Four U.S.-resident controlled foreign affiliates of a Canadian public corporation (“Canco”), namely, CFA1 (wholly-owned by Canco), and CFA2, CFA3 and CFA4 (wholly-owned by CFA1) performed, as their only activity, research and development services (“R&D Services”) for the benefit of Canco, and with the fees paid therefor by Canco being their only revenue. CFA1 filed an amended annual consolidated U.S. federal income tax return for the “US Consolidated Group”, including CFA2, CFA3 and CFA4 in which a significant amount as a “credit for increasing research activities” was deducted against the U.S. federal income tax otherwise payable.
The Directorate found that s. 95(2)(b) applied to the R&D Services provided to Canco so as to result in a foreign accrual property income inclusion to Canco. Although it was not asked to comment on this issue at this stage, the Directorate made some general comments on the foreign accrual tax deduction, including:
[T]he amount of foreign tax paid by CFA1 may only give rise to FAT to the extent it can reasonably be regarded as applicable to the FAPI inclusions in Canco’s income in respect of CFA1. For there to be FAT attributable to the FAPI inclusions in Canco’s income in respect of CFA2, CFA3 and CFA4, it would have to be an amount prescribed as such under paragraph 5907(1.3)(a) of the Regulations for the purposes of paragraph (b) of the FAT definition. As such, numerous requirements would have to be met, including that “tax sharing payments” were made.
In addition, if any amount is prescribed as FAT under paragraph 5907(1.3)(a) of the Regulations, the net operating losses from prior years and losses from other businesses used by members of the US Consolidated Group would have to be reviewed in order to assess whether the “FAT Denial Rule” of subsection 5907(1.4) of the Regulations applies. In this respect, the nature of the loss, the year it was incurred, and whether that year precedes an acquisition of control by Canco, by example, would be part of the facts that would have to be confirmed. Also, information would be required in respect of the functioning of the U.S. research and development credit regime in order to determine whether any amount can be deducted in that respect in the determination of any amount of FAT.