                                                                                                                                        May 28, 2019

HEADQUARTERS                                                                                                                          HEADQUARTERS
International, Large Business and                                                                                                   Income Tax Rulings Directorate 
  Investigations Branch                                                                                                                    Katie Campbell
XXXXXXXXXX                                                                                                                                 (613) 670-8918
Attention: XXXXXXXXXX
                                                                                                                                                          2018-077297

Sections 17, 94 and 247

We are responding to your query regarding the application of section 94 and, more specifically, the interaction between sections 17, 247, and 94 of the Income Tax Act (the “Act”). All statutory references that follow are to the Act.  Our understanding of the facts are as follows:

1.    CdnTrust is a trust resident in Canada that owns 100% of the shares of Canco.

2.    NRTrust is a factually non-resident trust that owns 100% of the shares of LLC1.

3.    Multiple wire transfers were made from Canco’s bank account to LLC1. In the books and records of Canco, these transfers were debited to an intercompany account named “due from LLC1”.  The loan amounts were as follows:

a)    XXXXXXXXXX;
b)    XXXXXXXXXX;
c)    XXXXXXXXXX; and
d)    XXXXXXXXXX.

4.    The loans did not have a specified period of repayment, a loan agreement, or a stated rate of interest.

5.    Canco filed T106 information returns for LLC1 indicating that the funds transferred from Canco to LLC1 are loans.  The rate of interest charged and paid on the intercompany loans was XXXXXXXXXX% which is neither reasonable nor an arm’s length rate of interest.

6.    None of Canco, LLC1, or the beneficiaries of the trusts deal at arm’s length with each other. The beneficiaries of the two trusts are members of the same family.  The beneficiaries are residents of either the United States or Canada.

7.    LLC1 has never made a payment to Canco in respect of interest on the loans.  In addition, Canco and LLC1 have not adjusted the intercompany balances to reflect any unpaid interest. Canco has a deemed income inclusion based on subsection 17(1) and/or subsection 247(2).

You have asked us to consider the following issues:

1.    Whether the non-interest bearing loan by Canco to LLC1 would result in the application of paragraph 94(2)(a);

2.    Whether an application of subsection 17(1) to deem an interest income inclusion to Canco would change our views regarding the application of section 94 to NRTrust;

3.    Whether an application of the transfer pricing rules in section 247 would change our views regarding the application of section 94 to NRTrust; and

4.    Whether our views would change if Canco provided services to LLC1 for no consideration rather than issuing a non-interest bearing loan.

Analysis

Issue #1

In order to determine if paragraph 94(2)(a) applies to the non-interest bearing loan, the first step is to determine whether the non-interest bearing loan would qualify as an arm’s length transfer.  If the loan is an arm’s length transfer, it will be excluded from the application of paragraph 94(2)(a).  In order to be an arm’s length transfer the loan must meet the conditions in paragraph (a) of the “arm’s length transfer” definition, contained in subsection 94(1), as well as at least one of the conditions contained in paragraph (b).

In this case, since the loan is non-interest bearing with no specific terms of repayment, the terms of the loan are not arm’s length terms.  As a result, the loan does not qualify as an arm’s length transfer since it does not meet at least one of the conditions contained in paragraph (b).

Since the non-interest bearing loan is not an arm’s length transfer, the next step is to determine whether the loan made by Canco to LLC1 results in an increase in fair market value of the shares of LLC1.  Since LLC1 borrowed funds in a situation where there was no cost to LLC1, the fair market value of the shares of LLC1 have increased as a result of the non-interest bearing loan.  While this is a matter of valuation, it is reasonable to conclude that the receipt of funds without having any cost of acquiring those funds would increase the fair market value of LLC1.

Therefore, we would be of the view that, at the time the non-interest bearing loan is made, there is an increase in the fair market value of the shares of LLC1 held by NRTrust.  As a result, Canco would be deemed to have made a contribution to NRTrust by virtue of paragraph 94(2)(a).  Consequently, since Canco is resident in Canada, NRTrust will have a resident contributor as defined in subsection 94(1).  Therefore, NRTrust will be deemed resident in Canada by virtue of subsection 94(3).

Issue #2

The question is whether an income inclusion under subsection 17(1) would change our views regarding the application of section 94 to NRTrust.

First, any income deemed to be included in the income of Canco by virtue of subsection 17(1) would not have any impact on the fair market value of the shares of LLC1.  Second, the increase in fair market value of the shares of LLC1 only needs to occur at the time of the loan in order for paragraph 94(2)(a) to apply to deem there to be a contribution.  The wording of paragraph 94(2)(a) requires that you determine whether there has been an increase in fair market value at the time the loan was made.  Therefore, any transactions or events that occur subsequent to the time the loan was made will not change the determination regarding the application of paragraph 94(2)(a).

As a result, the application of subsection 17(1) would not impact the application of paragraph 94(2)(a).

Issue #3

When an adjustment is made to increase the taxable income of Canco pursuant to subsection 247(2), the Competent Authority for the country of residence of LLC1 (if there is a treaty with the particular country of residence) may allow a corresponding downward adjustment to reduce the income of LLC1.  In addition, it is possible that a repatriation payment may be made from LLC1 to Canco.  However, as discussed above, the application of paragraph 94(2)(a) occurs at the time the loan is issued.  Consequently, any subsequent adjustments, by virtue of subsection 247(2), would not impact the increase to the fair market value of the shares of LLC1 at the time the loan was issued.  Therefore, any transfer pricing adjustments and repatriation that occur as a result of the non-interest bearing loan would have no impact on the application of section 94 to NRTrust.

Issue #4

If Canco provided services to LLC1, other than exempt services defined in section 94(1), paragraph 94(2)(f) would apply to deem Canco to have transferred property to LLC1.  Since Canco is deemed to have transferred property to LLC1, if this transfer would result in an increase in the fair market value of the shares of LLC1, paragraph 94(2)(a) would apply to deem Canco to have made a contribution to NRTrust.

It would seem reasonable to be of the view that services provided to LLC1 for no consideration would result in an increase in fair market value of the shares of LLC1.  Consequently, Canco would be deemed to have made a contribution to NRTrust with the result that NRTrust would be deemed resident in Canada. Furthermore, paragraph 94(2)(a) applies at the time the services are rendered for no consideration resulting in an increase in the fair market value of the shares of LLC1 at that time.  This test would continue to be met regardless of subsequent transactions or deemed income inclusions by virtue of subsection 247(2).  Consequently, our conclusions above would remain the same if the contribution resulted from the rendering of services for no consideration instead of a non-interest bearing loan.

Proposed subsection 247(1.1)

For the purpose of this memo, we have not considered what impact, if any, that proposed new subsection 247(1.1) might have on the conclusions contained herein.

We trust our comments will be of assistance.

Yours truly,

Phillip Kohnen, CPA, CMA, TEP
Manager, Trust Section I
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

XXXXXXXXXX
 

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