Canada: Subsection 88(3): A Policy Shift?

On August 19, 2011, the Department of Finance (Canada) released extensive proposed amendments to the foreign affiliate rules, some of which were enacted on June 26, 2013, and which relate to a liquidation and dissolution of a foreign affiliate into a Canadian shareholder and into another foreign affiliate. This paper focuses on the former and highlights what appears to be a significant policy shift.

General Rules on Liquidation and Dissolution

Subsection 88(3) of the Income Tax Act (Canada) (Act) is the key operative provision where there has been a liquidation and dissolution of a top-tier foreign affiliate. It provides that if at any time a Canadian shareholder receives property (Distributed Property) from a foreign affiliate (Disposing Affiliate) of the Canadian shareholder on a liquidation and dissolution of the Disposing Affiliate and the Distributed Property is received in respect of shares of the capital stock of the Disposing Affiliate that are disposed of on the liquidation and dissolution:

  1. the Distributed Property is generally deemed to have been disposed of by the Disposing Affiliate for proceeds of disposition equal to the relevant cost base (defined in subsection 95(4) of the Act generally as the amount that will not trigger any gain or loss) of the Distributed Property provided the liquidation and dissolution is a qualifying liquidation and dissolution (QLAD) as defined in subsection 88(3.1) of the Act or the Distributed Property is a share of the capital stock of another foreign affiliate that was, immediately before the liquidation, excluded property (defined in subsection 95(1) of the Act) of the Disposing Affiliate;
  2. if (1) above does not apply to the Distributed Property, the Distributed Property is deemed to have been disposed of by the Disposing Affiliate for proceeds of disposition equal to the Distributed Property's fair market value;
  3. the Distributed Property is deemed to have been acquired by the Canadian shareholder at a cost equal to the Disposing Affiliate's proceeds of disposition as determined under (1) or (2) above;
  4. each share (Disposed Share) of the Disposing Affiliate that is disposed of by the Canadian shareholder pursuant to the liquidation and dissolution is deemed to have been disposed of for proceeds of disposition equal to the Canadian shareholder's pro rata portion of the net distribution amount (as defined in subsection 88(3.2) of the Act) associated with the class of shares held by the Canadian shareholder; and
  5. where the liquidation and dissolution is a QLAD, any loss of the Canadian shareholder in respect of the disposition of the Disposed Share is deemed to be nil.

Net distribution amount is defined to mean the cost to the Canadian shareholder of the Distributed Property as determined under (3) above less all amounts owing (other than unpaid dividends) by or an obligation of the Disposing Affiliate that was assumed or cancelled by the Canadian shareholder in consideration for the Distributed Property. Consequently, where the cost to the Disposing Affiliate of the Distributed Property is equal to or less than the cost to the Canadian shareholder of its Disposed Shares, the liquidation and dissolution should occur on a tax deferred basis for both the Disposing Affiliate and the Canadian shareholder. Since this will often not be the case, the suppression election (discussed below) contained in subsection 88(3.3) of the Act will need to be relied on in most cases.

Qualifying Liquidation and Dissolution

Where Distributed Property consists of more than shares of another foreign affiliate that are excluded property, the liquidation and dissolution must qualify as a QLAD in order for the liquidation and dissolution to occur on a tax deferred basis. Subsection 88(3.1) defines a QLAD as a liquidation and dissolution in respect of which the Canadian shareholder elects in accordance with Regulation 5911(1) of the Act and the Canadian shareholder:

  1. owns at least 90% of the issued and outstanding shares of each class of the Disposing Affiliate; or
  2. receives at least 90% of the net assets of the Disposing Affiliate and has at least 90% of the voting power in the Disposing Affiliate's shares.

Regulation 5911(1) of the Act prescribes that the election for purposes of the QLAD definition must be made in writing on or before:

  1. if the taxpayer is a partnership, the earliest of the filing due dates of any member of the partnership for the member's taxation year that includes the last day of the partnership's fiscal period that includes the last day of the Disposing Affiliate's taxation year that includes the time of the distribution of the Distributed Property; and
  2. in any other case, the Canadian shareholder's filing due date for its taxation year that includes the last day of the Disposing Affiliate's taxation year that includes the time of distribution of the Distributed Property.

Suppression Election

As noted above, it is expected that in most circumstances a suppression election will be required in order for the liquidation to occur on a tax deferred basis. Subsection 88(3.3) of the Act provides that where a liquidation is a QLAD of the Disposing Affiliate and the Canadian shareholder would, in the absence of the suppression election, after taking into account any election filed under subsection 93(1) of the Act, realize a capital gain from the disposition of a Disposed Share, the taxpayer may elect that the Distributed Property that was capital property of the Disposing Affiliate be deemed to have been disposed of for proceeds of disposition equal to an amount specified in the election. This enables the Canadian shareholder's proceeds from the disposition of the Disposed Shares to be reduced so as to defer the gain that might otherwise arise.

Subsection 88(3.4) of the Act sets out the conditions under which a suppression election will be valid. It provides that a suppression election is valid only if:

  1. the elected amount in respect of each Distributed Property does not exceed the relevant cost base of the Distributed Property; and
  2. the elected amount does not exceed the capital gain that would otherwise have been realized on the Disposed Shares.

Consequently, a Canadian shareholder cannot use the suppression election to realize a loss on the Disposed Shares or trigger a gain on the Distributed Property in circumstances where paragraph 88(3)(a) of the Act applies.

Taxable Canadian Property Election

Lastly, subsection 88(3.5) of the Act deems, for the purposes of paragraph 88(3)(a) of the Act, the Distributed Property to have been disposed of for proceeds of disposition equal to the adjusted cost base of the Distributed Property if the liquidation and dissolution is QLAD, the Distributed Property is taxable Canadian property (other than treaty protected property) that is the share of the capital stock of a Canadian resident corporation and the Canadian shareholder and the Disposing Affiliate jointly elect. As with a QLAD election, regulation 5911(1) of the Act sets out the prescribed rules with respect to both a suppression election and the taxable Canadian property election.


What is interesting from a policy perspective is that the foregoing rules apply even where the Canadian shareholder is an individual. This represents a policy shift when compared to subsection 88(1) of the Act. Specifically, subsection 88(1) of the Act does not permit individuals to remove assets from a Canadian corporation on a tax deferred basis. Informal discussions with Department of Finance (Canada) officials on this point indicate that they are of the view that the foregoing rules apply where the Canadian shareholder is an individual but they were unclear as to whether that was the intended result. Consequently, it appears that increased flexibility, and possibly planning opportunities, now exist for individuals who choose to carry on business activities indirectly through a foreign corporation, as compared to a Canadian corporation.

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