10 February 1984 Income Tax Severed Letter RCT 55-081 F

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.

Dear XXX:

This is in reply to your letter dated October 27, 1983 wherein you requested our views on the application of section 55 of the Income Tax Act (the Act) in the following hypothetical circumstances:

Canco, a Canadian corporation, owns 100% of the shares of FA1. FA1 owns 100% of the shares of each of FA2 and FA3. Thus, FA1, FA2 and FA3 are all controlled foreign affiliates of Canco by virtue of the definition thereof in paragraph 95(1)(a) of the Act. The surplus and deficit accounts of the affiliates are as follows:

FA1: $10 million of exempt surplus FA2: $30 million of exempt deficit FA3: $15 million of exempt surplus.

Canco has owned all of the affiliates since incorporation and is calculating the amount of income earned or realized after 1971 that is attributable to these foreign affiliates pursuant to subsection 55(2) in relation to paragraph 55(5)(d) of the Act.

Before we present our views, we wish to note the following aspects:

(A) While the specific rules of paragraph 55(5)(d) of the Act must be considered, the broader provisions of subsection 55(2) must also be considered in formulating the final decision on whether or not the taxpayer should have a concern under section 55. Thus, for greater certainty, the Canadian taxpayer must have "received a taxable dividend in respect of which it is entitled to a deduction under subsection 112(1) or 138(6)"; it must be "part of a transaction or a series of transactions", and one of the purposes must have been "to effect a significant reduction in the portion of the capital gain but for the dividend" etc. As well, the "attributable to" concept thereunder will also have a significant impact.

(B) Based on the scenario you presented, Canco itself would not have a potential problem under subsection 55(2) vis a vis FA1, because Canco would never receive a dividend which would be deductible under subsection 112(1) or 138(6) in respect of a redemption of the shares of FA1. The reason, of course, is that FA1, being a foreign affiliate of Canco, would not meet the "payor" requirements specified in subsection 112(1) and 138(6). For this reason, we have assumed that the computation of Canco's "safe income" is relevant in the scenario presented, because Canco will pay the dividend to a parent corporation which would in fact be the Canadian taxpayer having the concern under section 55. If that is not the case, then it seems to us that Canco could proceed and elect under subsection 93(1) without a concern under section 55, as noted.

Comments:

It is our opinion that FA1 will be the "foreign affiliate of the other corporation", in computing "the income earned or realized" under paragraph 55(5)(d) of the Act, because of the assumption in subparagraph 55(5)(d)(i). On the further assumptions that Canco had disposed of the shares of FA1 at fair market value and had made an election under subsection 93(1), Canco must then determine the amount deductible under paragraph 113(1)(a) in respect of the shares it actually owns in FA1, which in this case is 100%. Since there is no taxable surplus, the amount is nil under paragraph 113(1)(b).

The amount deductible under paragraph 113(1)(a) of the Act is governed by subsection 5902(1) of the Regulations on the basis that an election under subsection 93(1) of the Act has been made. As you pointed out, Canco would aggregate the net surplus of FA1 and FA3 pursuant to subparagraph 5902(1)(a)(i) of the Regulations. Thus, the "exempt deficit" does not enter into the calculation of "net surplus" as defined by paragraph 5907(1)(h) of the Regulations. Accordingly, we are in agreement with your position under the hypothesis that the amount under paragraph 55(5)(d) of the Act is $25 million, being the aggregate of the net surplus of FA1 ($10 million) and FA3 ($15 million).

While we are in agreement with your computation under paragraph 55(5)(d), we are unable to agree that the exempt deficit of FA2 can be ignored in the final analysis, since the amount of the capital gain would be calculated with reference to the amount "that could reasonably be attributed to anything other than income earned or realized by any corporation after 1971", under subsection 55(2) of the Act. Thus, because of the emphasized word "any" in the foregoing phrase, it is our opinion that the computation of safe income should be done on a consolidated basis. In this particular situation FA2's large deficit has been financed by FA1 in some way and has thus had a direct impact on the value of the underlying companies. Accordingly, we feel that FA2's exempt deficit of $30 million should be taken into account with the result that Canco would have no safe income for purposes of section 55. At the 1981 Conference of the Canadian Tax Foundation, J.R. Robertson, F.C.A., then the Director General of this Directorate, gave a paper entitled "Capital Gains Strips: a Revenue Canada perspective on the provisions of section 55." In the area of that paper called "Guidelines to be followed in computing a Safe Dividend and Safe Income", paragraph (h) in part states the principle behind this position:

"Because of such things as losses for tax purposes, Safe Income in a particular corporation could be negative. When computing Safe Income on a consolidated basis positive amounts in some corporations will be off-set by negative amounts in others." (See page 87 of the 1981 Conference Report.)

While the above principle was probably directed more to the domestic situation, it is our position that it applies equally to the hypothesis which encompasses foreign affiliates.

We trust that the foregoing comments will adequately explain our position.