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: 1. How are the surplus accounts of a foreign affiliate computed when legal and economic rights to shares of the foreign affiliate are split? 2. A foreign affiliate pays a dividend to a shareholder, then the shareholder sells the shares of the foreign affiliate for a nominal amount. Can the dividend be recharacterized as a capital gain?
Position: 1. The holder of the legal rights is ignored. 2. Possibly
Reasons: 1. Previous positions. The bare trustee or nominee holds title to the shares on behalf of the beneficial owners. 2. A dividend may be deemed to be a capital gain under subsection 40(3) or GAAR may apply.
September 10, 2013
Mr. Luc Deslauriers HEADQUARTERS
International Auditor Income Tax Rulings
305 René Lévesque Boulevard West Directorate
Montreal QC H2Z 1A6 S.E. Thomson
We are writing in response to a memorandum from Bich-Ha Vu of your office dated March 30, 2012, which we received on June 13, 2012. In the letter, Ms. Vu asks two questions, which we set out below. Briefly, the facts are as follows:
Structure in XXXXXXXXXX
A corporation resident in Canada ("Canco") owns all of the shares of BCo, a resident of XXXXXXXXXX. BCo owns XXXXXXXXXX% of the Class B shares, XXXXXXXXXX% of the Class C shares and XXXXXXXXXX% of the Class D shares of CCo. CCo is resident in XXXXXXXXXX. The Class A shares and the remainder of the Class C and D shares of CCo are owned by an arm's length non-resident person (NR1). CCo has no other shares outstanding.
CCo owns XXXXXXXXXX% of the shares of DCo. DCo is a XXXXXXXXXX corporation resident in XXXXXXXXXX. The remainder of DCo is owned by a group of arm's length non-resident investors (NR2).
CCo also owns XXXXXXXXXX% of the interests in P1, a partnership formed in XXXXXXXXXX. DCo owns less than XXXXXXXXXX% of P1, and NR2 owns the remaining interests. DCo is the general partner of P1, and CCo and NR2 are limited partners.
DCo holds the legal rights to ECo, a XXXXXXXXXX corporation resident in XXXXXXXXXX. P1 holds the economic rights to ECo.
ECo owns less than XXXXXXXXXX% of the interests in P2, a partnership formed in XXXXXXXXXX. P1 owns the remaining interests. ECo is the general partner of P2, and P1 is the limited partner.
ECo holds the legal rights to Opco, a company resident in XXXXXXXXXX. P2 holds the economic rights to Opco.
Disposition in XXXXXXXXXX
In XXXXXXXXXX, NR1 paid $XXXXXXXXXX to CCo to acquire from CCo a XXXXXXXXXX% interest in P1. CCo declared a dividend of $XXXXXXXXXX on the Class D shares. NR1 waived its rights to the dividends on the Class D shares that it held, and the entire $XXXXXXXXXX dividend was paid to BCo. The Class D shares held by BCo were then redeemed for $XXXXXXXXXX, generating a capital loss.
In XXXXXXXXXX, NR1 wished to acquire the Class B and C shares of CCo held by BCo. NR1 paid $XXXXXXXXXX to CCo (footnote 1) , which we assume was equal to the fair market value of the Class B and C shares of CCo held by BCo. CCo declared a dividend of $XXXXXXXXXX on the Class C shares. The entire $XXXXXXXXXX dividend was paid to BCo (we presume that NR1 waived its rights to the dividends on the Class C shares that it held). No dividend was paid on the Class B shares. BCo then sold its Class C and Class B shares of CCo to NR1 for $XXXXXXXXXX, generating a capital loss.
Ms. Vu has concluded that, at the time that the dividends were paid by CCo to BCo, the shares of CCo were not excluded property of BCo as defined subsection 95(1) of the Act. Also, she concluded that the dividends were paid from pre-acquisition surplus, because CCo did not have sufficient exempt surplus. In the March 30, 2012 letter, Ms. Vu did not ask for our views on these points, and we have not attempted to determine if the shares of CCo were excluded property of BCo, nor have we attempted to determine whether CCo had sufficient exempt surplus.
A. How is surplus to be computed when a corporation holds legal rights to shares of a foreign affiliate, but a partnership holds the economic rights to the shares?
B. Would we agree with the view that the dividends paid on the Class C and D shares of CCo in XXXXXXXXXX are in fact, proceeds of disposition on the sale of the Class C and D shares?
A. The "exempt surplus" and "taxable surplus" of a foreign affiliate of Canco are computed under those definitions in subsection 5907(1) of the Income Tax Regulations (the "Regulations"). That is, the surplus pools of Opco will be computed for Opco in respect of Canco, if Opco is a foreign affiliate of Canco.
The definition of "foreign affiliate" is set out in subsection 95(1) of the Act. Opco will be a foreign affiliate of Canco if it is a non-resident corporation in which the equity percentage (EP) of Canco is not less than 1%, and in which the EP of Canco and related persons is not less than 10%.
The term "equity percentage" is defined in subsection 95(4) of the Act. A person's EP in any particular corporation is the total of the person's direct equity percentage (DEP) in the particular corporation, plus the total of all percentages each of which is the product obtained when the person's EP in any corporation is multiplied by that corporation's DEP in the particular corporation.
The term "direct equity percentage" is defined in subsection 95(4) of the Act. A person's DEP in a corporation is computed by determining the proportion of 100% of each class of issued shares of the corporation that is owned by the person, and by choosing the class (or classes) of shares that computes to the highest proportion.
Section 93.1 of the Act applies after November 1999 in order to determine whether a non-resident corporation is a foreign affiliate of a corporation resident in Canada, where, based on the assumptions in paragraph 96(1)(c) of the Act, shares of the non-resident corporation are owned by a partnership. Subsection 93.1(1) applies for certain purposes of the Act, including section 113 and the relevant regulations. It deems the shares of the non-resident corporation held by the partnership to be owned by each of the partners of the partnership in proportion to the fair market value of the partner's interest in the partnership.
In the facts presented, ECo holds XXXXXXXXXX% of the legal rights in Opco, and P2 owns XXXXXXXXXX% of the economic rights in Opco. We do not have enough information to determine why the shares of Opco were held this way, how the transactions were accomplished, or the exact nature of the legal relationships between the parties. However, we presume that ECo holds the title to the shares of Opco as a bare trustee or nominee on behalf of P2, and that P2 beneficially owns all of the rights to the shares of Opco, such as the right to vote, to receive dividends and to the return of capital. If that is the case, then the legal rights held by ECo would be ignored for purposes of determining whether Opco is a foreign affiliate of Canco for purposes of section 113 of the Act, and the relevant regulations. Similarly, the legal rights in ECo held by DCo would be ignored.
For example, based on the structure described above in XXXXXXXXXX:
- Canco owns XXXXXXXXXX% of the shares of BCo, therefore Canco's DEP and EP in BCo is XXXXXXXXXX%.
- BCo owns XXXXXXXXXX% of the Class B shares of CCo, therefore BCo's DEP in CCo is XXXXXXXXXX%, and Canco's EP in CCo is XXXXXXXXXX%.
- CCo owns XXXXXXXXXX% of the shares of DCo, therefore CCo's DEP in DCo is XXXXXXXXXX%, and Canco's EP in DCo is XXXXXXXXXX%.
- CCo owns XXXXXXXXXX% of the interests in P1, and DCo owns XXXXXXXXXX% of the interests in P1.
- P1 owns XXXXXXXXXX% of the shares of ECo (DCo's interest in ECo is ignored). Therefore, Canco's EP in ECo is XXXXXXXXXX% plus XXXXXXXXXX% of XXXXXXXXXX% = XXXXXXXXXX%.
- P1 owns XXXXXXXXXX% of the interests in P2, and ECo owns XXXXXXXXXX% of the interests in P2.
- P2 owns XXXXXXXXXX% of the shares of Opco (ECo's interest in Opco is ignored). Therefore, Canco's EP in Opco is XXXXXXXXXX% x XXXXXXXXXX% plus XXXXXXXXXX x XXXXXXXXXX% = XXXXXXXXXX%.
Therefore, ECo and Opco are foreign affiliates of Canco and the surplus accounts of ECo and Opco are computed no differently than they would be if the legal rights in their shares were not separated from the economic rights.
B. Ms. Vu's primary assessing position with regard to the XXXXXXXXXX dispositions is to recharacterize the dividends paid by CCo to BCo as proceeds of disposition. She bases this on the conclusion of the Tax Court of Canada in Granite Bay Charters Ltd. v The Queen, 2001 DTC 615 and 454538 Ontario Limited et al v MNR, 93 DTC 427. In those cases, the operating companies paid a dividend to the corporate shareholders prior to the sale of the operating companies' shares to an arm's length buyer. The Minister applied subsection 55(2) of the Act to recharacterize the dividends as proceeds of disposition, resulting in a capital gain to the shareholders.
We believe that the CRA would not be successful applying Granite Bay and 454538 Ontario to the current situation. Those two cases both applied subsection 55(2) of the Act, which applies only to dividends received by a corporation resident in Canada in respect of which the corporations are entitled to a deduction under subsection 112(1) (footnote 2) of the Act. Subsection 112(1) applies to dividends received from a taxable Canadian corporation or a corporation resident in Canada (footnote 3). If the dividend is paid from "safe income" (footnote 4), subsection 55(2) will not apply, and the dividend will not be recharacterized as a capital gain.
The mechanism for dealing with dividends received by a corporation resident in Canada from a foreign affiliate is similar, but not identical to section 55(2). The dividend will be included in the corporation's income under paragraph 12(1)(k) and section 90 (footnote 5). If the foreign affiliate does not have sufficient exempt surplus or taxable surplus (footnote 6) in respect of the corporation, subsection 5901(1) of the Regulations will deem the dividend to have been paid out of the foreign affiliate's pre-acquisition surplus, and the corporation will be entitled to a deduction under paragraph 113(1)(d) of the Act for the amount of the dividend. Under subsection 92(2) and paragraph 53(2)(b) of the Act, the dividend will reduce the adjusted cost base to the corporation of its shares in the foreign affiliate. If the adjusted cost base becomes negative as a result, the negative amount will be deemed by subsection 40(3) of the Act to be a capital gain to the corporation. On the other hand, if the dividend is paid from exempt surplus or taxable surplus, subsection 92(2), paragraph 53(2)(b) and subsection 40(3) will not apply, and the dividend will not be recharacterized as a capital gain.
Where the dividend is paid by one foreign affiliate to another foreign affiliate, section 90 and subsection 113(1) do not apply. The dividend will be deemed by subsection 5901(1) of the Regulations firstly to be paid out of the paying affiliate's exempt surplus or taxable surplus, and will be added to the receiving affiliate's exempt surplus and taxable surplus, respectively (footnote 7). If the paying affiliate (CCo in this case) does not have sufficient exempt surplus or taxable surplus, the dividend will be considered to be paid from CCo's pre-acquisition surplus. Subsection 92(2) and paragraph 53(2)(b) provide that pre-acquisition surplus dividends are deducted from the ACB of the shares, and subsection 40(3) will deem the receiving affiliate (BCo in this case) to have realized a capital gain from the disposition of the shares of CCo to the extent that the shares' ACB becomes negative.
If BCo is deemed by subsection 40(3) to have realized a capital gain from the disposition of the shares of CCo, Canco can elect under subsection 93(1) to deem any portion of the capital gain to be a dividend again. Section 5902 of the Regulations (footnote 8) would then apply to determine the character of the dividend for the purpose of computing BCo's surplus balances.
If the shares of CCo are excluded property of BCo, subsection 93(1.1) will apply to deem Canco to have made an election under subsection 93(1) of the Act in an amount equal to the lesser of the capital gain otherwise determined and the net surplus in the foreign affiliates under CCo (footnote 9). Ms. Vu has stated that the shares of CCo are not excluded property of BCo. If that is correct, then the subsection 93(1) election would have to be made by Canco.
If Canco does not elect under 93(1), one-half of the deemed capital gain is included in BCo's foreign accrual property income ("FAPI") under variable B of that definition in subsection 95(1) of the Act, since Ms. Vu has determined that the shares of CCo are not excluded property to BCo.
Ms. Vu's primary position is to recharacterize the dividends paid to BCo by CCo as proceeds of disposition from the sale by BCo of its shares in CCo to an arm's length party. Since subsection 55(2) does not apply in this case, the CRA would need to use section 245 of the Act (the "GAAR"). Such approach may make sense if the taxpayer is able to access more exempt surplus by paying a dividend than it would by selling the shares.
For example, assume that CCo had exempt surplus of $200, and neither CCo nor any of the foreign affiliates below CCo had any other surplus or deficit balances. If CCo then paid a $100 dividend to BCo on the Class D shares, and $100 on the Class C shares, both out of exempt surplus, neither of the dividends would result in FAPI to Canco.
Assume instead that BCo had sold the Class D and Class C shares to NR1 for a gain of $200 and elected under subsection 93(1) to be deemed to have received a dividend instead of a capital gain. In this case, the amount deemed to have been paid out of exempt surplus on the Class D and C shares will depend on the dividend entitlements of the company's shares. That is, we would need to examine the rights associated with all the shares of CCo and determine how much would be received by BCo on the CCo shares that it sold if CCo had paid a dividend equal to its net surplus at that time.
Depending on the terms of the CCo shares, the amount deemed to have been paid out of exempt surplus may be limited by the operation of subsection 5902(1) and section 5901 of the Regulations, and may be less than $200. Since the example assumes that CCo had no other surplus accounts, the remainder of the subsection 93(1) deemed dividend would be out of CCo's pre-acquisition surplus and would be deducted pursuant to paragraph 92(2)(c) from the ACB of the shares sold by BCo. Therefore, the portion of the 93(1) deemed dividend that is out of the pre-acquisition surplus of CCo would not reduce the capital gain realized by BCo. Assuming that the shares of CCo were not excluded property of BCO, one-half of the difference between the $200 capital gain, and the amount deemed to have been paid out of exempt surplus would be included in the FAPI of Canco.
The key determination that needs to be made in this file is whether the dividends paid by CCo to BCo were from CCo's exempt surplus, taxable surplus or pre-acquisition surplus and whether the CCo shares were "excluded property" of BCo. As explained earlier, if there is insufficient exempt surplus or taxable surplus, the dividend will reduce the adjusted cost base of the shares of the foreign affiliate and may result in a taxable capital gain that would be included in FAPI, just as treating the dividend as proceeds to BCo from the disposition of the shares of CCo would. However, if the dividends were paid in order to avoid the FAPI that would otherwise be expected to arise on the sale of shares to an arm's length person as described in the example above, we suggest that you consider application of the GAAR.
We trust that we have been of some assistance.
Olli Laurikainen, CPA, CA
Income Tax Rulings Directorate
Legislative Policy & Regulatory Affairs Branch
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 This appears to have been paid by an entity on behalf of NR1 called XXXXXXXXXX. We do not have details about this entity. Also, we do not know if any consideration was given by CCo for the payment.
2 Ignoring the reference to subsections 112(2) and 138(6), which are not relevant for this analysis.
3 Other than a non-resident owned investment corporation or a corporation exempt under Part I of the Act.
4 Essentially, income earned or realized by the corporation after 1971 and before the safe-income determination time, as described in subsection 55(2).
5 Ignoring the changes enacted by Bill C-48 on June 26, 2013, which do not appear to apply in this case.
6 "Exempt surplus" and "taxable surplus" as defined in subsection 5907(1) of the Regulations. Hybrid surplus, as introduced by Bill-C48 does not appear to apply in this case.
7 See the definition of exempt surplus and taxable surplus in subsection 5907(1) of the Regulations.
8 We understand that Canco has not made an election under subsection 93(1) because in its view, CCo had sufficient exempt surplus, and no amount was paid out of CCo's pre-acquisition surplus. So no gain was realized.
9 See paragraph 5902(6)(b) of the Regulations.
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