Canada

Late filing of pre-acquisition surplus elections

TAX ALERT  | 

The May 2019 International Fiscal Association (‘IFA’) roundtable provided some insight on Canada Revenue Agency’s (‘CRA’s’) discretionary power with respect to late filing of pre-acquisition surplus elections. Central to whether this discretion is to be exercised are the integrity and timeliness of surplus computations and supporting material in relation to such elections.

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Maintenance of, and repatriations from, surplus accounts

Generally, distributions received by a Canadian resident company (‘Canco’) from a foreign affiliate (‘FA’) are included in Canco’s income, with certain deductions allowed against all or a portion of the dividends under subsection 113(1) of the Income Tax Act (‘ITA’). The amount of the deduction depends on the FA’s notional surplus accounts, which, broadly speaking, are amounts available to the FA for distribution to Canco. 

Surplus accounts must be maintained consistently starting from the time the FA first became an FA of Canco. The accounts are continually adjusted to reflect, among other things, the FA’s income earned and any dividends received and paid. The computation and tracking of surplus accounts can be very complex, requiring detailed chronicled calculations, and in a manner that allows for substantiation of Canco’s subsection 113(1) dividend deduction claims.

There are four types of surplus accounts: exempt surplus, taxable surplus, hybrid surplus and pre-acquisition surplus. Of relevance to this article is pre-acquisition surplus, which can generally be described as the FA’s allowable earnings for a period when it was not an FA, and equivalent to the adjusted cost base (‘ACB’) of the FA’s shares.

Requirement to substantiate dividend deduction claims

A dividend deduction under subsection 113(1) may be denied by CRA if there is no surplus calculation to substantiate the claim.

The May 2019 IFA roundtable comments on this issue confirmed that, as the Canadian tax system relies on self-reporting, taxpayers must take care in determining the amount of the dividends deductible under subsection 113(1), and related allocations.

The IFA roundtable also highlighted the statutory requirement for maintaining supporting books and records in a form that allows the determination of taxes payable under the ITA. Such records are subject to examination by CRA for verification of surplus account calculations.

Pre-acquisition surplus elections

Under the normal surplus ordering rules, a dividend is deemed paid out of pre-acquisition surplus where an FA does not have a net exempt, hybrid, or taxable surplus balance at the time the dividend is paid. The full amount of a pre-acquisition surplus dividend received by Canco is deductible in computing its taxable income.

Reg. 5901(2)(b) allows Canco to elect to bypass the normal surplus ordering rules and have the whole dividend deemed to be paid out of pre-acquisition surplus. These pre-acquisition surplus elections allow Canco to skip over the FA’s other surplus pools, if any, and rely instead on the ACB of its FA shares in order to repatriate amounts tax-free.

Normally, a pre-acquisition surplus election is due by Canco’s tax return filing due-date for the year in which the pre-acquisition surplus dividend is paid. The IFA roundtable provided comments on CRA’s discretionary powers for accepting late pre-acquisition surplus elections.

In so doing, the CRA considered the following facts: Canco claimed a subsection 113(1) deduction in respect of dividends received under the normal ordering rules. Canco did not prepare calculations of the relevant surplus accounts at the time the subsection 113(1) deduction because it assumed that, should the dividend not be completely sheltered by the section 113 deduction, a late pre-acquisition surplus election and the related ACB of its FA shares would be sufficient to prevent any further net income inclusion.

In analyzing whether a late election would be permitted, CRA noted that under Reg. 5901(2.1) Canco must have, among other requirements, determined not to make the pre-acquisition surplus election by the original filing due-date, using reasonable efforts. CRA’s view was that relying on assumed surplus balances to support the deduction under subsection 113(1) without detailed computations would not meet the reasonable efforts condition.

Further, CRA observed that where the conditions under Reg. 5901(2.1) are met, Reg. 5901(2.2) deems late pre-acquisition surplus elections to be filed on time, provided that the CRA is of the opinion that it would be ‘just and equitable’ to permit the late filing of the election. The ‘just and equitable’ standard can be met, for example, where Canco’s decision not to file a pre-acquisition surplus election by the normal deadline was based on its reasonable expectations as to the relevant surplus balances, but those surplus balances subsequently require adjustment because of ensuing assessments made by a foreign tax authority or CRA. However, on the circumstances of the IFA roundtable question, CRA found that it would not be “just and equitable” to permit the late filing of a pre-acquisition surplus election; Canco did not prepare computations of surplus accounts, it merely assumed that a late pre-acquisition surplus election would cover any otherwise unsheltered dividend.

Takeaways for middle market businesses

CRA’s discretionary power to accept a late pre-acquisition surplus election appears to be contingent on maintaining timely surplus calculations and diligent record keeping.

CRA’s views on this topic could inform other situations that turn on whether the Minister believes that ‘reasonable efforts’ and ‘just and equitable’ circumstances have been established.

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