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
While the recent proposed legislation addresses the issue, it is
not clear why the CRA sought leave to appeal to the Federal Court
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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