3 December 2019 CTF Roundtable Q. 3, 2019-0824391C6 - Safe Income Determination Time

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: Which currency exchange rate should be used to calculate income earned or realized under paragraph 55(5)(d) when the rate that prevails immediately before the safe income determination time is different from the rate that prevails immediately before the payment of the dividend?

Position: The operation of paragraph 55(5)(d) requires the use of the rate that prevails immediately before the safe income determination time.

Reasons: See document.

2019 CTF Annual Conference

CRA Roundtable

Question 3: Safe Income Determination Time

Facts

1. Can Holdco owns all of the shares of Can Opco which owns all of the shares of US FA.

2. The ACB of all shares is nominal.

3. US FA has exempt surplus of US$100 (represented by cash) which was generated before the safe-income determination time. The FMV of the shares of US FA is US$100. Assume, for illustration purposes, that this cash represents the only asset of Can Opco and US FA.

4. The Canada-US foreign exchange rate at the safe-income determination time was 1:1.

5. A safe income dividend is paid by Can Opco to Can Holdco subsequent to the safe-income determination time.

The definition of safe-income determination time for a transaction or event or a series of transactions or events in subsection 55(1) refers to 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 55(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.

Paragraph 55(5)(d) states that the income earned or realized by a corporation for a period ending at a time where the corporation was a foreign affiliate of another corporation is deemed to be the lesser of:

(i) the amount that would be the tax-free surplus balance of the corporation in respect of the other corporation at that time, and

(ii) the fair market value at that time of all the issued and outstanding shares of the corporation.

If the Canada-US foreign exchange rate changes after the safe-income determination time such that the Canadian dollar equivalent of the US$100 cash is, say, C$90, the FMV of the shares of US FA and Can Opco should be limited to C$90 and the safe income should be limited to that same amount.

If, instead, the Canada-US foreign exchange rate changes after the safe-income determination time such that the Canadian dollar equivalent of the US$100 cash is, say, C$110, the FMV of the shares of US FA and Can Opco should be C$110.

It seems appropriate that the safe income should be $110 using the exchange rate at the time of the dividend payment.

Does the CRA agree that the exchange rate at the time of the dividend payment should be used rather than the exchange rate at the safe-income determination time?

CRA Response

Under subsection 55(2.1), a taxable dividend could be subject to the application of subsection 55(2) if the amount of the dividend exceeds the amount of the income earned or realized by any corporation after 1971 and before the safe income determination time that could reasonably be considered to contribute to the capital gain that could be realized on a disposition of the shares at fair market value immediately before the dividend.

The word “any” in the phrase “income earned or realized by any corporation” permits the consolidation of safe income within a corporate group. Paragraph 55(5)(d) provides rules for calculating the income earned or realized by a foreign affiliate that can be added to the income earned or realized of its Canadian parent which, in the above example, is Can Opco.

The test, under subsection 55(2.1), is whether the dividend paid by Can Opco exceeds the amount of income earned or realized of Can Opco before the safe income determination time that can reasonably be considered to contribute to the capital gain that could be realized on a disposition of the shares of Can Opco at fair market value immediately before the dividend.

Under the Canadian jurisprudence, “fair market value” means “the value obtained in a normal market, that is, a market which is not disturbed by unusual economic factors and where vendors, ready but not too anxious to sell, meet with purchasers ready and able to purchase (footnote 1).” As such, the fair market value at any time of a property denominated in foreign currency would normally be equal to the value of such property expressed in Canadian currency at the conversion rate that prevails at that time.

The discussion below uses the following assumptions, based on the hypothetical facts expressed above:

• Can Opco owns 100% of the shares of US FA and has no other assets
• The currency maintained by US FA for reporting purposes is the US$
• The ACB of the shares of Can Opco to Can Holdco is nil
• The ACB of the shares of US FA to Can Opco is nil
• The time (“Time 1”), that is immediately before the safe income determination time as determined under subsection 55(1) occurs before the time (“Time 2”) that is immediately before the payment of dividend from Can Opco to Can Holdco
• At both times, i.e., at Time 1 and at Time 2:

o US FA has US$100 of cash and no other assets,
o The “tax-free surplus balance” of US FA as referred to in subparagraph 55(5)(d)(i) is US$100, and
o There is no fluctuation in any amount between Time 1 and Time 2

• In Scenario 1, the exchange rate of the US dollar is US $1 = CDN $1 at Time 1 and US $1 = CDN $1.2 at Time 2.
• In Scenario 2, the exchange rate of the US dollar is US $1 = CDN $1.2 at Time 1 and US $1 = CDN $1 at Time 2.

Unless indicated otherwise, all currencies referred to below are expressed in Canadian dollars.

Scenario 1

At Time 2, Can Opco pays a dividend of $120 to Can Holdco.

If US FA pays a dividend of US $100 to Can Opco at Time 2, Can Opco would include $120 in its income based on the application of subsection 261(2).

If the FMV of the shares of Can Opco is equal to $120 at Time 2, there is a reduction of $120 of the capital gain on the shares of Can Opco that could have been realized on a disposition at FMV of the shares of Can Opco at that time as a result of the payment of the dividend.

The question is whether the dividend of $120 exceeds the amount of income earned or realized by Can Opco at Time 1, that could reasonably be considered to contribute to the capital gain of $120.

In the calculation of the income earned or realized by Can Opco at Time 1, there can be added, under paragraph 55(5)(d), an amount equal to the lesser of:

• The tax-free surplus balance of US FA at Time 1, and
• The FMV of the shares of US FA at Time 1

Provided that the tax-free surplus balance of US FA at Time 1 was US $100, the question is what amount would be included in the income earned or realized by US FA under subparagraph 55(5)(d)(i). Former paragraph 55(5)(d) was based on a conceptual election under subsection 93(1) that deems a dividend to be paid. The current version of paragraph 55(5)(d) excludes the application of Regulation 5905(5.6) which refers to the application of subparagraph 5902(1)(a)(i) to an election under subsection 93(1). Even where there is no deemed election under subsection 93(1), the scheme of paragraph 55(5)(d) indicates that the exchange rate to be used should be the rate that prevails at Time 1 as if that time was the time on which the “particular amount arose” under paragraph 261(2)(b). At that time, since the exchange rate was US $1 = CDN $1, the amount determined under subparagraph 55(5)(d)(i) would be $100. Even if it is argued that the exchange rate to be used for the amount under subparagraph 55(5)(d)(i) is the rate at Time 2, it remains that the FMV of the shares of US FA would not exceed $100 at Time 1. Therefore, the lesser of the amounts under subparagraphs 55(5)(d)(i) and 55(5)(d)(ii) is $100 and the amount of income of US FA to be added to the income earned or realized by Can Opco at Time 1 is $100.

Even if it is argued that the income earned or realized by Can Opco of $100 can reasonably be considered to contribute to the accrued gain of $120 that could be realized immediately before the dividend, it remains that the dividend paid of $120 exceeds the amount determined to be the income earned or realized by Can Opco, being $100.

Scenario 2

At Time 2, Can Opco pays a dividend of $100 to Can Holdco.

If US FA pays a dividend of US $100 to Can Opco at Time 2, Can Opco would include $100 in its income based on the application of subsection 261(2).

If the FMV of the shares of Can Opco is equal to $100 at Time 2, there is a reduction of $100 of the capital gain on the shares of Can Opco that could have been realized on a disposition at FMV of the shares of Can Opco at that time as a result of the payment of the dividend.

The question is whether the dividend of $100 exceeds the amount of income earned or realized by Can Opco at Time 1, that could reasonably be considered to contribute to the capital gain of $100.

In the calculation of the income earned or realized by Can Opco at Time 1, there can be added, under paragraph 55(5)(d), an amount equal to the lesser of:

• The tax-free surplus balance of US FA at Time 1, and
• The FMV of the shares of US FA at Time 1

Provided that the tax-free surplus balance of US FA at Time 1 was US $100, as indicated in Scenario 1, the amount determined under subparagraph 55(5)(d)(i) would be $120 because the exchange rate was US $1 = CDN $1.2 at that time. The FMV of the shares of US FA would also be $120 at Time 1. Therefore, the lesser of the amounts under subparagraphs 55(5)(d)(i) and 55(5)(d)(ii) is $120 and the amount of income of US FA to be added to the income earned or realized by Can Opco at Time 1 is $120.

Because the gain that could be realized on a disposition of the shares of Can Opco immediately before the dividend, i.e., at Time 2, is $100, the income earned or realized by Can Opco that can reasonably be considered to contribute to the accrued gain of $100 on the shares of Can Opco is limited to $100. The dividend paid by Can Opco of $100 would not exceed the amount determined to be the income earned or realized by Can Opco of $100.

Marc Ton-That
2019-082439
December 3, 2019

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 Withycombe Estate, Re, [1945] S.C.R. 267 (S.C.C.)