CRA considers whether preferred share investment in foreign affiliate is a loan

In 2012-0439741I7 (released October 23, 2013), the CRA’s Sudbury office considered treating a Canadian company’s preferred share investment in a first-tier foreign affiliate as a loan, with the result that tax-free dividends on the preferred shares were proposed to be treated instead as taxable interest income. The stated grounds for this re-characterization were (1) that the preferred shares were treated as a loan under the foreign tax regime (generating interest deductions in the foreign country), and (2) that the preferred shares were treated for accounting purposes (in Canada) as debt. Fortunately, the CRA’s Headquarters in Ottawa corrected the Sudbury office, and advised that the Canadian parent’s investment in the affiliate should be respected as shares, such that the dividends could not be re-characterized as interest income. However, the CRA’s Headquarters also referred the matter to the CRA’s foreign affiliate specialist to determine if the share investment could be ignored under the anti-avoidance rule in s. 95(6). Although the facts were not fully revealed, it appears the structure under consideration involved a fairly typical foreign affiliate financing arrangement. The Tax Court recently held that a similar arrangement was not subject to s. 95(6) because the arrangement was designed to reduce foreign tax not Canadian tax (see my quick update at http://thor.ca/blog/2013/06/cra-could-not-apply-s-956-to-foreign-affiliate-financing-structure). The government has appealed that Tax Court decision to the Federal Court of Appeal.