29 September 2000 External T.I. 2000-0024635 - EMPLOYEE-SHAREHOLDER SHARE SALES

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:

Scenario 1:

(1) Application of section 84.1 to a group of employees / shareholders who transfer their shares of an operating company to shares of a holding company.

(2) Will the employees be able to claim the capital gain exemption under subsection 110.6(2.1) if all other criteria in section 110.6 are satisfied?

(3) Will GAAR apply?

Scenario 2:

(4) Are cash and near cash assets required to be held by a construction company considered to be assets used principally in an active business?

Position TAKEN:

(1) Whether or not employees / shareholders deal at arm's length with Holdco is a question of fact. If they are not dealing at arm's length, section 84.1 will apply.

(2) Yes.

(3) No.

(4) Generally yes, but question of fact.

Reasons:

(1) See E9827901.

(2) If disposal results in capital gain, then subsection 110.6(2.1) may apply.

(3) See E9827901.

(4) Consistent with earlier opinions and IT-73R5.

XXXXXXXXXX 2000-002463
T. Young
Attention: XXXXXXXXXX

September 29, 2000

Dear sir:

Re: Application of Sections 84.1 and 245 and Property Used in an Active Business

This is in reply to your letter of May 4, 2000, requesting our opinion on two scenarios.

(1) Application of Sections 84.1 and 245 of the Income Tax Act (the "Act")

In the first scenario:

• A corporation ("A-Co") is a Canadian-controlled private corporation ("CCPC") as defined in subsection 125(7) of the Act and a "small business corporation" as defined in subsection 248(1) of the Act.
• All the shares of A-Co are widely held by employees of the corporation.
• Pursuant to a shareholders agreement between the shareholders and A-Co, upon the occurrence of certain events with respect to employee / shareholders (e.g., termination of employment, retirement, death, disability, etc.), such employee / shareholder is required to sell his or her shares of A-Co to B-Co. The purchase price will equal the fair market value of the shares based on a formula set out in the shareholders agreement and will be payable in instalments commencing at closing.
• B-Co is a wholly-owned subsidiary of A-Co and was formed specifically to act as the purchaser in the above-noted arrangement. A-Co would typically repurchase for cancellation the A-Co shares held by B-Co.
• The employees all deal at arm's length with each other and with A-Co and B-Co for purposes of the Act.

Specifically, you asked us to confirm that:

1. Section 84.1 of the Act will not deem an employee to have received a dividend in respect of his or her sale of shares of A-Co to B-Co.

2. To the extent that all of the other criteria related to the exercise of an employee's life-time capital gains exemption have been met with respect to the sale, an employee would be entitled to claim his or her life-time capital gains exemption in respect of the sale; and

3. The Canada Customs and Revenue Agency ("CCRA") would not generally apply subsection 245(2) of the Act to the transaction to recharacterise the tax effect of same to an employee.

Our Comments

Written confirmation of the tax implications inherent in particular transactions is given by this directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular 70-6R3, dated December 30, 1996. Where the particular transactions are completed, the enquiry should be addressed to the relevant Tax Services Office. Therefore, we can only provide you with the following general comments.

1. In situations where a company (the "Subject Company"), has set up or uses a related company (the "Purchasing Company") to facilitate the repurchase of company shares held by employees, the CCRA's general position is that section 84.1 of the Act does not apply as long as the employees and the companies are dealing with each other at arm's length and that the Purchasing Company is not purchasing the shares of the Subject Company as agent for the Subject Company.

2. To the extent that all of the other criteria in section 110.6 of the Act are met, an arrangement such as the one described above would not, in and of itself, preclude a taxpayer from claiming a deduction under subsection 110.6(2.1) of the Act.

3. The CCRA would generally not apply subsection 245(2) of the Act to this type of arrangement.

Please note that the above comments are general in nature and may not apply to a particular set of circumstances. Also, we do not have the necessary information to determine if the use of a wholly-owned subsidiary as the Purchasing Company is allowable under the relevant corporate law. To obtain assurance with respect to a specific proposed situation, an advance tax ruling would be necessary.

(2) Property Used Principally in an Active Business

You described a scenario where the taxpayer, a construction company, is typically required to post performance bonds in respect of construction projects undertaken by it. The construction company would purchase the performance bonds from a third-party bonding company. At all times, the taxpayer, the bonding company and the taxpayer's customer would deal with each other at arm's length for purposes of the Act. As a condition to obtaining bonding, the taxpayer is required to hold significant amounts of cash or near cash, which are pledged to the bonding company as security for the bond. Without said pledge, the taxpayer could not obtain the requisite performance bonds and, therefore, would not be able to obtain the construction contracts that are fundamental to its business.

You have asked for confirmation that the cash and near cash would be considered to be used in an active business for determining if the shares of the corporation are qualified small business corporation shares ("QSBC shares") as defined in subsection 110.6(1) of the Act.

Our Comments

The particular circumstances on which you have asked for our views relate to a factual situation involving a specific taxpayer. As we explained above and in Information Circular 70-6R3, it is not this Directorate's practice to comment on completed transactions. Therefore, you should submit all relevant facts and documentation to the appropriate Tax Services Office for their views. However, we are prepared to offer the following general comments which may be of some assistance to you.

One of the requirements of a QSBC share is that at the "determination time", the corporation must be a "small business corporation". A "small business corporation" means, at any particular time, subject to subsection 110.6(15) of the Act, a particular corporation that is a CCPC, all or substantially all of the fair market value of the assets of which at that time is attributable to assets that are used principally in an active business carried on primarily in Canada by the particular corporation or by a corporation related to it. In our view, all or substantially all means at least 90% of the assets must be used in the active business of the corporation. Thus, if more than 10% of the assets are non-active, that is, not used (in the normal sense of that word) in the business, the corporation is not a small business corporation.

You stated that your main concern is whether or not the cash and near cash would be considered to be assets used principally in an active business, within the meaning of the definition of a QSBC share in subsection 110.6(1) of the Act.

As you pointed out in your letter, the CCRA's general views as to when cash or near cash property held by a corporation will be considered to be used in the course of an active business are as follows:

1. The question of whether a particular asset is an "asset used principally in an active business" is one of fact which must be determined based on all the relevant facts and circumstances of each case. The relevant circumstances include the actual use to which the cash or near cash properties are put in the course of the business, the nature of the business and the practice in the particular business.

2. Cash or near cash property is considered to be used principally in the business if its withdrawal would destabilise the business.

3. Cash which is temporarily surplus to the needs of the business and is invested in short-term income producing investments could be considered to be used in the business.

4. Cash balances which accumulate and are then depleted in accordance with the annual seasonal fluctuations of an ongoing business will generally be considered to be used in the business but a permanent balance in excess of the company's reasonable working capital needs will generally not be considered to be so used.

5. The accumulation of funds in anticipation of the replacement or purchase of capital assets or the repayment of a long-term debt will not generally in itself qualify the funds as being used in the business.

6. Cash or near cash property is considered to be used principally in the business if its retention fulfils a requirement which had to be met in order to do business, such as certificates of deposit required to be maintained by a supplier.

7. The CCRA recognises that prudent financial management requires businesses to maintain current assets (including inventories and accounts receivable, as well as cash and near cash properties) in excess of current liabilities and will consider this requirement in assessing whether cash or near cash assets are used principally in a business. In the CCRA's view, cash and near cash assets held to offset the non-current portion of long term liabilities will not generally be considered to be used in the business.

We stress that the above guidelines are necessarily of a general nature. Whether cash and near cash will be considered to be used in the course of an active business can only be determined after an examination of all the relevant facts in the particular situation on a retrospective basis. This examination would normally be done by our Tax Services Offices.

Where, as in the situation you describe, a corporation has contractual obligations with the bonding company to maintain certain cash reserves as security for a bond, we would generally consider the required cash and near cash reserves to be active business assets. In making such a determination, we would also consider how the related interest was reported. That is, we would generally expect that the interest income earned on the required cash and near cash reserves would have been reported as active business income and not as investment income.

We caution, however, that our comments should not be taken as confirmation that the shares of the corporation described above would be QSBC shares as we have not examined all of the requirements which must be met pursuant to subsection 110.6(1) of the Act, for shares to qualify as QSBC shares.

We trust our comments will be of assistance to you.

Yours truly,

for Director
Business and Publications Division
Income Tax Rulings Directorate

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