2022-0929501C6 IFA 2022 - Q6 - Exempt Earnings and Residency Info

Principal Issues: What information, in addition to exempt surplus calculations, should taxpayers keep to support a deduction under paragraph 113(1)(a)?

Position: In addition to exempt surplus calculations, taxpayers should keep records to enable the determination of the residency of the foreign affiliate in a designated treaty country under common law principles. Taxpayers must keep records and books of account in such form and containing such information sufficient to substantiate that the conditions for claiming a deduction under paragraph 113(1)(a) have been met.

Reasons: In order to accumulate exempt earnings, the foreign affiliate must be resident in a designated treaty country, which requires the foreign affiliate to be resident in such country under common law principles and subsection 5907(11.2) of the Regulations must not apply to deem the foreign affiliate not to be resident in such country. Pursuant to subsection 230(1), and as described in IC77-9R, taxpayers must retain records and books of account sufficient to substantiate deductions claimed under section 113 in respect of dividends received from a foreign affiliate.

Author: Yew, Gina
Section: Paragraph 113(1)(a), definition of "exempt surplus" and "exempt earnings" in subsection 5907(1) of the Regulations, subsection 5907(11.2) of the Regulations, and subsection 230(1).

2022 International Fiscal Association Conference

CRA Roundtable

Question 6: Exempt Earnings and Residency Information

A corporation resident in Canada (“Canco”) receives a dividend from a wholly-owned foreign affiliate (“FA”). Canco claims a full deduction under paragraph 113(1)(a) in respect of the dividend. Canco prepares a complete calculation of the FA’s exempt surplus account.

FA is incorporated in a country (“Country A”) with which Canada has entered into a comprehensive agreement for the elimination of double taxation on income (the “Treaty”). FA has been carrying on an active business in Country A since its incorporation. The Treaty includes a dual residency tie-breaker rule based on the place of incorporation. Canco considers the FA to be a resident in Country A for purposes of the Treaty.

Should Canco maintain any other information, in addition to the surplus calculation, to support a deduction claimed under paragraph 113(1)(a)?

CRA Response

A deduction under paragraph 113(1)(a) is available if the dividend is prescribed to be paid out of the exempt surplus of the FA. Exempt surplus of the FA includes its exempt earnings. In order to accumulate exempt earnings under paragraph (d) of the definition of “exempt earnings” in subsection 5907(1) of the Income Tax Regulations (the “Regulations”), the FA must be “resident in a designated treaty country” throughout the relevant year.

The expression “resident in a designated treaty country” is not defined in the Income Tax Act (the “Act”) or the Regulations. The CRA has previously stated (see, for example, CRA documents 2007-0261551I7, 2003-0007347, 9619090, 6M12570) that there is a two-pronged test for an FA to qualify as a resident of a designated treaty country:

1. First, the FA must be resident in a designated treaty country under Canadian common law principles, which has generally established that a company is resident in the country in which its central management and control is exercised. This determination depends on the facts and, therefore, can only be made on a case-by-case basis. The fact that the FA is resident in Country A under the Treaty because of the dual residency tie-breaker rule is not relevant for the purposes of the residency test under common law.

2. Second, the FA must satisfy one of the conditions stipulated under paragraph 5907(11.2)(a), (b), (c) or (d) of the Regulations.

Pursuant to subsection 230(1) of the Act, and as described in Information Circulars IC77-9R, Books, Records and Other Requirements for Taxpayers Having Foreign Affiliates and IC78-10R5, Books and Records Retention/Destruction, taxpayers must keep records and books of account in such form and containing such information as will enable the taxes payable to be determined, including records to substantiate a deduction claimed under section 113. More specifically, paragraphs 7 and 8 of IC77-9R indicate that:

7. The requirements for the retention of records and books of account of a Canadian taxpayer are set out in Information Circular 78-10R. These requirements also apply to the books, records and information maintained by the Canadian taxpayer on the affairs of a foreign affiliate.

8. As a minimum, these records should be sufficient to substantiate the computation of foreign accrual property income and any deductions claimed under subsection 91(5) or section 113 in respect of dividends received from the foreign affiliate. It will be necessary to retain records relating to the surplus accounts, foreign taxes paid, reorganizations, amalgamations and changes in participating percentage or surplus entitlement percentage and any other relevant information beyond the mandatory retention period if these transactions have future tax consequences.

In addition to surplus calculations, Canco is required to keep records that support that FA is resident in Country A under common law principles to substantiate that the condition under paragraph (d) of the definition of “exempt earnings” in subsection 5907(1) of the Regulations that the FA is “resident in a designated treaty country” is met. In order to do so, the information in those records needs to be detailed and complete enough to support that the central management and control of FA is exercised in the treaty country, and include information relating to the whole “course of business and trading” of the FA and, thus, not be limited to the location of board meetings or where members of the board are resident.

Pursuant to paragraph 231.1(1)(a) of the Act, the books and records of a taxpayer may be inspected, audited or examined, by an authorized person of the CRA.

A deduction under paragraph 113(1)(a) will be available where all requirements are met and substantiated. If all of the requirements for claiming a deduction under paragraph 113(1)(a) have not been met and substantiated, the deduction will be denied.

Gina Yew
2022-092950
May 17, 2022

Response prepared by:
Darren Poiré, Pauline Motard and Marie-Hélène Chouinard
International Tax Division and International Tax Operations Division
International and Large Business Directorate|
Compliance Programs Branch

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