Regulation 5901

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.

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.