Subsection 55(5) - Applicable rules

Increasing the tax-free surplus balance for s. 55(5)(d)(i) purposes through Reg. 5907(2.1) election (p. 294)

[G]enerally, if a regulation 5907(2.1) election is made,…at a time when the accumulated depreciation for financial statement purposes is less than it is for tax purposes, the affiliate's earnings (and thus its exempt surplus pool, and ultimately its TFSB) will be increased by the difference between these amounts….

Relevance of deficits of lower-tier affiliates (p. 295)

[I]t is not clear whether in determining safe income on hand of a particular foreign affiliate, the deficit of a lower-tier foreign affiliate could reduce the safe income of the particular foreign affiliate even if the fair market value of its shares exceeds its TFSB. [fn 64: See… Brelco Drilling … [and] 2001-0093385] If a deficit of a lower-tier foreign affiliate does indeed reduce safe income on hand, the location of the deficit affiliate in a chain of foreign affiliates does not seem to be relevant—contrary to the general framework of the foreign affiliate surplus regime, in which so-called blocking deficits in a chain of foreign affiliates are generally more relevant (and potentially more problematic) than deficits in foreign affiliates that are at the bottom of the ownership chain.

Paragraph 55(5)(d) was amended in 2011. Arguably, one of the purposes of the fair market value test in paragraph 55(5)(d) was to capture deficits of lower-tier foreign affiliates, and therefore no adjustment should be required for lower-tier deficits in computing safe income on hand.

Use of FX rate at safe income determination time to translate surplus (p. 295)

[T]he general practice is for the surplus pools of a foreign affiliate to be included in computing safe income using the applicable foreign exchange rate at the safe-income determination time. [fn 65:… 9414365]

Blending of hybrid underlying tax applicable to maximize TFSB (p. 296)

[F]or the purposes of determining safe income, the TFSB is computed on a foreign-affiliate-by-foreign-affiliate basis….

[T]he TFSB includes hybrid surplus of a particular foreign affiliate only if such surplus is "fully sheltered" (that is, that hybrid surplus, if paid by the affiliate as a dividend to the Canadian corporation, would be fully offset by a deduction under paragraph 113(l)(a. 1)). As a result, if one foreign affiliate in a chain has a hybrid surplus pool with an insufficient amount of hybrid underlying tax applicable [fn 66: …[D]efined in … 5907(1).] whereas another affiliate has an excess of hybrid underlying tax applicable, that pool is not available for the purposes of the determination of safe income, notwithstanding that the hybrid surplus would be fully sheltered with hybrid underlying tax applicable if the surplus pools of those two affiliates were combined. Accordingly, and if circumstances permit, it might be prudent to try to "match up" or blend, prior to the safe-income determination time and through the payment of an interaffiliate dividend or other mechanism, the applicable excess hybrid underlying tax of one affiliate with a "low-taxed" hybrid surplus pool of another…

Increasing TFSB through interaffiliate dividends (p. 297)

Notwithstanding that the payment of a dividend from the exempt, hybrid, and/or taxable surplus of the affiliate reduces the surplus pool(s) from which the dividend is considered to be paid, depending on the facts this may not necessarily result in a corresponding reduction in the affiliate's TFSB. [fn 69: [F]or example,…only fully sheltered hybrid surplus is included in computing a foreign affiliate’s TFSB….] Similarly, whether or not the receipt of such a dividend increases the safe income of the recipient also depends on the facts.

For example, the receipt of such a dividend by another foreign affiliate of the taxpayer could increase that affiliate's TFSB by an amount up to the dividend amount, depending on

• the surplus pool of the distributing affiliate from which the dividend was paid and
• the surplus balance (deficit) of the recipient. [fn 71: For example, if the recipient has an exempt deficit at the time of receipt of an exempt surplus dividend from another affiliate (and such a deficit is, for one reason or another, not relevant for the purposes of determining safe income, in accordance with the court's rationale in Brelco Drilling, supra note 64), such a deficit could wholly or partially offset (or absorb) the exempt surplus so distributed, whereas that exempt surplus might have been included in computing safe income had it not been distributed by the other affiliate….]

[C]onsideration could be given to timely filing a regulation 5901(2)(b) election (or, alternatively, a subsection 90(3) election)…

Administrative inclusion of stub period surplus income (pp. 298-299)

[S]afe income includes income earned or realized up to the safe-income determination time. In contrast, the exempt and taxable earnings of a foreign affiliate (which include, among other things, a foreign affiliate's earnings [loss] from an active business) are added to the affiliate's exempt and taxable surplus pools, respectively, only at the end of its taxation year….

Nevertheless, the CRA has previously indicated, albeit prior to the changes to paragraph 55(5)(d), that it will administratively accept the inclusion of stub-period earnings in computing the safe income of a corporation when the affiliate was a foreign affiliate of another corporation. [fn 73: 9523075…and 9611945…]

Exclusion of pre-acquisition earnings (p. 299)

[T]he CRA has previously taken the position, in respect of the former version of paragraph 55(5)(d), that the preacquisition earnings of a foreign affiliate that were included in determining the surplus pools of a foreign affiliate should be excluded in determining safe income on hand, on the basis that the inclusion of such amount would, in effect, result in double-counting of the adjusted cost base of the shares of the foreign affiliate as safe income. [fn 77: 2013-049914117…]

Quaere whether there is a look-through rule for partnerships notwithstanding non-application of s. 93.1 (pp. 300-301)

[A]lthough subsection 93.1(1) permits looking through a partnership for the purposes of determining whether a direct or indirect subsidiary of the partnership is considered to be a foreign affiliate of a Canadian corporation that is a partner of a partnership, this lookthrough mechanism applies only for the purposes of the provisions that are specifically identified in subsection 93.1(1.1), and paragraph 55(5)(d) is not one of those provisions….

[However] paragraph 55(2.1)(c) merely refers to the amount of the income earned or realized by any corporation….

[L]amont Management…concluded that the reference to “any corporation” in subsection 55(2) (the predecessor of paragraph 55(2.1)(c)) can include a foreign non-affiliate.

Retroactive adjustments to surplus pools from amending Cdn or local returns (p. 301)

[I]f the Canadian tax return originally filed by a particular corporation is subsequently amended, it might be necessary to make one or more corresponding retroactive adjustments to the safe income that is determined as at a particular safe income determination time.

Likewise, since an affiliate's TFSB is potentially relevant in computing safe income, any retroactive adjustment that is required to be made to the surplus pools of a foreign affiliate could correspondingly affect its TFSB otherwise determined at the safe-income determination time….

[I]f one or more dividends have been paid in that intervening period, either by a foreign affiliate or by a Canadian corporation in the chain, it is possible that such adjustments could affect the quantum of safe income that was otherwise believed to have been available in respect of the dividend at the safe-income determination time.

There are a few instances where it might be necessary to make a retroactive adjustment to the surplus pools of a foreign affiliate. For instance, this might be the case if a foreign affiliate is solely engaged in carrying on an active business and the income (loss) reported by the affiliate in its income tax return filed with the tax authorities in its country of residence is amended or otherwise adjusted….

Retroactive adjustments to surplus pools from adjustments under Reg. 5907(1.1) to reduce (or increase) each group member’s surplus pools for tax borne by (or refunded to) it (pp. 302-303)

[A]ssuming that the entire tax liability of the combined or consolidated group has been paid by one affiliate ("the primary affiliate"), in principle regulation 5907(1.1)(a) only adjusts the surplus pools of the primary affiliate. As the initial step in this process, regulation 5907(1.1)(a) disregards the actual income or profits tax liability (refund) of the combined or consolidated group for the particular taxation year, and then requires the stand-alone tax liabilities of each of the primary affiliate and the other members of the group (each of which is referred to as a "secondary affiliate") to be computed on the basis that each of those affiliates had instead filed its own tax return and had no other taxation year. [fn 83: Regulations 5907(1.1)(a)(i) through (iv).]…

[I]f a loss"" arose in one year and is used by the combined or consolidated group in the immediately following year, the surplus pools of the primary affiliate are increased at the end of the prior taxation year as opposed to the year in which the loss is used.

Prior-year adjustments to surplus pools of the primary and/or secondary affiliates can also arise under regulation 5907(1.1)(b)… [I]f the primary affiliate compensates a secondary affiliate for the use of a loss of the secondary affiliate that arose in a prior taxation year, [so that] the surplus pools of both the primary and secondary affiliates are adjusted only as at the end of the year of the loss regardless of when the payment is made [fn :86: Regulation 5907(1.1)(b)(ii).] Similarly, if a secondary affiliate makes a tax compensatory payment to the primary affiliate in respect of a particular taxation year, the surplus pools of both the primary and secondary affiliates are adjusted only at the end of that taxation year. [fn 87: Regulation 5907(1.1)(b)(i).] This is the case regardless of whether that payment occurs in the particular taxation year or in a subsequent year….

Safe income of foreign affiliate (pp. 1069-1071)

Conceptually, the modified "tax-free surplus balance" definition in paragraph 55(5)(d) is the amount of tax-free surplus balance that could hypothetically be paid as a dividend by the foreign affiliate to the Canadian corporation free from Canadian tax, as if the shares of the foreign affiliate were directly owned by the Canadian corporation. [fn 50: Not including preacquisition surplus. The carve-out of regulation 5905(5.6) results in an effective "flattening" of a foreign affiliate structure for the purposes of the safe-income calculation, such that all foreign affiliates are treated as if they were direct subsidiaries of the relevant Canadian corporation.]...

The CRA has commented that it believes that

in general, in computing the safe income on hand attributable to the shares of the capital stock of a corporation, the losses of a subsidiary of the corporation must be taken into account when the loss results in a decrease in the FMV [fair market value] of the corporation's shares. [fn 54: ...2001-0093385.]

Nothing specific in the 2011 amendments to paragraph 55(5)(d) appears to directly address the exempt deficit issue in the computation of a foreign affiliate's safe income on hand.

...[S]ince safe income would generally be calculated in Canadian dollars, it is usually necessary to translate the tax-free surplus balance into Canadian dollars for the purposes of determining the amount of safe income in respect of a foreign affiliate. The CRA has stated that "[w]hen computing exempt or taxable surplus of a foreign affiliate at any particular time the exchange rate at that time should be used. [fn 57: ...9414365... .] In the context of foreign affiliate safe income, the CRA noted that the particular time would be the safe-income determination time.

[A] foreign affiliate's surplus balances are increased by the earnings of the foreign affiliate only at the end of the taxation year in which the earnings arise. [fn 60: The definition of "earnings" in regulation 5907(1) refers to the "earnings" of a foreign affiliate…for a taxation year."…] The CRA has provided administrative relief by indicating that this stub period income may be included in the calculation of safe income in respect of a foreign affiliate. [fn 61: ...9611945... .]

An election made under section 338(h)(10) of the US Internal Revenue Code by the purchaser and vendor in a share purchase permits the purchaser to treat the transaction as an asset purchase for US tax purposes, thereby achieving a step-up in US tax basis of the assets of the acquired corporation. The CRA has commented that tax depreciation in excess of amounts paid for assets would be added back in computing the safe income of a foreign affiliate in respect of which a Code section 338(h)(10) election has been made. [fn 63: ...2013-049914117... .]

Introduction of the bifurcation rules (p. 10)

Any other taxable dividend is no longer protected from recharacterization by the internal reorganization exception. Each such taxable dividend does not arise as a foundational component of a sanctioned divisive reorganization but, rather, has the potential, as in D & D Livestock, to effect a significant reduction in a capital gain on any share, a significant reduction in the fair market value of any share, or a significant increase in the total cost of property of the dividend recipient….

However, the holding corporation could forgo a designation under paragraph 55(5)(f). The full amount of the taxable dividend could be recharacterized by subsection 55(2) as a deemed capital gain that would increase its CDA. In that case, a portion of the safe income on hand of the dividend payer attributable to its shares held by the dividend recipient could be realized as a capital gain. This is the very notion of surplus stripping. The holding corporation could then elect to distribute to its individual shareholder another source of income, such as its active business income, as a capital dividend using such CDA generated by the deemed capital gain.

[T]o neutralize that threat, amended paragraph 55(5)(f) (and new subsection 55(2.3) for high-low stock dividends) (collectively, the "bifurcation rules") now compel die distribution of safe income on hand pursuant to a taxable dividend….

Each of the bifurcation rules divides a taxable dividend into a safe income dividend and a non-safe income dividend. As the safe income dividend reduces the dividend recipient's accrued gain in its shares of the dividend payer, the shareholder's CDA cannot be increased to the extent of the amount of that safe income dividend. This ensures that subsection 55(2) cannot transform the portion of a capital gain that is attributable to safe income on hand into a positive balance of CDA for purposes of surplus stripping.

Issue of whether the purpose of a whole taxable dividend is determined before or after bifurcation (pp. 10-11)

If the purpose of the whole taxable dividend under a safe income crystallization must be identified before bifurcation, one might concede that one of the purposes of the dividend…is to achieve that outcome of significantly reducing a capital gain, significantly reducing the fair market value of any share, or significantly increasing the total cost of property of the dividend recipient.

In contrast, if the bifurcation rules divide the whole taxable dividend into a safe-income dividend and a non-safe income dividend before the "purpose" of either divided is ascertained … [o]nly the purpose of the non-safe income dividend … must be ascertained. …

[C]onsider where a taxpayer miscalculates its safe income on hand before undertaking a safe income crystallization. The taxpayer's subjective purpose is not to give rise to a non-safe income dividend pursuant to the bifurcation rules….

[T]he three purpose tests are meant to inquire into the subjective purpose of the dividend payer and the dividend recipient in order to frustrate tax-driven capital gains stripping. Only the first interpretive approach meets that legislative objective….

CRA view consistent with purpose being identified before bifurcation (p. 11)

The CRA's position is that the 2015 amendments did not change the order of application of these rules but, rather, merely made the operation of paragraph 55(5)(f) automatic rather than discretionary. [fn 52: 2017-0726381C6]

[T]he CRA’s view ignores that bifurcation under paragraph 55(5)(f) occurs "for purposes of this section [55]", and that bifurcation under paragraph 55(2.3)(a) occurs "for the purpose of [subsection 55(2)]". This means that automatic bifurcation of the taxable dividend applies for purposes of the three purpose tests. Indeed, this is the very concept that raises the interpretive issue in the first place. Still, despite its unsound reasoning? the CRA came to the proper conclusion on that issue.

Incoherent scheme for divestitures: integration where Holdco sells Opco to arm’s length Holdco; no integration where Opco redeems Holdco shares (pp. 24-25)

To illustrate this incoherent legislative state, consider the following example. "Opco" is owned by three unrelated holding companies, "Holdco A", "Holdco B" and "Holdco C". Each of Holdco A, Holdco B and Holdco C are owned by individuals "A", "B" and "C", respectively. The shares of Opco owned by Holdco A have a fair market value of $100, PUC of nil, and ACB of nil. The safe income on hand attributable to the shares of Opco held by Holdco A is $30. "A" wishes to divest its indirect interest in Opco. Conceptually, a number of options are available, and the tax results differ depending on the structure chosen for the divestiture:

• "A" sells the shares of Holdco A to "B" and realizes a capital gain of $100, resulting in personal tax at the rate applicable to capital gains realized by individuals.
• Holdco A sells the shares of Opco to Holdco B and realizes a capital gain of $100. Although there is safe income of $30, the bifurcation rules do not apply because Opco did not pay a taxable dividend to Holdco A. Thus, Holdco A's capital gain augments its CDA. Holdco A can distribute its sale proceeds to A as a capital dividend and a noneligible dividend to achieve an effective combined tax rate on the distribution that approximates that applicable to capital gains realized directly by an individual.
• Opco redeems its shares held by Holdco A. A triggering event under paragraph 55(3)(a) occurs, since unrelated persons have an increase in interest in Opco. On the share redemption, subsection 84(3) gives rise to a deemed dividend. Paragraph 55(5)(f) bifurcates the resulting deemed dividend into a safe income dividend of $30 and a non-safe income dividend of $70, solely for purposes of section 55. The safe income dividend is excused from recharacterization as a deemed capital gain pursuant to the safe income exception. However, subsection 55(2) recharacterizes the non-safe dividend as a deemed capital gain in the amount of $70. Only this smaller quantum of the non-safe income dividend recharacterized as a deemed capital gain augments Holdco A's CDA. As the safe income dividend reduced the quantum of the deemed capital gain, Opco's safe income on hand that is attributable to its redeemed shares cannot be surplus stripped. The share redemption is treated as a corporate distribution that is taxed differently than a sale of its shares.

Consequently, the statutory regime governing divestitures is not consistent. Share redemptions caught by subsection 55(2) produce the most punitive results….

The Department of Finance (Canada) sought, through its withdrawn proposed section 246.1, to deny CDA created on an internal reorganization that was not caught by subsection 55(2) but which could have facilitated surplus stripping. Upon the abandonment of that measure, there is no clear tax policy against surplus stripping achieved through realizing the economic value of a corporation's safe income on hand by a sale of shares that does not invoke the bifurcation rules. Further, withdrawal of proposed section 246.1 indicates that there is no abuse from surplus stripping through so-called "mixing-and-matching" distribution.