In Print Foreign Affiliate Reorganizations: Where Are We Now? Synopsis

In Print
Foreign Affiliate Reorganizations:
Where Are We Now?
As originally published by the Canadian Tax Foundation.
Synopsis
Ken J. Buttenham
October 2014
The rules in the Income Tax Act governing foreign affiliate (FA) reorganization
transactions have been in a state of fluctuation for well over a decade; however,
with the enactment of Bill C-48 on June 26, 2013, stakeholders finally have a
welcome level of certainty regarding how these transactions should be treated for
tax purposes.
This article provides an overview of the "final" FA reorganization rules and
includes a discussion of the practical planning considerations that arise when
working with these provisions, including the potential impact of FA
reorganization transactions on FA surplus balances, existing and future upstream
loans, and foreign accrual property income computations.
Contact:
Ken J. Buttenham
[email protected]
First published by the Canadian Tax Foundation in Report of Proceedings of the
Sixty-Fifth Tax Conference, 2013 Conference Report (Toronto: Canadian Tax Foundation,
2014). Reproduced with permission. Copyright remains with the authors.
PwC refers to PricewaterhouseCoopers LLP, an Ontario limited liability partnership.
www.pwc.com/ca/inprint
Page 1
Foreign Affiliate Reorganizations:
Where Are We Now?
Heather O’Hagan and Ken J. Buttenham*
Heather O’Hagan. kpmg llp, Toronto. BA, BComm,
University of Ottawa; cpa, ca. Lecturer, cpa Canada In-Depth
Tax Course. Frequent speaker and writer on international
taxation for a variety of professional and business organizations.
Ken J. Buttenham. PricewaterhouseCoopers llp, Toronto. ba,
University of Waterloo; cpa, ca. Author of articles for the
Canadian Tax Journal; contributing editor, International Tax
Planning Journal. Member of Council, International Fiscal
Association (ifa). Speaker on international taxation for the
Canadian Tax Foundation, ifa (Canadian branch), the Tax
Executives Institute, and other organizations.
Abstract
The rules in the Income Tax Act governing foreign affiliate (fa) reorganization
transactions have been in a state of fluctuation for well over a decade; however,
with the enactment of Bill c- 48 on June 26, 2013, stakeholders finally have a
welcome level of certainty regarding how these transactions should be treated for
tax purposes.
The authors provide an overview of the “final” fa reorganization rules and
include a discussion of the practical planning considerations that arise when
working with these provisions, including the potential impact of fa reorganization
transactions on fa surplus balances, existing and future upstream loans, and
foreign accrual property income computations. At the end of each section, the
authors provide a summary of points that taxpayers and advisers should consider
when undertaking a specific fa reorganization transaction.
It is clear from the examples reviewed that the analysis of a particular fa
reorganization transaction may not be straightforward, and taxpayers should take
the time to analyze the full impact of a proposed transaction on a proactive basis
to avoid surprises. In addition, there is a certain amount of flexibility built into many
of the fa reorganization rules, and planning is required to take full advantage of
these opportunities.
* We would like to thank Dave Beaulne of KPMG LLP, Toronto, as well as Mickey Wu and Eric
Lockwood, both of PwC LLP, Toronto, for their assistance in the preparation of this paper. Any
errors that remain are our own.
Canadian Tax Foundation, 2013 Conference Report, 20:1 - 56
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Heather O’Hagan and Ken J. Buttenham
Keywords Foreign affiliates; reorganization; share exchanges; liquidation;
mergers; surplus.
Introduction
The rules in the Income Tax Act (including the regulations)1 governing foreign
affiliate (fa) reorganization transactions2 have been in a state of fluctuation for
well over a decade; however, with the enactment of Bill c-48 on June 26, 2013,3
stakeholders now have a welcome level of certainty relating to these rules that
has not existed for quite some time. Because many useful articles have been
written describing the numerous twists and turns that these rules have taken over
the past 10 years,4 our focus is not on the past but rather on the current rules
and the practical considerations that they raise.
In addition to providing an overview of the “final” fa reorganization rules, in
this paper we focus on certain planning considerations relating to the rules,
including the potential impact of fa reorganization transactions on fa surplus
balances, existing and future upstream loans, and foreign accrual property income
(fapi) computations. At the end of each section, we provide a summary of
relevant points that taxpayers and advisers should consider when undertaking a
specific fa reorganization transaction.
Transfer of Foreign Affiliate Shares:
Canco to a Foreign Affiliate
Overview of the Rules
Subsection 85.1(3)
Subsection 85.1(3) allows a Canadian-resident taxpayer to transfer ownership of
shares of an existing fa5 to any corporation (the acquiring affiliate) that is an FA
or that becomes one as a result of the transfer on a fully or partially tax-deferred
basis. For this provision to apply, the consideration receivable for the fa shares
must include at least one share of the acquiring affiliate. Contrary to the domestic rollover rule in subsection 85(1), where the necessary conditions are met
subsection 85.1(3) applies automatically (no elections are required to be filed).
The following are the results of the application of subsection 85.1(3):
• The cost to the taxpayer of any property other than shares of the acquiring
affiliate (the non-share consideration or boot) receivable by the taxpayer
as consideration is equal to the fair market value of that property at the
time of the transaction.
• The cost to the taxpayer of the acquiring affiliate shares receivable as consideration is equal to the excess, if any, of the adjusted cost base (acb) to
the taxpayer, immediately prior to the transfer, of the fa shares disposed
of over the fair market value of the non-share consideration receivable by
the taxpayer.6
Foreign Affiliate Reorganizations: Where Are We Now?20:3
•The taxpayer’s proceeds of disposition of the fa shares transferred is
deemed to be the aggregate of the cost to the taxpayer of (1) the non-share
consideration received, if any, and (2) the shares of the acquiring affiliate
received by the taxpayer.
• The cost to the acquiring affiliate of the fa shares acquired from the taxpayer is equal to the amount of the taxpayer’s proceeds of disposition for
the fa shares (as determined above).
Pursuant to subsection 85.1(3), if the fair market value of any non-share consideration exceeds the acb of the fa shares disposed of, the taxpayer will realize
a capital gain on the transaction. Therefore, it is important to know the taxpayer’s
acb of the fa shares being transferred not only for the purposes of determining
their acb to the acquiring affiliate but also for the purpose of receiving nonshare consideration on a tax-free basis.
In figure 1, Canco transfers the shares of fa 1 to fa 2 in exchange for a $100
note and additional common shares of fa 2. Subsection 85.1(3) should apply to
deem Canco’s cost of the note and additional fa 2 common shares to be $100
(the fair market value of the note) and $1, respectively. Canco’s proceeds of
disposition of the shares of fa 1 is deemed to be $101, resulting in no gain being
realized. In addition, the cost to fa 2 of the shares of fa 1 will also be $101.
The ability of Canco to avoid capital gain recognition on the receipt of nonshare consideration up to the acb of the fa 1 shares can be a useful planning
tool.7 In figure 1, debt has been introduced into fa 2 without having to actually
flow funds.8 If it is desirable to create a class of preferred shares of fa 2 with cost
basis equal to fair market value as part of this transaction, Canco could subscribe
for a class of preferred shares of fa 2 using the note. Of course, Canco’s cost
of the additional fa 2 common shares received would still be nominal.
Further planning may be available depending on the tax attributes of fa 1.
In the example above, if fa 1 has exempt surplus of $50, Canco could receive
a $150 note and common shares of fa 2 as consideration for the fa 1 shares. The
$50 capital gain realized by Canco on the disposition of the fa 1 shares could
be reduced or eliminated by filing a subsection 93(1) election. This crystallization
of exempt surplus into a note or cost basis that can be used to repatriate funds
to Canco may be useful if, for example, losses are anticipated for fa 1 in the
future or fa 2 has a large deficit that will inhibit the future repatriation of funds
via exempt surplus dividends. Figure 1 demonstrates the flexibility provided by
subsection 85.1(3) to create gains where it may make sense to do so.
Subsection 85.1(4)
Subsection 85.1(4) sets out certain situations where the provisions of subsection
85.1(3) do not apply. The first situation where a taxpayer cannot avail itself of
subsection 85.1(3) is in the context of planning for an ultimate disposition of fa
shares to an arm’s-length person or partnership. Specifically, subsection 85.1(3)
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Heather O’Hagan and Ken J. Buttenham
Figure 1
Canco
ACB: $101
FMV: $200
Consideration:
$100 note
FA 2 shares
Canada
Foreign
FA 1
FA 2
FA 1
will not apply to a disposition of the shares of a particular fa to another fa where
both of the following conditions are met:
1) Immediately prior to the share transfer, all or substantially all9 of the property of the particular fa is excluded property (ep),10 and
2)the fa share disposition to which subsection 85.1(3) would otherwise apply
is part of a transaction or event or a series of transactions or events for the
purpose of disposing of the fa shares11 to a person or partnership that,
immediately after the transactions, was a person or partnership with whom
the taxpayer was dealing at arm’s length (other than an fa of the taxpayer
in respect of which the taxpayer has, at the time of the transactions, a qualifying interest).12
The purpose of this exception to subsection 85.1(3) is to prevent taxpayers
from deferring (or eliminating) Canadian tax in respect of a capital gain that
would otherwise be realized on the disposition of shares of a directly held fa
to an arm’s-length person or partnership. This could be accomplished by first
transferring the shares of the directly held fa to another fa on a tax-deferred
basis under subsection 85.1(3) and then having the acquiring fa (rather than the
taxpayer) dispose of the fa shares to the arm’s-length party. If such a transaction
were permitted, the sales proceeds could be received offshore, and any Canadian
tax otherwise payable on the inherent gain would be deferred until those proceeds were repatriated to the Canadian taxpayer.
As set out above, there are certain arm’s-length persons to which the fa shares
can be sold without invoking this exception to subsection 85.1(3). An arm’s-length
person that is an fa of the taxpayer in respect of which the taxpayer has a qualifying interest can acquire the fa shares that were previously transferred pursuant
to subsection 85.1(3) without negating the application of subsection 85.1(3).13
The second situation where a taxpayer cannot avail itself of subsection 85.1(3)
occurs when the fa shares to be transferred have an inherent loss.14 In situations
Foreign Affiliate Reorganizations: Where Are We Now?20:5
where the taxpayer’s acb of the fa shares to be disposed of is greater than their
fair market value, no rollover will be available, and the taxpayer will be forced to
realize a capital loss on the transfer. This capital loss will be suspended pursuant
to the normal operation of the stop-loss rules in subsections 40(3.3) and (3.4) and
will not be released until one of the conditions in paragraph 40(3.4)(b) is met.15
The stated purpose of introducing this new exception to the application of
subsection 85.1(3) is to ensure that existing losses cannot be rolled over onto
shares of the acquiring fa acquired by the taxpayer as well as shifted from a
taxpayer to its fa (that is, absent this exception, the acquiring fa would acquire
shares of the acquired fa with an inherent loss).16 In addition, absent subsection
85.1(4) and similar changes made to other provisions discussed below, this accrued
loss could also be duplicated at other levels in the structure because the fa shares
with an accrued loss are dropped down a chain of fas using fa-to-fa share-forshare rollovers. These concerns are addressed by ensuring that the losses are
recognized only by the taxpayer in respect of which the losses accrued and are
subject to the stop-loss rules in subsections 40(3.3) and (3.4).
Practically, the loss of rollover treatment for shares with an accrued loss
means taxpayers now need to know the fair market value of the fa shares being
transferred to understand whether subsection 85.1(3) applies. In cases where
accrued losses exist, the acquiring fa’s acb of the fa shares acquired will be
dependent on the fair market value of the shares. Even if this information is not
required immediately, it will be required at some point, and presumably it is
best to gather this information when the shares are transferred from the Canadian
taxpayer. The taxpayer’s acb of any shares of the acquiring fa received as
consideration for the fa shares disposed of will also be limited to the fair market
value of those shares. As a result, the total amount of the taxpayer’s cross-border
cost basis in its fa shares will have decreased.
The operation of subsection 85.1(4) is illustrated in figure 2. Canco owns all
the shares of fa 1 that have an acb of $100. The current fair market value of the
shares of fa 1 is $50. Canco also owns all the shares of fa 2. Canco transfers
all of its shares of fa 1 to fa 2 in exchange for additional shares of fa 2.
Pursuant to paragraph 85.1(4)(b), subsection 85.1(3) does not apply in respect
of the disposition of the shares of fa 1 because Canco’s acb of the fa 1 shares
exceeds their fair market value. As a result, Canco is considered to dispose of
the fa 1 shares for proceeds equal to their fair market value ($50). The capital
loss of $50 ($50 − $100) would be deemed nil pursuant to paragraph 40(3.4)(a)
and deemed realized by Canco when the fa 1 shares are disposed of outside the
affiliated group or on any other triggering event set out in paragraph 40(3.4)(b).
fa 2’s acb in the fa 1 shares acquired and Canco’s acb of the additional shares
of fa 2 acquired would also be $50.
As a result of this transaction, $50 worth of a valuable cross-border tax attribute (cost basis) has been converted into a suspended capital loss in Canco.
While Canco’s cost basis in shares of fas can be used in the future to repatriate
funds to Canco free of Canadian tax17 and /or support a deduction to mitigate
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Heather O’Hagan and Ken J. Buttenham
Figure 2
Canco
ACB: $100
FMV: $50
Canada
Foreign
FA 1
FA 2
FA 1
income associated with an upstream loan,18 a suspended capital loss is likely of
no immediate use to Canco. Figure 2 demonstrates that taxpayers now need to
understand the implications of such fa share transfer transactions in relation
to all aspects of their tax situation. In the past, these transactions were neutral
from a tax perspective as a result of rollover treatment; however, taxpayers now
need to know the fair market value of the fa shares to be disposed of and determine whether the benefits of such a transaction still outweigh any costs.
Internal Share Reorganizations:
First-Tier Foreign Affiliate
As discussed above, the flexibility of subsection 85.1(3) (including the ability
to take back non-share consideration) makes it a useful tool to create a desirable
share structure in an acquiring fa. At the same time, subsection 85.1(3) can be
used to reorganize the share capital of the fa whose shares are being transferred
because the preamble of subsection 85.1(3) ensures that it applies “[w]here a
taxpayer has disposed of capital property that was shares of the capital stock of
a foreign affiliate of the taxpayer to any corporation that was, immediately following the disposition, a foreign affiliate of the taxpayer” (emphasis added).
There is no reason that the “any corporation” referred to in the preamble cannot
be interpreted to include the fa whose shares are being transferred by the taxpayer.19 This means that subsection 85.1(3) can apply in place of subsections
86(1) and 51(1) when undertaking internal share reorganization transactions;
however, it is more flexible.20
As described above, a taxpayer could dispose of fa shares to the fa in exchange for a note payable up to the taxpayer’s acb of the fa shares. As a result,
the taxpayer has converted a portion of its investment in the fa into debt. If
desired, the taxpayer could subsequently contribute the note to the fa in exchange for another class of shares of fa, such as preferred shares (with full
Foreign Affiliate Reorganizations: Where Are We Now?20:7
adjusted cost basis). Utilizing subsection 85.1(3) to undertake an internal share
reorganization does not seem to be a common practice; however, the flexibility
of the rule makes it a useful tool in this regard.
Surplus Implications
In situations where a Canadian taxpayer transfers the shares of a wholly owned
fa (fa 1) to another wholly owned fa (fa 2) in exchange for shares of fa 2,
there are no surplus implications to consider. This makes sense because nothing
has changed, and the Canadian taxpayer has access to the same amount of fa 1
and fa 2 surplus both before and after the share transfer.
In contrast, where a Canadian taxpayer (Canco) transfers shares of a wholly
owned fa (fa 1) to an fa that is not wholly owned (fa 2) in exchange for additional shares of fa 2, a change in Canco’s surplus entitlement percentage (sep)21
in respect of both fa 1 and fa 2 would result. In fact, Canco’s sep in respect
of fa 2 will increase and its sep in respect of fa 1 will decrease. These changes
in sep require that adjustments be made to the relevant surplus balances of each
of fa 1 and fa 2 in respect of Canco to ensure that Canco will continue to have
access to the same amounts of surplus (and be limited by the same deficits) after
the subsection 85.1(3) transaction as it did prior to the share transfer.22
In the past, the Act did not always operate as required to ensure that the necessary surplus adjustments were made without additional tax planning;23 however,
regulation 5905(1) now operates to require the necessary adjustments to both
fa 1’s and fa 2’s surplus (and deficit) balances.24 Taxpayers should take these
adjustments, if required, into account when undertaking a subsection 85.1(3)
transaction.
Surplus Entitlement Percentage Changes
and Deemed Year-End for Foreign Accrual
Property Income Purposes
With the introduction of proposed subsection 91(1.1)25—otherwise known as
the “stub-period fapi”26 rule—there are other potential implications to consider
where a Canadian taxpayer’s sep in respect of a controlled fa decreases as a
result of a subsection 85.1(3) transaction. The proposed stub-period fapi rule
deems a controlled fa to have a taxation year-end (for fapi inclusion purposes
only) immediately prior to the time when the Canadian taxpayer’s sep in respect
of the affiliate decreases. The application of this provision is somewhat narrowed
by subsection 91(1.2), which ensures that there is no deemed taxation year-end
if the Canadian taxpayer’s sep decrease is offset by a sep increase in that fa
by another taxpayer resident in Canada that is connected to the taxpayer.27
Prior to the introduction of this proposed rule, fapi earned by a controlled
fa was included in a Canadian taxpayer’s income on the basis of the Canadian
taxpayer’s participating percentage28 in respect of the affiliate determined at the
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Heather O’Hagan and Ken J. Buttenham
end of the fa’s taxation year. Where the shares of a controlled fa earning fapi
were disposed of prior to its taxation year-end, there was no participating percentage and no amount of fapi to pick up for that taxation year. The purpose of
this proposal is to ensure that stub-period fapi is included in the income of a
taxpayer for the taxation year in which the taxpayer disposes of or reduces its
interest in an fa.
Although this rule may make sense from a policy perspective, the fact that
the deemed year-end under the stub-period fapi rule is tied to a change in sep,
and not a change in participating percentage, can be problematic.
In figure 3, Canco is a Canadian corporation with a taxation year-end of
November 30. Canco owns all the shares of cfa 1 (with a corresponding sep
of 100 percent). cfa 1 has a December 31 taxation year-end for foreign tax
purposes and has an exempt surplus balance in respect of Canco of $1,000.
Canco also owns all the common and preferred shares of fa 2, a foreign holding
company with an exempt deficit in respect of Canco of $500. On October 31,
Canco transfers all of its shares of cfa 1 to fa 2 for additional common shares
of fa 2 pursuant to subsection 85.1(3). The transfer of the cfa 1 shares does
not create a deemed year-end for foreign tax purposes. For the period from
January 1 to October 31, cfa 1 has earned fapi of $1,000.
Canco’s sep in respect of cfa 1 after the share transfer is calculated pursuant
to regulation 5905(13) to be 50 percent as a result of applying the notional
distribution mechanism set out in regulations 5905(10) to (13).29 This decrease
in sep in respect of cfa 1 as a result of the transfer of its shares will result in
a deemed-year end immediately prior to October 31 for fapi computation purposes pursuant to proposed subsection 91(1.1). This would result in a perhaps
unexpected FAPI inclusion of $1,000 in Canco’s November 30 taxation year.30
Figure 3 demonstrates that the full impact of a subsection 85.1(3) transaction
should be considered in the context of a taxpayer’s specific facts prior to undertaking the transaction.
Implications for Upstream Loans
The impact of subsection 85.1(3) share transfers on the application of the upstream loan rules in subsections 90(6) to (15) should also be considered. 31 Such
share transfers should not affect existing loans (made after August 20, 2011)
because the upstream loan rules generally apply at the time that a loan is made.
However, transferring shares between fa ownership chains could affect future
loans by changing the amount of surplus and/or cost basis available in a particular
ownership chain to support a subsection 90(9) deduction.32 Share transfers before
August 20, 2014 could also have an impact on existing loans made before August 20, 2011 since these grandfathered loans are generally deemed to be made
on August 20, 2014 for the purposes of the upstream loan rules.
Consider a scenario (depicted in figure 4) in which a Canadian-resident corporation (Canco) owns all of the shares of two fas (fa 1 and fa 2). fa 2 owns
Foreign Affiliate Reorganizations: Where Are We Now?20:9
Figure 3
Canco
SEP = 100%
Preferred shares
Common
shares
CFA 1
FA 2
Exempt surplus
= $1,000
CFA 1
Exempt deficit
= ($500)
SEP = 50%
all of the shares of another fa (fa 3). fa 3 has made a $1,000 grandfathered
loan to Canco. fa 2 has exempt surplus of $1,000, while fa 1 has a $1,000
exempt deficit. If this structure remains in place on August 20, 2014 (and the
loan is not repaid by August 20, 2016), Canco should have a $1,000 income
inclusion under subsection 90(6) and an offsetting $1,000 deduction available
under subsection 90(9) owing to the exempt surplus in fa 2.
What if Canco reorganizes its fas before August 20, 2014? For example,
Canco could transfer the fa 2 shares to fa 1 under subsection 85.1(3). The
exempt surplus of fa 2 would effectively be eliminated by the exempt deficit of
fa 1 for the purposes of claiming a subsection 90(9) deduction. As a result, no
subsection 90(9) deduction would be available for the grandfathered loan.
Alternatively, consider a situation involving the same facts, except that fa 1
has $1,000 of exempt surplus and fa 2 has no exempt surplus or deficit. In this
case, no subsection 90(9) deduction would be available in the existing structure.
However, the reorganization would move fa 3 (the creditor affiliate) into the
same ownership chain as fa 1. The exempt surplus of fa 1 would then be available for a subsection 90(9) deduction when the loan springs to life on August 20,
2014.
Figure 4 suggests that subsection 85.1(3) could be used as a planning tool to
consolidate surplus within an fa chain before subsection 90(6) applies to a grandfathered loan in that chain or before future upstream loans are made from the
chain. However, any such planning must consider the impact of paragraph 95(6)(b).
This is a specific anti-avoidance rule that applies to a share acquisition or disposition where it can reasonably be considered that the principal purpose of the
acquisition (or disposition) is to permit any person to avoid, reduce, or defer
the payment of tax that would otherwise be payable under the Act. Where this
rule applies, the share acquisition (or disposition) is disregarded for the purposes
of the fa rules in subdivision i of division b of part i, other than section 90.
Paragraph 95(6)(b) was recently considered by the Tax Court of Canada (tcc)
and the Federal Court of Appeal (fca) in Lehigh Cement Limited v. The Queen.33
Heather O’Hagan and Ken J. Buttenham
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Figure 4
Canco
ACB = 0
Grandfathered
loan $1,000
ACB = 0
Exempt deficit
= ($1,000)
FA 1
FA 2
Exempt surplus
= $1,000
FA 2
FA 3
FA 3
Grandfathered
loan $1,000
Exempt surplus
= $1,000
Exempt surplus
= $0
Exempt surplus
= $0
The fca agreed with the tcc that paragraph 95(6)(b) did not apply, but applied
different reasoning. The fca considered the proper interpretation of paragraph
95(6)(b) on the basis of a textual, contextual, and purposive interpretation of this
provision and concluded that paragraph 95(6)(b) is directed at acquisitions or
dispositions of shares in a non-resident corporation where the principal purpose
of that acquisition or disposition is to manipulate the status of the non-resident
corporation for the purposes of the fa rules—that is, to meet or fail the relevant
test of fa, controlled fa, or related corporation status—in order to avoid, reduce,
or defer Canadian tax. The court also held that paragraph 95(6)(b) is concerned
with the purpose of the particular share acquisition (or disposition), rather than
the purpose of the series of transactions that includes the share acquisition (or
disposition), although the purpose of the series may be a relevant factor in determining the purpose of the particular share acquisition or disposition.
The fca’s decision in Lehigh Cement appears to confirm many practitioners’
long-held view that paragraph 95(6)(b) is primarily relevant to the manipulation
of fa status.34 As a result, it follows that paragraph 95(6)(b) should generally
not be relevant in the context of internal reorganizations of existing fa groups
(such as the restructuring described above, in which existing tax attributes are
consolidated to maximize the subsection 90(9) deduction) because these reorganizations should generally not affect the fa status of any corporation.
It could also be argued that paragraph 95(6)(b) should not be relevant in the
context of the upstream loan rules because these rules are found in subsections
90(6) to (15), and the deeming rule in paragraph 95(6)(b) does not apply for the
purposes of section 90. Thus, even if paragraph 95(6)(b) were to apply to disregard
a transaction, it is arguable that the operation of the upstream loan rules should
not be affected. However, the Canada Revenue Agency (cra) has stated that
the paragraph 95(6)(b) deeming rule applies to provisions of the Act that make
Foreign Affiliate Reorganizations: Where Are We Now?20:11
use of the fa concept, even if these provisions are not contained in the fa rules
in subdivision i of division b of part i.35 This position predates the introduction
of the upstream loan rules. It is not clear how the cra’s position would be applied to the references to “foreign affiliates” and “controlled foreign affiliates”
in the upstream loan rules.
Setting aside the issue whether paragraph 95(6)(b) is relevant in an upstream
loan context, it is useful to consider the application of this rule to the transfer
of the fa 2 shares to fa 1 in the second scenario discussed above (in which fa 1
has exempt surplus and fa 2 has no exempt surplus or deficit). Paragraph 95(6)(b)
should apply only if the principal purpose of the share transfer is to manipulate
the fa status of a non-resident corporation in order to avoid, reduce, or defer
Canadian tax. This is necessarily a factual determination. However, this share
transfer does not affect the fa status of any corporation (since fa 1 and fa 2
are existing fas of Canco, and continue to be fas following the transfer). While
the transfer could reduce tax (by increasing the subsection 90(9) deduction
available to offset the subsection 90(6) income inclusion), this tax reduction is
not related to any change in fa status. On the basis of the reasoning of the fca
in Lehigh Cement, it is difficult to see how this share transfer could have a
principal purpose that would cause paragraph 95(6)(b) to apply.
Taxpayers who undertake fa reorganizations should be aware of and analyze
the implications for their existing and future upstream loans because these transactions may have negative or positive implications. This analysis should consider
the potential impact of paragraph 95(6)(b), although it is expected that this rule
should generally not be relevant in the context of internal reorganizations.
Summary of Considerations for Subsection 85.1(3)
Share Transfers
1) Subsection 85.1(3) applies automatically to ensure that an fa share-forshare transfer will be tax-free unless
a) any boot taken back as consideration for the fa share disposition is in
excess of the transferor’s cost basis in the fa shares disposed of; or
b)all or substantially all of the property of the fa to be transferred is ep,
and the share transfer is part of a series of transactions for the purpose
of disposing of the fa shares to an arm’s-length person.
2) Subsection 85.1(3) is not applicable where the fa shares to be transferred
have an inherent loss. Any inherent losses will be realized and subject to
the stop-loss rules. As a result, taxpayers need to understand the fair market value of the fa shares to be transferred.
3) The ability to take back non-share consideration as part of an fa share
transfer can be a useful tool to create a desired capital structure for the
acquiring fa or to reorganize the capital of an fa.
4) If a subsection 85.1(3) transaction results in a change in sep in respect of
any fa, surplus accounts should be adjusted and the proposed stub-period
fapi rules should be considered.
Heather O’Hagan and Ken J. Buttenham
20:12
5) The implications of subsection 85.1(3) transactions on existing and future
upstream loans should be considered.
Transfer of Foreign Affiliate Shares: Affiliate to Affiliate
Overview of the Rules
Paragraph 95(2)(c)
Paragraph 95(2)(c) allows an fa of a taxpayer (the disposing affiliate) to transfer
shares of another fa36 to any corporation that was, immediately after the time of
the share transfer, an fa (the acquiring affiliate) on a fully or partially tax-deferred
basis. For this provision to apply, the consideration receivable in exchange for
the fa shares must include shares of the acquiring affiliate. Similar to subsection
85.1(3), where the necessary conditions are met paragraph 95(2)(c) applies
automatically (no elections are required to be filed).
The following are the results of the application of paragraph 95(2)(c):
• The cost to the disposing affiliate of any property, other than shares of the
acquiring affiliate, receivable by the disposing affiliate as consideration
for the share disposition is equal to the fair market value of that property
at the time of the transaction.
• The cost to the disposing affiliate of the acquiring affiliate shares receivable
as consideration for the share disposition is equal to the excess, if any, of
the “relevant cost base”37 (rcb) to the disposing affiliate of the shares disposed of over the fair market value of the non-share consideration receivable
by the taxpayer for the share disposition.38
• The disposing affiliate’s proceeds of disposition of the fa shares disposed
of is deemed to be the aggregate of the cost to the taxpayer of (1) the nonshare consideration received, if any, and (2) the shares of the acquiring
affiliate receivable by the taxpayer.
• The cost to the acquiring affiliate of the fa shares acquired from the disposing affiliate is deemed to be the amount of the disposing affiliate’s
proceeds of disposition for the fa shares (as determined above).
Similar to the operation of subsection 85.1(3), it is possible to realize a capital
gain in respect of a share disposition governed by paragraph 95(2)(c) if the fair
market value of any non-share consideration exceeds the acb of the disposed
fa shares;39 however, the concept of rcb (discussed below) provides taxpayers
with additional flexibility in certain fact situations.
Inherent Losses
Similar to the restriction in subsection 85.1(4), paragraph 95(2)(c) does not apply
to dispositions of fa shares by a disposing affiliate if the acb to the disposing
Foreign Affiliate Reorganizations: Where Are We Now?20:13
affiliate of the fa shares is greater than their fair market value.40 In situations
where there is an inherent loss on the fa shares being transferred, no rollover
is available, and the disposing affiliate will be forced to realize a capital loss on
the share disposition. The treatment of such a capital loss differs in the context
of an fa-to-fa share-for-share transaction.
Consider figure 5. Canco owns all the shares of fa 1. fa 1 owns all the shares
of fa 2 and fa 3. fa 1’s acb (and rcb) of the fa 2 shares is $100. The current
fair market value of the fa 2 shares is $50. fa 1 disposes of its fa 2 shares to
fa 3 in consideration for shares of fa 3.
Paragraph 95(2)(c) does not apply to the disposition of the fa 2 shares because
the acb of the fa 2 shares is greater than their fair market value. Therefore, fa 1
is deemed to dispose of the shares of fa 2 for proceeds equal to their fair market
value and to receive the fa 3 shares as consideration at that same fair market value
($50). The treatment of the capital loss otherwise realized depends on the ep
status41 of the fa 2 shares.
If the shares of fa 2 are ep at the time of disposition, the stop-loss rules in
subsections 40(3.3) and (3.4) are not applicable.42 Consequently the taxpayer is
forced to reduce fa 1’s hybrid surplus (or create a hybrid deficit) as a result of
the $50 ($100 − $50) realized capital loss. If the shares of fa 2 are not ep at the
time of disposition, the capital loss of $50 realized on the disposition will be
deemed to be nil pursuant to paragraph 40(3.4)(a) and will be deemed to be realized by fa 1 when the fa 2 shares are disposed of outside the affiliated group or
on any other triggering event set out in paragraph 40(3.4)(b). This is consistent
with the treatment of a subsection 85.1(3) share-for-share transfer. In this situation, the stop-loss rules operate to ensure that no fapi capital loss can be realized
on an fa-to-fa share-for-share transfer that could potentially be used to offset
fapi capital gains.43
In both cases, the total cost basis that fa 1 has in its subsidiaries has been
reduced by the amount of the capital loss. Although taxpayers should be aware
of this potential outcome, it is likely not as important as it is in the context of a
first-tier fa share-for-share transaction as discussed above. As in a first-tier fa
share-for-share transaction, taxpayers will now need to know the fair market value
of the fa shares being transferred as well as the ep status of those shares to
understand the tax implications of a lower-tier fa share-for-share transaction.
Importance of Relevant Cost Base
As noted above, pursuant to paragraph 95(2)(c) the rcb of the fa shares being
transferred by the disposing affiliate is relevant to the determination of the cost
of the acquiring affiliate shares receivable as consideration and therefore also
the determination of the disposing affiliate’s proceeds of disposition of the
transferred fa shares. The rcb of a property to an fa is essentially the amount
that could be received by the affiliate on the disposition of the property that
would result in no income, gain, or loss being realized for surplus purposes. In
20:14
Heather O’Hagan and Ken J. Buttenham
Figure 5
Canco
Canada
Foreign
FA 1
ACB: $100
FMV: $50
FA 2
FA 3
FA 2
many cases, the rcb of fa shares should be equivalent to the shareholder’s
cost—that is, the acb of the shares. One important consideration in the determination of rcb is the impact of foreign currency and how it is linked to the
type of property that is being disposed of by the fa.44
As an example, assume that a us-resident fa (fa 1) acquired all the shares
of a us subsidiary (fa 2) on incorporation for us $500. If the fa 2 shares are
considered ep at the relevant time, any foreign exchange gain or loss arising on
the disposition of the shares would be calculated relative to fa 1’s calculating
currency, which we can assume is the us dollar.45 The disposition of the fa 2
shares for us $500 would therefore result in no gain or loss, and that amount
should be the rcb of the shares to fa 1. If, however, the fa 2 shares were not
ep at the relevant time, any gain or loss on their disposition would be calculated
relative to the Canadian dollar. In order for no gain or loss to arise in determining fa 1’s surplus balances in this case, the disposition of the fa 2 shares would
have to take place at its historical Canadian-dollar cost amount. This amount
could be quite different from the Canadian-dollar equivalent of us $500 at the
time of the paragraph 95(2)(c) share disposition. Therefore, it is important to
know the ep status of fa shares being disposed of to determine their rcb.
The definition of rcb also takes into consideration (on a non-elective basis)
pre-acquisition accrued gains and losses that are otherwise carved out under
paragraph 95(2)(f.1).46 If, for example, a Canadian taxpayer acquired the shares
of fa 1 in the example above from an arm’s-length vendor several years after
fa 1 invested in fa 2, the rcb of the fa 2 shares to fa 1 at the time of acquisition
of the fa 1 shares would generally equal the fair market value of the fa 2 shares
at that time (assuming the value of the fa 2 shares has continued to increase).
This aspect of the rcb definition can result in a bump (or grind) in the cost basis
of the fa 2 shares to an acquiring fa (and a similar bump or grind in the cost
Foreign Affiliate Reorganizations: Where Are We Now?20:15
base of the shares of the acquiring affiliate shares issued as consideration) as
part of a paragraph 95(2)(c) transaction.
Figure 6 illustrates how paragraph 95(2)(c) (and the rcb definition) can operate
to bump the cost basis of fa shares. Consider the structure in figure 5; however,
in this case, fa 1’s historical acb of the fa 2 shares is $50. In addition, the fair
market value of the fa 2 shares at the date that Canco last acquired the fa 1
shares was $75, and the fair market value of the fa 2 shares today is $100. As
in figure 5, assume that fa 1 disposes of its fa 2 shares to fa 3 in consideration
for shares of fa 3.
In figure 6, the rcb of the fa 2 shares to fa 1 would be $75, being the aggregate of (1) the amount for which the fa 2 shares could be disposed of that
would not, in the absence of paragraph 95(2)(f.1), result in an income, gain, or
loss for surplus purposes ($50) and (2) the amount by which any gain from the
disposition of the fa 2 shares at fair market value would be reduced under paragraph 95(2)(f.1) ($25). The application of paragraph 95(2)(c) would ensure that
• the cost of the fa 3 shares issued to fa 1 as consideration would be deemed
to be $75;
• fa 1’s proceeds of disposition of the fa 2 shares would be deemed to be
$75 (as a result of the operation of the paragraph 95(2)(f.1) carve out, a
disposition of the fa 2 shares for proceeds of disposition of $75 should
not result on any gain for fa 1); and
• the cost to fa 3 of the fa 2 shares would also be deemed to be $75.
Figure 6 illustrates how a paragraph 95(2)(c) share-for-share transaction can
be used to crystallize a paragraph 95(2)(f.1) accrued gain into the cost basis of
both the acquiring fa shares issued and the transferred fa shares. There are a
number of reasons why it may be beneficial to undertake such a transaction
shortly after Canco acquires an fa group.
• The amount of an accrued gain subject to a paragraph 95(2)(f.1) carve-out
will never be larger than it is immediately after the acquisition of the fa
group; however, it can decrease if the fair market value of the relevant
fa decreases after the acquisition date.47 Therefore, it may make sense to
crystallize the accrued gain into cost basis when the amount is at its maximum. The determination of the fair market values of the relevant fas in
an fa group may be required for other reasons shortly after acquisition
and may be more easily obtained then if a transaction is undertaken many
years after the acquisition.
•Given the ability to rely on cost basis to repatriate funds through chains
of fas,48 that basis can be a valuable tax attribute. For example, if an fa
pays a pre-acquisition surplus dividend that is in excess of the shareholder’s
cost basis of the shares, the amount of the excess is deemed to be a gain
of the shareholder for the year from a disposition of the fa shares.49 There
20:16
Heather O’Hagan and Ken J. Buttenham
Figure 6
Canco
Canada
Foreign
FMV now: $100
FMV at acquisition: $75
ACB: $50
FA 2
FA 1
FA 3
ACB: $75
FA 2
may be negative consequences to such a gain, such as the realization of
fapi if the shares are not ep, and it is unclear how paragraph 95(2)(f.1)
may apply to such a deemed gain realized many years subsequent to acquisition. In general it is better to have a higher cost basis to minimize any
future deemed gains.
Relevant Cost Base Election
The definition of rcb allows a taxpayer to designate an amount up to fair market
value as the rcb of a particular property of an fa.50 In the context of figure 6,
this amount would become fa 1’s proceeds of disposition of the fa 2 shares and
the cost basis of the fa 3 shares received as consideration. However, this designation can be made only if the affiliate in question meets the definition of an
“eligible controlled fa”51 (ecfa). The definition of ecfa requires the fa to be
a controlled fa both at the time that the definition is applied and at the end of
the taxation year that includes that time. The ecfa definition further requires a
taxpayer to have a participating percentage52 in the affiliate of at least 90 percent
at the end of the applicable taxation year.
If an rcb election is made such that the proceeds of disposition of the fa 2
shares are greater than fa 1’s cost basis and any paragraph 95(2)(f.1) carve-out
amount (that is, an election at greater than $75 in figure 6 above), a capital gain
will be realized by fa 1.53 Even if the shares of fa 2 are ep, the resulting taxable
capital gain is included in the disposing affiliate’s fapi.54 As a result, even
though such a capital gain would normally be included in fa 1’s hybrid surplus,55
one-half of the capital gain would be included in taxable surplus, with the remaining half being included in exempt surplus.
Foreign Affiliate Reorganizations: Where Are We Now?20:17
Why Make a Relevant Cost Base Election?
Because a capital gain resulting from an rcb election will necessarily result in
fapi, there are limited reasons why such an election would make sense. For
example, if the Canadian shareholder has non-capital losses or the disposing
affiliate has foreign accrual capital losses (facls) or foreign accrual property
losses (fapls) that are not otherwise of use, the fapi inclusion should not result
in Canadian tax. If the property in respect of which the election is made is shares
of another fa, such as fa 2 in figure 6, the surplus of that underlying affiliate
could be used to offset the fapi pickup (see further discussion below).
The advantage of making the election is the increase in the cost basis of the
fa 2 shares to fa 3, which may be advantageous for the reasons set out above.
However, given the potential fapi consequences, it is important to fully assess
the impact of making the election on the Canadian taxpayer as well as on its fas.
Internal Share Reorganizations:
Second-Tier Foreign Affiliate
In contrast to subsection 85.1(3), paragraph 95(2)(c) can no longer be used to
reorganize the share capital of a second-tier fa. The preamble of paragraph 95(2)(c)
indicates that the target affiliate shares disposed of by the disposing affiliate
must be disposed of to “any other corporation” (emphasis added) that continued
to be or became an fa.56 For paragraph 95(2)(c) to apply, it appears that the
disposing affiliate, the subject fa, and the acquiring affiliate are now required
to be different entities. As a result, the current version of paragraph 95(2)(c)
does not apply to an internal share reorganization between the disposing affiliate
and the subject affiliate.
As a result of this wording change, taxpayers will need to rely on the more
general share exchange rollover provisions in subsections 51(1) and 86(1) to
accomplish an internal share reorganization of a lower-tier fa. However, as
mentioned above, these provisions are generally not as flexible as subsection
85.1(3) is currently and paragraph 95(2)(c) was historically.57
Subsection 51(1) provides rollover treatment in respect of an exchange of fa
shares for other shares of the same fa (where no other consideration is received
by the parent fa) by deeming the exchange not to result in a disposition of the
original fa shares held. In this case, the acb of the original fa shares carries
over to become the cost of the new fa shares received. The main restriction
associated with subsection 51(1) is that it does not provide for the ability to take
back any non-share consideration as partial consideration for the fa shares disposed of. Subsection 51(1) also does not apply where section 86 applies.58
Subsection 86(1) provides a tax-free rollover where, in the course of a reorganization of the capital of a subsidiary fa, a parent fa exchanges all the
shares of a particular class of the subsidiary fa for consideration, including
other shares of the subsidiary fa. Subsection 86(1) provides the flexibility to
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Heather O’Hagan and Ken J. Buttenham
take back non-share consideration as partial consideration for the fa shares
disposed of; however, it also contains additional conditions that must be met.
For subsection 86(1) to apply, the share exchange must take place “in the course
of a reorganization of capital”59 of the fa subsidiary, and the parent fa must
dispose of all of the shares of a particular class owned at the particular time.
Subsection 51(1) does not contain these same conditions.60
Care should be taken to ensure that the conditions of either subsection 51(1)
or 86(1) are met when undertaking transactions to reorganize the share capital
of an fa owned by another fa to ensure that no gain is realized.
Surplus Implications
Similar to share transactions governed by subsection 85.1(3), a transfer of fa
shares from one wholly owned fa to another generally should not result in any
adjustments to the surplus accounts of any of the relevant fas in respect of a
Canadian taxpayer.61 When fas are not wholly owned and a Canadian taxpayer’s
sep in respect of any of the fas involved in a paragraph 95(2)(c) transaction
changes, the necessary adjustments to the surplus (and deficit) amounts of all
such fas could be required pursuant to regulation 5905(1).
Of course, there may be surplus account implications if a taxpayer decides
to file an rcb election in respect of a paragraph 95(2)(c) transaction. If as a
result of the rcb election the disposing fa would otherwise realize a gain on
the disposition of the subject fa shares, the taxpayer will be deemed to have
made a subsection 93(1) election and to have designated in that election the
prescribed amount in respect of the disposition of the subject fa shares.62 As
mentioned above, a taxpayer may choose to file an rcb election where the
subject fa has net surplus amounts in respect of the taxpayer and the taxpayer
wishes to crystallize these surplus attributes into the cost basis of the fa shares.63
The result of a deemed subsection 93(1) election will be a reduction (equal
to the prescribed amount)64 of the relevant surplus balances of the subject fa
and an increase of the corresponding surplus balances of the disposing fa. These
surplus account impacts resulting from an rcb election should be kept in mind
because the resulting changes in tax attributes may affect future planning and
cash repatriation.
Implications for Upstream Loans
The potential impact of paragraph 95(2)(c) share transfers on the application of
the upstream loan rules should also be considered. In cases where fa shares are
simply being transferred down an existing chain of fas, there should be no
impact on existing or future upstream loans because the relevant tax attributes
for claiming a deduction under subsection 90(9) should remain in the same chain
of fas as the upstream loan.
However, in situations where shares of an fa (together with its surplus attributes and/or upstream loans) are transferred from one chain of fas to another
Foreign Affiliate Reorganizations: Where Are We Now?20:19
in exchange for, say, preferred shares, there may be implications to consider
similar to those discussed above in relation to a subsection 85.1(3) transaction.
Summary of Considerations for Paragraph 95(2)(c)
Share Transfers
1)Paragraph 95(2)(c) applies automatically to ensure a second-tier fa sharefor-share transfer will be tax-free unless
a) any boot taken back as consideration for the fa share disposition is in
excess of the transferor’s cost basis in the fa shares disposed of, or
b)an rcb election is made.
In both cases, any gain realized after any available subsection 93(1) election will be included in fapi.
2)Paragraph 95(2)(c) is not applicable where the fa shares to be transferred
have an inherent loss. Any inherent losses will be realized, and the application of the stop-loss rules will depend on the ep status of the shares disposed
of. As a result, taxpayers need to understand the fair market value and
potentially the ep status of the fa shares to be transferred.
3) As a result of the operation of the rcb regime, a paragraph 95(2)(c) transaction can be used to crystallize a paragraph 95(2)(f.1) accrued gain into
the cost basis of both the acquiring fa shares issued and the transferred
fa shares.
4) If a paragraph 95(2)(c) transaction results in a change in sep in respect of
any fa, surplus accounts should be adjusted, and the proposed stub-period
fapi rules should be considered.
5) The implications of paragraph 95(2)(c) transactions on existing and future
upstream loans should be considered.
First-Tier Foreign Affiliate Liquidations
Overview of the Rules
Subsection 88(3)
Subsections 88(3) to (3.5) now provide a complete set of rules for determining
the income tax implications of liquidations of fas held directly by a Canadian
corporation. These provisions set out the income tax consequences of such liquidations to (1) the liquidating affiliate on the disposition of its property, (2) the
Canadian shareholder on the acquisition of that property, and (3) the Canadian
shareholder on the disposition of its shares in the liquidating affiliate.65
In order for the measures in subsection 88(3) to (3.5) to apply, the Canadian
shareholder must receive property from the liquidating affiliate as a result of its
liquidation and dissolution. If the liquidating affiliate has no property to distribute, the rules might arguably not apply. Therefore, in order to ensure that the
shareholder can avail itself of these measures, it may be worthwhile to leave
some property, even if nominal, in the liquidating affiliate that can then be distributed on the liquidation.
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Heather O’Hagan and Ken J. Buttenham
There are two operative regimes contemplated in these rules: one that results
in a tax-deferred liquidation, and one that results in a taxable liquidation. The
choice of regime is up to the Canadian shareholder of the liquidating affiliate,
if certain qualifying conditions are met.
Qualifying Liquidations and Dissolutions
Subsection 88(3.1) sets out the conditions that must be met in order for a Canadian shareholder to elect to treat a liquidation of an fa as a qualifying liquidation
and dissolution (qlad), which essentially means that the liquidation can take
place on a tax-deferred basis. In order for the election to be made, one of two
conditions must be met.
The first condition requires the Canadian shareholder to own at least 90 percent of the issued shares of each class of the liquidating affiliate throughout the
liquidation.66 This requirement could cause problems where the liquidating affiliate has issued different classes of shares to different shareholders. Even if the
shareholders are related, this condition would not be met because there is no
provision for related-party ownership of shares. It may therefore be worthwhile
to transfer share ownership in the liquidating affiliate to one shareholder prior to
a contemplated liquidation.
Under this test, if one shareholder owns, for example, 95 percent of all of the
issued shares of the liquidating affiliate, and a related taxpayer owns the remaining 5 percent, it appears that only the 95 percent shareholder would be entitled
to make the qlad election. The minority shareholder would not be eligible to
make the election, and the liquidation would be taxable in respect of its 5 percent
ownership. While this may not be a significant issue in many cases, there could
nevertheless be Canadian income tax triggered as a result.
The second condition requires two tests to be met. First, the fair market value
of property distributed to the Canadian shareholder by the liquidating affiliate,
less the value of any obligation or amount owing by the affiliate that was assumed or cancelled by the shareholder on the liquidation, must equal at least
90 percent of the value of all property distributed, less all liabilities assumed or
cancelled, on the liquidation. Second, the shareholder must, at the time of each
distribution of property, own shares entitling it to cast at least 90 percent of the
votes at an annual general meeting of all shareholders if such a meeting were
held at the time of the distribution.
This condition could potentially solve the issue raised above, where, for example, one shareholder owns all of the voting common shares, and a related
shareholder owns all of the non-voting preferred shares of the liquidating affiliate. If the ownership of the preferred shares entitles their owner to less than
10 percent of the value of all property of the fa on its liquidation, the common
share owner could qualify under this second condition and would be able to
make the qlad election even though it does not own at least 90 percent of the
issued shares of each class of the liquidating affiliate.
Foreign Affiliate Reorganizations: Where Are We Now?20:21
To illustrate the application of the rules in subsection 88(3), assume that a
Canadian corporation (Canco) owns all of the shares of an fa (fa 1) that will
be liquidated. fa 1 holds the following property at the time of its liquidation:
(1) shares of another fa (fa 2) that are capital property and that meet the definition of ep, (2) shares of another fa (fa 3) that are capital property and do
not meet the definition of ep, (3) other ep that is not capital property, and
(4) other non-capital property that is not ep. All of fa 1’s property will be distributed to Canco as a result of fa 1’s liquidation. These facts are illustrated in
figure 7.
As indicated above, the rules in subsection 88(3) determine the Canadian tax
consequences of
1) the disposition of fa 1’s property to Canco,
2) the acquisition of that property by Canco, and
3) the disposition of the shares of fa 1 by Canco.
Disposition of FA 1’s Property
Qualifying Liquidation and Dissolution Election Is Made
In figure 7, Canco can make a qlad election in respect of the liquidation of
fa 1 because Canco owns all of fa 1’s only issued class of shares.67 By making
this election, the disposition of fa 1’s property can generally take place on a
tax-deferred basis.
Paragraph 88(3)(a) utilizes the same rcb concept discussed earlier in the
context of paragraph 95(2)(c) by deeming each property of fa 1 to be disposed
of to Canco for proceeds equal to its rcb to fa 1. As explained above, the rcb
of a property to an fa is the greater of (1) the amount that could be received by
the affiliate on the disposition of the property that would result in no income,
gain, or loss being realized for surplus purposes (the minimum rcb amount)
and (2) such other amount that Canco elects, not exceeding the fair market value
of the property (the maximum rcb amount).68 In addition, we explored the fact
that ep status is important to the determination of the minimum rcb amount of
a particular property.
In figure 7, the minimum rcb amounts would be determined as shown in the
accompanying table.
EP
rcb determination
Shares of fa 2 . . . . . . . . . . . . Yes
Based on acb in fa 1’s calculating
currency
Shares of fa 3 . . . . . . . . . . . . No
Based on acb in Canadian dollars
Other non-capital property . . . Yes
Based on foreign tax basis in fa 1’s
calculating currency
Other non-capital property . . . No
Based on cost amount in Canadian dollars
Heather O’Hagan and Ken J. Buttenham
20:22
Figure 7
Canco
FA 1
EP
FA 2
To be liquidated
Non-EP
FA 3
EP
Non-EP
Canco could file an election to have the dispositions take place at the maximum rcb amount.69 Assuming that there are inherent gains in each of fa 1’s
properties shown above, the results of Canco making a rcb election would be
as follows.
• Shares of fa 2 (ep) and shares of fa 3 (non-ep). Electing at the maximum
rcb amount in respect of the shares of fa 2 would trigger a capital gain.
Even though such a capital gain would normally be included in fa 1’s
hybrid surplus70 and notwithstanding the fact that the shares of fa 2 are
ep, paragraph (b) of variable b of the definition of fapi specifically includes
a taxable capital gain resulting from the application of paragraph 88(3)(a).
Accordingly, fa 1 would have a fapi capital gain, one-half of which would
be included in taxable surplus, with the remaining half being included in
exempt surplus. If fa 1 also has a facl or a fapl that would otherwise
cease to exist as a result of fa 1’s liquidation, the realization of a fapi
capital gain might not be problematic.
Electing at the maximum rcb amount in respect of the shares of fa 3
would trigger a fapi capital gain under paragraph (a) of variable b of the
fapi definition because the shares are not ep. The same surplus consequences would apply in this case.
• Other ep and non-ep that are not capital property. Electing at the maximum
rcb amount in respect of other non-capital ep would result in income that
would be included in fapi, as was the case above with the shares of fa 2.
In this case, 100 percent of the income would be included in fa 1’s taxable
surplus. If the rcb election is made in respect of other non-capital property
that is not ep, the resulting income would also be included in fapi, as was
the case above with the shares of fa 3. In this case, 100 percent of the
income would be included in fa 1’s taxable surplus.
Foreign Affiliate Reorganizations: Where Are We Now?20:23
These results are summarized in the accompanying table.
qlad election . . . . . . .
Shares of
fa 2
Shares of
fa 3
Non-capital
property (ep)
Non-capital
property
(non-ep)
Disposition
at rcb
Disposition
at rcb
Disposition
at rcb
Disposition
at rcb
fapi:
50% exempt
surplus
fapi:
50% exempt
surplus
fapi:
100% taxable
surplus
fapi:
100% taxable
surplus
50% taxable
surplus
50% taxable
surplus
rcb election: capital
or income gain . . . . .
Why Make a Relevant Cost Base Election?
As discussed above in relation to paragraph 95(2)(c) transactions, even though
an rcb election will result in fapi it still may make sense to file this election.
For example, if fa 1 has sufficient facls or fapls that would otherwise disappear or Canco has sufficient tax attributes that are not otherwise of use, the fapi
may not result in Canadian tax. If the property in respect of which the election
is made is shares of another fa, such as fa 2 and fa 3 in figure 7, the surplus
of that underlying affiliate could be used to offset the fapi pickup (see the
discussion below).
The advantage of making the election is the increase in the cost of the property in the hands of the Canadian shareholder, which could result in reduced
amounts of Canadian tax in the future. As discussed below, however, the increase
in the cost of the liquidating affiliate’s property will also increase the proceeds
that are deemed to be received by the Canadian shareholder on the disposition
of the shares of the liquidating affiliate. It is therefore important to assess the
impact of making the election on the Canadian shareholder as well as on the liquidating affiliate.
Qualifying Liquidation and Dissolution Election Is Not Made
If Canco does not to make the qlad election, all of fa 1’s property will be
deemed to be disposed of at its fair market value under paragraph 88(3)(b), with
the exception of the shares of fa 2. Because they are ep, the shares of fa 2 will
be deemed to be disposed of at their rcb even if the qlad election is not made.
This exception for ep shares of another fa ensures that a capital gain can be
realized only through an rcb election, which results in the taxable portion of
the gain being included in fapi.
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Heather O’Hagan and Ken J. Buttenham
Any inherent capital gains, income, and losses in the property of fa 1 would
therefore be realized (other than in respect of the shares of fa 2), with any losses
potentially being subject to the stop-loss rules as applicable.
• Shares of fa 3 (non-ep). The realization of a capital gain on the disposition
of the shares of fa 3 would result in fapi, with one-half of the gain being
included in exempt surplus and the balance being included in taxable
surplus. If there is an inherent loss in the shares of fa 3, their disposition
at fair market value would trigger a current-year fapi capital loss, which
would generally be suspended under the rules in subsections 40(3.3) and
(3.4). However, because fa 1 is subject to a non-qlad liquidation, its
liquidation will become a triggering event that will allow the loss to be
recognized under subparagraph 40(3.4)(b)(v). The stop-loss rules in subsection 93(2) would then need to be considered to determine if the loss
should otherwise be reduced by the balance of any exempt dividends paid
by fa 3 in the past. If fa 1 has existing FAPI capital gains, or realizes a
fapi capital gain because of other dispositions of non-ep in the course of
the liquidation, any remaining balance of this current-year fapi capital
loss could be used to offset those gains.
• Other ep and non-ep that are not capital property. If there is an inherent
gain or loss in non-capital property that is ep, its disposition at fair market
value would result in an increase or decrease in exempt surplus. In general,
losses that arise from dispositions of ep should not be subject to any stoploss measures. If there is an inherent gain or loss in non-capital property that
is not ep, its disposition at fair market value would result in fapi or a currentyear fapi loss and an increase or decrease in taxable surplus. In general,
such FAPI losses should not be subject to any stop-loss measures.
The results to fa 1 of the disposition of its property at fair market value are
summarized in the accompanying table.
No qlad election . . . . .
Shares of
fa 2
Shares of
fa 3
Non-capital
property (ep)
Non-capital
property
(non-ep)
Disposition
at rcb
Disposition
at fmv
Disposition
at fmv
Disposition
at fmv
na
fapi:
50% exempt
surplus
Exempt
surplus
fapi:
100% taxable
surplus
fmv disposition: capital
or income gain . . . . . .
50% taxable
surplus
Foreign Affiliate Reorganizations: Where Are We Now?20:25
fmv disposition: capital
or income loss . . . . . . .
na
facl:
initially
denied but
released
Exempt
deficit: not
denied
fapl: not
denied
100% taxable
deficit
50% exempt
deficit
50% taxable
deficit
na = not applicable
Acquisition of FA 1’s Property by Canco
Paragraph 88(3)(c) deems the shareholder to have received the distributed property at the same amount as it was disposed of by the liquidating affiliate. In this
way, an inherent gain or loss in the property that has not been realized by the
liquidating affiliate remains an inherent gain or loss in the property in the hands
of the Canadian shareholder. Because of the ability to crystallize pre-acquisition
capital or income gains under the rcb definition, the Canadian shareholder
would acquire such property at this higher basis amount.
The rules in subsection 88(3) allow upstream rollovers—that is, property with
an inherent loss, including fa shares, can be transferred by a liquidating affiliate
to its shareholder on a rollover basis. However, as discussed previously, subsection 85.1(3) and paragraph 95(2)(c) do not allow downstream rollovers—that
is, fa shares with an inherent loss cannot be transferred on a rollover basis by
either a Canadian or an fa shareholder to another fa.
As discussed above, the determination of rcb varies depending on the ep
status of the property distributed. If a liquidating affiliate distributes a us $500
receivable that is ep, the cost of the receivable to its Canadian shareholder will
be the current Canadian dollar equivalent of us $500. Conversely, if the receivable is not ep, the cost of the receivable to the Canadian shareholder will be the
historic Canadian dollar equivalent of us $500 based on the time at which the affiliate acquired the receivable. These different cost amounts will trigger different
gains, income, or loss balances in the future on the ultimate settlement of the
receivable by the Canadian shareholder.
Disposition of FA 1’s Shares by Canco
As a result of the liquidation and dissolution, the Canadian shareholder will have
disposed of the shares of the liquidating affiliate. Paragraph 88(3)(d) computes
the amount of proceeds that will apply to that disposition, defined as the net
distribution amount (nda) in respect of all property distributed by the liquidating affiliate to the shareholder. The nda is determined under subsection 88(3.2)
20:26
Heather O’Hagan and Ken J. Buttenham
and generally equals the cost of all property received from the liquidating affiliate, reduced by any liabilities assumed or cancelled by the shareholder on the
liquidation. Accordingly, the implications of making a qlad or rcb election
will extend to the potential realization of a capital gain or loss on the disposition
of the liquidating affiliate’s shares.
If the rcb of the liquidating affiliate’s property (the inside basis) is greater
than the basis of its shares (the outside basis), the distribution of its property at
rcb (which is only possible by making a qlad election) will result in a capital
gain realized by the Canadian shareholder. This is because the nda, based on
the total rcb of all property, would be greater than the acb of the affiliate’s
shares. If an rcb election is made or if the qlad election is not made, such that
the liquidating affiliate’s deemed proceeds are an increased rcb balance or fair
market value, the resulting capital gain to the shareholder would be even greater.
Conversely, if the inside basis of the liquidating affiliate’s property is less
than the outside basis of its shares, a capital loss would be realized by the shareholder because the nda in this case would be less than the acb of the affiliate’s
shares. Paragraph 88(3)(e) deems such a loss to be nil if a qlad election has
been made. However, even if a qlad election is not made, the resulting loss
could be reduced in a variety of ways. Subsection 93(2) could apply to reduce
the loss if the liquidating affiliate has paid exempt dividends to the shareholder
in the past, or subsection 93(4) could apply to push that loss down to the shares
of another fa received by the shareholder as a result of the liquidation.71
As a result of these rules, it will be imperative to take into consideration the
consequences of making a qlad or an rcb election to the Canadian shareholder
as well as to the liquidating affiliate. The triggering of a capital gain in Canada
may not be an issue if the shareholder is a private corporation that would be able
to add 50 percent of the gain to its capital dividend account. However, if the
realization of a capital gain would otherwise have adverse Canadian tax implications, there are a number of ways to mitigate that gain.
Subsection 88(3.3) Suppression Election
If a qlad election is made, the shareholder also has the ability to make another
election that operates to suppress the amount at which the liquidating affiliate’s
property is disposed of, thus also suppressing the nda of that property and the
resulting proceeds deemed to be received by the shareholder on the disposition
of the liquidating affiliate’s shares. This election, contained in subsection 88(3.3),
can be made, however, only in respect of capital property of the liquidating affiliate, and only if the Canadian shareholder would otherwise have realized a
capital gain (after taking into account any election under subsection 93(1)) on
the disposition of the liquidating affiliate’s shares.
In order to illustrate the effect of making a suppression election, assume that
Canco in figure 7 has made a qlad election in respect of the liquidation of fa 1,
but still has a capital gain on the disposition of fa 1’s shares. Also assume that
Foreign Affiliate Reorganizations: Where Are We Now?20:27
fa 1’s only property is the shares of fa 2. Canco will make a suppression election
in respect of the shares of fa 2, which are capital property to fa 1. The amount
claimed in the election will become the revised cost amount at which the FA 2
shares will be disposed of by fa 1. It will also become the acb of the fa 2 shares
to Canco, which essentially means that the potential to realize a capital gain on
the future disposition of those shares by Canco is increased because of the reduction in their acb.
The amount claimed in a suppression election is subject to two thresholds. The
first is that it cannot be greater than the amount at which the property would otherwise be deemed to be disposed of under paragraph 88(3)(a). This essentially means
that it has to be less than the rcb of the property. The second is that the rcb of
the property less the amount claimed in the election cannot exceed the capital gain
realized by the Canadian shareholder on the disposition of the liquidating affiliate’s
shares.72 This essentially means that a capital loss cannot be created on the disposition of the liquidating affiliate’s shares as a result of making the election.
Because the suppression election would result in the disposition of a capital
property at an amount that is less than its acb, a capital loss would otherwise
arise in the liquidating affiliate. The treatment of this loss depends on whether
the capital property in respect of which the election is made is ep. If the shares
of fa 2 are ep, the loss would potentially create a hybrid deficit in fa 1. However,
regulation 5907(9) contains specific rules that determine the surplus implications
of liquidations and deems property to be disposed of by the liquidating affiliate
without taking into consideration the suppression election. As a result, the shares
of fa 2 would continue to be deemed to be disposed of by fa 1 at their rcb for
surplus purposes, and no capital loss would arise.73
If the shares of fa 2 are not ep, the capital loss otherwise realized by fa 1
would be suspended under subsections 40(3.3) and (3.4) because the shares of
fa 2 remain in the affiliated group. Because fa 1 is subject to a qlad liquidation, the liquidation would not be considered a triggering event that will allow
the loss to be recognized under subparagraph 40(3.4)(b)(v). The loss can therefore
never be used, as is stipulated in part (a) of variable e in the definition of fapi.
The accompanying table summarizes the implications of making a suppression election. Assume that Canco owns the shares of fa 1, with an acb of $200,
and fa 1 owns the shares of fa 2, with an rcb of $500.
Amount claimed in election
(minimum threshold) . . . . . . . fa 1: loss on disposition
of fa 2 shares . . . . . . . . . . . . No suppression
election
Suppression
election (ep)
Suppression
election
(non-ep)
—
$200
$200
None;
disposition at
Loss otherwise
calculated
= $300
Loss otherwise
calculated
= $300
rcb
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Heather O’Hagan and Ken J. Buttenham
Treatment of loss . . . . . . . . . . . Canco: gain on disposition
of fa 1 shares . . . . . . . . . . . . Canco: shares of fa 2 . . . . . . . —
No loss created
for surplus
purposes
Loss
permanently
denied
nda = $500
None
None
Gain = $300
Proceeds
= $200
Proceeds
= $200
acb = $500
acb = $200
acb = $200
Subsection 93(1) Election
A capital gain that arises on the disposition of the liquidating affiliate’s shares
by the Canadian shareholder can also be sheltered by any exempt surplus that
exists in the liquidating affiliate. The shareholder could file a subsection 93(1)
election, thereby reducing the resulting capital gain by the balance of the liquidating affiliate’s exempt surplus.74
However, there is no requirement to file a subsection 93(1) election, even
where a suppression election is made. The rules in subsection 88(3.3) apply after
taking into consideration any election under subsection 93(1), but no such election is required.
Surplus Implications of Liquidations
Planning for the liquidation of an fa should consider the surplus and deficit
balances of the liquidating affiliate, as well as the surplus and deficit balances
of any underlying affiliates that will be transferred to the Canadian shareholder
as a result of the liquidation.
Regulation 5907(9)
Regulation 5907(9) contains two important rules that affect the computation of
the surplus and deficit balances of a liquidating affiliate. The first rule determines
the timing of the liquidating affiliate’s taxation year-end, and the second rule
determines the timing of the disposition of its property.
Taxation Year-End
In practice, there is often a delay between the date on which a liquidating affiliate distributes its property pursuant to the liquidation and the date of formal
dissolution of the fa. As a result, regulation 5907(9)(a) deems the liquidating
affiliate’s taxation year to end immediately before the time when it has distributed at least 90 percent of the value of all of its property (the final distribution
time). This deemed year-end will therefore allow the affiliate’s earnings (or loss)
Foreign Affiliate Reorganizations: Where Are We Now?20:29
for the stub period up to the final distribution time to be included in its surplus
(or deficit) balance.
Disposition of Property
Regulation 5907(9)(b) deems the distribution of the liquidating affiliate’s property to take place at the earlier of two specific times: (1) the actual time at which
the disposition takes place (the actual distribution time) and (2) the time that is
immediately before the time that is immediately before the final distribution time
(the deemed disposition time). This deemed disposition time allows any income,
gains, or losses arising on the distribution of its property to also be included in
the liquidating affiliate’s surplus (or deficit) balance.
The reason for both of these provisions becomes clear if they are placed on
a time line (see the accompanying illustration).
Start of
liquidation
year
Actual
disposition
time
Deemed
disposition
time
Deemed
taxation
year-end
Final
distribution
time
Disposition of
liquidating FA’s
shares on
dissolution
The deemed disposition time and the deemed taxation year-end are both
needed in order to ensure that the surplus balances of the affiliate include all
amounts arising as a result of the liquidation. This is especially important if
exempt surplus is generated either on the distribution of the affiliate’s property
or from its stub-period earnings.
For example, assume that fa 1, the liquidating affiliate, has a December 31
year-end. On October 15, it starts to distribute its property under a plan of liquidation. The actual distribution time for that property is therefore October 15. By
November 1, it has distributed more than 90 percent of its property; therefore,
it will have a deemed tax year-end on October 31. Its earnings (or loss) for the
period from January 1 to October 31 can therefore be included for surplus purposes. If it still has property that will be distributed subsequent to November 1,
that property will be deemed to be disposed of immediately before October 31,
such that any resulting income, gain, or loss will also be picked up for surplus
purposes.
Subsection 93(1) Elections
Deemed Subsection 93(1) Election
If the disposition of the shares of an underlying fa, such as fa 2 and fa 3 in
figure 7, results in a capital gain in the liquidating affiliate, either because of an
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Heather O’Hagan and Ken J. Buttenham
rcb election or a required disposition at fair market value, the net surplus of
the underlying affiliate would be used to effectively recharacterize all or a portion of that capital gain as a dividend paid out of that surplus to the liquidating
affiliate. This automatic deemed dividend could therefore prevent the recognition
of fapi arising as a result of an rcb election or a required fair market value
disposition of shares that are not ep, such as those of fa 3.
Thus, if an underlying affiliate has exempt, taxable, or hybrid surplus balances at the time of the distribution of its shares, some or all of those balances
would effectively be moved up to the liquidating affiliate. This inherited surplus
then becomes part of the surplus pools of the liquidating affiliate that would
need to be taken into consideration when its shares are disposed of by its Canadian shareholder.
Subsection 93(1) Election
As indicated above, there is no requirement for the Canadian shareholder to file
a subsection 93(1) election, even where a suppression election is made. Accordingly, if the liquidating affiliate has hybrid or taxable surplus balances that would
produce taxable income if levitated to Canada, those balances can remain in the
liquidating affiliate. There are no specific rules that force such surplus balances
to be recognized or carried over to another fa; therefore, they can essentially
be eliminated as a result of a liquidation.
If the liquidating affiliate has an exempt surplus balance but a capital loss is
realized on the disposition of its shares, the Canadian shareholder would not be
able to take advantage of making a subsection 93(1) election. The liquidating
affiliate could actually pay a dividend in advance of the liquidation to move that
surplus back to Canada; however, because the dividend would necessarily affect
the computation of the capital loss under subsection 93(2), there is really little
tax benefit to doing so.
Deficit of Liquidating Affiliate
If the liquidating affiliate has a hybrid or taxable deficit balance, those balances
will remain in the liquidating affiliate, and can therefore be eliminated as a result
of the liquidation. However, if the liquidating affiliate has an exempt deficit
balance, that deficit could be subject to the fill-the-hole rules in regulations
5905(7.1) to (7.7). These rules essentially push any exempt surplus in an underlying fa in which the liquidating affiliate has an equity percentage up to the
liquidating affiliate in an amount necessary to eliminate its exempt deficit.75
Thus, if shares of another fa are being distributed to the Canadian shareholder
as a result of a liquidation of a top-tier fa with an exempt deficit, these blocking
deficit rules could reduce or eliminate the exempt surplus balance of that underlying fa in respect of the Canadian shareholder going forward.
Foreign Affiliate Reorganizations: Where Are We Now?20:31
Surplus/Deficit of Underlying Affiliates
Other than the impact of a deemed subsection 93(1) election and the fill-the-hole
deficit rules outlined above, the surplus balances of fas in which the liquidating
affiliate has an equity percentage should not be affected by the liquidation.
However, if as a result of the liquidation, the Canadian shareholder’s surplus
entitlement percentage in these underlying affiliates changes, their surplus or
deficit balances would have to be adjusted in accordance with the rules in regulation 5905(1).
Upstream Loan Implications on Liquidation
If a liquidating affiliate has made an upstream loan to a “specified debtor,” as
defined in subsection 90(15), the effect of the liquidation on the application of
the upstream loan rules in subsections 90(6) to (15) needs to be considered. As
noted previously, these rules require such loans to be repaid within two years
to avoid an income inclusion in the hands of the Canadian shareholder.76 However, there are no specific provisions in the upstream loan rules that address the
liquidation of the creditor affiliate.
Where Specified Debtor Is the Canadian Shareholder
If the recipient of the loan is the Canadian shareholder of the liquidating affiliate, the loan receivable would be deemed to be distributed, along with the rest
of its property, by the liquidating affiliate as a result of the liquidation and would
effectively be extinguished. However, it is unclear whether the loan would in
fact be considered to be repaid, as required to stop the application of the upstream loan rules.
The cra’s response to a number of upstream loan questions is not too helpful
in this regard.77 One of the questions posed to the cra related to the sale of the
creditor fa prior to the two-year repayment period. The cra’s position is that
the relationship between the debtor and the creditor affiliate must be tested at the
time that the loan is received; therefore, even if this relationship changes in
the intervening two-year period, the rules will continue to apply if the loan is
not repaid. Where the creditor affiliate is liquidated, however, the loan could be
considered to remain outstanding indefinitely such that the exception in paragraph
90(8)(a) would not apply, thereby resulting in an income inclusion under subsection 90(6) with no offsetting deduction for repayment under subsection 90(14).78
The cra has further commented as follows:
While the wording of the proposed legislation is clear, we question whether
a proposed subsection 90(6) income inclusion is appropriate where the lending corporation is no longer a foreign affiliate at the time the two year time
limit referred to in proposed paragraph 90(8)(a) is reached. If the issue arises
20:32
Heather O’Hagan and Ken J. Buttenham
in the context of a ruling request or a referral from a cra auditor, we will
consult with the Department of Finance on this issue with a view to potentially taking an administrative position to alleviate the apparent anomaly.79
Where Specified Debtor Is a Non-Arm’s-Length Person
Other Than the Canadian Shareholder
Because the relationship between a creditor affiliate and a debtor is tested at the
time that an upstream loan is made, the rules would apply to a loan made by a
liquidating affiliate to a specified debtor other than the affiliate’s Canadian
shareholder. If the creditor affiliate is then liquidated prior to the end of the
two-year repayment period, the liquidation would result in the receivable being
distributed to the shareholder, and the specified debtor would continue to owe
the loan balance to that shareholder.
If the upstream loan is not repaid within the two-year period and must therefore
be included in the Canadian taxpayer’s income, it may be difficult to determine
whether an offsetting deduction in respect of the liquidating affiliate’s surplus
and cost base balances would be available as provided for in subsection 90(9).
The computation of these balances would have to be done at the time that the
loan was originally made; however, the balances would subsequently have been
affected by the liquidation. For example, it may be difficult to argue that a deduction should still be available for the acb of the liquidating affiliate’s shares,
given that the shares have been disposed of on the liquidation. Paragraph 90(9)(c)
prevents acb from being claimed if it has been relevant in determining the tax
consequences of any other distribution made during the period that the loan is
outstanding, which would arguably be the case in the context of a liquidation.
While it is hoped that the upstream loan rules will be amended to ensure
proper application to fa liquidations, because of the current lack of certainty
inherent in the rules, the best course of action may simply be to undertake preliquidation planning to repay all upstream loans in order to ensure that adverse
consequences do not arise.
Summary of Considerations for Subsection 88(3) Liquidations
1)A qlad is generally preferable for a number of reasons:
a) There should be no fapi or surplus implications arising on the liquidation (unless there is a pre-existing exempt deficit in the liquidating
affiliate or unless an rcb election is made).
b)There is an ability to make a suppression election to eliminate all or a
portion of a capital gain arising on the disposition of the liquidating
affiliate’s shares.
2) Because a capital loss arising on the disposition of the liquidating affiliate’s
shares is deemed to be nil if it is a qlad, this could be a significant factor
in determining whether to file an election or not.
Foreign Affiliate Reorganizations: Where Are We Now?20:33
3) If the inside basis of the liquidating affiliate’s property is greater than the
outside basis of its shares
a) a capital gain will be realized by the Canadian shareholder;
b)if there is “good” surplus (surplus that could be received tax-free if
distributed as a dividend to the Canadian shareholder) in the liquidating
affiliate (including from lower-tier affiliates), a subsection 93(1) election
can be filed, allowing the preservation of inside basis of property; and
c) if there is no good surplus in the system, a suppression election can be
filed, reducing the basis of property received by the shareholder on
liquidation.
4)Surplus and deficit balances in the liquidating affiliate are generally
eliminated.
a) If good surplus is not used, it will be lost.
b)A deemed subsection 93(1) election could levitate surplus (good and
bad) to the liquidating affiliate if there is a gain realized on the disposition of the shares of an underlying affiliate (as a result of an rcb
election or fair market value disposition).
c)An exempt deficit in the liquidating affiliate could be subject to the
fill-the-hole rules, and therefore could reduce exempt surplus balances
of underlying affiliates.
Second-Tier Foreign Affiliate Liquidations
Overview of the Rules
Paragraph 95(2)(e)
Paragraph 95(2)(e) is essentially the equivalent of subsection 88(3) in the context
of an fa shareholder and applies in very much the same way. Paragraph 95(2)(e)
provides a complete set of rules for determining the income tax implications of a
liquidation of an fa held by another fa. These measures lay out the income tax
consequences of such liquidations to (1) the liquidating affiliate on the disposition
of its property, (2) the fa shareholder on the acquisition of that property, and
(3) the fa shareholder on the disposition of its shares in the liquidating affiliate.
In order for the measures in paragraph 95(2)(e) to apply, the affiliate shareholder
must receive property from the liquidating affiliate as a result of its liquidation
and dissolution. If the liquidating affiliate has no property to distribute, the rules
may arguably not apply; therefore, in order to ensure that the shareholder can avail
itself of these rules, it may be worthwhile to leave some property, even if nominal, in the liquidating affiliate that can then be distributed on the liquidation.
There are two operative regimes contemplated in this set of measures: one that
results in a tax-deferred liquidation and one that results in a taxable liquidation.
In this case, the tax-deferred regime applies automatically if certain conditions
are met and there is no requirement, or ability, to make an election to choose
between the two.
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Heather O’Hagan and Ken J. Buttenham
Designated Liquidations and Dissolutions
The definition of a designated liquidation and dissolution (dlad) in subsection
95(1) sets out the conditions that must be met in order for the liquidation of an
fa to take place on a tax-deferred basis. The definition requires that one of three
conditions must be met.
The first condition requires the Canadian taxpayer to have a sep of at least
90 percent in the liquidating affiliate immediately before the time of the earliest
distribution of its property. In situations where the liquidating affiliate, or any other
fa in its chain of ownership, has issued more than one class of shares, the determination of a taxpayer’s sep could be difficult. Therefore, if this condition must be
relied on in order for a liquidation to qualify as a dlad, this determination must
be done in advance of any distribution of property by the liquidating affiliate.
The second condition is equivalent to that contained in the qlad definition
and requires two tests to be met. First, the fair market value of property distributed
to a shareholder affiliate by the liquidating affiliate, less the value of any obligation
or amount owing by the affiliate that was assumed or cancelled by the shareholder
on the liquidation, must equal at least 90 percent of the value of all property
distributed, less all liabilities assumed or cancelled, on the liquidation. Second,
the shareholder must, at the time of each distribution of property, own shares
entitling it to cast at least 90 percent of the votes at an annual general meeting
of all shareholders if such a meeting were held at the time of the distribution.
The third condition requires one shareholder affiliate to own at least 90 percent of the issued shares of each class of the liquidating affiliate throughout the
liquidation.
If one of these conditions is met, the liquidation will automatically be a dlad,
and it cannot take place on a taxable basis. Therefore if a taxable liquidation is
desirable, planning would need to be undertaken in advance to ensure that these
conditions are not met.
To illustrate the application of the rules in paragraph 95(2)(e), assume that a
Canadian corporation (Canco) owns all of the shares of an fa (fa 1), which in
turn owns all of the shares of another fa (fa 2), which will be liquidated. fa 2
holds the following property at the time of its liquidation: (1) shares of another
fa (fa 3) that are capital property and that meet the definition of ep, (2) shares
of another fa (fa 4) that are capital property and that do not meet the definition
of ep, (3) other ep that is not capital property, and (4) other non-capital property
that is not ep. All these properties will be distributed to fa 1 as a result of fa 2’s
liquidation, as shown in figure 8.
As indicated above, the rules in paragraph 95(2)(e) determine the Canadian
tax consequences of
1) the disposition of fa 2’s property to fa 1,
2) the acquisition of that property by fa 1, and
3) the disposition of the shares of fa 2 by fa 1.
Foreign Affiliate Reorganizations: Where Are We Now?20:35
Figure 8
Canco
FA 1
FA 2
EP
FA 2
To be liquidated
Non-EP
FA 3
EP
Non-EP
Disposition of FA 2’s Property
Liquidation Qualifies as a Designated
Liquidation and Dissolution
In figure 8, the liquidation of fa 2 will qualify as a dlad because at least one
of the required conditions is met. Accordingly, the disposition of fa 2’s property
should generally take place on a tax-deferred basis.
Subparagraph 95(2)(e)(i) deems each property of fa 2 to be disposed of to
fa 1 for proceeds equal to its rcb. Therefore, on the basis of the definition of
rcb discussed previously, no income, gain, or loss should be realized by fa 2
as a result of the dispositions, and no fapi or surplus implications should arise.
The considerations outlined above in determining rcb equally apply in this
context. Accordingly, the status of fa 2’s property as ep or non-ep will affect
the rcb amount of each property.
Relevant Cost Base Election
Canco could file an rcb election in respect of the disposition of any of fa 2’s
property because fa 2 would be an ecfa of Canco. As a result of filing the
election, fa 2’s property would be deemed to be disposed of at an amount designated by Canco in excess of its rcb but not greater than its fair market value.
The election would therefore trigger the realization of either a capital gain or
income in fa 2.
Assuming that there are inherent gains in each of fa 2’s property in figure 8,
the results of Canco making an rcb election would be as follows.
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Heather O’Hagan and Ken J. Buttenham
• Shares of fa 3 (ep) and shares of fa 4 (non-ep). Electing at an amount in
excess of rcb in respect of the shares of fa 3 would trigger a capital gain.
Even though such a capital gain would normally be included in fa 2’s
hybrid surplus, and notwithstanding the fact that the shares of fa 3 are ep,
paragraph (b) of variable b of the definition of fapi specifically includes
a taxable capital gain resulting from the application of subparagraph
95(2)(e)(i). Accordingly, fa 2 would have a fapi capital gain, one-half of
which would be included in taxable surplus, and the remaining half would
be included in exempt surplus. If fa 2 has a facl or a fapl carryover
balance, or a fapi loss that arises in the year, the realization of a fapi
capital gain may not be problematic.
Electing at an amount in excess of rcb in respect of the shares of fa 4
would trigger a fapi capital gain under paragraph (a) of variable b of the
fapi definition because the shares are not ep. The same surplus consequences would apply in this case.
• Other ep and non-ep that are not capital property. Electing at an amount
in excess of rcb in respect of other non-capital ep would result in income
that would be included in fapi, as was the case above for the shares of fa 3.
In this case, the entire amount of this income would be included in fa 1’s
taxable surplus. If the rcb election is made in respect of other non-capital
property that is not ep, the resulting income would also be included in fapi,
as was the case above with the shares of fa 4. Similar to the above, the entire
amount of this income would be included in fa 1’s taxable surplus.
These results are the same as those outlined above in respect of an rcb election made in the context of a subsection 88(3) liquidation.
Why Make a Relevant Cost Base Election?
The reasons outlined above for making an rcb election should apply equally
in this case. The ability to increase the cost of the property in the hands of the
affiliate shareholder could result in tax benefits in the future. As discussed below,
however, the increase in the cost of the liquidating affiliate’s property will also
increase the proceeds that are deemed to be received by the affiliate shareholder
on the disposition of the shares of the liquidating affiliate. It is therefore important to assess the impact of making the election on the affiliate shareholder as
well as on the liquidating affiliate.
Liquidation Does Not Qualify as a Designated
Liquidation and Dissolution
If the liquidation of fa 2 does not qualify as a dlad, all of its property will be
deemed to be disposed of at its fair market value under subparagraph 95(2)(e)(ii),
Foreign Affiliate Reorganizations: Where Are We Now?20:37
with the exception of the shares of fa 3. Because they are ep, the shares of fa 3
will be deemed to be disposed of at their rcb even if the liquidation is not a
dlad. As is the case in a subsection 88(3) liquidation, this exception for ep shares
of another fa ensures that a capital gain can be realized only through an rcb
election, which results in the taxable portion of the gain being included in fapi.
Any inherent capital gains, income, and losses in fa 2’s property would
therefore be realized (other than in respect of the shares of fa 3), with losses
potentially being subject to stop-loss rules as applicable.
• Shares of fa 4 (non-ep). As is the case if an rcb election is made, the
realization of a capital gain on the disposition of the shares of fa 4 would
result in fapi, with one-half of the gain being included in exempt surplus
and the balance being included in taxable surplus. If there is an inherent
loss in the shares of fa 4, their disposition at fair market value would trigger
a current-year fapi capital loss, which would generally be stopped under
the rules in subsections 40(3.3) and (3.4). However, because the liquidation
of fa 2 is not a dlad, its liquidation will become a triggering event that
will allow the loss to be recognized under subparagraph 40(3.4)(b)(v). The
stop-loss rules in subsection 93(2) would then need to be considered to
determine if the loss should otherwise be reduced by the balance of any
exempt dividends paid by fa 4 in the past. If fa 2 has existing fapi capital
gains, or realizes a fapi capital gain because of other dispositions of non-ep
in the course of the liquidation, any remaining balance of this current-year
fapi capital loss could be used to offset those gains.
• Other ep and non-ep that are not capital property. If there is an inherent
gain or loss in non-capital property that is ep, its disposition at fair market
value would result in an increase or decrease in exempt surplus. In general,
losses that arise from dispositions of ep held on income account should
not be subject to any stop-loss measures. If there is an inherent gain or loss
in non-capital property that is not ep, its disposition at fair market value
would result in fapi or a current-year fapi loss and an increase or decrease
in taxable surplus. As with ep held on income account, such FAPI losses
should not be subject to any stop-loss measures.
Acquisition of FA 2’s Property by FA 1
Subparagraph 95(2)(e)(iii) deems the shareholder affiliate to have received the
distributed property at the same amount as it was disposed of by the liquidating
affiliate. In this way, an inherent gain or loss in the property that has not been
realized by the liquidating affiliate remains an inherent gain or loss in the property in the hands of the affiliate shareholder. Because of the ability to crystallize
preacquisition capital or income gains under the rcb definition, the affiliate
shareholder would acquire such property at this higher basis amount.
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Heather O’Hagan and Ken J. Buttenham
Disposition of fa 2’s Shares by fa 1
As a result of the liquidation and dissolution, the shareholder affiliate will have
disposed of the shares of the liquidating affiliate. Subparagraph 95(2)(e)(iv)
computes the amount of proceeds that will apply to that disposition, and the
calculation differs depending on whether the liquidation is a dlad or not.
Although there is no defined nda in respect of a paragraph 95(2)(e) liquidation, the same concept applies. In this case, the net cost of property received
(ncpr) by a shareholder affiliate is determined under clause 95(2)(e)(iv)(b),
and generally equals the cost of all property received from the liquidating affiliate, reduced by any liabilities assumed or cancelled by the shareholder affiliate
on the liquidation.80
Designated Liquidation and Dissolution
The general premise of these measures is that no gains will be realized for either
fapi or surplus purposes, and losses will be realized only for surplus purposes.
If the ncpr of the shareholder affiliate is greater than the acb of its shares
in the liquidating affiliate, the proceeds are deemed to equal the acb. This situation would generally arise where the inside basis of the liquidating affiliate’s
property (the total cost base of all of its property) is greater than the outside basis
(the acb) of its shares, indicating that there has been an overall increase in the
liquidating affiliate’s value. In this case, no gain or loss would be realized on
the disposition of the liquidating affiliate’s shares by the shareholder affiliate.
If the acb of the liquidating affiliate’s shares is greater than the ncpr of the
shareholder affiliate, the determination of the proceeds will then depend on
whether the shares are ep or not. This situation would generally arise where the
inside basis of the liquidating affiliate’s property is less than the outside basis
of its shares, indicating that there has been an overall decrease in the liquidating
affiliate’s value.
The determination of the ep status of the shares of the liquidating affiliate
should be made at the time of the distribution of its property. Paragraph 95(2)(e)
applies where, at any time, an FA receives property from another FA on its liquidation and dissolution. At the same time, the shareholder affiliate is deemed to
dispose of the shares of the liquidating affiliate on its liquidation and dissolution.
Assuming that all of the liquidating affiliate’s property is distributed at roughly
the same time, the ep status of its shares should be determined at that time.
If the liquidating affiliate’s shares are ep, the proceeds are deemed to be the
ncpr, the lower amount. This would result in a capital loss being realized on
the disposition. This capital loss must be included in the shareholder affiliate’s
hybrid deficit.
If the shares are not ep, the proceeds are deemed to be their acb, the higher
amount, and no gain or loss would effectively be realized for fapi purposes.
There is, however, a surplus impact in respect of this disposition because an
Foreign Affiliate Reorganizations: Where Are We Now?20:39
economic loss has effectively been realized. This surplus impact arises by virtue
of a specific rule in subparagraph (iii) of variable b of the definition of hybrid
surplus in regulation 5907(1).
Non-Designated Liquidation and Dissolution
The deemed proceeds in the case of a non-dlad are simply the ncpr of the
shareholder affiliate. As a result, there could be either a capital gain (if the ncpr
is greater than the acb) or a capital loss (if the acb is greater than the ncpr)
realized on the disposition of the liquidating affiliate’s shares. This capital gain
or loss would be included in the shareholder affiliate’s hybrid surplus or hybrid
deficit if the shares are ep or would result in fapi or a current-year fapi loss if
the shares are not ep. In the case of a loss in respect of non-ep, the various
stop-loss rules could also come into play. Subsection 93(2) could apply to reduce
the loss if the liquidating affiliate has paid exempt dividends to the shareholder
affiliate in the past, or subsection 93(4) could apply to push that loss down to
the shares of another fa received by the shareholder affiliate as a result of the
liquidation.
The accompanying table provides a summary of these results.
Non-dlad
dlad
fa 1 disposes of
shares of fa 2
EP
Non-EP
EP
Non-EP
acb
acb
ncpr
ncpr
No gain
No gain
Proceeds:
ncpr > acb . . . . Gain
fapi gain
Hybrid
surplus
50% exempt
surplus
50% taxable
surplus
Proceeds:
acb > ncpr . . . . ncpr
ACB
ncpr
Loss
No FAPI loss
but impact on
hybrid deficit
Loss
fapi loss
Hybrid deficit
Subject to
stop-loss rules
Hybrid deficit
ncpr
Surplus Implications
In the case of a liquidation of an fa into a shareholder fa, planning for the liquidation needs to consider the surplus and/or deficit balances of the liquidating
affiliate, the shareholder affiliate, and any underlying affiliates that will be
transferred to the shareholder affiliate as a result of the liquidation.
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Heather O’Hagan and Ken J. Buttenham
Surplus of Liquidating Affiliate
The two rules contained in regulation 5907(9) as discussed above apply equally
to paragraph 95(2)(e) liquidations. The liquidating affiliate will have a deemed
year-end immediately before the time when it has distributed at least 90 percent
of the value of all of its property. It will also be deemed to have distributed its
property at the earlier of the actual distribution time and the deemed disposition
time. This will allow the liquidating affiliate to include all relevant income, gain,
and loss amounts in its surplus balances in advance of its dissolution.
Additional rules contained in regulation 5905(7) also apply to a paragraph
95(2)(e) liquidation, but only if it is a dlad. This provision deems the liquidating affiliate to have paid a dividend to its shareholder affiliate equal to its net
surplus81 immediately before the time of the liquidation, on the assumption that
it would have had a year-end at that time. This net surplus should therefore
include all earnings (or losses) of the liquidating affiliate up to the time of its
dissolution, as well as any surplus or deficit balances arising on the disposition
of its property. Because this rule applies only in the context of a dlad, however,
there should generally be no additional surplus or deficit balances being recognized on the disposition of the liquidating affiliate’s property unless an rcb
election is made. The levitation of the liquidating affiliate’s net surplus does allow
deficits to disappear, but only if those deficits are in excess of its overall surplus
balances (and subject to the fill-the-hole rules for exempt deficits).
This surplus levitation rule does not apply if the liquidation is not a dlad.
Accordingly, the surplus of a liquidating affiliate in this case would be lost unless
steps are taken to actually move that surplus in advance of the liquidation through
the payment of a dividend to the shareholder affiliate.
Deemed Subsection 93(1) Election
If the disposition of the shares of an underlying fa, such as fa 3 and fa 4 in
figure 8, results in a capital gain in the liquidating affiliate, either because of an
rcb election or a fair market value disposition, the surplus of the underlying
affiliate would be used to recharacterize that capital gain as a dividend paid out
of that surplus to the liquidating affiliate.82 This dividend could therefore prevent
the recognition of fapi arising as a result of an rcb election or a fair market
value disposition of shares that are not ep, such as those of fa 4.
Thus, if an underlying affiliate has exempt, taxable, or hybrid surplus balances at the time of the distribution of its shares, some or all of those balances
would effectively be moved up to the liquidating affiliate. This inherited surplus
then becomes part of the surplus pools of the liquidating affiliate that would
need to be taken into consideration when its shares are disposed of by its affiliate
shareholder.
Foreign Affiliate Reorganizations: Where Are We Now?20:41
Deficit of Liquidating Affiliate
As is the case for a subsection 88(3) liquidation, if the liquidating affiliate has
an overall hybrid or taxable deficit balance, those balances will remain in the
liquidating affiliate, and can therefore be eliminated as a result of the liquidation.
However, if the liquidating affiliate has an exempt deficit balance, that deficit
could be subject to the fill-the-hole rules described above. Thus, if shares of an
underlying affiliate are being distributed to the affiliate shareholder as a result
of a liquidation of an fa with an exempt deficit, these blocking deficit rules
could reduce or eliminate the exempt surplus balance of that underlying fa.
Foreign Accrual Property Loss/Foreign Accrual
Capital Loss of Liquidating Affiliate
Regulation 5903(5) allows fapls and facls of a liquidating affiliate to be carried
over to its shareholder affiliate, but only in the case of a dlad. The rules essentially have the shareholder affiliate step into the shoes of the liquidating affiliate
in respect of any fapls or facls that exist at the time of the liquidation.83
Surplus Planning Considerations
It therefore becomes very important to examine the impact of all of these rules
on the liquidating affiliate’s surplus balances, especially in the case of a nondlad liquidation. Because the disposition of the liquidating affiliate’s property
at fair market value will have surplus implications and because in this case the
liquidating affiliate’s surplus balances do not get automatically transferred to the
shareholder affiliate, planning for the use of such balances should be part of
the liquidation analysis.
The accompanying table summarizes the effects of a liquidation on the surplus accounts of the liquidating affiliate. Assume that in figure 8 fa 2’s regular
taxation year-end is December 31 and it does not make any rcb elections.
dlad
Non-dlad
Actual disposition of > 90% of property . . . October 1
October 1
Final distribution time: deemed year-end . . . September 30
September 30
Deemed disposition time of property . . . . . . September 29
September 29
For period ending
September 30
For period ending
September 30
No
Yes
Stub-period earnings/loss included
in surplus . . . . . . . . . . . . . . . . . . . . . . . . . . Income/gains/losses on disposition of
property included in surplus . . . . . . . . . . . 20:42
Heather O’Hagan and Ken J. Buttenham
Deemed subsection 93(1) election . . . . . . . . No, because no
capital gain
arises
Yes, if capital
gain realized on
disposition of
fa 3/fa 4 shares
Exempt deficit of fa 2 . . . . . . . . . . . . . . . . . Offsets exempt
surplus in fa 3
and /or fa 4
Offsets exempt
surplus in fa 3
and /or fa 4
Net surplus balance . . . . . . . . . . . . . . . . . . . Net balance
levitated to fa 1
No carryover
Net deficit balance . . . . . . . . . . . . . . . . . . . . Deficits
disappear unless
subject to fill-thehole rules
Deficits
disappear unless
subject to fill-thehole rules
fapl/facl . . . . . . . . . . . . . . . . . . . . . . . . . . Carried over in
fa 1
No carryover
Surplus/Deficit of Underlying Affiliates
Other than the impact of the fill-the-hole rules outlined above and the potential
to have a deemed subsection 93(1) election levitate net surplus, the surplus balances of fas in which the liquidating affiliate has an equity percentage should
not be affected by the liquidation. However, if as a result of the liquidation the
Canadian taxpayer’s SEP in these underlying affiliates changes for some reason,
its surplus or deficit balances would have to be adjusted accordingly.84
Surplus/Deficit of Shareholder Affiliate
As outlined above, the net surplus of the liquidating affiliate will be levitated to
its shareholder affiliate when the liquidation qualifies as a dlad. Its surplus
balances could also be affected as a result of the disposition of the liquidating
affiliate’s shares.
Upstream Loan Implications on Liquidation
If a liquidating affiliate (the creditor affiliate) has previously made an upstream
loan to an ultimate Canadian shareholder or another specified debtor, the loan
would be subject to the upstream loan rules at the time that it is originally made.
If the loan remains outstanding for more than two years such that it is included
in the income of the Canadian shareholder, the surplus balances of the creditor
affiliate could potentially be relied on to claim an offsetting deduction under
subsection 90(9).
In the case of a subsequent liquidation of the creditor affiliate, the upstream
loan would be distributed, along with the rest of its property, to its shareholder
Foreign Affiliate Reorganizations: Where Are We Now?20:43
affiliate. There is no provision that would deem the original upstream loan to
be settled or repaid as a result of the liquidation of the creditor affiliate. From a
policy perspective, this is understandable on the basis that there is still an amount
owing from a specified debtor to an fa of the Canadian shareholder; however,
subsequent to the liquidation, it could also be argued that the specified debtor
has become indebted to the shareholder affiliate at the time of the transfer of
the upstream loan on the liquidation. This would cause the upstream loan rules
to apply a second time to the same amount owing. At the same time, although
the liquidating affiliate’s surplus balances could have been levitated to its shareholder affiliate (for example, if the liquidation is a dlad), those surplus balances
would already have been relied on for the purposes of a subsection 90(9) deduction and therefore may not be used again because of the non-duplication rule in
paragraph 90(9)(b).
While this is obviously an innocuous result, the upstream loan rules currently
do not address this situation. Arguably, the provisions of subsection 248(28)
could apply to ensure that the same amount is not included in income twice. The
cra and the Department of Finance are aware of this unintended consequence
of the rules, and we are hopeful that the relevant amendments to the upstream
loan rules will be made. In the meantime, the best course of action may be to
undertake preliquidation planning to repay all upstream loans in order to ensure
that adverse consequences do not arise.
Summary of Considerations for
Paragraph 95(2)(e) Liquidations
1) A liquidating affiliate’s net surplus will be levitated to the shareholder
affiliate only if the liquidation is a dlad.
a)If the liquidation is not a dlad, a deemed subsection 93(1) election
would move surplus only up to the amount of a capital gain realized on
the disposition of the liquidating affiliate’s shares.
b)Planning should be undertaken if the liquidation is not a dlad and
“good” surplus balances exist in the liquidating affiliate, including any
surplus levitated from underlying affiliates.
2) It is necessary to know the ep status of the shares of the liquidating affiliate
to determine their proceeds of disposition.
3) If the outside basis of the liquidating affiliate’s shares is greater than the
inside basis of its property, the following matters must be considered.
a)Deficits in the liquidating affiliate will be eliminated, other than preexisting exempt deficits that are subject to the fill-the-hole rules.
b)If the liquidation is a dlad, a capital loss realized by the shareholder
affiliate on the disposition of the liquidating affiliate’s shares is included
in its hybrid deficit, even if the shares are not ep. If the liquidation is
not a dlad, the capital loss will be a fapi capital loss if the shares
are not ep.
20:44
Heather O’Hagan and Ken J. Buttenham
Foreign Affiliate Mergers
Overview of the Rules
The rules applicable to mergers of fas are in some respects more straightforward
than those applicable to fa liquidations. Paragraph 95(2)(d.1) generally allows
a rollover for all property of the predecessor affiliates, with the new merged
affiliate essentially stepping into the shoes of the predecessors in respect of that
property. Paragraph 95(2)(d) generally allows a rollover for shares of predecessor
affiliates owned by another fa that become shares of the new merged affiliate.
Subsection 87(8) allows a similar rollover where the shares of one or more predecessor affiliate are owned by a Canadian taxpayer. However, the ability to take
advantage of these rules is predicated on meeting the definition of foreign merger,
which is not always a straightforward matter.
What Is a Foreign Merger?
The definition of foreign merger is contained in subsection 87(8.1), with the
definition applying to mergers of any foreign corporations, whether or not they
are fas of a Canadian taxpayer. The definition requires the following conditions
to be met:
• There must be a merger or combination of two or more corporations resident in a country other than Canada (the foreign predecessors). The foreign
entities involved in the merger must be corporations from a Canadian tax
standpoint; therefore, entities that are treated as partnerships under Canadian
tax principles would not qualify. The entities need not be resident in the
same foreign jurisdiction.
• A new corporation (the foreign mergeco) resident in a country other than
Canada must be formed as a result of the merger, but the foreign mergeco
need not be resident in the same jurisdiction as the foreign predecessors.
• All or substantially all of the property and the liabilities of the foreign predecessors immediately before the merger must become property and liabilities
of the foreign mergeco as a result of the merger. This excludes intercompany
receivables, payables, and shares of a foreign predecessor. The transfer of
property and liabilities to the foreign mergeco must not occur as a result
of a windup of a predecessor affiliate. It is therefore important to distinguish, under foreign corporate law, whether the reorganization is in fact a
merger and not a windup.
• All or substantially all of the remaining shares of the foreign predecessors
must be exchanged for, or become, shares of the foreign mergeco as a result
of the merger. The rules also contemplate triangular mergers such that if
the foreign mergeco is controlled by another foreign corporation (the foreign
parent), the shareholders of a foreign predecessor can receive shares of the
foreign parent on the merger instead of shares of the foreign mergeco.
Foreign Affiliate Reorganizations: Where Are We Now?20:45
Absorptive Mergers
Mergers are generally accomplished under corporate law, with a particular juris­
diction’s tax results often being based on how its corporate law effects the merger.
As a result, it is not always easy to equate the parameters of such foreign corporate law to Canada’s tax rules. Many foreign jurisdictions, including the
United States, have corporate laws that allow for mergers that operate by way
of absorption of one entity into another, with the latter entity being the survivor.
Such absorptive mergers do not fit neatly into the definition of foreign merger,
both because there is no “new” entity formed and because the assets and liabilities of the survivor are not affected in any way. Depending on the legal steps
effecting the merger, shares of a predecessor affiliate could simply be cancelled
without any exchange for new shares taking place. Because of the prevalence of
absorptive mergers in corporate laws around the world and the resulting difficulty
in meeting the definition of foreign merger, subsection 87(8.2) was introduced
to alleviate these concerns.85
Figure 9 highlights the general characteristics of an absorptive merger.
In figure 9, an fa (fa 2) of a Canadian taxpayer (Canco) is acquiring the shares
of a target operating company (Target Opco), located in the same jurisdiction,
from its shareholder (Target Parent). The following steps will be implemented
to effect the acquisition:
• fa 2 sets up a new corporation (Mergerco).
•Mergerco and Target Opco undergo an absorptive merger, with Target Opco
surviving.
• The shares of Mergerco are cancelled for no consideration.
• Target Parent receives cash from fa 2 as consideration for the shares of
Target Opco.
In figure 9, there is technical uncertainty whether a new corporate entity has
been formed and whether the assets and liabilities of Target Opco become assets
and liabilities of the merged entity. Because the shares of Mergerco are cancelled
for no consideration and there is no change in the shares of Target Opco, it is
not clear whether all or substantially all of the shares of the foreign predecessors
(Mergerco and Target Opco) can be said to have been exchanged for or to have
become shares of the foreign mergeco (Target Opco). As a result, it is questionable
whether the definition of foreign merger should apply in this example.
The absorptive merger rules in subsection 87(8.2) are designed to clarify this
result. Thus, if one or more foreign predecessors cease to exist and immediately
after the merger another foreign predecessor (the surviving corporation) owns
property representing all or substantially all of the value of the property that
was owned by each foreign predecessor, the rules in subsection 87(8.2) will
apply. The provisions in paragraphs 87(8.2)(a) to (e) essentially deem the surviving corporation to be a newly formed corporation and deem all of its premerger
Heather O’Hagan and Ken J. Buttenham
20:46
Figure 9
Canco
FA 1
Shares
cancelled
Cash
Target Parent
FA 2
Mergerco
Target Opco
Survivor
property, liabilities, and shares to become its property, liabilities, and shares as
a result of the merger. Under paragraph 87(8.2)(f ), the shares of another foreign
predecessor that cease to exist on the merger are deemed to be exchanged for
shares of the surviving corporation as a result of the merger. Accordingly, all of
the conditions required for the definition of foreign merger to apply will now
be met because of these absorptive merger rules.
The application of the deeming rules in subsection 87(8.2) apply only for the
purposes of the definition of foreign merger in subsection 87(8.1), and not more
generally to the rollover rules in subsection 87(8) and paragraphs 95(2)(d) and
(d.1).
Foreign Affiliate Mergers
Property of Foreign Affiliate Predecessor Corporations
In order for the rollover rules in paragraph 95(2)(d.1) to apply, three conditions
must be met:
1) there must be a foreign merger of two or more foreign predecessors to form
the foreign mergeco,
2) the foreign mergeco must be an fa of the taxpayer immediately after the
merger (FA mergeco), and
3) at least one of the foreign predecessors must be an fa of the taxpayer immediately before the merger (FA predecessor).
Subsection 95(4.1) imports the meaning of these terms from subsection 87(8.1).
However, as noted above, the absorptive merger deeming rules in subsection
87(8.2) are not specifically imported into paragraph 95(2)(d.1). Although there
Foreign Affiliate Reorganizations: Where Are We Now?20:47
could be a technical argument that absorptive mergers would not meet the conditions outlined in the preamble of paragraph 95(2)(d.1) because no new entity is
“formed” as a result of the merger, the addition of subsection 87(8.2) was clearly
meant to accommodate absorptive mergers for the purposes of the foreign merger rollover provisions.86
Where these conditions are met, the property of each fa predecessor is deemed
to be disposed of at its rcb and to be acquired by the fa mergeco at that same
rcb. As discussed previously, the definition of rcb effectively crystallizes preacquisition gains and losses in the basis of a property. Accordingly, this same
effect should apply to property of the fa predecessors that become property of
the fa mergeco.
Although the determination of a property’s rcb requires knowledge of its
status as ep or non-ep, as discussed previously, there is no immediate requirement to determine this status at the time of the merger unless an rcb election
is to be made. There is no differentiation in the merger rules between ep and
non-ep because all property is subject to a rollover. However, if an rcb election
is made in respect of an fa predecessor’s property, the resulting income or capital gain will be included in fapi87 even if the property is ep, in the same way
as where an rcb election is made on the liquidation of an fa or a share transfer
under paragraph 95(2)(c).
There are a number of continuity rules in subsection 95(2)(d.1) that deem the
fa mergeco to be the same corporation as and a continuation of each fa predecessor, particularly in the application of the fapi rules to dispositions of
property to which the rollover rules apply. There are also continuity rules dealing
with certain stop-loss and debt-forgiveness provisions.
Shares of Foreign Affiliate Predecessor Corporations
The shares of an fa that is subject to a foreign merger could be held by another
fa or by a Canadian shareholder (see figure 10). In either case, it is generally
preferable to have the disposition of those shares take place on a rollover basis
rather than triggering a capital gain in Canada, or realizing fapi or hybrid surplus in an fa.
If the shares of an fa predecessor are owned by a Canadian shareholder, the
rules in subsection 87(8) should generally allow, by reference to subsection 87(4),
a deemed disposition of the shares at acb and a deemed acquisition of the shares
of the fa mergeco at that same acb. Subsection 87(8) also provides the ability
to elect out of the rollover rules if the taxpayer does in fact want to trigger a
capital gain (or loss, which could be denied) on the disposition of the shares of
the fa predecessor.
The same result arises where the shares of an fa predecessor are owned by an
fa shareholder under paragraph 95(2)(d), also by reference to subsection 87(4).
However, in this case the disposition takes place at rcb rather than at acb. On
Heather O’Hagan and Ken J. Buttenham
20:48
Figure 10
Canco
FA 1
Canco
FA 2
Foreign mergeco
FA 2
FA 1
FA 2
Canco
Canco
FA 1
FA 1
FA 3
Foreign mergeco
Foreign
mergeco
FA 2
Foreign
mergeco
FA 3
the basis of the definition of rcb, as previously discussed, this allows preacquisition gains and losses to be crystallized into the cost basis of the shares.
It also allows a shareholder to elect to have the disposition of the shares take
place at an amount in excess of their basis. If such an election is made, the resulting capital gain will be included in fapi even if the shares are ep.
In the context of an absorptive merger, there is also some uncertainty whether
the conditions of either subsection 87(8) or paragraph 95(2)(d) can be met, given
that the shares of the fa predecessors must be “exchanged for” or “become”
shares of the fa mergeco. However, as noted previously, such uncertainty should
be resolved on the basis of the overall purpose of the addition of the absorptive
merger rules to the Act. It is important to ensure, however, that the legal steps
of the absorptive merger allow for the preservation of cost basis in the shares of
the fa mergeco. This can sometimes be challenging if certain shares are automatically cancelled on the merger, but steps can generally be put in place to
alleviate this issue as long as those steps are introduced as part of the merger
prior to its implementation.
Foreign Affiliate Reorganizations: Where Are We Now?20:49
Non-Foreign Mergers
Mergers or combinations of foreign entities that occur in some jurisdictions may
not meet the definition of a foreign merger simply because of the methodology
used to effect the merger under the particular corporate law of that jurisdiction.
As a result, the rules in subsection 87(8) and paragraphs 95(2)(d) and (d.1) cannot be used to achieve a rollover of the fa predecessors’ property or shares.
However, there are no other specific fa provisions that would come into play
in this case, thus leaving the effects of the merger to be analyzed under general
legal principles rather than under specific tax rules. It therefore becomes imperative to understand the application of the corporate law in the merger jurisdiction
to the property and shares of a foreign predecessor because the foreign legal
results would dictate the Canadian tax results.
Surplus Implications of Foreign Affiliate Mergers
The surplus implications of fa mergers are quite straightforward. Regulation
5905(3) essentially requires the surplus and deficit balances of each fa predecessor to be combined and to become the surplus and deficit balances of the fa
mergeco. Unlike fa liquidations, deficits do not disappear as a result of a foreign
merger, but instead become deficits of the merged affiliate.
For surplus purposes, the taxation year of each fa predecessor is deemed to
have ended immediately before the merger, and a new taxation year of the fa
mergeco is deemed to commence at the time of the merger under regulation
5907(8). As a result, earnings of a fa predecessor for the period that ends at the
time of the merger should be included in its surplus balance and transferred to
the fa mergeco.
Regulation 5903(5)(a) includes continuity rules for fapl and facl balances of
fa predecessors that allow such balances to be carried over to the fa mergeco.
Upstream Loan Implications of
Foreign Affiliate Mergers
If an fa predecessor has previously made an upstream loan to an ultimate Canadian shareholder or another specified debtor, the loan would be subject to the
upstream loans rules at the time that it is originally made. If the loan remains
outstanding for more than two years such that it is included in the income of the
Canadian shareholder, the surplus balances of the fa predecessor could potentially be relied on to claim an offsetting deduction under subsection 90(9).
Where the fa predecessor that has made an upstream loan subsequently merges
with another fa, the loan receivable would become property of the fa mergeco,
resulting in the specified debtor arguably becoming indebted to the fa mergeco
at the time of the merger.88 There are currently no provisions in the upstream
loan rules (or foreign merger rules) that would deem the fa mergeco to be a
20:50
Heather O’Hagan and Ken J. Buttenham
continuation of the original fa predecessor, or that would otherwise avoid a
second application of the upstream loan rules to the same amount. Again, it
could be argued that subsection 248(28) should apply to ensure that the same
amount is not included in income twice. The cra and the Department of Finance
are aware of this unintended consequence of the rules, and we are hopeful that
relevant amendments to the upstream loan rules will be made. In the meantime,
the best course of action may be to undertake pre-merger planning to repay all
upstream loans in order to ensure that adverse consequences do not arise.
Summary of Considerations for
Foreign Affiliate Mergers
1) It is important to understand how a merger will be effected under the relevant foreign corporate law, both in terms of the types of entities being
merged and in terms of the steps being undertaken to accomplish the
merger. This will help to avoid any unforeseen Canadian tax consequences
that could otherwise arise.
2) As long as the definition of foreign merger is met, it is generally possible
to obtain a complete rollover in respect of both property and shares of FAs
that are being merged to form the new FA.
Conclusion
One thing should be clear from the discussion in this paper: finally having a
welcome level of certainty relating to the rules applicable to fa reorganization
transactions (and no longer having to undertake tax analysis pursuant to various
versions of proposed rules or comfort letters as well as enacted rules for each
fa reorganization transaction) does not mean that the analysis is necessarily
straightforward. The rules applicable to fa reorganization transactions have
become more complicated (as compared with the prior version of enacted rules).
Taxpayers and advisers should take the time to fully analyze the impact of
fa reorganization transactions on a proactive basis. This analysis should include
not only the direct tax implications of the reorganization transaction itself but
also the consideration of certain indirect implications to items such as surplus
balances, cross-border tax attributes, and current or future upstream loans. To
make this assessment, one will find that in many cases additional information
will be required that was not required in the past. In addition, there is a certain
amount of flexibility built into many of the fa reorganization rules, and planning
will be required to take full advantage of these opportunities.
Foreign Affiliate Reorganizations: Where Are We Now?20:51
Notes
1 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “the Act”). Unless otherwise stated,
statutory references in this paper are to the Act.
2 The specific FA reorganization transactions considered for the purposes of this paper include
FA share transfers pursuant to subsection 85.1(3) and paragraph 95(2)(c), FA liquidations
pursuant to subsection 88(3) and paragraph 95(2)(e), and FA mergers.
3 Bill C-48, Technical Tax Amendments Act, 2012, SC 2013, c. 34, which received royal assent
on June 26, 2013.
4 See, for example, Patrick Marley and Sandra Slaats, “Foreign Affiliate Reorganizations—Recent
Amendments to the Rules,” in Report of Proceedings of the Sixty-Fourth Tax Conference, 2012
Conference Report (Toronto: Canadian Tax Foundation, 2013), 27:1-29 and Penny Woolford
and Francis Favre, “The Latest Foreign Affiliate Proposals: Selected Aspects” (2010) 58:4
Canadian Tax Journal 791-843.
5 The preamble of subsection 85.1(3) requires that these shares be held as capital property to
qualify for rollover treatment.
6 Where different classes of shares of the acquiring affiliate are receivable in respect of the share
transfer, this excess amount is allocated pro rata on the basis of the relative fair market values,
immediately after the share transfer, of the classes of shares received to determine the cost to
the taxpayer of each class of acquiring affiliate shares. It is not possible, using the provisions
of subsection 85.1(3) only, to allocate cost first to one class of shares up to the fair market
value of that class (for example, preferred shares) and the residual to another class (for example,
common shares). Steps necessary to disproportionately allocate cost basis among share classes
of the acquiring affiliate are discussed further below.
7 A taxpayer cannot otherwise complete a tax-free conversion of ACB in FA shares into boot on
an FA share disposition transaction (such as a redemption); however, this same result may be
accomplished via distributions (see regulation 5901(2)(b)).
8 While this transaction may be tax-free for Canadian tax purposes, foreign tax implications
should be carefully considered.
9Generally viewed by the Canada Revenue Agency (CRA) as meaning 90 percent or more.
10 As defined in subsection 95(1).
11 Only a subsequent disposition of the specific FA share(s) disposed of by the taxpayer in what
would otherwise have been a transaction subject to subsection 85.1(3) is subject to the subsection 85.1(4) anti-avoidance provision. In CRA document no. 9414095, October 25, 1994, the
CRA was asked to comment on a series of transactions that included a Canadian corporation
transferring (pursuant to subsection 85.1(3)) the shares of its US operating company to a US
holding company prior to the US holding company going public. The Canadian corporation
subsequently sells some of its US holding company shares. The CRA commented that “subsection 85.1(4) would not apply to preclude the application of subsection 85.1(3), as a result
of the above transactions in and by themselves, as the shares that were subject to the rollover
(the shares of USco) are not the shares that are now being disposed of as part of the series of
transactions or events.” However, the CRA has also previously indicated that paragraph 95(6)(b)
could apply to a share disposition otherwise subject to subsection 85.1(3) even where the conditions of subsection 85.1(4) are not met. See CRA document no. 2005-0155331E5, December 5,
2005 and CRA document no. 9M19020, October 10, 1997.
12 As defined in paragraph 95(2)(m).
13Previously, all arm’s-length FA purchasers were carved out from the application of subsection
85.1(4) such that subsection 85.1(3) could apply; however, this carve-out was narrowed such
that only arm’s-length FAs in which the taxpayer has a qualifying interest will be exempt from
this anti-avoidance rule. This change applies to dispositions that occur after August 19, 2011.
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The CRA’s “95(6) Committee” has historically recommended the application of paragraph
95(6)(b) to situations where shares were issued principally to create FA status and avoid the
application of subsection 85.1(4). It is assumed that the narrowing of the exception from subsection 85.1(4) by introducing a qualifying interest requirement is to address this concern.
Proposed subsection 87(8.3) is another example of a legislative change designed to prevent
taxpayers from avoiding the application of the anti-avoidance rule in subsection 85.1(4). See
Canada, Department of Finance, Legislative Proposals Relating to Income Tax, Excise Duties
and Sales Tax (Ottawa: Department of Finance, July 12, 2013), at clause 3.
14Paragraph 85.1(4)(b) applies to dispositions that occur after August 19, 2011. For completeness,
there were other more minor amendments to subsection 85.1(4) also enacted as part of Bill
C-48 that are not discussed here. Paragraph 85.1(4)(a) now captures dispositions that are part
of a single transaction or event, as well as those that are part of a series. Paragraph 85.1(4)(a)
was also extended to apply to dispositions to arm’s-length partnerships.
15 For a discussion of the relevant stop-loss rules, see Ruth M. Spetz, “The New Stop-Loss Rules,”
in 1997 Prairie Provinces Tax Conference (Toronto: Canadian Tax Foundation, 1997), 3:1-42.
The intention to ensure that all FA share-for-share transactions are subject to the same stop-loss
rules that apply to other transfers of capital property between affiliated persons is evidenced
by amendments to paragraph 95(2)(c) and subsection 88(3).
16 See the comments in Canada, Department of Finance, Explanatory Notes Relating to the Income
Tax Act, the Excise Tax Act and Related Legislation (Ottawa: Department of Finance, October
2012), at clause 63.
17 See regulation 5901(2)(b), which provides for an election to treat an FA dividend to be paid
out of preacquisition surplus.
18 See paragraph 90(9)(a).
19 This is further supported by the discussion later in this paper regarding recent amendments to
paragraph 95(2)(c).
20 Subsections 86(1) and 51(1) can apply in the context of transactions involving FA shares since
these provisions are not restricted to the reorganization of capital or the conversion of shares
of a Canadian corporation.
21 As defined in subsection 95(1) and regulations 5905(10) to (13).
22 FA 1’s surplus balances in respect of Canco should be grossed up to reflect the reduction of
Canco’s SEP in respect of FA 1, and FA 2’s surplus balances should be ground down to reflect
the increase in Canco’s SEP in respect of FA 2.
23 For a discussion of these past technical issues and potential remedies, see Woolford and Favre,
supra note 4.
24 Under regulation 5905(1), an FA’s opening surplus and deficit balances are multiplied by the
ratio of Canco’s SEP in respect of the FA immediately before the transaction to Canco’s SEP
in respect of the FA immediately after the transaction.
25Part of the legislative proposals released on July 12, 2013, supra note 13. If enacted, this provision could apply to transactions undertaken on or after July 12, 2013.
26 “Foreign accrual property income,” as defined in subsection 95(1).
27 For this purpose, taxpayers are connected if one holds, directly or indirectly, 90 percent or
more of each class of shares of the other or if another taxpayer resident in Canada holds, directly or indirectly, 90 percent or more of each class of shares of each taxpayer.
28 As defined in subsection 95(1) and regulation 5904.
29 SEP is defined in subsection 95(1) and regulation 5905(13), and is essentially equivalent to
the taxpayer’s equity percentage in the liquidating affiliate. However, if the transferred affiliate
or any other affiliate that is relevant to the determination of the taxpayer’s equity percentage
Foreign Affiliate Reorganizations: Where Are We Now?20:53
has more than one class of shares, or if there are upstream shareholdings in the applicable chain
of affiliates, the computation of SEP becomes dependent on the net surplus of the transferred
affiliate and its subsidiary affiliates.
30 As discussed in the Joint Committee on Taxation of the Canadian Bar Association and Chartered
Professional Accountants of Canada submission to the Department of Finance, September 13,
2013, there are a number of anomalies that may result from the application of the stub-period
FAPI rules as currently proposed. We believe that the Department of Finance is aware of many
of these anomalies, and it is hoped that amendments will be made to the stub-period FAPI rules
prior to enactment.
31 A review of the upstream loan rules is beyond the scope of this paper. For a detailed discussion
of these rules, see Ken J. Buttenham, “Are You Ready for the Upstream Loan Rules?” International Tax Planning feature (2013) 61:3 Canadian Tax Journal 747-68.
32 The deduction provided by subsection 90(9) generally takes into account the surplus balances
of the creditor affiliate, as well as the surplus balances of other FAs of the taxpayer that are in
the same vertical ownership chain as the creditor affiliate.
33 2013 TCC 176; aff ’d. 2014 FCA 103. A more detailed discussion of this case is beyond the
scope of this paper. For additional discussion of the TCC’s decision, see Paul L. Barnicke and
Melanie Huynh, “Lehigh and Paragraph 95(6)(b)” (2013) 21:6 Canadian Tax Highlights 1-2;
and Angelo Nikolakakis, “Lehigh Cement Limited v. The Queen—A Bridge Too FAAAR”
(2013) 19:1 International Tax Planning 1284-97.
34 See Elizabeth J. Johnson, Geneviève C. Lille, and James R. Wilson, “A Reasoned Response to
the CRA’s Views on the Scope and Interpretation of Paragraph 95(6)(b)” (2006) 54:3 Canadian
Tax Journal 571-632.
35 CRA document no. 9903126, March 18, 1999 and Income Tax Technical News no. 36, July 27,
2007. The CRA’s reasoning is that the general FA definition in subsection 248(1) refers to the
FA definition in subsection 95(1), which is part of subdivision i of division B of part I. Because
paragraph 95(6)(b) applies for the purposes of subdivision i (other than section 90), it applies
for the purposes of the FA definition in subsection 95(1), and in the CRA’s view also applies to
other provisions that use the term “FA.”
36 The preamble of paragraph 95(2)(c) requires that the FA shares disposed of be held as capital
property by the transferring FA to qualify for rollover treatment.
37 As defined in subsection 95(4).
38 Similar to the operation of subsection 85.1(3), where different classes of shares of the acquiring
affiliate are receivable in respect of the share transfer, this excess amount is allocated pro rata
on the basis of the relative fair market values, immediately after the share transfer, of the shares
received to determine the cost to the taxpayer of each class of acquiring affiliate shares. It is
not possible to allocate cost first to one class of shares up to the fair market value of that class
(for example, preferred shares) and the residual to another class (for example, common shares).
39 Ignoring the application of paragraph 95(2)(f.1).
40 See the preamble of paragraph 95(2)(c).
41 As defined in subsection 95(1).
42 The disposition by an FA of capital property that is EP is carved out of the application of subsection 40(3.4) for the purposes of computing the exempt surplus/deficit, hybrid surplus/deficit,
and taxable surplus/deficit of an FA pursuant to paragraph 40(3.3)(a).
43 Effective for FAPI capital losses of an FA incurred in taxation years that end after August 19,
2011, such losses can be applied only against FAPI capital gains.
44Melanie Huynh and Eric Lockwood, “Foreign Affiliates and Adjusted Cost Base,” International
Tax Planning feature (2007) 55:1 Canadian Tax Journal 141-59.
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45 The rules in paragraphs 95(2)(f.12) to (f.15) apply to determine whether capital gains and
losses are to be calculated using an FA’s calculating currency or Canadian currency.
46Paragraph 95(2)(f.1) carves out income, capital gains, and losses that accrued while the property was held by someone other than a “specified person or partnership” in respect of the
Canadian taxpayer, as defined in subsection 95(1).
47Pursuant to paragraph 95(2)(f.1), the carve-out amount is calculated as a portion of the gain
or loss otherwise calculated under paragraph 95(2)(f ). Therefore, if the value of an FA decreases
subsequent to the acquisition of the FA group, the absolute amount of the carve-out will also
decrease.
48 This can be done via a “qualifying return of capital” if the necessary conditions in subsection
90(3) are met or via a preacquisition surplus election pursuant to regulation 5907(2)(b). These
mechanisms can be used to repatriate funds without reducing the surplus balances of the FAs.
49 See subsection 40(3).
50 Under regulation 5911(5), an RCB election must be made by the corporate shareholder of a
disposing affiliate no later than its filing-due date for the taxation year that includes the last
day of the affiliate’s taxation year in which the RCB determination is relevant. There are no
provisions that would allow this election to be late-filed.
51 As defined in subsection 95(4).
52 Supra note 28.
53 The definition of RCB ensures that an amount designated in respect of a particular property
cannot be less than the amount determined under paragraph (a) of that definition; therefore, it
is not possible to trigger a loss as a result of making an election.
54Paragraph (b) of variable B of the definition of FAPI in subsection 95(1) specifically includes
a taxable capital gain resulting from the disposition of EP if paragraph 95(2)(c) applied to the
disposition.
55 The definition of hybrid surplus in regulation 5907(1) generally includes capital gains (and
losses) from the disposition of FA shares. However, the definition specifically excludes capital
gains the taxable portion of which are otherwise included in FAPI under variable B of that
definition in subsection 95(1).
56 The previous version of paragraph 95(2)(c) was less restrictive and allowed the subject shares
to be disposed of “to any corporation,” which could include the FA whose shares are being
disposed of. This change to paragraph 95(2)(c) is effective for share dispositions that occur
after August 19, 2011.
57 As referenced above in relation to figure 1, in many situations the flexibility lost as a result of
the inability to use paragraph 95(2)(c) in respect of internal share reorganizations may not be
of practical significance now that taxpayers can file a preacquisition surplus election pursuant
to regulation 5901(2)(b).
58 See subsection 51(4).
59 There is some uncertainty concerning the interpretation of the phrase “in the course of a reorganization of the capital” because it is not defined in the Act. In CRA document no. 2010-0373271C6,
October 8, 2010, the CRA states that a reorganization for the purposes of subsection 86(1)
requires that the corporation’s articles be amended. See also Daniel Lang, “Linkage Required
for Section 86 Reorganization” (2011) 17:1 Corporate Finance 1944-46.
60 For additional discussion see R. Ian Crosbie, “Canadian Income Tax Issues Relating to CrossBorder Share Exchange Transactions,” in Current Issues in Corporate Finance, 1997 Corporate
Management Tax Conference (Toronto: Canadian Tax Foundation, 1998), 12:1-36.
61 In situations where no RCB election is made and no subsection 93(1) election is made.
Foreign Affiliate Reorganizations: Where Are We Now?20:55
62 The rules in subsections 93(1.1) and (1.11) deem a subsection 93(1) election to have been made
where an FA realizes a capital gain on the disposition of the shares of another FA. Regulation
5902(6) deems the amount designated to be the lesser of the amount of the capital gain and
the balance of the underlying net surplus of the affiliate whose shares are sold, as determined
by aggregating all surplus balances of any lower-tier affiliates under regulation 5902(1)(a).
63 For example, if losses were expected for the subject FA that would significantly reduce or
eliminate its net surplus, it may be beneficial to crystallize the existing net surplus into cost
basis. This cost basis could be used to repatriate funds in the future via the preacquisition
surplus election pursuant to regulation 5901(2)(b).
64 The prescribed amount could be in excess of the surplus balances of the subject FA on a
stand-alone basis if the subject FA has subsidiaries. In fact, the subject FA could be left with
deficits as a result of the surplus adjustments required because of the deemed subsection 93(1)
election.
65 The rules in subsections 88(3) to (3.5) generally apply to liquidations of FAs that begin after
February 27, 2004.
66 This 90 percent ownership test is meant to equate to the test in our domestic liquidation rules
in subsection 88(1), although it is somewhat more flexible because there are no conditions
attached to the ownership of the other 10 percent of the liquidating affiliate’s shares.
67 Under regulation 5911(1), a QLAD election must be made by a corporate shareholder of a
liquidating affiliate no later than its filing-due date for the taxation year that includes the last
day of the affiliate’s taxation year in which any of its property is distributed. There are no
specific provisions that would allow this election to be late-filed.
68 Assuming that the FA meets the definition of an ECFA.
69 As discussed in the context of paragraph 95(2)(c) above.
70 The definition of hybrid surplus in regulation 5907(1) generally includes capital gains (and
losses) from the disposition of FA shares. However, the definition specifically excludes capital
gains the taxable portion of which are otherwise included in FAPI under variable B of that
definition in subsection 95(1).
71 A detailed discussion of the loss limitation rules in subsections 93(2) and 93(4) is beyond the
scope of this paper. For a detailed discussion of these rules, see Jim Samuel, “Stopping the Losses:
The Application of Stop-Loss Rules to Transactions Involving Foreign Affiliates” (2010) 58:4
Canadian Tax Journal 897-925.
72 This calculation must be done on a per-share basis because the suppression election is made
in respect of specific property being disposed of by the liquidating affiliate.
73 This rule is designed to avoid circularity where a subsection 93(1) election is made to reduce
a capital gain on the disposition of the shares of FA 1. If not for this rule, the surplus of FA 1
would be reduced by the loss created from the suppression election, thus reducing the surplus
balance available for the subsection 93(1) election, leaving a balance of the capital gain not
sheltered by the suppression election.
74 Subsection 93(1) allows a Canadian taxpayer to designate an amount, up to the balance of what
would otherwise be a capital gain, as a dividend received from an FA on the disposition of its
shares. Regulation 5902 stipulates that the amount of such a dividend can be computed on the
basis of the net surplus of the applicable FA and of other affiliates in which it has an equity
percentage. In the case of a liquidation, however, the shares of any underlying affiliates would
already have been distributed to the Canadian shareholder; therefore, only the exempt surplus
of the liquidating affiliate would be available for the purposes of the election, although this
exempt surplus balance could already include surplus moved up from underlying affiliates as
a result of a deemed subsection 93(1) election, as discussed below.
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75 An in-depth discussion of the fill-the-hole rules is beyond the scope of this paper. For a detailed
discussion of these rules, see Woolford and Favre, supra note 4.
76 The two-year repayment requirement does not apply to grandfathered loans that arose prior to
August 19, 2011. If such loans remain outstanding on August 19, 2014, they are deemed to be
new loans at that time, and will then be subject to the two-year repayment period such that
they must be repaid by August 19, 2016.
77 CRA document no. 2013-0483791C6, May 22, 2013, includes questions posed to the CRA at
the International Fiscal Association’s 2013 Canadian conference.
78 See also Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional
Accountants of Canada, “Re: October 24, 2012 Notice of Ways and Means Motion/Bill C-48,
the Technical Amendments Act, 2012,” submission to the Department of Finance, August 7, 2013,
for other related issues with respect to the treatment of upstream loans on FA reorganizations.
79 CRA document no. 2013-0483791C6, May 22, 2013.
80 The NCPR must be calculated on a per-share basis. This becomes important in cases where a
class of shares of the liquidating affiliate is owned by more than one shareholder.
81 Net surplus, as defined in regulation 5907(1), requires the set off of all surplus and deficit
balances of a liquidating affiliate. In this case, it is only the liquidating affiliate’s net surplus
that is subject to this rule.
82 Under subsections 93(1.1) and (1.11).
83 There are certain FAPI and stop-loss continuity rules contained in subparagraph 95(2)(e)(v)
that apply if the liquidation is a DLAD to deem the shareholder affiliate to be the same corporation as the liquidating affiliate.
84 Under the rules in regulation 5905(1).
85 Subsection 87(8.2) was enacted on June 26, 2013 as part of Bill C-48; however, it generally
applies to mergers or combinations that occur after 1994 unless an election was filed to limit
its application to mergers or combinations that occur after August 19, 2011.
86 The explanatory notes accompanying the legislation that added subsection 87(8.2) to the Act,
supra note 16, at clause 64, state that the rule is designed to “ensure that certain common forms
of U.S. mergers qualify for the rollover provisions that are provided for in the foreign affiliate
rules.”
87 Under paragraph (b) of variable B of the definition of FAPI in subsection 95(1).
88 Assuming that the merger is not an absorptive merger where the FA predecessor is the survivor.