5-901398
Dear Sirs:
Re: Interest Deductibility
We are writing in response to your letter of July 4, 1990 in which you requested our views concerning the inclusion in a Canadian corporation's ("Canco's") accumulated profits, as that term is used in the Department of Finance's November 24, 1989, Notice of Ways and Means Motion (extended on December 20, 1990) concerning interest deductibility; of certain amounts described below, arising in respect of a transfer of shares in a foreign affiliate ("FA") as defined in paragraph 95(1)(d) of the Income Tax Act (Canada) to a non-arm's length corporation incorporated in the Netherlands ("Dutchco"). We regret the delay in responding to your letter.
You advised that it was typical in the 1970's for a Canco to reorganize its foreign holdings pursuant to the provisions of subsection 85.1(3) on a tax-deferred basis. Canco would take back a non-interest bearing demand note equal in value to the aggregate of the tax cost of the FA shares and the FA's exempt surplus (as defined in the Income Tax Regulations). Often the shares of FA would have been owned prior to valuation day ("V-Day") and an amount equal to the gain to V-Day in the value of the shares of FA was included, pursuant to paragraph 85.1(3)(a), in Canco's tax cost of the note taken back from Dutchco. Canco would elect pursuant to subsection 93(1) to treat a portion of the proceeds of disposition of its shares of FA as a deemed dividend. In your view, both the V-Day value of the FA shares and the deemed dividend should be included in the calculation of Canco's accumulated profits.
At the 1988 Round Table (53:14 of the Conference Report) Revenue Canada, Taxation stated:
Accumulated profits means accounting profits computed on an unconsolidated basis with investments accounted for on a cost basis. Accumulated profits does not include appraisal surplus and profits resulting from non-arm's length transactions which transform appraisal surplus into accumulated profits on a non-taxable or a tax-deferred basis.
We understand that the transaction described above would be recorded for accounting purposes at fair market value, so that Canco's accounting profits would be equal to the gain on the sale (i.e., the value of shares of the FA on the day of reorganization less the cost of those shares) less the preferred income taxes resulting from the transaction. We note, however, that those accounting profits are wholly attributable to the appraisal surplus of the FA shares which were transferred to a non arms length corporation on a tax-deferred basis.
Therefore, in our opinion, neither the V-Day value of the FA shares nor the deemed dividends pursuant to subsection 93(1) would be included in the calculation of Canco's accumulated profits since neither the crystallization of the V-Day value nor the deemed dividend have resulted from a currently taxable arm's length transfer.
The views expressed in this letter are provided in accordance with the practice described in paragraph 21 of Information Circular 70-6R2.
Yours truly,
for Director financial Industries DivisionRulings Directorate
Statement of Principal Issues
File: 5-901398 T. Murphy April 24, 1991
24(1)
Background
24(1)
has requested our views concerning the inclusion in a Canadian corporation's ("Canco") accumulated profits of amounts recognized by Canco in a reorganization of its foreign affiliate ("FA") to transfer ownership of FA to a non-arm's length holding corporation incorporated in the Netherlands ("Dutchco").
Typically, in the 1970's, a Canco would reorganize its foreign holdings pursuant to the provisions of subsection 85.1(3) on a tax-deferred basis. Canco would take back a non-interest bearing demand note from Dutcho equal in value to the total of the adjusted cost base of the FA shares and the exempt surplus (as defined in the Income Tax Regulations) of FA. Often the shares of FA would have been owned prior to valuation day ("V-Day") and the gain to V- Day was crystallized in the tax cost of the note as a result of the transfer. Canco would elect pursuant to subsection 93(1) to treat a portion of the proceeds as a deemed dividend.
Issues
l. Should the portion of the proceeds characterized as a dividend under subsection 93(1) be included in Canco's accumulated profits?
2. Should the gain on the disposition of the FA shares to V-Day be included in Canco's accumulated profits given that the gain was not subject to tax?
Analysis
1. The realization of accumulated profits issue which arises on a non-taxable or tax-deferred transfer of shares using the provisions of subsection 85.1(3) is very similar to that which arises on the nontaxable or tax-deferred transfer of shares or other assets utilizing the provisions of subsection 85(1).
At the 1988 Round Table (53:14 of the Conference Report) Revenue Canada, Taxation stated that
Accumulated profits do not include any appraisal surplus and profits resulting from non-arm's length transactions that transform appraisal surplus into accumulated profits on a non-taxable or tax-deferred basis. For example, a tax-deferred basis may involve a situation in which A Co. transfers an asset to B Co. with which it does not deal at arm's length, receiving as consideration preferred shares, and both file elections under subsection 85(l). While A Co. has a gain for accounting purposes, this gain does not form part of A Co.'s accumulated profits.
A deemed dividend arising under subsection 84(3) on the redemption of the shares received as consideration in the above situation would not be added to either the accounting or accumulated profits of A Co.
In this opinion request, while Canco has a gain for accounting purposes on the transfer of the shares of FA to Dutcho, the 1988 Round Table statement establishers that the gain does not form part of Canco's accumulated profits. Similarly, the deemed dividend under subsection 93(1) is not included in either accounting or accumulated profits.
2. While it is true that the subsection 85.1(3) transfer causes a crystallization in the tax cost of the note of the V-Day value of the FA shares to Canco, it is also true from a consolidated point of view that Canco still has an indirect interest in the shares since Canco controls Dutchco.
While accrued gains to V-Day are not subject to tax on dispositions, the accrued gain to V-Day in this instance has not been crystallized in an arm's length transaction.
Decision
1. It is not acceptable to include the subsection 93(1) dividend in Canco's accumulated profits.
2. It is not acceptable to include the gain on the FA shares to V-Day in Canco's accumulated profits.