25 October 2017 Internal T.I. 2016-0658171I7 - Regulation 5900(3) and subparagraph 93.1(2)(d)(i)

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.

Principal Issues: Whether a subsection 91(5) deduction is taken into account in determining the amount referred to in subparagraph 93.1(2)(d)(i).

Position: Yes.

Reasons: Textual, contextual and purposive interpretation of subparagraph 93.1(2)(d)(i) and Regulation 5900(3).

							October 25, 2017

XXXXXXXXXX						Income Tax Rulings Directorate
Large File Case Auditor				International Division
XXXXXXXXXX						John Meek

							2016-065817

Application of Regulation 5900(3) and subparagraph 93.1(2)(d)(i)

Dear XXXXXXXXXX,

This letter is in response to a memorandum dated July 15, 2016 in which you raised questions in connection with the interaction of subsection 5900(3) of the Income Tax Regulations (the “Regulations”) and subparagraph 93.1(2)(d)(i) of the Income Tax Act (the “Act”). Unless otherwise indicated, all statutory references herein are to the Act.

The questions raised in your memorandum deal with a particular Canadian corporate taxpayer whose international corporate structure is extremely complex. However, the questions you raised can be discussed and analyzed based on the following reasonably simple hypothetical example:

• Assume a partnership (“LP”) only has one class of units issued and outstanding.
• A taxable Canadian corporation (“X”) owns 99 % of these units and its wholly owned Canadian subsidiary (“Y”) owns the remaining 1%. For purposes of this example, X and Y are collectively referred to as “Canco”.
• LP owns 100% of a non-resident corporation (“FA1”).
• Canco, LP and FA1 all have the same fiscal year end.
• In its 2015 taxation year, FA1 has foreign accrual property income (“FAPI”) of $1,000 (no foreign income tax is paid thereon) and pays a $1,500 dividend to LP.
• That dividend would be prescribed to be a $1,500 dividend paid out of the exempt surplus of FA1 in respect of Canco.
• FA1 had no FAPI in any prior year.
• LP’s income/loss for its 2015 fiscal year (excluding any FAPI inclusion) consisted of the $1,500 dividend received from FA1 and interest expense of $200 on a borrowing used to acquire the FA1 shares. Canco has no source of income or loss other than the amount required to be included in its income under subsection 96(1) in respect of its LP partnership interest.

Your questions are:

1. For purposes of subsection 91(5), does Regulation 5900(3) apply to deem the $1,500 dividend received by LP to be paid out of the taxable surplus of FA1?

2. For purposes of subparagraph 93.1(2)(d)(i), what is the portion of the amount of the dividend included in the income of Canco under subsection 96(1)?

Our comments

As a preliminary comment, we note that if Canco, in the above example, had directly owned the FA1 shares, and had directly incurred the interest expense of $200, its taxable income for 2015 would have been $800, determined as follows:

Dividend from FA1 – subsection 90(1)	1,500
Interest expense – paragraph 20(1)(c)	(200)
FAPI – subsection 91(1)				1,000
Subsection 91(5) deduction			(0)
Income						2,300
Paragraph 113(1)(a) deduction			(1,500)
Taxable income					800

Question 1

Subsection 91(5) is designed to ensure that a shareholder of a controlled foreign affiliate (“CFA”) does not get taxed twice on the FAPI of a CFA – once when the FAPI is earned, and then when the FAPI is distributed to the shareholder as a dividend. Where a shareholder of a particular foreign affiliate (“FA”) is a corporation resident in Canada, the FAPI of the FA is included in the taxable surplus of the FA in respect of that corporation. Surplus accounts of a FA are not maintained in respect of a partnership.

Subsection 91(5) applies when a taxpayer resident in Canada has received a dividend that is prescribed to have been paid out of the taxable surplus of the affiliate. For purposes of subsection 91(5), in the case of a taxpayer that is not a corporation, subsection 5900(3) of the Regulations deems a dividend received by that taxpayer to be prescribed to have been paid out of taxable surplus. In our view, this provision would apply to deem the $1,500 dividend received by LP to be paid out of the taxable surplus of FA1 for purposes of subsection 91(5). As such, LP would, in this example, be entitled to a subsection 91(5) deduction of $1,000 in its 2015 taxation year, resulting in LP having net income of $1,300. Furthermore, subsection 92(1) and paragraph 53(1)(d) would cause a reduction in the ACB of LP’s shares of FA1 by the subsection 91(5) deduction amount of $1,000.

Question 2

Subparagraph 93.1(2)(d)(i) reads as follows (emphasis added):

Where, based on the assumptions contained in paragraph 96(1)(c), at any time shares of a class of the capital stock of a foreign affiliate of a corporation resident in Canada (in this subsection referred to as “affiliate shares”) are owned by a partnership and at that time the affiliate pays a dividend on affiliate shares to the partnership (in this subsection referred to as the “partnership dividend”), …

(d) notwithstanding paragraphs (a) to (c),

(i) where the corporation resident in Canada is a member of the partnership, the amount deductible by it under section 113 in respect of the dividend referred to in paragraph (a) shall not exceed the portion of the amount of the dividend included in its income pursuant to subsection 96(1), and …

In this example, we must determine the portion of the $1,500 dividend that is included in Canco’s income under subsection 96(1). Is it the gross amount of the dividend ($1,500), the net dividend amount of $300 ($1,500 - $200 - $1,000), or some other amount?

Paragraph 96(1)(f) and subparagraph 93.1(2)(d)(i)

Under paragraph 96(1)(f), the Act requires the partnership to compute its income on a source by source basis. Income from a source is required to be computed on a net basis (i.e. net of allowable deductions with respect to that source). (footnote 1) (footnote 2)

On this basis, for the purposes of subparagraph 93.1(2)(d)(i), the net amount of $1,300 included in the income of Canco under subsection 96(1) as income from property needs to be broken down between dividend and other income. In our view, the portion of income attributable to the dividend in the example is $300, computed net of the interest expense incurred to earn the dividend income and the subsection 91(5) deduction. The remaining balance of $1,000 is attributable to FA1’s FAPI.

However, it has been the CRA’s long-standing position that interest deductions relating to acquisitions by a partnership of foreign affiliate shares are not to be taken into account in applying the limitation in subparagraph 93.1(2)(d)(i). As such, in our view it would be appropriate to only consider the subsection 91(5) deduction to reduce the dividend for the purpose of applying subparagraph 93.1(2)(d)(i). This would give a result that is consistent with the results that would be obtained if Canco had held the shares of FA1 directly. It is also our view that it would be appropriate in these circumstances to reinstate the exempt surplus of FA1 in respect of Canco that is denied recognition by the operation of subparagraph 93.1(2)(d)(i), being $1,000, and to reduce the taxable surplus by the same amount.

For your information, 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. 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 latter version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca. In such cases, a copy will be sent to you for delivery to the taxpayer.

We trust that these 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

FOOTNOTES

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

1 Paragraph 4(1)(a) of the Act.

2 See endnote in document 2007-024755. “It should be noted that under subsection 96(1) of the Act, income of the partnership vis-à-vis a partner is to be computed in respect of each particular source. In principle, income from a source is to be computed on a net basis (i.e., income net of expenses with respect to that source).”