Tim Fraser, Jim Samuel, "The Preacquisition Surplus Election: More Than Meets the Eye?", Canadian Tax Journal (2021) 69:2, 595 - 627

Summary Under
Tax Topics - Income Tax Act - Section 90 - Subsection 90(3)

Tertium quid distributions under foreign corporate law (p. 602)

  • Not all foreign affiliate distributions fit neatly into the categories of a dividend or a return of paid-up capital – it is often the case that a distribution is characterized as a return of “paid-in capital” ( PIC), e.g., contributed surplus, share premium, or additional PIC.

Two-step approach to determining whether QROC election available (p. 603)

  • Since the s. 90(2) election is available only to a resident corporation, the QROC election was also introduced to permit a non-corporate taxpayer, such as an individual or a partnership, to achieve a similar result respecting a distribution that is considered to be a reduction of PUC under the two-step characterization approach (see 2011-0427001C6) – although Canadian corporations can also make the QROC election.
Summary Under
Tax Topics - Income Tax Regulations - Regulation 5901 - Subsection 5901(2) - Paragraph 5901(2)(b) - Subparagraph 5901(2)(b)(i)

Whether the holding of an interest in the FA by an LP with unrelated CRICs or their FAs as members precludes making the election (pp. 605-608)

  • Interpreted literally, the Reg. 5901(2)(b)(ii) precludes the election - for a whole dividend paid by a foreign affiliate (FA) of a corporation resident in Canada (a “CRIC”) to come out of preacquisition surplus – if any other CRIC (or a foreign affiliate of any other CRIC) is a member of a partnership that is a shareholder of the FA, regardless whether the other CRIC is related to the particular CRIC, or the partnership is a recipient of any portion of the dividend.
  • However, 2020 IFA Roundtable, Q.7 found that where Canco1 owned 100% of the Class A shares, and a limited partnership (LP) with partners (including Canco 2) at arm’s length with Canco1 owned 100% of the Class B shares, of a foreign affiliate (FA) respecting Canco1 and 2, and FA paid a dividend to Canco1 on the Class A shares, the Reg. 5901(2)(b)(ii)(A) requirement, that no member of LP (i.e., Canco 2) be a corporation that is otherwise eligible to elect under Reg. 5901(2)(b)(i), was only applicable where such LP in fact was receiving a dividend that otherwise could be elected upon to reduce the ACB of shares, so that Canco1 was not disqualified from making the election – but that the Reg. 5901(2)(b)(ii)(A) tainting of a dividend by FA to Canco1 (and Canco 2) would apply if FA had only one class of shares and a dividend was paid on a pro rata basis to both Canco1 and LP.
  • Since the surplus pools of FA are computed separately from the perspective of each of Canco 1 and Canco 2, and the election relevant only to the computation of surplus pools from the perspective of the electing CRIC, it is not clear from a policy perspective why Canco 1 should be prohibited from making such an election in the latter circumstances.
Summary Under
Tax Topics - Income Tax Act - Section 93 - Subsection 93(1.1) - Paragraph 93(1.1)(b)

Automatic s. 93(1.1) dividend if s. 40(3) gain (p. 599, f.n. 13)

  • Ss. 93(1.1) and (1.11) generally provide that any s. 40(3) gain realized by a recipient affiliate is automatically converted into a dividend received from the surplus of the payer affiliate to the extent of the underlying net surplus of any subsidiary foreign affiliates of the payer affiliate that could hypothetically be elevated to the payer affiliate under the notional distribution mechanics of Reg, 5902.

S. 93(1.1)(b) can elevate more taxable or other surplus than if the Reg. 5901(2)(b) is not made (pp. 610-611)

  • S. 93(1.1)(b) contemplates that any s. 40(3) capital gain that would otherwise would be deemed to be realized by the CRIC as a result of a Reg. 5901(2)(b) election is automatically converted back into a dividend to the extent of the net surplus of the foreign affiliate that is deemed to be otherwise available at the time of the distribution.
  • S. 93(1.1)(b) may not entirely restore the tax treatment of the dividend that would have arisen if the Reg. 5901(2)(b) election had the CRIC had not been made.
  • For example, Canco hold all the shares of a single class (having an ACB of $50 million) of FA 1, which has no surplus balances other than $10 million of taxable surplus, with FA 1 owning all the shares of a single class of FA 2, which has no surplus balances other than $20 million of taxable surplus. FA 1 pays a $100 million dividend to Canco
  • If Canco does not elect under Reg. 5901(2)(b), $10 million and $90 million of the dividend are deemed to be paid from taxable surplus, and preacquisition surplus, respectively, thereby triggering a $40 million capital gain (and s. 93(1) would not apply if Canco did not elect thereunder.)
  • If Canco instead elects, the $100 million dividend is treated as having been paid from preacquisition surplus, triggering a $50 million gain – but s. 93(1.1)(b) then applies to recharacterize a portion of that gain as a distribution from taxable surplus. However, because s. 93(1) takes into account the “consolidated” net surplus of FA 1 and its subsidiaries, the portion of the gain recharacterized as a taxable surplus dividend also includes the additional $20 million of taxable surplus of FA 2, so that Canco is deemed to receive a taxable surplus dividend of $30 million (not $10 million), and to have realized a s. 40(3) capital gain of only $20 million.
Summary Under
Tax Topics - Income Tax Regulations - Regulation 5901 - Subsection 5901(2) - Paragraph 5901(2)(b)

Election can be used to bypass untaxed taxable or hybrid surplus (p. 608)

  • The election may be beneficial where a CRIC has received a dividend from a foreign affiliate that would otherwise come out of hybrid or taxable surplus that has borne insufficient income tax.

Beneficial to pay multiple whole dividends (p. 609)

  • Since the election must be made respecting a whole dividend it may be desirable for a distribution from a foreign affiliate to be paid as multiple sequential dividends of varying amounts, to increase the flexibility of the CRIC in the presence of uncertainties as to the ACB of the foreign affiliate shares (or its surplus balances).

Examples of adverse consequences of making the Reg. 5901(2)(b) election

  • There can be adverse (or favourable) consequences of making the Reg. 5901(2)(b) election rather than using surplus.

Example 1 (pp. 612-613)

  • Canco (which has not made a functional currency election) holds all the shares (having an ACB of $150 million) of a single class of FA, which pays a US$ 100 million dividend (equivalent to Cdn.$140 million) at a time that its only surplus/deficit accounts (which it maintains in US dollars) is an exempt surplus balance of US $100 million. If it subsequently realized operating losses of US$ 100 million (thereby wiping out any unutilized exempt surplus balance), it would have been better off not to have elected (so that the dividend came out of exempt surplus), as maintaining the ACB of $150 million would permit FA to distribute up to that amount to Canco as preacquisition surplus dividends notwithstanding FA’s exempt deficit.

Example 2 (p. 615)

  • Rather than there being subsequent operating losses, the only relevant subsequent change is that the Canadian dollar appreciates relative to the US dollar. If it does not make the election, Canco will have a greater relative benefit from having maintained most of its Canadian dollar basis in the FA shares rather than maintain a US dollar exempt surplus balance.

Example 3 (pp. 616-617)

  • FA, a US subsidiary, which has exempt earnings, pays two dividends of US$ 100 million in the same year: the first being subject to 5% US withholding tax because it is paid out of earnings and profits for US purposes; and the second being not subject to withholding because it was not out of E&P. Respecting the first dividend, the ACB reduction will only be $95 million if the Reg. 5901(2)(b) election is made, whereas if the election is not made, the exempt surplus balance is reduced by the gross amount of the dividend irrespective of whether there is withholding tax. Accordingly, it may be preferable to make the election only respecting a dividend that is subject to withholding tax.

Example 4 (pp. 618-619)

  • Canco, which has elected under s. 261 to compute its Canadian tax results in US dollars, holds cumulative preferred shares of FA with a face value and ACB of US $100 million. The dividends come out of exempt surplus unless Canco makes the Reg. 5901(2)(b) election. If it makes the election, it might seem that this would increase the amount of exempt surplus it could access so as to shelter under s. 93(1) the resulting gain when the preferred shares are subsequently redeemed. However, the rules in Reg. 5902 might limit its access in that redemption scenario to exempt surplus only in the amount of the accrued but unpaid dividends on the shares at the time of redemption, thereby resulting in the realization of a capital gain that would have been avoided if the election instead had not been made.

Desirability or undesirability of elevating surplus from lower-tier affiliates rather than making

  • It may be beneficial for the payer of an interaffiliate dividend, who has sufficient tax-free surplus, to pay a dividend to a higher-tier foreign affiliate from such tax-free surplus, so as to elevate tax-free surplus up the foreign affiliate chain, thereby making such surplus more readily available to shelter the payment of any subsequent dividends to the CRIC – and also safeguarding that tax-free surplus from erosion by any subsequently-incurred losses of the payer affiliate.

Example 5 (pp. 620-623)

  • Canco wholly-owns FA 1 (which has no exempt, hybrid, or taxable deficits), which wholly-owns FA 2 and FA 3, whose shares constitute excluded property. FA 3 pays a dividend of $10 million to FA 1 while it has exempt surplus of $10 million (and no hybrid and/or taxable deficits), with FA 1’s ACB in the FA 3 shares being $110 million. Subsequently, FA 1 contributes the shares of FA 3 (having a FMV of $100 million) to FA 2 in exchange for additional shares of FA 2.
  • Assuming no Reg. 5901(2)(b) election respecting the dividend paid by FA 3 to FA 1, FA 3’s exempt surplus of $10 million is elevated to FA 1, and FA 1’s ACB in the FA 3 shares remains at $110 million. On the subsequent contribution of the FA 3 shares to FA 2, FA 1 realizes a $10 million loss that is included in computing its hybrid deficit. Consequently, FA 1’s ability to pay a dividend from its $10 million of exempt surplus (previously elevated from FA 3) may be blocked by the $10 million hybrid deficit created on the transfer of the shares of FA 3 to FA 2.
  • If, however, Canco instead makes the election respecting the $10 million dividend, the exempt surplus of FA 3 would not be elevated. Instead, FA 1’s ACB in the FA 3 shares would be reduced to $100 million. No loss, or hybrid deficit, would arise to FA 1 on its subsequent disposition of the FA 3 shares to impede its ability to pay tax-free surplus dividends to Canco.