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The Canada Revenue Agency (CRA) has finally released the long-awaited Income Tax Technical News (ITTN No. 36) describing its position on paragraph 95(6)(b) of the Income Tax Act (the Act). Paragraph 95(6)(b) is an anti-avoidance rule that can apply in certain circumstances where a person or partnership acquires or disposes of shares of a corporation or interests in a partnership. The rule may apply to deem the acquisition or disposition not to have taken place if it can reasonably be considered that the principal purpose for the acquisition or disposition is Canadian tax avoidance, reduction or deferral.

If paragraph 95(6)(b) applies, the corporation’s status as a foreign affiliate or controlled foreign affiliate of a taxpayer may be affected. If a foreign corporation is not treated as a foreign affiliate, one important consequence, among other potential implications, is that dividends received from the corporation may be fully taxed when received in Canada without a deduction available in computing taxable income.

The CRA had provided a confidential copy of the draft Technical News to a number of tax organizations in early 2005. The details of that draft officially remain confidential despite widespread discussion by practitioners. As well, the CRA publicly discussed their view of the provision at a May 2005 conference of the Canadian branch of the International Fiscal Association and at a Deloitte tax conference in October 2005. At these conferences, CRA officials gave examples of the application of the provision to a number of fact situations. 

Therefore, it was widely known that the CRA was considering adopting a broad interpretation of the provision and applying it to many common situations involving foreign affiliates. However, the final Technical News is very limited in scope compared to the 2005 draft and contains a much more limited series of examples than contained in the CRA’s prior presentations.

The Technical News contains little guidance on the principles that should be used to interpret the scope of the provision. Consistent with its prior interpretations, the CRA expresses the view that paragraph 95(6)(b), due to its relevance to the determination of foreign affiliate status, affects all provisions of the Act in which foreign affiliate status is relevant, not only the determination of foreign accrual property income. The application of the provision would thus affect the rollover on the disposition of one foreign affiliate to another (subsection 85.1(3) of the Act) and the dividend received deduction (section 113 of the Act).

Only five examples were discussed in the Technical News; the provision was stated to apply in four of these.

• The acquisition of a time-limited investment in an unrelated entity in order to achieve foreign affiliate status and avoid foreign accrual property income during the term of a loan to the unrelated entity. This example – Example 1 – was based on the example in the Department of Finance technical notes and is not generally controversial.
• The acquisition of preferred shares of a related foreign corporation by a Canadian subsidiary of a foreign parent company. In this example – Example 3 – the investment is entirely financed by third-party debt of the Canadian subsidiary and almost completely eliminates its taxable income. It is unclear whether the same conclusion would be reached if excess cash was used to fund the investment since this alternative was not discussed. Based on prior discussions with the CRA it is likely that the same position would be taken. The inclusion of this example was not unexpected and the conclusion is highly controversial.
• The acquisition by a vendor of shares of a subsidiary of a purchaser to achieve foreign affiliate status in respect of the subsidiary in order to qualify for a subsection 85.1(3) rollover on the disposition of a foreign affiliate. This example – Example 4 – is also highly controversial, particularly where the investment is substantial and of indefinite duration.
• Certain transactions to create exempt surplus on internal transfers (which are no longer viable under proposed legislation) (Example 5).

The Technical News does not discuss second-tier finance company structures. In recent years, the CRA has reassessed a number of so-called second-tier finance company structures¹ using paragraph 95(6)(b) and has threatened to apply it in various other circumstances. The only court decision on the application of the provision, Univar, was decided in favour of the taxpayer, but did not provide much guidance on its scope.

However, in the context of an example of a structure entered into by a Canadian multinational (Example 2), the Technical News states that paragraph 95(6)(b) will not be applied to a typical double-dip transaction involving the investment in equity of a financing affiliate by a Canadian company and a loan by that financing affiliate to an operating affiliate. This is one of the transactions, along with “Tower” structures, recently targeted by the government’s proposed anti-double-dip measures. Interest expense that can be traced to the investment in such structures may be denied after 2011. The Technical News does not mention Tower structures, which the CRA previously indicated would be treated in the same manner as any other double-dip involving a financing affiliate. The government’s proposed anti-double dip measures are noted in the Technical News without comment.

A number of potential applications of paragraph 95(6)(b) previously raised by the CRA are not discussed in the Technical News, including:

• The refinancing of an existing debt of a foreign affiliate using double-dip structures (referred to by the CRA as “debt importation” transactions);
• The use of a foreign affiliate as a “mixer” company to average high-tax and low-tax taxable surplus;
• The use of a foreign holding company to reduce foreign withholding tax on the repatriation of dividends; and
• The use of a foreign holding company to defer the taxation of a capital gain on the eventual sale of a foreign affiliate (in circumstances where a subsection 85.1(3) rollover applies and the transfer to the holding company does not take place in contemplation of a sale to an arm’s-length purchaser).

Based on prior statements, it was understood that the CRA had been considering applying paragraph 95(6)(b) in such circumstances and those statements had been strongly criticized as unjustified on the basis of the wording of the provision and inequitable on a policy basis. While the Technical News indicates that the list of examples provided is not exhaustive of the situations where the CRA will or will not apply the provision, it is welcome news that these examples were omitted.

All potential paragraph 95(6)(b) reassessments must be reviewed by the CRA at headquarters in Ottawa. The Technical News states that, in addition to paragraph 95(6)(b), the CRA may consider applying the general anti-avoidance rule or the transfer pricing rules in subsection 247(2) of the Act, depending on the facts.

While taxpayers and their advisers will likely disagree with some of the positions taken in the Technical News, particularly Examples 3 and 4, the scope of the transactions targeted is relatively narrow. Most importantly, it appears that the government’s attack on outbound double-dip transactions (other than the second-tier finance company cases currently before the courts) will not be waged using paragraph 95(6)(b).

¹In a second-tier finance company structure, a Canadian subsidiary or a foreign parent company typically borrowed or used excess cash to invest in the equity of a foreign affiliate in a low-tax jurisdiction. The financing affiliate then made loans to other foreign subsidiaries of the foreign parent company. The CRA has sought to attack the investment in the shares of the financing affiliate using paragraph 95(6)(b) (or the general anti-avoidance rule).

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