22 March 2016 Internal T.I. 2013-0506561I7 - Property acquired on a return of capital

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 property acquired on a return of capital "in kind" has a cost to the shareholder and whether the shareholder makes or incurs an outlay or expense.

Position: The shareholder has a cost and an outlay equal to the FMV of the property at the time of the distribution.

Reasons: Based on a textual, contextual and purposive interpretation of the Act.

								March 22, 2016

								HEADQUARTERS
								Income Tax Rulings
								  Directorate
	XXXXXXXXXX Tax Services Office		Hugo Gravel

								2013-050656

Property acquired on a return of capital “in kind”

We are writing in reply to an email dated September 26, 2013 from your office in which our views are requested as to whether a property acquired, in 2008, by a corporation resident in Canada as a result of a return of capital “in kind” from one of its wholly-owned foreign affiliates has a cost to the corporation and whether such corporation is considered to have made or incurred an outlay or expense for the purposes of the definition “eligible capital expenditure” (“ECE”) in subsection 14(5) of the Income Tax Act (the “Act”). The property in question is intellectual property with an unlimited life.

Unless otherwise noted, all statutory references herein are to the Act.

Cost

One of the sources of your uncertainty seems to be that there is no equivalent to subsection 52(2) for a return of capital in kind. Subsection 52(2) provides that a property received by a shareholder as a dividend payable in kind is deemed to be disposed of by the distributing corporation for proceeds equal to its fair market value (“FMV”) at the time of distribution, but it also provides that the recipient shareholder is deemed to acquire the property at a cost equal to that FMV. In the absence of this rule, it may be questioned as to whether the shareholder has given up anything on the receipt of such a dividend and, thus, whether the property received has a cost to the shareholder. Subsection 69(4), which could apply to many returns of capital in kind, presents similar uncertainties in that it provides only for a deemed FMV disposition of the distributed property vis-à-vis the distributing corporation, but no deeming rule for the recipient.

Notwithstanding the preceding, we believe there are other provisions of the Act that create a context which suggests that it would be appropriate to conclude that the cost of a property acquired by a Canadian corporate shareholder on a return of capital in kind from its wholly-owned foreign affiliate should be equal to its fair market value.

For example, if such foreign affiliate had distributed the intellectual property to its Canadian-resident shareholder on a liquidation and dissolution of the affiliate, and the shareholder had not elected to have “qualifying liquidation and dissolution” treatment under subsection 88(3.1), paragraphs 88(3)(b) and (c) would provide, respectively, that the foreign affiliate disposes of the property for proceeds equal to FMV and that the shareholder acquires the property at a cost equal to FMV. Thus, one could question the appropriateness of giving different cost treatment to the acquired property solely as a matter of the timing and/or the legal form of the distribution. We find similar support in the “qualifying return of capital” (“QROC”) rules in subsection 90(3). A return of capital by a foreign affiliate that is made on a pro rata basis in respect of all the shares of a particular class is generally deemed to be a dividend, under subsection 90(2). However, by electing under subsection 90(3) to have QROC treatment, the distribution can maintain its return of capital treatment. Thus, if the shareholder doesn’t elect QROC treatment, the distribution would be a dividend and subsection 52(2) would apply to give the shareholder a cost equal to FMV, but if it does so elect, then subsection 52(2) doesn’t apply. Again, one could question the appropriateness of giving different cost treatment to the acquired property simply based on whether or not an election is filed. Although the distribution in question is not subject to the QROC rules, as it occurred in 2008 – a time prior to the coming-into-force of these rules – we still find the above contextual analysis to be informative.

Even more relevant and informative in the case at hand is the transitional rule for subsection 88(3) which, if the taxpayer had so elected, would apply directly to the “in kind” return of capital. Specifically, subsection 65(2) of the Technical Tax Amendments Act, 2012 (the “65(2) election”) provides for an election whereby a taxpayer can have a slightly modified version of subsection 88(3) also apply to, among other things, a return of capital made by a foreign affiliate. These elective rules would clearly provide FMV cost to the Canadian shareholder in respect of the property distributed on the return of capital, under the transitional reading of paragraph 88(3)(c). One might then ask whether a negative inference can be drawn for taxpayers that choose not to make such an election and, similarly, for returns of capital occurring on or after August 19, 2011 to which even the elective rule cannot apply. However, it is our understanding that there was no intention to have different treatment in respect of returns of capital either pre or post August 19, 2011, whether or not the 65(2) election was made, and that the transitional rule was provided solely to preserve the previously proposed law in respect of subsection 88(3) in the event that certain taxpayers might find it advantageous.

Furthermore, it has been our long-standing position that the cost of a property received by a corporation from its shareholder for no consideration, for example as a capital contribution, would, in the absence of a specific provision of the Act to the contrary, result in the corporation having a cost of the property equal to its FMV. Although that position was issued in the context of a “downstream” transfer of property, we are of the view that it should also generally apply in the context of an “upstream transfer”, including a return of capital.

Thus, on the basis of all of the considerations presented above, it is our general view that the cost of property received by a Canadian corporate shareholder from its wholly-owned foreign affiliate on a return of capital should be considered to be equal to the FMV of the property at the time of the distribution.

Outlay or expense

We see no reason to apply different reasoning in respect of the determination as to whether the shareholder has “made or incurred” an “outlay or expense” for the purpose of the ECE definition in subsection 14(5). Thus, provided that the property duly qualifies as an eligible capital property, we are of the general view that a Canadian corporate shareholder that receives such property from its wholly-owned foreign affiliate on a return of capital should be considered to have “made or incurred” an “outlay or expense” in an amount equal to the FMV of the property at the time of the distribution.

Given that the property was acquired from a non-arm’s length person, it is possible that variable A.1 in the definition “cumulative eligible capital” in subsection 14(5) (“Variable A.1”) could apply to reduce the amount otherwise deductible under paragraph 20(1)(b) in respect of the intellectual property acquired by the shareholder. However, we understand that there is no gain realized by the foreign affiliate on the disposition. Thus, it is not necessary for us to consider whether Variable A.1 can apply in these circumstances.

Subsection 5907(2.02)

It is our understanding that the return of capital “in kind” occurred in 2008. Had the transaction occurred after August 19, 2011, the anti-avoidance rule in subsection 5907(2.02) of the Income Tax Regulations would have had to be considered in respect of the proper classification of any earnings of the foreign affiliate arising from its disposition of the property in question. We would also point out that the computation of such earnings would not necessarily be made on the same basis as the gain or loss computation for the purposes of Variable A.1.

For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. A severed copy will also be distributed to the commercial tax publishers, following a 90-day waiting period (unless advised otherwise), for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca.

We trust these comments will be of assistance, and thank you for your enquiry.

Dave Beaulne, CPA, CA
Section Manager
for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch