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HOW CANADIAN COMPANIES CAN USE EXEMPT SURPLUS TO REDUCE TAXABLE GAINS ON SALE OF FOREIGN SUBSIDIARIES

Envision the following situation: Canco, a private corporate based in Ontario, has just gotten an offer to buy its wholly-owned U.S. subsidiary (“Usco”) for $10 million US.

This is far more that the management of Canco thought it was really worth, so they jump at the offer.

They ask Joe Numbers, their VP Finance to let them know how much tax they will have to pay.

He tells them that, since their cost base of the Usco shares is nominal, and since the effective tax rate on capital gains would be about 25.08%, the tax hit would be about $2,508,000 US.

They ask him if there is any way that they can cut that tax, and Joe says he will think about it.

Then he gets a brainstorm! Usco has about $3million US in retained earnings, which represents undistributed, after-tax profits from its active business in the US. He remembers from dividends paid in prior years that this would be tax-free in Canco’s hands, since it is “exempt surplus”. The only tax would be the US tax on the dividend, which is just 5% under the Canada-US Tax Convention.

They could use this to reduce the capital gain in Canada, since they would just turn that retained earnings into a note payable, and that would reduce the price paid for the shares. The $3million US would be allocated to the note instead.

Hence, Canco would save 20.08% net, or over $600,000 US in tax.

Everyone is thrilled with Joe’s creativity in cutting the tax.

Just before the dividend was to be paid, Joe happened to be talking to Sam Slashit, the international tax specialist at the accounting firm that Canco uses. Joe told him about how clever he was. However, Sam said to him “Joe, you are not so clever! You can get the same result just by filing a CRA form and save $150,000 US in tax!”.

As Sam went onto explain, “You don’t have to actually pay a dividend. You just make an election under subsection 93(1) of the Income Tax Act , by filing form T2107 with the CRA, to treat the $3million US as a dividend, and not proceeds of disposition of the shares. You get the same tax savings, don’t have to do any actual transaction, and more significantly avoid the 5% US tax.”

Being the smart guy that Sam Slashit was, he said to Joe, “This will be our little secret. Just tell the boss you figured this out all by yourself, and saved Canco another $150,000 US!”.