Canada´s Section 17 Imputation Rules

Substantial amendments to section 17 of the Canadian federal Income Tax Act¹ were announced as part of the federal Budget tabled in the House of Commons on February 24, 1998. This announcement was followed by detailed draft legislation released by the Department of Finance on October 27, 1998, by a Notice of Ways and Means Motion tabled in the House of Commons on December 10, 1998 and by a further Notice of Ways and Means Motion (the "March Motion") tabled in the House of Commons on March 10, 1999. The proposed amendments were initially to be effective for taxation years beginning after February 23, 1998. However, the implementing legislation deferred the effective date of the changes in subsections 17(2) and (3) until taxation years beginning after 1999².

Essentially, previous subsection 17(1) imputed interest income to Canadian resident corporations on certain loans³ made to non-resident persons. Subject to certain exceptions, this rule applied where a loan remained outstanding for one year or longer without interest at a reasonable rate having been included in computing the Canadian corporate lender’s income. In such a case, the lender was deemed, on the last day of each year in which the loan was outstanding to have received, and therefore, was required to include in computing its income, interest on the loan at a prescribed rate for the period during which the loan remained outstanding. By way of exception, this rule did not apply in two circumstances – firstly, where withholding tax under Part XIII of the Act was paid⁴ on the amount of the loan (i.e., where the loan was treated as a deemed dividend from the Canadian resident corporation to a non-resident person) and, secondly, where the loan was made to a subsidiary controlled corporation and amounts advanced were used in the latter’s business for the purpose of gaining or producing income⁵.

Subsection 17(1) remained substantively unchanged for decades after its introduction into the Act as section 23A of the Income War Tax Act in 1934⁶. As indicated above the exceptions were added later. The only other changes to have occurred were those implemented in 1978 and in 1985⁷.

The most controversial of the provisions of old section 17 was the exception contained in subsection 17(3). The exception was available where two conditions are met. The loan had to be made to a subsidiary controlled corporation and the funds advanced had to be used by the borrower in its business for the purpose of gaining or producing income. A "subsidiary controlled corporation" was defined in subsection 248(1) to be "a corporation more than 50% of the issued share capital of which (having full voting rights under all circumstances) belongs to the corporation to which it is subsidiary". Only directly owned subsidiaries satisfied this requirement⁸. Revenue Canada, traditionally, took a liberal approach in interpreting the second condition for the application of the exception⁹. Revenue Canada's position encouraged Canadian resident corporations to employ subsidiary controlled corporations as financial intermediaries to finance related non-resident corporations' business activities abroad. The activities of such financial intermediaries, generally, were accepted by Revenue Canada as sufficient to meet the test of use of funds borrowed in gaining or producing income from a business. Generally, section 17 had little impact on Canadian taxpayers. Its application was most often easily avoided by prudent planning.

Other than those modifications described above, no substantive amendments were made to section 17 after 1951. However, the Minister of Finance in his federal Budget of November 12, 1981 did propose a series of amendments which, if they had been implemented, would have had serious consequences for Canadian corporations that, at the time, were using intermediary entities in order to finance foreign group activities. The proposal would have extended the interest imputation requirement to any form of indebtedness and would have removed the exception for loans to subsidiary controlled corporations. The proposals, when first introduced in November of 1981, were designed to take effect for any period commencing after 1981. As a result of representations made in connection with the proposed amendments¹⁰, the Minister of Finance, in December of 1981, initially deferred the application of the proposed amendments to any period after 1983¹¹ and, in the release which accompanied the tabling of a comprehensive Notice of Ways and Means Motion relating to the November 12, 1981 Budget in June of 1982, announced that the proposed changes would not be proceeded with before studies had been concluded and a discussion document made public¹².

The 1998 Budget expanded the rule in section 17 in three principal respects. First, the section applies not only to Canadian resident corporations but also to trusts and partnerships of which a Canadian resident corporation is a beneficiary or member. Second, it applies to all amounts owing by non-residents either directly or indirectly to a Canadian resident corporation or a trust or partnership of which such a corporation is a beneficiary or member. As noted above, the previous rule applied only where a Canadian resident corporation had made a loan to a non-resident person. Third, though the exception in subsection 17(3) remains, it has been significantly restated to extend its application to loans made to controlled foreign affiliates of the Canadian taxpayer.

New subsection 17(1) applies to impute interest income to a Canadian resident corporation where a non-resident person owes or is deemed to owe any amount to the corporation which has been or remains¹³ outstanding for more than one year¹⁴ and the amount of interest on the indebtedness (or amounts received or receivable from a trust, and amounts imputed to the corporation as foreign accrual property income ("FAPI") under the foreign affiliate rules, that can reasonably be attributed to interest on the amount owing) which has been included in computing the Canadian resident corporation’s income is less than the interest which would be included in computing the corporation’s income in respect of the amount owing if that interest were computed at a "reasonable rate". In such a case, interest is imputed in an amount equal to the difference between the amount actually included and the amount determined in accordance with a prescribed rate¹⁵.

Section 17 also contains a number of "anti-avoidance" rules. These rules apply to certain amounts owing to a trust, or to or by a partnership.

Subsections 17(4) and (5), for purposes of section 17, deem an amount owing to a partnership or a non-discretionary trust to be owing to each member or beneficiary of the partnership or trust in the proportion 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 the interests in the partnership or trust. Similarly, subsection 17(5) deems the entire amount owing to a discretionary trust to be owing to each "settlor" of the trust. For purposes of section 17 only, the word "settlor" is defined in subsection 17(15) as any person or partnership that make a loan or transfer of property to the trust – other than a loan at a reasonable rate of interest, or a transfer for fair market value consideration, made by an arm’s length person or partnership.

Both of these rules appear to be intended to prevent Canadian resident corporations from avoiding the application of subsection 17(1) by acquiring interests in partnerships or trusts to which amounts are owing by non-residents. Interestingly, however, and despite the fact that these rules are described as anti-avoidance rules, neither is conditional upon a determination that the purpose (or even one of the purposes) of the Canadian resident corporation acquiring an interest in a partnership or a trust is to avoid the application of subsection 17(1). Moreover, neither rule provides for an exception with respect to investment vehicles, nor for any de minimus threshold. Thus, even where a Canadian resident corporation acquires only a very minor interest in a partnership or trust, whether or not publicly traded (i.e., less than 1%), or where the partnership or trust has only a very minor proportion of its holdings in indebtedness of non-residents which do not qualify for the exceptions described below, the Canadian resident corporation will technically be required to determine whether or not all amounts owing to the partnership or trust by non-residents bear interest at a reasonable rate – or a rate which equals or exceeds the prescribed rate – or to determine that the indebtedness otherwise qualifies for an exception from the application of subsection 17(1).

In addition, subsection 17(6) deems, again only for purposes of section 17, any amount owing by a partnership to be owing by each of its members in the proportion that the fair market value of such member’s interest in the partnership is of the fair market value of all the interests in the partnership. This particular rule, which is also described as an anti-avoidance rule, appears to be intended to prevent Canadian resident corporations from avoiding the application of subsection 17(1) by acquiring indebtedness of partnerships having non-resident members rather than directly acquiring indebtedness of such non-resident members. Again, however, there is no "purpose test" and no de minimus threshold. Moreover, there is no rule which deems the rate of interest on indebtedness owing by a partnership to be reasonable with respect to each of its members if it is reasonable with respect to the partnership as a whole. Thus, each time a Canadian resident corporation acquires any indebtedness of a partnership, it will, presumably, be required to determine whether or not the partnership has any non-resident members and whether or not the rate of interest on any indebtedness of the partnership is reasonable with respect to each member.

Most tax advisers initially believed subsection 17(1) would apply to all amounts owing or deemed to be owing, both those owed at arm's length and those at non arm's length. The appropriateness of the application of imputation rules such as those in section 17 to arm's length transactions, such as trade debts, long term sales contracts, sale or return contracts and debts which become uncollectible as a result of financial circumstances affecting a debtor, was questioned. In response and to exclude such transactions, subsection 17(9) excludes amounts owing (or deemed to be owing) by a non-resident to a Canadian corporation if

• the corporation was not related to the non-resident throughout the period in the year during which the amount owing was outstanding,
• the amount owing arose in respect of goods or services provided to the non-resident person in the ordinary course of the business carried on by the corporation, and
• the terms and conditions in respect of the amount owing are such that persons dealing at arm's length¹⁶ would have been willing to enter into them at the time that they were entered into.

In addition, subsection 17(7), carries forward the rule in old subsection 17(2) which provides for an exception with respect to any amount owing on which withholding tax under Part XIII of the Act has been paid. The proposals have not remedied timing issues raised in 1982 which result from the use of the word "paid". However, the new rule does address a concern from the perspective of the fisc in providing that even where an amount has been paid under Part XIII of the Act, if the amount is refunded or applied to other amounts owing by the taxpayer, it will be deemed not to have been paid for purposes of section 17.

Subsection 17(8), is an amended version of old subsection 17(3). The scope of this exception is, at once, expanded and restricted in certain respects. In its previous formulation, the exception applied only to a loan made to a subsidiary controlled corporation. By contrast, subsection 17(8) would apply to an amount owing by a controlled foreign affiliate of the Canadian resident corporation. For these purposes, the definition of "controlled foreign affiliate" in subsection 95(1) would be restricted to foreign corporations coming within the ambit of the definition in subsection 17(15). Subsection 17(15) defines a controlled foreign affiliate, for purposes only of section 17, to be a foreign affiliate which is controlled by the relevant Canadian resident corporation, by not more than four other Canadian residents (either alone or together with the relevant Canadian resident corporation) or by one or more Canadian residents with whom the relevant Canadian resident corporation does not deal at arm’s length (either alone or together with the relevant Canadian resident corporation).¹⁷ In addition, new subsection 17(13) extends the definition in subsection 17(15) by providing that any non-resident corporation that is a controlled foreign affiliate of a corporation resident in Canada at any time is deemed also to be a controlled foreign affiliate of any corporation resident in Canada that is related to such corporation at that time (otherwise than by reason of paragraph 251(5)(b))¹⁸. These provisions are intended to limit the application of this exception to non-resident corporations, whether actual or deemed debtors, that among other things, are controlled by Canadian residents. Any amount owing by a related non-resident corporation, such as, for example, an amount owing by a debtor that was a sister corporation of the Canadian resident corporation owned by a foreign parent of such corporation are not excepted.¹⁹

The scope of this exception could, however, be considered to be expanded, in certain cases, in that the Canadian resident lender need no longer have control, directly, of the non-resident debtor. Moreover, supporting rules in subsections 17(10) and (12) add to the definition of "controlled foreign affiliate" in subsection 95(1) to provide for circumstances in which the shares of a non-resident corporation are held by a partnership or trust. Essentially, each member or beneficiary of a partnership or non-discretionary trust is deemed to own the proportion of the number of shares of a corporation owned by the partnership or trust that the fair market value of the member’s or beneficiary’s interest in the partnership or trust is of the fair market value of all the interests in the partnership or trust. In addition, each "settlor of a discretionary trust is deemed to own the number of shares of a corporation owned by the trust which is determined by dividing the number of shares owned by the trust by the number of "settlors" of the trust. Thus, the application of the exception is not jeopardized by reason only that the shares of a corporation are held by a partnership or trust in which the relevant Canadian resident corporation has an interest.

The exception has also been modified to adopt the definition of "active business" in subsection 95(1), and the related supporting rules in subsection 95(2). The Revised Explanatory Notes which accompanied the draft legislation described the exception to subsection 17(1) contained in subsection 17(8) as applying to:

• the amount owing [which] arose as a loan or advance to the affiliate that the affiliate has used…either to earn income that is 'income from an active business' (as defined in subsection 95(1) of the Act) or, generally, to make a loan or advance to another foreign affiliate of the corporation that is an unrelated foreign affiliate²⁰ or a controlled foreign affiliate (as defined in subsection 17(15)) provided that the other affiliate uses the loan or advance for the purpose of earning income from an active business; or
• the amount owing [which] arose in the ordinary course of an "active business" (as defined in subsection 95(1) of the Act) that was carried on by the affiliate throughout the period…

The effect of adopting the definition of "active business" in subsection 95(1) is to restrict the scope of the exception. As noted above, under the previous rule, subsection 17(1) did not apply where a debtor used the proceeds of a loan in its business for the purpose of gaining or producing income, which would include a wide range of commercial and financial activities. By contrast, the definition of "active business" in subsection 95(1) excludes an "investment business", which is defined to include many types of financial activities. Thus, in order for the exception to apply in respect of an amount owing by a non-resident, it will not be sufficient for the non-resident to use the proceeds of the indebtedness to earn income from, or for the amount owing to arise in the course of, activities that constitute a business under general principles; the activities will have to constitute an active business as defined in subsection 95(1). On the other hand, the scope of this exception could be expanded in circumstances in which the non-resident uses the proceeds of the indebtedness to fund qualifying financing activities which, although they may not constitute a business under general principles (and, therefore, would not come within the scope of the exception under current rules), nevertheless, give rise to active business income under the deeming rules in subsection 95(2).

Perhaps the most controversial aspects of the rules are those which deem amounts to be owing by a non-resident to a Canadian resident corporation by virtue of the fact that the Canadian resident corporation had either made a loan or a transfer of property to a person who had then made a loan to the non-resident in question.

More specifically, subsection 17(2) provides that, where certain conditions are met and subject to certain exceptions, the indebtedness of a non-resident person may be deemed to be owed to a Canadian resident corporation. The conditions are as follows:

• a non-resident person (the "debtor") owes an amount (the "indebtedness") to a particular person (other than a Canadian resident corporation) or a partnership (the "creditor"), and
• it is reasonable to conclude that the creditor entered into the transaction under which the indebtedness became owing, or permitted the indebtedness to remain outstanding, because a Canadian resident corporation (the "taxpayer") made a loan or a transfer of property (or the creditor anticipated that the taxpayer would make a loan or a transfer of property) either directly or indirectly to or for the benefit of any person or partnership (other than an exempt loan or transfer).

The simplest example of this – and, by far, the most troublesome because it is so common – would be where a Canadian resident corporation (i.e., the taxpayer) capitalizes a foreign affiliate (i.e., the creditor) which, in turn, lends funds to another foreign affiliate or a related non-resident corporation (i.e., the debtor). Unless an exception applies, the loan made by the creditor would be deemed to be owing by the debtor to the Canadian resident corporation. Even if the loan by the creditor bears interest at a reasonable rate, the Canadian resident corporation would be subject to interest imputation under subsection 17(1)²¹, except to the extent that interest on the loan gives rise to FAPI which is attributed to the Canadian resident corporation and taxed, currently, in Canada.

Three exceptions to the application of subsection 17(2) are contained in the legislation. The first, which would be incorporated into subsection 17(2), would apply where the loan or transfer of property by the taxpayer is determined to be an exempt loan or transfer. An exempt loan or transfer is defined in subsection 17(15) to be a loan or a transfer of property²² made by a corporation to a person or partnership in the circumstances described in subsection 17(2) where

• at the time of the loan the corporation was not related²³to the person or to any member of the partnership,
• the loan or the transfer of property was not part of a series of transactions or events at the end of which the corporation was related to the person or any member of the partnership, and
• the terms and conditions of the loan or the transfer (determined without reference to any other loan or transfer of property to either a person related to the corporation or a partnership any member of which was related to the corporation) are such that persons dealing at arm's length would have been willing to enter into them at the time that they were entered into.

Another exception, which is similar to the first, is incorporated into subsection 17(3). Subsection 17(3) applies in circumstances where an amount is owing by a non-resident person to a person or partnership (that is not a resident of Canada). It would apply where the debtor and the creditor (or, where the creditor is a partnership, each member of the partnership) are not related, where the terms and conditions in respect of the indebtedness (determined without reference to any other loan or transfer of property by the Canadian resident corporation) are such that persons dealing at arm’s length would be willing to enter into them and, where, if there were an amount of interest payable on the indebtedness that would be required to be included in computing the income of a foreign affiliate of the Canadian resident corporation, that interest would not be required to be included in computing the foreign affiliate’s FAPI²⁴.

Essentially, the differences between the exception contained in subsection 17(2) and that contained in subsection 17(3) are, on the one hand, that the first requires an exempt loan or transfer of property by the Canadian resident corporation on terms which are arm’s length, while the second requires arm’s length terms and conditions with respect to the amount owing between the non-resident creditor and the non-resident debtor and that the proceeds of the indebtedness to be used by the non-resident debtor to earn income from an active business or to fund qualifying financing activities.

A third exception (also in relation to an amount owing between two non-residents) applies where both the debtor and the creditor are controlled foreign affiliates of the taxpayer. In this context, arm’s length terms and conditions are not required either with respect to the loan or transfer of property by the taxpayer or with respect to the amount owing by the debtor.

These exceptions appear to be intended to restrict the application of subsection 17(2) to circumstances in which the debtor is not related to the Canadian resident corporation and is not controlled by Canadians (i.e., a sister corporation controlled by a common foreign parent corporation).

Consider the following example:

Since the taxpayer, the creditor and the debtor are related persons, neither of the first two exceptions described above would apply. Moreover, under the restricted definition of "controlled foreign affiliate" in proposed subsection 17(15), the debtor would not be a controlled foreign affiliate of the taxpayer and, therefore, the third exception would not be applicable. Thus, the loan would be deemed to be owing by the debtor to the taxpayer for purposes of subsection 17(1).

Quite often parties to a joint venture arrangement will be required to commit to subsidize the financing of the joint venture in some manner. Consider the following fact pattern:

As the debtor, the creditor and the taxpayer would not be considered to be related, the exceptions in 17(2) or 17(3) would, if the other tests were satisfied, apply to exclude the loan from the ambit of section 17(1).

Subsection 17(14) contains a specific anti-avoidance rule which has the effect of requiring that rights to acquire shares and acquisitions and dispositions of shares undertaken for the principal purpose of avoiding the application of section 17(1) to be income of a Canadian resident corporation will be disregarded in applying the imputation rules. A similar rule introduced into the Act with application to the Canadian rules which govern the taxation of foreign source income has received little attention and therefore, offers no guidance as to the potential for future application of the rule. Taxpayers and their advisers, faced with the option of winding up arrangements which will not qualify for the exceptions to subsection 17(1) or of attempting to restructure them to bring them on-side the new rules, will debate at some length whether such restructurings will themselves be disregarded under this rule.

Given that the type of arrangements described above are not only very common, but that they are contemplated by the rules in subsection 95(2), it is not surprising that the new rules resulted in controversy. Canada has had a long standing approach to the taxation of the foreign source income of Canadian resident corporations. That policy, contained in sections 90 - 95, section 113 and Part LIX of the Regulations, is based on a combination of the exemption and foreign tax credit systems. The FAPI rules attribute passive investment income earned by a controlled foreign affiliate to its Canadian controlling shareholder, thus eliminating undue avoidance of Canadian tax on such income. Active business income is not attributed. The exemption system applies to dividends from such income earned by corporations in countries with which Canada has concluded tax treaties. Dividends from other active business income fall within the foreign tax credit system. The theory being that Canadian resident corporations are thereby able "to compete abroad without being at a fiscal disadvantage vis-a-vis their competitors"²⁵, in a system with which it is simpler to comply. Relying on these rules, and assuming that certain conditions are satisfied in respect of the use of funds advanced by a controlled foreign affiliate of a Canadian resident corporation to another related non-resident corporation, subsection 95(2) would apply to require the interest on the loan to be included in the creditor’s active business income. In addition, provided that the debtor and creditor are resident in a country with which Canada has concluded a comprehensive income tax treaty and the qualifying activities of the debtor are carried on in that country, the interest income should be included in computing the creditor’s "exempt earnings" and its "exempt surplus", which could be distributed to the taxpayer in the form of a dividend free of tax under the Act.

Section 17 overrides the Canadian system for the taxation of foreign source income of Canadian resident corporations in certain respects. What is the policy justification for such an income imputation type of provision?²⁶. In 1982, Victor Peters²⁷ suggested two policy justifications. The first was the attribution of a minimum amount of foreign source income on capital invested outside Canada. In this regard, he concluded that "such an approach [the attribution of an arbitrary amount of income that bears no relationship to actual amounts earned] is inconsistent with other basic principles inherent in Canadian income tax law"²⁸. The second potential policy justification involved the protection of the Canadian revenue base, i.e. through the reduction of Canadian source income by deduction of expenses such as interest. In this regard, also, section 17 was described as "only partially effective … a back-door approach … which attempts to create taxable income rather than attacking the deductibility of the expenses"²⁹. The interest deduction which Canada affords to Canadian resident corporations funding investments in foreign operations has long been a source of controversy. Eliminating the deduction, however, would, it is believed, result in Canadian enterprises becoming less competitive in foreign markets. The effect of the imputation rule, contained in the new rules, however, is to affirm the Canadian system's support of Canadian multi-nationals, while, at the same time, eliminating its benefits in circumstances where foreign multi-nationals seek to access the Canadian tax base through their Canadian subsidiaries to finance non-Canadian controlled foreign operations.

1 RSC 1985, c. 1 (5^th Supplement), as amended, hereinafter referred to as the "Act". Unless otherwise stated, statutory references in this article are to the Act.

2 Department of Finance Press Release No. 98 - 131 dated December 18, 1998. See also Resolution 8(2) of the March Motion.

3 The reference to loans considerably restricted the scope of the section in the past. See decisions in the cases of Banister v. MNR, 73 DTC 42 (TRB) and K. R. Ranches Ltd. v. MNR, 73 DTC 49 (TRB). Based on earlier jurisprudence (MNR v. T. E McCool Ltd., 49 DTC 700 (SCC); Minshall Organ Ltd. v. MNR, 51 DTC 6 (TAB); and Reinhorn v. MNR, 50 DTC 116 (TAB)), these decisions required that the relationship between the Canadian resident corporation and the non-resident be that of lender and borrower, respectively, if the section was to apply.

4 It is important to note that liability for withholding tax is insufficient to entitle the Canadian resident corporation to the exception. The Canadian non-resident withholding tax must actually have been paid.

5 The first exception, found in subsection 17(2), was added in the major tax revision of 1948 (Income Tax Act, SC 1948, c. 52.) as section 19(2). The subsection was added in response to a decision of the Exchequer Court in Julius Kayser & Co. Ltd. v. MNR, (1940), 1 DTC 499-54 (Ex. Ct.). The second exception, found in subsection 17(3), was added to the Act in 1951 (SC 1951, c. 51, section 5) as section 19(3).

6 SC 1934, c. 55 section 12 amended the Income War Tax Act, RSC 1927, c. 97, to add section 23A.

7 In 1978, an amendment replaced the previous reference to 5 per cent with a reference to the prescribed rate (SC 1977-78, c. 1, subsection 10(1)). In 1985, the wording of the section was tinkered with slightly (SC 1985, c. 45, section 8). The Technical Notes issued by the Department of Finance, 10^th Edition (1998, Thomson Canada Limited, page 113) describe the amendment as "for the purpose of making the wording consistent with that in other provisions of the Act that refer to a prescribed rate of interest".

8 See Massey-Ferguson Ltd. v. The Queen, 77 DTC 5013 (FCA reversing 74 DTC 6529 (FCTD) and 73 DTC 66 (TRB) and Distillers Corporation-Seagrams Ltd. v. MNR, 80 DTC 1649 (TRB).

9 See Revenue Canada Round Table in Report of the Proceedings of the Thirty Second Tax Conference (Toronto, Canadian Tax Foundation, 1981) at pages 591-628 and 613-614 and Revenue Canada Round Table in Report of the Proceedings of the Thirty First Tax Conference (Toronto, Canadian Tax Foundation, 1980) at pages 601-38 and 626.

10 See, for example, the submission of the Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants dated December 1, 1981, page 16.

11 Department of Finance Press Release No. 81 - 126 dated December 18, 1981. The relevant section of the Release read at page 14 as follows:

12 Department of Finance Press Release No. 82 - 72 dated June 28, 1982. No discussion document on the subject was ever made public.

13 Presumably, the intent of the legislators is to insure that the rules, the application of which was specifically deferred to taxation years commencing after 1999, will apply without further delay. Prior to the addition of the phrase to the legislation, it was thought that outstanding loans, would only be subject to the imputation rules in subsection 17(1) in the taxation year following the taxation year commencing after 1999.

14 Other provisions of the Act, notably subsection 15(2) dealing with "shareholder" debt, also impose a cut off of a year. Strangely, however, section 17 does not contain a provision such as that found in, for example, subsection 15(2.6) which requires that for the repayment of an amount to be effective for purposes of the Act it can not be a part of a series of loans and repayments. The absence of such a provision suggests that, barring the application of the Canadian general anti-avoidance rule, Canadian corporations may still be able to extend loans to non-residents for periods of less that one year, even if such loans are part of a continuing series of transactions, which might involve loans and repayments, between the non-resident and the Canadian corporation.

15 Section 17 has always been a bit out of step with the other international sections of the Act. Its role when introduced was unclear and it remained, after tax reform and the introduction of a system of rules to deal with the taxing of foreign source income of Canadian taxpayers, a misfit. For an interesting analysis of the historical and judicial background on the section and, in particular, for a discussion of the punitive nature of the use of a prescribed rate in the section , see Victor Peters, "The Role of Section 17 in the Taxation of Foreign Source Income - Past, Present, and Future", Canadian Tax Journal, Volume 30, No. 4, page 501.

16 For purposes of the Act, related persons (a term defined in the statute) are deemed not to deal with each other at arm's length (even in circumstances where the terms on which they deal can be considered to be reflective of prevailing market conditions). Where persons are not related they may still be considered not to deal at arm's length based on their conduct and the circumstances of the transactions into which they enter: see Swiss Bank Corp. v. MNR, [1972] C.T.C. 614 (SCC); Robson Leather Co. Ltd. v. MNR, [1977] C.T.C. 132 (FCA).

17 Recent proposals will, when enacted, ensure that the election available under Canada's proposed foreign investment entity to treat certain non-resident corporations as controlled foreign affiliates will not apply for purposes of section 17.

18 Paragraph 251(5)(b) requires any person with a right under a contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently, to or to acquire shares of a corporation, to, or to acquire or to control the voting rights of such shares, to cause a corporation to redeem, acquire or cancel shares owned by other shareholders or to cause a reduction in the voting rights held by another shareholder, to treat the right as fully exercised for certain purposes of the Act, notably those provisions which determine whether corporations are related. The paragraph can produce unexpected results, sometimes advantageous and sometimes disadvantageous to a taxpayer.

19 Interest paid on such an amount might well be considered to be active business income of a foreign subsidiary of the Canadian resident corporation in the lending business. It would benefit, under the Canadian foreign affiliate system, from both deferral and exemption in the hands of the Canadian corporation when repatriated to Canada. However, a prescribed amount will now be imputed to the Canadian corporation as interest in respect of each year (after the first) in which the amount remains outstanding even if the actual amount is distributed by the foreign subsidiary to the Canadian corporation. No attempt has been made to integrate section 17 with the current provisions of the Act which provide for the taxation of foreign source income of Canadian resident taxpayers.

20 This term is not used in the legislation, nor is it defined in the Act or the Explanatory Notes. It is thought that one of the purposes of the exception is to eliminate double imputation in circumstances where the deeming rules discussed below would require an imputation in respect of the amount owing from the ultimate borrower. In such circumstances, it would be unduly harsh to impute interest on a loan to the intermediate borrower as well.

21 The imputation will be at an arbitrary rate prescribed from time to time by the Act and the Regulations and which will bear no reference to interest actually earned by the creditor (and indirectly by the taxpayer) even if such interest reflects current prevailing market rates based on the credit of the debtor, the amount of the loan and the currency in which it is denominated, the term to maturity and other relevant conditions.

22 A proposed amendment to the definition of exempt loan or transfer will make it clear that payment of a dividend or a return of capital by a Canadian corporation to its foreign parent will be considered an exempt loan of transfer for purposes of section 17.

23 Parties are considered to be related for purposes of the Act if they are connected by blood, marriage or adoption or, in the case of corporations, if there exists, generally, a common control as specified in section 251 of the Act. In addition, subsections 17(10) and (11) contain rules that apply for the purpose of determining whether parties are related for purposes of section 17. A proposed amendment contained in subsection 17(11.1) will ensure that subparagraph 251 (5)(b)(i) rights are disregarded if exercise of those rights is prohibited under foreign laws restricting foreign ownership or control of the corporation.

24 A further proposed amendment in subsection 17(11.2) disregards an intermediary in a back-to-back loan arrangement in the determination of who is the initial lender, thus eliminating the possibility of using such an arrangement to avoid the application of section 17.

25 E.J. Benson, Proposals for Tax Reform, (Ottawa: Queen's Printer, 1969), page 73.

26 It is to be noted that at the time of its introduction into the Act, the then Minister of Finance explained that it and other provisions were required to counter attempts to evade the law through subsidiary loans to parent companies without interest. At the time, however, a predecessor provision to current subsection 15(2) which deems certain loans to related persons to be a dividend (subject to Canadian non-resident withholding tax) existed, raising some question as to the need for a section 17 type provision. Indeed, prior to the abortive attempt to amend section 17 in 1981, the impact of section 17 was described by Victor Peters, supra, footnote 15, page 515, as follows: "A loan to a shareholder … is excepted from the provision’s application … A loan to a person related to a shareholder, other than a downstream affiliate of a Canadian corporation, is also excepted … A loan to a direct subsidiary … is excepted… Loans to indirect subsidiaries can usually be accommodated … In the end, the only loans that seem incapable of escape are those to arm’s length parties."

27 Supra, footnote 15, page 519.

28 Supra, footnote 15, page 524. The same criticism can be made in the context of the new rules.

29 Supra, footnote 15, page 526. It is interesting that the proposed amendments to section 17 come on the heels of a lengthy debate as to the deductibility of interest by Canadian companies on funds borrowed to invest in both domestic companies and foreign affiliates. See the Report of the Technical Committee on Business Taxation (December 1997). The proposed amendments also follow upon Revenue Canada audit activity which has focused on investment, inter alia, by Canadian subsidiaries of foreign multinationals in foreign financing subsidiaries.