7 July 2009 External T.I. 2008-0265311E5 - Loss resulting from the interaction 112(4)& 186(1)

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.

Principal Issues: If a corporation buys a share that has a low paid-up capital and the share is redeemed, the corporation will be out of pocket by the amount of Part IV tax payable by the corporation on the resulting deemed dividend

Position: The Income Tax Act operates in that way.

XXXXXXXXXX 							2008-026531
								Yves Moreno
July 7, 2009

Dear XXXXXXXXXX ,

In your letter dated January 15, 2008, you express some concerns about the economic loss that could result from the payment of Part IV tax on a dividend deemed by subsection 84(3) to have been received by a corporation on the redemption of low paid-up capital shares by another corporation with which it is not connected.

You suggest two alternative ways to ensure that the amount of Part IV tax payable does not leave the shareholder out of pocket in respect of the redemption of the shares.

Your first proposition is that Part IV tax would not be payable on that portion of the deemed dividend which gives rise to an adjustment under subsection 112(4) on the basis that it is not an "assessable dividend" as defined in subsection 186(3) as it is not "deductible" under section 112.

The proceeds of disposition on a redemption of shares are reduced by the related deemed dividend, but any resulting loss would in turn be reduced according to subsection 112(4) by the amount of the deemed dividend. The effect of subsection 112(4) is to offset any loss resulting from the fact that the proceeds of disposition are reduced by the amount of the deemed dividend.

Subsection 112(4) adjusts the amount of a loss and not the amount that is deductible under subsection 112(1). One of the conditions for the application of subsection 112(4) is that the dividend has to be "deductible" under subsection 112(1). Hence, if a dividend is "deductible" under subsection 112(1), it is prone to being both an "assessable dividend" as defined in subsection 186(3) and a dividend subject to the application of subsection 112(4), subject to the other conditions for the application of those provisions being met. Paragraph 10 of Interpretation Bulletin 328R3 confirms that Part IV applies to an "assessable dividend" as defined in subsection 186(3), "even though the dividend, or a part thereof, was applied to reduce a loss for purposes of subsection 112(3), (3.1), (3.2), (4)".

You suggest as an alternative that if no deduction is claimed under subsection 112(1) in respect of the deemed dividend resulting from a redemption: (i) the proceeds of disposition will not be reduced by the amount of the deemed dividend; (ii) subsection 112(4) would not be applicable, either because no loss results from the reduction to the proceeds of disposition or because no deduction under subsection 112(1) was claimed; and (iii) the dividend is not an "assessable dividend" under Part IV. The result would be that the inclusion in income of the deemed dividend resulting from the redemption would be offset by a loss and tax would only be paid under Part I on the "gain" portion of the dividend.

Subsection 112(1) indicates that a taxpayer "may" deduct the amount of certain taxable dividends, thereby suggesting that the deduction is elective. However, the word "deductible" used in subsections 112(4) and in the definition of "assessable dividend" in subsection 186(3) has to be contrasted with the word "deducted" used in other provisions. It appears that the word "deducted" is used in the Income Tax Act to make reference to amounts that have actually been deducted whereas the word "deductible" refers to amounts that are capable of being deducted, irrespective of whether they have been or not (Dauphinais v. The Queen, 94 DTC 1153).

Furthermore, we are not convinced that replacing the word "deductible" by the word "deducted" would resolve the perceived problem described in your letter. It is true that the temporary economic loss resulting from the payment of Part IV tax as described in your letter would be reduced or cancelled if subsection 112(4) and Part IV did not apply to the deemed dividend resulting from the redemption of the shares, but that is only true to the extent that the redeemed shares were held on account of income. If they were held on account of capital, the loss would be of a capital nature and would not offset the amount of the deemed dividend. The corporation would be required to pay tax under Part I on the full amount of the dividend resulting from the redemption of the shares instead of paying Part IV tax on that dividend.

The regimes applicable to surplus distributions by way of dividends or deemed dividends and to capital gains differ. The former provides for the payment of Part IV tax that reverts to the corporate group under section 129 when sufficient dividends are ultimately paid out to a shareholder that cannot avail itself of a deduction under section 112, paragraph 113(1)(a), (b) or (d) or subsection 113(2) of the Income Tax Act. In contrast, the regime applicable to capital gains provides for the payment of tax on the appreciation in value of the shares as they are disposed of by a taxpayer to a person other than the issuing corporation.

Although we sympathize with the fact that a corporate taxpayer can be temporarily out of pocket when a corporation returns accrued earnings in the circumstances described above, this result appears to be a consequence of the inherent structure of the Income Tax Act.

We trust that our comments are of some assistance.

Yves Moreno
Manager
Corporate Reorganizations Section I
Reorganizations and Resources Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch