2020-0851731E5 CEWS - 125.7(4)(d) election - NAL chain

Principal Issues: Can the election provided in paragraph 125.7(4)(d) be made in a chain of non-arm's length entities?

Position: It doesn't appear that this is possible given the requirements of the calculation.

Reasons: Non-arm's length sales are not permitted in elements C and D of the formula; as well, it seems that the "qualifying revenue" in elements C and D must be based on actual amounts, not deemed amounts.

Author: Ross, Matthew
Section: 125.7

XXXXXXXXXX                                                      2020-085173
                                                                              Matthew Ross, CPA, CA
September 28, 2020

Dear XXXXXXXXXX:

Re:  Paragraph 125.7(4)(d) election

We are writing in response to your email of June 12, 2020, regarding the Canada Emergency Wage Subsidy (“CEWS”). You would like to know whether the election provided in paragraph 125.7(4)(d) of the Income Tax Act (“the Act”) may be made in a given situation.

You presented the following facts:

*     Canco is an “eligible entity,” as that term is defined in subsection 125.7(1) of the Act.
*     Canco manufactures the Product.
*     Canco sells all of the Product to Forco A, a corporation related to Canco within the meaning of subsection 251(2) of the Act.  Canco and Forco A are deemed not to deal with each other at arm’s length pursuant to paragraph 251(1)(a). As such, all of Canco’s revenue is from a non-arm’s length person.
*     Forco A uses the Product in its manufacturing process to make the Finished Goods.
*     Forco A sells all of the Finished Goods to Forco B, a corporation who is related to both Canco and Forco A.  Accordingly, all of Forco A’s revenue is from a non-arm’s length person.
*     Forco B is the distributor for the Finished Goods and sells all of the Finished Goods to arm’s length customers.
*     Canco is resident in Canada for income tax purposes.  Forco A and Forco B are not resident in Canada for income tax purposes.

You have asked whether the election provided in paragraph 125.7(4)(d) of the Act may be made in the situation presented where there is a multi-tiered structure or chain of entities that are not dealing with each other at arm’s length.

Our comments

This technical interpretation provides general comments about the provisions of the Act and related legislation (where referenced).  It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination.  The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R9, Advance Income Tax Rulings and Technical Interpretations.

The CEWS, which is calculated under subsection 125.7(2) of the Act, is calculated with reference to the reduction in “qualifying revenue” experienced by a “qualifying entity.”  In determining the revenue reduction for a “qualifying period,” a qualifying entity compares its qualifying revenue for the “current reference period” with that of the “prior reference period,” as those terms are defined in subsection 125.7(1).

Qualifying revenue, of an “eligible entity” for a prior reference period or a current reference period, is defined in subsection 125.7(1) of the Act to mean the inflow of cash, receivables or other consideration arising in the course of the ordinary activities of the eligible entity in Canada in the particular period, subject to certain inclusions or exclusions.  By virtue of paragraph (d) of the definition, qualifying revenue excludes amounts derived from persons or partnerships not dealing at arm’s length with the eligible entity.

Subsection 125.7(4) of the Act requires that, for the purposes of the definition of qualifying revenue in subsection 125.7(1), the qualifying revenue of an eligible entity is to be determined in accordance with its normal accounting practises, subject to certain special rules described in paragraphs 125.7(4)(a), (b), (c), (d) and (e).

Paragraph 125.7(4)(d) of the Act is available where all or substantially all (which generally means at least 90%) of an eligible entity’s qualifying revenue – determined without reference to paragraph (d) of the definition “qualifying revenue” of the subsection 125.7(1) - is from one or more particular persons or partnerships with which it does not deal at arm’s length (“NAL entity”).

Where this condition is met and each of the NAL entities jointly elect with the eligible entity, in determining the revenue reduction for the eligible entity for a particular qualifying period, its qualifying revenue for the prior reference period is deemed by subparagraph 125.7(4)(d)(i) of the Act to be $100 and a weighted-average approach, provided for in subparagraph 125.7(4)(d)(ii), is used to determine qualifying revenue for the current reference period.  In applying this approach, the eligible entity’s qualifying revenue is based solely on amounts derived in the course of its ordinary activities in Canada from the NAL entities. The amount used for each of the NAL entities’ qualifying revenue includes revenues earned from ordinary activities both inside and outside of Canada but excludes amounts derived from persons or partnerships not dealing at arm’s length with it.

The election in paragraph 125.7(4)(d) of the Act may be made only by an eligible entity and those NAL entities with whom it directly earns qualifying revenues.  Accordingly, in the situation provided, were Canco and Forco A to make the election in paragraph 125.7(4)(d), in determining Canco’s decline in qualifying revenue based on Forco A’s decline in qualifying revenue, Forco A would not have any qualifying revenue because it earns all of its revenue from persons or partnerships not dealing at arm’s length with it (Forco B).  As such, in this situation, the election in paragraph 125.7(4)(d) would not work.  In our view, the election in paragraph 125.7(4)(d) may not be made by a multi-tiered structure or chain of entities that are not dealing with each other at arm’s length.

An election under another special rule under subsection 125.7(4) of the Act may, however, be available, depending on the facts of a particular situation, to allow an alternate method of calculating qualifying revenue for an eligible entity, such as the election for affiliated eligible entities in paragraph 125.7(4)(b).

We trust our comments will be of assistance.

Yours truly,

Pamela Burnley, CPA, CA
Manager
Business Income and Capital Transactions
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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