Background and MAP agreement
Canco 1, which was an in direct wholly-owned subsidiary of ACo (a Canadian public corporation), was reassessed by CRA under s. 247(2) on the basis that it was undercharging for services rendered by it to counterparties and, by implication, permitting Forco 1 (an indirect wholly-owned subsidiary of ACo resident in Country A) to earn higher fees from counterparties than should have been the case from a transfer-pricing perspective. Under a “MAP Settlement” negotiated between the competent authorities for Canada and Country A, it was agreed that
- there would be a downward adjustment for Country A taxation purposes in the fee amounts that Forco 1 was treated as earning (the “MAP Adjustment”),
- there was no required adjustment to the amount of such fees earned for commercial purposes
- no secondary adjustment would be made in respect of the MAP Adjustment to the income of Canco 1 or Forco 1 or to create a loan or other obligation between them
- Canco 1 waived its rights to appeal respecting the matter
As a consequence of the MAP Adjustment, Forco 1 expects to receive an income tax refund (the “Country A Repayment”) from Country A.
Proposed transactions and additional information
Forco 1 will declare and pay a dividend to ACo. It will not make any election under Reg. 5901(2) to reorder its surplus distributions. Its surplus balances before the above adjustments were nil as a result of earning and fully distributing its active business earnings.
Forco 1 estimates that it will have a net loss from an active business for each of various taxation years. The amount of the Country A Repayment will be added to Forco 1’s distributable reserves/retained earnings for financial accounting purposes.
Rulings
The earnings of Forco 1, as determined under s. (a)(i) of the definition of “earnings” in Reg. 5907(1) equals its income from an active business as computed in accordance with the Country A income tax law, which reflects the MAP Adjustments. However, such adjustments are added to the earnings of Forco 1 pursuant to Reg. 5907(2)(f). In this regard, the CRA summary states:
i) The corresponding adjustment and the resulting reassessment by the foreign tax authority changes the income or profit from active business of the foreign affiliate computed in accordance with the foreign tax law and the income taxes paid by the foreign affiliate in respect of that income or profit. ii) The money realized and retained by the foreign affiliate, but excluded from its income for foreign income tax purposes as a result of the corresponding adjustment by the foreign tax authority, would be "revenue, income, or profit" derived by the foreign affiliate for purposes of paragraph 5907(2)(f) of the Regulations.
Upon receipt of the Country A reassessment reflecting such adjustments reducing its income, the “net earnings” of Forco 1 for those years as defined in Reg. 5907(1)(a) will be increased by the amount of income taxes that were correspondingly overpaid. Conversely, the payment of Country A income taxes owing as a result of Country A reassessment increasing income, its “net earnings” will be decreased by the amount of such income taxes paid for such taxation year.