May 13, 2002
Question 1. Interpretation Bulletin IT-221R3
Interpretation Bulletin IT-221R3 dealing with determinations of individual residence status was issued on December 21, 2001. Please comment on why this interpretation bulletin was revised and what significant changes to the CCRA interpretative and administrative positions in the area of individual residence status determinations are reflected in the revisions. In particular, please comment on the apparent elimination of the “two-year presumption”.
CCRA’s Response
Interpretation Bulletin IT-221R3 reflects both recent amendments to the Income Tax Act and recent changes in the CCRA’s administrative and interpretative positions on the issue of how individual residence status should be determined for Canadian income tax purposes.
The CCRA has wanted to eliminate the so-called “two-year presumption” for several years now, partly because of concerns about the potential for abuse of such a presumption, but also because the presumption has no basis in law and is, if anything, contrary to law. Generally, it has always been our position that every determination of residence status must be decided on its facts, which has been the position taken by Canadian courts throughout Canadian jurisprudence. In particular, Canadian courts that have reviewed how individual residence status should be determined for income tax purposes have either explicitly or implicitly stated that there is no particular time period required or necessary for being considered resident or not resident in Canada for income tax purposes. We note that even in IT-221R2, the predecessor to the present interpretation bulletin, the “two-year presumption” is set out in language that is meant to remind the reader that the facts of the case – specifically, the ties to Canada – are still ultimately what is important in determining an individual’s residence status. However, we acknowledge that, administratively, the “two-year presumption” has been given a substantial amount of weight by the CCRA.
The conflict between our administrative practice and our interpretative position was one of the main reasons that our electronic residence determination system was changed in April 2001 to eliminate length of time inside or outside Canada as a significant factor for purposes of determining individual residence status. The electronic system is used by the CCRA to make all preliminary determinations of individual residence status, and is an important component of our administrative process. In many cases, no other evaluation of the individual’s residence status is pursued either by the individual or by the CCRA, although further review is always possible and the result of the electronic residence status determination is not binding on the CCRA or the individual. Of course, where appropriate or where specifically requested by the individual, an employee of the CCRA will review an individual’s residence status in more detail, and length of time inside or outside Canada may be taken into account as a factor at that stage.
The timing of the change to the electronic system and to the bulletin relates in part to the repeal of paragraph 250(1)(e) of the Act. Prior to its repeal, this provision deemed spouses of certain individuals (for example, diplomats, government employees, and members of the Canadian Forces), to be resident in Canada while they and their spouse were outside Canada. Following the repeal of paragraph 250(1)(e), the CCRA received a number of complaints from individuals who believed themselves to be residents of Canada for tax purposes who were being told by the CCRA that, with the repeal of the deeming rule, they could no longer be considered to be resident in Canada because of the length of their stay outside Canada. This conflicted with our interpretative position that in many – if not most – cases involving spouses of Canadian diplomats, government employees, and members of the Canadian Forces, the individuals continue to have significant ties to Canada while abroad, and are therefore ordinarily resident in Canada. Thus, paragraph 250(1)(e) should not have applied in most cases, and its repeal should not have affected how individual residence status was determined as much as it did. This strongly suggested to us that both the electronic residence determination system and the interpretation bulletin needed to be revised to better reflect the law regarding determining individual residence status and distinguishing between factual residence and deemed residence.
The revised interpretation bulletin sets out one other significant change in position on the part of the CCRA with respect to determining an individual’s residence status. Our previous position was that in applying the “permanent home” test found in the “tie-breaker rules” in the residence article of our tax treaties, a house or apartment in Canada that was leased or sublet to a third party while an individual was outside Canada would be considered a “permanent home available” to the individual in Canada. Our new position is that as long as the house or apartment is leased or sublet to an unrelated third party on arm’s-length terms and conditions, it will not be considered to be such a “permanent home available” to the individual in Canada. The new position was adopted as being more consistent with the approach taken in interpreting the term “permanent home available to him [or her]” for tax treaty purposes by the majority of Canada’s tax treaty partners, and by the Organization for Economic Cooperation and Development (OECD).
The change in position regarding the “permanent home” test, along with the recent addition of individuals to the “deemed non-resident” rule in subsection 250(5) of the Act, was another reason that the interpretation bulletin was revised to eliminate the “two-year presumption”. The CCRA anticipates that most Canadians leaving Canada for more than two years to work in a treaty country (and who have not severed their significant residential ties to Canada), will be deemed to be non-residents of Canada as a result of the interaction of the treaty “tie-breaker” rules and amended subsection 250(5). That is, we expect that in most cases where an individual is absent from Canada for an extended period of time, the individual will have a permanent home available to him or her in the treaty country but not in Canada, and as a result the individual will be resident in the treaty country for purposes of the treaty and subsection 250(5) will apply.
Presenter: Jim Wilson
Prepared by: Eliza Erskine
Phone number: 952-1361
Division: Income Tax Rulings Directorate
Question 2. Section 86.1 Issues
Section 86.1 of the Income Tax Act (the “Act”) provides a Canadian resident with the opportunity for a tax deferral in respect of a distribution of common stock of a foreign corporation owned by another foreign corporation of which the Canadian resident is a shareholder (a “spin-off” distribution).
(a) In order to qualify for the tax deferral, the distribution must be an eligible distribution as defined by section 86.1 of the Act. Among other requirements, the distribution must consist solely of common shares of the common stock of a corporation that were owned by the corporation making the distribution immediately before their distribution to the taxpayer. We understand that the CCRA has been considering whether or not the provisions of this section can apply to a distribution of common shares with attached shareholder rights under a shareholders rights plan of the kind often referred to as a “poison pill” rights plan. A number of the U.S. public corporations who have made spin-off distributions have put in place shareholder rights plans (which duplicate the shareholder rights plan in place with respect to the distributing corporation) immediately before the distribution of the common shares. The CCRA has been taking the position that the receipt of the rights under the shareholder rights plan means that such a distribution includes something other than common shares and is therefore not an eligible distribution under section 86.1. This means that the Canadian shareholders of the distributing corporation are not entitled to elect for the tax deferral provided by section 86.1. We understand that the CCRA is currently reconsidering this position. Could you please comment on the status of the CCRA’s review of this issue and also comment on the implications of the position taken for other Canadian rollovers.
(b) In order for a Canadian resident shareholder to be able to elect for the tax deferral it is necessary for the “particular corporation” (the distributing corporation) to provide to the Minister information satisfactory to the Minister establishing, among other things, that in the case of a distribution that is not prescribed, the distribution is not taxable under the U.S. Internal Revenue Code, and in other cases that it is not taxable under the laws of the relevant foreign country. Can you comment on what would constitute “information satisfactory to the Minister establishing” these facts. Would a foreign ruling be necessary, or would it be sufficient to provide an opinion from foreign counsel? Would it be sufficient to submit a copy of the prospectus or other similar document prepared in order to comply with applicable securities laws (assuming it contains a tax discussion on this point)?
(c) Will the CCRA accept elections for tax deferral under section 86.1 of the Act that are filed late by the Canadian resident shareholder?
CCRA’s Response
(a) The International Fiscal Association is the first person or group to ask the Income Tax Rulings Directorate (“Rulings”) for the CCRA’s official interpretative position on this matter. To date, Rulings has not received any written requests for either non-binding interpretations or binding advance income tax rulings with respect to whether a foreign spin-off that includes a distribution of rights pursuant to a typical shareholder rights plan can qualify as an “eligible distribution”.
At the present time, the CCRA does not intend to establish an administrative position with respect to the shareholder rights plan issue. The CCRA is concerned that there is no legal basis for such a position, given the restrictive nature of the words used in section 86.1 of the Act. In our view, the words used in section 86.1 suggest that the policy underlying the provision was that foreign spin-offs involving the distribution of anything other than common shares were not intended to benefit from the tax deferral provided. We note that as section 86.1 clearly contemplates that property other than common shares could be distributed as part of a particular foreign spin-off, and as it appears that the mere existence of such property prevents the foreign spin-off from being an “eligible distribution”, the value of such property, whether nominal or not, is not relevant in the context of this provision. We acknowledge, however, that although the wording of section 86.1 is slightly different in this respect from other rollover provisions in the Act that require that only share consideration be received by the taxpayer (for example, subsections 51(1), 85.1(1) and 87(4) of the Act), the position we take on this matter may have an impact on our interpretation of such provisions.
In order to consider a particular foreign spin-off that includes rights under a shareholder rights plan to be an “eligible distribution”, the CCRA will require legal support that either
……(i) the particular “poison pill rights” are not property separate from the common shares being distributed; or
……(ii) the issuance of the rights is not part of the particular distribution.
Our initial reaction to these arguments is that “poison pill rights” probably do constitute property separate from the common shares and that such rights are part of a particular distribution where the shareholder rights plan is put in place prior to the distribution. We plan to seek legal advice on these issues once we have a live file to review. We strongly recommend that anyone who has a client who will be receiving share rights pursuant to a particular foreign spin-off consider requesting an advance income tax ruling on the application of section 86.1 of the Act. We would give high priority to any such ruling request.
In conclusion, we will not provide any kind of administrative exception for “poison pill”-type rights in the context of section 86.1 of the Act, nor will we seek legal advice on this matter, until we have a live file to review that sets out all of the relevant facts of the foreign spin-off and includes a copy of the shareholder rights plan in question. The informal submissions that we have received to date have not convinced us that share rights issued in the context of a foreign spin-off are not property separate from the related common shares. There are a number of issues to clarify before we could accept such an argument. In particular, we would want to understand why, in the context of a spin-off transaction, the share rights plan has to be created immediately before the distribution. There may be U.S. considerations behind this particular ordering; if so, we would want to examine these considerations in the context of a particular proposed foreign spin-off.
(b) At the present time, the CCRA will accept only a ruling from the United States Internal Revenue Service (IRS) as “information satisfactory to the Minister establishing” that the distribution of the spin-off shares is not a taxable transaction in the United States. However, where such a ruling is not available, but a legal opinion from foreign counsel has been provided stating that the distribution is not taxable in the United States, the CCRA, through its function as Canadian Competent Authority and under the Exchange of Information provisions of the Canada-United States Income Tax Convention, will request the IRS, in its capacity as U.S. Competent Authority, to confirm that the distribution is not a taxable transaction in the United States. If no such confirmation is received from the IRS, then the spin-off will not be an eligible distribution for purposes of section 86.1 of the Act.
The legal opinion from foreign counsel may be separate from or incorporated within the documents related to the spin-off transaction prepared in order to comply with applicable U.S. securities laws. We note that in the case of a “prescribed distribution”, similar criteria would apply, that is, either a ruling from the foreign taxing authority would be required or the CCRA would have to obtain confirmation that the distribution is not taxable in the foreign jurisdiction from the foreign taxing authority through the competent authority process.
(c) A legislative amendment has been made to the Income Tax Regulations to extend the application of the fairness provisions to the election which allows a tax deferral of eligible distributions of foreign spin-off shares. Among other things, the fairness legislation gives the Minister of National Revenue and her delegated officials discretion to allow late and amended elections, or to revoke them for taxation years dating back to 1985.
The Governor in Council, on the recommendation of the Minister of National Revenue, has amended section 600 of the Regulations to add paragraph 86.1(2)(f) to the list of elections set out in paragraph 600(c). As a result, the Minister of National Revenue may, under the fairness provisions of subsection 220(3.2) of the Act, extend the time for making the election for a tax deferral of eligible distributions of foreign spin-off shares.
Presenter: Jim Wilson
Prepared by: Eliza Erskine
Phone number: 952-1361
Division: Income Tax Rulings Directorate
Question 3. Electronic Commerce
There have been various electronic commerce initiatives at the CCRA and OECD recently. Has the Income Tax Rulings Directorate prepared any publications or papers regarding the taxation of electronic commerce as a result? If yes, will the publications be made available to the public? Are there any significant announcements that the Income Tax Rulings Directorate can make now with respect to this study?
CCRA’s Response
The Income Tax Rulings Directorate is currently working on two papers with respect to electronic commerce.
1.…… Position Paper Internet Commerce, which evolved from 2 sources:
…….. …–..a 1998 CCRA Technical Advisory Group (TAG) on Interpretation & International Cooperation; and
…….. …–..The “Taxation Framework Conditions”, agreed upon in Ottawa in 1998 by member countries of the OECD.
2.…… Characterization Issues Arising From Electronic Commerce, which evolved from the OECD TAG on
…….. ..Treaty Characterization of Electronic Commerce Payments.
The above two papers have not been completed, but preliminary drafts have been forwarded to the Department of Finance for consultation purposes. Once the consultation process is completed with the Department of Finance, and once the OECD has finalized its positions on electronic commerce, the CCRA will make a decision as to how to communicate to the public the content of these two papers or, at least, how to communicate any significant discrepancies between the views of the OECD and the CCRA on this subject.
Computer Software
An issue that did come to the forefront as a consequence of the work done so far on the above two papers dealt with computer software. In the Commentary on Article 12 of the OECD Model Tax Convention on Income and Capital (April 29, 2000 condensed version) concerning the taxation of royalties, at paragraph 27, Canada has an observation that states:
Canada does not adhere to paragraphs 14 through 14.3. In Canada, payments by a user of computer software pursuant to a contract that requires that the source code or program be kept confidential, are payments for the use of a secret formula or process and thus are royalties within the meaning of paragraph 2 of the article.
After consultations with the Department of Finance, the Department of Finance wrote to the OECD on March 28, 2002 to inform them that Canada is removing its observation on Article 12 of the Commentary. Accordingly, as of March 28, 2002, for the purposes of Canada’s Income Tax Conventions, subject to the exceptional cases described in paragraph 14.3 of the commentary on Article 12, the CCRA will no longer view such a payment as a payment for a “secret formula” and the CCRA will apply this interpretation for the Conventions in force as of March 28, 2002 and subsequent Conventions that come into force after that date.
However, for the purposes of Canada’s Income Tax Conventions, the CCRA does view such a payment as a payment for “other intangible property”, where the definition of a “royalty” in the royalty article in the particular Convention refers to “other intangible property”. Also, the CCRA continues to view that Part XIII tax applies to such a payment pursuant to paragraph 212(1)(d) of Canada’s Income Tax Act, unless the payment is in respect of what the CCRA refers to as “shrinkwrap” or the exception in subparagraph 212(1)(d)(vi) applies, because the payment is a “rent, royalty or similar payment, including, …, any payment (i) for the use of or for the right to use in Canada any property … or other thing whatever”.
The CCRA intends to make an announcement regarding computer software payments in our next Technical News publication.
Presenter: Jim Wilson
Prepared by: Gilles Gosselin
Phone number: 946-3553
Division: Income Tax Rulings Directorate
Question 4. Resident of a Contracting State
Since the decision of the Supreme Court of Canada in Crown Forest there has been much debate and discussion concerning the concept of resident of a contracting state for the purposes of Canada’s bilateral income tax conventions. What are the CCRA’s current views on this issue? Has a coordinated view been developed in conjunction with the Department of Finance and the Department of Justice?
CCRA’s Response
The CCRA is presently in consultation with the Department of Finance on this matter. We are currently looking at a number of preferential tax regimes and have asked the Department of Finance for their views on various tax policy issues as they relate to the concept of residence for purposes of our income tax conventions and, in particular, the meaning of the phrase “liable to tax” for purposes of paragraph 1 of the Residence Article of those conventions. As our consultation is still ongoing, we prefer to refrain from making any general comments at this time.
Presenter: Jim Wilson
Prepared by: Tim Kuss
Phone number: 957-2117
Division: Income Tax Rulings Directorate
Question 5. Tower Structure
Canadian multinational corporations frequently in the past financed U.S. subsidiaries through structures taking advantage of the hybrid status of limited liability companies. Until U.S. domestic law changes rendered such structures less attractive, the Canadian parent company would benefit from a reduced treaty withholding rate on the interest paid by the U.S. subsidiary and such interest would then be distributed as dividends out of the exempt surplus of the LLC, and not subject to tax in Canada. With the demise of this U.S. withholding tax relief, a number of more complex structures have been suggested for such financings. What experience has Rulings had to date with these structures?
CCRA’s Response
The Income Tax Rulings Directorate was recently asked by one of our local tax services office to comment on foreign tax credit issues with respect to an outbound financing arrangement using the following structure:
A Canadian parent company (“Parentco”) together with its wholly-owned Canadian subsidiary formed a U.S. partnership (“LP”) which elects to be taxed in the U.S. as a domestic corporation. Parentco contributed equity as well as loaned money to LP. LP invested all its funds in the share capital of a Nova Scotia unlimited liability company (“ULC”) which is treated as a partnership for U.S. tax purposes. ULC in turn invested the funds in the share capital of a U.S. limited liability company (“LLC”) which is also treated as a partnership for U.S. tax purposes. LLC loaned the funds to a U.S. operating company which is owned solely by Parentco.
There are many issues involved in this kind of tower structure. One of the issues is whether the U.S. income tax paid by LP on its profits and the U.S. withholding tax paid by Parentco on the interest received from LP are deductible under subsection 20(12) or creditable under section 126 of the Income Tax Act (“Act”).
The above-noted tower structure appears to aim at getting around the U.S. domestic rule of prohibiting a non-resident of the U.S. to take advantage of the favorable treaty rate on income flowing through a U.S. LLC from a U.S. operating company while such income is not taxed in Canada. It appears that the taxpayers used this structure mainly for tax purposes. In essence, after cutting through all the corporate and partnership tiers, it is Parentco which owns 100% of the U.S. operating company and which loaned money to that U.S. company for use in the latter’s operations. While interest paid by the U.S. operating company directly to Parentco is subject to tax in Canada in the hands of Parentco and the U.S. withholding tax on such interest is deductible or creditable, this tower structure provides a way that such interest is first converted into a dividend out of exempt surplus of LLC to ULC and then to a tax deductible dividend from ULC to Parentco through LP, without incurring any Canadian income tax. While we have been provided limited information on this structure, our initial reaction is that the U.S. taxes paid by LP and Parentco are neither deductible under subsection 20(12) nor creditable under section 126 of the Act because these taxes can reasonably be regarded as having been paid by Parentco in respect of income from a share of the capital stock of a foreign affiliate of Parentco.
As these outbound financing tower structures are complicated and raise many issues, it is strongly recommended that Canadian corporations consider an advance income tax ruling before implementing such an arrangement.
Presenter: Jim Wilson
Prepared by: Simon Leung
Phone number: 946-3252
Division: Income Tax Rulings Directorate
Question 6 – SNCs
The CCRA has confirmed in two technical interpretations that in its view a French société en nom collectif (“SNC”) constitutes a partnership for Canadian tax purposes even in circumstances where it has made an election under French law to be taxed domestically in France as a corporation (see AC59718 and 9221815). The CCRA has recently also confirmed that an SNC that has made an irrevocable election to be taxed as a corporation in France would not be considered a resident of France for the purposes of the Canada-France Income Tax Convention “as it is not liable to tax in France by reason of its domicile, residence, place of management or any other criterion of a similar nature” (Technical Interpretation 2000-0048855, September 13, 2001). Can the CCRA comment on this position in the broader context of its views with respect to partnerships and limited liability companies that are subject to elective rules under the U.S. Internal Revenue Code.
CCRA’s Response
We originally opined that where a French SNC makes an irrevocable election to be taxed as a corporation in France, it would not be considered a resident of France for purposes of the Canada-France Income Tax Convention as it is not liable to tax in France by reason of its domicile, residence, place of management or any other criterion of a similar nature. Pursuant to a technical interpretation request, we are now reconsidering this issue.
Our original opinion was based on limited information on the French corporate tax system. We have therefore requested additional information so that we can fully analyze the issue. We are also considering our position on an SNC that elects to be taxed as a corporation in France in light of our position that a U.S. limited liability company that elects to be treated as a corporation under the U.S. “check-the-box” regulations is a resident of the U.S. for purposes of the Canada-U.S. Income Tax Convention.
We realize that it is difficult to distinguish the case of an SNC that elects to be taxed as a corporation in France from the case of a U.S. LLC that elects to be treated as a corporation for U.S. tax purposes. While we have not reached a final decision on whether an SNC that elects to be taxed as a corporation in France is a resident of France for purposes of the Canada-France Income Tax Convention, subject to receiving confirmation of certain information, we hope we could come to a view that is consistent with our position on a U.S. LLC that elects to be treated as a corporation for U.S. tax purposes.
Presenter: Jim Wilson
Prepared by: Sabrina Wong
Phone number: 957-9231
Division: Income Tax Rulings Directorate
Question 7 – Subsection 18(4)
The thin capitalization rules in subsections 18(4) to 18(6) of the Income Tax Act (the “Act”) deny an interest deduction to a corporation resident in Canada to the extent that its debt to equity ratio with regard to specified non-residents exceeds 2 to 1. For purposes of calculating the debt portion of the ratio, the greatest amount of outstanding debts to specified non-residents during each calendar month is used, while in calculating equity, the contributed surplus and paid-up capital of specified non-resident shareholders at the beginning of each calendar month is used. As a result, if amounts are advanced in the required ratio at a time other than the beginning of a month, the debt to equity ratio of the debtor corporation in respect of the advance will exceed 2 to 1 until the next month. In the opinion of the CCRA, would an advance made on the first day of a calendar month form part of the equity of the Canadian corporation at the “beginning” of that month?
In order to deal with a mid-month requirement for funding, a taxpayer might issue indebtedness that is non-interest bearing for the rest of the month in which it is issued, but which becomes interest bearing at the beginning of the next month. What are the views of the CCRA on whether:
- The new debt only becomes an outstanding debt for purposes of the thin capitalization rules in the subsequent month (i.e. when it becomes interest bearing)?
- A shareholder benefit is conferred by reason of the conversion of the non-interest-bearing debt to interest-bearing debt?
CCRA’s Response
Beginning of a Calendar Month
- We are of the view that the phrase “the beginning of a calendar month” in subparagraph 18(4)(a)(ii) is a reference to the earliest moment of the particular calendar month. Therefore, an advance of equity on the first day of the month can be included in calculating a corporation’s debt to equity ratio as long as the advance is made at the earliest moment on that day; however, an advance made at any other time on the first day would not be included in the corporation’s debt to equity ratio until the next month. As a corollary, we note that it is not necessary for an advance of equity to have been made prior to the end of the previous month in order to be effective for thin capitalization puposes.
Outstanding Debt
- We are of the view that a debt structured so as to be initially non-interest bearing, but which later in the same tax year bears interest, would be an outstanding debt for purposes of the thin capitalization rules from the time it is issued. One of the requirements for “outstanding debts to specified non-residents” is that they are debts or obligations on which an amount in respect of interest is or would be, but for subsection 18(4), “deductible in computing the corporation’s income for the year”. Even though no interest accrues during the non-interest bearing period, there would still be an interest amount that would be deductible for computing the corporation’s income for the year in respect of the particular debt by virtue of the later interest bearing period. We have previously stated “outstanding debts to specified non-residents” would not normally include a debt where interest payable for the tax year in question has been formally waived by the creditor (see the 1993 Congress of the Association de Planification Fiscale et Financiere, Question 37). These two positions are consistent because in the case of an interest waiver for an entire tax year, there is no interest amount paid or payable in respect of the debt that would otherwise be deductible in computing the corporation’s income for the year.
Shareholder Benefit
- Since the use of an initial non-interest bearing period would not be effective in preventing a debt from qualifying as an outstanding debt to specified non-residents at the time the debt is issued, it is not necessary to comment on whether a shareholder benefit is conferred by reason of the conversion of a non-interest bearing debt to interest bearing debt in the context of the above question.
Presenter: Jim Wilson
Prepared by: Ted Cook
Phone number: 946-4165
Division: Income Tax Rulings Directorate
