2015-0581611C6 IFA 2015 Q7: Foreign affiliates-surplus adjustments

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA. Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Whether a deficit in a foreign affiliate that ceases to exist in an absorptive merger reduces both the surplus accounts of the merged affiliate and a subsidiary affiliate.

Position: Deficit counted only once.

Reasons: Purpose.

Author: Meek, John

Section: Reg. 5905(3) and Reg. 5905(7.2)

2015 International Fiscal Association Conference
CRA Roundtable

Question 7 - FA Merger and Deficit Double Counting

Assume that Canco owns 100% of the shares of a foreign affiliate (FA1”), FA1 owns 100% of the shares of a second foreign affiliate (“FA2”), and FA2 owns 100% of the shares of a third foreign affiliate (“FA3”).  FA1 and FA2 merge to form “Merged FA” in a merger that qualifies as a “foreign merger” within the meaning assigned by subsection 87(8.1) of the Act, and the shares of FA3 become property of Merged FA as a consequence of the merger.  Further assume that immediately prior to the merger FA1 has an exempt surplus balance of $200, FA2 has an exempt deficit balance of $125, and FA3 has an exempt surplus balance of $150, and that upon the merger, FA2 ceases to exist.  None of FA1, FA2 and FA3 has any other surplus/deficit balances. Finally, assume that section 93 has no application in respect of the merger.

Subsection 5905(3) of the Income Tax Regulations (the “Regulations”) applies to determine the opening surplus balances of a foreign affiliate of a corporation resident in Canada where the foreign affiliate has been formed as a result of a foreign merger. This determination is based on the surplus balances of the predecessor corporations immediately before the merger.  On the other hand, subsection 5905(7.2) of the Regulations applies when an upper-tier foreign affiliate of a corporation resident in Canada has an exempt deficit and any shares of a lower tier foreign affiliate in the same corporate chain are acquired by the corporation or by another foreign affiliate of the corporation.  Subsection 5905(7.2) of the Regulations applies to achieve a result comparable with the result that would have occurred had a dividend been paid, immediately before the targeted transactions, to the extent necessary to "fill the hole" in the deficit affiliate. This is effected by the reduction, under paragraph 5905(7.2)(a) of the Regulations, of the exempt surplus balance of the lower-tier affiliate and the reduction, under paragraph 5905(7.2)(b) of the Regulations, of the exempt deficit balance of the upper-tier affiliate.  The latter adjustment is deemed to take place immediately after the acquisition.  In the above case, both of the above provisions have application and due to the timing of the adjustments provided for under subsections 5905(3) and 5905(7.2) of the Regulations, it would appear that the deficit of FA2 would reduce not only the opening exempt surplus of Merged FA but the exempt surplus of FA3 as well.  Is it CRA’s view that Merged FA’s opening exempt surplus as determined under paragraph 5905(3)(a) of the Regulations is $75 and, at the time specified in paragraph 5905(7.2)(a) of the Regulations, FA3’s exempt surplus is reduced to $25?  In other words, is it CRA’s view that in this case FA2’s exempt deficit is effectively used to reduce both Merged FA’s opening exempt surplus and FA3’s exempt surplus? 

CRA Response

Based on our consultations with representatives of the Department of Finance we understand that it was intended there should be symmetry with the “adjustments” required as a result of paragraphs 5905(7.2)(a) and (b) of the Regulations.  In other words, it was intended that the adjustment to the deficit of FA2 under paragraph 5905(7.2)(b) should have effect before the operation of subsection 5905(3) of the Regulations.  In the above case, the CRA is therefore of the view that, for purposes of determining the amount in the description of A of the formula in paragraph 5905(3)(b) of the Regulations, the amount of FA2’s exempt deficit immediately before the merger is reduced by the amount otherwise determined in respect of FA2 under paragraph 5905(7.2)(b) of the Regulations.  On this basis, while the exempt surplus of FA3 would be reduced to $25, the CRA accepts that Merged FA’s opening exempt surplus is $200.  The Department of Finance concurs that this approach achieves the correct policy result.


John Meek
May 28, 2015

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