26 June 1995 External T.I. 9515315 - 55(2)

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Whether subsection 55(2) of the Act would apply to a deemed dividend arising on the redemption of shares.

Position TAKEN:

Unless there is safe income attributable to the shares or Part IV tax is paid on the dividend, the dividend will be subject to the application of subsection 55(2) of the Act.

Reasons FOR POSITION TAKEN:

The deemed dividend has resulted in a significant reduction in the capital gain that would have been reported by the corporation on the disposition of the shares that were redeemed.

				951531
XXXXXXXXXX			A. Seidel

Attention: XXXXXXXXXX

June 26. 1995

Dear Sirs:

This is in reply to your facsimile dated June 6, 1995 which was forwarded to us by the Vancouver Tax Services Office.

You have asked for our opinion as to whether subsection 55(2) of the Income Tax Act (the "Act") would apply in the following situation:

An individual ("Mr. X") has been a shareholder of a corporation ("Opco") since 1979. He has bought and sold shares of Opco at various times as employees joined or left the company. He currently holds 71 common shares of Opco and they have an adjusted cost base of $179.01 per share.

The series of transactions described below have been initiated by the forced termination of Mr. X by the other shareholders of Opco. Opco has 16 other shareholders. The total number of shares of Opco that are issued and outstanding prior to the redemption of Mr. X's shares is 681 common shares.

Upon the settlement of the termination agreement, Mr. X will roll his 71 shares of Opco into a new corporation ("Newco") pursuant to subsection 85(1) of the Act in exchange for 187,865 $1.00 par value preferred shares of Newco and a promissory note in the amount of $12,709.71. The agreed amount will be determined so that Mr. X can use the balance of his lifetime capital gains exemption.

Opco will enforce the terms of the Shareholder's Agreement and will redeem its shares held by Newco at their fair market value. The purchase price will be satisfied by a promissory note in the amount of $160,000 and cash of $40,575. The note will be secured and repayable at $3,333.33 per month plus interest.

The redemption of the shares by Opco will result in Newco having received a deemed dividend pursuant to subsection 84(3) of the Act. The amount of the dividend will be equal to the excess of the redemption price paid for the shares and the paid-up capital of the shares so redeemed. The deemed dividend is a taxable dividend within the meaning thereof in subsection 89(1) of the Act and would be deducted by Newco in the calculation of its income for tax purposes pursuant to subsection 112(1) of the Act.

Pursuant to subsection 55(2) of the Act, where a corporation receives a taxable dividend under subsection 84(3) of the Act in respect of which it is entitled to a deduction under subsection 112(1) of the Act as part of a series of transactions or events, one of the results of which was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on the disposition at fair market value of any share of capital stock immediately before the dividend and that could reasonably be considered to be attributable to anything other than income earned or realized after 1971 and before the commencement of the series of transactions or events (referred to as "safe income"), the amount of the dividend is deemed not to be a dividend received by the corporation and, in the situation where the corporation has disposed of the shares, the amount of the taxable dividend is deemed to be proceeds of disposition of the share. Pursuant to subparagraph (b)(i) of the definition of "disposition' in section 54 of the Act, the redemption of the Opco shares is a disposition of those shares for purposes of the Act.

Based on the information provided, it is our view that the series of transactions which results in Newco receiving a deemed dividend on the redemption by Opco of its shares and also results in a significant reduction in the capital gain that would have been realized by Newco on the disposition of the Opco shares would be subject to the application of subsection 55(2) of the Act such that the dividend would be deemed not to be a dividend and the amount of the deemed dividend would be deemed to be proceeds of disposition of those shares if the amount of the taxable dividend exceeds the aggregate of:

(i)the safe income on hand attributable to the Opco shares owned by Mr. X, and

(ii)4 times the amount of any Part IV tax payable by Newco in respect of such dividends.

However, a designation may be filed by Newco under paragraph 55(5)(f) of the Act to designate the amount of the dividend referred to in (i) above as a separate dividend. In such case subsection 55(2) of the Act will only apply to the amount by which the taxable dividend exceeds the aggregate of the amounts in (i) and (ii) above.

These comments are provided in accordance with the guidelines set out in paragraph 21 of Information Circular 70-6R2.

Yours truly,

for Director
Reorganizations and Foreign Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch