21 February 2000 External T.I. 1999-0008485 - safe income and convertible preferred shares

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: How is safe income attributed to preferred shares that are convertible into common shares.

Position: Question of fact but if the portion of a capital gain that was reduced by the dividend arose from safe income of the corporation generally the preferred shares should share pro-rata with the common shares based on the number of common shares that could be acquired if the shares had actually been converted.

Reasons: The law.

XXXXXXXXXX 		1999-000848

Attention: XXXXXXXXXX

February 21, 2000

Dear Sirs:

Re: Safe Income and Convertible Preferred Shares

This is in reply to your facsimile letter to Mr. Ted Fitz-Clarke of the Vancouver TSO dated November 22, 1999 which was forwarded to us for reply. In your facsimile you requested the Canada Customs and Revenue Agency's ("CCRA") views on the determination of safe income for the purposes of subsection 55(2) of the Income Tax Act ("the Act") in the following fact situation.

A taxpayer owned common shares of a corporation that were transferred to another taxable Canadian corporation ("other corporation") under section 85. The shares issued by the other corporation as consideration for the common shares transferred to it were shares of a special class ("preferred shares") that could be converted into common shares of the other corporation on a 1 for 1 basis. You indicated in our telephone conversation on February 15 (Cooke/XXXXXXXXXX) that the preferred shares taken back as consideration have a high redemption value, adjusted cost base and paid-up capital such that at the time the preferred shares were issued no capital gain or loss would result on their redemption or sale at that time.

It is your view, that the amount of safe income attributable to the convertible preferred shares should be the amount of safe income attributable to the same number of common shares that could be acquired if the preferred shares had actually been converted into common shares. As support for your view you state that this issue is similar to our published position concerning safe income where stock options exist (i.e., see the 1988 Conference Report article by R. Read on pages 18:8/9).

As your request relates to a completed transaction involving a specific taxpayer confirmation of the income tax consequences of such transactions can only be provided by the taxpayer's local Tax Services Office where the identity of the specific taxpayer is known. However, we are prepared to provide the following general comments.

It remains a question of fact as to whether a portion of capital gain that would have otherwise occurred on a disposition of a share but for the dividend would be attributable to income earned or realized by a corporation after 1971 and before the safe income determination time ("safe income on hand"). In this regard, the statement made by Michael Hiltz at page 15:2 in his paper titled "Income Earned or Realized: Some Reflections" published in the 1991 Canadian Tax Foundation Conference Report, is relevant:

"To determine whether a dividend reduces a portion of a capital gain that could reasonably be considered to be attributable to anything other than income earned or realized, it is necessary to analyze the elements that make up the gain on the share."

While the fair market value of a preferred share that can be converted into a common share of the corporation may increase as the fair market value of the common shares increases it remains a question of fact as to whether any such increase would be attributable to the amount of income earned or realized by the corporation. Although preferred shares may be convertible into common shares it does not always follow that all income earned or realized by the corporation after the time of issuance of the preferred shares will contribute to a gain that would be realized by the preferred shareholder on the shares. For example, where the fair market value of the number of common shares that could be acquired under the conversion right is less than the adjusted cost base of the preferred shares, any income earned or realized by the corporation can not be reasonably attributable to the preferred shares at that time since there is no gain inherent in the shares.

Therefore, as noted above, an analysis of the elements that make up any capital gain on the preferred shares would be required and such analysis would also require consideration of other factors, such as the terms and conditions of the preferred shares (i.e., dividend and liquidation entitlements) and/or whether there are any restrictions on the conversion rights, since these factors may also affect the fair market value of the preferred shares.

Where the fair market value of the number of common shares that could be acquired under the conversion right is greater than the adjusted cost base of the preferred shares and it has been determined that some part of the gain inherent in the preferred shares that would have otherwise been realized but for a dividend was attributable to income earned or realized by the corporation and which is on hand at that time, a portion of the corporation's safe income on hand would appear to be reasonably attributable to the preferred shares. Generally, the amount of safe income on hand attributable to the preferred shares in these circumstances should be the amount of safe income on hand during the holding period for the preferred shares that would be attributable to the same number of common shares that could be acquired if the preferred shares had actually been converted. For greater certainty, the amount of safe income on hand for the holding period of the preferred shares would not include any safe income earned during any period where the fair market value of the common shares which could be received on the conversion was less than the adjusted cost base of the convertible preferred shares.

Our comments are provided in accordance with the practice described in paragraph 22 of Information Circular 70-6R3 dated December 30, 1996.

Yours truly,

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