28 November 2007 Internal T.I. 2007-0254441I7 - Corporate Distributions

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 a particular distribution of profits from a Brazilian entity is a dividend.

Position: In this case, yes.

Reasons: The "quota" of a Brazilian limitada would be considered to be "shares" such that a distribution in respect of such shares would be a dividend.

								November 28, 2007

Lynda Gibson
Senior Technical Applications Officer		HEADQUARTERS
GAAR & Technical Support Section 			A. Seidel, CMA
Tax Avoidance & Special Audits Division		(613) 957-2058
Compliance Programs Branch
								2007-025444

Payments to Canadian Parent

We are writing in response to your October 1, 2007 submission in which you requested our comments concerning the appropriate income tax treatment of amounts received by a Canadian corporation from an entity in Brazil.

Issue

A Canadian corporation ("Canco") owns 99% of the equity interests in a Brazilian entity and a sister corporation owns the remaining 1% equity interest in the Brazilian entity. Canco treats the Brazilian entity as a foreign affiliate, within the meaning thereof in subsection 95(1) of the Income Tax Act (the "Act"). The Brazilian entity has made a payment to Canco that is described as "interest on quotaholders' equity". You query whether the payment from the Brazilian entity may be treated as a dividend for Canadian income tax purposes since there is no debt outstanding between Canco and the Brazilian entity on which "interest" would be paid.

Our Comments

For Canadian income tax purposes, it is the CRA's view that the appropriate approach to classifying an entity is the two-step approach that has been adopted by the Canadian courts. The first step is to determine the characteristics of the foreign business association under foreign commercial law and the second step is to compare these characteristics with those of recognized categories of business association under Canadian commercial law in order to classify the foreign business association under one of those categories.

To be classified as a corporation for Canadian income tax purposes, the entity must have a legal personality and existence separate and distinct from the personality and existence of its members, it must have the capacity to acquire rights and to assume liabilities, and any rights acquired or liabilities assumed by it must not be the rights or liabilities of its members. In addition, the timing of the profit distribution must be determined by the entity. Based upon information gathered from various websites, it is our understanding that a Brazilian entity that has "quotaholders" is a Brazilian Limitada (a "Limitada"), the Brazilian equivalent of a US Limited Liability Corporation. Under Brazilian commercial law, a Limitada has a separate legal existence from its owners, the Limitada has the capacity to acquire rights and to assume laibilitites which are not the rights or liabilities of its owners, the profit distribution is determined by the Limitada and the Limitada owns any property used in carrying on the business of the Limitada. The personal liability of the owners for obligations of the Limitada is restricted to the capital that the owners have invested in the Limitada. A Limitada's capital is divided into equity units ("quotas") that are owned by "socio cotistas", generally referred to as "quotaholders", as opposed to shareholders, and the quotas are registered as part of a Limitada's "Contracto Social" (articles of incorporation/association), but the Limitada does not issue "quota certificates" to the quotaholders.

Based on the foregoing, we are of the view that a Limitada would be considered to be a corporation for purposes of the Act and that the quotas held by a quotaholder would be a share of the capital stock of a corporation for purposes of the Act.

In terms of taxation, a Limitada is subject to income tax on its earnings. A Limitada is not treated as a flow-through entity under Brazilian income tax legislation in any circumstances. A Limitada may pay a "dividend" to its quotaholders, however, a dividend is not deductible in computing a Limitada's income and is not subject to any further income tax in Brazil or any withholding tax.

Under Brazilian corporate law, a Limitada may also pay "interest" to its quotaholders, instead of dividends, which is computed by reference to the legislated "long-term interest rate". The maximum amount that a Limitada can pay as "interest" in a given year is limited to the greater of 50% of the annual profit of the Limitada and 50% of the accumulated earnings and profits of the Limitada. Such "interest" is deductible by the Limitada when computing its income subject to tax in Brazil and is subject to a 15% withholding tax at the time of payment. If the amount is paid to an individual that is resident in Brazil, the payment is not subject to any further income tax. If the amount is paid to a legal entity, other than an individual, that is subject to income tax in Brazil, the legal entity can reduce its income tax otherwise payable by the 15% withheld by the Limitada.

Is it Interest?

As is noted in paragraph 1 of Interpretation Bulletin IT-533, although the term "interest" is not defined in the Act, the courts have generally accepted that an amount is "interest", for purposes of the Act, if it is calculated on a day-to-day accrual basis, is calculated on a principal sum, and represents compensation for the use of the principal sum. See, in this respect, HMQ v. Sherway Centre Limited, 98 DTC 6121 (FCA).

With respect to the "interest" amounts in this case, there is no debt outstanding between Canco and its 99% owned Limitada such that one of the three fundamental requirements for the payments to be considered to be interest is missing (i.e., the requirement that the amount be computed on a principal sum). Accordingly, it is our view that the "interest" payment on quotaholder's equity from the Limitada to Canco would not be a payment of "interest" for purposes of the Act.

Is it a Dividend?

Subsection 248(1) of the Act does not define a "dividend" other than to state that it includes certain stock dividends. Black's Law Dictionary defines a "dividend" as "a portion of a company's earnings or profits distributed pro rata to its shareholders, usually in the form of cash or additional shares" and Investopedia defines a "dividend" as "a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders". In R. A. Hill and others v. Permanent Trustee Company of New South Wales, Limited, and others, (1930) A.C. 720, at 731, the Judicial Committee of the Privy Council made the following observation regarding the payment of dividends:

A limited company not in liquidation can make no payment by way of return of capital to its shareholders except as a step in an authorized reduction of capital. Any other payment made by it by means of which it parts with moneys to its shareholders must and can only be made by way of dividing profits. Whether the payment is called a "dividend" or a "bonus" or any other name, it still must remain a payment on division of profits. So long as a company is a going concern and is not restricted as to the profits out of which it may pay dividends, it may distribute as dividends to its shareholders the excess of its revenue receipts over expenses.

The R. A. Hill case was followed by the Tax Appeal Board in No. 463 v. Minister of National Revenue, (57 DTC 530). In that case the Tax Appeal Board concluded that distributions made by companies which were not in the process of winding-up, being discontinued, reducing their capital structure, or reorganizing their capital structure, were dividends.

Paragraph 2 of Interpretation Bulletin IT-67R3 reflects the view of the courts and states that "any distribution by a corporation of its income or capital gains made pro rata among its shareholders may properly be described as a dividend unless the corporation can show that it is another type of payment. The fact that a distribution of this kind may not be called a dividend does not affect the nature of the distribution."

Conclusion

It is our view that the "quotas" of the Limitada, that are held by Canco, are shares of the capital stock of a corporation not resident in Canada and that any distribution of the Limitada's current and/or accumulated income made pro rata among its quotaholders (referred to as interest on quotaholder's equity) would be a dividend for purposes of the Act.

We hope that our comments are of assistance. If you wish to discuss any of the above, please contact the writer. For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers 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 your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

Daryl Boychuk
for Director
International & Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch