Citation: Geoffrey S. Turner, "Finance Comfort Letter on the 95(2)(f) and (f.1) FAPI Accrual Rules – A Comment on its Implications for the Tax Cost Bump" International Tax, Report # 31 (CCH: December 2006)
A recent Department of Finance comfort letter publicly released November 1, 2006 (but dated September 1, 2006)1 recommends amendments to paragraph 95(2)(f) and to proposed paragraph 95(2)(f.1) of the Income Tax Act (Canada) (the "ITA"). The proposed changes relate to the postamble of paragraph 95(2)(f), and in particular to the circumstances in which the "FAPI accrual carryover" will apply when two Canadian corporations amalgamate and one of the predecessors has a foreign affiliate which owns capital property with an accrued gain or loss. The comfort letter is interesting in a number of respects, including the tax policy issues it engages in relation to the paragraph 88(1)(d) tax cost bump when applied to a Canadian target corporation's shares of a foreign affiliate. This article examines the issues addressed in the Finance comfort letter, and considers some of its implications and possible further circumstances in which the FAPI accrual carryover rules could be amended.
The 95(2)(f) and (f.1) FAPI Accrual Carryover Rules
Paragraph 95(2)(f) establishes the rules for calculating the taxable capital gains and allowable capital losses of a foreign affiliate of a Canadian taxpayer. These rules are relevant both for determining the FAPI of the foreign affiliate (where the property disposed of is not excluded property), and for determining the taxable surplus/deficit and exempt surplus/deficit balances of the foreign affiliate.
In general terms, paragraph 95(2)(f) provides that capital gains and losses of the foreign affiliate are to be determined using the Canadian rules set out in Part I of the ITA. Where the property disposed of is not excluded property and the foreign affiliate is a controlled foreign affiliate (i.e., where a gain would give rise to a FAPI inclusion for the Canadian taxpayer), the gain or loss is to be computed using Canadian dollars. In any other case, the gain or loss is to be computed using the appropriate foreign calculating currency.
However, the postamble of paragraph 95(2)(f) requires that the capital gain or loss calculation exclude the portion of the gain or loss that can reasonably be considered to have accrued during the period that the foreign affiliate was not a foreign affiliate of the particular Canadian taxpayer, a person with whom the Canadian taxpayer was not dealing at arm's length, or a predecessor of the Canadian taxpayer (or non-arm's length person) pursuant to a subsection 87(1) amalgamation. In other words, for purposes of computing the capital gain or loss of a foreign affiliate of the Canadian taxpayer, the adjusted cost base of the property subsequently disposed of should effectively be reset to its fair market value at the time the foreign affiliate becomes a foreign affiliate of the Canadian taxpayer, so that the accrued gain or loss before that time is ignored or disregarded, and only the gain or loss accruing after that time is taken into account for FAPI and surplus calculation purposes. Thus, paragraph 95(2)(f) can be said to effectively permit a "bump" in the foreign affiliate's adjusted cost base of its capital property, in a manner similar to the tax cost bump available to a Canadian corporation under paragraph 88(1)(d). However, in the case of an amalgamation of two Canadian corporations under subsection 87(1), the "FAPI accrual carryover" in the postamble of paragraph 95(2)(f) provides that the gain or loss realized on a disposition of capital property by a foreign affiliate of the amalgamated corporation must take into account the portion of the gain or loss that accrued prior to the amalgamation at any time when the foreign affiliate was a foreign affiliate of one of the predecessor Canadian corporations. In this amalgamation context, the tax cost bump of a foreign affiliate's capital property would not be available.
Proposed paragraph 95(2)(f.1) effectively extends the same accrual carryover concepts to FAPI calculations beyond the mere computation of capital gains and losses addressed in current paragraph 95(2)(f). In particular, the version of paragraph 95(2)(f.1) proposed in the February 27, 2004 draft legislation will require use of the Canadian rules in the Act and Canadian dollars for the more general purposes of computing a foreign affiliate's income from property or income from a business other than an active business, and will also require the exclusion of the portion of any such income or loss that can reasonably be considered to have been realized or accrued during any period in which the foreign affiliate was not a foreign affiliate of the particular Canadian taxpayer or any non-arm's length persons or predecessors referred to in the paragraph 95(2)(f) postamble.
The effect of the FAPI carryover principles in paragraphs 95(2)(f) and (f.1) is that, for all relevant FAPI calculation purposes, unrealized FAPI that accrues to a foreign affiliate of a Canadian corporation will not be disregarded, and will instead carry over, when that Canadian corporation amalgamates under subsection 87(1). The amalgamated corporation will, in essence, inherit the accrued FAPI (or FAPL) in a foreign affiliate of its predecessor.
Notably, however, this carryover principle will not apply where a Canadian corporation acquires a foreign affiliate from a subsidiary Canadian corporation on a winding-up of the subsidiary pursuant to subsection 88(1). In the case of a winding-up, the accrued capital gain or loss or property income or loss of the foreign affiliate of the subsidiary will be disregarded and will not carry over to or be inherited by the Canadian parent corporation.
The Comfort Letter Recommendations
The facts considered in the September 1, 2006 Finance comfort letter are fairly straightforward and are illustrated below. Target is a taxable Canadian corporation that owns all of the shares of FA1, a controlled foreign affiliate of Target. FA1 in turn owns shares of FA2, another foreign affiliate of Target, but these shares are not excluded property and there is an accrued capital gain which, if realized, would give rise to FAPI in FA1.2 In addition, FA1 has accrued property income that will be FAPI.3
Parent (also a taxable Canadian corporation) wishes to acquire all of the Target shares, and incorporates Acquisitionco (another taxable Canadian corporation) for this purpose. Acquisitionco acquires the Target shares, and following the acquisition of control, Acquisitionco and Target amalgamate to form Amalco pursuant to section 87. Amalco uses the tax cost bump permitted by subsection 87(11) and paragraph 88(1)(d) to increase its adjusted cost base of the FA1 shares acquired on the amalgamation. FA1 then disposes of the FA2 shares and distributes the cash proceeds to Amalco, presumably in a manner that utilizes the bumped tax cost of the FA1 shares and the February 27, 2004 proposed version of subsection 88(3) to avoid or minimize adverse tax consequences for Amalco.
The key issue is this – is it appropriate that the FAPI accrual carryover rule in the postamble of paragraph 95(2)(f) should require Amalco to compute FA1's capital gain on the sale of the FA2 shares in a manner that includes the gain that accrued while FA1 was owned by Target, a predecessor of Amalco by amalgamation? Stated another way, should Amalco enjoy a "fresh start" allowing it to reset or bump FA1's adjusted cost base of the FA2 shares to their fair market value when Acquisitionco acquires control of Target, thereby excluding the accrued FAPI gain on the FA2 shares? Similarly, should Amalco be taxed on the FAPI that accrued to FA1 before Acquisitionco acquired control of Target?
The comfort letter refers to the submission of the taxpayer that, because Acquisitionco acquired control of Target4 in an arm's length transaction, the FAPI capital gain (and the property income) that accrued to FA1 prior to the acquisition of control of Target should be excluded in computing FA1's FAPI in respect of Amalco. Finance agreed with the taxpayer, and indicated that it would recommend that paragraphs 95(2)(f) and (f.1) be amended to achieve these results in the circumstances described in the letter. The proposed amendments would be applicable in computing FAPI of a foreign affiliate of a Canadian taxpayer for taxation years of the foreign affiliate beginning after the announcement date of draft legislation incorporating the amendments, although the taxpayer would be permitted to elect to have the amendment apply to taxation years of all of its foreign affiliates beginning after February 27, 2004.
The Unstated Tax Cost Bump Policy Rationale
As noted above, the comfort letter does not provide an explicit tax policy reason for the proposed amendments, apart from repeating the taxpayer's suggestion that the arm's length acquisition of control of Target justifies excluding the FAPI that accrued to FA1 while it was a foreign affiliate of Target prior to the acquisition of control. This argument seems to be based on the notion, perhaps imported from the exempt surplus and taxable surplus rules in Regulation 5907(1), that the relevant time for earnings and FAPI computations begins with the time a non-resident corporation first becomes a foreign affiliate of the particular Canadian taxpayer in respect of whom those calculations are relevant.
However, arguably the correct rationale for these amendments is not that Acquisitionco acquires control of Target, but rather that, following the acquisition of control, Amalco applies the paragraph 88(1)(d) tax cost bump in order to increase Amalco's adjusted cost base of the FA1 shares potentially up to their fair market value as at the time Acquisitionco acquires control of Target. This may well be Finance's unstated reason for recommending the amendments, since the comfort letter does indicate the amendments to paragraphs 95(2)(f) and (f.1) would exclude the FAPI accrued before the acquisition of control, in the circumstances described in the letter, which circumstances of course include the bump designation made by Amalco as a result of the vertical amalgamation.
By way of explanation, consider the results in the case of an amalgamation of Acquisitionco and Target, but in the absence of a bump designation. Existing paragraph 95(2)(f) would require Amalco to take into account the gain or loss on the FA2 shares that accrued during the holding period while FA1 was a foreign affiliate of Target. Moreover, Regulation 5905(5)(b) would require the surplus balances of FA1 and FA2 in respect of Amalco to be computed by adding the surplus balances of FA1 and FA2 in respect of each of Target and Acquisitionco, effectively preserving and carrying over the historical surplus balances generated before the acquisition of control of Target by Acquisitionco. These carryover rules are appropriate because the tax attributes of FA1 and FA2 in respect of Target (surplus balances, adjusted cost base, FAPLs, accrued gains and losses, etc.) are already within the Canadian tax system (since Target is a taxable Canadian corporation) and should be preserved in Amalco following an amalgamation, consistent with the comprehensive carryover rules in subsection 87(2) that provide, for numerous purposes, that the new corporation formed on the amalgamation is deemed to be the same corporation as, and a continuation of, each predecessor.
On the other hand, where an amalgamation is a vertical amalgamation that subsection 87(11) permits to be treated as a winding-up for purposes of the tax cost bump (such as the amalgamation of Target and Acquisitionco), and a paragraph 88(1)(d) bump designation is in fact made in respect of the top-tier foreign affiliate shares of FA1 held by Target, the carryover of tax attributes in FA1 and its underlying chain of foreign affiliates is no longer warranted. As I have argued in a previous article in this journal in relation to the bump as it applies to foreign affiliates,5 the tax cost bump conceptually is intended to place the acquiror in the same position in relation to the bumped foreign affiliate shares as if the acquiror had purchased them directly. If Acquisitionco had purchased the FA1 shares directly, paragraphs 95(2)(f) and (f.1) would have appropriately excluded the gain on the FA2 shares, and the accrued FAPI of FA1, in respect of the period preceding the acquisition of control. Arguably therefore the comfort letter is correct to recommend that those provisions be amended to provide the same results where Acquisitionco acquires control of Target and subsequently amalgamates to bump the tax cost of the FA1 shares.
One might ask whether the proposed amendments in the comfort letter would allow the accrued FAPI of FA1 to escape Canadian taxation where the tax cost bump is employed and the accrued FAPI does not carry over to Amalco following the amalgamation. Is it appropriate that the accrued FAPI should simply disappear? Yet in a sense this is not the correct question, since the accrued FAPI in FA1 does not disappear. The accrued FAPI would be reflected in the value of the FA1 shares that are indirectly acquired by Acquisitionco through its purchase of the Target shares. Thus the accrued FAPI would already be effectively taxed, or at least taken into account within the parameters of the Canadian tax system, when the Target shares (shares of a Canadian corporation) are disposed of to Acquisitionco. The subsequent amalgamation of Target and Acquisitionco and bump of the FA1 shares should then permit Amalco to be treated in a manner consistent with a direct acquisition of the FA1 shares – Amalco should have a "fresh start" and a reset of all relevant tax attributes of FA1 as at the time of the acquisition of control, as is now the case under proposed Regulations 5905(5.1) and (5.2) in relation to FA1's surplus and deficit balances.
The policy underlying the amendments to paragraphs 95(2)(f) and (f.1) proposed in the comfort letter can be tested by changing the facts somewhat. Suppose instead that the FA2 shares were excluded property, so that FA1 had a substantial accrued capital gain that, if realized, would create substantial exempt surplus and taxable surplus. Under existing paragraph 95(2)(f), FA1's unrealized exempt surplus in respect of the excluded property FA2 shares would carry over to Amalco following the amalgamation of Acquisitionco and Target. This would allow Amalco after the bump of the tax cost of the FA1 shares and the sale of the FA2 shares to benefit both from the creation of the exempt surplus (which accrued before the acquisition of control of Target), and from the bumped tax cost of the FA1 shares. Potentially this would give rise to a "double dip" of tax attributes. The amendments recommended by Finance would prevent this result by requiring FA1's capital gain on the excluded property FA2 shares to be computed without regard to the gain that accrued before Acquisitionco acquired control of Target, which would have the effect of eliminating the unrealized exempt surplus. This is arguably appropriate where Amalco has bumped the tax cost of the FA1 shares, since Amalco should be treated in a manner consistent with a direct acquisition of the FA1 shares, and in a direct acquisition of the FA1 shares Amalco would effectively be required to reset all relevant tax attributes of its new foreign affiliate, FA1, as at the time of the acquisition of control.
Implications of the Recommended Amendments
Seen in the context of the paragraph 88(1)(d) tax cost bump, the amendments to paragraphs 95(2)(f) and (f.1) recommended in the comfort letter are consistent with the tax policy underlying the bump and with other proposed amendments to the Act including Regulations 5905(5.1) and (5.2) and paragraph 88(1)(d.4) (as proposed by Finance to be further modified). The theme of all of these amendments is that a Canadian acquiror of a Canadian target corporation that owns foreign affiliates should, if the acquiror utilizes the bump to increase the tax cost of the target's top-tier foreign affiliates, be treated under the foreign affiliate rules as though the acquiror purchased directly the shares of those bumped top-tier foreign affiliates. This implies a reset of all tax attributes of those foreign affiliates in relation to the acquiror, including surplus and deficit balances, adjusted cost base amounts, and FAPI and FAPL accruals in those foreign affiliates.
Yet the comfort letter also suggests or anticipates a further possible amendment that could be considered by Finance. In particular, why does the current FAPI accrual and carryover apply only on a subsection 87(1) amalgamation and not on a subsection 88(1) winding-up? There does not appear to be a compelling justification to apply the tax attribute carryover under paragraphs 95(2)(f) and (f.1) to an amalgamation but not to a winding-up. In each case the successor corporation should in principle inherit the foreign affiliate tax attributes of the predecessor, just as Regulation 5905(5) now accomplishes with respect to surplus and deficit balances on both an amalgamation and a winding-up. Perhaps the appropriate rules would apply the same accrual carryover to an amalgamation or winding-up, but not, as contemplated in the comfort letter, where the amalgamation or winding-up is accompanied by a bump designation under paragraph 88(1)(d) in respect of a top-tier foreign affiliate of the subsidiary predecessor.
1 See Department of Finance comfort letter of Brian Ernewein dated September 1, 2006, headed "Foreign Affiliates – Exclusions in Computing Foreign Accrual Property Income".
2 The comfort letter does not refer to the possibility of an automatic election under subsection 93(1.1) reducing FA1's proceeds of disposition on the sale of the FA2 shares. The current version of subsection 93(1.1) would not apply because the FA2 shares disposed of are not excluded property, but the February 27, 2004 version of subsection 93(1.1) is broadened to apply to a disposition of foreign affiliate shares, regardless of their excluded property status. The discussion in this article will follow the implicit assumption in the comfort letter that FA2 has no surplus balances that could reduce FA1's capital gain by virtue of a deemed subsection 93(1) election pursuant to subsection 93(1.1).
3 The comfort letter states in the facts that it is FA2 that has accrued FAPI, but the remaining discussion in the comfort letter establishes that it is accrued FAPI in FA1, not FA2, that is relevant.
4 The comfort letter refers to control of Acquisitionco being acquired in an arm's length transaction but this is understood to be an inadvertent typographical error.
5 See Geoffrey S. Turner, "Bumping Foreign Affiliate Shares under the February 27, 2004 Proposals", International Tax, Report # 28 (CCH: June 2006).