Canada: Tax Court Of Canada Allows Foreign Tax Credit Generator Arrangement
Major changes have occurred with respect to foreign tax credit (FTC). The Department of Finance announced in the federal budget of March 4, 2010, a proposed legislation regarding FTC generators (FTCG) and released modified draft legislation on August 27, 2010. These new FTCG rules target the FTC per subsections 126(4.11)-(4.13) of the Income Tax Act (ITA), the foreign accrual tax (FAT) per subsections 91(4.1)-(4.5) and the underlying foreign tax (UFT) per subsections 5907(1.03)-(1.06) of the Income Tax Regulations.
In 4145356 Canada Ltd. v. R. (2011 TCC 220), the Canada Revenue Agency challenged for the first time existing FTC before the Tax Court of Canada after the proposal of new legislation for FTCG. The facts in this case are common to a FTCG arrangement. Essentially, a subsidiary of the Royal Bank of Canada (Canco) acquired units in a Delaware limited partnership (USLP) for CDN$ 400 million. Two subsidiaries of the Bank of America (US Subs) also acquired units for a total value of CDN$ 1.2 billion. USLP then made a loan of approximately CDN$ 1.6 billion to Mecklenburg Park, Inc. (MPI) another subsidiary of the Bank of America which generated about CDN$ 38 million of interest income for USLP. Since USLP elected to be treated as a corporation for U.S. tax purposes, it paid CDN$ 13 million of U.S. income taxes with respect to its income earned for the 2003 taxation year. Finally, USLP allocated to Canco around CDN$ 9 million (according to Canco’s 24.7678% detention in USLP as well as a limit pursuant to an existing agreement). Thus, Canco deducted approximately CDN$ 3 million as FTC (which represented the U.S. taxes paid by USLP) providing Canco with a net income of CDN$ 6 million.
At issue was whether Canco was entitled to the CDN$ 3 million FTC in respect of its share of the U.S. income taxes paid either under subsection 126(2) ITA or under Article XXIV(2) of the Canada-US Income Tax Treaty.
The basis of the CRA denial of Canco’s FTC was that Canco did not pay any taxes and that the partnership could not claim any FTC. However, the Court stated that Canadian tax law (i.e. section 96 and subsection 126(2) ITA) and not U.S. tax law should be considered and held that subsection 126(2) ITA does not require that the person paying taxes (USLP) and the one liable to tax (Canco) be the same, as the expression “paid by the taxpayer” in subsection 126(2) should be read “as a harmonious whole” pursuant to the Supreme Court’s construction of the Act. The Honourable Webb J added that denying the FTC to Canco will result in double taxation of the same income. Finally, considering the conclusion, it was not necessary to analyze the Canada-US Income Tax Treaty argument.
Would the tax treatment of this case be the same considering the new FTCG rules? Pursuant to proposed subsection 126(4.11), the new FTCG rules would likely deny the FTC claimed by Canco, as Canco’s interest in USLP under U.S. tax law (which is viewed as a loan, thus nil) is less than its interest under Canadian tax law (which is about 25%).
Tax practitioners should bear in mind that the main criteria with respect to the application of FTCG rules is the presence of a hybrid instrument. If there is a hybrid instrument in the corporate structure, it will most likely give rise to an asymmetrical result, and thus may give rise to the application of the FTCG rules. For instance, in the present case, Canco and one of the US Subs entered into a repo agreement. A repo agreement is a hybrid instrument where, in this case, Canco’s investment in USLP is considered for U.S. tax purposes as a debt whereas it is treated as equity for Canadian tax purposes.
Finally, care must be given to the use of hybrid instruments if foreign taxes paid represent significant amount, because it is not only the proportion of the foreign tax related to the hybrid instrument which will be denied but the whole amount of FTC, FAT or UFT.
While the recent proposed legislation addresses the issue, it is not clear why the CRA sought leave to appeal to the Federal Court of Appeal.