In 2013-0499141I7, a Canadian company (Canco) acquired a U.S. group through Canco’s foreign affiliate in the U.S. (FA).  The U.S. seller and FA filed a joint election under s. 338(h)(10) of the U.S. IRC; this had the effect of deeming a sale and reacquisition the U.S. group’s assets at FMV immediatelyprior to the sale – stepping up their U.S. tax basis.  The U.S. group subsequently sold some of these assets to a third party and Canco thereafter redeemed some of its shares held by a private Canadian company (Private Co).  On the share redemption, Private Co received a deemed dividend that was subject to re-characterization as a capital gain under s. 55(2)  On these facts, the CRA confirmed its views as follows:

  1. Exempt Surplus Adjustments:  The U.S. group’s exempt surplus in respect of Canco had to be adjusted by (a) ignoring (adding back) any depreciation and amortization arising directly from the increased tax basis under the s. 338(h)(10) election, and (b) ignoring the stepped-up tax basis under the s. 338(h)(10) election in computing any income gain on the intangibles and any recapture on the tangibles (Reg. 5907(2)(b) and (f)).  No adjustment could be made, however, for the increased tax basis under the s. 338(h)(10) election when computing any capital gain on the tangibles (s. 95(2)(f)(i), s. 95(2)(f.1), and Reg. 5907(5)).
  2. Safe Income under s. 55(2):  Although the adjustments in 1 above would increase Canco’s underlying “safe income” from Private Co’s perspective (computed under former s. 55(5)(d)), in the CRA’s view no portion of the accrued gain on Private Co’s shares of Canco “could reasonably be considered to be attributable to” this safe income for purposes of s. 55(2).  Rather, the accrued gain on Private Co’s shares of Canco could more reasonably be considered to be attributable to FA’spurchase cost on its shares of the top-tier U.S. company; this view was also consistent with the object and purpose of s. 55(2).