Have you received exceptionally large dividends from a foreign asset? It may have been a result of a "foreign spin-off".
Foreign spin-offs are relatively common operations in which a foreign company (the original company) distributes shares of one of its subsidiaries to its shareholders. The former becomes a public company just as the original company. The shareholder becomes a holder of shares of two companies instead of one, but the total value of their investment remains the same as it was before the spin-off. They may therefore be eligible for a tax deferral by making an election under section 86.1 of the Canada Income Tax Act.
About Section 86.1 of the Canada Income Tax Act
Spin-offs are often tax-exempt. This applies to shareholders who live in the country of residence of the companies involved in the spin-off. However, the market value of the subsidiary shares transferred to shareholders by the original company will generally be a taxable dividend for those who reside in Canada, unless the transaction meets all the conditions specified in section 86.1 of the Income Tax Act ("ITA") and the taxpayer has made an election under ITA section 86.1 in their tax return for the year in question.
Conditions of Application
A series of conditions must be met in order for this election to be made and for the dividend received by a Canadian resident from a foreign spin-off to be tax-exempt. For this to be possible, the foreign company must provide certain information to the Canada Revenue Agency within the prescribed delay.
How to Use Section 86.1 of the ITA
The election under ITA section 86.1 can be made equally by individuals and corporations residing in Canada if they are shareholders of the foreign company concerned. In the case of an individual, the shareholder must file their income tax return in paper format (TED or NETFILE electronic formats are not permitted) and include a letter containing the following information:
- A written notice indicating that the shareholder has elected to defer the taxes related to the foreign spin-off, describing the original shares and shares received from the spin-off;
- The number of original shares belonging to the shareholder immediately before and after the spin-off, their cost (adjusted cost base or "ACB") and their fair market value ("FMV") at that time;
- The number of spin-off shares that the shareholder received immediately after the distribution and their fair market value at that time;
- If necessary, all T5 (or corresponding foreign tax slips) received regarding the dividend.
Why Make This Choice
Failing to make an election under ITA section 86.1 will require the shareholder to immediately declare a foreign dividend income taxable at the full rate (46.57% for companies and 49.97% for individuals at the highest marginal tax rate) while no money has been received by the taxpayer for the transaction. By making an election under ITA section 86.1, the tax on dividend income is deferred until the shares are sold, and will then result in a capital gain for which only half of the amount will be taxable, unlike a foreign dividend which is fully taxable.
It is therefore in the investor's interest to make an election under ITA section 86.1 whenever possible, unless the investment is held within a registered plan (RRSP, TFSA or similar plan), since there would be no tax consequences in these cases.
Depending on the amounts involved, it may be useful to make a late election if this choice is available for a previous year and has not already been used for the year of the spin-off. However, a delay penalty of $100 per month is applied by both tax agencies, up to a maximum of $8,000 for federal and $5,000 for Quebec taxes.
When make an election under ITA section 86.1, the dividend distribution received is non-taxable, and the adjusted cost base (ACB) of the shares of the original company is distributed among all the shares held by the shareholder after spin-off (original company and subsidiary subject to the spin-off).
Eligible Securities in 2013
For 2013, if you held shares of one of the following companies, you may be eligible for a tax deferral if you make an election under ITA section 86.1:
- Leucadia National Corporation
- Murphy Oil Corporation
- News Corporation Inc.
- Dean Foods Company
- Valero Energy Corporation
- Abbott Laboratories Inc.
- Liberty Media Corporation
- PPG Industries Inc.
These company names are taken from the CRA website, which publishes a list of eligible spin-offs since 1998 and for which the dividend distribution was eligible for ITA section 86.1 (http://www.cra-arc.gc.ca/tx/bsnss/tpcs/spnffs-eng.html). This list is quite extensive but may nonetheless be incomplete, since it shows only companies that have authorized the CRA to publish their names. It is therefore possible that an eligible spin-off is not listed there. One should be cautious and check eligibility with the issuer if your tax slips show an unusually large dividend (without a corresponding payment) and the company name is not mentioned in the list of eligible distributions issued by the CRA.
Example: Abbott Laboratories
The following is an example for 2013. On January 31, 2013, Canadian shareholders of the U.S. company Abbott Laboratories ("Abbott") were advised by the company that it had made a distribution that was eligible under ITA section 86.1 as of January 1, 2013. Abbott shareholders received as dividend one (1) share of the subsidiary AbbVie Inc. for each share of Abbott owned.
In the case of fractional shares, it appears that the company chose to consolidate and sell them on the open market. The net proceeds were then distributed to shareholders as product of a disposition of fractional shares for purposes of calculating capital gains.
According to the information available, the tax consequences of the spin-off are as follows:
|Number of Abbott shares formerly held:||2,000|
|ACB per share:||$30 CAN|
|Total ACB of Abbott shares formerly held:||$60,000 CAN|
|% of FMV||Number of Shares||ACB2
|Total||$67.22||100.0%||Not applicable||$60,000||$60,000||Not applicable|
1. FMV: Fair market vale.
2. ACB: Adjusted cost base.
The market value of Abbott and AbbVie shares immediately after the spin-off is provided by Abbott in their letter of January 31, 2013. The rest of the calculations depend on the ACB and number of shares held by the shareholder.
In the example above, making an election under ITA section 86.1 avoids the burden of a taxable dividend of $69,840 (2,000 shares x $34.92). For an individual at the highest tax rate of 49.97% this represents a considerable tax of $34,899, especially as no money was received for the deemed dividend.
By making an election under ITA section 86.1, the taxpayer should eventually declare additional taxable capital gain of $34,920 ($69,840 x 50%), resulting in a maximum tax of $17,450 which would, however, apply only in the year of disposition of the securities and offset by any available capital loss carried forward.
If you hold foreign securities, it may be worthwhile for you to check if the ITA section 86.1 applies to your situation.
Since the levels and bases of taxation can change, any reference in this publication to the impact of taxation should not be construed as offering tax advice; as with any transaction having potential tax implications, clients should consult with their own tax advisors.