Two LLCs in a US consolidated group beneath Canco made tax compensations indirectly to the top CFA in that group in respect of the share of the U.S. taxable income of the US consolidated group earned through those LLCs during their 2011 and 2012 taxation years. LLC1 and LLC2, which were disregarded for IRC purposes had, as their sole members, CFA3 (a direct subsidiary of CFA2) and CFA4 (an indirect subsidiary of CFA2). CFA2 was held as to approximately 80% by CFA1 and as to 20% by third parties. CFA1 formed a consolidated group for US purposes and all such CFAs (and others) were CFAs of Canco, which earned FAPI in respect of LLC1 and LLC2 for their 2011 and 2012 taxable years.
Pursuant to a Tax Sharing Agreement (TSA) entered into on December 20, 2013, LLC1 and LLC2 made payments in June 2014 to CFA2 representing the notional U.S. federal income tax that could reasonably be regarded as being in respect of the share of the U.S. taxable income of the US consolidated group earned through those LLCs during their 2011 and 2012 taxation years, and such amounts were included amounts paid in turn by CFA2 to CFA1 in respect of the share of the U.S. taxable income of the US consolidated group earned by the members of the CFA2 Subgroup (i.e., in CFA2 and beneath). However, no US income taxes were paid by the US consolidated group for those years because of operating losses for those years.
In finding that the payments pursuant to the TSA by LLC1 and LLC2 qualified under Reg. 5907(1.3)(a) as amounts that could reasonably be regarded as being in respect of income tax that would otherwise have been payable by CFA3 or CFA4 in respect of the FAPI had their US tax liabilities been determined for US purposes on an unconsolidated basis, the Directorate indicated that:
- although it was only the CFAs and not LLC1 and LLC2, as disregarded entities, who severally bore the liability to pay the US consolidated group’s tax liability, the payments made by LLC1 and LLC2 to CFA2 were made on behalf of their respective sole members
- the indirect routing of their payments to CFA1 through CFA2 made no difference
- although the payments for the 2011 taxation years were not made pursuant to a written agreement, there was no requirement that tax sharing payments be made pursuant to a written agreement, and here, it would be reasonable for the TSO to consider that those payments have been made pursuant to an unwritten tax indemnity agreement
- furthermore:
[T[he fact that the tax sharing payments have been paid in June 2014 does not prevent paragraph 5907(1.3)(a) … from applying to these amounts for the purposes of Canco’s 2011 and 2012 taxation years. In our view, the deduction under subsection 91(4) is available in the taxation year of the taxpayer in which the taxation year of the FA, for which an income or profits tax would have been payable in the circumstances described in subsection 5907(1.3) of the Regulations, ends. …
The amounts constructively paid by CFA3 and CFA4 were determined in a manner that, in our view, supports that they can reasonably be regarded as being in respect of the income tax that these foreign affiliates would have paid in respect of FAPI earned by their disregarded subsidiaries (LLC1 and LLC2 respectively) if the tax liabilities of CFA3 and CFA4 had those amounts not been determined as members of the US Consolidated Group but rather had been determined separately. Accordingly these amounts should give rise to a prescribed amount under paragraph 5907(1.3)(a) … .
However, given that the income from LLC1 and LLC2 was offset for US purposes by reported operating losses from the active businesses of other members of the US consolidated group, Reg. 5907(1.4) reduced the prescribed amounts recognized for Canco’s 2011 and 2012 taxation years to nil, resulting in no FAT being recognized regarding the above tax sharing payments until (and to the extent that) Regs. 5907(1.5) and (1.6) applied in respect of one or more of Canco’s five subsequent taxation years.