7 October 2016 APFF Roundtable Q. 12, 2016-0655911C6 F - Partial Leveraged Buy-Out and Monetization of ACB -- translation
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: Whether subsection 84(2) and/or 245(2) would apply in a situation involving a partial leveraged Buy-out.
Position: General comments provided.
Reasons: Based on jurisprudence and previous positions.
APFF 2016
Question 12
Partial sale of an operating company and monetization of ACB (subsection 84(2))
Subsection 84(2) is a provision essentially intended to counter the stripping of the surplus of a corporation and under which a taxable dividend is deemed to have been paid to a shareholder who has disposed of part or all of their shares in connection with transactions in the course of which funds or property of a corporation have been distributed or otherwise appropriated to the shareholders on the winding-up, discontinuance or reorganization of its business. Any such deemed dividend corresponds to the value of the funds or property received in excess of the reduction of the paid-up capital in respect of the shares of the particular class.
It is apparent from the jurisprudence and technical interpretations rendered by the CRA that subsection 84(2) has a broad scope and may apply in cases of a partial sale to a third party or where shares have a high ACB and section 84.1 does not apply to their transfer.
Consider the following situation:
Mr. A and Mr. B are individuals resident in Canada who deal at arm's length with each other. Mr. A and Mr. B each hold 50 common shares of the capital stock of an operating company ("Opco"). The ACB to Mr. A and Mr. B of the common shares in the capital stock of Opco is $100 and $100,000 respectively (being ACB to which section 84.1 does not apply). The paid-up capital of all the shares is $100 while the fair market value of the shares is estimated to be $1,000,000.
Mr. A wishes to retire progressively from the business operated by Opco and to cash out a portion of the shares held in the capital stock of the latter. To this end, Mr. A agrees to sell to Mr. B 30 common shares in the capital stock of Opco.
Accordingly, Mr. B incorporates a new corporation ("Newco") to which he transfers his 50 common shares in the capital stock of Opco in consideration for the issuance of a $100,000 note payable on demand and for 100 common shares in the capital stock of Newco, all by way of a rollover pursuant to subsection 85(1). Newco subsequently obtained a loan from a financial institution in the amount of $300,000 and proceeded to purchase the 30 common shares in the capital stock of Opco held by Mr. A.
Newco and Opco amalgamate to form Amalco, so that the bank loan can be repaid from Amalco's business income. The new common shares of the capital stock issued by Amalco are allocated as to approximately 22% to Mr. A and approximately 78% to Mr. B. In addition, the note issued by Newco to Mr. B will be repaid by Amalco as soon as cash flow permits.
Questions to the CRA
(a) Does the CRA consider that subsection 84(2) or 245(2) would apply to the sale of the shares by Mr. A to Newco?
(b) Does the CRA consider that subsection 84(2) or 245(2) would apply to the transfer of the shares by Mr. B to Newco?
CRA response
Subsection 84(2) is a specific anti-avoidance rule to counter the direct or indirect stripping of the surplus of a corporation. According to the Federal Court of Appeal in The Queen v. MacDonald (footnote 1), the conditions for the application of subsection 84(2) are as follows:
"A plain reading of the text reveals several elements that are necessary for its application: (1) a Canadian resident corporation that is (2) winding-up, discontinuing or reorganizing; (3) a distribution or appropriation of the corporation’s funds or property in any manner whatever; (4) to or for the benefit of its shareholders."
The wording of subsection 84(2) indicates that item (2) above is respecting the winding-up, discontinuance or reorganization of the business of the corporation.
It appears that Newco would be formed to: 1) acquire from Mr. B 50 shares in the capital stock of Opco; 2) secure a loan of $300,000 from a financial institution; and 3) to acquire from Mr. A 30 common shares in the capital stock of Opco. At first sight, there could be arguments to conclude that Newco would not carry on a business.
Similarly, assuming that Amalco would carry on the same business as that of Opco, it could be difficult to argue that this business would be reorganized due to the amalgamation given that the amalgamation would not have the effect of changing this business.
Given the hypothetical situation described above, it is difficult to conclude that there would a winding-up, discontinuance or reorganization of the business of Opco or Amalco.
Consequently, it could be that subsection 84(2) is not applicable in a situation similar to this. However, the wording of this question only briefly described the given hypothetical situation. Among other things, this question gives no information regarding the nature of the business carried on by Opco, the composition of the assets of Opco (for example, the level of liquidity), the magnitude of the surplus of the corporation or the time within which the loan from the financial institution and the note due to Mr. B would be repaid by Amalco. In the absence of such information, the CRA is not in a position to pronounce definitively on the potential application of subsection 84(2).
Moreover, before determining whether subsection 245(2) applies in a real given situation, it must be determined whether another legislative provision applies, such as for example section 84.1 or subsection 84(3).
Thus, in an actual particular situation, it must be demonstrated that the parties are dealing at arm’s length before concluding that section 84.1 does not apply to a situation such as in the situation described for Mr. A. The question of whether the vendor and the corporation which acquires the shares are dealing at arm's length is a question of fact. The CRA's guidelines for whether people are related persons or dealing at arm's length are set out in paras. 1.38 to 1.41 of the Income Tax Folio S1-F5-C1, Related persons and dealing at arm's length.
Similarly, if section 84.1 applied, it would be necessary to determine that the ACB of the transferred shares was not reduced in accordance with subsection 84.1(2) in order to determine the tax consequences of the application of section 84.1 in Mr. B’s situation.
In the facts of a particular situation, it must also be determined that there was no redemption, acquisition or cancellation in any manner whatsoever (other than a transaction referred to in subsection 84(2)) of any share of any class in the capital stock of Opco by it. Otherwise, subsection 84(3) would apply to the redemption, acquisition or cancellation.
Furthermore, it is only following consideration by the CRA of a series of transactions, whether during an audit of the series of transactions or as part of a request for an advance tax ruling in respect of such transactions, that the CRA could reach a definite conclusion on the application of the general anti-avoidance rule in subsection 245(2) with respect to a situation similar to that described above.
Finally, the wording of this question does not specify how the ACB was established for Mr. B’s shares in the capital stock of Opco, except for the fact that it did not ensue from a capital gains deduction under section 110.6 nor from the FMV of such shares at the valuation date. Although it is not possible to pronounce definitively in the context of this question, the CRA is concerned about "in-house" transactions to manipulate the tax base. The CRA continues to pay special attention to this type of transaction and, if necessary, could consider the application of subsection 245(2) in such circumstances.
Jean Lafrenière
(613) 670-9013
October 7, 2016
2016-065591
FOOTNOTES
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 2013 FCA 110">2013 FCA 110
2 Ibid. at para. 17.
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