25 March 2004 Internal T.I. 2002-0134201I7 - Foreign accrual tax-timing of Deduction (2024)

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Whether the deduction for foreign accrual tax can be claimed in the taxation year of the taxpayer in which the taxation year of the foreign affiliate for which it is paid, ends, or the taxation year of the foreign affiliate in which it is paid, ends.

Position: It is deductible in the taxation year of the taxpayer in which the taxation year of the foreign affiliate for which it is paid, ends.

Reasons: Consistent with position on the timing of the foreign tax credits.

March 25, 2004

Montréal Tax Services Office International SectionInternational AuditIncome Tax RulingsSection 446-2-1

Attention: Mary Seccareccia2002-013420

"Foreign Accrual Tax" and Subsection 91(4)

The purpose of this memorandum is to outline our views on various matters as they relate to the definition "foreign accrual tax" in subsection 95(1) of the Income Tax Act (the "Act") and the deduction therefor in subsection 91(4). We apologize for the delay in responding.

In general terms, "foreign accrual tax" (FAT) is the portion of any income or profits tax that has been paid by a particular affiliate that may reasonably be regarded as applicable to an amount included in income under subsection 91(1) in respect of the particular affiliate. It also includes the portion of any income or profits tax that was paid by any other affiliate in respect of a dividend received from the particular affiliate that may reasonably be regarded as applicable to an amount included in income under 91(1) in respect of the particular affiliate. Lastly, FAT includes any amount prescribed in respect of the particular affiliate to be FAT. Regulation 5907(1.3) subject to draft Regulation 5907(1.4) prescribes such amounts. These Regulations relate to "compensatory payments" that are made between affiliates that are part of a group of affiliates that file their tax returns in the foreign jurisdiction on a consolidated basis. To satisfy Regulation 5907(1.3) the amount ("compensatory payment") must be paid and reasonably be regarded as being in respect of income or profits tax that would have been payable by the particular affiliate in respect of an amount included in income under 91(1) had the tax liability of the particular affiliate and the other corporations not been determined on a consolidated basis. There is no requirement that the tax be paid in the year in which the foreign accrual property income (the "Fapi") was earned.

An amount is not recognized as FAT until it is paid. Once a payment qualifies as FAT, the issue becomes when and to what extent is a deduction under subsection 91(4) available.

91(4) Deduction in Year for Which Foreign Tax was Paid

In our view, the deduction under subsection 91(4) is available in the taxation year of the taxpayer in which the taxation year of the affiliate for which the amount in respect of foreign tax is paid [or for which an income or profits tax would have been payable in the circ*mstances described in subsection 5907(1.3)], ends. The amount must be payable for the year of the affiliate for which the Fapi is included in the taxpayer's income under 91(1), or the 5 immediately succeeding years. In those rare situations where the amount pertains to a taxation year preceding the year in which the Fapi is reported (this could be due to timing differences in how Fapi is computed under Canadian rules versus how the income is computed under the foreign law), the deduction may be made in the taxation year of the taxpayer in which the Fapi is reported.

In applying subsection 91(4), some meaning has to be given to the phrase "or for any of the 5 immediately preceding years" in the preamble to the subsection, as well as the phrase "the portion of the foreign accrual tax applicable to the income amount that was not deductible under this subsection in any previous year" found in subparagraph 91(4)(a)(i).

Under this interpretation, there are a number of situations in which this could be relevant.

First, where foreign tax has been paid in an earlier year, but the income that it related to was not recognized as Fapi until a later year, such tax would become FAT in the year the Fapi was reported and the deduction would be taken in that year. It would not have been deductible in any previous year notwithstanding that the tax had been paid in a previous year.

Second, FAT that is applicable to an amount that has been included in Fapi in a previous year can occur in a number of situations where the foreign tax liability arises in a year subsequent to the year the Fapi was included in income under 91(1). For example, withholding tax in respect of a dividend paid out of income that was included in Fapi will only be recognized as FAT at the time the withholding tax liability arises. Such tax is treated FAT at that time and such FAT was not deductible in a previous year (there having been no obligation under the foreign tax law to pay such FAT). In another example, where Fapi is included under 91(1) in a particular year, but the income for foreign purposes is recognized over a period of years because of a reserve allowed under the foreign tax law, so long as it was eventually paid the FAT would be deductible in respect of the year the affiliate became obligated to pay it.

Because the deduction cannot exceed the amount included in income, the reference to the previous 5 years in 91(4)(b) has relevance. For example, if the deduction in respect of the withholding tax on the dividend out of Fapi (when combined with deduction taken earlier in respect of tax paid by the affiliate that earned the Fapi) exceeds the income included in Fapi, the deduction in respect of the withholding tax will be restricted.

Other Issues

"May Reasonably be Regarded as Applicable"

In determining whether a tax paid may reasonably be regarded as applicable to an amount included in income under 91(1) (and thereby considered FAT), it is necessary to consider all of the facts and it may be necessary to look at a series of taxation years. For example, assume in year 1 a particular affiliate has $100 Fapi income and a $50 active business loss (paying tax on $50 taxable income). In year 2 the affiliate has $100 Fapi income and $130 active business loss (paying no tax for the year) and having a $30 loss carry forward. In year 3 the affiliate has $100 Fapi income and $500 active business income (paying tax on $570 taxable income after using the $30 loss carried forward). This was the fact pattern described in Rulings document 971905 dated

October 29, 1997. In that interpretation we considered it reasonable to look at the three-year period in determining what portion of the tax paid in year 3 reasonably related to an amount included in Fapi. Over the three-year period the total Fapi income was $300 and the total active business income was $320. It was our conclusion that the total tax paid for the three years that should be considered FAT would be 300/620 of the total tax. The tax paid in year 1 clearly related to Fapi and would be considered FAT. Accordingly, a deduction could be computed under subsection 91(4) in respect the tax paid by the affiliate in year 1 and deducted in the taxation year of the taxpayer in which taxation year 1 of the affiliate ended. The balance of the FAT would be recognized in year 3 and would be available for the computation of a deduction under subsection 91(4) in the taxation year of the taxpayer in which taxation year 3 of the affiliate ends. Some of such FAT in year 3 is pertains to the Fapi included in the taxpayer's income in respect of the each of the affiliate's three taxation years.

While we consider this is a reasonable determination in the circ*mstances, this fact pattern is relatively straightforward and other fact patterns can be much more problematic.

Regulation 5907(1.4)

The effect of Regulation 5907(1.4) is to preclude any compensatory payment from being prescribed to be FAT under Regulation 5907(1.3) unless the amount paid can reasonably be considered to be in respect of a "foreign accrual property loss". At issue is the application of the coming-into-force (c-i-f) provision of Regulation 5907(1.4). Under the c-i-f, as it presently reads, Regulation 5907(1.4) will be applicable to taxation years that begin after November 1999.

As Regulation 5907(1.4) ties into Regulation 5907(1.3), there was some concern that the taxation year referred to in the c-i-f would be the taxation year in which the particular amount was included in the taxpayer's income under subsection 91(1) and not the taxation year in which the compensatory payment was made. While we consider the better view to be that the provision will apply to compensatory payments made in a taxation year beginning after November 1999, we raised the matter with the Department of Finance. XXXXXXXXXX.

Payment Through Journal Entry

When is an amount considered "paid" for purposes of compensatory payments and the definition of FAT?

Where journal entries are made in various foreign affiliates in respect of liabilities for compensatory payments, and these liabilities remain outstanding for many years, should the compensatory payment be considered "paid" at the time of the journal entry or at a later time when the account is "settled"?

Where the companies are going concerns and the entry is made to an inter-company account that has many offsetting entries, it may be reasonable to consider payment made at the time of the entry. Where the payable remains outstanding for a longer period of time, in our view it is not reasonable to consider the amount "paid".

In Income Tax Technical News No. 14 dated December 9, 1998 (as a result of the decision in Cartier Mining) we have stated that the mere recording of a payable by way of journal entry, regardless that such amounts are payable on demand and the debtor has the capacity to pay such

amount if such amounts are demanded, does not constitute "credited" for purposes of 212(1). Clearly the threshold required for an amount to be considered "paid" is even higher.

Constructive Payment Via U.S. Stock Basis Adjustments

We have been advised that under the Internal Revenue Code (the "Code") where a member of a consolidated group has not made a payment to another member in satisfaction of its allocable tax liability, that member is deemed to have received a contribution of capital and certain adjustments are made (for U.S. tax purposes) to the adjusted cost base of the member's shares. It has been suggested that this should be accepted as constructive payment of the tax.

In our view, such deeming provisions (under U.S. tax law) have no relevance for purposes of Canadian tax law.

Summary and Conclusion

The above comments, while general in nature, reflect how we consider the law should be applied. We trust this will assist you in any particular fact situation. If you have any questions, or require further assistance, please contact the undersigned at 613-957-2116.

Olli Laurikainen
Manager
International Section II
International and Trusts Division
Income Tax Rulings Directorate
Policy and Planning Branch