Translation disclaimer
This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.
Principal Issues: Xco and Yco own, respectively, 60% and 40% of the common shares of the capital stock of Opco. A corporate freeze would be implemented. Xco and Yco, the corporate taxpayers, would receive preferred shares having a redemption amount equal to the value of the common shares they held. 60 common shares would be issued to the child of Xco's shareholder and 40 common shares would be issued to Yco. The safe income is lower than the redemption amount of the preferred shares.
1. Would the issuance of the common shares to the child of Xco's shareholder constitute a significant increase in the direct interests in Opco of that child?
2. Would 55(2) apply with respect to the redemption of the preferred shares held by Yco?
3. Would 55(2) apply with respect to the redemption of the preferred shares held by Xco where there is a proportionate number of preferred shares held by Yco and Xco that are redeemed at the same time?
4. Would 55(2) apply with respect to the redemption of the preferred shares held by Xco where there is a proportionate number of preferred shares held by Yco and Xco that are redeemed in the same day but where the redemption of Xco's shares occurs first?
Position: 1. Yes.
2. Yes.
3. No.
4. Yes.
Reasons: 1. The son acquires 60% of the future value of Opco.
2. Yco and the child of Xco's shareholder are not related persons. Yco and Opco are not related persons. The exception provided for in subsection 55(3)(a) does not apply because the transactions will result in significant increase in interests described in paragraphs 55(3)(a)(ii) and (v) and in a disposition described in paragraphs 55(3)(a)(i) and (iii). According to the example provided, there is a significant reduction of the gain that would be realized on a disposition at fair market value of the redeemed shares and that could be attributable to anything other than the safe income.
3. There is no significant increase of the interests of Yco and the child of Xco's shareholder is related to Xco. Therefore, the exception provided for in subsection 55(3)(a) applies.
4. There may be a significant increase of the interest of an unrelated person, Yco, in Opco that would be described in paragraphs 55(3)(a)(ii) and (v). Therefore, the exception provided for in subsection 55(3)(a) may not apply. According to the example provided, there would be a significant reduction of the gain that would be realized on a disposition at fair market value of the redeemed shares and that could be attributable to anything other than the safe income.
XXXXXXXXXX 2010-035979
Sylvie Labarre, CA
May 5, 2010
Dear Sir,
Subject: Significant increase in interest - Paragraph 55(3)(a)
This is in response to your e-mail of March 2, 2010, in which you asked our opinion on the application of paragraph 55(3)(a) of the Income Tax Act (the "Act") in a hypothetical situation.
Facts
Holdco, Opco and 3rd-Party Holdco were Canadian-controlled private corporations.
All of the shares of Holdco were held by X.
The issued and outstanding capital stock of Opco consisted of 1,000 Class A common (voting and participating) shares.
Prior to a capital reorganization, Holdco held 600 Class A shares of the capital stock of Opco while 3rd-Party Holdco held 400 Class A shares of Opco.
Holdco and 3rd-Party Holdco were not related persons.
In Year 1, a freeze was effected for the benefit of X's child. In the course of a reorganization of capital, the 1,000 Class A shares of the capital stock of Opco were converted into 1,000 Class B preferred shares of the capital stock of Opco with a paid-up capital of $1,000 and a redemption amount of $5,000,000. Subsection 86(1) applied to this transaction. The safe income on hand attributable to the 1,000 Class A shares of the capital stock of Opco was $2,000,000 and was allocated proportionately between Holdco and 3rd-Party Holdco.
Immediately after that share conversion, Opco issued 100 Class A shares of its capital stock, namely, 60 shares to X's child for consideration of $60 and 40 shares of the same class to 3rd-Party Holdco for consideration of $40.
As a result of this share subscription, X's child had de jure control of Opco.
Opco is in the process of redeeming Class B preferred shares of its capital stock.
Questions
For the purposes of your first question, you wish us to assume that the redemption of the Class B shares of the capital stock of Opco would always be carried out on a proportional basis, namely 60% in favour of Holdco and 40% in favour of 3rd-Party Holdco. The redemption of the Class B shares held by these two shareholders would always occur simultaneously. Based on this assumption, you wish to know whether subsection 55(2) would apply respecting the deemed dividend received by Holdco and 3rd-Party Holdco, respectively, under subsection 84(3).
You also wish to have our opinion on the same issue under a slightly different assumption. Under this new assumption, the Class B shares of the capital stock of Opco held by each holder would still be redeemed proportionately, as described above, but Opco would effect two redemptions during the same day: i.e., a first redemption corresponding to 60% of the redemptions of the day, in favour of Holdco; and a second redemption corresponding to 40% of the redemptions of the day, in favour of 3rd-Party Holdco. You also indicated the following assumption: the deemed dividend paid by Opco to Holdco, resulting from the first redemption in favour of Holdco, would be designated as an eligible dividend from Opco's general rate income pool (GRIP) and the deemed dividend paid by Opco to 3rd-Party Holdco, resulting from the second redemption in favour of 3rd-Party Holdco, would not be designated as an eligible dividend from Opco's GRIP.
Our Comments
As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, it is the practice of the Canada Revenue Agency (the "CRA") not to issue a written opinion regarding proposed transactions otherwise than through advance rulings. Furthermore, when it comes to determining whether a completed transaction has received appropriate tax treatment, the determination is made first by our Tax Services Offices as a result of their review of all facts and documents, which is usually performed as part of an audit engagement. However, we can offer the following general comments that we hope may be helpful to you. These comments may, however, in some circumstances, not apply to your particular situation.
As you stated, in a situation such as the one you are presenting to us, the CRA generally considers that there could be two transactions that could result in a significant increase in interests described in subparagraphs 55(3)(a)(ii) and (v): the acquisition of the participating shares under the freeze and the redemption of the preferred shares.
At the time of the acquisition of the participating shares under the freeze, there would have been no significant increase in 3rd-Party Holdco's interest in Opco. The increase in absolute dollars would be only $40 on a value of $5,000,100 while the percentage of shares held by 3rd-Party Holdco would remain at 40%. 3rd-Party Holdco would also retain a percentage of 40% of the future value of Opco. Similarly, we are of the view that the redemption of Class B shares held by Holdco and 3rd-Party Holdco which would be effected simultaneously and in proportion to the total Class B shares held by each (i.e., 60% for Holdco and 40% for 3rd-Party Holdco) would not result in any increase in the direct interest of 3rd-Party Holdco in Opco. Consequently, in such a case, the deemed dividend paid by virtue of subsection 84(3) on the simultaneous redemption of the Class B preferred shares held by Holdco would not be subject to subsection 55(2).
On the other hand, at the time of the acquisition of the participating shares under the freeze, there would be an increase in the direct interest of X’s child, who is not related to 3rd-Party Holdco, in Opco. We are of the view that there would be a significant increase in the interest of X’s child in the current hypothetical situation because the child would acquire 60% of the future value of Opco. Similarly, the redemption of Class B shares held by Holdco and 3rd-Party Holdco which would be carried out simultaneously and in proportion to the total Class B Shares held by each (i.e. 60% for Holdco and 40% for 3rd-Party Holdco) could result in a significant increase in the direct interest of X's child in Opco for purposes of subparagraphs 55(3)(a)(ii) and (v). It should also be noted that the reorganization of the share capital pursuant to subsection 86(1) would result in a disposition of the Class A shares to Opco, a person unrelated to 3rd-Party Holdco. This disposition of shares would come within subparagraphs 55(3)(a)(i) and (iii).
In light of the foregoing, the deemed dividend paid by virtue of subsection 84(3) on the simultaneous redemption of the Class B preferred shares held by 3rd-Party Holdco would be subject to subsection 55(2).
The assumptions given in your second question would lead to a different answer in part. Our comments regarding the increase in interest at the time of the issuance of the participating shares would remain the same despite the change in assumptions. Our comments with respect to the consequences resulting from a redemption of the Class B shares for 3rd-Party Holdco would also be the same in the case of consecutive redemptions on the same day.
However, we would generally take a different view of the consequences for Holdco in a situation where the Class B shares are redeemed on consecutive redemptions, even if they are redeemed on the same day.
In this regard, we are of the view that a determination should be made as to whether there is a significant increase in the total direct interest in Opco by an unrelated person immediately after the redemption that would be subject to subparagraphs 55(3)(a)(ii) and (v). Thus, if a certain number of Class B shares held by Holdco were redeemed, the percentage of the value of the shares held by 3rd-Party Holdco in relation to the total value of the issued and outstanding shares immediately after redemption would increase. If this increase were significant, the deemed dividend paid pursuant to subsection 84(3) on the redemption of the Class B preferred shares held by Holdco, in a scenario of consecutive redemptions, would technically be subject to subsection 55(2).
In closing, it may be that, in reviewing the facts and circumstances surrounding a particular situation, we may find that we are dealing with a scheme that results in a surplus stripping of a particular corporation that would engage the application of subsection 245(2. However, we are unable to comment specifically in this regard in a technical interpretation as it is generally the practice of the Income Tax Rulings Directorate to rule on the application of subsection 245(2) only after reviewing all the facts and circumstances surrounding transactions in the context of an advance income tax ruling request.
These comments are not advance income tax rulings and are not binding on the CRA in respect of any particular situation.
Best regards,
Stéphane Prud'Homme, Notary, M. Fisc.
for the Director
Corporate Reorganization and Resource Industries Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.
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