The taxpayer (“Emergis”), a Canadian public company, financed its acquisition of an arm’s length U.S. operating company through a "tower structure" under which:
- Emergis made an interest-bearing loan (the “First Loan”) to a Delaware general partnership (“USGP”) of which it and a Canadian subsidiary were 99.9% and 0.1%, partners, respectively;
- USGP funded such interest payments out of dividends received from a wholly-owned Nova Scotia ULC (“NSULC”);
- NSULC, in turn, received dividends out of the exempt surplus of a wholly-owned LLC; and
- the LLC received interest on the acquisition-financing loan made to “US Holdco,” with that interest being recharacterized under s. 95(2)(a) as active business income.
Emergis’ 99.9% effective share of the interest deduction of USGP for the First Loan largely offset its interest income from the First Loan and, in addition, it claimed the s. 112(1) deduction for its effective share of the dividend income from NSULC. From a U.S. perspective, the interest on the First Loan was deductible interest paid by a U.S. corporation (USGP) to a Canadian resident (Emergis), and was subject to U.S. withholding tax. (In this regard, the structure differed from FLSmidth, where the partnership paid interest to an arm’s length lender, which was exempt from U.S. withholding tax.)
Before concluding that Emergis could not claim the s. 20(12) deduction for such withholding taxes, on the basis that they were “taxes … that can reasonably be regarded as having been paid by a corporation [Emergis] in respect of income from a share of the capital stock of a foreign affiliate of the corporation [the LLC],” Favreau J stated (at paras. 68, 74):
[T]he words “in respect of” are very broad … .
Given the flow of funds in this tower structure, there is some connection between the interest income paid by USGP and the dividends paid by LLC to USGP, which were reclaimed and reported by Emergis through its partnership interest in USGP.
After stating (at para. 81) that the s. 20(12) exclusion at issue was “intended to restrict the availability of foreign tax relief where the provisions that deal with foreign affiliates can be said to have provided sufficient relief,” he noted that additional connecting factors between the interest payments and the underlying dividend from the LLC included:
- the interest deduction on the First Loan was “dependent on a purpose of earning income which in this case is the dividend flowing from LLC and on from NSULC” (para. 83)
- “the only cross-border source of income recognized by the Act is the income from a share of LLC, which can reasonably be regarded as the income on which foreign tax was levied, since the interest income [itself] is seen as paid by a Canadian resident to another (para. 85)
- “99.9% of the interest received, Emergis’ foreign source of income can reasonably be regarded to be that of the LLC dividend, such that if any foreign tax was paid it must be regarded as having been paid in respect of that foreign source income. (para. 87)