TEI-Canadian Department of Finance liaison meeting - income tax issues - Tax Executive Institute's December 11, 1996 meeting

Tax Executive, The, May-June, 1997

The need to manage a foreign group's liquidity and interest-rate and currency risks in a centralized manner exposes many of the group's companies to the hazard that their businesses will be deemed to be carried on principally with persons with whom they are not at arm's length. The difficulty is not so much with their related-party asset positions and revenue streams (which will normally give rise to deemed active business income under special rules) as with the income derived directly from third-party borrowers, which may be taxable in Canada as non-excepted investment business income.

As the statute is currently drafted, the arm's-length test must seemingly be met at all times throughout the taxation year of the controlled foreign affiliate. TEI submits that the costs of monitoring compliance with the arm's-length requirement on a continuous basis combined with the likelihood of errors by employees unfamiliar with, or occasionally forgetful of, detailed Canadian tax rules exposes Canadian financial institutions to exacting even unreasonable standards. A simple and elegant solution to this problem would be to deem intra-group assets and revenue streams that generate deemed active business under the various provisions of subsection 95(2) to count as arm's length for purposes of meeting the requirements of an investment business. In order for income to qualify as deemed active business income, it must arise from an active business of a related company, i.e., a business that is carried on principally with persons with whom the affiliate deals at arm's length. If adopted, the requested change would extend the existing policy without penalizing intra-group transactions that relate to the underlying third-party active business of the group.

Finance response: The submission requested a new deeming rule to treat intra-group assets and revenue streams at arm's length in those cases where they are deemed to generate active business income. This would ensure that such assets would not inadvertently tip the balance in favour of a majority of non-arm's length assets or revenues thus causing otherwise qualifying third party income to be treated as FAPI.

Finance is not receptive to an amendment of this type due to a concern that such a new deeming rule might actually convert some truly passive income that should be FAPI into qualifying active business income. It was suggested that an alternative approach that would not carry this risk might consist of ignoring or excluding the intra-group assets and revenues that generate deemed active business income rather than deeming them to be arm's length.

TEI looks forward to exploring this alternative further with Finance perhaps at the May Conference.

Foreign Group of Companies

Subclause 95(2)(a)(ii)(D)(v) requires that the interaffiliate interest payments be relevant for purposes of computing the liability for income taxes of the members of a group of corporations composed of the second affiliate and one or more other foreign affiliates of the taxpayer (the shares of which are excluded property). Most taxpayers and tax professionals interpret subclause (v) as providing that only foreign affiliates whose shares are excluded property are to be considered as part of the group in applying the test in subclause (v). At the 1996 Canadian Tax Foundation's Corporate Management Tax Conference Roundtable, however, representatives from Revenue Canada, in commenting on the application of subclause (v) to interaffiliate payments involving a U. S. consolidated group, said that foreign tax laws determine the composition of the group rather than Canadian tax law. Will the Department of Finance confirm whether the intended meaning for subclause (v) is that only foreign affiliates whose shares are excluded property are to be considered? If the Department agrees with taxpayers' interpretations, will the Department support an amendment to clarify the interpretation?