This article was originally published in Blakes Bulletin on Cross Border Taxation - March 2005
The American Jobs Creation Act of 2004 (AJCA) contains numerous international tax provisions that may be relevant to companies with foreign subsidiaries. Section 422 enables a U.S. corporation to repatriate eligible earnings from offshore affiliates during a designated taxable year with a modest U.S. tax cost. If specified investment requirements and other criteria are met, the taxpayer may claim an 85% dividends received deduction, but no foreign tax credit or deduction for foreign taxes paid. An election to take advantage of this repatriation entitlement may only be made for either a company’s last taxable year beginning before October 22, 2004 or its first taxable year beginning in the one-year period commencing on October 22, 2004.
If dividends are to be paid by a Canadian subsidiary to take advantage of the AJCA provision, they will be subject to general corporate law limitations in Canada on the amount of the dividend that may be declared and will in most cases attract Canadian non-resident withholding tax. Where dividends are paid out of available cash or by liquidating near cash assets, there should generally be few if any other Canadian tax considerations. Where funds are borrowed to provide the amount of the dividend, or assets are sold that were previously acquired with borrowed funds, however, attention will have to be given to issues relating to deductibility of interest expenses.
Subject to the thin-capitalization rules, interest is generally deductible in Canada when debt is incurred to fund a reduction in legal or stated capital (as defined for corporate law purposes) or to redeem preferred shares for their paid up capital. A corporation may also borrow money to pay dividends up to a limit of its accumulated profits and deduct a related interest expense. In this case, accumulated profits will generally be considered to be equal to the retained earnings of the corporation calculated under Canadian generally accepted accounting principles but on a non-consolidated basis and with investments recorded at cost. Retained earnings may include gains realized in related party transactions undertaken in the ordinary course of business, but not otherwise.
Considerable care must be taken in other than very straightforward situations. For example, the origin of contributed or any other form of surplus should be reviewed to ascertain whether interest would be deductible on funds borrowed to pay dividends that reduce such surplus. Because accumulated profits are determined on a non-consolidated basis, it may be necessary actually to pay dividends "up the chain" to the senior Canadian company from its domestic or foreign subsidiaries in order to have the retained earnings of the subsidiaries counted in this regard. If this is to be done, particular attention should be paid to the timing of the series of dividends to ensure that they are included in the necessary calculation.
Other circumstances may require even more focused attention. For example, if an asset originally acquired with borrowed money is sold to fund a dividend, the future deductibility of interest on the borrowing may be jeopardized because the debt can no longer be said to have been incurred, directly or indirectly, for use in the business. Similarly, if any of the assets of the corporation are used for a non-eligible (e.g. non-business) purpose, interest deductibility should be carefully analyzed.
The payment of a dividend will generally reduce the debt/equity ratio of the corporation under Canadian thin capitalization rules. It should be considered whether the payment of a dividend could result in non-deductible interest under these rules.
As in most situations involving tax matters, general rules are useful but interest deductibility in Canada is not always intuitive and is in somewhat of a state of flux. US corporations contemplating receipt of a significant dividend from a Canadian subsidiary to take advantage of the AJCA should carefully consider whether there is any impact on interest deductibility to the subsidiary.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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