Canadian corporations form US Subsidiaries, and US Corporations form Canadian Subsidiaries, all the time.
What are the cross-border tax implications when those subsidiaries are wound-up? This article will provide an overview of those implications.
Winding-up a US Subsidiary (“USco”) of a Canadian Corporation (“Canco”)
For US tax purposes, proceeds received on the wind-up of USco are generally not treated as a dividend, and hence no U.S. withholding tax should apply.
Rather, such amounts would generally represent proceeds from the shares which should not be subject to US tax.
Nevertheless, liquidation of USco into Canco will result in an “outbound toll charge” whereby the US taxes any accrued gain on the appreciation of assets. Exceptions apply in the case of certain assets that will still be subject to US taxation in Canco’s hands on an ultimate sale, including particularly US Real Property Interests.
For Canadian tax purposes, the amounts received would be proceeds of disposition of the shares, thereby resulting in a capital gain to the extent that those proceeds exceed the adjusted cost base of those shares.
However, it is possible for Canco to file an election under subsection 93(1) of the Income Tax Act (“the Act”) to treat all or any part of the proceeds of disposition as a dividend for Canadian tax purposes. This would be advantageous if there is “exempt surplus” in USco, in relation to Canco, since such amounts are tax-free under paragraph 113(1)(a) of the Act. In addition, if there is “taxable surplus”, it is also possible to eliminate or reduce any taxation of the deemed dividend by claiming a deduction for underlying foreign taxes under paragraph 113(1)(b) of the Act.
In addition, subsection 88(3) of the Act can also be applied to avoid any deemed gain on appreciated assets.
Winding-up a Canadian Subsidiary (“Canco”) of a US Corporation (“USco”)
Unlike the situation in the US, Canadian tax laws treat a wind-up of a domestic corporation as the payment of a dividend for tax purposes.
Under subsection 84(2) of the Act, the wind-up of Canco will result in a deemed dividend for Canadian tax purposes to the extent that the amount distributed to USco, on account of the shares, exceeds the “paid-up capital” of those shares. Generally, this will mean that any retained earnings existing at the time of the wind-up will be treated as a dividend. In addition, if there are any appreciated assets existing at the time of the wind-up, the unrealized gain, minus any resulting corporate tax, will also increase the amount of the deemed dividend.
This deemed dividend would be eligible for a reduced Canadian tax rate of only 5% under Article X(2)(a) of the Canada-US Tax Convention, assuming USCo is a US resident corporation for the purposes of the Convention.
In addition, if there are any appreciated assets distributed to USco, a gain will be recognized by Canco, since those assets will be deemed to be disposed of at fair market value. Thus, corporate-level taxes will be payable on that deemed gain. This is similar to the US “outbound toll charge”, however, there are no exceptions. Therefore, even Canadian real estate will be subject to this deemed disposition.