FINANCING ISSUES. Evelyn (Evy) Moskowitz

Transcription

1 FINANCING ISSUES FINANCING OF NON-RESIDENTS AND SECTION 17 Evelyn (Evy) Moskowitz Moskowitz & Meredith LLP, an affiliate of KPMG LLP May 29, 2011 June 3, 2011

2 2 FINANCING OF NON-RESIDENTS AND SECTION 17 The provisions of section 17, like the thin capitalization rules found in subsections 18(4) to 18(8) of the Income Tax Act, (Canada) 1 deal with interest on indebtedness between a Canadian resident corporation and a non-resident. However, whereas the thin capitalization rules address the situation in which the indebtedness is owed by a Canadian resident corporation to a nonarm s-length non-resident and determine whether a portion of the interest paid by such corporation on such indebtedness is to be disallowed as an expense, the rules in section 17 focus on indebtedness owed to a Canadian resident corporation by a non-resident (non-arm s length or otherwise) and determine whether such corporation should be required to include in income an amount in respect of interest that should otherwise have been paid to it by the non-resident. The purpose of section 17 is to prevent Canadian corporations from employing their capital outside Canada by way of non-interest bearing or low interest loans and thereby avoiding Canadian tax on all or part of the income that would otherwise be derived from such capital. Prior to extensive amendments made in 1998, 2 section 17 consisted of three subsections. Subsection 17(1) was the charging provision which provided that where: a Canadian resident corporation had lent money to a non-resident person; the loan had been outstanding for one year or longer; and interest on the loan, computed at a reasonable rate, had not been included in computing the corporation s income, 1 2 RSC 1985, c.1, (5 th Supp.), as amended (the Act ). All statutory references in this paper are to the Act. The amendments to section 17 (the Amendments ) were first announced in the federal budget of February 24, 1998, and were to have taken effect for taxation years beginning after February 23, Detailed draft legislation was then released on October 27, 1998 (the Draft Legislation ) and was followed by a Notice of Ways and Means Motion dated December 10, This motion contained certain amendments to the Draft Legislation that were designed to address a number of concerns that had been raised in response to the Draft Legislation. These concerns also resulted in the application of new subsections 17(2) and (3) being deferred until taxation years beginning after 1999 (see Department of Finance Press Release No , dated December 18, 1998). A further Notice of Ways and Means Motion was then introduced on March 10, 1999 (the March Motion ), as was the bill related thereto (Bill C-72), which again contained numerous amendments to the Draft Legislation. These latter amendments were, for the most part, relieving in nature although, as is discussed elsewhere in this paper, they did not go far enough in dealing with the various anomalies to which the Amendments gave rise. Bill C-72 received Royal Assent and was proclaimed into force on June 17, It was enacted in its original form except with respect to certain transitional rules relating to the application of new subsection 17(7) (discussed below).

3 - 3 - the corporation was deemed to have received, on the last day of each taxation year during which such loan was outstanding, interest on the loan at the prescribed rate 3, 4 applicable to the period in the taxation year during which such loan was outstanding. 5 Subsections 17(2) and 17(3) provided for exceptions to the rule in subsection 17(1) where Part XIII withholding tax had been paid on the loan in question (subsection 17(2)) or where the loan had been made to a subsidiary controlled corporation that used the loan proceeds in its business for purposes of gaining or producing income (subsection 17(3)). The Amendments significantly changed the foregoing provisions and rendered them far more onerous than was previously the case. The range of lenders and borrowers now caught by section 17 was greatly expanded as were the types of transactions that fell within its scope. The discussion below compares the Amendments with the old rules in section 17 and describes how section 17 was changed from a relatively innocuous section to one that is now of concern in many cross-border financing transactions. I. AMOUNTS SUBJECT TO SECTION 17 A. The Old Rules Previously, subsection 17(1) only applied to loans. However, not all indebtedness qualifies as a loan. There is a difference between indebtedness arising as a result of a debtor/creditor relationship (for example, for an unpaid purchase price) and that arising as a result of a borrower/lender relationship. 6 It is only in the context of this latter type of The prescribed rate is set out in Regulation Although old subsection 17(1) deemed the Canadian resident corporation to have received interest, it was paragraph 12(1)(c) that actually required that interest to be included in the corporation s income. (See Liampat Holdings Limited v. HMQ, 96 DTC 6020 (FCTD)). Under the Amendments, however, this income inclusion is provided for in subsection 17(1) itself. The application of the rules in old subsection 17(1) had to be made on an annual and continuous basis. Thus, for example, if the non-resident borrower became a resident of Canada, subsection 17(1) would not have applied to any amount outstanding after such time. (See Interest on Loan to Non-Resident, Technical Interpretation, Reorganizations and Foreign Division, Rulings Directorate February 16, 1995.) MNR v. T.E. McCool Ltd., 49 DTC 700 (SCC). See also A.C. Simmonds & Sons Limited v. MNR, 89 DTC 707 TCC) at 709, whereat the Court stated: I think, as acknowledged by Mr. Hodgson, that Dynacharge US was indebted to the appellant in respect of the amounts paid by it with reference to the letter of credit. But this does not much

4 - 4 - relationship that a loan is considered to be made and that old subsection 17(1) would therefore have applied. For example, the Canada Revenue Agency (the CRA ) (formerly the Canada Customs and Revenue Agency ) took the position, based on the case of The Queen v. Pollock Sokoloff Holdings Corp., 7 that where a loan made to a non-resident had been assigned, subsection 17(1) (as it previously read) did not apply to the assignee because, although the assignee was a creditor of the non-resident, the assignee had not made a loan to the nonresident. 8 As well, although former subsection 17(1) could arguably have continued to apply to an original lender after an assignment of a loan (on the theory that the assignment would not have discharged the original loan), the CRA did not apply subsection 17(1) in those circumstances on the basis that it would have been unreasonable to do so. 9 Other examples of indebtedness arising in circumstances that would not constitute the making of a loan are the issuance of a letter of credit, 10 the honouring of a guarantee, and the incurring of trade receivables. 11 B. The Current Rules The Amendments rendered moot the foregoing distinction between lenders and creditors by extending the application of subsection 17(1) to all amounts owing. Consequently, all forms of indebtedness, including those referred to above as previously having been exempt from subsection 17(1), are now subject to these rules. advance the solution of the problem because a person may be financially indebted to another without the relationship of lender-borrower existing between them. (emphasis added) See also Reinhorn v. MNR, 50 DTC 116 (TAB), Minshall Organ Ltd. v. MNR, 51 DTC 6 (TAB), and Parthenon Investments Ltd. v. MNR, 97 DTC 5343 (FCA) DTC 6181 (FCA). See Deemed Interest on Loans to Non-Resident - Effect of Assignment, Memorandum, Reorganizations and Non-Resident Division, October 3, 1990, Window on Canadian Tax (CCH), paragraph Ibid. See also Banister v. MNR, 73 DTC 42 (TRB) in which the Tax Review Board held that the original lender ceased to be a lender after an assignment of the loan in question. A.C. Simmons & Sons Limited v. MNR, supra footnote 6. E.H. Price Limited v. MNR, 91 DTC 135 (TCC).

5 - 5 - II. THE LENDER A. The Old Rules Subsection 17(1), as it previously read, only applied where the lender was a corporation resident in Canada and, therefore, did not apply if the lender was an individual. It also did not apply if the lender was a partnership or a trust, even if all or some of the members or beneficiaries of such partnership or trust were Canadian resident corporations. B. The Current Rules The Amendments did not change the fact that the lender (or, now, the creditor) must be a Canadian resident corporation. They did, however, provide for look-through rules where the lender or creditor was a partnership or trust. These look-through rules, which are found in subsection 17(4) and paragraph 17(5)(a), respectively, provide that, for the purposes of section 17, where the lender or creditor is a partnership or a non-discretionary trust, 12 the non-resident borrower/debtor is deemed to owe to each member or beneficiary of the partnership or trust a certain portion of the amount owing to the partnership or trust (the Indebtedness ). That portion is equal to that proportion of the Indebtedness that the fair market value of such member s or beneficiary s interest in the partnership or trust is of the fair market value of all interests in the partnership or trust. Furthermore, this proportional amount is deemed to be owing on the same terms as those that apply to the Indebtedness itself. These look-through rules do not deem the entire Indebtedness to be subject to the rules in subsection 17(1), but rather deem only the portion thereof as is owing to partners or beneficiaries that are Canadian resident corporations to be subject to these rules. Thus, for example, where a partnership of three individuals and one Canadian resident corporation makes a non-interest bearing loan to a non- 12 Subsection 17(15) provides that the term non-discretionary trust, at any time, means a trust in which all interests are vested indefeasibly at the beginning of the trust s taxation year that includes that time. The Explanatory Notes to subsection 17(15) state that in order for all interests in the trust to vest indefeasibly: (a) the trust must have one or more beneficiaries; and (b) the trust arrangement must not: (i) permit the creation of any new beneficiaries in the future; or (ii) give anyone a discretionary power with respect to any of the income or capital of the trust.

6 - 6 - resident, only 25% of that loan will be subject to the rules in subsection 17(1). If the lender or creditor is a discretionary trust, the non-resident borrower/debtor is deemed under paragraph 17(5)(b) to owe to each settlor of the trust an amount equal to the full amount of the Indebtedness, on the same terms as those that apply to such amount. Again, the look-through nature of this rule will have the effect of rendering subsection 17(1) applicable only where a settlor is a Canadian resident corporation. However, given that the rule applies to each settlor of the trust, the same section 17 amount may be taxed a multiple number of times depending on the number of settlors of the trust that are Canadian resident corporations. For purposes of paragraph 17(5)(b), the term settlor is defined in subsection 17(15) to mean any person or partnership that has, in any manner whatever, made a direct or indirect loan or transfer of property to the trust before the time in question. Where, however, the person or partnership is dealing at arm s length with the trust and, in the case of a loan, has made the loan at a reasonable rate of interest or, in the case of a transfer, has made the transfer for fair market value consideration, such person or partnership will not be considered to be a settlor. 13 It should be noted that the rules in subsections 17(4) and 17(5) are referred to in the Amendments as anti-avoidance rules. Presumably, therefore, they are intended to prevent a Canadian resident corporation from avoiding the application of subsection 17(1) by making a loan or advance to a non-resident through a partnership or trust. Notwithstanding this antiavoidance purpose, however, the actual rules in subsection 17(4) and 17(5) make no reference to any such purpose and therefore apply whether or not the partnership or trust loan or advance is made for the purpose of avoiding subsection 17(1). 14 It should also be noted that these look-through rules do not apply to any amount to which the indirect loan or debt rules in subsection 17(2) apply. The reasons for this are explained below in the discussion of these indirect loan or debt rules The Explanatory Notes to subsection 17(4) and 17(5) clarify that these rules operate to apply through tiers of partnerships and/or trusts. See Elinore J. Richardson and Angelo Nikolakakis, Proposed Amendments to the Taxing of Foreign Source Income in Corporate Finance, Volume VII, No. 1, 1999, Federated Press, at 575.

7 - 7 - III. THE BORROWER A. The Old Rules In its previous form, subsection 17(1) applied to any non-resident borrower whether it was a corporation, trust or individual since the subsection spoke in terms of a Canadian resident corporation making a loan to a non-resident person. The CRA was of the view that, for these purposes, a person also included a partnership 15 but this position did not appear to be supported by the jurisprudence. 16 B. The Current Rules The foregoing ambiguity with respect to borrower partnerships was resolved in new subsection 17(6), which provides for a look-through rule similar to the rules found in subsections 17(4) and 17(5), where the borrower/debtor is a partnership. Specifically, subsection 17(6) deems each member of a borrower/debtor partnership to owe to the lender or creditor that proportion of the amount owing by the partnership that the fair market value of that member s partnership interest is of the fair market value of all interests in the partnership. Again, as in the case of the rules in subsections 17(4) and 17(5), this proportional amount is deemed to be owing on the same terms as those that apply to the full amount owing by the partnership. As well, as in the case of the look-through in subsection 17(4) and 17(5), the effect of this look-through rule is not to deem the entire amount owing to be subject to subsection 17(1), but rather to deem only that portion thereof as is attributable to non-resident partners to be subject to subsection 17(1). 17 Subsection 17(6) is also referred to in the Amendments as an anti-avoidance rule but, as in the case of subsection 17(4) and 17(5), there is no purpose test in this rule, and it will therefore apply whether or not the Indebtedness owing by the borrower/debtor partnership is incurred for the purpose of avoiding subsection 17(1). As well, even though subsection 17(6) See CRA Technical Interpretation , dated September 25, See Leonard Reeves Incorporated v. MNR, 91 DTC 425 (TCC) wherein the Court held that a loan to a foreign partnership was not subject to the rules in old subsection 17(1). The Explanatory Notes to subsection 17(6) clarify that the subsection will operate to look through any number of tiers of partnerships.

8 - 8 - deems the proportional loan or debt to be made on the same terms as the full loan or debt, there is no rule that deems the rate of interest on the indebtedness owing by the partnership to be reasonable with respect to each of its members, if it is reasonable with respect to the partnership as a whole. Since the issue as to whether a particular rate of interest is reasonable depends, in part, on the creditworthiness of the particular debtor, it will be necessary to look to each of the non-resident members of the partnership to determine whether or not the interest rate charged on the indebtedness is reasonable with respect to each such member. 18 IV. IMPUTED AMOUNT A. The Old Rules 1. Reasonable Rate of Interest/Double Taxation As indicated above, subsection 17(1) formerly applied where the loan in question had been outstanding for one year or longer without interest on the loan, computed at a reasonable rate, having been included in the lender s income. In such circumstances, the lender was deemed to have received, on the last day of each taxation year during which the loan was outstanding, interest on the loan at the prescribed rate computed for the period in the taxation year during which the loan was outstanding (the Imputed Amount ). The question as to whether a reasonable rate of interest has been charged on a loan is one of fact, to be determined by a consideration of all the factors relevant to the financial arrangement at issue. 19 Basically, a reasonable rate of interest should reflect what an arm slength lender would expect to receive in similar circumstances. 20 Some factors that may be Supra footnote 14, at 577. Revenue Canada Round Table in Report of Proceedings of the Forty-Third Tax Conference, 1991 Conference Report (Toronto: Canadian Tax Foundation, 1992), 50:1-82, question 51. See also infra footnote 22. Ibid. The CRA has accepted in the past that it is possible for a nil rate of interest to be a reasonable rate in a particular situation. (See Reasonable Rate of Interest on Loans to Non-Resident, Technical Interpretation, Financial Industries Division, Rulings Directorate, in CCH Tax Window Files [this is an online data base], document number , dated February 6, 1992.) However, in Loans to Non-Residents, Memorandum, in CCH Tax Window Files, document number , dated May 7, 2001, the CRA has stated that a zero rate of interest would not be considered reasonable for purposes of section 17. See also "Subsection 17(1)", Technical Interpretation, in CCH Tax Window Files document number , dated March 6, 2003.

9 - 9 - relevant are current Canadian rates, commercially available rates in a foreign jurisdiction, 21 and international market rates. 22 Under these old rules, if a reasonable rate of interest was not charged on a loan and the lender was therefore deemed to have received an Imputed Amount under subsection 17(1), there was no reduction in the Imputed Amount for any interest that the lender actually received on the loan. Thus, the amount of this interest was effectively subject to double taxation. 2. Retroactivity For purposes of determining whether a loan has been outstanding for one year or longer within the meaning of subsection 17(1), the term year means twelve consecutive months commencing at any time in a calendar year and does not mean a calendar year or a fiscal year. 23 Accordingly, it is likely the case that in most situations to which subsection 17(1) applies, the one-year period that is relevant for the purposes of subsection 17(1) (the Loan Year ) will straddle two taxation years. Under the old rules, where a Loan Year straddled two taxation years, subsection 17(1) appeared to retroactively apply to the first of such taxation years. For example, assume that a corporation resident in Canada with a December 31 st year-end, made an interest-free loan to a non-resident on July 1, 2002 (that is, in the corporation s year ending December 31, 2002) and that such loan was not repaid until August 1, The loan would therefore have been outstanding for more than twelve months as of June 30, 2002, and subsection 17(1) would have become operational as of that date to deem the corporation to have an Imputed Amount on the last day of each of its taxation year during which the loan was outstanding. Since the loan would have been outstanding during each of the corporation s 2002 and 2003 taxation years, the corporation would have had an Imputed Amount for each of those years even though, in the case of the corporation s year ending December 31, 2002, the loan would not have been outstanding, as at that year-end, for the requisite twelve-month period. In other words, once it was ultimately Ibid. See Loans to Non-Resident Reasonable Rate of Interest, Memorandum, Rulings Directorate, October 27, 1992, Window on Canadian Tax (CCH), paragraph Bain Wagon Co. Ltd. v. MNR, 70 DTC 1507 (TAB).

10 determined that a loan had been outstanding for twelve months, subsection 17(1), as it previously read, appears to have applied retroactively to any taxation year ending within that twelve-month period. 24 B. The Current Rules 1. Reasonableness Rate of Interest/Double Taxation The Amendments, like the previous rules, only apply if a reasonable rate of interest is not otherwise charged on the amount owing. However, unlike the old rules, the Amendments deal with the issue of double taxation. Specifically, under subparagraph 17(1)(b)(i), the Imputed Amount is reduced by the amount of any interest actually included in the lender s income in the year on account of the amount owing. As well, because the new look-through rule in subsection 17(5) can, on the one hand, operate to include an Imputed Amount under subsection 17(1) in the income of a beneficiary or settlor, and the trust rules under the Act can, on the other hand, also operate to include in the income of that beneficiary (or the settlor if it too is a beneficiary) the actual interest received by the trust in respect of the amount owing (if such interest is paid or payable by the trust to the beneficiary), the Imputed Amount is also reduced by any amount received or receivable by the beneficiary from the trust in the year or in any subsequent year, if such amount is included in computing the income of the beneficiary for such year or subsequent 25, 26 year and is reasonably attributable to interest on the amount owing. Finally, as is discussed This retroactive application of subsection 17(1) is similar to the retroactive operation of subsection 15(2). As is discussed elsewhere in this paper, subsection 15(2) requires certain shareholder loans to be included in the shareholder s income in the taxation year of the shareholder in which the loan is made (the Relevant Year ) if the loan is not repaid within one year from the end of the taxation year of the corporation making the loan. Since this one-year period will often end after the end of the Relevant Year, the CRA has adopted the practical approach of waiting until the expiration of the one-year period and, if the loan has not been repaid by the end of that period, will retroactively include the loan in the shareholder s income for the Relevant Year. This reduction is provided for in subparagraph 17(1)(b)(ii). Note, however, that if the trust is resident in Canada, or is resident in another jurisdiction that subjects the trust to tax on the interest received by it, there will effectively be double taxation of such interest. This is so because once the interest has been taxed in the hands of the trust, the remaining after-tax portion of such interest will become part of the trust s capital for Canadian tax purposes and, accordingly, when such after-tax income is paid out to the corporate beneficiary, it will be treated as a non-taxable capital receipt in the corporate beneficiary s hands rather than an income receipt. Since the reduction provided for in subparagraph 17(1)(b)(ii) requires that the amount received or receivable from the trust be included in computing the corporate beneficiary s income, and since a capital receipt will not be so included, the reduction under subparagraph 17(1)(b)(ii) will not apply in the circumstances. As a result, the interest paid or payable in respect of the underlying trust loan will effectively be taxed twice once in the hands of the trust (as income actually received) and once in the hands of the corporate beneficiary (as part of the Imputed Amount deemed to be received under section 17). In effect, therefore, in order for the reduction in paragraph 17(1)(b)(ii)

11 to become operative, it is necessary that the interest never be taxed in the trust s hands. For a resident trust, the non-taxation of interest can be accomplished by ensuring that the trust pays or becomes obligated to pay such interest to the corporate beneficiary in the same taxation year of the trust as the one in which the interest is received by the trust (the Trust s Receipt Year ) rather than in a subsequent year. For a non-resident trust however, the taxation of the interest in the trust s hands will, of course, depend on the taxation laws of the foreign jurisdiction in which the trust is resident. 26 Based on the comments set out supra footnote 25, it would appear that the subparagraph 17(1)(b)(ii) reduction cannot apply if the interest in question is paid or made payable by a Canadian resident trust to a corporate beneficiary in a year that is subsequent to the Trust s Receipt Year. If this is the case, one might then ask what purpose is served by the reference in subparagraph 17(1)(b)(ii) to an amount received or receivable that is included in the corporate beneficiary s income in a subsequent year. The answer is that while the interest cannot be paid or made payable to the corporate beneficiary in a taxation year of the trust that is subsequent to the Trust s Receipt Year, it can be paid or made payable to the corporate beneficiary in a taxation year of the corporate beneficiary that is subsequent to the Trust s Receipt Year, as long as such interest is included in the corporate beneficiary s income for that subsequent year. For example, consider the following fact situation: (a) the corporate beneficiary has an October 31 st year-end; (b) the trust has a December 31 st year-end; (c) the trust makes a low interest loan to a non-resident on October 1, 2002 i.e., in the trust s taxation year ending December 31, 2002 and in the corporate beneficiary s taxation year ending October 31, 2002; (d) the loan is repayable on October 1, 2005; and (e) the corporate beneficiary is the sole beneficiary of the trust. Under subsections 17(1) and 17(5), the corporate beneficiary will be deemed to have made the loan to the nonresident on October 1, 2002, which falls into the corporate beneficiary s year ending October 31, Since the loan will not be outstanding for 12 months as at that year-end, subsection 17(1) will not apply to the corporate beneficiary in such year in respect of the trust loan (on the assumption that the author s interpretation as to the non-retroactive application of current subsection 17(1) is correct. See the discussion below). Under the trust rules, it is the trust that will be considered to have made the loan in its year ending December 31, 2002, and any interest received by the trust on the loan from October 1, 2002 to December 31, 2002 will be taxed in the hands of the trust for its taxation year ending December 31, 2002, if it does not pay or become obligated to pay such interest to the corporate beneficiary on or before that year-end. Conversely, if the trust does pay or becomes obligated to pay such interest to the corporate beneficiary on or before December 31, 2002 (the Year 1 Trust Distribution ), the interest received by the trust in its year ending December 31, 2002 will be taxed in the hands of the corporate beneficiary in its taxation year ending October 31, At this point in time, therefore, the interest will only be taxed once either in the hands of the trust or in the hands of the corporate beneficiary because section 17 will not yet apply. In the second year of the loan, however, the tax results will be quite different. Specifically, during the corporate beneficiary s taxation year ending October 31, 2003, the loan will have become outstanding for more than 12 months (i.e., as of October 1, 2003) and, as such, subsections 17(1) and 17(5) will together apply in such taxation year to include an Imputed Amount in the corporate beneficiary s income for its year ending October 31, Under the trust rules, however, any interest received by the trust from January 1, 2003 to December 31, 2003 will be included in the trust s income for its taxation year ending December 31, 2003, unless the trust pays or becomes obligated to pay such interest (the Year 2 Trust Distribution ) to the corporate beneficiary on or before December 31, If the trust does do so, the interest will be included in the corporate beneficiary s income in its year ending October 31, 2004 i.e., in the taxation year of the corporate beneficiary that is subsequent to its taxation year in which the subsection 17(1) Imputed Amount will have been included in its income. The reference in subparagraph 17(1)(b)(ii) to an amount received by the corporation in the year or a subsequent year, however, will not only allow the corporate beneficiary to reduce that subsection 17(1) Imputed

12 below, the Amendments also expand the scope of subsection 17(1) to indirect loans or debts. These indirect loan or debt rules (found in new subsection 17(2)) can, in certain circumstances, have the effect of including an Imputed Amount in the income of a Canadian resident corporation where a non-resident owes an amount, not to the corporation itself, but rather to an intermediary (other than another Canadian corporation). If such intermediary is a controlled foreign affiliate of Canco, any interest received or receivable by it in respect of such amount, however, will also be included in its foreign accrual property income ( FAPI ) if its lending activities do not amount to an active business within the meaning of subsection 95(1) or its income is not deemed to be income from an active business. Such FAPI will, in turn, be included in the income of the Canadian resident corporation under subsection 91(1), thereby effectively subjecting that FAPI amount to double taxation once under subsection 17(1) and once under subsection 91(1). To avoid this double taxation problem, subparagraph 17(1)(b)(iii) reduces the Imputed Amount by the amount of any FAPI that is included in the Canadian resident corporation s income under subsection 91(1) in the year or in any subsequent year, if such FAPI is reasonably attributable to interest on the amount owing. 27 The foregoing reductions for actual interest, trust amounts, and FAPI are collectively referred to herein as Interest Otherwise Received. 2. Retroactivity The Amendments, although not as clearly worded as one would have liked, appear to eliminate the retroactive application of subsection 17(1) to taxation years ending before the expiry of the Loan Year although the Explanatory Notes to the subsection indicate otherwise. 28 Amount for its year ending October 31, 2003, by the amount of the Year 1 Trust Distribution (which also occurs in the corporate beneficiary s year ending October 31, 2003), but also by the amount of the Year 2 Trust Distribution (which occurs in the corporate beneficiary s taxation year ending October 31, 2004), to the extent that such Year 2 Trust Distribution relates to the corporate beneficiary s 2003 year. (However, this right to reduce the Imputed Amount for a particular taxation year by an income inclusion occurring in a subsequent taxation year requires a retroactive adjustment to the Imputed Amount and there does not currently appear to be any provision in the Act that would allow the corporate beneficiary to require that such retroactive adjustment be made (see, for example, subsection 152(6)) Based on the wording of subparagraph 17(1)(b)(iii), however, there is a technical problem with this FAPI deduction. See Examples 5 and 6 at the end of this paper. See infra footnote 32.

13 Specifically, subsection 17(1) now applies where, at any time in a taxation year of a corporation resident in Canada: a non-resident owes an amount (the Indebtedness ) to the corporation; the Indebtedness has been or remains outstanding for more than one year 29 (i.e., the twelve-month period referred to above as the Loan Year); and the total of the Interest Otherwise Received for the year 30 is less than the amount of interest that would be included in computing the corporation s income for the year in respect of the Indebtedness if that interest were computed at a reasonable rate for the period in the year during which the Indebtedness was owing. If the foregoing conditions are satisfied, the corporation is required to include in its income for the year an amount equal to the amount by which interest on the Indebtedness, calculated at the prescribed rate for the period in the year during which the Indebtedness was owing, exceeds the Interest Otherwise Received for the year (or, in the case of trust amounts or FAPI, the Interest Otherwise Received for the year or a subsequent year). On first reading, it is not absolutely clear whether the italicized references above to the year are to the corporation s taxation year in which the loan has been outstanding for twelve consecutive months (the Taxation Year ) or to the Loan Year (which, as stated above, can straddle two separate taxation years). However, given that these references are references to a year in which amounts are included in income and given that amounts are only included in income in respect of a taxation year, the references to the year must mean the Taxation Year rather than the Loan Year. 31 On this basis, subsection 17(1) will only apply to taxation years Note this slight change from the old rules which applied where a loan had been outstanding for one year or longer. The Amendments apply where the Indebtedness has been outstanding for more than one year, thereby clarifying that the Indebtedness must now be outstanding for a full year before the rules in subsection 17(1) will apply. Or, a subsequent year, in the case of Interest Otherwise Received that is a trust amount or FAPI. See supra footnote 26. This interpretation is further supported by the fact that the reference to the prescribed rate in subsection 17(1) is to the prescribed rate for the period in the year during which the Indebtedness was outstanding. If the reference to the year in subsection 17(1) was to the Loan Year, this reference to the period in the year during which the Indebtedness was outstanding, would not make any sense because, by definition, the Indebtedness is outstanding throughout the Loan Year.

14 during or after which the Loan Year has expired. Thus, if the Loan Year happens to straddle two taxation years, subsection 17(1), as it currently reads, does not apply to the first such taxation year As stated above, however, the CRA does not agree with this interpretation and believes that subsection 17(1) does apply retroactively to any year during which the loan in question was outstanding. This difference in interpretation is based on a different grammatical reading of subsection 17(1), the exact wording and punctuation of which is as follows: Where, at any time in a taxation year of a corporation resident in Canada, a non-resident person owes an amount to the corporation, that amount has been or remains outstanding for more than a year and the total under (b) for the year The key difference between the author s interpretation of this provision and that of the CRA lies in how the foregoing sentence is broken down grammatically, and is illustrative of how the placement of a single comma can make a difference in legislative interpretation. The specific issue in this instance is whether the term taxation year that is found in the introductory words where, at any time in a taxation year of a corporation resident in Canada, is modified only by the phrase a non-resident person owes an amount to the corporation or whether it is also modified by the next two following phrases. As indicated above, the author s interpretation of subsection 17(1) is based on the latter reading - i.e., the taxation year in question is one that must meet all three modifiers. It must be a taxation year during which a non-resident person owes an amount to a corporation resident in Canada. It must also be a taxation during which the amount in question has been or remains outstanding for more than twelve months, and it must be a taxation during which the Interest Otherwise Received for the year is less than a reasonable amount. The CRA s interpretation, however, is based on the former reading which would require that subsection 17(1) be grammatically broken down as follows: where, at any time in a taxation year of a corporation resident in Canada, a nonresident person owes an amount to the corporation; that amount has been or remains outstanding for more than a year; and the total determined under paragraph (b) for year On this reading, the phrase that amount has been or remains outstanding for more than a year does not modify the term taxation year with the result that subsection 17(1) applies to any taxation year during which a nonresident owes an amount to a Canadian corporation, whether or not such taxation year is also one during which the amount has been owing for more than twelve months. In the author s view, the CRA s interpretation is inconsistent with the punctuation of the subsection. Specifically the comma that follows the introductory phrase where at any time in a taxation year of a corporation resident in Canada, serves to separate that phrase from the phrase a non-resident person owes an amount to the corporation, in the same way that it separates that introductory phrase from the phrase that amount has been or remains outstanding for more than a year. If the CRA s interpretation were correct, there would be no need for such comma. The foregoing views of the CRA are set out in "Section 17, Application to Taxation Years" Technical Interpretation, International and Trust Division, in CCH Tax Window Files [this is an on-line service], document number , dated August 2, For the difference that one comma can make to interpreting a provision, see Rogers Communication Inc. v. Aliant Inc., a decision of the CRTC (CRTC , dated July 28, 2006; overturned an appeal on other grounds on August 20, 2007).

15 V. THE PART XIII EXCEPTION A. The Old Rules Subsection 17(2) previously provided that subsection 17(1) would not apply if withholding tax had been paid on the amount of the loan in question under Part XIII of the Act. Part XIII tax is exigible with respect to a loan if the amount of the loan would be required to be included in the non-resident s income under subsection 15(2), if the non-resident were subject to Part I tax under the Act. In such circumstances, paragraph 214(3)(a) applies to deem the loan amount to be a dividend and will thus subject such amount to withholding tax at the rate applicable to dividends. 33 Subsection 15(2) generally applies to include a loan amount in a borrower s income, if the borrower is a shareholder of the lender, 34 is connected with a shareholder of the lender, 35 or 33 If subsection 15(2) does not apply to the loan, not only will subsection 17(1) apply to the lender, but subsections 80.4(2), 15(9) and 214(3) may also apply to the non-resident borrower to deem the borrower to have received, as a deemed dividend in each taxation year, an amount equal to the difference between the interest on such loan computed at the prescribed rate(s) in effect during such taxation year and the amount of interest, if any, paid by the borrower on such loan within 30 days after the end of such taxation year. The foregoing subsections will apply if: (a) the borrower is a shareholder of the lender, deals non-arm s length with a shareholder of the lender, or is a member of a partnership or beneficiary of a trust that is a shareholder of the lender; (b) the borrower receives a loan from the lender by virtue of such shareholdings; and (c) the rate of interest charged on the loan is less than the rate that would have been charged on the loan, at the time such loan was made or incurred. To the extent that any such deemed dividend arises, the lender will be required to withhold and remit tax on such deemed dividend. (See CRA Views, Conference C6.) 34 Subsection 15(2) also applies to other forms of indebtedness as well as to loans. However, this fact would have been irrelevant to subsection 17(1) as it previously read because, as stated above, subsection 17(1) formerly only applied to loans. This broader application of subsection 15(2), however, is relevant under the Amendments and, specifically, to subsection 17(7) (discussed below) since, as also stated above, the Amendments apply to all forms of indebtedness. 35 Subsection 15(2.1) provides that a person will be connected with a shareholder if that person does not deal at arm s length with the shareholder. This non-arm s-length rule, however, does not apply if the person is a foreign affiliate of the lender or a foreign affiliate of a Canadian resident with whom the lender does not deal at arm s length.

16 is a member of a partnership or beneficiary of a trust that is a shareholder of the lender. 36 The subsection, however, does not apply if the loan is made in the ordinary course of the lender s business and the lending of money is part of the lender s ordinary business, 37 or if the loan is made to an employee of the lender for certain specified purposes, provided that bona fide arrangements are made at the time the loan is made for repayment of the loan within a reasonable time. 38 Alternatively, subsection 15(2) does not apply if the loan is made for any reason and is repaid within one year after the end of the lender s taxation year in which the loan was made and the repayment is not part of a series of loans and repayments. This exception is found in subsection 15(2.6). In sum, if any of the foregoing exceptions to subsection 15(2) applied with respect to a particular loan made under the old rules, the loan would not have been subject to withholding tax, the exception in old subsection 17(2) would therefore not have applied, and the rules in subsection 17(1) would have applied to include an amount of interest in the lender s income. At first glance, it might appear that the exception in subsection 15(2.6) could never have applied in those situations in which subsection 17(1) might have been an issue under the old rules since that subsection would only have applied if the loan to the non-resident had been outstanding for more than one year, while the exception in subsection 15(2.6) requires that the loan be repaid within one year. However, the one-year periods referred to in each of old subsections 17(1) and subsection 15(2.6) are not the same. Specifically, the one-year period referred to in old subsection 17(1) ran from the date that the loan was made, 39 whereas the oneyear period referred to in subsection 15(2.6) runs from the end of the lender s taxation year in which the loan is made. Thus, for example, if a lender were to have made a loan to a non The CRA is of the view that the application of subsection 15(2) is to be determined at the time that the loan is made or the debt incurred. Thus, if at such time, the borrower/debtor does not meet the shareholder criteria set out in subsection 15(2), that subsection will not apply even if such borrower/debtor becomes a shareholder at a later point in time. (See Exemptions in Subsection 15(2) Not Affected by Change in Status of the Borrower, Technical Interpretation, Reorganizations and Non-Resident Division, November 19, 1990, Window on Canadian Tax (CCH), paragraph 1050.) Subsection 15(2.3). Subsection 15(2.4). 39 Bain Wagon Co. Ltd. v. MNR, supra footnote 23.

17 resident on the first day of the lender s taxation year, the non-resident would have had almost two years to repay that loan before the provisions of subsection 15(2) would have applied. However, subsection 17(1) would have started to apply to the lender once the loan had been outstanding for more than twelve months. Accordingly, even though subsections 17(1) and 15(2.6) could have applied in the same situation, a timing problem would have arisen where the application of subsection 17(1) depended on the application of subsection 15(2.6), since at the time at which it would have had to be determined whether subsection 17(1) applied, it may not have yet been known whether subsection 15(2.6) would also have applied to exempt the loan in question from withholding tax. B. The Current Rules Under the Amendments, the Part XIII exception was moved to subsection 17(7), in a slightly amended form. Whereas old subsection 17(2) required that Part XIII tax be paid on the loan or indebtedness, subsection 17(7) not only requires that Part XIII tax be paid, but also requires that it not be refunded or applied under subsection 227(6.1). 40 Subsection 227(6.1) is the provision that allows a non-resident to apply for a refund of Part XIII tax that has been paid pursuant to subsection 15(2) and paragraph 214(3)(a) in respect of a shareholder loan or debt if the shareholder has repaid the loan or debt. 41 The request for a refund must be made within two years of the repayment. Given that there is no time limit set out in subsection 227(6.1) for the loan or debt repayment, one may never know whether a loan or debt that is otherwise subject to subsection 17(1) will ever be the subject of a subsection 227(6.1) refund. Accordingly, one may never know whether subsection 17(1) does or does not apply to such loan or debt. In the result, not only have the Amendments not addressed the timing problem described above with respect to the old Part XIII exception, but they have exacerbated that problem to such a degree that it is not clear how the exception can now ever be relied upon. That said, the CRA takes the position that the exception in subsection 17(7) applies whenever The CRA maintains that this particular Amendment is simply a codification of the manner in which it previously administered old subsection 17(2) and that this Amendment therefore has not changed the exception in any practical way. Subsection 227(6.1), however, allows the Minister to instead apply such refund amount to any payment that the non-resident is, or is about to become, liable to make to the federal Crown.

18 Part XIII tax has been paid on the amount owing, unless and until such Part XIII tax is repaid or applied in accordance with subsection 227(6.1). 42 The CRA acknowledges, however, that this administrative position will preclude the CRA from retroactively assessing the Canadian corporate lender under subsection 17(1) if the repayment or application under subsection 227(6.1) occurs at a time that is beyond the normal reassessment period for the lender s taxation year during which subsection 17(1) would have applied but for the exception in subsection 17(7). (That said, it should be remembered that under subparagraph 152(4)(b)(iii), the normal reassessment period with respect to non-arm s-length transactions involving non-residents is six years.) VI. THE SUBSIDIARY CONTROLLED CORPORATION EXCEPTION A. The Old Rules Subsection 17(3) previously provided that subsection 17(1) did not apply where the loan in question was made to a subsidiary controlled corporation (an SCC ) and it was established that the money was used in the SCC s business for the purposes of gaining or producing income. 43 The phrase subsidiary controlled corporation is defined in subsection 248(1) to This position apparently reflects the manner in which the CRA previously administered old subsection 17(2). See supra footnote 40. As well, see Interaction Between 17(7) and 227(6.1), Technical Interpretation, International and Trusts Division, Rulings Directorate, in CCH Tax Window Files [this is an online database] document number , dated November 26, Note that subsection 247(7) previously provided that the transfer pricing rules set out in section 247 did not apply to a loan transaction to which the SCC exception applied. As part of the Amendments, subsection 247(7) was amended to provide that the transfer pricing rules do not apply to amounts owing that are exempt from section 17 because of the controlled foreign affiliate exception set out in subsection 17(8) (discussed below). These amendments to subsection 247(7), however, make no reference to amounts that are exempt from section 17 because of the exceptions set out in subsection 17(7), 17(9), 17(2) or 17(3). (These latter three exceptions are also discussed below). However, in paragraph 21 of Information Circular 87-2R, September 27,1999, which deals with transfer pricing, the CRA has stated that the more specific provisions of section 17 would be applied before the more general transfer pricing rules found in section 247. Note, as well that proposed subsection 247(7.1) provides that subsection 247(2) will not apply to the provision of a guarantee by a Canadian corporation of the indebtedness of a non-resident corporation if: (a) throughout the period in the particular year during which the guaranteed amount is owing, the non-resident was a controlled foreign affiliate of the Canadian corporation within the meaning of section 17; and (b) if the amount owing were owed to the Canadian corporation, it would be an amount referred to in subsection 17(8) (as described below, subsection 17(1) does not apply to subsection 17(8) amounts). Finally, note that the CRA takes the position that the exemption in 247(7) only applies to preclude an adjustment to the amount of interest paid; it does not apply to preclude an adjustment to the cost of the loan under the transfer pricing rules. (See Technical Interpretation E5.)

19 mean a corporation, more than 50% of the voting shares of which belong to the corporation of which it is a subsidiary. 1. Determination of SCC Status Old subsection 17(3) required that the loan in question be made to an SCC. This wording implied that the borrower was required to be an SCC at the time that the loan was made. The CRA s position, however, was that SCC status also had to be maintained for each year that the loan was outstanding and was to be determined by the facts that prevailed in each such year. For example, where a corporation resident in Canada ( Canco ) transferred shares of its SCC to a related corporation, the SCC would have ceased to be an SCC of Canco after the transfer and, according to the CRA, the exception in old subsection 17(3) would no longer have applied to any outstanding loan that had previously been made by Canco to the SCC. 44 Similarly, if Canco made a loan to a corporation that did not qualify as an SCC of Canco at the time that the loan was made but that later became an SCC of Canco, the old subsection 17(3) exception would still not have applied because the borrower did not qualify as an SCC at the time that the loan was made Business of the SCC As stated above, in order for the SCC exception to have applied, it was not enough for the non-resident borrower to be an SCC of Canco: the SCC must also have used the borrowed funds in its business. As was the case for all other issues arising under old section 17, the question as to whether the activities of an SCC amounted to a business was one of fact, to be determined on an annual and continuous basis. If the primary activities of the SCC consisted of financing other corporations, such financing activities might have constituted a business depending, for example, on the number of This position however has now been overriden by the decision of the Tax Court of Canada in Canadian Occidental U.S. Petroleum Corporation v. The Queen, 2001 DTC 295. See Loan to Non-Resident, Technical Interpretation of the Reorganizations and Non-Resident Division, Rulings Directorate, in CCH Tax Window Files [this is an online data base], document number AP , dated April 17, 1991.