3 September 1991 External T.I. 9111825 F - Foreign Pension Arrangements

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.

5-911182

Dear Sirs:

Re: Foreign Income Tax Paid By a Foreign Affiliate

This is in response to your letter dated April 26, 1991.

You requested a technical interpretation concerning subsection 91(4) and paragraph 95(1)(c) of the Income Tax Act (the "Act") and paragraph 5907(1)(1) of the Regulations to the Act (the "Regulations" ) in reference to a hypothetical situation.  Please note that in simplifying your example we have made certain changes to the facts presented in your letter.  Our comments are based on the following set of facts:

1)     FA, a corporation resident in the United States a wholly-owned subsidiary of a corporation ("Canco") resident in Canada.

2)     During its 1990 taxation year, FA disposes of capital property other than excluded property which has an adjusted cost base for Canadian tax purposes greater than that for the purposes of I.R.S. Code (the "Code").  Therefor, the capital gain for Canadian tax purposes ($10,000) is less than the gain for the purposes of the Code ($20,000) This difference came about as a result of a previous disposition and re-acquisition of the property which was recognized for Canadian tax purposes but not for U.S. tax purposes.

3)     After the deduction of a reserve of $8,000 under subparagraph 40(1)(a)(iii) of the Act and a deductible loss under subparagraph 95(1)(b)(v) of the Act, FA has no foreign accrual property income (FAPI) in 1990.

4)     Under the Code taxation of 3/4 ($15,000) of the $20,000 gain is deferred until 1991.

5)     In 1991, in computing its FAPI, FA brings in the reserve under subparagraph 40(1)(a)(ii) thereby arriving at a taxable capital gain ("TCG") of $6,000 (3/4 of $8,000).  The total FAPI of FA (and income inclusion under subsection 91(1) of the Act for Canco) is $10,000 being the taxable capital gain of $6,000 plus passive interest income of $6,000 less a subparagraph 95(1)(b)(v) deductible loss of $2,000.

6)     Under the Code, FA computes taxable income of $16,000 for 1991. This amount is made up of the $15,000 referred to in 4 above plus the $6,000 of interest income less a loss carry-forward of $5,000. This taxable income is subject to tax in the United States at a rate of 38%.

You question what portion of the 1991 tax can be reasonably regarded as applicable to the 1991 FAPI and taxable earnings of FA.

The Capital Gain

It is the Department's view that foreign tax paid in respect of a capital gain may reasonably be regarded applicable to an amount included in computing a taxpayer's income by virtue of subsection 91(1) of the Act for the purposes of subsection 91(4) and paragraph 95(1)(c) of the Act and as having been paid in respect of taxable earnings of a foreign affiliate for the purposes of paragraph 5907(1)(1) of the Regulations to the extent that such foreign tax is required to eliminate the Canadian income tax that would otherwise be payable in respect of the gain under the FAPI rules or through the repatriation of the taxable surplus resulting from the gain.

In order to determine what portion of the net FAPI was attributable to the TCG, and therefore subject to the above guidelines, it is necessary to allocate the deductible loss to the two types of FAPI income.  In our view this should be done on a pro rata basis thereby producing a figure of $5,000 for the TCG portion of the FAPI (i.e. $6,000 - [6000/(6,000 + 6,000) x $2,000]).

The total U.S. tax paid in the year was $6080 (i.e. the taxable income for U.S. tax purposes of $16,000 multiplied by the U.S. tax rate of 38%) The portion of such amount that is applicable to the capital gain computed pursuant to Canadian tax law is in our view $2,316 (i.e. the proportion of the U.S. tax that the capital gain for Canadian tax purposes is of the U.S. taxable income before the application of the U.S. loss carry-forwards).  In circumstances where the losses applied under the foreign tax law can be traced to a particular source, it may not be appropriate to allocate such losses proportionately to all sources of income in order to determine the amount of tax borne by a particular source as was done above.  However, in this case there were no facts that would indicate that the losses were applicable to either of the sources of income reported in 1991.

The portion of the $2,316 that would need to be considered reasonably applicable to the 1991 FAPI TCG in order to eliminate Canadian tax in respect thereof would be $1,900 as this amount multiplied by the relevant tax factor for the purposes of paragraph 91(4)(a) produces a deduction equal to the 1991 FAPI TCG ($5,000).  A further deduction in respect of U.S. tax paid on the balance of the capital gain reported for U.S. tax purposes may be available under subsection 91(4) of the Act if the original disposition of the property gave rise to an income inclusion under subsection 91(1) of the Act in the 5 immediately preceding years.

In order to provide for a deduction under paragraph 113(1)(b) of the Act equal to the amount that is added to the taxable earnings and therefore the taxable surplus of FA by virtue of the TCG, it would be necessary to regard $2,280 of the $2,316 total U.S. tax paid in 1991 on the capital gain for Canadian tax purposes to be underlying foreign tax for the purposes of subparagraph 5907(1)(1)(v) of the Regulations.  That is, the taxable earnings attributable to the TCG of $6,000 net of the $2,280 in U.S. tax could be used to pay a dividend equal to $3,720 (net surplus must be equal to or greater than $3720) and a deduction equal to the full amount of such dividend could be computed under paragraph 113(1)(b) of the Act by multiplying $2,280 by the number determined in clause (i)(A) and (B) thereof.

The amount added to the underlying foreign tax account of a controlled foreign affiliate in respect of a particular Canadian corporation as a result of having been taxed on certain income other than active business income generally corresponds to the foreign accrual tax applicable to the FAPI of the Canadian taxpayer associated with such income.  However, as you point out in your letter, the taxable earnings of FA in respect of the TCG will by virtue of subparagraph 5907(1)(f)(ii) of the Regulations be increased by an amount equal to the TCG ($6,000) before the deduction of a deductible loss minus such portion of any income or profits tax paid to the U.S. that may reasonably be regarded as a tax in respect of such income.  Therefore, the amount added to the underlying foreign tax of FA in respect of Canco by virtue of the capital gain will in this case, exceed the amount that represents the foreign accrual tax in respect of that gain.

The non-taxable portion of the capital gain (1/4 X $8,000) net of the U.s. tax applicable to the gain not but to the TCG ($2,316-2,280) would be included in exempt earnings as provided under paragraph 5907(1)(b) of the Regulations.

The Interest Income

The amount included in computing Canco's income in 1991 by virtue of subsection 91(1) of the Act in respect of the passive interest earned by FA after the deduction of the relevant portion of the deductible loss is $5,000 (i.e.$6,000-[6,000/(6,000 + 6,000) x $2,000]). The U.S. tax that may be reasonably regarded as applicable to such interest is $1,737 (i.e. the proportion of the U.S. tax that the interest income for Canadian tax purposes before the deduction of the deductible loss is of the U.S. taxable income before the application of U.S. lose carry-forwards).  This amount multiplied by the relevant tax factor produces a subsection 91(4) of the Act deduction of $4,571.

The $6,000 of interest income less the $l,737 of U.S. tax applicable thereto would be added to taxable earnings and therefore taxable surplus of FA in respect of Canco pursuant to subparagraph 5907(1)(f)(ii) of the Regulations.  The $1,737 would also be added to FA's underlying foreign tax in respect of Canco by virtue of subparagraph 5907(1)(1)(v) of the Regulations

Possible Additional Underlying Foreign Tax

The U.S. tax that are not applicable to the amounts included in the taxable or exempt earnings of FA ($6,080-($2,316+$1,737)) in 1991, would by default only affect pre-acquisition surplus unless a portion of such taxes may reasonably be regarded as having been paid in respect of the taxable or exempt earnings of FA in respect of Canco earned in a previous taxation year (i.e. the year of the original disposition of the property), in which case an appropriate amount would be deducted from both the taxable and the exempt surplus of FA in respect of Canco.  In addition, a portion would be added to the underlying foreign tax account of FA in respect of Canco.  Any additional amount added to the underlying foreign tax of FA in respect of the U.S. taxes paid on the capital gain reported in 1991 for the purposes of the Code, would be determined in the same manner as was the underlying foreign tax amount of $2,280 in respect of the portion of such capital gain that was included in taxable surplus in 1991.

We hope the above will be of assistance to you.

Yours truly,

for DirectorReorganizations and Non-Resident DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch