22 July 1997 External T.I. 9716825 - DEEMED DIVIDEND

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:

In calculating a deemed dividend under 84(3), we use the exchange rate prevailing at the time of the redemption to determine proceeds and the rate prevailing at the time of the share issue to determine the paid-up capital.

Position:

No change in position.

Reasons:

File 9222207 XXXXXXXXXX

7-971682
XXXXXXXXXX D. Yuen

July 22, 1997

Dear XXXXXXXXXX:

Re: Your letters of May 22 and June 2, 1997

We have been requested by Mr. Dyer at the Ottawa Tax Services Office to reply to the above letters.

Situation

1. XXXXXXXXXX.

In 1996, these shares were redeemed for US$XXXXXXXXXX each. The term "paid-up capital", as used here and subsequently, has the meaning assigned by subsection 89(1) of the Income Tax Act.¹

2. XXXXXXXXXX received a 1996 T5 form which included a deemed dividend from the redemption in the amount of US$XXXXXXXXXX per share.

3. Subsequently, XXXXXXXXXX received a new and amended T5 which included a deemed dividend from the redemption in the amount of C$XXXXXXXXXX per share. This amount was described in a letter from

XXXXXXXXXX

Your Questions

1. In your letter of May 22, 1997 you have indicated "

XXXXXXXXXX

"

2. In the above letter you have also indicated the following: "

XXXXXXXXXX

"

3. It is your view that subsection 84(3) has been misinterpreted for the following reasons:

(a) "

XXXXXXXXXX

"

(b) "

XXXXXXXXXX

"

4. In your letter of May 22, 1997 it is indicated that the cost of acquisition was $XXXXXXXXXX and the redemption proceeds was XXXXXXXXXX. It is your view that this results in a net gain of ($XXXXXXXXXX). You have asked whether this "negative deemed dividend" can be used to reduce other dividends for tax purposes, or is it a case of "If negative - write 0"?

5. In your letter of June 2, 1997 you have asked whether the additional tax owing by XXXXXXXXXX is really a sales tax disguised as a tax on a deemed dividend since the added tax has been levied on money spent on a purchase.

Our Comments

I. It is our view that in the year that the shares were redeemed, pursuant to subsection 84(3), XXXXXXXXXX will be deemed to have received a dividend equal to the amount received, converted into Canadian dollars at the rate prevailing at the time of redemption, less the paid-up capital of the shares, with the paid-up capital being converted to Canadian dollars at the rate prevailing at the time the shares were issued.

The case of Gaynor v. The Queen 88 DTC 6394 (copy enclosed) supports this position. In that case, the taxpayer had disposed of securities purchased while resident in the United States. In computing the gain or loss resulting from this disposition, the taxpayer calculated the adjusted cost base and proceeds of disposition of the securities in Canadian dollars at the average exchange rate prevailing in the year the securities were sold. The Minister calculated the gains and losses on the basis that the adjusted cost base and proceeds of disposition should be calculated in Canadian dollars at the exchange rate prevailing at the time of acquisition and at the time of disposition, respectively. In agreeing with the method employed by the Minister, Mr. Justice Pinard of the Federal Court, Trial Division made the following comments at page 6396 of the decision:

"Now, in that context, when the Income Tax Act, a Canadian statute, requires that a gain, a loss, a cost or a price be established or considered, that must be done in Canadian dollars at the relevant time, i.e. at the average exchange rate prevailing at the time such gain or loss occurs and such cost or price is encountered. Income is assessed under the Act in terms of Canadian dollars."

Thus, it is our view that it is appropriate that the amount received upon redeeming the shares be converted to Canadian dollars at the rate prevailing at the time of the redemption, just as it is appropriate in calculating the paid-up capital to convert the paid-up capital to Canadian dollars at the rate prevailing at the time the shares were issued. Assuming that the figures provided in subparagraph (ii) of the letter from XXXXXXXXXX are accurate, the deemed dividend of $XXXXXXXXXX per share appears to have been correctly calculated.

II. You have indicated that, in your view, the taxable dividend resulting from the redemption should be $XXXXXXXXXX calculated as follows: XXXXXXXXXX (being the excess of redemption price over the original paid-up capital in U.S. dollars of XXXXXXXXXX.

As indicated above, the court has stated that the redemption proceeds should be converted at the average exchange rate prevailing at the time of the redemption. We therefore disagree with the XXXXXXXXXX exchange rate used in your calculation. It is presumed that this was the exchange rate at the time the shares were originally issued. We also do not know the basis or reason for using the factor of XXXXXXXXXX in your calculation.

It is our understanding that the revised T5 slip was in the amount of $XXXXXXXXXX. We are unable to determine if this amount included the deemed dividend on the redemption of the shares of $XXXXXXXXXX and the dividend for the period XXXXXXXXXX which were described in the letter from XXXXXXXXXX. We expect that the balance of the $XXXXXXXXXX would reflect any dividends for the period prior to XXXXXXXXXX. It is suggested that you confirm the above with XXXXXXXXXX.

III. As described in paragraph II above, it is our view that XXXXXXXXXX received a deemed dividend of $XXXXXXXXXX. Although the exchange rate was higher at the time of the redemption, it is our view, and that of the court, that the redemption price may appropriately be converted at that exchange rate. A dividend is deemed to have been received under subsection 84(3) where the amount paid by the corporation exceeds the paid-up capital in respect of the redeemed shares. The term "amount" is defined in subsection 248(1) to mean "money, rights or things expressed in terms of the amount of money or value in terms of money of the right or thing.." It is our view that the amount of money paid by the corporation is the converted amount of money that XXXXXXXXXX received. Although XXXXXXXXXX did not receive Canadian dollars, we do not feel that the money was "never received".

The amount that the vendor received from XXXXXXXXXX is the amount that is used to determine the vendor's capital gain on the sale. The amount that XXXXXXXXXX paid for the shares forms her cost of the shares and is not subject to tax when she sells them. The determination of fair market value of the shares would take into account the undistributed earnings of the corporation but when corporate earnings are paid out to the shareholders, the distribution is treated as a dividend. It is our view that the vendor was taxed on a gain in value of the shares while XXXXXXXXXX was taxed on the distribution of corporate earnings.

IV. We are unable to confirm that the cost of acquisition was $XXXXXXXXXX. Provided that the conversion rate and the redemption amount is as indicated, the redemption proceeds appear to be $XXXXXXXXXX. Although the difference between these amounts results in a "loss" of $XXXXXXXXXX this "loss" may not be used for any other tax purposes.

However, the Act provides, in paragraph (j) of the definition of "proceeds of disposition" found in section 54, for the deduction of the deemed dividend from the proceeds of disposition of the shares on the redemption. This eliminates the deemed dividend from the calculation of capital gains so that there will be no double taxation of the deemed dividend (once as dividend income and the other as capital gain income). Thus, using the above amounts, the proceeds of disposition would be $XXXXXXXXXX and the capital loss would be $XXXXXXXXXX. The capital loss on the disposition will be deductible against capital gains.

V. The additional tax that XXXXXXXXXX has incurred is the result of the operation of a provision of the Act, namely subsection 84(3), which taxes income in the form of dividends as described in these circumstances. It is not, and is not intended to reflect, a sales tax on a purchase but is a tax that applies on the receipt of income.

Should you have any further questions or need clarification of the above comments, please contact Dan Yuen at 957-8967.

Yours truly,

for Director
Reorganizations and International Division
Income Tax Rulings and Interpretations Directorate
Policy and Legislation Branchendnotes

1 All statutory references in this letter are to the Income Tax Act (Canada), R.S.C. 1985 (5th Supp.) c. 1, as amended (the "Act").