15 December 1997 External T.I. 9642275 - LIQUIDATION OF A 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:

Application of 88(3) and 95(2)(e) to a particular

scenario where a foreign affiliate is liquidated.

Position:

Both provisions apply.

Reasons:

Subsection 111(4) does not apply to the capital property

of a foreign affiliate. No relief under 95(2)(f) -

wrong foreign affiliate and gain did not accrue before

acquisition.

964227
XXXXXXXXXX J. Stalker

Attention:XXXXXXXXXX

December 15, 1997

Dear Sirs:

Re: Subsections 88(3) and 95(2)(e) of the Income Tax Act (the Act')

We are writing in response to your letter of November 15, 1996 in respect of the application of subsection 88(3) and paragraph 95(2)(e) of the Act to a dissolution of a controlled foreign affiliate.

You have presented a scenario where a Canadian corporation (Canco) owns 100% of a foreign affiliate (FA1). Canco and FA1 each acquire 50% of the shares of another foreign affiliate (FA2) from an arm's length party for the fair market value of $1. FA2 holds shares in another foreign affiliate (FA3) at the time FA1 and Canco acquire control of FA2. FA1, FA2 and FA3 are resident and carry on an active business in a designated treaty country.

FA2 is liquidated shortly after its shares are acquired by FA1 and Canco. FA2's adjusted cost base in FA3 at the time of the purchase and liquidation of FA2 is $50. The fair market value of the shares of FA3 at the time of the purchase and liquidation of FA2 is $2. Therefore the relevant cost base of the shares of FA3 at those times is $50. No surplus is created during the period FA1 and Canco hold shares in FA2.

You have asked for our comments on the application of subsection 88(3) and paragraph 95(2)(e) of the Act to this scenario. We assume that the distribution of the shares of FA3 on the liquidation of FA2 is a taxable transaction under the income tax laws of the country in which FA1 and FA2 are resident so that paragraph 95(2)(e) and not paragraph 95(2)(e.1) applies to the transaction.

Pursuant to paragraph 88(3)(b) of the Act, Canco's proceeds of disposition of the FA2 shares is equal to the adjusted cost base to FA2 of the FA3 shares, and accordingly Canco would realize a capital gain of $24. It is our position that paragraph 111(4)(c) of the Act is not applicable in this situation. As stated at the 1994 Canadian Petroleum Tax Society Conference (Question 25):

Subsection 111(4) does not generally apply to the capital property of a foreign affiliate upon the acquisition of
control of the affiliate or the Canadian parent of the affiliate. Although a foreign affiliate is not specifically excluded from the application of subsection 111(4), the reference in paragraphs 111(4)(d), (e) and (f) to "the taxation year that ended immediately before that time" is a reference to the taxation year deemed by paragraph 249(4)(a) to have ended immediately before the acquisition of control.

Subsection 249(4) does not apply to the acquisition of control of a foreign affiliate unless the foreign affiliate
carried on business in Canada at any time in its last taxation year commencing before the acquisition of control.

The various rules in subsection 111(4) are all interdependent. Paragraph 111(4)(c) does not operate in isolation notwithstanding that the paragraph does not refer to "the taxation year that ended immediately before that time".

If, as may be the case in the above scenario, the shares of FA2 are not excluded property, the liquidation of FA2 would result in a capital gain of $24 to FA1 and the appropriate inclusion in the FAPI of Canco in this situation. Pursuant to paragraph 95(2)(e), FA1 is deemed to dispose of its shares of FA2 for proceeds equal to the relevant cost base of the shares of FA3 to FA2 immediately before the dissolution of FA2.

You have also asked if paragraph 95(2)(f) could apply. Paragraph 95(2)(f) provides that in computing any gain or loss from the disposition of property owned by a foreign affiliate, that portion of the gain or loss that accrued before the affiliate became a foreign affiliate is excluded. However, paragraph 95(2)(f) does not give relief in the above situation because the property in question, the shares of FA2, was not owned by FA1 at the time FA1 became a foreign affiliate of Canco as required by the midamble of paragraph 95(2)(f). Furthermore, the gain cannot be said to have accrued before the acquisition of FA2 but instead is a result of a transaction that took place after that acquisition. Instead, it is a mechanical gain resulting from the application of paragraph 95(2)(e) to a wind-up, which can not be reasonably attributed to the period before acquisition of that foreign affiliate.

If, in another scenario paragraph 95(2)(e) were not applicable because 95(2)(e.1) applies, FA1 would not realize a gain.

Instead the capital property of FA2 that is distributed to FA1 would be deemed to have been disposed of by FA2 for proceeds of disposition equal to the cost amount of the property to FA2, and FA1 would be deemed to have disposed of its shares in FA2 at the adjusted cost base of those shares to FA1.

The above comments represent our general view 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 22 of Information Circular 70-6R3, are not binding on the Department.

Yours truly,

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