Principal Issues: a) When a foreign affiliate receives the proceeds of an exempt life insurance policy, which surplus account of the foreign affiliate will such proceeds go into?
b) Assuming the foreign affiliate does not otherwise have an exempt, hybrid, or taxable surplus balance, if the proceeds of the life insurance policy are distributed by way of dividend, will the full amount of the dividend result in a capital gain to the Canadian parent?
Position: a) Pre-acquisition surplus pool.
Reasons: a) Since the proceeds received by the foreign affiliate are exempt from taxation in the foreign country and the facts do not otherwise indicate that the insurance policy was related to the active business of the foreign affiliate, such proceeds are not included in the earnings from an active business of the foreign affiliate. Moreover, since no capital gain or foreign accrual property income arises in respect of such life insurance proceeds, there is no adjustment to the foreign affiliate's surplus balances.
b) Since the Canadian parent's adjusted cost base in the shares of the foreign affiliate is nominal, a capital gain will result by virtue of paragraph 113(1)(d), subsection 92(2) and subsection 40(3) of the Act equal to the amount of dividend paid by the foreign affiliate to the parent (less foreign withholding tax, if any) less the nominal ACB of the shares of the foreign affiliate.