Principal Issues: Reasoning behind the CRA's reversal of position with respect to the application of clause 95(2)(a)(ii)(D) to a particular fact situation.
Position: Clause 95(2)(a)(ii)(D) applies to the particular facts.
Reasons: Based on a textual, contextual and purposive analysis of the Act.
2015 International Fiscal Association Conference
CRA Roundtable
Question 6 Reasons for CRA's reversal of position on clause 95(2)(a)(ii)(D)
In document no. 2013-0496841I7 (the "First Document") the CRA took the position, in the context of a question from a TSO, that clause 95(2)(a)(ii)(D) did not apply to recharacterize interest on a debt issued to acquire a note that was subsequently contributed to the capital of another foreign affiliate without the receipt of shares. The CRA appeared to reverse that position in document no. 2014-0519801I7 (the "Second Document"), but gave no reasons. Could you now provide us with the reasons for this apparent reversal?
CRA Response
The CRA generally keeps an open mind as to the positions it takes such that when new arguments are presented by a taxpayer or its advisors in the context of an audit, they will be taken into consideration. However, the decision as to whether to involve the Income Tax Rulings Directorate rests solely with the audit staff of the CRA taxpayers are not to contact us directly in the context of an interpretive issue relating to an audit. This is consistent with our statements in IC 70-6R6, paragraph 7(c), in the context of requests for technical interpretations.
The relevant facts, in their most basic form, are as follows:
1. A corporation resident in Canada ("Canco") owns all of the shares of two foreign affiliates, FA1 and FA2;
2. FA2 owns all of the shares of another foreign affiliate, FA3;
3. FA3 owns all of the shares of another foreign affiliate, FA4;
4. FA2 acquired from FA1 an interest-bearing note issued by FA4 ("Note 1") in consideration for the issuance by FA2 of an interest-bearing note ("Note 2");
5. FA2 then made a contribution of capital "in-kind" to FA3 by transferring Note 1 to FA3 for no consideration.
If certain conditions are met, pursuant to clause 95(2)(a)(ii)(D), the income earned by FA1 on Note 2, which would otherwise be income from property, can be recharacterized into income from an active business if such income is derived from amounts paid to it by FA2, to the extent that, inter alia, the amounts of income are paid or payable by FA2:
[ ]
(II) on an amount payable for property acquired for the purpose of gaining or producing income from property
where
(III) the property is, throughout the particular period, excluded property of [FA2] that is shares of the capital stock of a corporation [FA3] which is, throughout the particular period, a foreign affiliate of the taxpayer in respect of which the taxpayer has a qualifying interest, and
[]
In the First Document, the Income Tax Rulings Directorate took the position that clause 95(2)(a)(ii)(D) did not apply because the property acquired on the issuance of Note 2, being Note 1, was not shares of another foreign affiliate, as required by subclause 95(2)(a)(ii)(D)(III) ("Subclause (III)"), and because FA2 did not acquire any property on the transfer of Note 1 to FA3. However, in the Second Document, this position was reversed, i.e. it was accepted that clause 95(2)(a)(ii)(D) applied to recharacterize the interest as income from an active business.
The basis for this reversal is that we are now of the view that the purpose test that must be met when reading subclause 95(2)(a)(ii)(D)(II) ("Subclause (II)") in conjunction with Subclause (III) being that the purpose of the acquisition of a property be the earning of income from property where the property is shares of a foreign affiliate will be met even if the property acquired (Note 1) on the issuance of Note 2, as referred to in Subclause (II), is not the same property as that referred to in Subclause (III), being the shares of FA3, as long as the property (Note 1) has been acquired for the purpose of earning income from those shares of FA3.
In this situation, since the contribution to FA3 of the property acquired (Note 1) enhanced the dividend earning capacity of FA2 with respect to the FA3 shares, we consider, notwithstanding that no new shares of FA3 were issued, that the acquisition of Note 1 by FA2 meets the purpose test, i.e. Note 1 was acquired for the purpose of gaining or producing income from property being the shares of FA3, as of the time of the contribution. Therefore, we are of the view that the interest paid on Note 2 by FA2 to FA1 would be recharacterized as active business income of FA1 as of the time of the capital contribution, provided all other conditions are met.
Hugo Gravel
2015-058160
May 28, 2015