Words and Phrases - "disposition to"

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

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

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

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

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

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

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

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

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

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

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

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

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

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

…[E]xempt earnings include

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

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

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

Carve-out for money (p. 1258)

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

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

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

Meaning of deduction from exempt loss (p. 1259)

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

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

Assumed tax benefit (p. 1260)

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

Implied surplus conversion object (p. 1263)

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

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

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

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

Primary purpose of the disposition (p. 1264)

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

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

Conclusion (p. 1266)

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