24 August 1993 Internal T.I. 9315817 F - 93(1) Election - Shares With No Dividend Entitlement

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.

London District OfficeRulings Directorate

Attention:  C.W. Gee International Audit

XXXXXXXXXX

This is in reply to your memorandum dated May 20, 1993 concerning the interpretation of subsection 5902(1) of the Regulations to the Income Tax Act (the "Regulations"). The salient facts are as follows:

XXXXXXXXXX

XXXXXXXXXX

You are attempting to determine from which surplus account(s) of XXXXXXXXXX, the subsection 93(1) deemed dividend on the preferred shares was paid. In this context, you request our interpretation of the phrase "the amount that would have been received on the shares (of that class) in respect of which an election is made, if the particular affiliate had at that time paid dividends the aggregate of which on all shares of its capital stock was equal to the amount of its net surplus" for the purpose of paragraph 5902(1)(b) of the Regulations.

In our view, the amount determined under paragraph 5902(1)(b) of the Regulations in respect of the preferred shares in these circumstances would be nil because immediately before the time the shares were redeemed, the holders thereof were not entitled to receive any dividends. Indeed, in the hypothetical circumstances described in paragraph 5902(1)(b) of the Regulations, any dividends paid by XXXXXXXXXX would have all been paid on the other class of XXXXXXXXXX shares (e.g. the common shares). As a result, it is our view that the entire subsection 93(1) deemed dividend would be determined to be paid out of the pre-acquisition surplus of XXXXXXXXXX pursuant to paragraph 5900(1)(c) of the Regulations.

This result is determined as follows. Notwithstanding that technically the amount determined by the formula in clause 5902(1)(c)(ii)(B) in these circumstances is undefined, it is in our view reasonable say that as the amount determined in paragraph 5902(1)(b) of the Regulations approaches zero, the amount of the hypothetical whole dividend computed in clause 5902(1)(c)(ii)(B) of the Regulations approaches infinity. Following this logic, the denominator of the fractions (proportions) determined in paragraphs 5900(1)(a) and (b) of the Regulations to be the proportion of the 93(1) deemed dividend paid out of exempt and taxable surplus of XXXXXXXXXX would be a number approaching infinity thereby producing amounts approaching zero to be the portion of the deemed dividend to have been paid out of exempt and taxable surplus. The fraction (proportion) of the dividend computed under paragraph 5900(1)(c) of the Regulations to have been paid out of pre-acquisition surplus would be a fraction approaching one (e.g. infinity less portion of whole divided paid out of exempt surplus and taxable surplus divided by infinity). On this basis, we conclude that where the amount determined in paragraph 5902(1)(b) is nil, the related subsection 93(1) dividend would be computed to have been paid out of pre-acquisition surplus.

We disagree with the comment by the taxpayer's representative that in the hypothetical circumstances described in paragraph 5902(1)(b) of the Regulations, " XXXXXXXXXX". Preferred shareholders might, depending upon the circumstances be inclined to retract their shares if a large dividend were to be declared. However, it is our view that what takes place on the redemption of shares generally is not a distribution of surplus but rather the shareholder is returned the capital he originally invested. The surplus of a foreign affiliate represents the equity of such corporation which is attributable to retained earnings and should not in our view be considered distributed on the redemption of shares when such shares are redeemed at an amount equal to their paid-up capital.

Similar to paragraph 5902(1)(b) of the Regulations, a taxpayer is also asked to hypothesise that a foreign affiliate pays a dividend equal to its net surplus in other Regulations (e.g. 5902(1)(a)(i), 5904(2)(b), and 5905(10)(a)(i)). If one employs the taxpayer's interpretation of paragraph 5902(1)(b) of the Regulations in interpreting those other provisions, it is clear that the results are unreasonable and not in keeping with the object and spirit of those provisions. For instance, employing the taxpayer's interpretation in computing "participating percentage" as defined in section 5904 of the Regulations, provided a foreign affiliate has sufficient net surplus in the year, preferred shares would have a "distribution entitlement" equal to their redemption amount annually. This could result in the inclusion in income of a preferred shareholder of FAPI amounting to such preferred share redemption amount every year. Such a result would be absurd in any case where common shares have also been issued by the affiliate to other Canadian taxpayers. It would not be difficult to devise similar examples where the representative's interpretation would produce equally inappropriate results under the other above referenced Regulations. In our view identical or virtually identical phrases employed in different parts of the foreign affiliate regulations should be interpreted consistently. It seems clear from the above example that the results produced do not support the interpretation proposed by the taxpayer.

We note that XXXXXXXXXX may not have fully utilized its entitlement to the exempt surplus of the two U.K. foreign affiliates earned in taxation years ending while the common shares of those affiliates were held by XXXXXXXXXX directly. The reason why such surplus was not utilized is not entirely clear but we note that it would have been possible for XXXXXXXXXX to do so without incurring any Canadian tax liability on the transfer of the shares of those affiliates in XXXXXXXXXX. Depending on the reason why the surplus was not taken advantage of, there may be an argument that it would be equitable for the taxpayer to have access to such surplus. However, we are unaware of any technical grounds for arriving at such a result. Furthermore, the balance of any gain on the preferred shares (i.e. the amount of any gain that would have been deferred on the transfers of the common shares in XXXXXXXXXX after utilizing all the exempt surplus available at that time) should be subject to tax in Canada. The fact that the taxpayer's interpretation would also eliminate this portion of the gain on the preferred shares of XXXXXXXXXX further demonstrates the absurd results produced under that interpretation.

In conclusion, it is our view that in the circumstances you describe, the amount determined under paragraph 5902(1)(b) of the Regulations in respect of the preferred shares of XXXXXXXXXX is nil and therefore the subsection 93(1) of the Act deemed dividends on such shares were out of the pre-acquisition surplus of XXXXXXXXXX

for DirectorReorganizations and Foreign DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch