The new surplus reclassification rule may not apply to fresh starts

The fresh start rule (which generally deems a disposition of property of a foreign affiliate (FA) carrying on an active business at fair market value if it commences to carry on an investment business) may significantly boost the exempt surplus balance in respect of FA.  Would Reg. 5907(2.02) reclassify this increment as taxable surplus?

The first condition for Reg. 5907(2.02) to apply is that the increment result from a disposition "to" a non-arm’s length person (or other "designated person or partnership"). Instead the fresh start rule provides for a deemed disposition and reacquisition by the same person (FA) – although the Explanatory Notes do not recognize this point.

Respecting the second ("avoidance transaction" as defined in s. 245(1)) condition (which also must be satisfied for the reclassification rule to apply), the business change engaging the fresh start rule often will have occurred for non-tax reasons and will have occurred even more rarely with a view to distributing exempt earnings.

Neal Armstrong.  Summary of Jenny Li, "The Interaction of the Fresh Start and Surplus Reclassification Rules", International Tax, Wolters Kluwer CCH, April 2014, No. 75, p. 8 under Reg. 5907(2.02).