Subsection 90(3) - Commentary

S. 90(3) override of s. 90(2)

S. 90(2) deems most distributions to a taxpayer by a foreign affiliate (made pro rata to its shareholding), other than on a liquidation of the foreign affiliate or a redemption of its shares, to be dividends. However, s. 90(3) deems such a distribution to instead be a qualifying return of capital (QROC) if a valid election is so made and it is "a reduction of the paid-up capital of the affiliate" in respect of which the distribution was made.

A QROC election may be beneficial to a taxpayer, such as a trust, which is not able to access the corporate deductions under s. 113 for dividends paid out of surplus (including pre-acquisition surplus).

Approach to determining foreign PUC

Given that the foreign corporate law often will differ from Canadian concepts, how is it determined whether a distribution received by a taxpayer represents a reduction of the paid-up capital of the payer foreign affiliate in respect of the taxpayer's shares of the foreign affiliate?

In determining the status of a foreign entity for Canadian tax purposes, CRA (consistently with Memec) examines the characteristics of the foreign business association under foreign commercial law and governing commercial documents, and then compares these characteristics with those of recognized categories of business associations under Canadian commercial law in order to classify the foreign business association under one of those categories. (See, for example, 2014-0523041C6.) Similarly, in determining the character of a distribution from a foreign corporation to a shareholder for Canadian tax purposes, CRA first determines the characteristics of the distribution under foreign corporate law (not tax law), and then compare these characteristics with those of recognized categories of distributions under Canadian common law and corporate law in order to classify the distribution under one of those categories. However, it has stated that "as a practical matter…[w]here the distribution is a dividend or a return of legal capital under the foreign corporate law, that characterization will generally not be challenged by the CRA." See 2011-0427001C6 (below). This two-step approach suggests an examination of the concept of paid-up capital under Canadian corporate law.

Corporate stated capital

In fact, modern business corporations statutes in Canada do not use the phrase "paid-up capital," and instead refer to the concept of stated capital. In the context of domestic transactions, it is well accepted (for reasons discussed below) that a corporation's paid-up capital for tax purposes is based on its stated capital for corporate purposes.

Under present Canadian corporate law, the concept of stated capital is used to track a corporation's share capital for purposes of solvency tests that are used to protect creditors of the corporation from potential prejudice by transactions between the corporation and its shareholders (and, in some cases, to protect the interests of shareholders holding other classes of shares as well). The concept of stated capital was thus described in Proposals for New Alberta Business Corporations Act (Edmonton: Institute of Law Research and Reform, 1980) Vol. 1, at pp. 76-77:

The [CBCA] introduced to Canada the term 'stated capital'. The essence of the provisions with regard to stated capital is that there must be a stated capital account for each class and series of shares … and that the appropriate stated capital account must include the full amount of any consideration which the corporation receives for any shares it issues … .

The ability of the corporation to pay dividends is tied to its stated capital accounts: … The corporation must not declare or pay a dividend if the realizable value of [the] corporation's assets would thereby be less than the aggregate of its liabilities and stated capital of all classes. The retention of the amount of the consideration received from the sale of shares is, on the face of it, an additional protection for creditors. The value of that protection however is limited by the fact that the corporation is not obliged to obtain any substantial amount of capital from the sale of its shares, and by the fact that the CBCA allows the corporation to reduce the stated capital account. …

The principal provision[s] in the CBCA for reduction of stated capital … carry out the CBCA policy of leaving a corporation's affairs in its own hands; the requirement of confirmation by the court … has no counterpart in the CBCA. On the other hand, the CBCA does establish liquidity and solvency tests which must be satisfied, and it allows creditors to apply for orders compelling shareholders to make restitution.

Other transactions involving a return of capital to shareholders, such as the redemption or purchase by a corporation of its own shares, similarly require that solvency tests be passed, which take into account the relevant stated capital accounts of the corporation.

Pre-CBCA PUC concept

The Act utilized the concept of paid-up capital well before the statutory concept of stated capital was first introduced by the CBCA in 1975 and then adopted in other modern Canadian business corporation statutes, including the OBCA in 1982. S. 81(8) of the pre-1972 Act provided for the deemed payment of a dividend "where a corporation has at any time increased its paid-up capital otherwise than by [specified transactions]". The term paid-up capital was customarily used in corporate law to refer to the amounts that shareholders had paid in respect of the shares issued to them, at least since the time (approximately 150 years ago) of the first statutes permitting the general incorporation of business corporations with shareholder limited liability.

The significance of paid-up capital in Canadian corporate law, prior to the modern era, derives from a theory developed by the courts, by inference from the corporate statutes, that the capital of a corporation, in the sense of the amounts contributed by shareholders in exchange for their shares, represented a fund that, in order to protect creditors of the corporation, could only be returned to shareholders, directly or indirectly, under tight constraints. In effect, the courts decided that the intent of the statutes was that the quid pro quo for shareholder limited liability was that shareholders must pay the entire amounts which they had agreed to contribute to the corporation in exchange for their shares and must leave those amounts in the corporation. Although shares could be issued partly-paid, which is not possible under present-day Canadian business corporation statutes (that is, upon the allotment of shares the subscriber paid only a portion of the share's par value, the nominal capital ascribed to the share), the shareholder remained fully liable to the corporation, or its liquidator, for any amount remaining unpaid on the share, until the share had been fully "paid up". The role of paid-up capital in this legal theory, and the way in which the courts elaborated rules for the maintenance of capital by inference from the corporate statutes, is shown clearly in the following passage from one of the most influential English judicial decisions in this area, which decided that a corporation could not repurchase its own shares, Trevor v. Whitworth (1887), 12 App. Cas. 409 (H.L.) at pp. 423-24:

In the case of a company limited by shares, the Act of 1862 requires that the amount of its capital, and the shares into which it is divided, shall be set forth in the memorandum of association; and sect. 12, which prescribes the extent to which the conditions contained in the memorandum may be modified, empowers the company to increase but not to diminish its capital. That limitation has been so far relaxed by the Act of 1867 as to permit a company to reduce its capital, with the sanction of the Court, after due notice to creditors, upon such terms as the Court may think fit to impose. The Act of 1877, upon the preamble that doubts had been entertained whether the power of reduction given by the preceding Act extended to paid-up capital, enacts (sect. 3) that the word 'capital,' as used in that Act, shall include paid-up capital. That declaration clearly expresses the will of the legislature that neither the paid-up nor the nominal capital of the company shall be reduced otherwise than in the manner permitted by the statutes.

One of the main objects contemplated by the legislature, in restricting the power of limited companies to reduce the amount of their capital as set forth in the memorandum, is to protect the interests of the outside public who may become their creditors. In my opinion the effect of these statutory restrictions is to prohibit every transaction between a company and a shareholder, by means of which the money already paid to the company in respect of his shares is returned to him, unless the Court has sanctioned the transaction. Paid-up capital may be diminished or lost in the course of the company's trading; that is a result which no legislation can prevent; but persons who deal with, and give credit to a limited company, naturally rely upon the fact that the company is trading with a certain amount of capital already paid, as well as upon the responsibility of its members for the capital remaining at call; and they are entitled to assume that no part of the capital which has been paid into the coffers of the company has been subsequently paid out, except in the legitimate course of its business.

The manner in which the courts elaborated rules by inference from the corporate statutes, to ensure that paid-up capital was maintained by a corporation, and the consistent application of these rules in Canada as well as England, is summarized as follows in F.W. Wegenast, The Law of Canadian Companies (Toronto: Burroughs, 1931) at p. 144:

"It seems clear also that a transaction may be ultra vires because of an implied, instead of an express, prohibition in the statute. The outstanding instance is the rule against a company's trafficking in its own stock. There is no express provision, either in England or in Canada, forbidding the issue of shares at a discount. The rule against such transactions rests on an inference arising out of the provisions of the statute. In Ooregum Gold Mining Co. of India v. Roper [[1892] A.C. 125 at p. 133] Lord Halsbury said: 'The Act of 1862 makes one of the conditions of the limitation of liability that the memorandum of association shall contain the amount of capital with which the company proposes to be registered, divided into shares of a certain fixed amount. It seems to me that the system thus created by which the shareholder's liability is to be limited by the amount unpaid upon his shares, renders it impossible for the company to depart from that requirement, and by any expedient to arrange with their shareholders that they shall not be liable for the amount unpaid on the shares.' In other words, because the statute requires applicants for incorporation to state the amount of capital and the number of shares into which it is to be divided, it is implied that except as expressly authorized by statute, the company is not competent to tamper with the amount of that capital. On the same reasoning it has been held that a company is not competent to purchase its own stock, or to supply money or security for the purchase of it, or to accept a surrender of any of it, or to 'cancel' it. Under the Canadian Companies Act the implied prohibition against trafficking in shares rests on statutory provisions in different terms, but is fully established."

The concepts of corporate capital applied in Trevor v. Whitworth continued to be applied in Canadian corporate law until the present generation of Canadian business corporation statutes, such as the OBCA. For example, the Canada Corporations Act, which was the Canadian federal statute of general application providing for the incorporation of business corporations until its replacement in 1975 by the CBCA, contained provisions permitting a reduction of capital, subject to certain constraints, that were recognizably based upon the same theory as that set out in Trevor v. Whitworth:

52(1) Subject to confirmation by supplementary letters patent, a company may by by-law reduce its capital in any way, and in particular without prejudice to the generality of the foregoing power, may

(a) extinguish or reduce the liability on any of its shares in respect of capital not paid-up;

(b) either with or without extinguishing or reducing liability on any of its shares, cancel any paid-up capital which is lost or unrepresented by available assets; and

(c) either with or without extinguishing or reducing liability on any of its shares and either with or without reducing the number of such shares pay off any paid-up capital that is in excess of the wants of the company. …

53(1) Where the proposed reduction of capital involves either diminution of liability in respect of unpaid capital or the payment to any shareholder of any paid-up capital, and in any other case if the Minister so directs, every creditor of the company who at the date of the petition for supplementary letters patent is entitled to any debt or claim that, if that date were the commencement of the winding-up of the company, would be admissible in proof against the company, is entitled to object to the reduction. …

As can be seen from the above discussion, under Canadian corporate law prior to the OBCA and CBCA, detailed rules were developed by the courts, and later often reflected in whole or in part in corporate statutes, to ensure the preservation of the corporation's paid-up capital for the protection of its creditors. Although these rules lacked the precision of the present-day statutory rules relating to stated capital, their purpose was essentially the same. These rules, both statutory and drawn by inference from corporate statutes, were replaced by the present-day stated capital rules under the OBCA and the CBCA, and therefore no longer form part of Canadian corporate law.

Is a distribution of PUC?

Once it is determined that shares of a foreign affiliate have paid-up capital, the determination as to whether a distribution received by the taxpayer on its shares of the foreign affiliate is a mechanical one, based on whether the procedure in the foreign jurisdiction for distributing capital has been followed. As stated in First Nationwide:

The jurisprudence is well-established. Payments made by a company in respect of shares are either income payments, or, if the company is not in liquidation, by way of an authorised reduction of capital. The courts have recognised no more than that dichotomy. The distinction has depended upon the mechanics of distribution. If the payments are made by deploying the mechanisms appropriate for reduction of capital, then they are payments of capital. Such mechanisms can be readily identified as designed to protect the capital of a company. If the payments are not made by such mechanisms but are made by way of dividend, they are income payments.

PUC of C-Corps

S. 154 of the Delaware General Corporate Law does not distinguish between earned surplus (i.e., retained earnings) and capital surplus (similar to the Canadian concept of contributed surplus) and instead simply provides that "the excess, if any, at any given time, of the net assets of the corporation over the amount so determined to be capital shall be surplus." The stated capital of shares without par value (subject to subsequent adjustment) is the amount of the consideration for the issuance of the shares determined by the board to be their capital. S. 170 of the DGCL provides for the payment of dividends out of surplus. There is no provision for the making of distributions of shares' stated capital. Given this labeling, the position of CRA (e.g., in 9415515) is that where an amount is transferred from capital to surplus and then distributed, it will be treated as a dividend rather than a distribution of capital, as that is the character of the distribution under the Delaware corporate law.

Somewhat similar issues may arise under other U.S. corporate statutes. For example, s. 510(b) of the New York Business Corporation Law provides that dividends and "other distributions" may be paid out of surplus (which is effectively defined as the excess of net assets over stated capital). Although this contemplates that a distribution can be paid otherwise than as a dividend, it also contemplates that the distribution is paid out of surplus rather than stated capital – and the type of surplus (capital or earned) is not specified.

In Ohio, s. 1701.33 of the Ohio Revised Code provides that the directors may declare dividends or other "distributions" on outstanding shares, and specifies that "when any portion of a dividend or distribution is paid out of capital surplus, the corporation, at the time of paying the dividend or distribution, shall notify the shareholders receiving the dividend or distribution as to the kind of surplus out of which the dividend or distribution is paid." Accordingly, it appears to be possible to specify that a shareholder is receiving a non-dividend distribution out of capital surplus. However, given that the U.S. concept of capital surplus appears to be similar to the Canadian concept of contributed surplus (which in Canada cannot be directly distributed as a stated capital distribution), it is not clear that such a distribution would qualify as a distribution of paid-up capital under ITA s. 90(3).

PUC of LLCs

The statutory provisions governing Delaware limited liability companies (and most or all other LLCs) are intended to accord a broad flexibility in the establishing of the governing of their affairs, and do not have provisions specifying how their paid-up capital is determined. Thus the determination of the paid-up capital attributable to the membership interests (which are deemed under draft s. 93.3 to be shares) is effectively delegated by statute to those drafting the relevant LLC Agreement or Articles. Provided that such drafting employs similar concepts to Canadian corporate law so that, for example, capital can be returned by redemption or purchase by the LLC of its own shares provided that solvency tests are passed, it would be appropriate for paid-up capital determined in accordance with such internal documents to be respected as paid-up capital for purposes of s. 90(3).

In a number of rulings given respecting the conversion of regular Delaware or California corporations to LLCs (for example 2004-0065921R3 respecting the conversion of "USco 2" to "LLC2"), the description of the "shares" of the new LLC included a description of its capital:

"Capital" of Shares is the aggregate of all amounts paid to LLC 2 and the monetary value at the time of contribution of property contributed to LLC 2 (in each case including amounts paid or contributed prior to USco 2's conversion to LLC 2) in consideration for the issuance of Shares together with any amounts added thereto by the Board of Managers or the Stockholders in accordance with the provisions of the LLC 2 Agreement, less the aggregate of all amounts by which such capital has been reduced by the Stockholders or the Board of Managers in accordance with the LLC 2 Agreement.

However, no rulings were given in respect of any future distributions of such capital.

Germany

Under the capital maintenance rule in section 30 of the Limited Liability Companies Act, a limited liability company (GmbH) is prohibited from distributing an asset to its shareholders to the extent that this would result in net assets not being equal to the stated capital of the GmbH. Conversely, equity in excess of the stated capital (typically retained earnings plus surplus capital) can be distributed to the shareholders. Accordingly, similar considerations as for U.S. C-Corps in stated capital states may apply.

Mexico

Mexican corporate law has concepts of fixed capital shares and variable capital shares. Typically, most of the capital of a Mexican subsidiary will be the variable portion. Although the fixed capital rules are more complicated, those for variable capital are generally similar to the Canadian corporate law. The variable capital of shares which are no-par-value shares will initially be the amount subscribed therefor. By an extraordinary resolution of the shareholders, the Mexican corporation can resolve to distribute a portion of the variable capital to the variable shareholders. A balance sheet is required to be filed with the public Registry of Commerce evidencing the capital account. However, if all the capital of variable capital shares is distributed, the shares are required to be cancelled.