Regulation 5902

Canco owns all of the shares of BCo (a foreign affiliate) which in turn owns redacted percentages of the Class B, D and D shares of CCo (also a foreign affiliate). CCo owns X% of the limited partnership interest in a foreign partnership (P1), with the balance of the limited partnership interest being held by a group of arm's length non-resident investors (NR2). CCo and NR2 also jointly own the non-resident general partner (DCo) of P1.

NR1 paid $X to CCo to acquire a further LP interest in P1. CCo declared a dividend of on its Class D shares, with NR1 waiving its rights thereto, so that BCo received the entire dividend. The Class D shares held by BCo were then redeemed, generating a capital loss.

NR1 wished to acquire the Class B and C shares of CCo held by BCo. Accordingly, NR1 paid an amount to CCo equal to the fair market value of the Class B and C shares of CCo held by BCo. CCo declared a dividend on the Class C shares out of this receipt, which was paid in its entirety to BCo, with NR1 waiving its rights thereto. BCo then sold its Class C and Class B shares of CCo to NR1, thereby generating a capital loss.

The field auditor believed that the shares of CCo were not excluded property.

The Rulings Directorate noted that application of s. 245 "may make sense if the taxpayer is able to access more exempt surplus by paying a dividend than it would by selling the shares." This could be the case given that the payment of the dividends may have fully accessed any available exempt surplus of CCo, whereas if there instead had been a sale of CCo shares to NR1 at a gain followed by a s. 93(1) election, the amount of exempt surplus which was accessed under the operation of Regs. 5902(1) and 5901 could be more limited – which would result in pre-acquisition surplus dividends grinding basis under s. 92(2) which, in turn, would result in a taxable capital gain which was foreign accrual property income. The Directorate then stated:

if the dividends were paid in order to avoid the FAPI that would otherwise be expected to arise on the sale of shares to an arm's length person as described in the example above, we suggest that you consider application of the GAAR.

Where a corporation resident in Canada owns 95% of the common shares of FA1 which, in turn, owns 100% of the common shares of FA2 which, in turn, owns 5% of the commons shares of FA1, and the Canadian corporation disposes of its shares of FA1 to a third party and elects under s. 93(1), FA2 will be the particular foreign affiliate for the purposes of Regulation 5902(2)(a).