Principal Issues:
1) Whether amounts received on the wind-up of a U.K. foreign affiliate are to be treated as proceeds of disposition, dividends or reduction of PUC and whether the administrative position on "earnouts" would be applicable here.
2) When does the disposition shares occur on a wind-up.
Position TAKEN:
1) The company law under which the affiliate is created will determine the nature of the distributions on the wind-up. Presumably if there is no declaration of dividends and no resolution to reduce the PUC of the shares, the amounts distributed to a shareholder must be considered to be proceeds of disposition of the shares. The circumstances required for the application of the department's administrative position on earnouts are not present here.
2) The shares of a corporation are disposed of on a wind-up when the activities of the corporation have ceased and the assets distributed shareholders. Generally, that point in time coincides with time the share certificates are cancelled.
Reasons FOR POSITION TAKEN:
While the wording of the definition of "disposition" in section 54 of the Act is extremely broad and would appear to circumscribe any transaction giving rise to proceeds of disposition, it is unreasonable to consider shares of an active corporation to have been disposed of because partial proceeds of disposition are made available to the shareholder. Such an interpretation would give rise to anomalies such as whether FAPI earned by the affiliate in the time following the initial distributions could be considered to relate to shares "owned" by the taxpayer for the purposes of subsection 91(1) (i.e. if the shares were considered to disposed of prior to that time). Also without knowledge of the full amount of the proceeds it is impossible to compute a gain.
March 6, 1995
Montreal District Office Rulings Directorate Olli Laurikainen (613) 957-2116
Attention: Luc Dezainde International Audit Section
940994
Liquidation of a Foreign Affiliate
This document contains advice or recommendations developed by a government department and an account of consultations or deliberations involving officials of a government department and is therefore considered to be exempt from disclosure under subsection 21(1) of the Access to Information Act.
This is in reply to your memorandum dated April 15, 1994 wherein you requested our comments in reference payments received by XXXXXXXXXX, a resident of Canada, from its subsidiary XXXXXXXXXX ("XXXXXXXXXX UK") a resident of the United Kingdom, on the dissolution of XXXXXXXXXX UK.
It is our view that legally the nature of these payments for the purposes of the Act would be determined pursuant to the U.K. company law under which XXXXXXXXXX UK was established and the characterisation under U.K. tax law of these payments would be irrelevant in making that determination. If such payments are neither a reduction of capital nor a dividend under such company law, they would represent proceeds of disposition of the shares since they were received by XXXXXXXXXX after XXXXXXXXXX UK went into voluntary dissolution. The legally correct treatment would therefore appear to be to compute a capital gain at the time the shares are disposed of. At that time XXXXXXXXXX may elect to treat all or any portion of the proceeds of disposition as a deemed dividend under subsection 93(1) of the Act.
The Timing of the Disposition
The disposition of the shares on the dissolution of a corporation generally coincides with the cancellation of the share certificates unless there is reason to believe that this event was artificially delayed beyond the time the activities of the corporation had ceased and the assets had been distributed, simply for the tax purpose of deferring the recognition of the gain. In such circumstances, it might be argued that a disposition for all intents and purposes, took place prior the cancellation of the share certificates by virtue of the broad definition of "disposition" in section 54 of the Act. Since the delays in this case appear to be warranted we would recommend that the disposition be reported in the year in which the share certificates are cancelled. Amounts received prior to the disposition of the shares would be considered advances and would have no tax consequences at the time they are received by the shareholder but they would be included in the proceeds of disposition in computing the gain.
It should be noted that, it would be inconsistent with the spirit of the law to consider the disposition of the shares of a controlled foreign affiliate to have occurred as soon as the shareholders become eligible for partial proceeds of disposition on a wind-up because not only is it impossible to compute the full amount of the gain at that time, any FAPI that may be earned by the affiliate subsequent to that time presumably could not be considered to be in respect of shares owned by the taxpayer for the purposes of subsection 91 of the Act.
The taxpayer implies that the administrative position set out in IT-426R entitled "Shares Sold Subject to an Earnout Agreement" should have application here. The conditions that are required to be present before the Department will accept the use of the cost recovery method for reporting a gain are set out in paragraph 1 of the IT and are clearly not met here. Therefore you are not under any obligation to accept such treatment.
The taxpayer may elect to treat a portion of the proceeds of disposition as a dividend received on the shares under 93(1) of the Act. In this respect, it is our understanding that you have already received a recommendation concerning late filed elections made under subsection 93(5.1) of the Act from the International Tax Programs Directorate.
Other Issues
The information presented in your referral suggests certain areas of concern in relation to the computation XXXXXXXXXX UK surplus accounts and the deduction taken by XXXXXXXXXX under subsection 91(4). Since in we do not have all of the facts necessary to make a definite determination of these amounts, we will simply attempt to deal with these issues in point form setting out our concern.
U.K. Advance Corporations Tax
It is our understanding that the U.K. has an imputation system of taxation under which a U.K. corporation pays an advance corporation tax ("ACT") when it pays dividends. The ACT is computed at a rate of 1/3 of the dividend. Under U.K. tax law, ACT paid can be credited against a corporation's mainstream corporate income tax liability, if any, subject to a limitation of 25% of the corporation's U.K. taxable profits. It is the Department's view, that the ACT should not be taken into account in the computation of a foreign affiliate's FAPI, and only in the computation of the foreign affiliate's surplus accounts, and determination of deductions under section 113 of the Act as specifically set out in subparagraph 5907(1)(d)(vi.1) and subsection 5907(7.1) of the Regulations. Furthermore, any ACT refund available to XXXXXXXXXX as a consequence of a dividend paid by XXXXXXXXXX UK would be treated as a dividend paid by the U.K. foreign affiliate to XXXXXXXXXX for the purposes of the Act.
Since the ACT is not computed on the basis of the foreign affiliate's income or profits, it is the Department's position that it should not be considered an "income or profits tax" for the purposes of the Income Tax Act. Moreover, any ACT which is applied to offset U.K. mainstream corporate tax should not be recognized in the determination of the amount of an affiliate's "foreign accrual tax" under subsection 95(1) or in the computation of its surplus or underlying foreign tax accounts under the Regulations to the Act. That is, those amounts should be as otherwise determined before the offset in respect of the ACT. Due to the "in and out" nature of the ACT, this treatment generally does not lead to inappropriate results in the computation of a foreign affiliate's FAPI or its surplus accounts.
The schedules attached to your referral show an amount in respect the U.K. ACT being included in the determination of a subsection 91(4) deduction as well as in the computation of the surplus accounts. This, based on our position set out above, is inappropriate.
Adjusted Cost Base of XXXXXXXXXX UK Shares
The FAPI included in the income of XXXXXXXXXX in respect of the shares of XXXXXXXXXX UK would be added to the ACB of those shares pursuant to paragraph 92(1)(a) while any deduction taken under subsection 91(4) or 91(5) would be deducted under paragraph 92(1)(b) of the Act.
for Director
Reorganizations and Foreign Division
Rulings Directorate
Policy and Legislation Branch
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