23 October 1981 Income Tax Severed Letter 6-1834D

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.

Your opinion is requested with respect to the following situations:

SITUATION I

• a) A foreign corporation (FORCO) incorporated in the Bahamas is wholly owned by a Canadian corporation (Canco) which in turn is wholly owned by a U.K. resident. Canco has no liability and its only asset consists of the FORCO shares.
• b) FORCO's only source of income is income from property which is subject to Canadian taxation pursuant to 91(1).
• c) The U.K. resident will create a new Bahamian corporation (Newco). All the common shares of Newco will be owned by the U.K. resident.
• d) Canco will sell the FORCO shares to Newco in exchange for preferred shares of the capital stock of Newco (the Preferred Shares).
• e) If Canco were wound up before the proposed transactions described in (c) and (d) above, the U.K. resident would be deemed to have received a dividend under 84(2) computed with reference to the FMV of the FORCO shares.
• f) If Canco was wound up after the proposed transactions, the U.K. resident would be deemed to have received a dividend under 84(2) computed with reference to the FMV of the Preferred Shares to be issued by Newco as described in (d) above.

SITUATION 2

The facts are the, same as in Situation 1 above except that FORCO and Newco are U.S. corporations and the only activity of FORCO is the carrying on of an active business. Therefore, any dividend paid by FORCO to Canco would be exempted from Canadian taxation pursuant to 113(1)(a). However, these dividends would be subject to 15% U.S. withholding tax but Canco would not be entitled to any deduction in respect of such tax.

We would appreciate your comments on the following points:

• 1. Is it possible for Newco to issue Preferred Shares having a FMV equal to the FMV of the FORCO shares to be received in exchange? (The ideal, of course, would be the issuance of common shares by Newco but it is not possible in this particular case).
• 2. In our view the Preferred Shares should be at least cumulative with a reasonable rate of dividend but should the Preferred Shares also be preferred as to dividends and redeemable at the option of the holder?
• 3. Should the rate of dividend by variable? (Fluctuating with prime for example).
• 4. What rate of dividend would be reasonable?
• 5. Should the rate be determined with reference to the vendor's country (Canadian prime), the purchaser's country (Bahamian prime or U.S. prime) or should it be the LIBOR? (London Interbank Offered Rate).
• 6. Should the tax payable by Canco be taken into consideration in computing a reasonable rate of dividend? In Situation 1 it would appear that the tax payable would be the same whether interest is received on a note or dividends are received on preferred shares. (No deduction would be permitted under 113(1)(a) since the dividends would not be paid out of exempt surplus and there would be no deduction under 113(1)(b) and (c) since no tax would be paid in the Bahamas).
• However, in Situation 2 a formula for determining the rate of dividend could be as follows:

773  (prime + 3%) =         dividend rate. --- 1020

• Assuming a prime rate of 20%, the equivalent dividend rate would be 17.43%.

a)   Prime rate                                     20.00 Risk premium since 100% of the assets acquired are financed.                                      + 3.00                                                     23.00  Tax 23 x 46%                     10.58 Foreign tax credit 23  x 15% =    3.45             - 7.13                                                     15.87  Refundable Dividend Tax  Taxable income                                      23.00 10/4 x 3.45                                          8.63 14.37 x 25% x 2/3                                    2.40                                                     18.27  Withholding tax 23 x 15%                             3.45 Net return on promissory note after tax             14.82  b) Dividend rate                                    17.43 Withholding tax 15% x 17.43                          2.61 Net return on preferred shares after tax            14.82

We would appreciate receiving an opinion at your earliest convenience.