CRA Confirms Interpretation of Cap B in Partnership Context

In a technical interpretation (2016-0680801I7, August 31, 2017; released mid-January 2018), the CRA has confirmed that subclause 95(2)(a)(ii)(B)(II) ("subclause II") does not allow for full recharacterization of property income as active business income (ABI) where payments are made to a foreign affiliate (FA) by a partially owned partnership of which another FA is a qualifying member. Clause 95(2)(a)(ii)(B) ("Cap B") instead recharacterizes only a portion of the income, based on the percentage participation of that other FA in the partnership.

The TI resolves some of the uncertainty following amendments made in December 2007 that left the requirements of subclause II open to interpretation. (For further discussion of this uncertainty, see "Inconsistent Treatment of Partnerships in the Foreign Affiliate Rules," 2009 Conference Report, 24:30-32.)

The simplified situation described in the TI involved a partnership (MLP), which was carrying on an active business in the United States; MLP was owned 60 percent by the foreign parent of Canco (FP) and 40 percent by a wholly owned FA of Canco (FA 1). MLP borrowed $200 million from another wholly owned FA of Canco (FA Luxco) and paid $10 million of interest. The CRA stated that only 40 percent of the $10 million of interest received by FA Luxco should be recharacterized as ABI, resulting in FA Luxco having FAPI of $6 million.

In the CRA's view, a textual reading of subclause II requires that the particular expenditure (or portion thereof) by the partnership meet two separate tests: (1) the expenditure (or portion thereof) must be deductible in computing the other FA's share of the income of the partnership for the purposes of paragraph 96(1)(f), and (2) the expenditure (or portion thereof) must be included in computing the other FA's prescribed earnings.

The CRA relied in part on the December 2007 amendments to Cap B. Prior to those amendments, Cap B referred to "expenditures that were or would be, if the partnership were [an FA] of the taxpayer, deductible . . . by the other [FA] or the partnership" in computing prescribed earnings. The CRA considered the amendments a "tightening measure" and said that it is the intent of "new" subclause II to potentially differentiate the tax results to an FA with respect to interest paid to it by a partially owned partnership versus interest paid to it by a partially owned FA.

According to the CRA, the rationale for this potential difference is that because a partnership is treated as a flowthrough entity for Canadian tax purposes, interest paid by a partnership should be viewed as interest paid proportionately by each of its members. To the extent that a portion of the interest paid to FA Luxco by MLP is considered to have been paid by FP, that portion should not be recharacterized as ABI because it would not be recharacterized if it had been paid directly by FP.

In my view, the CRA's position finds support in the policy of the FA system of preventing international double taxation of ABI earned indirectly by Canadian residents in treaty jurisdictions. In the situation described in the TI, only the interest allocable to FA 1 is within the so-called Canadian cone—the foreign economic activity that happens "under" a Canadian-resident taxpayer that, from a Canadian policy perspective, may be taxed by Canada—such that the interest should benefit from the Cap B exemption from the FAPI regime. By contrast, the interest allocable to FP is outside the Canadian cone and therefore should arguably not benefit from the exemption. As the TI notes, if MLP were a corporation that was an FA of Canco, all of the interest would be recharacterized.

Olivia Khazam
Davies Ward Phillips & Vineberg LLP, Montreal

Canadian Tax Focus
Volume 8, Number 1, February 2018
©2018, Canadian Tax Foundation