22 May 2008 Roundtable, 2008-0276731C6 - Proposed loss denial rules on shares

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: Comfort letter dated April 12, 2006 issued by the Department of Finance adds additional and distinct rules to the rules provided for in subsection 88(3) (dissolution of a foreign affiliate) applicable when certain circumstances are met and where a taxpayer elects in writing to have these rules apply. Under those new rules, there is a loss denial rule on shares. Taxpayers are requesting comments about the fairness or the unfairness of that loss denial rule.

Position: Proposed answer sent to Calgary TSO stating our general understanding of the additional rules included in the comfort letter without commenting on the fairness or the unfairness of the rules.

Reasons: Request for comments on a comfort letter should be sent to the Department of Finance. We do not comment on comfort letter before it is incorporated in draft legislation.

Proposed answer sent to Calgary TSO for the ICAA/CRA Round Table 2008 in Ponoka, Alberta held on May 22, 2008.

Facts :

Canco is in the Oil and Gas business;

Canco forms a wholly owned subsidiary in country x ("Forco");

Forco is a controlled foreign affiliate of Canco;

Forco undertakes various exploration activities;

Canco makes a capital contribution (through the purchase of treasury shares) of $50 million in Forco;

Forco used the $50 million in exploration activities that did not result in a discovery and as such, the value of Forco is nominal;

Canco would like to realize a loss on its investment in Forco.

Under existing rules, Canco could liquidate and realize a capital loss in respect of the disposition of its shares in Forco. However, a proposal contained in a Department of Finance comfort letter dated April 12, 2006 provides that any loss of the taxpayer resident in Canada from the disposition of a particular share of the foreign affiliate that was redeemed, acquired or cancelled by the foreign affiliate in the course of the liquidation and the dissolution would be deemed to be nil.

That new proposal appears unfair to some taxpayers in certain situations because this treatment appears to leave Canco at an economic disadvantage as it does not allow Canco to obtain the benefit of the loss that has been realized.

Comments

Under the proposed version of subsection 88(3) included in the draft legislation on foreign affiliates issued on February 27, 2004, paragraph 88(3)(c) deems the taxpayer's proceeds of disposition of the shares of the foreign affiliate to include an amount equal to the total of all amounts each of which is the cost to the taxpayer of a distributed property received by the taxpayer as a consideration for the disposition of the shares. In this respect, the cost to the taxpayer of property distributed to the taxpayer on the dissolution (other than an excluded property and a share of another foreign affiliate) would be deemed, by proposed paragraph 88(3)(b), to be equal to its fair market value. According to this version of subsection 88(3), there is no provision deeming a loss on the shares of the foreign affiliate that is liquidated to be nil.

Since the publication of the draft legislation on February 27, 2004, the Department of Finance issued some comfort letters indicating that some changes would be made to the Income Tax Act. Those changes have not yet been incorporated in draft legislation. We do not comment on comfort letters written by the Department of Finance before they are incorporated in draft legislation. Requests for comments on comfort letters should be addressed to the Department of Finance.

If our understanding of the comfort letter of April 12, 2006 as it concerns subsection 88(3) is correct, the rules described in that part of the comfort letter (which include the deeming rule for the loss on the shares) would be additional and distinct rules applicable when certain circumstances are met and where a taxpayer elects in writing to have these rules apply. The loss denial rule is apparently similar to the loss denial rule found in paragraph 88(1)(b) of the Income Tax Act and operates when electing to transfer property of a wound-up foreign affiliate to its parent at its tax-cost. The comfort letter of April 12, 2006 does not indicate that the proposed legislation contained in the draft legislation of February 27, 2004 will be changed in other circumstances or where the taxpayer does not elect in writing to apply the new rules.

Sylvie Labarre
2008-027673
May 22, 2008