An Unpaid Amount Could Be an Upstream Loan

Assume that Canco owns a foreign affiliate (FA). Both Canco and FA have calendar taxation years. On January 1, 2015, FA provides services to Canco in consideration for a fee. Canco accrues an expense in respect of the fee and deducts the amount from its taxable income in 2015. If the expense remains unpaid for years, both subsection 78(1) and subsection 90(6) could potentially apply, subjecting the fee to Canadian tax twice.

Subsection 78(1) generally applies if a deductible expense (interest, fees, etc.) is not paid by the end of the taxpayer’s second taxation year following the year in which the expense was incurred, and results in an income inclusion in the taxpayer’s third taxation year. This inclusion can be avoided if the taxpayer and the creditor file an agreement under paragraph 78(1)(b).

The upstream loan rules are designed to prevent Canadian taxpayers from repatriating funds in an FA group by making long-term loans (which would not be taxable in Canada) instead of distributions that would be subject to Canadian tax. The upstream loan rules require an income inclusion of a “specified amount” in Canada when an FA of a Canadian taxpayer makes a loan to a person that is a “specified debtor” (which includes the Canadian taxpayer) and the loan remains outstanding for more than two years from the day that the loan was advanced or the indebtedness arose. (Certain surplus and basis offsets may be available to wholly or partially offset the amount of the inclusion in Canada, but assume that for the purposes of this example such offsets are not available.)

On January 2, 2017, if Canco has not settled its account payable, the upstream loan rules could apply to include the amount of the accrued fee in Canco’s 2015 income (unless the indebtedness is considered to have arisen in the ordinary course of the lender’s business). In 2018, if no paragraph 78(1)(b) agreement is filed and the payable is still outstanding, Canco may also be required to add the expense back into income under subsection 78(1). (The CRA’s administrative position that accrual-basis taxpayers are not subject to subsection 78(1), set out in Interpretation Bulletin IT-109R2, “Unpaid Amounts,” April 23, 1993, paragraph 15(a), should be considered.) The fee could then be subject to tax under both subsections 90(6) and 78(1), albeit at different times.

It may be possible to prevent such a double inclusion of the fee—for example, pursuant to subsection 248(28). Relief under that provision is permitted “unless a contrary intention is evident.” The fact that subsections 78(1) and 90(6) have different objectives (namely, preventing the deductibility of accrued expenses that are not paid within a reasonable time, and preventing tax-free distributions in excess of tax attributes) might be evidence of such a contrary intention and therefore that double taxation is intended. However, the FCA in Holder v. Canada (2004 FCA 188) seems to stand for the opposite conclusion: the starting point, prima facie, is no double taxation, and different objectives do not automatically displace that presumption. In summary, double taxation does not seem probable, but it remains a risk.

Another way to avoid the double inclusion is to file a paragraph 78(1)(b) agreement. However, it is not clear whether and how subsection 90(6) will apply to the loan that is then deemed to be made to the taxpayer (Canco) by the creditor (FA) on the first day of the taxpayer’s third taxation year.

Thus, until the interaction between subsections 78(1) and 90(6) is clarified, taxpayers and their FAs in situations like the one described above can avoid uncertainty and complexity by ensuring that unpaid amounts owing to an FA are settled in a timely manner.

Clara Pham
KPMG LLP, Toronto

Canadian Tax Focus
Volume 5, Number 3, August 2015
©2015, Canadian Tax Foundation