CRA indicates that it will not extend its policy on set-off of unequal redemption notes beyond a butterfly reorg

As described in 2015-0601441R3, a partnership was wound-up under s. 98(5) by one partner (Sub2) transferring its partnership interest under s. 85(1) to the other partner (Sub2) for consideration including Sub1 Preferred Shares.

A second ruling letter deals with the elimination of this cross-shareholding in reliance on the s. 55(3)(a) rule. This is accomplished by the Parent of Sub2 exchanging its common shares of Sub2 under a s. 86 reorg for new common shares and (non-voting redeemable retractable) Sub2 Preferred Shares – and then transferring the Sub2 Preferred Shares under s. 85(1) to Sub1 under s. 85(1) in exchange for common shares of Sub1. Notes arising from the cross-redemption of the Sub1 Preferred Shares and Sub2 Preferred Shares then are set-off.

CRA ruled that the debt forgiveness rules would not apply to the note set-offs provided that the two notes were equal in amount. This is not as vacuous as it sounds. On a spin-off that complied with the butterfly rules, CRA would have ruled that s. 80 did not apply to the note set-off even though the two note amounts differed. This note difference typically arises because the value of the shares of the distributing corporation has a discount for underlying taxes, whereas the assets distributed by it to the transferee corporation do not. Here, the summary answered the question of “Whether administrative position in respect of section 80 applies” with “No,” stating: “Set-off and cancellation of debts not occurring in context of a distribution as defined in subsection 55(1).” The value of the Sub1 Preferred Shares reflected the value of a partnership interest for which there would be no discount for underlying taxes, whereas the value of the Sub2 Preferred Shares was effectively required to be based on the value of that partnership interest even though their redemption value was being carved out of a Sub2 equity value that likely reflected such a discount.

After the ruling application went in, a paragraph was added stipulating that, on the s. 86 reorg of Sub2, the paid-up common shares of the old common shares of Sub2 would be divided between the Sub2 Preferred Shares and the new common shares based on their relative fair market value.

Neal Armstrong. Summary of 2016 Ruling 2015-0623731R3 under s. 55(3)(a), s. 80(1) – forgiven amount and s. 86(1).