Regulation 5901 - Order of Surplus Distributions

Survivor merger or liquidation of CFA after generating exempt earnings in current year (p. 10)

A foreign affiliate (Parent) owns all of the outstanding shares of another foreign affiliate (Sub). Sub pays a dividend to Parent more than 90 days after Sub's taxation year begins. Sub generates exempt surplus in excess of the dividend amount in the same year the dividend is paid. In the absence of Regulation 5901(2), the dividend paid by Sub would be paid out of pre-acquisition surplus. Later in the same year Sub is liquidated or merged into Parent. Parent survives the merger under the relevant corporate law.

Deemed year end for Reg. 5901(2) purposes before merger/liquidation (p. 10)

Under either Regulation 5907(8) or (9) Sub is deemed to have a year end at a time prior to the merger or liquidation… Since the deeming rule in Regulation 5901(2) affects an affiliate's exempt, hybrid, and/or taxable surplus, the deemed year end arguably applies for the purposes of the year-end deeming rule in Regulation 5901(2).

Shareholder may hold the CFA at the moment after its deemed taxation year (p. 10)

In the event that the deemed year end applies for the purposes of Regulation 5901(2), the question is whether the 90-day rule will apply to deem the distribution to be paid from Sub's exempt surplus. The CRA has held [1991-55] that the 90-day rule does not apply to a dividend paid by a foreign affiliate in a taxation year if the shareholder does not hold the shares of the foreign affiliate immediately after the end of that taxation year. However, because the tax year end is deemed under Regulation 5907 to take place prior to the foreign merger or liquidation, Sub arguably continues to exist for at least a moment after the deemed year end….

Exempt dividend amount included in Parent's ES (on receipt) but not subtracted from Sub's ES until after deemed year end (p. 11)

If the deemed year end…applies…and the 90-day rule applies to the dividend paid by Sub…:

• Under…Regulation 5907(1)(c)(A)(v) the exempt surplus dividend paid by Sub to Parent is included in Parent's surplus at the date Parent receives the dividend.
• Under Regulation 5901(2), Sub is deemed to pay the dividend to Parent immediately following the end of the year. As a result, Sub's exempt surplus balance immediately before the tax year end (and before the merger or liquidation time) includes the exempt surplus distributed from Sub to Parent earlier in the year.

On this basis, double-counting of sub’s distributed exempt surplus (p. 11)

The surplus paid out through Sub's dividend to Parent is double-counted in the exempt surplus balance after the merger or liquidation. First, under Regulation 5905 the opening surplus balances combines the surplus and deficit balances of Sub and Parent immediately before the merger time or deems a dividend equal to the net surplus of the Sub immediately before the liquidation to have been paid to Parent. Next, the 90-day rule in Regulation 5901(2) deems Sub to pay the dividend to Parent immediately following the end of the year. As a result of this timing, Sub's surplus balance before the merger or liquidation time includes the surplus previously paid out and already included in Parent's surplus as a result of the dividend.

Election can be used to bypass untaxed taxable or hybrid surplus (p. 608)

• The election may be beneficial where a CRIC has received a dividend from a foreign affiliate that would otherwise come out of hybrid or taxable surplus that has borne insufficient income tax.

Beneficial to pay multiple whole dividends (p. 609)

• Since the election must be made respecting a whole dividend it may be desirable for a distribution from a foreign affiliate to be paid as multiple sequential dividends of varying amounts, to increase the flexibility of the CRIC in the presence of uncertainties as to the ACB of the foreign affiliate shares (or its surplus balances).

Examples of adverse consequences of making the Reg. 5901(2)(b) election

• There can be adverse (or favourable) consequences of making the Reg. 5901(2)(b) election rather than using surplus.

Example 1 (pp. 612-613)

• Canco (which has not made a functional currency election) holds all the shares (having an ACB of $150 million) of a single class of FA, which pays a US$ 100 million dividend (equivalent to Cdn.$140 million) at a time that its only surplus/deficit accounts (which it maintains in US dollars) is an exempt surplus balance of US $100 million. If it subsequently realized operating losses of US$ 100 million (thereby wiping out any unutilized exempt surplus balance), it would have been better off not to have elected (so that the dividend came out of exempt surplus), as maintaining the ACB of $150 million would permit FA to distribute up to that amount to Canco as preacquisition surplus dividends notwithstanding FA’s exempt deficit.

Example 2 (p. 615)

• Rather than there being subsequent operating losses, the only relevant subsequent change is that the Canadian dollar appreciates relative to the US dollar. If it does not make the election, Canco will have a greater relative benefit from having maintained most of its Canadian dollar basis in the FA shares rather than maintain a US dollar exempt surplus balance.

Example 3 (pp. 616-617)

• FA, a US subsidiary, which has exempt earnings, pays two dividends of US$ 100 million in the same year: the first being subject to 5% US withholding tax because it is paid out of earnings and profits for US purposes; and the second being not subject to withholding because it was not out of E&P. Respecting the first dividend, the ACB reduction will only be $95 million if the Reg. 5901(2)(b) election is made, whereas if the election is not made, the exempt surplus balance is reduced by the gross amount of the dividend irrespective of whether there is withholding tax. Accordingly, it may be preferable to make the election only respecting a dividend that is subject to withholding tax.

Example 4 (pp. 618-619)

• Canco, which has elected under s. 261 to compute its Canadian tax results in US dollars, holds cumulative preferred shares of FA with a face value and ACB of US $100 million. The dividends come out of exempt surplus unless Canco makes the Reg. 5901(2)(b) election. If it makes the election, it might seem that this would increase the amount of exempt surplus it could access so as to shelter under s. 93(1) the resulting gain when the preferred shares are subsequently redeemed. However, the rules in Reg. 5902 might limit its access in that redemption scenario to exempt surplus only in the amount of the accrued but unpaid dividends on the shares at the time of redemption, thereby resulting in the realization of a capital gain that would have been avoided if the election instead had not been made.

Desirability or undesirability of elevating surplus from lower-tier affiliates rather than making

• It may be beneficial for the payer of an interaffiliate dividend, who has sufficient tax-free surplus, to pay a dividend to a higher-tier foreign affiliate from such tax-free surplus, so as to elevate tax-free surplus up the foreign affiliate chain, thereby making such surplus more readily available to shelter the payment of any subsequent dividends to the CRIC – and also safeguarding that tax-free surplus from erosion by any subsequently-incurred losses of the payer affiliate.

Example 5 (pp. 620-623)

• Canco wholly-owns FA 1 (which has no exempt, hybrid, or taxable deficits), which wholly-owns FA 2 and FA 3, whose shares constitute excluded property. FA 3 pays a dividend of $10 million to FA 1 while it has exempt surplus of $10 million (and no hybrid and/or taxable deficits), with FA 1’s ACB in the FA 3 shares being $110 million. Subsequently, FA 1 contributes the shares of FA 3 (having a FMV of $100 million) to FA 2 in exchange for additional shares of FA 2.
• Assuming no Reg. 5901(2)(b) election respecting the dividend paid by FA 3 to FA 1, FA 3’s exempt surplus of $10 million is elevated to FA 1, and FA 1’s ACB in the FA 3 shares remains at $110 million. On the subsequent contribution of the FA 3 shares to FA 2, FA 1 realizes a $10 million loss that is included in computing its hybrid deficit. Consequently, FA 1’s ability to pay a dividend from its $10 million of exempt surplus (previously elevated from FA 3) may be blocked by the $10 million hybrid deficit created on the transfer of the shares of FA 3 to FA 2.
• If, however, Canco instead makes the election respecting the $10 million dividend, the exempt surplus of FA 3 would not be elevated. Instead, FA 1’s ACB in the FA 3 shares would be reduced to $100 million. No loss, or hybrid deficit, would arise to FA 1 on its subsequent disposition of the FA 3 shares to impede its ability to pay tax-free surplus dividends to Canco.

QROC election intended to address unavailability of Reg. 5901(2)(b)(ii) election to partnerships

[A]lthough subsections 93.1(1) and (2) are meant to allow a CRIC to access this [FA dividend] regime through partnerships, no pre-acquisition surplus election is available to a partnership that is a shareholder of the distributing FA, even if each of its members is a CRIC or an FA of a CRIC….

[W]hile available to all taxpayers, the QROC election is really for the benefit of partnerships and of other taxpayers that are ineligible for the pre-acquisition surplus election….

Greater flexibility for subsequent surplus ascertainment if multiple dividends paid (p. 2)

Up-to-date figures on an FA's surplus pools may not be available at the time that a dividend is to be paid….

[T]he FA [could] pay multiple smaller dividends totalling the desired distribution amount

In this way, there is more flexibility to elect under regulation 5901(2)(b) as needed in respect of each whole, smaller dividend at a later time when surplus and basis computations are clearer or more complete. … Any dividend on which an election is not made will first come out of exempt surplus….

Retroactive election (p. 3)

… Bill C-48 permits taxpayers to electively apply Regulation 5901(2)(b) (together as a package with subsections 90(2) and 93(1.11)) retroactively to foreign affiliate distributions made after December 20, 2002.

Choice between surplus and basis grind (p. 3)

By electing to apply Regulation 5901(2)(b) retroactively, and by thereby electing to apply subsection 90(2) retroactively to deem each post-December 20, 2002 foreign affiliate distribution to be a dividend (regardless whether it was in fact paid as a dividend or a capital distribution), taxpayers can either (i) choose to treat the particular distribution as a dividend that accessed the relevant surplus balances of the distributing foreign affiliate (by not further electing to apply Regulation 5901(2)(b) to that particular dividend or deemed dividend), or (ii) choose to treat the particular distribution as a pre-acquisition surplus dividend that accessed the basis of the foreign affiliate before potentially dipping into the relevant surplus balances of the distributing foreign affiliate (by further electing to apply Regulation 5901(2)(b) to that particular dividend or deemed dividend).

E.g., resolving divided/capital character or surplus balances or using subsequently-ground exempt surplus (p. 3),

For example, consider an historic foreign affiliate distribution, paid for foreign corporate law purposes out of share premium, contributed surplus, or similar equity-type account where the Canadian tax treatment (as a dividend or capital distribution) might have been unclear. Or consider an historic dividend where the surplus balances might have been uncertain and there was a risk of elevating taxable surplus with insufficient underlying tax. Alternatively, consider an historic capital distribution paid by a foreign affiliate with exempt surplus that might have subsequently been eroded by exempt losses. In each of these cases, the Canadian parent now has the time-limited opportunity to reconsider the originally intended surplus and basis consequences of the distribution….

From a group structure perspective, taxpayers may also wish to capitalize on the enhanced superiority of basis over surplus, by reorganizing their foreign affiliate groups to consolidate basis in one or more holding company foreign affiliates....The effect is to aggregate and consolidate the basis in those transferred top-tier foreign affiliate shares, into the basis of the newly issued top-tier foreign affiliate holding company shares held directly by the Canadian parent corporation. Future distributions sourced from the various underlying chains could then ultimately be paid to the Canadian parent by the top-tier foreign affiliate "basis consolidator" as dividends electively deemed by Regulation 5901(2)(b) to be pre-acquisition surplus dividends. In this manner, the potential adverse consequences from elevating possible "bad" hybrid surplus or taxable surplus from the underlying foreign affiliates could be deferred to the greatest extent. Moreover, by strategically electing under Regulation 5901(2)(b) in respect of those lower-tier foreign affiliate distributions, it may be possible to defer the elevation of any such "bad" hybrid surplus or taxable surplus up the chain.

Taxpayers may now hold their foreign affiliate groups under a "basis and surplus mixer" foreign affiliate holding company, and routinely use the Reg. 5901(2)(b) election for top-tier foreign affiliate distributions.

Includes comparison with previous comfort letter proposals.