20 December 1982 Income Tax Severed Letter

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.

XXXX

December 20, 1982

Director Provincial and International Relations Revenue Canada, Taxation 875 Heron Rd. Ottawa, Ontario K1A 0L8

Dear Sir

We would appreciate your comments on the following matter concerning the Canada-U.K. Tax Treaty and its application to a repurchase of shares by a U.K. resident corporation, where the shareholder is a Canadian resident individual or corporation owning less than 10% of the voting power of the U.K. corporation.

As you may be aware, the U.K. has recently introduced legislation permitting U.K. corporations in certain situations to repurchase their shares. Under the 1982 Finance Act where these shares being repurchased are held by a non-resident of the U.K., the repurchase is treated as a distribution of profits to the extent of the difference between the repurchase price and the paid-up capital of these shares. This treatment seems analogous to the provisions of subsection 84(3) of the Canadian Income Tax Act where a Canadian corporation repurchases its shares.

We are concerned with how this new legislation will effect the taxation of a U.K. share repurchase where the holder of the share is resident in Canada. For purposes of illustration we shall assume that the share to be repurchased was acquired by the Canadian resident at a cost of $1,000. Its paid-up capital is $100 and the repurchase price is $1,500. Exchange fluctuations will be ignored.

Under normal circumstances, a Canadian resident shareholder would treat the repurchase of a share in a non-resident corporation as a capital disposition for Canadian tax purposes. This would give rise to a capital gain or loss computation measured as the differences between the shareholder's proceeds of disposition on repurchase and his adjusted cost base. In the illustration and given no taxes in the repurchasing corporation's country of residence a capital gain of $500 would be realized.

This matter is however complicated in situations involving U.K. corporations because of "the deemed dividend" rules in the domestic legislation. While arguments could be advanced that this repurchase represents an alienation of capital property and so, in general, exempt from U.K. tax under Article 13 of the Canada-U.K. Tax Treaty, our information from the U.K. is that it is likely the domestic "deemed dividend" rules would continue to apply. This seems confirmed by the definition of dividends in Article 10, paragraph 4, of the Canada-U.K. Tax Treaty which includes "income assimilated to or treated in the same way as income from shares by the taxation law of the state of which the company making the payment is a resident". Accordingly Article 10 of the treaty would apply to the repurchase.

Where the Canadian resident shareholder is an individual or a corporation owning less than 10% of the voting power of the U.K. corporation the effects of the domestic legislation and the treaty seem to be as follows.

(a) A deemed dividend of $1,400 would arise on the repurchase.

(b) Under paragraph 3(b) of Article 10 this dividend will be grossed up for the tax credit available of 3/7 X the deemed dividend or $600 to give a total dividend for treaty purposes of $2,000.

(c) U.K. withholding tax of 15% or $300 would then be levied under paragraph 3(a)(ii).

None of these provisions etc. would normally affect the status of the transaction as a capital transaction in Canada but in this case Article 27, paragraph 4, of the treaty states that the aggregate amount of the dividend and the amount of the tax credit referred to in paragraph 3(b) of Article 10 shall be treated as a dividend for Canadian income tax purposes. This rule seems clearly intended to ensure that the tax credit would be treated as a dividend for Canadian purposes notwithstanding that it is not a distribution from the corporation but rather is a refund by the U.K. tax authorities. However its wording seems broad enough to have general application and in this case to treat what would otherwise be capital proceeds on the repurchase as a dividend for Canadian tax purposes.

If this is the case the Canadian resident will be considered to have received, in this example, a dividend of $2,000 which will be fully taxable for Canadian tax purposes subject to a foreign tax credit for the 15% U.K. withholding tax. The Canadian tax effect of this is set out in Appendix I.

To the extent that part of the proceeds is considered to be a dividend for Canadian tax purposes it would not seem to be proceeds of dispostion for capital gains purposes and so it would seem the Canadian resident shareholder would also realize a capital loss of $900 on the repurchase. The tax effect of this is also set out in Appendix I, where the assumption is made that the Canadian resident may fully utilize the capital loss which arises. This would clearly depend on the actual fact situation and some restriction of the resident's ability to use the loss, particularly where the shareholder is a corporation, might arise.

From Appendix I it will be seen that the effective tax rate to the Canadian resident on what is essentially a capital gain is 70.5%. This seems an unreasonably high rate.

Appendix II to this letter shows the tax that would arise were the repurchase to be treated as a capital transaction for Canadian tax purposes. Here, based on the assumptions in the Appendix regarding average tax rates etc., the effective tax rate on the capital is 34.7%. While this rate is higher than normal for a capital gain it merely reflects the imposition of the U.K. tax and the inability to obtain a full credit for that tax against Canadian tax. However the rate is clearly more acceptable than the 70.5% rate applicable under the dividend treatment.

In summary the effects of Articles 10 and 27 of the Canada-U.K. Tax Treaty are to increase significantly the amount of Canadian tax which a Canadian resident has to pay on the repurchase of shares which he owns in a U.K. corporation. Given the basic purpose of tax treaties, namely, that they are relieving in nature and are not designed to raise additional revenue nor to extend domestic legislation this seems to be an inappropriate result and appears an unintended consequence of the treaty wording. We recognize that subsection 30(2) of S.C. 1980-81 chapter 44 implementing the Canada-U.K. Tax Treaty states that "in the event of any inconsistency between the provisions of this part, or the convention, and the provisions of any other law, the provisions of this part and the convention prevail to the extent of the inconsistency". We do not believe, however, that this should be enforced to the significant detriment of the Canadian resident.

In the circumstances we should be grateful for your comments on this matter, in particular whether you would interpret the treaty strictly in the manner set out in Appendix I or whether you would permit the Canadian taxpayer to continue to treat the repurchase as wholly a capital transaction with the consequences set out in Appendix II.

By copy of this letter we would also request the comments of the Department of Finance in this matter and whether they consider there is any need for the language of the Canada-U.K. Tax Treaty to be amended or clarified.

If you have any queries or require further information on this matter please contact the writer at XXXX

Yours very truly

XXXX