8 January 1996 External T.I. 9428025 - RETURN OF CAPITAL FROM A DELAWARE CORPORATION

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Whether a return of capital from a Delaware Corporation to a Canadian shareholder which has to be distributed from the Corproation's "surplus" account is a "dividend".

Position:

Yes.

Reasons:

It is a dividend under Delaware corporate law.

									942802
XXXXXXXXXX							Jim Wilson
									613-957-2123

Attention: XXXXXXXXXX

January 8, 1996

Dear Sirs:

Re: Return of Capital from a U.S. Corporation

We are writing in response to your letter of October 24, 1994 in which you requested our opinion on the tax treatment of certain distributions made to a Canadian shareholder from a corporation resident in the United States. Specifically, a U.S. corporation intends to pay its shareholders an extraordinary dividend of $XXXXXXXXXX per share. The company has been advised, for U.S. tax purposes, that about $XXXXXXXXXX of the dividend will be treated as ordinary income and depending on individual tax circumstances most, if not all of the remainder as a return of capital. The U.S. corporation is not a foreign affiliate of any of its Canadian shareholders.

You have indicated that the U.S. corporation was created under Delaware law. The Delaware Corporation Law ("DCL") utilizes the concept of "par value" and "surplus". Par value is the basic component of a corporation's capital stock account. All stock must be issued for at least the par value of the respective class of capital stock, unless the class is no par value stock, in order to be validly issued. When a Delaware corporation issues stock for a price in excess of its par value, the consideration received by the corporation in excess of the stock's par value is allocated to the corporation's "capital" account, usually reflected on the financial statements as "additional paid-in capital", unless its board of directors takes contrary action to allocate a portion of the excess to the corporation's "surplus" account. Under the DCL, cash distributions to shareholders can only be made from a "surplus" account. In order to distribute any cash from the capital contributed to the corporation by the shareholders, the corporation must first transfer the amount from its capital account to its surplus account. Moreover, under the DCL, any distribution of cash from surplus is considered to be a dividend.

You have also stated that, in your opinion, the definition of "dividend" in paragraph 3 of Article X of the Canada-United States Income Tax Convention (the "Treaty") "applies to treat the distribution based on the source country's tax rules" because such definition "applies the source country's tax rules in determining the character of the distribution".

Our Comments

The situation described in your letter involves an actual proposed transaction. Assurance as to the tax consequences of actual proposed transactions will only be given in the context of an advance income tax ruling. The procedures for requesting an advance income tax ruling are outlined in Information Circular 70-6R2 dated September 28, 1990 issued by Revenue Canada, Taxation. However, we can offer the following general comments which we hope will be of assistance to you.

Pursuant to subsection 90(1) of the Income Tax Act (the "Act"), a shareholder who is a resident of Canada must include in his income dividends received from corporations not resident in Canada. A distribution of property by a corporation to its shareholders can be either a dividend or a non-taxable return of capital. Whether a cash distribution is a dividend or a return of capital in any particular situation is a question of fact to be determined with regard to the relevant corporate law. The tax treatment in the foreign jurisdiction of such distributions is not relevant for the purposes of subsection 90(1) of the Act.

Subsection 248(1) generally defines a dividend as including a stock dividend, but does not define the word beyond that; consequently, we must look to the accepted ordinary meaning of the term for the purposes of the Act. Generally, it is our view that a dividend can include any distribution of property by a corporation to its shareholders that is not a return of the paid-up capital of a corporation. For this purpose, it does not matter whether the corporation making the distribution is a Canadian resident or not. We find support for this position in Cangro Resources Limited (In Liquidation) v. Minister of National Revenue, 67 DTC 582.

In some jurisdictions, a corporation can return capital to its shareholders by reducing its capital account as determined under corporate law. A reduction in the stated capital account of a class of shares of a corporation produces a corresponding decrease in the "paid-up capital" of that class of shares since paid-up capital, as defined in subsection 89(1) of the Act generally reflects, subject to some exceptions, the stated capital of a corporation. A reduction in the paid-up capital of a class of shares does not constitute a dividend for the purposes of the Act, but instead gives rise to a reduction in the adjusted cost base of the shares of the corporation pursuant to subparagraphs 53(2)(a)(ii) or (b)(ii), depending on the circumstances.

As mentioned in paragraph 2 of Interpretation Bulletin IT-463R dated July 12, 1991 (the "Bulletin"), the paid-up capital of a class of shares of a corporation is determined, pursuant to clause 89(1)(c)(ii)(C), without reference to the Act. The calculation is therefore based on the relevant corporate law rather than tax law. The paid-up capital is frequently referred to as stated capital under corporate law and is usually identified as such in the corporation's financial statements. Paragraph 3 of the Bulletin states that the stated capital account reflects the par value of shares issued with a par value and the amount ascribed by the directors for shares issued without par value. Paragraph 4 of the Bulletin states that neither amounts contributed by shareholders that are not represented by issued shares (contributed surplus for example) nor premiums received for a particular share issue constitute part of paid-up capital under clause 89(1)(c)(ii)(C) unless it forms part of stated capital under the applicable corporate law.

We understand, from the information provided in your letter and attachments therewith, that under the DCL, it is not possible for a corporation to make any asset distribution by reducing its capital. Instead, cash distributions must be made from the surplus account and constitute dividends under the DCL. Although these payments may not necessarily be distributions of corporate profits, this does not appear to have any bearing on the matter as such distributions are still regarded as dividends under the DCL. In our view, a distribution of the extraordinary dividend described in your letter would not lead to a reduction in the adjusted cost base of the shares pursuant to subparagraph 53(2)(b)(ii) since it would not be an amount received by a taxpayer on a reduction of the paid-up capital of the corporation; the amount would instead be received as a distribution of the surplus of the corporation. The transfer of an amount from the additional paid-in capital of the corporation, as a consequential step preceding the cash distribution, would not appear to give rise to any Canadian tax consequences since their is no payment to the shareholder and no increase in the paid-up capital account of the corporation.

In conclusion, it seems to us that a distribution as described above would be regarded as a dividend and not as a return of capital, regardless of whether the initial contribution was made to capital or to surplus, and that this tax result is attributable to the fact that the DCL does not permit any return of capital except as a dividend distribution from a surplus account. While we have not explored this question further, it seems conceivable that a similar result could be found in other jurisdictions as well, including possibly some Canadian jurisdictions.

Application of Paragraph 3 of Article X of the Treaty

With respect to paragraph 3 of Article X of the Treaty, we disagree with your interpretation thereof. Once it is determined how a transaction will be taxed under the Act, the Department would then look to the Treaty to determine if Canada's right to tax that particular amount has been preserved. Except as provided in paragraph 3 of Article XXIX of the Treaty, nothing in the Treaty shall be construed as preventing Canada from taxing its residents. In this regard, an amount received by a Canadian resident that is to be included in income under the Act as a dividend will generally meet the definition of "dividend" in Article X of the Treaty because such amounts would normally be considered "income from shares or other rights, not being debt-claims, participating in profits". Accordingly, paragraph 1 of Article 10 would apply and Canada's right to tax is preserved. In a situation where an amount included in income under the Act is neither "income from shares or other rights, not being debt-claims, participating in profits" or "income subjected to the same taxation treatment as income from shares by the taxation laws of the State of which the company making the distribution is a resident", Article X does not apply. Article XXII of the Treaty would then apply to those sources of income not otherwise dealt with in the Treaty and again Canada's right to tax an amount received by a Canadian resident would be preserved.

The purpose of the "source-country deemed dividend rule" in the definition of "dividend" in paragraph 3 of Article X of the Treaty is to ensure that the source country's right to tax an amount that would not otherwise meet the definition of a "dividend", but is treated as such in the source country, will be governed by paragraph 2 of Article X of the Treaty. For example, in the situation described in this letter, whether Canada treated the entire $XXXXXXXXXX extraordinary dividend as a dividend or a non-taxable return of capital, the United States would still have been entitled to withhold tax in accordance with paragraph 2 of Article X of the Treaty on the portion of the extraordinary dividend (i.e. $XXXXXXXXXX) that constituted a dividend under the Internal Revenue Code.

We regret that our answer could not be more favourable. We would like to apologize for the lengthy delay in responding, which was attributable to a number of reasons.

The foregoing represents our general views with respect to the subject matter of your letter. The foregoing opinions are not rulings and are given in accordance with the guidelines set out in paragraph 21 of Information Circular 70-6R2 dated September 28, 1990.

Yours truly,

for Director
Reorganizations and Foreign Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch

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