Section 93

But for s. 94(3), a Canadian corporation (ACo) would have realized a capital loss of $1 million on the liquidation and dissolution of a wholly-owned non-resident subsidiary (FA1) which, in turn, held FA2 and FA3. The Directorate found that s. 94(3) applied to deny the loss and add it to the ACB to ACo of the shares of FA2 and FA3. The FA2 shares were sold by ACo to a third party for cash of $110,000, and ACo under an s. 93(1) election designated $10,000 of the proceeds to be a dividend (based on its view that s. 93(4) did not apply). The Directorate stated:

[U]nder paragraph 93(1)(a), the “elected amount” cannot exceed the amount of the taxpayer’s otherwise determined gain. … ACo has no gain on the disposition of the FA2 shares, in which case ACo’s elected amount would become $ nil.

See the diagram for the 2016-0630761R3 transactions.

A Canadian-resident corporation (ACo) wished to transfer its shares of a foreign subsidiary (FA1) to a Canadian subsidiary of ACo (BCo). This was to be accomplished by ACo transferring its FA1 shares on a s. 85.1(3) rollover basis to a newly-formed non-resident subsidiary (New FA), with New FA then transferring its FA1 shares to BCo for a note – which then was to be repaid in cash out of share subscription proceeds from ACo, and with FA1 then distributing such cash to ACo (with a Reg. 5901(2)(b) designation being made). FA1 then is wound up.

In order to satisfy a CRA requirement that the cost to BCo of the FA1 shares (which were excluded property) be limited to the sum of their relevant cost base and the net surplus (being exempt surplus) of FA1 – rather than being stepped up to their higher fair market value, the note equalled such sum. S. 69(1)(c) deemed the proceeds to New FA to be the higher FMV. However, the disposition of the FA1 shares did not give rise to FAPI), their exempt surplus was levitated under s. 93(1.11)(a) to New FA, and the note repayment proceeds were received by ACo out of pre-acquisition surplus and (to the extent of any amount that otherwise would be a negative ACB gain) out of New FA’s exempt surplus pursuant to s. 93(1.11)(b) and Reg. 5902(6).

Background

ACo wholly-owns BCo, which is a foreign corporation with its central management and control in Canada, and FA1, the fair market value of whose shares exceeds their ACB and the consolidated net surplus of FA1, all of which is exempt surplus. Substantially all the property of FA1 is excluded property.

Subject transactions

1. ACo transferred all of its FA1 shares to a newly-incorporated foreign affiliate (New FA) for FMV consideration satisfied by the issuance of common shares, and with the stated capital of those shares equalling the principal amount of the BCo Note referenced in 2 below.
2. New FA transferred to BCo all of its FA1 for a purchase price equalling the “Transfer Amount,” being the sum of the FA1 Shares’ relevant cost base and the consolidated net surplus of FA1 (but not exceeding the shares’ FMV), to be satisfied by the issuance of the BCo Note (whose amount is subject to a price adjustment clause).
3. ACo subscribed for additional BCo Common Shares for cash in an amount equal to the principal amount of the BCo Note.
4. BCo repaid the BCo Note.
5. Such amount was distributed by New FA as a stated capital distribution to ACo, with ACo electing under Reg. 5901(2)(b) to treat the distributions as having come out of New FA’s pre-acquisition surplus.

Proposed transaction

New FA will be liquidated and dissolved, and its property and obligations (principally respecting potential operation of price adjustment clauses respecting 2 and 3) will be distributed to and assumed by ACo.

Purpose

The purpose for the transfer in 2 occurring at the Transfer Amount rather than FMV is “to address certain policy concerns of the CRA by restricting BCo’s aggregate ACB of its FA1 Shares to the Transfer Amount.”

Rulings

Re application of s. 85.1(3) to drop-down in 1.

To the extent of any capital gain otherwise realized by New FA from the disposition of its FA1 Shares to BCo in 2:

(a) ss. 93(1), (1.1) and (1.11) and the relevant Regulations applied to cause the amount prescribed under Reg. 5902(6) to be treated as a dividend received by New FA from FA1 immediately before the disposition and not to be proceeds of disposition of such FA1 Shares; and

(b) provided that the FA1 Shares were excluded property of New FA at the time of the disposition, the amount of any capital gain (determined after the application of s. 93(1)) from the disposition of such shares would not have been included in the FAPI of New FA.

The distribution in 5 came first out of pre-acquisition surplus and, to the extent of any amount that otherwise would be a s. 40(3) gain, the Reg. 5902(6) amount was deemed to be a dividend received by ACo from New FA immediately before the time of such distribution (presumably coming out of exempt surplus), with any excess (apparently none) being a s. 93(1) capital gain of ACo.,

Ss. 15(1), 56(2), 69(4) and 246(1) did not apply to the transfer by New FA of all of its FA1 Shares to BCo in 2.

The Taxpayer, a taxable Canadian corporation, used the proceeds of a U.S.-dollar loan to subscribe for shares of a wholly-owned foreign affiliate (“Subsidiary”). After receiving a dividend, which the Taxpayer had treated in part as a return-of-capital and in part as an exempt dividend, Subsidiary was wound-up (at a time that its net worth was nil), with the Taxpayer realizing a capital loss, which was entirely attributable to the depreciation in the U.S. dollar. The Taxpayer repaid the loan in a subsequent year and realized a capital gain.

In finding that s. 93(2) applied to reduce the capital loss, the Directorate stated:

[T]he term "loss" in subsection 93(2) cannot be interpreted to exclude a loss realized by a taxpayer on the disposition of shares of a FA solely because of a fluctuation in the value of a foreign currency relative to Canadian currency. …

In addition … February 24, 2004 Legislative Proposals … which provides relief from the application of the loss limitation rule in subsection 93(2) in certain circumstances, confirms, in our view, that this provision is technically applicable in a situation where a loss on the disposition of shares of a FA is solely due to a currency fluctuation.

But for s. 94(3), a Canadian corporation (ACo) would have realized a capital loss of $1 million on the liquidation and dissolution of a wholly-owned non-resident subsidiary (FA1) which, in turn, held FA2 and FA3.After the Directorate found that s. 94(3) applied to deny the loss and add it to the ACB to ACo of the shares of FA2 and FA3, it then considered the question:

If the portion of such denied loss added to the ACB of the FA2 shares under s. 93(4)(b) was $50,000 (resulting in ACo’s ACB of the FA2 shares becoming $100,000 (as otherwise determined under s. 88(3)) + $50,000 = $150,000), would the s. 93(2.01) rules determine ACo’s loss on the disposition of the FA2 shares?

The Directorate responded:

“Yes”. Absent the subsection 93(2.01) loss limitation rule, ACo would have an otherwise determined (capital) loss of $40,000 (i.e. $110,000 - $150,000) arising on its disposition of its FA2 shares … . [P]aragraph 93(2)(a) mandates the application of subsection 93(2.01), and the $40,000 loss is limited by the exempt dividends previously paid on the FA2 shares or on shares for which the FA2 shares were substituted.

A wholly-owned foreign affiliate (“Luxco1”) of Canco held 1/3 of the shares of a corporation ("NRco") resident in a Treaty country. Another wholly-owned affiliate of Canco (“Luxco2”), used the proceeds of an interest-free loan from Canco to make an interest-bearing loan to NRco, with resulting deemed active business income to Luxco2 under s. 95(2)(a)(ii)(B) being paid to Canco as exempt dividends.

Subsequently, the shares of Luxco2 were contributed as capital contribution by Canco to Luxco1 without share consideration, and Canco then sold the shares of Luxco1 to a third party, thereby realizing a capital loss. Luxco1 did not pay any dividends to Canco. Is the capital loss reduced under s. 93(2.01)?

In finding that the shares of Luxco1 were substituted shares for those of Luxco2, so that the loss was so reduced, CRA stated that the s. 92(2.01) rule contains no purpose test and that:

The concept of "substituted share" in subsection 93(2.01) must…be given its ordinary meaning, taking into account inter alia that the interpretive rule in subsection 248(5) does not stipulate a definitive meaning for this concept for the purposes of the Act.

CRA considered that the s. 93(2.01) stop loss rule applied where Canco made a contribution of capital to a foreign subsidiary (FA2) of its shares of a non-resident Finco subsidiary (FA1) which had paid dividends out of its deemed active business income to Canco – so that s. 93(2.01) denied a subsequent capital loss realized on an arm’s length sale of the FA2 shares to the extent of such dividends. This was so even though the contribution did not entail any exchange of property and even though the FA1 shares likely would never have generated an accrued loss (with CRA observing in its oral comments that “there is no purpose test inherent in subsections 93(2) and (2.01), and other similar rules.)

CRA stated:

[W]e may be prepared to develop administrative solutions to the extent this could result in double-counting, or the same dividends being counted, or producing two or more losses.

A Canadian-resident corporation did not elect under s. 88(3.1) for the winding-up of its wholly-owned controlled foreign affiliate (CFA) to be a qualifying liquidation and dissolution. Would s. 93(2.01) limit the loss on the disposition of CFA shares disposed of in a wind-up where the loss is primarily due to FX fluctuations and no exempt dividends had been paid on the shares or substituted shares? CRA stated:

If no exempt dividends had been paid on the CFA shares or shares for which the CFA shares were substituted, then the amount determined under paragraph 93(2.01)(a) will not be less than the particular loss determined without reference to the subsection [i.e., per the Summary, "without the payment of exempt dividends, paragraph 93(2.01)(a) will not operate to reduce the loss.]

A shareholder having an accrued foreign exchange loss on common shares of an FA and an accrued foreign exchange gain on a related party debt used to acquire those shares acquires a separate class of the FA's shares and pays dividends thereon with a view to such dividends not reducing a loss to be realized on the a sale of the original FA shares owned - in order that such loss can offset the FX gain on settlement of the debt. Would the conclusion at the 2013 IFA conference (see below) that GAAR would apply change if the funds used to acquire the original FA shares had been borrowed from an arm's length party more than 30 days before the acquisition of the shares?

In responding "no," CRA indicated that a loss would be denied "unless the related debt is a debt described in subparagraph 93(2.01)(b)(ii), a provision which precisely specifies which gains are intended to have an effect on the computation of the amount of a loss to be denied on the disposition of FA shares," and that one such requirement was that an "arm's length foreign currency debt… was entered into within 30 days of the acquisition of the FA share."

Tower 1

Under a Tower structure (Structure 1) a taxable Canadian corporation (Parent), all of whose shares were held directly or indirectly by a Canadian public company (Publico), was partner together with its subsidiary (Canco1) in a limited partnership (LP1), which had borrowed from banks and which held all the shares of a ULC (Canco2), which was the member of an LLC (LLC1). Interest received by LLC1 on a loan to a US Opco (USCO2, held by USCO1, held in turn by Parent) was deemed to be active business income by s. 95(2)(a)(ii), so that dividends paid by it to Canco2 were exempt dividends. Dividends received in turn by Parent and Canco1 through LP1 were deducted under s. 112(1).

Dismantling of Tower 1

Parent subscribed for preferred shares (A Shares) of USCO1 (1), with USCO1 lending the funds at interest to USCO2 (2), which repaid the loan from LLC1 (as well as a loan from LP1) (3). Parent acquired the shares of Canco2 for a note (4), LLC1 distributed the loan repayment funds to Canco2 as a capital reduction (5) with Canco2, in turn, making a matching capital distribution to Parent (6). Parent repaid the note (7), with LP1 using such proceeds to make an interest-bearing loan to Parent (8). LLC2 was continued under the CBCA (9), Canco2 was wound-up into Parent under s. 88(1) (10), LLC1 was wound-up into Parent and Canco1 under s. 88(2), with Parent claiming a capital loss on its shares of LLC1 (11). Such capital loss "technically" was not reduced under s 112(1) or 93(2) but CRA denied the loss under s. 245(2).

Realization of capital loss at issue

In connection with transactions described in 2007-023929, Parent transferred its A Shares to an affiliated company (Canco4) (12), which was wound-up into Parent under s. 88(1) (13). There then was an acquisition of control of Parent (14), so that it reported a capital loss under s. 40(3.4)(b)(iii).

Question 1

Was the membership interest in LLC1 a share for which the A Shares were substituted for purposes of s. 93(2)?

CRA response

In indicating "no", CRA stated (TaxInterpretations translation):

Paragraph 248(5)(a) circumscribes this concept [of substituted property] by providing that it refers to a property acquired in a disposition or exchange of a particular property, so that the latter property is the subject of a legal transaction. The second part of paragraph 248(5)(a) expands the scope of this concept in envisaging an indeterminate number of substitutions, establishing a link between the initial property under consideration and the property acquired in the final substitution. It should be noted that it is not necessary for a particular expression to be reproduced in a particular provision of the Act in order to apply the rules of interpretation governing the concept of substituted property in subsection 248(5). In this context, the use of the terms "action de remplacement" and "share for which the affiliate share was substituted" in the French and English versions of paragraph 93(2.01)(a) refer to the concept governed by paragraph 248(5) in respect of property that is shares.

In this case, the XXXXXXXXX A Shares of USCO1 were issued in the course of a legal transaction which did not involve in any way the interest in LLC1 or a property acquired in replacement for such interest. Accordingly ... the interest in LLC1 cannot be considered as a share for which XXXXXXXXXX A Shares of USCo1 were substituted for the purpose of determining Element B.

Tower 2

Publico and Parent were the partners of LP2, which held all the shares of a ULC (Canco3). Canco3 held preferred shares of a limited liability company (LLC2) and LP2 held the remainder shares. Interest received by LLC2 on a loan to a US Opco (USCO3, held by USCO2) was deemed to be active business income by s. 95(2)(a)(ii), so that dividends paid by it to Canco3 were exempt dividends. Dividends received in turn by Parent and Canco1 through LP2 were deducted under s. 112(1). No dividends were paid on the remainder shares of LP2.

Dismantling of Tower 2

Parent used borrowed money to lend US dollars to Publico at interest (1), which Publico used to make a capital contribution to LP2 (thereby changing their relative partnership interests) (2). LP2 repaid its 3^rd party loan (3) before being wound-up into Publico and Parent under s. 98(3) (4). Parent transferred its undivided interest in the shares of Canco3, as well as the remainder shares of LLC2, to Publico in consideration for a note (5). As a result, Parent claimed a capital loss which was not reduced by s. 112(3). Publico transferred such properties, in turn, to USCO1 in consideration for the issue of preferred shares (B Shares) (6). As a result, Publico claimed a capital loss which also was not reduced by s. 112(3). Publico transferred the B Shares to Parent in repayment of a portion of the note (7). Canco3 effected a stated capital distribution of a portion of its preferred shares of LLC2 to USCO1 as a capital distribution (8). Canco3 was wound-up into USCO1 (9), and USCO3 and LLC2 were merged (10).

Realization of capital loss at issue

In connection with transactions described in 2007-023929, Parent transferred its B Shares to an affiliated company (Canco4) (11), which was wound-up into Parent under s. 88(1) (12). There then was an acquisition of control of Parent (13), so that it reported a capital loss under s. 40(3.4)(b)(iii).

Question 2

Did the preferred shares of LLC2 represent shares for which the B Shares held by parent were substituted for purposes of s. 93(2)?

CRA response

In indicating "no", CRA stated (TaxInterpretations translation):

[T]he loss realized ... by Parent respecting the ... B Shares of USCO1 was attributable entirely to a fluctuation in the exchange rate for the Canadian dollar over the course of the period ... .

[T]he ... B Shares of USCO1 held by Parent were issued in the course of a legal transaction which did not directly involve the Preferred Interest in LLC2 or a property acquired in replacement of such interest. ... [T]he Preferred Interest in LLC2 cannot be considered as a share for which USCo1's XXXXXXXXXX Class B Shares were substituted for the purpose of the application of Element B. Those shares instead were acquired by Parent in replacement of shares of Canco3, and no Exempt Dividend was paid in respect of the latter shares. Furthermore ... the wording of element B does not support the amounts of the dividends received by Canco3 in respect of the Preferred Interest it held in LLC2 being indirectly considered for purposes of the application of the rules.

GAAR review status

Finally, the subject facts have also been provided to the specialized audit team of your Tax Services Office in order that they can decide as to the possible application of the general anti-avoidance provision of the Act ("GAAR") regarding an avoidance transaction. We have received confirmation from a member of that team that the analysis has not been concluded and that a referral to the Abusive Tax Planning Division at National Headquarters has not been made in this file.

Canco owns all the shares of Forco1, which it transfers to Forco2 for a promissory note payable in U.S. dollars, and then transfers the note to Forco3 in exchange for shares of Forco3. In finding that such shares of Forco3 were substituted for the shares of Forco1, CRA indicated that the concept of "share substituted" was not restricted "to a chain of substitutions in which only shares are substituted."

On a liquidation and dissolution (“L&D”) of FA1, it distributed to its parent (ACo) its shares of (wholly-owned) FA2 and FA3 and other property. Ss. 88(3) to (3.5) applied to the L&D. As it was not a “qualifying liquidation and dissolution,” the FA1 properties were disposed of at their fair market value. Prior to the L&D, FA2 and FA1 had paid exempt dividends to FA1 and ACo, respectively. But for s. 93(4), Canco realized a capital loss of $1 million (after the application of s. 93(2.01) to reduce such capital loss by the exempt dividends previously paid by FA1) on its disposition of the FA1 shares. Since the FA2 and FA3 shares were acquired by ACo prior to FA1’s dissolution, did s. 93(4) apply? The Directorate responded:

ACo acquired the shares of FA2 and FA3 as part of the process of liquidating and dissolving FA1, which included ACo disposing of its shares of FA1. In our view, the distribution of the property of FA1 to ACo was “on” the disposition of the shares of FA1.

Consequently, ACo’s otherwise determined capital loss of $1 million on the disposition of its FA1 shares is deemed by paragraph 93(4)(a) to be nil. The denied capital loss is added by paragraph 93(4)(b) to the ACB to ACo of the shares of FA2 and FA3 that ACo acquired on the disposition in proportion to their respective fair market values.