9 February 1998 External T.I. 9725475 - foreign affiliates - active business income

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

If the shares of a foreign affiliate which survives a merger of two foreign affiliates are excluded property, would the fact that the shares of one of the predecessor foreign affiliates which were not excluded property and which were acquired with borrowed funds, cause interest paid after the merger on those borrowed funds to fail the test in 95(2)(a)(ii)(D)(III)

Position:

No. The borrowed funds would satisfy the test in 95(2)(a)(ii)(D)(III) after the merger.

Reasons:

After the merger, the borrowed funds are considered to be used for the purpose of earning income from the shares of foreign affiliate which survives the merger.

972547
XXXXXXXXXX Olli Laurikainen
(613) 957-2116
Attention: XXXXXXXXXX

February 9, 1998

Dear Sirs:

Re: Foreign Affiliates - Paragraph 95(2)(a)(ii)(D)

This is in reply to your letter dated September 22, 1997. You request our interpretation of the above provision in several different circumstances. You provide the following basic set of hypothetical facts.

1) Canco is a corporation resident in Canada.

2) Canco owns 100% of the shares of another corporation resident in Canada ("Cansub").

3) Canco owns 80% of the shares of two corporations resident in the United States ("U.S. Holdco and U.S. LLC"). Cansub owns the remaining 20% of the shares of each of those two corporations.

4) U.S. Holdco owns 100% of the shares of four corporations resident in the United States ("Subs 1 - 4").

5) U.S. LLC has loaned money to U.S. Holdco and the funds from the loan were used by U.S. Holdco to purchase the shares of Subs 1 - 4.

6) All of the assets of Subs 1- 3 are used in an active business but 30% of the assets of Sub 4 are used to earn income from property.

7) U.S. Holdco and Subs 1 - 4 are members of a group of corporations that report income for tax purposes in the United States on a consolidated basis.

You point out that in a similar hypothetical example at the June 1996 Corporate Management Tax Conference Revenue Canada Forum, the Department took the view that because the shares of Sub 4 are not "excluded property" as defined in subsection 95(1) of the Act, the interest paid by U.S. Holdco to U.S. LLC would not qualify for the deeming provisions of clause 95(2)(a)(ii)(D) for the reason that the requirements of subclause (V) thereof would not have been satisfied. You request the Department's view whether the following amendments to the hypothetical fact pattern set out above would change that result.

A) Sub 4 is merged with Sub 3 and the surviving company's shares qualify as excluded property. Would the full amount of the interest on the loans used by U.S. Holdco to purchase the shares of Subs 1 - 4 qualify for the deeming provisions of clause 94(2)(a)(ii)(D) of the Act effective for interest paid or payable during the taxation year of U.S. LLC in which the merger took place?

B) Sub 4 is resident in the United Kingdom, not in the Unites States such that it would not be included as a member of the group of corporations that files a consolidated tax return in the United States.

C) Same as in situation B above, except that the shares of Sub 4 are transferred by U.S. Holdco to Sub 3 in exchange for more shares of Sub 3. The shares of Sub 3 continue to qualify as excluded property and Sub 4 continues to be resident in the United Kingdom.

D) Sub 4's sole asset is an office building from which it derives property income. More than 50% of the building is leased to Sub 2. More than one-half of the income of Sub 4 is derived from lease payments from Sub 2 and such income is included Sub 4's income from an active business pursuant to subparagraph 95(2)(a)(ii) of the Act.

E) You request our interpretation whether the shares of a particular foreign affiliate of a Canadian taxpayer would qualify as excluded property where 60% of the value of its assets were comprised of an interest-free loan to a non-resident corporation to which the particular foreign affiliate and the taxpayer are related such that had interest been paid on such loan, such interest would have been subject to the deeming provisions of subparagraph 95(2)(a)(ii). The remaining 40% of the assets of the particular corporation are used in an active business carried on by it.

Our Comments

We assume that in each case below, the shares of U.S. Holdco are excluded property as defined in subsection 95(1) of the Act.

A) The taxation year referred to in clause 95(2)(a)(ii)(D) is the taxation year of U.S. LLC whereas the taxation year of U.S. Holdco and Subs 1- 4 may be an entirely different period. Due to this fact and because we have not done an in-depth analysis of the relevant U.S. tax law to determine the effects of the merger on the consolidated reporting of income under such law, it is difficult to ascertain the effects of the merger on the application of clause 95(2)(a)(ii)(D) in the taxation year of U.S. LLC that the merger takes place and possibly the subsequent taxation year.

Assume that U.S. LLC's taxation year is the calendar year and the consolidated group comprised of U.S. Holdco and Subs 1 - 4 reports its income for U.S. tax purposes on the basis of that same taxation year. Assume further that the merger of Sub 4 with Sub 3 takes place on December 1, 1997 and U.S. tax law provides that the group will report in its income for the taxation year ending December 31, 1997, all of the consolidated income of U.S. Holdco and the Subs (i.e. including Sub 4) notwithstanding Sub 4 is no longer in existence at December 31, 1997. In such case, because the income of Sub 4 for the period January 1, 1997 - December 1, 1997 is included as a component of the income of the group for the taxation year ended December 31, 1997, Sub 4 remains a member of the group for the purposes of the consolidated tax reporting notwithstanding that it no longer exists at the end of the taxation year of the group and subclause 95(2)(a)(ii)(D)(V) of the Act would not in our view be satisfied.

In the above example, in event that the income of Sub 4 from January 1 to December 1, 1997 became part of the income of Sub 3 for the year ended December 31, 1997 as a result of the amalgamation, the interest paid for the full year on the money borrowed by U.S. Holdco to purchase Subs 1 - 3 would appear to satisfy all the tests set out in clause 95(2)(a)(ii)(D) of the Act. However, the interest paid or payable prior to the merger in respect of the portion of the loan that was used to purchase the shares of Sub 4 would still not satisfy the test in subclause 95(2)(a)(ii)(D)(III) of the Act even if the other tests in clause 95(2)(a)(ii)(D) had been met. Therefore that interest would not qualify for the deeming provisions of clause 95(2)(a)(ii)(D).

B&C) If Sub 4 is a corporation resident in the United Kingdom, it would not be included in the particular group of corporations for the purposes of subclause 95(2)(a)(ii)(D)(V). In such case the "group" would be made up of U.S. Holdco and Subs 1- 3. Interest paid or payable on the portion of loan money used to purchase the shares of Subs 1 - 3 would qualify for the deeming provisions of clause 95(2)(a)(ii)(D) of the Act. In the event the shares of Sub 4 are transferred by U.S. Holdco to Sub 3 in exchange for additional shares of Sub 3, the shares of Sub 3 would be substituted for the shares of Sub 4 as the "property" for the purposes of subclauses 95(2)(a)(ii)(D)(I) and (III) of the Act. Therefore subsequent to such transfer, provided that the shares of Sub 3 continue to be excluded property, the full amount of the interest paid or payable on the loan from U.S. LLC to U.S. Holdco (including the portion thereof used by U.S. Holdco to purchase the shares of Sub 4) would qualify for the deeming provisions of clause 95(2)(a)(ii)(D).

D) In the circumstances described in question D above, the office building would be excluded property by virtue of paragraph a) of the definition of "excluded property" in subsection 95(1) of the Act. As a result the shares of Sub 4 would in those circumstances qualify as excluded property by virtue of paragraph (b) of the definition of excluded property.

E) In the circumstances described in question E above, the interest-free loan would be excluded property by virtue of clause (c) of the definition in subsection 95(1) and the remainder of the assets of the affiliate would qualify as excluded property under paragraph (a) of the definition. As a result, all of the assets of the affiliate described in that question would be excluded property and by virtue of that fact, the shares of the affiliate would be excluded property to the holder by virtue of paragraph (b) of the definition.

Exempt Earnings

For the purposes of determining whether the income derived by U.S. LLC from interest received on loans made to U.S. Holdco is included in the exempt earnings of U.S. LLC, the definition of exempt earnings in subsection 5907(1) of the Regulations to the Act contains certain special rules. In particular, in reference to our comments in paragraph E above, we note subclause (d)(ii)(H)(III) of the definition of exempt earnings provides that for the purposes of clause (H) of that definition, the definition of "excluded property" in subsection 95(1) is to be read without reference to amounts receivable referred to in paragraph (c) of that definition where the interest on the amounts is not, or would not, if interest were payable on the amounts be deductible by the debtor in computing its exempt earnings or exempt loss. Therefore, even though the interest received by U.S. LLC from U.S. Holdco may be deemed to be income from an active business, it may be included in the computation of taxable surplus of U.S. LLC rather than its exempt surplus because shares of a subsidiary of U.S. Holdco which may be excluded property for the purposes of clause 95(2)(a)(ii)(D) of the Act may not satisfy the excluded property test in subclause (d)(ii)(H)(II) of the Regulations to the Act.

We provide no opinion as to whether the provisions of subsection 245(2) of the Act would apply to the transactions described above as such determination would require full knowledge of all the facts and circumstances surrounding a factual situation.

The foregoing comments are given in accordance with the practice referred to in paragraph 22 of information Circular 70-6R3 and are not binding on Revenue Canada.

We trust this is the information you require.

Yours truly,

for Director
Reorganisations and International Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch
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