Regulation 5907

General reduction under Reg. 5907(1.4) (p. 523)

[R]egulation 5907(1.3) can prescribe the particular FA's tax compensation payments to other members of the group to be FAT….

[R]egulation 5907(1.4) reduces the amount otherwise prescribed to be FAT pursuant to regulation 5907(1.3) to the extent that the amount "can reasonably be considered to be in respect of" a loss or capital loss of another corporation, where that loss or capital loss would not be a FAPL of a CFA of a relevant person or partnership in respect of the taxpayer….

Purpose of Reg. 5907(1.4) (p. 524)

The-[Finance] explanatory notes to regulation (1.4) clarify its purpose merely by stating that any resulting FAT denial is "consistent with the fact that... active business losses and capital losses resulting from the disposition of excluded property of a foreign affiliate are not included in the computation of a FAPL." This can be interpreted to mean that, just as a stand-alone FA cannot use active business losses to reduce FAPI, so too an FA should not be able to generate FAT by compensating a separate entity for its active business losses. Regulation 5907(1.4) blocks a taxpayer from increasing FAT deductions on the reassignment of active business losses within a consolidated group.

One-shot reinstatement only when full notional loss deduction (pp. 524-5)

[I]f regulation 5907(l.5) reinstates FAT, it does so all at once—with prescribed FAT in the taxpayer's taxation year that includes the last day of the FA's designated taxation year. Thus, if the [Finance] explanatory notes example is modified so that FA 3 earns active business income of $299 in 2006 and $1 in 2007, the FAT is still reinstated only in 2007, with no FAT deductionin2006.

FAT deduction under s. 91(4) (in e.g. 2007) in respect of year (e.g. 2004) of FAPI inclusion (p. 527)

[C]anco, pursuant to Finance's approach, is viewed as having a FAT reduction in 2004 and therefore a net FAPI income inclusion for that year. Canco's deduction in respect of reinstated FAT, however, is delayed until 2007. A taxpayer may be prevented from carrying back a loss resulting from reinstated FAT to the FAPI year….

Imaginary nature of deduction/application of local rules (pp. 527-8)

[U]nder regulation 5907(1.6), 2007 is a designated taxation year of FA 2, because the 2004 losses of the members of the consolidated group could "reasonably be considered" to have been fully deducted in computing US taxable income in that year. The local deductions in this context are hypothetical. Regulation 5907(1.6)(a) requires a taxpayer to ignore all FAPI earned by the members of the consolidated group, whereas, in reality, FA 3's losses are applied against FA2's FAPI in 2004, and no losses are available for carryover….

In evaluating the hypothetical carryover, the FAT reinstatement regulations only authorize the assumption that no FAPI is earned by the relevant affiliates. All other local prerequisites for loss carryovers must be applied, regardless whether they resemble those under the Act….

[A] taxpayer cannot be certain of its intended deduction for reinstated FAT until it resolves its income and losses under local rules for each period that might have losses that can be carried back to a relevant year.

No reinstatement if FAPI earner ceases to be FA (p. 528)

…FAT reinstatement is seemingly possible only if the FA that has earned the relevant FAPI remains an FA of the taxpayer. The requisite relationships may be lost if, for example, the taxpayer transfers the FA to a parent or sister company.

Tainting effect of Losscos joining group (p. 529)

The hypothetical carryover under the FAT reinstatement regulations does not seem to ignore losses of entities that join the consolidated group, even while ignoring the income of such entities. Regulation 5907(1.6)(a) authorizes only one assumption in analyzing the carryover: that FAPI is ignored. The hypothetical deductions are arguably prevented if income in periods following the FAPI year is actually offset by losses of entities that are newly formed, or acquired… .

Requirement to utilize capital losses? (p. 529)

[R]egulation 5907(1.6) appears to require that all "losses" from the FA years ending in the FAPI year be fully deducted. "All losses" presumably includes capital losses, FAPLs, and FACLs realized by the group companies. [fn 29: While FAPLs realized by members of a consolidated group would not of themselves cause regulation 5907(1.4) to reduce FAT, this provision can nonetheless apply when there are FAPLs in a group if other members of the group realize active business losses in the year.]…

Several local taxation periods ending in FAPI year (p. 530)

[A] taxpayer is eligible for FAT reinstatement only if losses for all taxation years ending in the FAPI year are hypothetically deducted against non-FAPI income. The FAPI year is a taxation year of the Canadian taxpayer. The relevant FAs might have several local taxation periods ending in this FAPI year. There could be situations where losses in some of the periods ending in the FAPI year did not "cause" the relevant FAT denial….

Blocking effect of FAPLs (p. 530)

[T]he losses in question must be fully deducted against any income on the assumption that the relevant foreign corporations have no FAPI. Thus, a taxpayer could arguably fail to get FAT reinstated even if the members of the group have active business income that would offset the FAPI-year losses, if those members also have FAPLs in the relevant years.

In the example illustrated by table 3, FA 1 has a FAPL of $200 in 2006. Seemingly, no 2004 losses can be deducted hypothetically against FA 3's 2006 active business income because, this income can be viewed as being already offset by FA l's FAPL in that year….

Reinstatement by deducting FAPI-year losses against passive income earned by non-FAs (p. 532)

The members of the consolidated group might include non-FAs, which by definition cannot earn FAPI. [fn 30: FAPI is defined in subsection 95(1) only relative to FAs of a taxpayer. To illustrate, an FA ("US Sub 2") of a Canadian taxpayer ("Canco") might be a member of a consolidated group that includes non-FAs if Canco is wholly owned by a US parent ("USP"); USP directly owns all the common shares of US Sub I and US Sub 2; USP, US Sub 1, and US Sub 2 form a consolidated group; and Canco owns only all of the special shares of US Sub 2.] As a result, one could arguably achieve reinstatement by deducting FAPI-year losses against passive income earned by non-FAs, even if that income would have been FAPI had the non-resident entities been FAs of the taxpayer….

Deduction against 50% of non-excluded property capital gains (p. 532)

The FAT reinstatement regulations seemingly permit losses to be used against other kinds of non-active business income, such as passive income earned by FAs for local purposes that is excluded in computing FAPI. For example…assuming that "income" for the purposes of regulation 5907(1.6)(a) can include capital gains, one should arguably be able to deduct FAPI-year losses against 50 percent of an FA's gains on the disposition of non-excluded property because the FA would still have such gains even assuming that it had no FAPI.

No reinstatement when no FAPI-year losses (p. 533)

…FA 1 compensates FA 2 in year 2 for the use of its active business losses realized in year 1. FA 2 later earns active business income in year 6. The FAT in respect of FA 1 otherwise prescribed by regulation 5907(1.3) is arguably reduced under regulation 5907(1.4), by the amount of FA l's compensation payment to FA 2, since FA 2 is not being compensated for a FAPL. However, this FAT seemingly cannot be reinstated, despite the active business income earned in year 6, because regulations 5907(1.5) and (1.6) trigger such reinstatement only when FAPI-year losses are hypothetically carried over, and in this example there are no FAPI-year losses whatsoever.

Initial multi-year perspective (pp. 537-8)

The CRA had applied [in 901876] a multi-period perspective in an even earlier head office memorandum [than in9719055 and 2002-013420117]...in interpreting the FAT definition and regulation 5907(1.3). ... FA 1 and FA 2 are FAs of a Canadian taxpayer; FA 1 is the head company of a consolidated group that includes FA 2. … The CRA accepted that FA 2's compensation payment in year 1 could constitute FAT in respect of its FAPI in year 2 if the consolidated group could hypothetically carry back the active business loss from year 2 to offset its active business income in year 1….

Multi-year perspective where local differences (p. 542)

Many provisions in the Act and regulations require a taxpayer to determine whether income or profits taxes can "reasonably be considered" to have been paid "in respect of" income from a specific source. Where a taxpayer has different sources of income for local purposes in various years, the challenge is to determine in what respects a multi-period perspective can be adopted in determining what the taxes reasonably relate to….

For some time, the CRA has respected a multi-period perspective in analyzing some of these broad provisions. … In implementing regulations 5907(1.5) and (1.6), Parliament codified an application of the multi-period perspective – but only in the context of FAT denial rules applicable to consolidated groups. The FAT reinstatement regulations were intended to permit FAT deductions when active business losses causing FAT denial are hypothetically deducted against active business income earned in subsequent years.

It is not clear whether the legislature, in enacting the FAT reinstatement regulations, sought to change how the multi-period perspective was already being applied. Parliament may have merely been clarifying how to apply the multi-period perspective in more difficult, multiple company scenarios.

Current pack and sale transaction rule (p. 6)

• Reg. 5907(2.01) overrides the non-recognition rules in Regs. 5907(5.1) and 5907(2)(f ) and (j), so that where an FA’s assets are packaged for sale and the conditions set out in Reg. 5907(2.01)(a) are met (including the disposition to an arm’s-length person, within 90 days, of the shares of another FA received as consideration for the packaged assets), surplus recognition on any unrealized value on the packaged assets is allowed.

Amendment requiring that share consideration be of the receiving FA (p. 6)

• An amendment to Reg. 5907(2.01)(a) adds a requirement that the shares received by the disposing affiliate as consideration for the packaged assets be shares of the receiving affiliate.

Amendment to accommodate assumption of ordinary-course debt (p. 6)

• A second amendment allows the consideration received to include “the assumption by the other affiliate of a debt or other obligation owing by the particular affiliate that arose in the ordinary course of the business of the particular affiliate to which the affiliate property relates.”
• This reflects a delayed reaction to 2014-0550451E5, which found that the requirement for relief under the current version, that the "only consideration received in respect of" the drop-down is shares of the new foreign affiliate, will not be satisfied if the new foreign affiliate assumes any liabilities of the transferor FA as part of the purchase.

Need to avoid assumption of liabilities on the drop-down transaction in a “pack and sale” transaction

• Reg. 5907(2.01) to some extent accommodates “pack and sale” transactions (respecting a drop down of a business unit to a foreign Newco followed by an arm’s length sale of the Newco) by rendering Reg. 5907(5.1) inoperative to transactions occurring on a rollover basis under the foreign tax law (so that exempt surplus may be generated) if certain conditions are met, one of which is that the only consideration received in respect of the particular disposition is shares of the capital stock of another FA of the taxpayer. Thus, the assumption of liabilities on the drop-down transaction would exclude access to Reg. 5907(2.01). See 2014-0550451E5. (p. 36: 33)

Example of what the 1992 Auditor General’s Report had in mind as conversion of taxable surplus into exempt surplus (pp. 1242-1243)

Suppose that FA 1 is a holding corporation whose only assets are shares of FA 2. FA 2 is resident in, and carries on an active business in, a low-tax jurisdiction that is not a designated treaty country. As a result, the income of FA 2 gives rise to taxable surplus, and since FA 2 operates in a low-tax jurisdiction, it is assumed that FA 2 has no underlying foreign tax. The shares of FA 2 have a large accrued capital gain, and it is assumed that these shares are excluded property to FA 1 on the basis that all or substantially all of FA 2's assets are excluded property, being operating assets used or held by FA 2 principally for the purpose of gaining or producing income from its active business. If FA 2 paid a dividend to FA 1, and FA 1 paid a dividend to Canco, the dividends would be prescribed to be paid out of the taxable surplus of FA 2 and FA 1, respectively. Canco would be required to include the dividend received from FA 1 in income and would not be entitled to claim a deduction under section 113 since there is no underlying foreign tax applicable to the taxable surplus divi­dend prescribed to be paid by FA 1.

However, notwithstanding the specific anti-avoidance rules described in the previous section, FA 1 could generate exempt surplus if it sold the shares of FA 2 to FA 3, or FA 2 could generate exempt surplus if it sold its active business assets to FA 3. In the case of a sale of shares by FA 1, provided that FA 1 did not receive share con­sideration from FA 3 on the sale, former paragraph 95(2)(c) would not apply, so that FA 1 would realize a capital gain on the disposition of the shares of FA 2; further, since the FA 2 shares are excluded property, this gain would not give rise to FAPI. The capital gain realized by FA 1 would be recharacterized as a dividend to the extent of FA 2's taxable surplus pursuant to the automatic election in former subsec­tions 93(1) and (I.I). However, any capital gain in excess of the taxable surplus of FA 2 would remain a capital gain; the non-taxable portion of the gain would be added to FA 1 's exempt surplus, and the taxable portion of the gain would be added to FA l's taxable surplus. Former regulations 5907(2)(f) and (5.1) would not apply to suppress these surplus additions since FA 1 is a holding corporation that does not hold the shares of FA 2 as part of an active business. Further, FA 3 would acquire the FA 2 shares with a cost equal to their fair market value, and FA 2 would continue to own assets with accrued gains that could give rise to exempt and taxable surplus when those assets were disposed of in the future. In the case of a sale of assets by FA 2, the rollover rules and former subsections 93(1) and (1.1) would not be relevant and the surplus suppression rules would not apply, provided that the income and capital gains realized by FA 2 on the sale were taxable in its home jurisdiction, albeit at a low rate of tax.

In either of these situations, FA 1 or FA 2 would be able to generate exempt sur­plus with no adverse Canadian tax implications under the FAPI rules, and under the ordering rule in former regulation 5901(1), this surplus could then be repatriated to Canco on a tax-free basis.

Requirement for a disposition “to” a designated person or partnership (pp. 1254-1255)

[R]egulation 5907(2.02) is confined to dispositions of property “to" certain persons or partnerships, and the phrase "disposition to" been interpreted by the courts to effectively mean dispositions by means of a transfer of property by one person to another. [Fn. 60: See, for example, Anderson et al. v. MNR, 74 DTC 1103 (TRB); rev'd on other grounds, sub nom. The Queen v. Huestis, 75 DTC 5042 (FCTD); further appeals dismissed, The Queen v. Huestis, 7 5 DTC 5393 (FCA), and sub nom. Stevenson Construction Co. Ltd. et al. v. The Queen, 77 DTC 5044 (SCC). See also Devon Canada Corporation v. The Queen, 2018 TCC 170. These cases considered the issue in the context of property that ceased to exist under the doctrine of merger in connection with the transfer. As illustrated in the Devon Canada case, the question of whether there is an acquisition of property by the transferee in this circumstance is a separate question from whether there has been a disposition of the property.] Arguably, this would exclude, for example, a deemed disposition and reacquisition of shares arising under the negative adjusted cost base rule in subsection 40(3).

Exclusion of exempt surplus items that are not in exempt earnings (pp. 1255-1256)

…[S]ince regulation 5907 (2.02) focuses on exempt earnings and exempt loss, the other items that are reflected in exempt surplus or exempt deficit are outside the scope of this rule. For 2011 and later periods, these items include

■ exempt surplus dividends received ( or deemed to have been received) from another foreign affiliate;

■ tax refunds or credits received by a shareholder affiliate in respect of exempt surplus dividends received from another foreign affiliate;

■ taxable dividends received by an affiliate from a corporation resident in Can­ada that would be deductible under section 112 if the dividend were instead received by the Canadian taxpayer in respect of which the affiliate is a foreign affiliate;

■ certain amounts in respect of tax payments or tax losses in a consolidated group added under regulation 5907(1.02), (1.1), or (1.2); and

■ certain adjustments under regulation 5905, such as those required under the fill-the-hole rule in regulation 5905(7.2).

Inclusion in exempt earnings of taxable gain already recognized in Canada or abroad (p. 1257)

…[E]xempt earnings include

■ the taxable portion of capital gains from dispositions of capital property used in active business operations that, if the dispositions are internal, have been recognized under foreign tax laws as required by regulation 5907(5 .l); and

■ the non-taxable portion of capital gains where the taxable portion of the cap­ital gain has been included in FAPI, either because the property was not excluded property or, if it was excluded property, because the disposition was subject to one of the rollover rules.

There is no apparent reason from a policy perspective why any of the foregoing should be subject to potential recharacterization under regulation 5907(2.02) given that the taxable portion of the gain has been properly recognized under foreign or Canadian tax rules, as applicable.

Carve-out for money (p. 1258)

…in response to concerns regarding the scope of the version of regulation 5907(2.02) in the 2011 proposals, the Department of Finance added the carve-out for money in regulation 5907(2.02):

A particular concern was expressed in respect of transfers of money in the context of interest payments that are recharacterized as active business income under paragraph 95(2)(a)-income that should normally result in exempt surplus. The application of the surplus reclassification rule to interest payments was not intended.

This exception makes sense from a policy perspective in that inter-affiliate interest payments have the effect of simply moving active business income, and thus exempt earnings, from one foreign affiliate to another and do not generate any additional exempt earnings from the perspective of the particular Canadian taxpayer.

Meaning of deduction from exempt loss (p. 1259)

Regulation 5907(2.02) also potentially applies when a disposition of property gives rise to an amount that is deducted in computing exempt loss. …

… Presumably the word "deduction" was intended to capture positive amounts that, when netted with negative amounts arising in the same year, result in an overall loss that is included in exempt loss. For example, if a foreign affiliate carries on an active business in a designated treaty country that has a loss for a particular year, but subsumed in that loss is an income gain in respect of an internal disposition of property, presumably regulation 5907(2.02) is intended to apply to that income gain.

Assumed tax benefit (p. 1260)

[O]ne is to assume that the increase in exempt earnings (or the decrease in exempt loss) arising from the disposition of property is a tax benefit. This assumed tax benefit was pre­sumably added to counter the argument that the mere addition to exempt earnings (or decrease in exempt loss) is outside the scope of the rule …

Implied surplus conversion object (p. 1263)

[I]t is clear that the mischief that is the intended target of regulation 5907(2.01) is a situation where a foreign affiliate has a balance of low-taxed taxable surplus and disposes of excluded property to generate exempt earnings ( or decrease exempt loss), without the imposition of Canadian income tax, in order to take advantage of the ordering rule and distribute the resulting exempt surplus in lieu of the low-taxed taxable surplus, thereby minimizing Canadian income taxes on the distribution. In light of this, and consistent with the approach adopted by the court in Lehigh Cement, in assessing whether there is a tax benefit, the approach that accords with the purpose of the regulation is a comparison between the tax treatment of a foreign affiliate distribution from a surplus perspec­tive following the disposition of property versus the tax treatment of a distribution if no such disposition of property occurred. If there is a tax benefit arising from the generation and distribution of exempt surplus (factoring in the tax consequences should the disposition of property give rise to FAPI), as compared with a distribution of existing low-taxed taxable surplus, and the purpose test (discussed below) is satisfied, the rule applies to reclassify the new exempt surplus back to the type of surplus that existed prior to the disposition.

…[O]ne would expect that Canadian tax avoidance is a necessary prerequisite to its application and that an increase in exempt earnings (or a decrease in exempt loss) is not enough on its own to engage the rule. A more reasonable interpretation is that the legislative drafters were merely ensur­ing that the rule could apply to dispositions of property that give rise to an increase in exempt earnings (or a decrease in exempt loss) where the exempt surplus balance is not distributed but rather is itself relied on in lieu of low-taxed taxable surplus.

Potential indifference to surplus in bump transaction (p. 1264)

[W]hen effecting a bump transaction, the Canadian taxpayer will often be indifferent as between rely­ing on the bump and relying on the tax-free surplus balance, and may in fact prefer to rely on the bump in order to avoid the time and effort required to ensure that the foreign affiliate surplus balances are accurate and up to date.75 Therefore, purely from a bump perspective, one would expect that there would be limited circum­stances where regulation 5907 (2 .02) could apply.

Primary purpose of the disposition (p. 1264)

Since the disposition is a transaction for the purposes of the avoidance transaction definition, it is clear from the text of this definition that in all cases one is testing the purpose of the disposition, and not the purpose of a series that may include the disposition.

… [A]s noted by the court in Lehigh Cement, the focus of the analysis should nonetheless be the purpose that is the specific target of the anti-avoidance rule under consideration (in this case, regulation 5907(2.02)) and not some other tax-avoidance purpose.

Conclusion (p. 1266)

… On the basis of the legislative history leading up to Bill C-48, it is clear that regulation 5907(2.02) is one of several rules designed to target a specific form of tax avoidance, namely, foreign affiliate surplus-stripping transactions, which involve a disposition of excluded property by a foreign affiliate for the purpose of converting, on a tax-free basis, low-taxed taxable surplus into exempt surplus that can then be repatriated, or otherwise relied on, to minimize Canadian income taxes. A textual, contextual, and purposive interpretation of regu­lation 5907(2.02) supports the view that the rule should apply only in these limited circumstances.

Application of rule to non-rollover reorgs, cf. fresh start rule (p. 5)

The main target of this anti-avoidance rule may be intercompany excluded-property transfers, but its application can be much broader. It may be possible to consider in this light (1) an FA that pays a dividend in kind; (2) a non-QLAD (qualifying liquidation and dissolution) subsection 88(3) liquidation; and (3) an FA-to-FA liquidation or merger that is not structured as a rollover. One should also ask whether the asset-packaging rule in regulation 5907(2.01) may, in the right circumstances, be caught by regulation 5907(2.02), because, for example, surplus maximization is a stronger motivation than any conditions that were stipulated by the third-party purchaser. Moreover, on the basis of Finance's technical notes, regulation 5907(2.02) may also apply to exempt earnings generated from a deemed disposition of active business assets under the fresh start rules in paragraphs 95(2)(k) and (k.l). However, it is questionable whether the FA's deemed disposition and reacquisition of its asset is considered a disposition of the asset by the FA to itself; a disposition to a person is a precondition of regulation 5907(2.02).

Two conditions under Reg. 5907(2.02) (p. 9)

[T]he "surplus reclassification rule". [fn 5: Regulation 5907(2.02).]…rule reclassifies an amount of exempt earnings as taxable earnings if the following two conditions are met:

• Condition 1: The amount is an increase in exempt earnings (or a decrease in exempt losses) that arises from a disposition of property (other than money) to a "designated person or partnership". [fn 7: …defined in Regulation 5907(1)]
• Condition 2: The disposition is a transaction that is an "avoidance transaction as defined in section 245… .

Example of FA of Canco ("USSub") switching to s. 95(2)(a)(ii) licensing business (p.9)

In 2014, USSub decides to change its business from producing and selling its energy food bars to licensing its "secret" recipe. The primary licensee of the secret recipe will be a company related to USSub. Under subparagraph 95(2)(a)(ii) of the Tax Act, the future income of USSub will be deemed to be active business income and thus classified as exempt surplus. This strategy shift is in response to business and economic conditions in the United States. This strategy shift will cause USSub's business to change from an active to a passive business. [fn 8: USSub's business will be an "investment business" as defined in subsection 95(1) because, among other reasons, its business of licensing property will be principally carried on with non-arm's length persons.]

Boosting of USSub exempt surplus under fresh start rule (p.9)

Under the fresh start rules [in ss. 95(2)(k) and (k.1)], USSub will be deemed to have disposed of and reacquired its assets used in the business at their fair market value at December 31, 2013. A potentially large amount of exempt surplus could be created when the fictional tax reset button is pushed. The assets will be stepped-up to fair market value and subsequently amortized, thereby reducing the exempt surplus of USSub.

Should the surplus reclassification rule re-characterize this exempt surplus as taxable surplus in these circumstances?

Application of Reg. 5907(2.02) 1st condition (disposition "to") (p.10)

Has an increase in exempt earnings arisen from a disposition of property to a "designated person or partnership"? ...[T]he fresh start rules do not explicitly deem USSub to have disposed of its property to any person in particular. Rather, the rules only provide that there is a deemed disposition and a deemed re-reacquisition of such property… .

[T]he Technical notes…stated that: …any exempt earnings that are otherwise created by these rules are subject to the new anti-avoidance rule in subsection 5907(2.02)….

Clearly, the government intended a deemed disposition and reacquisition under the fresh start rules to be within the ambit of regulation 5907(2.02). Whether this position is correct is unclear… .

Application of Reg. 5907(2.02) 2nd condition ("avoidance transaction") (p.10)

What about the primary purpose?...USSub clearly changes its business for bona fide business reasons and not to obtain a tax benefit (e.g., to generate exempt surplus). In some cases, this may not be so clear… .

[E]ven if a possible tax benefit is realized, the intent of USSub was not to accelerate or create exempt surplus in order to repatriate cash to Canada…The absence of excess cash that cannot be repatriated due to a lack of exempt surplus in USSub could support the position that the transaction (i.e., the change in business) was not undertaken to realize a tax benefit.…

Whether maximum CCA should be treated as having been claimed for pre-acquisition taxation years of an LLC (p. 9)

• US LLC acquired depreciable property in 2015 for use in its active business, and then on January 1, 2022, its shares were acquired by a Canadian taxpayer (Acquireco).
• Reg. 5907(1)(a)(iii) generally provides that earnings from an active business of an LLC foreign affiliate of a taxpayer resident in Canada shall be computed as if the business were carried on in Canada and the LLC were resident in Canada; and Reg. 5907(2.03) generally provides that its income or loss from that business for a particular taxation year shall be computed on the basis that for that year and “any” preceding taxation year ending after August 19, 2011. It claimed the maximum CCA and other deductions in computing its income from the business.
• Under the above wording, it could be considered that the maximum CCA should be treated under Reg. 5907(2.03) as having been claimed in the prior years, thereby increasing the earnings for 2021 and subsequent years.

Arguments for no prior-year claims (p. 9)

• On the other hand, it could be argued that no CCA should be considered to be claimed for the pre-acquisition period, given that (i) prior to the acquisition, US LLC was not a foreign affiliate of Acquireco and, therefore, never claimed depreciation in computing income with respect to Acquireco, (ii) the defined term for each taxation year is an “earnings or loss year,” and no earnings or losses were computed respecting Acquireco for the pre-acquisition period, and (iii) the technical notes indicate that the purpose of Reg. 5907(2.03) was to prevent taxpayers from inflating surplus.

Description of offshore metal streams transactions (pp. 647-8)

While a detailed description of offshore metal streams transactions is beyond the scope of this article, a brief description of the typical, or base-case, "offshore" transaction is warranted. The usual situation involves a Canadian parent company that owns a foreign affiliate ("Mineco"), which has a mineral project under development in a foreign country. Mineco enters into an off-take contract for the sale of metal at spot prices with another foreign affiliate ("Saleco") of the Canadian parent, which is resident in a low or no-tax jurisdiction. Saleco in turn enters into a metal stream agreement with an arm's length third party, under which Saleco agrees to sell a metal to the third party under certain terms and conditions. One of the terms is that the third party is required to advance money to Saleco as a deposit, which deposit is reduced and applied as part payment for metal to be delivered by Saleco (the amount of deposit so applied is the difference between the spot price that day and a specific fixed amount for each unit of metal).

This structure is intended to allow the upfront deposit to escape foreign taxation in the country in which Mineco operates because Mineco does not receive the upfront deposit as proceeds from the metal sale. Instead, the upfront amount will usually find its way from Saleco by way of equity or debt investment by the Canadian parent.

Treatment before Reg. 5907(2.03) (p. 648)

Absent subsection 5907(2.03) of the Regulations, provided Saleco is resident in, say the Cayman Islands, it would compute its earnings from an active business using Canadian rules by reason of subparagraph (a)(iii) of the definition of "earnings." Assuming typical terms to the metal stream agreement, in computing earnings, Saleco would be required to include the amount of the upfront deposit in income under paragraph 12(1)(a) and would be entitled to claim a reasonable reserve in respect of that amount for goods to be delivered after the end of the year pursuant to paragraph 20(1)(m). However, Saleco would not claim the deduction under paragraph 20(1)(m) so as to allow it to add the entire amount of the deposit to its earnings from an active business. Thus, the deposit could be distributed by Saleco to the Canadian parent by way of dividend in accordance with the usual rules in Part LIX of the Regulations. This would allow the Canadian parent to invest the money downstream in Mineco, which for foreign tax reasons is often much more desirable than having Saleco make the investment in Mineco.

Effect of Reg. 5907(2.03) (p. 648)

Regulation 5907(2.03) curtails this result because it requires Saleco to claim the maximum amount of a reserve under paragraph 29(1)(m) of the Act in computing Saleco's earnings. Thus, Saleco cannot distribute the cash on hand to its Canadian parent by way of dividend. If it has none of the balances described in subsection 90(9) of the Act (typically not), then it is unlikely that Saleco will be able to loan the money upstream unless it was certain it could be repaid within the two-year period required by paragraph 90(8)(a) of the Act.

Repeal of ECP regime will affect the consequences of the election (p. 4)

Assume for instance that a US business is acquired by an FA of a Canadian taxpayer in an asset deal and that goodwill is a significant portion of the acquisition. Because goodwill is amortized for US tax purposes on a straightline basis over 15 years but is generally carried at historical cost for the purposes of financial statements, the benefit of following accounting rules rather than tax rules may be significant if there has been no impairment. At the same time, the opposite could be true if a significant impairment was recognized for accounting purposes in a subsequent year before the purchased goodwill was the subject of an equivalent amount of amortization for tax purposes.

An election under regulation 5907(2.1) has retroactive effect and can never be revoked: therefore, the decision whether to make an election requires careful consideration. The repeal of the ECP regime not only will have an impact on a taxpayer that is deciding whether to make an election under regulation 5907(2.1), but also may have an impact on a taxpayer that already made an election at a time when purchased goodwill was not a relevant consideration.

Advantage of book depreciation election (p.1071)

[A]n election is available under regulation 5907(2.1) to use book depreciation rather than tax depreciation deducted under foreign tax law in computing income from an active business in respect of the foreign affiliate. Particularly in the case of jurisdictions where accelerated depreciation deductions are permitted, a foreign affiliate's ability to pay dividends from exempt surplus may be decreased as a result of this reduction in taxable income and thus earnings….

This is relevant for the determination of a foreign affiliate's tax-free surplus balance as well since the computation does not make adjustments for temporal differences, including depreciation….

Application of s. 93(2.01) stop-loss rule to DLAD capital loss (p. 1282)

Regulation 5907(5) requires that capital gains and losses for surplus purposes are to be calculated in accordance with the rules in subsection 95(2) of the Act, which rules obviously include paragraph 95(2)(e). The reference to subsection 93(4) in the Regulation's definition of "hybrid surplus," however, makes clear that recourse should also be had to other relevant rules in the Act, including the stop loss rule in subsection 93(2). Subsection 93(2), in combination with newly introduced subsection 93(2.01), provides that any loss realized by a Canadian resident corporation or a foreign affiliate of the corporation on the disposition of a share of a foreign affiliate must be reduced by the total of any "exempt dividends" received or deemed to have been received on the share by the corporation or affiliate prior to the disposition. Accordingly, where a shareholder affiliate's capital loss on a DLAD is otherwise recognized for the purpose of calculating an affiliate's hybrid surplus, the loss is nevertheless reduced under subsections 93(2) and (2.01) by the amount of any exempt dividends previously paid on the shares of the disposing affiliate. An "exempt dividend" is defined in subsection 93(3) and generally refers to a dividend that is deductible from a Canadian-resident corporation's income under section 113 of the Act.

Example showing reduction of DLAD capital loss by exempt dividend (p. 1282)

Consider the following example:

• FA1 owns all the shares of FA2, which shares have an adjusted cost base of $100.
• FA2 has only one asset ("Asset"), which Asset has an adjusted cost base and fair market value of $100; the Asset is not an "excluded property" within the meaning assigned under subsection 95(1).
• FA2 has $100 of exempt surplus.
• FA2 distributes the Asset by way of an exempt dividend to FA1.
• FA2 is then liquidated on a DLAD.

Save for subclause 95(2)(e)(iv)(A)(II)1, FA1 would realize a capital loss on the disposition of FA2's shares equal to their cost basis of $100. This loss is recognized for hybrid surplus purposes, but is nevertheless deemed nil because of the $100 exempt dividend paid prior to the DLAD. Accordingly, no amount in respect of the loss is included in FA1's hybrid surplus calculation.