19 November 1999 Ministerial Correspondence 1999-0010440 - Exempt surplus - compensatory payments

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

DOCUMENT TYPE: Round Table Response

Principal Issues: Will the CCRA provide administrative relief regarding the application of Regulation 5907(1.1) in the circumstances described in the attached round table question?

Position: No, there is no apparent need to consider administrative relief in the circumstances set out in the question

Reasons: See CCRA response for detailed analysis of the issues.

1999 TEI Round Table

Question XIX

Calculation of Exempt Surplus

The incorporation of a new holding company in the United States to hold the shares of an existing U.S. corporation and the formation of a new U.S. consolidated group seemingly produces unintended results in the calculation of exempt surplus where the pre-existing group has loss carryovers. To illustrate the issues for discussion assume the following facts.

U.S. Loss Company (Lossco) has at all times since its creation been a wholly-owned subsidiary of a Canadian corporation (Canco). Canco incorporates a new U.S. holding company (Holdco) and forms a U.S. consolidated group by transferring all of the shares of Lossco to Holdco for additional shares of Holdco. Lossco has U.S. losses carried forward from taxation years prior to the incorporation of Holdco. These losses are deducted in subsequent taxation years in computing the taxable income (and thereby taxes) of the consolidated group.

Subsection 5907(1.1) of the Regulations provides rules for the adjustment of the exempt surplus pools of consolidated groups by equitably shifting the surplus to the appropriate members of the group. In this situation, Holdco would be the "primary affiliate" for the purposes of subsection 5907(1.1).

Under subparagraph 5907(1.1)(a)(i) of the Regulations, any income or profits tax paid for the year by the "primary affiliate" is deemed not to have been paid and under subparagraph 5907(1.1)(a)(ii) of the Regulations, any such tax that would have been payable by the primary affiliate, had the affiliate not been a member of the consolidated group, is deemed to have been paid for the year.

Subparagraph 5907(1.1)(a)(v) of the Regulations, deals with situations where the losses of a "secondary affiliate" have been used to reduce the tax that would otherwise have been payable by the primary affiliate. In this case, it is expected that Holdco's exempt surplus would be increased by the tax that would otherwise be payable. In other words, since Holdco's dividend-paying potential is increased by the amount of taxes avoided by offsetting the losses of Lossco against Holdco income, Holdco's exempt surplus should be increased by the amount of tax savings. Under the Regulation, however, the increase in exempt surplus is made at the "end of the year of the loss" and where Lossco's carryforward losses are used to offset Holdco income, Holdco has no taxation year at the "end of the year of the loss".

It is our understanding that the Canada Customs and Revenue Agency (the "CCRA") will not permit the exempt surplus of Holdco to be increased in this circumstance. As a result, even though Lossco's surplus will have been reduced by the operating losses and Holdco's surplus will be reduced under subparagraph 5907(1.1)(a)(ii) of the Regulations in respect of the taxes otherwise payable, there is no compensating increase under subparagraph (v). Would the CCRA confirm TEI's understanding of the CCRA's position. Assuming our understanding is correct, would the CCRA consider changing its position in order to mitigate this anomaly?

CCRA Response

The scheme of the rules in subsection 5907(1.1) of the Regulations contemplates that compensatory payments will be made. The purpose of these rules is to treat each affiliate in the consolidated group as if it were taxed on a stand-alone basis and where a foreign affiliate only had losses which were utilized to reduce the consolidated group's tax liability it was compensated for such loss utilization. While some adjustments in subsection 5907(1.1) of the Regulations are not conditional on compensatory payments being made, in certain circumstances such payments are necessary to achieve the intended results. This can be demonstrated in the following two examples.

Assume Holdco and Lossco each had $100 of income for the year (and Lossco did not have any losses carried forward). If we assume a tax rate of 50%, Holdco will have paid $100 tax on behalf of the group. Under subparagraph 5907(1.1)(a)(i) of the Regulations, the $100 tax is deemed not to have been paid. Under subparagraph 5907(1.1)(a)(ii) of the Regulations, Holdco is deemed to have paid the tax that it would otherwise have paid if it were not part of the consolidated group ($50). Under subparagraph 5907(1.1)(a)(iv) of the Regulations, the tax that would otherwise have been paid by the "secondary affiliate" (Lossco) had it not been a member of the consolidated group ($50) is deducted from the surplus of the primary affiliate (Holdco). If there is no compensatory payment by Lossco to Holdco for the payment of tax on Lossco's behalf, subsection 5907(1.1) of the Regulations provides no further adjustments and Holdco's net increase to surplus for the year will be nil, while Lossco's increase to surplus will be $100. This is not an appropriate result. Had Lossco made a compensatory payment of $50 to Holdco, subparagraph 5907(1.1)(b)(i) of the Regulations would increase Holdco's surplus by $50 and decrease Lossco's surplus by $50. Both Holdco's and Lossco's net increase to surplus for the year would $50, an appropriate result.

In a different example, assume Holdco had income of $100 for the year and that Lossco had a loss of $100 for the year. Lossco does not have any losses carried forward and the tax rate is 50%. As the consolidated income for the year is nil, no tax is payable by the group. Under subparagraph 5907(1.1)(a)(ii) of the Regulations, Holdco is deemed to have paid $50 tax (the amount that it would have paid had it not been a member of the consolidated group) leaving a surplus balance of $50. Under subparagraph 5907(1.1)(a)(v) of the Regulations the tax reduction relating to the utilization by Holdco of the loss of Lossco ($50) is added to Holdco's surplus at the end of the year of the loss, restoring the balance to $100. If no compensatory payment is made by Holdco to Lossco for the use of its loss, no further surplus adjustments occur under subsection 5907(1.1) of the Regulations. Lossco's net decrease to surplus for the year would be $100. In this example it is not intended or appropriate for Holdco's exempt surplus to be computed on a "gross basis" as a result of its ability to reduce its taxes with use of Lossco's tax losses. Had Holdco paid Lossco a $50 compensatory payment for the use of its loss, under subparagraph 5907(1.1)(b)(ii) of the Regulations Holdco's surplus would be decreased by $50 and Lossco's surplus would be increased $50 at the end of the year of the loss. We consider this an appropriate result.

In the situation described in the above question, if Holdco made a compensatory payment to Lossco for the use of its loss, under clause 5907(1.1)(b)(ii)(B) of the Regulations the amount of the payment would be considered a refund to Lossco for the year of the loss and deducted from Lossco's exempt deficit at that time. As Holdco was not in existence at the end of the year of the loss, the adjustment described in subclause 5907(1.1)(b)(ii)(A)(I) of the Regulations would not be made. As neither the adjustment in subparagraph 5907(1.1)(a)(v) nor subclause 5907(1.1)(b)(ii)(A)(I) would be made, the end result would be appropriate. Holdco's exempt surplus will be the same as it would have been if it were not a member of the consolidated group and Lossco's exempt deficit will be reduced by the amount of the compensatory payment.

While in certain circumstances advantageous results may occur depending on whether compensatory payments are made, there is no apparent need to consider administrative relief in the circumstances set out in the question.

Prepared by:	Tim Kuss
Date:		November 1999
Control #	992963