23 December 1999 Internal T.I. 9825577 - FOREIGN AFFILIATES EARNINGS - INFLATION

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:

1. Should monetary adjustments for inflation in Brazil be recognized in calculating surplus?

2. Application of paragraph 4 of Article 22 of Brazilian treaty.

3. Whether US dollars should be the calculating currency.

Position:

1. No.

2. Dividends are paid from exempt surplus as calculated under Canadian rules.

3. No.

Reasons:

1. Monetary corrections are notional, are not attributable to actual income or losses from carrying on an active business and, if recognized would result in duplication of surplus.

2. "Profits... from carrying on an active business" in paragraph 4 should result in the same surplus as under Act. Monetary correction amounts are not real "profits".

3. U.S. dollars would not reflect the real value that could be paid from the affiliate.

		December 23, 1999

Jack Dempsey International Section
A/Manager J. Stalker
International Audit 957-2118
Toronto TSO

	Attn: Larry Forget
	        International Audit
	        Group 452-2-1	982557

Exempt Surplus of XXXXXXXXXX

We are writing in response to your memorandum in respect of the exempt surplus calculation for XXXXXXXXXX, in particular with respect to the effect of the monetary correction for inflation. You enclosed a submission on this matter from the taxpayer's representative, XXXXXXXXXX.

Our understanding of the facts is as follows:

1. XXXXXXXXXX.

2. It is our understanding that in 1964, in order to take into account the effects of high inflation in that country, Brazil introduced inflation accounting measures under which certain balance sheet accounts were revalued for tax purposes at the end of every fiscal period. In very general terms, the value of fixed assets, certain long-term investments, deferred charges, foreign currency denominated debts, and shareholders' equity accounts were adjusted under the Brazilian measures to recognize the decline in the value of Brazilian currency. For example, if inflation in a particular year was 100%, a land account with a tax value of 100 Brazilian cruzeiros at the commencement of the year would be adjusted to 200 cruzeiros (i.e. a debit of 100 cruzeiros) at the end of that year and an inflationary adjustment account would be credited 100 cruzeiros. If such inflationary adjustment account indicated a net expense (i.e. a debit balance) after all the relevant accounts had been revalued for Brazilian tax purposes, such expense was deductible in the year. If the net result was a credit, the credit could for the most part be deferred except that at least 5% of such amount was required to be included in income annually. Any deferred portion had to be recognized for tax purposes in a subsequent year to the extent that it had been realized during that year (e.g. on the disposition or write down of an asset).

In 1995 the economy in Brazil stabilized and inflation had fallen to 15%. Since it was expected to remain at this relatively low level in 1996, the Brazilian government revoked the monetary adjustment for tax purposes. However, under certain transitional provisions, the outstanding balance of the deferred inflationary gain account as at December 31, 1995, may be recognized for tax purposes. It is our understanding that while it is not mandatory to bring the deferred inflationary account balance into income before the underlying inflationary gains are realized, such balance would be subject to tax prior to 1997 at a reduced rate of only 10%. On the other hand, if the taxpayer chooses to recognize the deferred inflationary adjustment at a subsequent time (i.e. when actually realized), the gains will be subject to tax at the normal tax rate of 25%.

Issue

We understand from discussions with you (Stalker/Forget) that you currently propose to adjust the exempt surplus of XXXXXXXXXX on the basis that inflationary monetary adjustments (referred to as monetary corrections below) should not affect surplus. Although you have not mentioned the reassessment of the operating subsidiaries of XXXXXXXXXX, we assume the same approach would be taken.

1. Treatment of Monetary Correction

As a result of your proposed exclusion of monetary correction amounts from XXXXXXXXXX exempt surplus calculation, exempt surplus in XXXXXXXXXX would be substantially eliminated and would result in certain dividend amounts being characterized as pre-acquisition surplus resulting in significant reductions in the adjusted cost base to XXXXXXXXXX of its shares in XXXXXXXXXX.

The taxpayer's representative, XXXXXXXXXX, has proposed two alternatives: under Alternative A the monetary correction would be included in exempt earnings in the year the monetary correction is made and under Alternative B the monetary correction would be included in exempt earnings in the year(s) the related assets or liabilities are depreciated, sold or repaid.

Our view

We agree that the monetary correction amounts should be ignored in the calculation of the exempt surplus of XXXXXXXXXX and its operating subsidiaries in Brazil.

• The monetary corrections are notional income inclusions and deductions which are not attributable to actual income or losses from carrying on an active business and therefore they not income from such a business for the purpose of paragraph (a) in the definition of earnings in subsection 5907(1) of the Regulations. As noted below if such monetary correction amounts were recognized for that purpose such amounts would result in duplications in the computation of the surplus account balances. Furthermore the monetary correction amounts do not reflect an actual amount that is available for payment of dividends from earnings.
• It is our understanding that for Brazilian tax purposes the full amount of the net monetary adjustment is not included in income of the subsidiaries where that net adjustment is positive, and in the case of a holding company like XXXXXXXXXX, the net monetary adjustment does not apply at all. Accordingly, some of these adjustments would never be in earnings as calculated under subsection 5907(1) of the Regulations. Nevertheless, the representative argues that our position on paragraph 5907(2)(f) of the Regulations would allow the inclusion of the net monetary correction in calculating exempt surplus because it is allowed for financial statement purposes. However, as noted above these amounts are not elements of the foreign affiliate's actual income from an active business and do not affect the amount available for distribution as a dividend. These adjustments do not represent actual revenues or outlays of the current period. Consequently, the net amount is not "revenue, income or profit" for the purposes of paragraph 5907(2)(f) nor is it "derived in the year from such business carried on in that country". In addition, in the case of XXXXXXXXXX, as a holding company it does not even carry on an active business and so does not derive income to which paragraph 5907(2)(f) could apply..
• Recognizing the monetary corrections would result in duplication of surplus amounts:

(a) Firstly , if monetary corrections were recognized, any amount in the surplus of XXXXXXXXXX relating to its subsidiaries would be duplicated in the surplus of its subsidiaries.

(b) Capital gains on the disposition of assets are computed under the rules of the Act and those rules do not provide for an increase in the adjusted cot base of an asset for a monetary correction amount. The inclusion of monetary correction amounts in the earnings of a foreign affiliate would therefore in most cases result in duplication of surplus. Surplus would be created once when the monetary correction amount was included in computing earnings from the active business of a subsidiary and again when the related capital property was disposed of since the inflationary gain would be included in the normal computation of a capital gain.

(c) There would also be duplication of surplus in respect of depreciable assets if the monetary correction were recognized. Although depreciation would be based on a higher cost base for an asset adjusted by inflationary accounting, there has been no increase in the actual cost of the asset to a foreign affiliate. Consequently, paragraph 5907(2)(b) would allow an addback to surplus of the excess of the aggregate depreciation taken over the amount of the actual expenditure for the asset. This is the appropriate correction for the impact of inflation. However, if the monetary correction amount was also recognized, that is, if the surplus account has already been adjusted annually for the increased cost of the asset, there would be double counting of surplus.

• As the inflationary adjustment is on account of capital and not on account of income, the amount is not available to pay a dividend since it is tied into the value of non-monetary assets. However, when a related asset is disposed of cash may be made available for the purposes of paying a dividend. To reflect this, the inflationary gain tied to that asset will be included in the computation of the capital gain and in the surplus accounts at the time of disposition. This is appropriate at that time since the amount is now realized and available to pay a dividend.
• The rules in section 5907 of the Regulations provide for inclusion of the monetary correction amounts when they are realized:
  • Realized capital gains on revalued property for Brazilian purposes would be calculated under Canadian rules using the original adjusted cost base, so that the full gain on excluded property including the portion attributable to inflation will also be included in exempt surplus.
• In the case of depreciable property, depreciation based on a revalued cost base for Brazilian purposes would be added back to adjusted earnings under paragraph 5907(2)(b) to the extent it is greater than the actual expenditure made in respect of the property..
• While it is our understanding that inventory in general was not subject to monetary correction the representative uses an example where land is inventory. In such a case realized inventory gains on items of inventory previously revalued for Brazilian purposes would be included in income pursuant to paragraph 5907(2)(f) of the Regulations, to the extent not included in income pursuant to paragraph (a) of the definition of earnings in 5907(1), as this amount reflects actual income when the inventory is sold.
• XXXXXXXXXX also discusses the treatment of a debt receivable held by XXXXXXXXXX which is owing by its operating subsidiary and which is denominated in cruzeiros. (It is our understanding that such debt was only subject to monetary correction if that was required by the terms of the debt.) Again any inflationary increase or decrease would only be recognized for the purpose of computing the surplus account when it is realized on the disposition of the receivable. Assuming the debt receivable is excluded property to XXXXXXXXXX, any gain on account of capital will be included in XXXXXXXXXX exempt surplus when realized. If the gain were instead on account of income, the amount of the gain would also be included in XXXXXXXXXX exempt surplus when realized, because the amount paid would be deductible in computing the subsidiary's earnings from an active business under paragraph 5907(2)(j) of the Regulations. We note that inflationary gains and losses on intercompany debt between XXXXXXXXXX and its subsidiaries would offset each other and there would be no net increase or decrease in the consolidated surplus of the group.
• XXXXXXXXXX describes in general how section 5907 of the Regulations applies to compute the surplus account of XXXXXXXXXX and its subsidiaries in his "Alternative B", except for his references to monetary correction amounts . As we understand it, XXXXXXXXXX and its subsidiaries have incorrectly taken monetary correction amounts into account in computing their respective surplus accounts but such action does not prevent the Regulations from also applying to include inflationary amounts when they are realized. Accordingly, prior to making any adjustment under "Alternative B" it may be prudent to ensure that the relevant amounts have not already been taken into account in the surplus calculations.

In summary, the monetary correction amounts should not be reflected in exempt surplus.

It is also not clear to us why in any event XXXXXXXXXX exempt surplus is so low. We would have thought that in an inflationary economy, in order to pay dividends back to a parent, any available cruzeiros would be hedged or simply converted to U.S. dollars as soon as possible. The foreign currency gain that results when the dividend is paid would be included in the earnings and exempt surplus.

2. Canada - Brazil Income Tax Convention (the "Convention")

This issue is whether paragraph 4 of Article 22 of the Canada - Brazil Income Tax Convention (the "Convention") allows tax-free dividends to be paid without a requirement for those dividends to be paid from exempt surplus as calculated under Canadian rules.

Paragraph 4 of Article 22 states:

Dividends received by a company which is a resident of Canada from a company which is a resident of Brazil shall be exempt from tax in Canada if the company receiving the dividends holds an equity percentage of at least 10 per cent in the company paying the dividends and if the profits out of which the dividends are paid are derived from carrying on an active business in Brazil or in a country with which Canada has concluded a double taxation convention;....

Our view

• The key words are "profits ... from carrying on an active business". As previously stated, the monetary correction amounts are notional and not real "profits". In addition, it is our view that these notional amounts do not arise from carrying on an active business. Accordingly, the profits from carrying on an active business should result in the same amount of exempt surplus as is calculated under the rules for determining exempt surplus in the Act. Those rules determine profits (earnings) from carrying on an active business for the purposes of the Act and Regulations.
• As a sidenote, XXXXXXXXXX also states that the "profits" should be "based on financial statements prepared under applicable and generally accepted accounting principles, including principles of consolidation and equity accounting where the payor of the dividends is a holding company". Each company is a separate entity, which has its own profits. The domestic rules for calculating exempt surplus recognize that by having surplus pots for each company.
• There is nothing in the context in which the words "profits..... from carrying on an active business" are used in paragraph 4 of Article 22 of the Convention that requires a different interpretation than what we would use for the purpose of the Act. Therefore, in accordance with paragraph 2 of Article 3 of the Convention and section 3 of the Income Tax Conventions Interpretations Act, the words "profits ...... derived from carrying on an active business" should have the same meaning for the purpose of the Convention as they do for the purposes of the Act.

3. Calculating Currency

The taxpayer's representative, XXXXXXXXXX , has proposed that, if the monetary corrections are not included in the exempt earnings, XXXXXXXXXX is prepared to recalculate the exempt surplus of XXXXXXXXXX and its subsidiaries using U.S. dollars as the calculating currency, on the basis that such currency is "reasonable in the circumstances" as required by subparagraph 5907(6) of the Regulations.

Our view

• In our view, it would not be reasonable to use US. dollars as the calculating currency for XXXXXXXXXX and its subsidiaries, as the real value that could be paid out from the Brazilian companies would not be reflected. Instead, in such an inflationary regime, the use of U.S. dollars would inflate the value of the surplus. For example, if the year one earnings of XXXXXXXXXX are stated in U.S. dollars in XXXXXXXXXX exempt surplus, and a dividend is paid to XXXXXXXXXX in year 2 when the Brazilian currency has been further devalued, the surplus account no longer reflects the value in Brazilian currency that can be paid out, but is overstated. XXXXXXXXXX states that annual calculations in U.S. dollars would indicate a substantial balance of exempt surplus remaining in XXXXXXXXXX. However, the amount of cruzeiros that would have equated to U.S. $100 of surplus in 1985 would not be the same amount in 1992. A substantial balance of surplus in U.S. dollars in 1985 would not reflect the surplus that is available to be paid out at a later date.
• In addition, U.S. currency is not the currency used in Brazil except for limited purposes. If it were more widely used, the issues in this memo would be moot

We trust our comments will be of assistance. Please call Jane Stalker or Ken Major (613-957-2124) if you have any further questions.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at 819-994-2898. The severed copy will be sent to you for delivery to the client.

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

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