Tax Court of Canada Shaves Benefits of Hybrid Entity Financing Structure

Transcription

1 Volume 65, Number 6 February 6, 2012 Tax Court of Canada Shaves Benefits of Hybrid Entity Financing Structure by Nathan Boidman and Michael Kandev Reprinted from Tax Notes Int l, February 6, 2012, p. 455

2 Tax Court of Canada Shaves Benefits of Hybrid Entity Financing Structure by Nathan Boidman and Michael Kandev Nathan Boidman and Michael Kandev are with Davies Ward Phillips & Vineberg LLP in Montreal. On January 3 the Tax Court of Canada rendered its decision in FLSmidth Ltd. v. The Queen. 1 This case involved a hybrid entity structure for financing U.S. acquisitions of a Canadian group, which is known to tax geeks as a tower structure, and raised an issue of relief in Canada for certain U.S. taxes triggered by the plan. This article briefly considers the high-wire act of international tax planning using hybrid entities, 2 particularly in the sub-genre in which it is most often seen: tax-efficient internal debt financing of multinational enterprise groups. This article will focus on the Canada-U.S. cross-border context. Background The structure at issue in FLSmidth reflects a basic tax management strategy of multinationals to finance cross-border acquisitions, start-ups, or expansions using intragroup interest-bearing debt. For Canadian multinationals, the potentially diverging results of how such foreign activity is funded, particularly regarding the high-tax environment of the U.S., can be startling. For example, if a corporation resident in Canada and a qualifying person under the Canada-U.S. tax treaty were to finance its U.S. subsidiary with only equity, 3 every dollar of the subsidiary s net taxable profit would attract 35 percent 4 U.S. federal corporate tax and, potentially, state and city tax, for a combined total, depending upon the state and city involved, of as much as 47 percent. 5 Also, any dividends paid by the U.S. subsidiary to its Canadian parent out of its after-tax profits should be subject to the treaty-reduced 5 percent 1 FLSmidth Ltd. v. The Queen, 2012, TCC 3. See David D. Stewart, Canadian Court Denies Deduction for Taxes Paid by Hybrid Entity, Tax Notes Int l, Jan. 16, 2012, p. 178, Doc , or 2012 WTD The term hybrid entity generally refers to a legal person or relationship that is treated as a taxpayer in one jurisdiction but is considered as fiscally transparent in another. This article does not focus on another genre of cross-border tax planning: that involving hybrid financial instruments or arrangements (that are treated differently, as either debt or equity, or having the composite effect of debt or equity, in different countries). Notably however, tax planning using such instruments or arrangements seems to have gained in popularity and, at least in a Canada-U.S. crossborder context, is frequently seen in place of hybrid entity planning. 3 If the U.S. subsidiary borrows from a third party, this may raise in one or both countries issues related to any requisite Canadian parent guarantees. See Nathan Boidman, Pricing Canada-U.S. Guarantees After GE Capital: Still Evolving, Tax Mgmt. Transfer Pricing Rep., Vol. 19, No. 19, Feb. 10, 2011, p If the taxable profit is less than $10 million, the rate would be 34 percent, leaving aside lower rates when income is less than $75,000. See IRC section 11(b). 5 This would be the rounded rate applicable in New York City, which is calculated as follows: New York state 9 percent, New York City 9 percent; as such taxes are deductible against federal taxes, the effective state-city combined rate would be 11.7 percent, which added to 35 percent yields 46.7 percent. TAX NOTES INTERNATIONAL FEBRUARY 6,

3 PRACTITIONERS CORNER dividend withholding tax. 6 Therefore, the overall U.S. tax burden on profits earned by the U.S. subsidiary and repatriated to Canada would be nearly 50 percent. The above result would be materially improved if the Canadian parent corporation directly injected a portion of the investment in its U.S. subsidiary by way of an interest-bearing loan. Assuming IRC sections 163(j) and 385 requirements regarding earnings stripping and debt-equity mix are complied with, each dollar of interest paid by the U.S. subsidiary to its Canadian parent would eliminate the corresponding U.S. corporate level tax and dividend withholding tax and substitute for them no U.S. interest withholding tax 7 and Canadian corporate tax of about 25 percent, assuming a publicly traded corporation. 8 Such a simple debt financing strategy should reduce the overall taxes of the group by almost 25 percentage points for each dollar of interest. But the tax bill of the Canadian multinational group can be further reduced. The Canadian tax system, and in particular its rules regarding foreign affiliates 9 and 6 The unreduced U.S. withholding tax would otherwise be 30 percent. 7 Article XI(1) of the treaty eliminates source interest withholding tax. 8 Effective 2012, the general Canadian effective federal corporate tax rate is 15 percent. Canada s provinces and territories impose corporate tax at rates ranging from 10 to 16 percent, but several of them either provide a 10 percent rate or are in the process of reducing their rate to 10 percent, which is the provincial tax rate assumed for federal tax purposes. Special tax provisions are applicable to Canadian-controlled private corporations (CCPCs). Essentially, a CCPC is a Canadian corporation that is not a public corporation and that is not controlled by nonresidents of Canada, by public corporations, or by a combination thereof. To the extent that such corporations have taxable capital of less than C $15 million, they may be eligible for a federal tax reduction of up to 17 percentage points of tax on the first C $500,000 of active business income earned in Canada. (Many provinces provide similar, albeit smaller, income tax rate reductions. The active business income threshold may also vary.) A CCPC is also subject to special tax treatment on aggregate investment income (such as interest income). Such income is taxed at the unreduced abated posted federal corporate rate (28 percent) plus an additional anti-deferral federal tax of percent, but percent of that total federal tax paid on aggregate investment income is refunded to the corporation when the corporation makes sufficient taxable dividend distributions to shareholders. 9 A foreign affiliate (defined in section 95(1) of the ITA) of a taxpayer resident in Canada is a corporation not resident in Canada regarding which the Canadian taxpayer s equity percentage is not less than 1 percent and the total equity percentages of the taxpayer and of persons related to the taxpayer is not less than 10 percent. The terms equity percentage and direct equity percentage are defined in section 95(4). The result of the combined operation of these expressions is to look through various levels of corporations to determine the Canadian taxpayer s effective equity interest in the particular foreign corporation. Canada s foreign affiliate system is contained in sections and 113 of the ITA and Regulation 5900ff. For a discussion of (Footnote continued in next column.) interest deductibility, 10 provides the basis for internal debt financing structures that offer even more substantial tax benefits than those just described. These are the so-called double-dip financing structures. 11 The general concept of such plans is that, unlike in the case of direct debt financing, the U.S. tax savings would not be transferred to the Canadian treasury. The key notions underlying such structures can briefly be summarized as follows: The Income Tax Act provides for a participation exemption for dividends paid by a foreign affiliate to a Canadian corporate shareholder as long as: the foreign affiliate is resident in a designated treaty country, that is, a country with which Canada has either a comprehensive tax treaty or a tax information exchange agreement 12 ; and the dividend stems from the foreign affiliate s actual or deemed active business income carried on in a designated treaty country or Canada (referred to as the exempt surplus system). Significantly, this participation exemption is effected through a deduction of the dividends from the taxable income of the Canadian parent instead of as an actual exemption. 13 In appropriate circumstances, section 95(2)(a) deems interest paid by an operating foreign affiliate to a financing foreign affiliate to be active business income. This rule is significant because it allows for a reduction of the foreign tax bill of the operating foreign affiliate through deductible interest, while the interest income of the financing foreign affiliate is carved out of Canada s antideferral attribution rules applicable to foreign passive income and can be repatriated to Canada as tax-free dividends. the overall system, see Nathan Boidman and Marc Darmo, How Are Multinationals Faring Under Canada s Incomplete International Tax Reform? Tax Notes Int l, June 13, 2011, p. 901, Doc , or2011 WTD In general, section 20(1)(c) of the ITA allows the current deduction of reasonable interest on borrowed money used to earn income from a business or property other than borrowed money used to acquire property the income from which would be exempt. 11 Not every such structure yields a double dip, because the group may use only internal equity without an external borrowing. But in such cases, if the preexisting assets of the group were generating taxable yields in the area of the internal lending rate, they will have the effect of a double-dip structure. Where they do not, they serve to basically fully preserve the tax savings in the operating country. 12 Canada has 89 comprehensive tax treaties and 13 TIEAs in force. 13 Section 113 of the ITA. 456 FEBRUARY 6, 2012 TAX NOTES INTERNATIONAL

4 Section 20(1)(c) allows a Canadian taxpayer to deduct interest on funds borrowed to finance the acquisition of shares of a foreign corporation against any source of income even when dividends received on such shares are not taxable in Canada because of Canada s participation exemption. 14 Double-dip financing structures historically did not involve hybrid entities or hybrid financial instruments. They would generally see: the Canadian parent borrowing from a third party; using the debt proceeds to fund with equity a financing foreign affiliate resident in effectively a low-tax designated treaty country, such as the Netherlands or Luxembourg 15 ; and the foreign affiliate lending at interest to an operating foreign affiliate of the Canadian parent resident in a high-tax designated treaty country, such as the U.S. This type of planning would allow for stripped U.S. active business earnings to be distributed to the Canadian parent without U.S. interest withholding tax, Significantly, the March 2007 federal budget proposed, as part of the government s so-called International Tax Fairness Initiative, a highly controversial measure to completely eliminate the deductibility of interest on debt incurred by Canadian corporations to finance their foreign subsidiaries. Faced with a wave of indignation from businesses and their advisers for having put into question one of the cornerstones of Canada s tax system interest deductibility Finance Minister Jim Flaherty was forced to retreat on this measure. As a result, a new tamed-down proposal was put forward in May 2007 and enacted into law as new section 18.2 in December Its stated intent was to prevent multinational corporations from using tax havens and other tax avoidance structures to generate two expense deductions for only one investment, so-called double dipping. Under this so-called Anti-Tax-Haven Initiative, beginning in 2012, section 18.2 would block such arrangements by disallowing the interest deduction of a Canadian corporation except to the extent that the interest expense exceeded the operating income shifted to a financing subsidiary. In carrying out consultations on how to enhance Canada s international tax system, the Advisory Panel on Canada s System of International Taxation, which was established under the 2007 budget, heard strong opposition to section 18.2 and proposed unequivocally that section 18.2 be repealed. As a result, in the 2009 federal budget, the government followed the advisory panel s advice and repealed the anti-double-dip provision before it became effective in Michael Kandev, Budget Reinstates Double-Dipping, Law. Wkly. (Mar. 20, 2009), at 7; Nathan Boidman, Reforming Canada s International Tax Regime: Final Recommendations, Part 1, Tax Notes Int l, Jan. 19, 2009, p. 247, Doc , or 2009 WTD 12-16; and Nathan Boidman, Reforming Canada s International Tax Regime: Final Recommendations, Part 2, Tax Notes Int l, Jan. 26, 2009, p. 345, Doc , or2009 WTD Various techniques would be used to reduce the tax in such countries. 16 This assumes an applicable treaty between the U.S. and the country of the financing foreign affiliate that provided for no (Footnote continued in next column.) without Canadian tax, and without material tax in the country of the financing subsidiary. The double-dip effect of this structure would result from the interest deductibility both in the U.S. and in Canada of economically the same amount. Then, with the advent of the U.S. check-the-box rules that spurred the proliferation of hybrid entities, Canadian groups often sought out double-dip arrangements that did not require the use of a third-country financing foreign affiliate. A simple structure of this type would involve the Canadian parent financing with equity a subsidiary U.S. limited liability company, which in turn would lend to a U.S. operating subsidiary of the Canadian parent. Since the LLC would be treated as fiscally transparent (disregarded) from a U.S. perspective, deductible interest paid by the U.S. operating subsidiary would be seen by the U.S. as paid to the Canadian parent and would normally bear the reduced 10 percent interest withholding tax under the treaty (before the fifth protocol). From a Canadian perspective, the LLC would be treated as a foreign affiliate, and distributions from it would benefit from Canada s participation exemption. In August 1997, however, IRC section 894(c) was enacted and caused the simple concept of the above hybrid entity structure to become much more complex. The tower structure, such as the one in the FLSmidth case, is the classic example of such post-section 894(c) arrangements. The Structure PRACTITIONERS CORNER The FLSmidth Case In FLSmidth, a Canadian corporate group, headed by Groupe Laperrière & Verrault ( Canco ), wished to fund the acquisition of U.S. business operations. For this purpose it set up the following structure: Canco established a Canadian subsidiary (Dorr- Oliver), a predecessor to the appellant in the case, to become a 98.9 percent limited partner of a Delaware limited partnership, with Canco taking a 1 percent limited partner interest and another of Canco s wholly owned subsidiaries taking a 0.1 percent general partner interest. The Delaware partnership elected to be treated as a corporation under the IRC. 17 The partnership borrowed what presumably was the majority of the funding requirements from a third party and invested all of its funds in the interest withholding tax. Such planning relied on the absence of a limitation on benefits clause in such treaty. The progressive renegotiation by the U.S. of its tax treaties to include LOB clauses resulted in different countries being popular at different times. 17 IRC section 7701(a)(3) and Treas. reg. section (a). TAX NOTES INTERNATIONAL FEBRUARY 6,

5 PRACTITIONERS CORNER shares of a Nova Scotia unlimited liability company (NSULC), which under the IRC was disregarded. 18 NSULC invested its funds in equity of an LLC established under the laws of an unidentified U.S. state. The LLC was also disregarded under the IRC. 19 Finally, the LLC loaned all of its funds, at interest, to a U.S. holding corporation ( Holdco ), owned by Canco, to fund the target U.S. acquisitions. 20 Holdco would have separately been funded with equity by Canco in order to comply with IRC sections 163(j) and 385 requirements. Interest paid to LLC was distributed to NSULC, which in turn paid dividends to the partnership, which used those dividends to pay interest to the third-party lender, to pay the U.S. tax in dispute in the case and to make distributions of the after-tax balance to its three Canadian partners. U.S. Tax Treatment of the Structure From a U.S. tax perspective, as noted above, the partnership was treated as a U.S. domestic corporation and the NSULC and LLC were disregarded. This meant that the loan to Holdco was treated as having been made by the partnership which, as a deemed U.S. corporation, realized net income equal to the excess of the interest paid to it by Holdco over the interest paid by it to the third-party lender. 21 The partnership was subject to normal U.S. corporate tax on that spread and distributions of the spread, net of the U.S. corporate tax thereon, would have been treated as dividends subject to U.S. withholding tax. 22 Finally, U.S. tax law would have ignored the dividends paid by LLC and NSULC. Canadian Tax Treatment of the Structure From a Canadian tax perspective, the partnership was treated as fiscally transparent, with its income being computed at the partnership level, but being allocated to its partners for inclusion in their reportable income for Canadian tax purposes. 23 NSULC was treated as a regular taxable Canadian corporation. LLC was treated as a nonresident corporation 24 that was a foreign affiliate of NSULC. LLC was also a foreign affiliate of Dorr-Oliver. 25 As outlined above, interest paid by Holdco to LLC was recharacterized by section 95(2)(a)(ii) from passive property income to active business income so as to not constitute attributable foreign accrual passive income and, instead, be exempt surplus that was distributed free of Canadian tax by LLC to NSULC. In turn, the partnership included the NSULC dividends it received from NSULC in its income and deducted the interest paid on the money it borrowed to subscribe for the NSULC shares. It also deducted the U.S. tax it paid during the year, which is the deduction at issue in the case. Dorr-Oliver then included its share of the partnership s income in computing its income, and such amount included in income by Dorr-Oliver was net of its proportionate share of disputed deduction taken by the limited partnership under section 20(12). In computing its taxable income, Dorr-Oliver deducted its share of the NSULC dividends received by the limited partnership under Canada s general exclusion for domestic intercorporate dividends. 26 This all meant that the stripped earnings from the U.S. operations were not taxable in Canada and the cost of borrowing served as deduction in Canada against Canadian operating income of the group. Whether there was U.S. withholding tax on the interest paid to the lender is not discussed in the decision. 27 Canadian Relief for U.S. Taxes Overview The only things both Canada and the U.S. saw in the same way were Holdco (as a regular U.S. corporation), the interest it paid, and the interest payments to the third-party lender. The U.S. tax paid on the interest 18 Treas. reg. section (b)(2). 19 Treas. reg. section (b)(1). 20 In that respect, the case report is difficult to understand. Paragraph 11 of the judgment states: Holdings used to proceeds of the LLC/loans to provide capital and loans to indirectly wholly-owned subsidiaries of [Canco] to purchase U.S. companies. Given the basic U.S. requirement, in order that interest paid by Holdings to LLC be deductible against group profits, that the relevant corporations be part of a consolidated group, under IRC section 1500ff, one would think that Holdings would be the direct or indirect parent of those subsidiaries, unless Holdings was itself the subsidiary of an upper-tier U.S. corporation in the group. 21 As discussed below, that spread was likely relatively thin. 22 Since 2010, under new Article IV(7)(b) of the treaty (included by the fifth protocol), such dividends would be subject to the unreduced 30 percent U.S. withholding tax, but for the years at issue the applicable rate for Dorr-Oliver should have been 5 percent. 23 Section 96 of the ITA. 24 This status is based on incorporation outside of Canada (with no subsequent corporate continuance to Canada) and an assumption that the LLC s central mind and control was not located in Canada. 25 Oddly enough, the rules for determination of foreign affiliate status operate not only for the direct Canadian shareholder of the foreign subsidiary but also for a direct or indirect Canadian parent of such Canadian shareholder. Nonetheless, section 95(4) ensures that Canada s foreign passive income attribution rules do not operate for several Canadian corporations simultaneously. See FLSmidth, at paras. 16 and Section 112 of the ITA. 27 If lender were a U.S. resident, no withholding tax would apply; if the lender were Canadian, whether U.S. withholding tax applied would depend on whether the lender was a bank. If there was U.S. withholding, the lender would have presumably sought to be grossed-up. 458 FEBRUARY 6, 2012 TAX NOTES INTERNATIONAL

6 spread is what gave rise to the issue in this case. Such tax unquestionably was an outlay that reduced the estate of the group, but the same was apparently not treated as a simple business expense deductible under section 9 of the ITA. 28 Instead, the taxpayer claimed it could deduct the U.S. tax under section 20(12), 29 which reads as follows: In computing a taxpayer s income for a taxation year from a business or property, there may be deducted such amount as the taxpayer claims not exceeding the non-business income tax paid by the taxpayer for the year to the government of a country other than Canada (within the meaning assigned by subsection 126(7) read without reference to paragraphs (c) and (e) of the definition non-business-income tax in that subsection) in respect of that income, other than any such tax, or part thereof, that can reasonably be regarded as having been paid by a corporation in respect of income from a share of the capital stock of a foreign affiliate of the corporation. There were two issues before the Tax Court under this provision. The taxpayer won one, but the government won the other and, consequently, the taxpayer was unsuccessful, because the issue it lost was fatal to its case. The taxpayer also argued that Article XXIV of the treaty forces Canada to provide relief for the U.S. tax, but this position was also rejected by the court. The Two Domestic Issues First, the Tax Court considered whether the U.S. tax paid by the limited partnership was in respect of income from a business or property under the ITA. The government argued that the foreign tax must be on the same item of income as the one recognized by the ITA. Since Canadian tax law did not see the partnership deriving any interest income from Holdco, the U.S. tax did not relate to any income derived by the partnership. In other words, the government said that a direct link was required between the U.S. tax and the dividend income derived by the partnership under the ITA. The Tax Court refused to follow this line of reasoning. Instead it adopted a broad reading of the expression in respect of income from a business requiring only some relationship or connection between the foreign tax and the income being computed under the ITA. The court concluded on this point that the U.S. tax was related to or connected with the dividend 28 Section 9 merely provides that a taxpayer s income from a business or property is the taxpayer s profit from that business or profit, which implies a net concept of profit revenues net of expenses. Section 18(1)(a) clarifies that expenses are deductible for tax purposes only to the extent that they were made or incurred for the purpose of gaining or producing income from a business or property. Section 18(1)(b) limits the current deduction of capital outlays, subject to other provisions of the ITA. 29 Section 20 contains a series of rules regarding deductions of payments not otherwise deductible under section 9. PRACTITIONERS CORNER income received by the partnership from NSULC because the indirect source of the dividend income received by the partnership was the interest income received by LLC from Holdings, and the payment of the tax reduced the amount available to NSULC that could be paid out to the partnership as dividends. Second, the Tax Court considered whether Dorr- Oliver s share of the U.S. tax paid by the limited partnership could reasonably be regarded as having been paid by Dorr-Oliver in respect of income from a share of the capital stock of a foreign affiliate of Dorr- Oliver. Significant to this issue was the fact, acknowledged by both parties, that LLC, though a direct wholly owned subsidiary of NSULC, was also a foreign affiliate of Dorr-Oliver. On this question, the court sided with the government. Based on the same broad interpretation of the expression in respect of that it adopted in addressing the first issue, the Tax Court held that the language of subsection 20(12) supports the government s position that the U.S. tax paid by the limited partnership was paid in respect of dividends on the shares of LLC. Even though the taxpayer won the first issue, not all requirements of section 20(12) were met, and therefore the deduction was unavailable. The Treaty Issue The taxpayer in FLSmidth also argued that Article XXIV of the treaty forces Canada to provide relief for the U.S. tax based on the OECD model treaty and the 1999 OECD partnership report. The Tax Court rejected this argument on the basis that the treaty did not require a general deduction for foreign taxes, such as the one in section 20(12), but instead provided for certain focused tax deductions from any Canadian tax payable in respect of the income at issue (that is, a credit in computing tax, not a deduction in computing income on which tax is imposed), which were implemented in Canada by section 126 of the ITA. The court concluded that the treaty is not intended to provide for any relief for U.S. tax on U.S.-source income that is not taxed in Canada. The judge noted that neither the U.S.-source income of the limited partnership that was taxed in the U.S. (and which was not recognized as income of the limited partnership under the ITA) nor the dividend income that was received by the limited partnership from NSULC, and which flowed through to the partners including the appellant, was taxed in Canada. Furthermore, the LLC dividends received by NSULC (which were the source of the dividends paid by NSULC to the partnership) were not taxed in Canada because they were paid out of the exempt surplus of LLC. It was clear to the court that no Canadian tax was payable in respect of the dividends received by the limited partnership from NSULC. Comments and Observations The following factors may be of assistance in considering the full scope and limits of the FLSmidth case. TAX NOTES INTERNATIONAL FEBRUARY 6,

7 PRACTITIONERS CORNER First, the relevance of the legal issues in this case must be evaluated against the presumed relative immateriality of the money at stake. Although the Tax Court decision does not provide the actual figures involved, based on the norms that are seen in tower structure arrangements, it would not be unreasonable to speculate that the net Canadian tax dollars at stake in the dispute could represent about one-tenth of 1 percent of the total debt financing provided to Holdco and that amount may have represented no more than 1.75 percent of the amount of taxes saved in the two countries through the structure. 30 Second, section 20(12) must be considered within the overall scheme of the ITA. Canada, like most countries, provides, under section 126 of the ITA, a conventional credit against Canadian taxes otherwise payable on foreign-source income for foreign taxes paid on that foreign-source income. That credit cannot exceed the amount of Canadian tax otherwise payable. Foreign taxes that exceed the applicable Canadian taxes and that relate to a business that the Canadian carries on in the foreign country (a business income tax under section 126(7)) may be carried back or forward within the limitations of section 126(2) and (2.1) 30 It is not unreasonable to assume that for every $1,000 of debt financing provided to Holdco (and leaving aside proportionate separate equity that IRC sections 163(j) and 385 would have otherwise required), $900 would have been borrowed by the partnership from the third-party lender and $100 would have been provided by the partners as equity. Assuming that both the loan to Holdco and the loan from the third-party lender bore 10 percent interest, there would be a $10 spread between the interest income and interest expense of the partnership, which at a U.S. tax rate of 35 percent would result in U.S. tax of $3.50 (per thousand). Assuming a Canadian tax rate of 35 percent, the Canadian tax savings resulting from the deduction of that $3.50 of U.S. tax would be $1.225 per thousand. In other words, this would be a dispute over roughly basis points (BPS) per dollar of financing, compared with the benefit of the double-dip financing, which would have been, say, $1,000 x 10 percent x 35 percent or $35 per thousand or 350 BPS per dollar of financing in each country and 700 BPS per dollar of financing in the two countries combined. So the Canadian dispute over BPS per dollar of financing would be a small sliver (1.75 percent) of the 700 BPS per dollar benefits of the plan. Thus, if, for example, the total debt financing to Holdco were $100 million, the amount of Canadian tax at issue would be roughly $122,500 in relation to tax savings of some $7 million. of the ITA. If, however, the foreign tax relates either to foreign-source income from a business carried on in Canada or to income from property (a non-business income tax, as defined in section 126(7)) a credit is available under section 126(1), but any excess cannot be carried back or forward, and, instead, can be deducted under section 20(12) in determining the net income from the particular business or property source of income for which it was incurred. Finally, built into both the section 126(1) credit rule and the section 20(12) deduction rule is a prohibition against claims for any foreign tax that relate to income derived from shares in a foreign affiliate. This is because any such taxes are separately dealt with under the foreign affiliate rules. 31 It is not clear whether the relief for U.S. taxes claimed by the taxpayer in FLSmidth could be seen to fit within this basic scheme and purpose of section 20(12). Third, the decision in FLSmidth emphasizes the nature and role, generally, of the expression in respect of in Canadian tax law and, in particular, the very wide ambit it has been given by Canadian courts. This expression appears twice in section 20(12) and, as seen above, it turned out that the taxpayer would lose regardless of whether it was given a wide reading or a narrow reading in this case. 32 Finally, the decision in FLSmidth is consistent with that in Canada Limited, 33 which dealt with whether a Canadian taxpayer is eligible for a foreign tax credit for U.S. taxes paid by a hybrid limited partnership. In that case, the tax court ruled in favor of the taxpayer on the basis that the foreign tax was paid by the taxpayer through the partnership. This was not at issue in FLSmidth, but the court s holding on the first issue under section 20(12) is consistent with Canada Limited. 31 See section 113 of the ITA. 32 The court opted for a broad reading, which resulted in the taxpayer winning the first issue but losing the second. Had the court read in respect of narrowly, the taxpayer would probably have lost the first issue, but may have won the second. In either case, the taxpayer would not meet both requirements at issue in the case TCC FEBRUARY 6, 2012 TAX NOTES INTERNATIONAL