Canada’s Upstream Loan Rules - 2017 Update

Canada’s so-called “upstream loan rules” were enacted in 2011 to protect the integrity of Canada’s detailed foreign affiliate rules.  In broad terms, the new rules were designed to prevent a foreign affiliate of a Canadian corporation from making “synthetic dividend distributions” in the form of loans to the Canadian corporation.  The mischief arose in those cases where an actual dividend distribution (instead of a loan) would otherwise be taxable to the Canadian corporation in Canada.  The upstream loan rules were thus designed with this basic tax avoidance feature in mind.  Of course, the rules ultimately enacted (and subsequently amended) are far more extensive than this brief introduction would suggest – but this basic tax policy rationale is a useful place to begin.  The purpose of this report is to briefly summarize the upstream loan rules as they stand in February 2017.  

 

CONTENTS OF REPORT

 

Original Transitional Rules………….	1	GAAR Warning…………………………	10
2016 Changes to Transitional Rules....	2	Downstream Surplus & Upstream Deficit.	10
Income Inclusion for Upstream Loan..	4	No Double Deduction……………………	11
Exceptions to Income Inclusion……..	5	Deduction for Repayment………………..	12
Deductions – Reserve Mechanism…..	6	Corporate Reorganizations……………….	12
Back-to-Back Upstream Loans………	9

 

Transitional Rules

 

1. Original Transitional Rules

 

Any loans or indebtedness existing as at August 19, 2011 (the date of introduction), and that remained outstanding on August 19, 2014, were deemed to be separate loans or indebtedness issued on August 20, 2014.  This triggered the exception for repayment within two‐years under the general rules (discussed below).  The effect of these rules was to permit a transitional repayment date of August 19, 2016 for pre-existing loans – to avoid an income inclusion under the new rules.  Finance said this transitional rule was intended to ensure that all pre‐August 20, 2011 loans or indebtedness were essentially entitled to a five‐year repayment window.  In the absence of such repayment, these loans would become subject into the new income-inclusion rules.

 

The original transitional rules provided relief in respect of foreign exchange (FX) gains or losses of a Canco on the repayment of a debt obligation owing to a foreign affiliate, by permitting such FX gains or losses to be set off against the related losses or gains of the foreign affiliate arising from that repayment (s. 39(2.1)).[1]  The rule applied only where Canco’s gain or loss was equal to the foreign affiliate's loss or gain, as the case may be.  A companion rule provided that the foreign affiliate's gain or loss was otherwise deemed to be nil in these circumstances (s. 95(2)(g.04)).  The application dates for these relieving rules corresponded with the transitional rule just described.  In other words, the provisions applied only to a foreign exchange gain (or loss) of Canco on the repayment of the portion of a debt obligation outstanding on August 19, 2011 where that repayment occurred on or before August 19, 2016.  Loans and debts repaid after August 19, 2016 do not benefit from this relieving rule.

 

In 2015-0581561C6, the CRA said that a gain deemed to be "made", or a loss deemed to be "sustained", under s. 261(10) would constitute a gain or loss contemplated by s. 39(2) such that it would, in turn, be deemed to be a capital gain or a capital loss from the disposition of currency.[2]  On this basis, the CRA said that s. 39(2.1) should equally apply to such gains or losses, assuming the other conditions of that provision were met.  However, the CRA further said that in situations where the Canco and its foreign affiliate did not have the same taxation year end, and as a result did not convert to the functional currency regime on the same day, the matching requirement in s. 39(2.1) (as it then read) would not generally be expected to be met.

 

1. 2016 Changes to Transitional Rules

 

On September 16, 2016, the Department of Finance announced amendments to the above transitional rules.

 

1. Set-Off in s. 39(2.1)

 

Three amendments are being made to the rule in s. 39(2.1).  First, a reference will be added to the stop-loss rule in s. 40(2)(g)(ii).  This is a helpful change.  This will ensure that relief under s. 39(2.1) remains available if the upstream loan was a non-interest bearing loan.  In the absence of this amendment, relief would technically not be available in respect of a non-interest bearing loan because the FX loss on repayment would otherwise be denied under s. 40(2)(g)(ii).  The latter would arise because the non-interest bearing loan would not have been acquired by the creditor foreign affiliate for the purpose of earning income.

 

Second, the rule in s. 39(2.1) will be modified to apply in cases where the FX gains or losses of the creditor foreign affiliate is not precisely equal to the debtor’s FX losses or gains from the repayment.  This is also a helpful change. 

 

Third, the rule in s. 39(2.1) will be modified to introduce the concept of a “qualifying entity” (as defined in s. 39(2.2)).  This is intended to extend relief under s. 39(2.1) to situations where the specified debtor is not the taxpayer of which the creditor foreign affiliate is a foreign affiliate, but rather another member of the taxpayer’s corporate group.  For example, a taxpayer (Canco) might have a foreign affiliate that lent funds to a wholly-owned Canadian subsidiary of Canco (Subco), and Subco might not hold any shares in the foreign affiliate.  These changes also allow relief in limited circumstances where the specified debtor not a member of the Canadian taxpayer’s group.  However, all or substantially all of the shares of the Canadian taxpayer must be owned by corporations resident in Canada that are specified debtors in respect of upstream loans from the particular creditor foreign affiliate because of the application of the back-to-back upstream loan rule in s. 90(7).  Prior to these amendments, the set-off under s. 39(2.1) was available only where the debtor was the taxpayer itself.

 

The application dates for these amendments correspond with the transitional rules applicable to s. 39(2.1).  Thus, the amendments apply only to an FX gain or loss of a taxpayer on the repayment of the portion of a debt obligation that was outstanding on August 19, 2011, provided such repayment occurred on or before August 19, 2016.

 

1. Creditor Foreign Affiliate – FX Gain or Loss

 

As noted above, rule in s. 95(2)(g.04) is directly related to s. 39(2.1).  The result of the application of s. 95(2)(g.04) is that the applicable FX gains and losses of the foreign affiliate are reduced.  This rule will be amended in two ways, each of which expands the scope of its application and parallels the amendments to s. 39(2.1) described above.

 

First, s. 95(2)(g.04) is modified to apply in cases where the FX gains or losses of the creditor foreign affiliate (resulting from the repayment of an upstream loan) are not equal to the borrowing party’s FX losses or gains from the repayment.  Because the rule can now apply where the amount of the creditor’s FX gain or loss exceeds that of the borrowing party’s FX loss or gain, a formula is added to s. 95(2)(g.04) for determining the amount by which the creditor’s FX gain or loss is reduced.

 

Second, s. 95(2)(g.04) is modified to apply in situations where the debtor under an upstream loan is not the taxpayer of which the creditor foreign affiliate is a foreign affiliate, but rather another member of the taxpayer’s corporate group (e.g., a wholly-owned subsidiary of the Canadian taxpayer) of which the creditor foreign affiliate is not a foreign affiliate.   The amendments to s. 95(2)(g.04) apply to a FX gain or loss of a foreign affiliate on the repayment of the portion of a debt obligation outstanding on August 19, 2011 where that repayment occurs on or before August 19, 2016.  This is consistent with the amendments to s. 39(2.1).

 

1. Back-to-Back Loans

 

Existing s. 90(7) (described below) collapses certain back-to-back loans into one loan, to the extent of the lesser loan amount.  This rule operates iteratively so that multiple loans may, in appropriate circumstances, all be collapsed into one.  This rule will be amended to add references to s. 39(2.1), s. 39(2.2), and s. 95(2)(g.04).  As a result, the back-to-back loan rules will apply for the purposes of these three provisions.

 

the GENERAL Rules[3]

 

1. Income Inclusion for Upstream Loan

 

S. 90(6) provides for an inclusion of a "specified amount" in the income of a taxpayer resident in Canada where a loan is made by a foreign affiliate of the taxpayer to a "specified debtor".[4]  "Specified amount" and "specified debtor" are defined in s. 90(15).  "Specified amount" is determined by multiplying the amount of the upstream loan (or other indebtedness) by the difference between the taxpayer's equity interest in the creditor affiliate and its equity interest in the specified debtor, if any.  The latter factor is relevant only where the specified debtor is a foreign affiliate of the taxpayer.  

 

A "specified debtor" includes the taxpayer and certain non-arm's length persons.  An exception is made for controlled foreign affiliates of the taxpayer, where the control is effectively held by Canadian corporations.  In this latter case, in essence there has been no synthetic dividend distribution outside the controlled foreign group. 

 

On September 16, 2016, the Department of Finance announced an amendment by adding a new exception to the definition of "specified debtor" in s. 90(15) for certain persons in addition to the existing exception for CFAs.  The new exception is for a non-resident corporation (other than a CFA, as defined in s. 17(15)) that meets the following conditions: (1) it is a foreign affiliate of the taxpayer; and (2) each share of the corporation is owned by any of the taxpayer, persons resident in Canada, non-resident persons that deal at arm’s length with the taxpayer, CFAs of the taxpayer (as defined in s. 17(15)), partnerships each member of which is a person or partnership described in this list, and corporations each shareholder of which is a person or partnership described in this list.

 

The above amendment applies in respect of loans received and indebtedness incurred after August 19, 2011, and in respect of any portion of a particular loan received or indebtedness incurred on or before August 19, 2011 that remained outstanding on August 19, 2014.

 

In 2014-0526731C6, the CRA said that s. 90(6) can apply to accrued interest that has not yet become payable under the terms of a loan.  Accordingly, the interest would itself be subject to the two‐year repayment exception in s. 90(8) discussed below.   

 

1. Exceptions to Income Inclusion

 

S. 90(8) provides important exceptions to including an upstream loan into the Canadian taxpayer’s income.  Specifically, s. 90(6) generally does not apply to: (1) a loan or indebtedness that is repaid, other than as part of a series of loans or other transactions and repayments, within two years of the day the loan was made or the indebtedness arose; (2) indebtedness that arises in the ordinary course of a business of the creditor, or (3) a loan made in the ordinary course of a money-lending business of the creditor, provided certain conditions are met.[5]  

 

In 2013-0499121E5, the CRA confirmed that legal set-off of debt obligations under commercial law represents a legal discharge of the full amount of the debts.  Accordingly, such legal set-off will constitute repayment of an upstream loan for purposes of s. 90(8) of the Act.  This view is based on jurisprudence and the CRA’s previous positions in the context of s. 15(2).

 

As noted above, the two‐year repayment exception does not apply if the repayment is “part of a series of loans or other transactions and repayments”.  In Meeuse v. The Queen, 94 DTC 1397, the Tax Court of Canada considered the phrase “series of loans or other transactions and repayments” in the context of s. 15(2), now contained in s. 15(2.6).  At paragraph 16, the Court said:

 

I do not think that a mere succession of loans is sufficient to constitute them a series without more. This, I think, is a mechanical and simplistic interpretation of paragraph 15(2)(b) of the Income Tax Act that ignores its purpose. It must be borne in mind that the purpose of subsection 15(2) is to prevent corporate funds to be paid out to shareholders or persons connected with them otherwise than by way of dividend under the guise of loans. Where a loan is made to a shareholder and is repaid near to the end of the expiry of the year mentioned in paragraph 15(2)(b) and then immediately a similar amount is reloaned to the shareholder after the year-end, and this process is repeated year after year it is obvious that this rolling forward of the obligation constitutes a perpetual deferral of the tax obligation and defeats the purpose of subsection 15(2). Where we have a bona fide borrowing for a genuine business purpose, a repayment of the funds from an independent source, and a unrelated subsequent borrowing for a wholly different purpose, I do not think that this is the type of abuse at which the concluding words of paragraph 15(2)(b) are aimed.

In 2013-0491061R3, the CRA ruled that a Canadian company’s repayment of upstream loans, followed by the sale of an entire foreign affiliate group to the foreign parent company, would be considered a bona fide repayment and not part of any series of loans and repayments – notwithstanding that shortly after the sale the Canadian company would borrow precisely the same amount.  The facts considered were quite complex.  In short, the existing group involved a foreign parent company (Parent)[6] with companies in Canada and many foreign affiliates (FAs) under Canada.  Existing loans (Upstream Loans) were in place from one FA to a Canadian company in the group (Canco).  The group proposed the following: (1) Canco would repay the Upstream Loans from the FA, (2) the Canadian companies would restructure their share ownership of the FAs under Canada, and (3) the Canadian companies would sell (to Parent) the FAs out from under Canada at fair market value for cash.  In addition, following the sale in step (3), Canco would borrow from the same foreign entity precisely the same amount as it repaid in step (1), but at this point the foreign entity would no longer be a FA.  The CRA ruled that none of the restructure transactions in step (2) would trigger the “foreign affiliate dumping” (deemed dividend) rule in 212.3(2), by virtue of the corporate reorganization exceptions found in s. 212.3(18).  Furthermore, the CRA said that Canco’s repayment of the Upstream Loans in step (1) and a borrowing of the same amount following the sale in step (3) would not be considered a “series of loans…and repayments”.  Accordingly, the Upstream Loans would be considered fully repaid by Canco within the two-year period allowed under s. 90(8). 

 

In 2016-0642151C6, the CRA said that a series of transactions involving the repayment of an upstream loan followed by a loan that qualifies a “pertinent loan or indebtedness” as defined in subsection 15(2.11) would not constitute a series of loans and repayments for purposes of the two‐year repayment exception in paragraph 90(8).   

 

1. Deductions – Reserve Mechanism

 

S. 90(9) and s. 90(12) provide for a deduction and inclusion, respectively, on an annual basis for the period during which the upstream loan or indebtedness remains outstanding.  Essentially the deduction reflects an underlying tax policy that allows upstream loans from foreign affiliates to be made free of immediate Canadian tax where there is no apparent intention to achieve any particular Canadian tax benefit.

 

The Deduction:  The deduction in s. 90(9) is for a particular amount in respect of the amount included in income under s. 90(6) (or in respect of an amount included in income under s. 90(12) discussed below) where the particular amount is the total of certain notional deductions (described below) that could have been claimed had the upstream loan instead been distributed as one or more actual dividends.  As noted below, these same notional deductions cannot have been claimed in respect of any other upstream loans or distribution (i.e., no double count is permitted).

 

Locked-In Amount:  It is not necessary that the full amount of the upstream loan be covered by the foregoing notional deductions.  Partial deductions under s. 90(9) are permitted.  However, the deductible amount is "locked in" at the time the upstream loan is made.  For example, there is no ability to subsequently increase the s. 90(9) amount based on future earnings of the foreign affiliate.   

 

Foreign Affiliate Surplus Accounts:  The deduction under s. 90(9)(a) is computed by reference to the exempt surplus, taxable surplus, hybrid surplus, pre‐acquisition surplus, and/or previously‐taxed FAPI amounts, in respect of the foreign affiliates in the chain of ownership extending from the taxpayer down to the creditor affiliate.  Not all of these surplus accounts are available in some cases, as will be explained.  

 

This general scheme is meant to replicate the tax attributes that would be available if an actual dividend had been paid by the creditor affiliate, followed by dividends from any other affiliates between the taxpayer and the creditor affiliate.  In such cases, the surplus (and deficit) balances of these intervening affiliates would also be relevant.  In addition, as noted below, the surplus amounts of the creditor affiliate are based on a notional aggregation of surplus amounts from any foreign affiliates that are "downstream" from the creditor affiliate (s. 90(11)).

 

90-Day Rule:  Under s. 5901(2)(a) of the Regulations, where a foreign affiliate (FA) pays a dividend at any time in its taxation year that is more than 90 days after the commencement of that year (the “90-day rule”), the portion of the dividend that would otherwise be deemed to have been paid out of FA's pre-acquisition surplus is instead deemed to have been paid out of FA's exempt surplus (“ES”), hybrid surplus (“HS”), and/or taxable surplus (“TS”) in respect of a Canadian resident corporation, to the extent that it would have been deemed to have been so paid if, immediately after the end of that year, that portion were paid as a separate dividend. 

 

In 2013-0488881E5 (See Scenario 1), the CRA confirmed its view that the 90-day rule would not be applicable for purposes of the deduction under s. 90(9).  Although a Canadian corporation might be in a position to have s. 5901(2)(a) of the Regulations apply to deem an actual dividend to be paid out of FA's current year exempt surplus, the CRA said it would be contrary to the words “exempt surplus – at the lending time in respect of the corporation” in s. 90(9)(a)(i)(A) to consider the application of s. 5901(2)(a) of the Regulations in determining the amount deductible under s. 90(9).  The CRA further said that this interpretation is consistent with the Technical Notes to s. 90(9), which state that the deductible amount under s. 90(9) is “locked in” at the time the loan is made and there is no ability to increase the s. 90(9) amount based on future earnings of the FA. 

 

Underlying Foreign Tax:  In respect of taxable surplus, only taxable surplus amounts equal to the grossed‐up balance of underlying foreign tax may be considered distributed for the purposes of the notional deductions contemplated in s. 90(9).  In respect of hybrid surplus, the hybrid surplus amounts will be included in this determination only where the grossed‐up hybrid underlying tax is greater than or equal to the hybrid surplus balance.  In other words, the deduction in s. 90(9) in this respect may be taken only where the hybrid surplus amounts are "fully covered" by hybrid underlying tax.  In 2013-0488881E5 (Scenario 2), the CRA said that for the purposes of determining the amount deductible by a Canadian corporation pursuant to s. 90(9), Canco can be considered to have filed a claim – known as the disproportionate election – under paragraph (b) of the definition of “underlying foreign tax applicable” in s. 5907(1) of the Regulations, in order to access such underlying foreign tax applicable in respect of taxable surplus.

 

Pre‐Acquisition Surplus:  S. 90(9) provides a deduction in respect of the pre‐acquisition surplus balance, but only to the extent of the Canadian corporation’s adjusted cost base (ACB) in the shares of a relevant directly held foreign affiliate.  The latter could be the creditor affiliate or another foreign affiliate that is higher up in the chain.  In other words, Canadian corporations can also claim deductions under s. 90(9) to the extent they have ACB in the shares of the top‐tier foreign affiliate in the chain.  However, this deduction is not available where the debtor under the loan is a non‐arm's length non‐resident person.  This latter exclusion is meant to counter certain tax planning strategies used by foreign multinationals to synthetically repatriate surplus of their Canadian subsidiaries free of Canadian withholding tax.

 

S. 5901(2)(b) of the Regulations provides that where a whole dividend is paid by a foreign affiliate at any particular time in its taxation year and a valid election is made, the portion of the whole dividend that would otherwise be deemed by s. 5901(1) of the Regulations to have been, in whole or part, paid out of the exempt surplus, hybrid surplus, or taxable surplus of the foreign affiliate, in respect of a Canadian resident corporation, is instead deemed to have been paid out of the pre-acquisition surplus of the foreign affiliate in respect of the Canadian resident corporation.  In 2013-0488881E5 (Scenario 3), the CRA confirmed its view that provided a Canadian corporation (Canco) would have been in a position to make this election (and had sufficient ACB in the top-tier affiliate), then for the purposes of s. 90(9) Canco could demonstrate that the dividend amount may “reasonably be considered to have been deductible” by Canco – provided that Canco actually claims the full amount of this available deduction.    

 

The CRA made similar comment in 2013-0488881E5 (Scenario 4) with respect to the ability to effectively make an election under s. 5901(1.1) of the Regulations, i.e., to treat a dividend as having been paid out of taxable surplus after exempt surplus but before hybrid surplus.

 

Previously‐Taxed FAPI:  Previously‐taxed FAPI is also an element of the s. 90(9) deduction, but only where the pre‐acquisition surplus deduction is not available.  As originally framed, the deduction was only relevant where the specified debtor was a non‐arm's length non‐resident person.  On September 16, 2016, Finance announced that this rule (in s. 90(9)(a)(ii)) will be amended to instead include previously-taxed FAPI only in the converse case: i.e., only where the specified debtor is a person other than a non-resident person that does not deal at arm’s length with the taxpayer.  This amendment is intended to ensure that the s. 90(9) deduction does not include previously-taxed FAPI in circumstances where a foreign multinational group may otherwise synthetically repatriate FAPI free of Canadian withholding tax.  This restriction is conceptually similar to the restriction that applies to a foreign multinational group accessing the ACB of shares in a first-tier foreign affiliate.  This amendment to s. 90(9)(a)(ii) applies in respect of loans received and indebtedness incurred after August 19, 2011, and any portion of a particular loan received or a particular indebtedness incurred on or before August 19, 2011 that remains outstanding on August 19, 2014.

 

No Double Count:  S. 90(12) adds back, in computing income for the immediately following taxation year, any amounts claimed under s. 90(9) as a deduction in computing income for a taxation year.  Accordingly, new deductions must be claimed under s. 90(9) every year.  If in any taxation year the relevant conditions are not met, the taxpayer loses the ability to claim deductions under s. 90(9) for that and future taxation years.  Essentially the rules in s. 90(9) are anti‐double‐counting rules.  In other words, Canadian corporations cannot use the same amounts of surplus or ACB during the period in which the upstream loan is outstanding for: (1) any other loan or indebtedness contemplated by the rules, or (2) for any dividends paid.  This is an all or nothing condition: any amount used twice, no matter how small, results in the denial of future deductions under s. 90(9). 

 

In 2015-0581501C6, the CRA said it would consider a “last-in, first-out” ordering approach to give an appropriate result in this context, i.e. so that the limitation in s. 90(9)(b) would not be breached. 

 

In this same document (2015-0581501C6), the CRA considered: (1) whether an exempt loss incurred after the time an upstream loan is made affects the ability to claim an ongoing s. 90(9) deduction, and (2) whether surplus that is "frozen" by s. 90(9) can still be relied on to determine eligibility for a s. 5901(2)(b) "pre-acquisition surplus" election.  The CRA said that, absent tax avoidance activity, a s. 90(9) deduction should not be affected by an exempt loss subsequently incurred – because a subsequent loss is not an event contemplated in either s. 90(9)(b) or (c).  Furthermore, the relevant time at which to measure surplus is the “dividend time”, and not at any time in a subsequent year in which a s. 90(9) deduction is claimed to offset a s. 90(12) inclusion.  The CRA was also of the view that the conditions for making a s. 5901(2)(b) election could be met, in concept, because the provisions of s. 90(9) in no way affect the actual surplus balances of a foreign affiliate. 

 

1. Back-to-Back Loans

 

The rule in s. 90(7) is modeled on s. 17(11.2) and collapses certain back-to-back loans into one loan (to the extent of the lesser loan amount).  This rule operates iteratively so that multiple loans may, in appropriate circumstances, be collapsed into one loan.  The rule was enacted primarily as a relieving measure to prevent inappropriate consequences with respect to multiple loans.  However, the rule can equally work against taxpayers. 

 

In 2013-0508151C6, the CRA considered a case where a Canadian corporation’s foreign affiliate (FA) lent $1,000 to an arm’s length intermediary (Intermediary), and the Intermediary in turn lent $500 to the Canadian corporation.  Under s. 90(7), the FA would be deemed to have lent $500 directly to the Canadian corporation (Canco).  The CRA noted that no statutory rules apply to determine when this deemed $500 loan is considered to have been repaid.  Rather, the CRA will apply a “facts and circumstances” test.  For example, assume Canco later repaid $100 to the Intermediary (leaving $400 outstanding on that loan), and the Intermediary repaid $700 to FA (leaving $300 outstanding on that loan).  In this example, the CRA would consider the $500 deemed loan to Canco under s. 90(7)(a) to have been repaid to the extent of $200.  Canco would still owe $400 to Intermediary, but only $300 of this $400 amount could reasonably be traced back to funds originally provided by the FA.  As a result, the remaining deemed loan from FA to Canco under s. 90(7) would be $300.      

 

1. GAAR Warning

 

Finance expressly stated in its Explanatory Notes to the upstream loan rules that any attempt to: (a) circumvent s. 90(6); (b) fit into one of the exceptions in s. 90(8); or (c) qualify for a deduction in s. 90(9) in a manner that is not within the scope of the intended application of these rules will be subject to review under the general anti‐avoidance rule in s. 245 (the GAAR).  Finance noted that the use of debt‐like equity interests (such as preferred shares) or the use of other synthetic lending arrangements (such as factoring of receivables or the sale of securities at a discount) in order to avoid the application of s. 90(6) would be considered an abuse justifying the application of the GAAR.

 

1. Downstream Surplus & Upstream Deficit

 

S. 90(11) allows a creditor affiliate to aggregate so‐called "downstream surplus" for the purposes of the notional deductions in s. 90(9).  This rule in s. 90(11) is intended to eliminate the need for Canadian corporations to force the payment of actual dividends from lower‐tier affiliates in order to move surplus balances up to the creditor affiliate, with a view to increasing the amounts deductible under s. 90(9).

 

S. 90(11) incorporates only the surplus accounts of the downstream foreign affiliates that are directly or indirectly owned by the creditor affiliate.  On the other hand, if the lowest-tier foreign affiliate makes an upstream loan, s. 90(11) does not apply.  In this latter event, the Canadian corporation must apply the notional distribution analysis in s. 90(9) based on the surplus and deficit balances of each relevant foreign affiliate in the chain, and a “blocking deficit” in a top-tier foreign affiliate could well result in an income inclusion under the upstream loan rules.[7]

 

The CRA addressed this point in 2016-0642091C6 in the following fact pattern.  Canco, a corporation resident in Canada, directly owned all the shares of FA1, a foreign affiliate of Canco.  FA1 owned all the shares of FA2, another foreign affiliate of Canco.  FA2 generated excess liquidity in its active business and lent $10 million to FA1.  FA1 immediately used the funds to make a $10 million loan to Canco.  The shares of FA1 held by Canco had a $4 million ACB.  At the lending time, FA1 had an exempt deficit of $20 million and FA2 had exempt surplus of $100 million.  The loans were not repaid within two years.  The CRA recognized that this scenario illustrates what may be perceived by some as a deficiency in the upstream loan rules – based on the apparent policy intent of s. 90(11).  For example, if FA2 had loaned $10 million directly to Canco, Canco would not be able to access enough of FA2's surplus to eliminate the deficit in FA1 – with the result that Canco would not be entitled to a full deduction under s. 90(9).  However, because FA1 made the loan to Canco, s. 90(11) would apply to “bring up” FA2's $100 million surplus to FA1 so as to create a sufficiently large exempt surplus in FA1 balance to fully cover the $10 million upstream loan to Canco.

 

The CRA recognized that the back-to-back loan rule in s. 90(7) could potentially defeat the result just described.  However, the CRA usefully confirmed that given the overall context and purpose of the upstream loan rules, as informed by the more specific intent of s. 90(7) and s. 90(11), the CRA would not generally apply the back-to-back loan rule in this scenario (absent the presence of abusive tax avoidance).  Rather, s. 90(6) would be applied only to the loan made by FA1 to Canco.  This meant that s. 90(11) would apply, and the entire exempt surplus balance of FA2 would be included for purposes of the deduction available to Canco under s. 90(9).

 

The CRA also considered an alternate scenario in which a bank lent money to FA2, which in turn lent money to FA1, which in turn lent money to Canco.  The CRA applied the back-to-back rule in s. 90(7) to conclude that the bank would be considered to have lent money to Canco directly.  This in turn meant that s. 90(6) would generally not apply to such an arrangement.

 

1. No Double Deduction

 

S. 90(13) prevents a double deduction in respect of the same loan or indebtedness, or portion thereof. This rule "turns off" the s. 90(9) deduction for the year in which the relevant portion of a loan or indebtedness is repaid, and for all future years, as the repayment should instead give rise to a deduction under s. 90(14) discussed below. 

 

 

 

1. Deduction for Repayment

 

As noted earlier above, s. 90(14) provides for a deduction from a Canadian corporation’s income to the extent that an upstream loan that was subject to s. 90(6) is repaid in a subsequent taxation year.  However, similar to the two-year repayment exception in s. 90(8), the deduction is only available if it is established, by subsequent events or otherwise, that the repayment was not part of “a series of loans or other transactions and repayments”.  See the discussion of “series of loans” in the context of the two-year repayment exception in s. 90(8) above. 

 

In 2013-0488881E5 (Scenario 7), the CRA agreed that where there is a “series of loans and repayments”, such that no deduction is available under s. 90(14) for repayments, one does not (double) count each of the loans in the series for purposes of s. 90(6).  One counts only the first loan.  The rule in s. 248(28) might also be raised as support for this position.     

 

1. Corporate Reorganizations

 

In 2013-0499121E5, the CRA was asked to consider the liquidation of a second-tier foreign affiliate (FA2) into a first-tier foreign affiliate (FA1), where FA2 had lent $1,000 (its exempt surplus) to the Canadian parent corporation (Canco).  The CRA concluded that the conditions in s. 90(14) – relating to a repayment of an upstream loan – would not apply to allow Canco to claim a deduction in respect of the loan from FA2 on the liquidation of FA2.  A deduction of $1,000 under s. 90(9) would remain available to Canco if all the conditions specified therein were satisfied.  However, the obvious problem is that s. 90(6) would also apply to include $1,000 in Canco's income in its taxation year in which the liquation occurred, as a result of Canco becoming indebted to FA1 (assuming none of the exceptions in s. 90(8) applied to that debt).  As a result, s. 90(6) would result in duplicate inclusions in Canco's income in respect of what is essentially the same loan.  In these circumstances, the CRA concluded that s. 248(28)(a) would apply to remedy the situation and avoid such double taxation of the same amount. 

 

On September 16, 2016, Finance announced amendments to upstream loan rules to facilitate corporate reorganizations (no doubt in response to issues similar to the above).  New “continuity rules” will be added in s. 90(6.1) and s. 90(6.11) for purposes of the rules in s. 90(6) and s. 90(7) through s. 90(15) (and certain related temporary relieving rules).  These new provisions are intended to ensure that the upstream loan rules continue to apply (and cannot be avoided) where a reorganization occurs following the making of an upstream loan.  They are also intended to ensure reorganizations do not result in double tax, either (1) by causing the upstream loan rules to apply multiple times in respect of what is in substance the same debt obligation, or (2) by preventing a repayment of a debt from being effective for purposes of these rules.  New s. 90(6.1) provides that s. 90(6.11) will apply where all of the following conditions are met:

 

1. Immediately before the reorganization, a person or partnership (the “original debtor”) owes an amount in respect of a loan or indebtedness (the “pre-transaction loan”) to another person or partnership (the “original creditor”).

 

1. The pre-transaction loan was, at the time it was made or entered into, a loan or indebtedness that is described in s. 90(6). 

 

1. In the course of an amalgamation, merger, foreign merger, winding-up, or liquidation and dissolution:

 

1. the amount owing in respect of the pre-transaction loan becomes owing by another person or partnership (the “new debtor”);

 

1. the amount owing in respect of the pre-transaction loan becomes owing to another person or partnership (the “new creditor”); or

 

1. the taxpayer, in respect of which the original debtor was a specified debtor at the time the pre-transaction loan was entered into, ceases to exist or merges with one or more corporations to form one corporate entity (the “new corporation”).

 

Where these conditions are satisfied in respect of a reorganization, s. 90(6.11) provides deeming rules for the purposes of s. 90(6), s. 90(7) to (15), s. 39(2.1), s. 39 (2.2) and s. 95(2)(g.04).  Specifically, where, in the course of the reorganization, the amount owing in respect of the pre-transaction loan becomes owing by a new debtor, or to a new creditor, s. 90(6.11) deems the loan or indebtedness that becomes owing by the new debtor, or to the new creditor, to be the same as that owing by the original debtor, or to the original creditor.  S. 90(6.11) also deems the new debtor or new creditor to be the same as the original debtor or original creditor, respectively.  Similarly, where the taxpayer is involved in a reorganization, the new corporation (in the case of an amalgamation), or any entity that held a partnership interest in or owned shares of the taxpayer immediately prior (in the case of a wind-up), is deemed to be the same as, and a continuation of, the taxpayer.

 

New subsections s. 90(6.1) and s. 90(6.11) apply in respect of transactions and events that occur on or after September 16, 2016.  However, if a taxpayer filed an election with the Minister before 2017, s. 90(6.1) and s. 90(6.11) apply in respect of the taxpayer as of August 20, 2011.

 

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[1] Section references in this report are to the Income Tax Act (Canada) or the Income Tax Regulations (Canada) as the case may be.

[2] S. 261(10) generally deals with locked-in gains and losses on debt obligations that are subject to a functional currency election.

[3] In this brief summary, a description of the rules for partnerships is intentionally omitted.

[4] The rule in s. 90(6) does not apply if s. 15(2) applies to the upstream loan.

[5] Rules pertaining to insurance companies and financial institutions are not described in this breif report.

[6] In this report, where concepts are defined with reference to a word or words in parenthesis, such definitions are intended to apply only to the immediate context in which they are used.

[7] See the excellent article by Ian Bradley, Marianne Thompson, and Ken J. Buttenham entitled "Recommended Amendments to the Upstream Loan Rules," in "International Tax Planning" (2015), vol. 63, no. 1 Canadian Tax Journal, 245-267.