14 March 2014 Internal T.I. 2013-0499141I7 - IRC 338(h)(10), "earnings" and safe income

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. What is the impact of a U.S. Internal Revenue Code 338(h)(10) election made by the purchaser and seller of a target foreign affiliate on the computation of the target's subsidiaries' earnings from an active business carried on by them subsequent to the target's acquisition by the purchaser?
2. Could the income earned or realized ("Intangible Property Safe Income") by the target's subsidiaries on the disposition of the intangible property of the subsidiaries, in a period after the purchaser acquired the target shares ("post-acquisition period"), that is in respect of gains that accrued on the intangible property of the subsidiaries, in a period before the purchaser acquired the target shares ("pre-acquisition period"), contribute to a gain that accrued on the shares of the purchaser in the post-acquisition period?

Position:

• 1(a). To the extent the actual expenditure made by the target with respect to a depreciable property or an intangible property has been fully depreciated or amortized, respectively, any further depreciation or amortization taken in excess of the actual expenditure, as the result of the Stepped-up Tax Basis resulting from the IRC 338(h)(10) election, may be added to the earnings amount pursuant to paragraph 5907(2)(b) of the Regulations.
• 1(b). To the extent an intangible property having no actual expenditure (i.e., goodwill) has been amortized, the amortization taken on the Stepped-up Tax Basis resulting from the IRC 338(h)(10) election should be added to the earnings amount pursuant to paragraph 5907(2)(f) of the Regulations (or, in the alternative, should not be considered in computing the earnings amount determined under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations).
• 1(c). To the extent non-depreciable property (i.e., intangibles including goodwill) was disposed of resulting in income or profit from an active business, the increase in tax basis, as the result of the IRC 338(h)(10) election, of intangible property disposed of other than goodwill may be added to the earnings amount pursuant to paragraph 5907(2)(b) of the Regulations and the Stepped-up Tax Basis (as the result of the IRC 338(h)(10) election) of the goodwill disposed of should be added to the earnings amount pursuant to paragraph 5907(2)(f) of the Regulations (or, in the alternative, should not be considered in computing the earnings amount determined under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations).
• 2. No, any capital gain realized on a subsequent disposition of the shares of the purchaser could not reasonably be considered to be attributable to the Intangible Property Safe Income for purposes of subsection 55(2) of the Act.

Reasons:

1. As noted in the text Canadian Taxation of Foreign Affiliates by K.J. Dancey, R.A. Friesen and D.Y. Timbrell: "In general, the types of income and expenditure included in the earnings amount are governed by the Canadian tax law, but the timing of their inclusion or deduction is governed by the foreign tax law."
2. The Intangible Property Safe Income should be allocated to the purchaser's ACB of the shares of target.

March 14, 2014

XXXXXXXXXX TSO HEADQUARTERS
Income Tax Rulings
Directorate
L Carruthers CPA, CA
Attention: XXXXXXXXXX 613 957-2113

2013-049914

Internal Revenue Code 338(h)(10) Election and the Computation of Exempt Earnings - XXXXXXXXXX ("Canco")

We are writing in response to your email dated July 25, 2013, and memorandum dated August 6, 2013, wherein you described the scenario (see detail of the facts described in Section III below) summarized below. We also acknowledge that your memorandum to our Directorate was further to your October 14, 2011 referral on this subject to what was then the Foreign Accrual Property Income and Foreign Affiliate Section of the International Tax Division of the International and Large Business Directorate of the Compliance Programs Branch (the "Original Referral").

On XXXXXXXXXX, an indirect wholly-owned foreign affiliate ("FA") of Canco acquired all of the issued and outstanding shares of another corporation ("US Holdco") resident in the United States for fair market value ("FMV") consideration. At the time of the acquisition, US Holdco's XXXXXXXXXX subsidiary wholly-owned corporations ("US-Opcos") had accrued gains inherent in their appreciated assets, such as capital property, depreciable property and intangible property including goodwill. The US-Opcos each carried on an active business in the United States.

For U.S. tax purposes, FA and the common parent of the selling consolidated group filed a joint election under paragraph 338(h)(10) of the Internal Revenue Code (the "IRC") with respect to FA's acquisition of the US Holdco shares. The effect of such election is described in detail in Section III below.

On XXXXXXXXXX, the US-Opcos disposed of their XXXXXXXXXX operations to an arm's-length purchaser. The assets of the US-Opcos' XXXXXXXXXX operations included depreciable property and intangible property (including goodwill).

On XXXXXXXXXX, Canco redeemed XXXXXXXXXX Canco common shares that were owned by a private corporation ("PrivateCo") (that did not deal at arm's length with Canco). The share redemption gave rise to a subsection 84(3) deemed dividend to PrivateCo. PrivateCo deducted such deemed dividend under subsection 112(1) of the Income Tax Act ("Act") in computing its income for the year in which the deemed dividend was received.

It is our understanding that Canco calculated its income earned or realized by including the income earned or realized by the US-Opcos under paragraph 55(5)(d) as it formerly read (which is applicable in the context of your query), which included the US-Opcos' exempt surplus computed pursuant to section 5907 of the Regulations to the Income Tax Act ("Regulations").

Also, it was alleged that a portion of the subsection 84(3) deemed dividend to PrivateCo was paid out of the income earned or realized by the US-Opcos that was attributable to PrivateCo's XXXXXXXXXX Canco common shares. Consequently, it was argued that such portion of the subsection 84(3) deemed dividend to PrivateCo should be exempt from the application of subsection 55(2).

You requested our views on two issues:

• First, whether Canco's determination of the US-Opcos' exempt earnings and exempt surplus under section 5907 of the Regulations and the income earned or realized by the US-Opcos under former paragraph 55(5)(d) was appropriate?
• Second, for purposes of subsection 55(2), whether the gains that accrued on PrivateCo's XXXXXXXXXX Canco common shares immediately before their redemption on XXXXXXXXXX, could reasonably be considered to be attributable to the income earned or realized by the US-Opcos that was determined under issue #1 as described above, or to something else? In other words, what part of the income earned or realized by the US-Opcos could reasonably be considered to contribute to the gains that accrued on PrivateCo's XXXXXXXXXX Canco common shares immediately before their redemption on XXXXXXXXXX?

Our response to your query will address the two issues as follows:

• I. Overview of subsection 55(2) of the Act
• II. Relevant year ends and stub periods
• III. The facts
• IV. Canco's and the TSO's views
• V. Our comments
  • First Issue
    • V.1 The US-Opcos' exempt earnings
    • V.1.1 Pre-acquisition accrued gains on intangible property vs. depreciable property
  • Second Issue
    • V.2 Reasonably be attributable to anything other than income earned or realized

I. Overview of subsection 55(2) of the Act

1. Subsection 55(2) is a capital gains stripping anti-avoidance provision that applies to an intercorporate dividend that, inter alia, reduces "the portion of the capital gain that, but for the dividend, would have been realized on a disposition at fair market value of any share of capital stock immediately before the dividend and that could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971 and before the safe-income determination time." Where subsection 55(2) applies, it will recharacterize an intercorporate dividend to be proceeds of disposition or a capital gain, as the case may be.

In other words, subsection 55(2) will apply to an intercorporate dividend paid on a share unless, inter alia, the dividend is paid out of the income earned or realized by any corporation after 1971 and before the safe-income determination time that is attributable or allocable to the share.

As subsection 55(2) refers to "income earned or realized by any corporation after 1971 and before the safe-income determination time," it permits a parent corporation to take into account the income earned or realized by a direct or indirect subsidiary corporation of the parent corporation in computing the income earned or realized by the parent corporation that is attributable to the shares of the parent corporation. (endnote 1) Consequently, in your case, for purposes of subsection 55(2), in computing the income earned or realized by Canco that was attributable to PrivateCo's XXXXXXXXXX Canco common shares, income earned or realized by the US-Opcos is relevant.

For purposes of subsection 55(2), the period of time ("holding period") (endnote 2) that is relevant to the calculation of "the income earned or realized" by a corporation in relation to a particular share of the corporation, in general, will commence on the later of January 1, 1972 and the date of acquisition of that share, and will end at "the safe-income determination time," which is defined by subsection 55(1) to mean the time that is the earlier of:

(a) the time that is immediately after the earliest disposition or increase in interest described in any of subparagraphs (3)(a)(i) to (v) that resulted from the transaction, event or series, and

(b) the time that is immediately before the earliest time that a dividend is paid as part of the transaction, event or series.

Furthermore, the holding period can contain two stub periods:

(i) the period from the date of acquisition of the share (or 1971 if the share was acquired prior to that time) to the first year-end of the corporation occurring after the acquisition of the share; and

(ii) the period between the date of the last year-end subsequent to the acquisition of the share and the safe income determination time.

2. Paragraphs 55(5)(b), (c) and (d) define "income earned or realized by a corporation" for purposes of subsection 55(2). "Income earned or realized" (referred to as "safe income") with respect to a share of a corporation refers to the income earned or realized by any corporation during the holding period of a particular share of a corporation that can reasonably be considered to be allocable to that share in the particular circumstances.

Paragraph 55(5)(d) deals with income earned or realized by a foreign affiliate of a particular corporation. Former paragraph 55(5)(d) provided that the income earned or realized by a foreign affiliate would equal the amount that would be deductible under paragraph 113(1)(a) of the Act (a deduction for a dividend paid from exempt surplus) and paragraph 113(1)(b) (a deduction in respect of underlying foreign tax for a dividend paid from taxable surplus) on the assumption that the particular corporation (i) owned all of the shares of the foreign affiliate, (ii) had disposed of the shares for proceeds equal to their FMV and (iii) had made an election under subsection 93(1) in respect of the full amount of the proceeds of disposition described in (ii).

3. For purposes of subsection 55(2), in order to contribute to a gain on a share, income earned or realized must be on hand immediately before a dividend is paid. Consequently, "safe income on hand" at a particular time with respect to a share of a corporation held by a particular shareholder refers to the portion of the income earned or realized by any corporation (i.e., safe income) during the relevant holding period that could reasonably be considered to contribute to the capital gain that would be realized on a disposition at FMV of the share at that time. For example, amounts that have been distributed as a dividend or amounts being laid out or set aside to pay income taxes, or other amounts not deductible for tax purposes, will reduce the corporation's safe income on hand, as these amounts will not contribute to the gain inherent in the corporation's shares. (endnote 3)

II. Relevant year ends and stub periods

4. Throughout the Original Referral you made reference to the US-Opcos' exempt surplus available for distribution to Canco at XXXXXXXXXX. Moreover, the documents you provided entitled XXXXXXXXXX appear to be Canco's calculation of the net earnings of each of the US-Opcos for the years ended XXXXXXXXXX.

In our view, for purposes of subsection 55(2), the holding period that was relevant for computing the income earned or realized by Canco that was attributable to PrivateCo's XXXXXXXXXX Canco common shares, would commence on the later of January 1, 1972 and the date of the acquisition by PrivateCo of the XXXXXXXXXX Canco common shares and would end on the safe-income determination time.

In your case, the safe-income determination time that is applicable to PrivateCo's XXXXXXXXXX Canco common shares, would be the time immediately before the redemption of PrivateCo's XXXXXXXXXX Canco common shares on XXXXXXXXXX, which resulted in the subsection 84(3) deemed dividend to PrivateCo.

In addition, for purposes of subsection 55(2), income earned or realized by Canco during the holding period of PrivateCo's XXXXXXXXXX Canco common shares would include income earned or realized by the US-Opcos that could reasonably be considered to be allocable to PrivateCo's XXXXXXXXXX Canco common shares.

In your case, the relevant period of time for computing the income earned or realized by the US-Opcos would commence from the date of the acquisition by FA of the US Holdco shares (i.e., on XXXXXXXXXX) to the safe-income determination time that is applicable to PrivateCo's XXXXXXXXXX Canco common shares (i.e., immediately before the redemption of PrivateCo's XXXXXXXXXX Canco common shares on XXXXXXXXXX).

Furthermore, the relevant period of time (for computing the income earned or realized by the US-Opcos) contained two-stub periods:

(a) the first stub-period from the date of the acquisition by FA of the US Holdco shares (i.e., XXXXXXXXXX) to the first year-end of the US-Opcos occurring after FA's acquisition of the US Holdco shares (i.e., XXXXXXXXXX); and

(b) the second stub-period between the date of the last year-end subsequent to FA's acquisition of the US Holdco shares (i.e., XXXXXXXXXX) and the safe income determination time that is applicable to PrivateCo's XXXXXXXXXX Canco common shares (i.e., on XXXXXXXXXX).

Consequently, for purposes of subsection 55(2), income earned or realized by the US-Opcos (i) prior to FA's acquisition of the US Holdco shares; and (ii) after the safe income determination time, would not be included in the computation of the income earned or realized by Canco that was attributable to PrivateCo's XXXXXXXXXX Canco common shares during the holding period.

The reason for not including the income earned or realized by the US-Opcos prior to FA's acquisition of the US Holdco shares is because, for purposes of subsection 55(2), such income earned or realized did not contribute to any gain that accrued on the US Holdco shares in the period after FA's acquisition of the US Holdco shares because it was reflected in the purchase price and, therefore, the adjusted cost base ("ACB"), of the US Holdco shares that FA acquired on XXXXXXXXXX. (endnote 4)

5. Furthermore, the computation of the safe income earned or realized by the US-Opcos arising in the two stub periods should be reasonable in the circumstances and should be made on a basis consistent with computation methods used in other periods within the holding period of PrivateCo's XXXXXXXXXX Canco common shares. (endnote 5)

III. The facts

Our understanding of the relevant facts, which are further described in the Original Referral, is as follows:

6. On XXXXXXXXXX a U.S. resident foreign affiliate ("FA") of Canco acquired all the shares of another corporation resident in the U.S. ("US Holdco") for approximately USD $XXXXXXXXXX. US Holdco, which held all the shares of the XXXXXXXXXX US-Opcos, dealt at arm's length with FA immediately before the acquisition. US Holdco and the US-Opcos were members of a selling consolidated group.

7. For U.S. income tax purposes, FA and the common parent of the selling consolidated group filed a joint election under paragraph 338(h)(10) of the Internal Revenue Code (the "IRC") with respect to the share purchase which resulted in the following for the purposes of the IRC:

a. no gain or loss was recognized by the selling consolidated group on its sale of the US Holdco shares;

b. the US-Opcos recognized a gain as if they had sold all their assets at FMV. The tax on this gain was paid by the selling consolidated group; and

c. the US-Opcos were treated as having purchased all of their assets for an amount equal to the purchase price of the shares of US Holdco. FA's total purchase price for the US Holdco shares was first apportioned to the XXXXXXXXXX US-Opcos and then further allocated to the various classes of assets owned by each US-Opco in proportion to their relative FMV. According to the Form 8023s filed with the IRC 338(h)(10) election, the classes of assets owned by the US-Opcos and the allocation of the purchase price was as follows:

8. The IRC 338(h)(10) election had the effect of increasing the U.S. tax basis of the US-Opcos' assets, above the actual expenditures made by the US-Opcos to acquire them, up to their FMV (i.e., up to a "Stepped-up Tax Basis" equal to the purchase price allocation shown above).

9. On XXXXXXXXXX, Canco disposed of the XXXXXXXXXX operations of the US-Opcos for approximately USD $XXXXXXXXXX.  The sale was carried out as an asset sale by the US-Opcos (i.e., a subset of the US-Opcos' assets listed above were disposed of). Approximately USD $XXXXXXXXXX of the selling price was allocated to the disposition of intangibles including goodwill (i.e., a subset of the Class VI and VII property listed above). For U.S. income tax purposes, the US-Opcos' gain on the disposition of these assets (including goodwill which had an expenditure amount of XXXXXXXXXX) was computed as the difference between the selling price and the Stepped-up Tax Basis.  This resulted in a small gain being reported for U.S. tax purposes. More specifically, a small capital gain with respect to the sale of depreciable assets and a small amount of active business income with respect to the sale of intangibles including goodwill.

10. As noted in the documents you provided entitled XXXXXXXXXX, Canco made the following adjustments (endnote 6) to the US-Opcos' U.S. taxable income for the years ended XXXXXXXXXX in order to arrive at the earnings of the US-Opcos pursuant to section 5907 of the Income Tax Regulations (the "Regulations") (i.e., as adjusted by subsection 5907(2) of the Regulations).

11. The above noted adjustments represent the following:

• $XXXXXXXXXX The sum total of the US-Opcos' annual excess depreciation taken, in computing income or profit from an active business, on depreciable property as the result of the IRC 338(h)(10) election for the years ended XXXXXXXXXX (i.e. the total annual depreciation taken on the amount by which the Stepped-up Tax Basis was greater than the actual expenditure incurred to acquire the asset).
• $XXXXXXXXXX The sum total of the US-Opcos' annual excess annual amortization taken, in computing income or profit from an active business, on intangible property (including goodwill) as the result of the IRC 338(h)(10) election for the years ended XXXXXXXXXX (i.e. the total annual amortization taken on the amount by which the Stepped-up Tax Basis was greater than the actual expenditure incurred to acquire the asset (which for goodwill was XXXXXXXXXX)).
• $XXXXXXXXXX Excess tax basis, as the result of the IRC 338(h)(10) election, deducted in computing income or profit from an active business in respect of the XXXXXXXXXX sale of intangible property (including goodwill) (i.e. the amount by which the Stepped-up Tax Basis was greater than the actual expenditure incurred to acquire the intangible property disposed of (which for goodwill was XXXXXXXXXX)).
• $XXXXXXXXXX Gain on the XXXXXXXXXX, sale of depreciable capital property.

12. It is our further understanding that your query relates to the first three amounts described in paragraph 11 above.

IV. Canco's and the TSO's views

Enclosed with your August 6, 2013 memorandum were the documents noted below which contained the following views:

Canco's views

13. A letter from Canco dated XXXXXXXXXX, to the XXXXXXXXXX Tax Services Office (the "TSO"), in support of their view that because the IRC 338(h)(10) election resulted in a Stepped-up Tax Basis of the US-Opcos' capital property, intangibles and goodwill, in calculating the US-Opcos' income or profit in accordance with U.S. income tax law, excessive deductions had been claimed with respect to tax depreciation/amortization as well as cost base on the disposition of certain intangibles. Canco considers the excessive deductions to be notional or phantom amounts in the sense that they represent U.S. tax deductions in respect of amounts that were not actually expended by the US-Opcos. Canco believes it is appropriate to back out such notional or phantom amounts under paragraph 5907(2)(b) of the Regulations or, alternatively, that such notional amounts should not be considered in the earnings amount determined under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations in the first instance.

The TSO's views

14. In the Original Referral you expressed the view that the excessive deductions are not notional nor do they fictitiously reduce the amount available for the payment of dividends out of the exempt surplus of the US-Opcos and, therefore, their reversal in computing the earnings amount of the US-Opcos is not warranted. You also indicated that, in your view, the excessive deductions do not represent an amount deducted in excess of the expenditure made by the US-Opcos and, therefore, an addition under paragraph 5907(2)(b) of the Regulations to the earnings amount determined under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations is unwarranted. You further indicated that in your view, this is particularly so in the case of goodwill and intangible property, however, it may be possible to argue otherwise in the case of capital property such as depreciable property.

The International and Large Business Directorate's (ILBD's) Views

15. In the response from the ILBD dated October 30, 2012, the ILBD generally concluded that they were in agreement with Canco with respect to paragraph 5907(2)(b) of the Regulations being applicable to add back the "excessive" deductions claimed for the purposes of the IRC as a result of the Stepped-up Tax Basis resulting from the IRC 338(h)(10) election, in arriving at the adjusted earnings amount under subsection 5907(2) of the Regulations. The ILBD also noted that alternatively, our Directorate has opined in the past that "notional" income or deductions are simply excluded from the earnings amount determined under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations.

16. In its response to your follow-up email, the ILBD advised you on June 6, 2013, that their views continued to be as expressed in their memorandum dated October 30, 2012. The ILBD also indicated that, in respect of the disposition of intangible property, the starting point is the income as determined under the foreign tax law, not as determined under the provisions of the Act. However, in their view paragraph 5907(2)(b) or 5907(2)(f) of the Regulations would, in the present circumstances, apply to adjust the amount to more properly reflect the earnings that would have resulted had the IRC 338(h)(10) election not taken place.

V. Our comments

First Issue

V.1 The US-Opcos' exempt earnings

17. We are in general agreement with Canco's and the ILBD's view that the U.S. income tax effects of the IRC 338(h)(10) election should be adjusted for in the calculation of the US-Opcos' exempt earnings. More specifically, it is our view that:

• To the extent a depreciable property or an intangible property has been fully depreciated or amortized, respectively, the depreciation or amortization taken in excess of the actual expenditure as the result of the Stepped-up Tax Basis resulting from the IRC 338(h)(10) election, should be added to the earnings amount pursuant to paragraph 5907(2)(b) of the Regulations.
• To the extent an intangible property having no actual expenditure (i.e., goodwill) has been amortized, the amortization taken on the Stepped-up Tax Basis resulting from the IRC 338(h)(10) election should be added to the earnings amount pursuant to paragraph 5907(2)(f) of the Regulations (or in the alternative should not be considered in computing the earnings amount determined under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations).
• To the extent non-depreciable property (i.e., intangible property including goodwill) was disposed of resulting in income or profit from an active business, the increase in tax basis as the result of the IRC 338(h)(10) election (net of any accumulated amortization taken thereon under the IRC), of intangible property disposed of other than goodwill may be added to the earnings amount pursuant to paragraph 5907(2)(b) of the Regulations and the Stepped-up Tax Basis (as the result of the IRC 338(h)(10) election (net of any accumulated amortization taken thereon under the IRC)), of the goodwill disposed of should be added to the earnings amount pursuant to paragraph 5907(2)(f) of the Regulations (or, in the alternative, should not be considered in computing the earnings amount determined under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations).

18. We are unable, however, to conclude whether the actual adjustments made by Canco are correct because we lack the information to do so.

$XXXXXXXXXX tax deductions in excess of actual expenditure – depreciation of fixed assets:

19. Pursuant to paragraph 5907(2)(b) of the Regulations, an addition to the amount determined under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations is allowed in a taxation year if an amount deducted in respect of an expenditure by the affiliate exceeds the amount of the expenditure less the aggregate of all amounts previously deducted with respect to the expenditure. In this respect, it is not the annual increase in depreciation taken as the result of the Stepped-up Tax Basis being greater than the actual expenditure that is added back to the earnings amount but, rather, once the total depreciation claimed exceeds the actual expenditure, any additional depreciation claimed as the result of the Stepped-up Tax Basis resulting from the IRC 338(h)(10) election may be added in computing the earning amount.

20. The information we were given did not contain the amount of the US-Opcos' actual expenditures with respect to their depreciable property nor did it specify whether the actual expenditures had been fully depreciated. Therefore, we are unable to confirm what portion, if any, of the $XXXXXXXXXX is the amount of depreciation deducted with respect to the US-Opcos' depreciable property in excess of their actual expenditures in respect of those properties.

21. In order to support the $XXXXXXXXXX add back to the earnings amount, we would recommend that you request that Canco establish that the actual expenditures with respect to the US-Opcos' depreciable property had been fully deducted and that $XXXXXXXXXX is the amount of depreciation taken that pertains to the period prior to the redemption of Canco's common shares on XXXXXXXXXX, in excess of the actual expenditures.

$XXXXXXXXXX tax deductions in excess of actual expenditure – amortization of intangibles:

22. Amortization taken with respect to intangible property other than goodwill is an amount deducted in respect of an "expenditure made" for the purpose of paragraph 5907(2)(b) of the Regulations and, therefore, would be treated in the same manner as depreciation with respect to depreciable property as described above.

23. Amortization taken with respect to goodwill for which there was no expenditure made by the US-Opcos would not, in our view, be in respect of an "expenditure made" and, therefore, could not result in an add back pursuant to paragraph 5907(2)(b) of the Regulations. However, such amortization would, in our view, result in the income or profit of the US-Opcos being understated and pursuant to paragraph 5907(2)(f) of the Regulations, any income or profit not otherwise required to be included in computing a US-Opco's earnings amount under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations may be added in computing its earnings amount. Therefore, in our view, the amortization taken with respect to goodwill on the Stepped-up Tax Basis resulting from the IRC 338(h)(10) election should be added to the earnings amount pursuant to paragraph 5907(2)(f) of the Regulations (or, in the alternative, should not be considered in computing the earnings amount determined under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations).

24. The information we were given did not contain the US-Opcos' actual expenditures with respect to their intangible property (other than goodwill which was XXXXXXXXXX) nor did it specify whether the actual expenditures had been fully depreciated. Therefore, we are unable to confirm what portion, if any, of the $XXXXXXXXXX is the amount of amortization deducted on account of the US-Opcos' intangible property other than goodwill in excess of their actual expenditures in respect of those properties and what portion is on account of their goodwill.

25. In order to support the $XXXXXXXXXX add back to the earnings amount, we would recommend that you request that Canco establish what portion of that amount is on account of intangible property other than goodwill and what portion is on account of goodwill. Moreover, with respect to the portion on account of intangible property other than goodwill, the taxpayer should establish whether the actual expenditures with respect to that intangible property had been fully deducted and if that portion of the $XXXXXXXXXX is the amount of amortization taken in excess of the actual expenditures that pertains to the period prior to the redemption of Canco's common shares on XXXXXXXXXX.

$XXXXXXXXXX tax deductions in excess of actual expenditure – sale of intangibles:

26. The increase in tax basis of the US-Opcos' intangible property (including goodwill) as the result of the IRC 338(h)(10) election would, in our view, result in the earnings from the XXXXXXXXXX sale of that property by the US-Opcos being understated. Therefore, in our view, the increase in tax basis of the intangibles other than goodwill disposed of (net of any amortization that was added back to earnings in a previous period) may be added to the earnings amount pursuant to paragraph 5907(2)(b) of the Regulations and the unamortized tax basis of the goodwill disposed of should be added to the earnings amount pursuant to paragraph 5907(2)(f) of the Regulations (or, in the alternative, should not be considered in computing the earnings amount determined under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations).

27. The information we were given did not contain the US-Opcos' actual expenditures with respect to their intangible property (other than goodwill which was XXXXXXXXXX), therefore, we are unable to confirm whether $XXXXXXXXXX is the increase in tax basis of the US-Opcos' intangible property as the result of the IRC 338(h)(10) election (net of amortization that was added back to earnings in a previous period).

28. In order to support the $XXXXXXXXXX add back to the earnings amount, we would recommend that you request that Canco establish what the U.S. adjusted basis (actual expenditure less amortization) of the intangible property disposed of was prior to FA's acquisition of US Holdco. Canco should also establish what the Stepped-up Tax Basis resulting from the IRC 338(h)(10) election was of the goodwill and the other intangible property disposed of, and what amount of amortization, if any, had been taken by the US-Opcos with respect to that goodwill and that other intangible property, following FA's acquisition of US Holdco but prior to the disposition those properties.

29. Moreover, Canco should establish that any adjustment made to the earnings amount as the result of this $XXXXXXXXXX would not duplicate the effect of any adjustment made to the earnings amount as the result of the $XXXXXXXXXX discussed above. For example, to the extent a US-Opco amortized the Stepped-up Tax Basis of its goodwill prior to the XXXXXXXXXX disposition of that goodwill and that amortization was added to the earnings amount pursuant to paragraph 5907(2)(f) of the Regulations (or, in the alternative, was not considered in the earnings amount determined under subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations) as discussed above, that same amount should not be added (or not considered) a second time as the result of the US-Opco's disposition of that goodwill.

General comments

30. Although we are unable to conclude whether the actual adjustments made by Canco are correct because we lack the information to do so as discussed above, in our view, adjusting the US-Opcos' earnings amount as discussed above is appropriate as it would result in the calculation of their exempt earnings being similar to what would have been calculated if no IRC 338(h)(10) election had been made. More specifically, if no IRC 338(h)(10) election had been made, the income or profit from the active business of the US-Opcos computed in accordance with subparagraph (a)(i) of the definition of "earnings" in subsection 5907(1) of the Regulations would have reflected:

• depreciation and amortization only to the extent of the original cost of the property (i.e., only to the extent of the actual expenditure made by the US-Opcos to acquire the property, not the Stepped-up Tax Basis); and
• gains that had accrued prior to the US-Opcos becoming foreign affiliates of Canco on the intangible property (including goodwill) disposed of by the US-Opcos on XXXXXXXXXX (i.e., not the reduced gain as the result of the Stepped-up Tax Basis).

V.1.1 Pre-acquisition accrued gains on intangible property vs. capital property

31. Further to the last bullet point above, we would like to specifically address your follow-up query to the ILBD regarding the different treatments provided for under the Act and the Regulations when determining the exempt earnings of the US-Opcos from the disposition of property they held prior to becoming foreign affiliates of Canco. You queried whether there was any legislative support for the ILBD's view that the exempt earnings of the US-Opcos should include gains that had accrued prior to the US-Opcos becoming foreign affiliates of Canco on the intangible property (including goodwill) disposed of by the US-Opcos on XXXXXXXXXX (i.e., the $XXXXXXXXXX discussed above), while it would not include any such accrued gains on capital property disposed of. The legislative support comes from subparagraph 95(2)(f)(i) and paragraph 95(2)(f.1) of the Act; paragraph (a) and subparagraph (d)(i) of the definition of "exempt earnings" in subsection 5907(1) of the Regulations and subsection 5907(5) of the Regulations.

32. More specifically, the capital gains of a US-Opco are considered in the calculation of its "exempt earnings" pursuant to paragraph (a) of the definition of that term in subsection 5907(1) of the Regulations and, pursuant to subparagraph 95(2)(f)(i) of the Act, paragraph 95(2)(f.1) of the Act and subsection 5907(5) of the Regulations, for the purpose of computing the surplus accounts capital gains of a US-Opco are to be calculated as if the US-Opco were a resident of Canada and are not to include any gains that had accrued prior to the US-Opco becoming a foreign affiliate of Canco. Whereas, when the disposition of intangible property (including goodwill) results in income or profit from an active business rather than a capital gain, that income or profit is considered in the calculation of a US-Opco's "exempt earnings" pursuant to subparagraph (d)(i) of the definition of that term in subsection 5907(1) of the Regulations which refers to the "net earnings" of the affiliate which itself refers to the "earnings" of the affiliate. Each of these terms (net earnings and earnings) are defined in subsection 5907(1) of the Regulations and neither definition contains a carve-out rule for gains on account of income that accrued prior to the US-Opcos becoming foreign affiliates of Canco. We acknowledge that this results in gains that had accrued prior to the US-Opcos becoming foreign affiliates of Canco on their intangible property being treated differently than such accrued gains on their capital property, however, if the legislators had intended for income or profit from an active business to be computed in a manner similar to that of capital gains as provided by paragraph 95(2)(f.1) of the Act, they would have legislated such a rule.

Second Issue

V.2 Reasonably be considered to be attributable to anything other than income earned or realized

33. As discussed in paragraphs 26 -– 29 above, included in the computation of the income earned or realized by the US-Opcos during the relevant period of time was the income earned or realized ("Intangible Property Safe Income") by the US-Opcos, under former paragraph 55(5)(d), on the disposition of the intangible properties (including goodwill) of the West coast operations on XXXXXXXXXX (i.e., in a period after FA acquired US Holdco shares on XXXXXXXXXX, referred to as "Post-acquisition period"), that was in respect of gains that accrued on those intangible properties, in the period before FA acquired the US Holdco shares (referred to as "Pre-acquisition period"). The Intangible Property Safe Income was reflected in the purchase price and, therefore, the ACB, of the US Holdco shares that FA acquired on XXXXXXXXXX.

The issue, therefore, becomes whether, in interpreting the phrase "reasonably be considered to be attributable" in subsection 55(2), the gains that accrued on FA's US Holdco shares in the Post-acquisition period and, therefore, the gains that accrued on PrivateCo's XXXXXXXXXX Canco common shares immediately before their redemption on XXXXXXXXXX, could reasonably be considered to be attributable to the Intangible Property Safe Income or to something else. In other words, for purposes of subsection 55(2), could the Intangible Property Safe Income reasonably be considered to contribute to or be allocable: (a) to the gains that accrued on FA's US Holdco shares in the Post-acquisition period and, therefore, to the gains that accrued on PrivateCo's XXXXXXXXXX Canco common shares immediately before their redemption, or (b) to something else, i.e., to FA's ACB of the US Holdco shares.

34. In our view, allocating the Intangible Property Safe Income to the gains that accrued on FA's US Holdco shares in the Post-acquisition period would offend the object and spirit of subsection 55(2) because such an allocation would result in "capital gains stripping" which is what subsection 55(2) is designed to prevent. This is because such an allocation would give rise to a "double counting" of FA's ACB of the US Holdco shares as safe income which could then be allocated to a gain that accrued on the US Holdco shares in the Post-acquisition period and that is attributable to the unrealized appreciation in the value of the underlying assets of the US-Opcos.

35. In our view, allocating the Intangible Property Safe Income to FA's ACB of the US Holdco shares would avoid the double counting problem as described above.

In addition, such safe income allocation would not result in double taxation. This is because the Intangible Property Safe Income amount could be distributed by FA to Canco by way of a return of capital.

36. In conclusion, under the circumstances, for purposes of subsection 55(2), the Intangible Property Safe Income did not contribute to the gains that accrued on FA's US Holdco shares in the Post-acquisition period and, therefore, did not contribute to the gains that accrued on PrivateCo's XXXXXXXXXX Canco common shares immediately before their redemption on XXXXXXXXXX.

37. We note that depreciable properties were included in the disposition of the US-Opcos' West coast operations on XXXXXXXXXX (see paragraph 10 above). Consequently, to the extent that the recaptured depreciation realized on the disposition of the depreciable properties was included in the computation of the income earned or realized by the US-Opcos (referred to as "Recaptured Depreciation Safe Income") under former paragraph 55(5)(d), and was reflected in FA's ACB of the US Holdco shares, for the same reasons as described above, the Recaptured Depreciation Safe Income did not contribute to the gains that accrued on FA's US Holdco shares in the Post-acquisition period and, therefore, did not contribute to the gains that accrued on PrivateCo's XXXXXXXXXX Canco common shares immediately before their redemption.

For your information a copy of this memorandum may be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. Such a severed copy would also be distributed to the commercial tax publishers for inclusion in their databases. The severing process would 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 could be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Ms. Celine Charbonneau at (613) 952-1361. A copy would be sent to you for delivery to the client.

Olli Laurikainen CPA, CA
for Director
International Section II
International Division
Income Tax Rulings Directorate

ENDNOTES

1 See Trico Industries Limited v. MNR, 94 DTC 1740 (TCC). The Tax Court of Canada in Trico Industries stated that the word "any" in subsection 55(2) permitted the consolidation of safe income within a corporate group.

2 See Robert J.L. Read, "Section 55: A Review of Current Issues," in Report of Proceedings of the Fortieth Tax Conference, 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989), 18:1-28 at 18:5.

3 We discussed the "safe income" and the "safe income on hand" concepts at the 1993 CTF Conference (the CRA Round Table Question 12) (see document #9328340) as follows:

"Safe income" with respect to a share of a corporation is equivalent to the "income earned or realized" by the corporation during the relevant holding period. The expression "income earned or realized" by a corporation is deemed to be the amount determined pursuant to paragraph 55(5)(b), (c), or (d) of the Act, as the case may be. Consequently, safe income with respect to a share of a corporation refers to the corporation's net income, as determined for purposes of the Act, as adjusted by paragraphs 55(5)(b), (c) or (d), as the case may be, that is attributable to that particular share during the relevant holding period.

In order to contribute to a gain on a share, income earned or realized must be on hand. Consequently, "safe income on hand" with respect to a share of a corporation refers to the portion of the income earned or realized by the corporation during the relevant period of time that could reasonably be considered to contribute to the capital gain that would be realized on a disposition at fair market value of the share at that time.

Since "safe income" is computed on the basis of net income as determined for purposes of the Act, amounts that have been distributed as a dividend or amounts laid out or set aside to pay income taxes, charitable donations, or other amounts not currently deductible for tax purposes will not generally reduce a corporation's safe income. However, since such amounts will not contribute to the gain inherent in the corporation's shares, they will reduce the corporation's safe income on hand. In addition, certain contingent liabilities, accrued interest on income debentures, and certain accounting provisions that are not currently deductible for income tax purposes are other examples of items that will not affect a corporation's safe income but will normally reduce its safe income on hand. A liability for dividends payable will not affect the calculation of safe income but will reduce the safe income on hand attributable to other classes of shares of the corporation.

4 See John R. Robertson article "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55", 1981 CTF Conference Report 81 to 105 at page 84.

5 See Read, supra note ii, at 18:6.

6 We would note that the Original Referral refers to $XXXXXXXXXX and $XXXXXXXXXX being added to the earnings amount as tax deductions in excess of actual expenditure re fixed assets and intangibles, respectively. However the document entitled XXXXXXXXXX includes the data as represented in the body of this memorandum.