9 December 1996 External T.I. 9611945 - CALCULATION OF SAFE INCOME FOR FOREIGN AFFILIATE

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:

Calculation of safe income of a foreign affiliate, in particular stub period earnings.

Position:

a) Concept of safe income of foreign affiliate not a relevant concept vis à vis the Canco that has a direct interest in the foreign affiliate. However, could get same result as payment of dividend out of safe income by electing appropriate amount and using 93(1) election.

b) In another situation where safe income was relevant, stub period accounting is appropriate, with conditions.

Reasons: a) Law

b) Position previously taken - eg. see E9523075

								961194
XXXXXXXXXX								J. Stalker

Attention: XXXXXXXXXX

December 9, 1996

Dear Sirs:

Re: Paragraph 55(5)(d) and the Calculation of
Safe Income for a Foreign Affiliate

We are writing in response to your letter dated April 2, 1996 in respect of the interpretation of the above-noted provision.

You have presented the following scenario:

1.From incorporation on January 1, 1994 until December 28, 1994 Opco owned all of the shares of a U.S. Corporation (USCo) which is engaged in an active business carried on in the United States.

2.Both Opco and USCo have December 31 year ends. The December 31, 1994 year-end was USCo's first taxation year.

3.On December 28, 1994 Opco transferred all of its shares of USCo to a Canadian holding corporation ("Holdco") pursuant to subsection 85(1) of the Act. The consideration received by Opco from Holdco was redeemable retractable preferred shares having an aggregate redemption amount equal to the fair market value of the USCo shares acquired by Holdco. The preferred shares issued by Holdco to Opco provide for a noncumulative dividend at a variable rate not to exceed 8% per year based on the redemption amount of the preferred shares.

4.The common shares of Holdco are owned by individuals who are related to the sole shareholder of Opco.

5.The aggregate redemption amount of the Holdco preferred shares issued to Opco on December 28, 1994 was equal to the tax-paid retained earnings of USCo at December 31, 1994 (which was computed once the 1994 financial statements for USCo were completed) plus an additional amount representing the unrecorded goodwill of USCo (the "Goodwill Increment"). The aggregate of the December 31, 1994 tax-paid retained earnings of USCo and the Goodwill Increment equalled the fair market value of the USCo shares at December 28, 1994.

6.On December 31, 1995 Holdco repurchased its preferred shares held by Opco by paying the aggregate redemption amount of the preferred shares to Opco.

7.During its 1995 taxation year USCo earned substantial amounts of after-tax income which exceeded the Goodwill Increment.

8.Holdco has no other source of income other than the shares of USCo.

You have asked for clarification on the calculation of the "safe income" of USCo, in particular in respect of stub period earnings of such a foreign affiliate.

It would appear that your query involves a factual situation involving a possibly completed transaction. As indicated in paragraph 21 of Information Circular 70-6R2, issues involving completed transactions should be addressed by the appropriate Taxation Services Office of Revenue Canada. However, we offer the following general comments.

At the time of the transfer Opco has no safe income in USCo

The concept of safe income is not applicable in the situation you have described. Opco can not have safe income in respect of its direct interest in USCo at any time. If Opco transfers that interest to Holdco for an indirect interest, Opco will still have no entitlement to the safe income in respect of the holding period when Opco had a direct interest in USCo. At the time of the transfer, OPCo has not received a taxable dividend to which it would be entitled to a deduction under subsection 112(1) or 138(6) of the Income Tax Act (Canada) (the "Act") as required by the preamble of subsection 55(2). Since there is no safe income of USCo vis à vis Opco, the calculation in paragraph 55(5)(d) is not relevant. (In contrast, the concept of safe income of USCo vis à vis the shareholder(s) of Opco could be relevant in different circumstances.)

However, the Act does provide for results similar to those achieved by the payment of dividends out of safe income, even where dividends are not actually paid, by electing the appropriate amount on a transfer and using a subsection 93(1) election.

Shareholders of Opco may have safe income in USCo

In a situation involving a foreign affiliate where safe income was relevant (that is vis à vis the shareholder(s) of Opco where the requirements in the preamble of subsection 55(2) of the Act were met) stub period accounting in the calculation of the safe income of USCo would be appropriate, but not for the reasons you have suggested. It is our view that stub period earnings of a foreign affiliate of a corporation, to the extent they accrued during the relevant holding period, should be included in the income earned or realized by that corporation for purposes of subsection 55(2), but only to the extent that those earnings could be considered to represent exempt surplus or an amount of taxable surplus which could be repatriated tax-free to Canada because underlying foreign tax has been paid. This includes both the stub period commencing immediately after acquisition of the subject shares and the stub period ending immediately prior to the particular time. It is a question of fact as to what portion of an affiliate's income or loss for a taxation year has accrued at a particular time during that year.

The above comments represent our general views with respect to the subject matter of your letter. These comments do not constitute an advance income tax ruling and therefore, as described in paragraph 21 of Information Circular 70-6R2, are not binding on the Department.

Yours truly

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