20 March 2001 Internal T.I. 2000-0062937 - Flow through shares - prescribed 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:

1. Is it still Rulings position that the cost of acquisition of a prescribed share, that would have otherwise be a flow through share, would not be deemed to be nil by 66.3(3).

2. Can a taxpayer claim an ABIL on prescribed shares.

Position:

1. Yes.

2. Yes.

Reasons:

1. Our position given in letter E9216157 of August 21, 1992 and at the 1999 Annual Conference of Quebec Technical Advisors states that the cost of the shares will not be deemed to be nil under 66.3(3).

2. As long as all the requirements of 39(1)(c) are met, an ABIL could occur on the disposition of the prescribed shares.

            March 20, 2001

      TA/Specialty Audit Section    HEADQUARTERS
      Harry Hayes Building    Reorganizations and
      Calgary TSO   Resources Division
      David Shugar
      957-2134
      Attention: G. A. Lawrence
      2000-006293

Flow-Through Shares Found to be Prescribed Shares

This is in reply to your correspondence of December 19, 2000, wherein you asked us to confirm whether our opinion expressed in our letter E9216157, dated August 21, 1992, is current, and whether an allowable business investment loss ("ABIL") can be claimed in respect of shares that are prescribed shares as defined under section 6202.1 of the Income Tax Regulations (the "Regulations"). All references are to the Income Tax Act unless otherwise indicated.

The facts of the situation described in your letter are as follows:

1. Investors purchased shares in Corporation A pursuant to a flow-through share purchase agreement by way of cash or a loan received from Corporation B;

2. Corporation A and Corporation B are related;

3. Corporation A is a small business corporation, as defined in subsection 248(1);

4. It was determined that Corporation B was a specified person, as defined under subsection 6202.1(5) of the Regulations;

5. Audit has determined that the shares issued to investors who received a loan in respect of their shares, do not meet the definition of flow-through share under subsection 66(15), by virtue of being prescribed shares as defined under paragraph 6202.1(2)(b) of the Regulations.

Our Comments

In our letter of August 21, 1992, we stated that "... a share would be a "prescribed share" (as defined in section 6202.1 of the Regulations) and thereby not a flow-through share, if any of the conditions identified in paragraphs (a) - (f) of the Regulation are met. If it is established that the shares are "prescribed shares" their cost would not be deemed to be nil by 66.3(3)." That position was restated at the 1999 Round Table - Annual Conference of Quebec Region Technical Advisers, in question 24, Calculating the ACB, which is reproduced in its entirety below:

Question: When an investor acquires flow-through shares, as defined in subsection 66(15), the investor is deemed to have acquired them at a cost of nil under subsection 66.3(3).

If, further to an audit, the Department decreases or disallows the exploration expense deduction, for example, because the expenses were not incurred, the adjusted cost base of the shares is not changed to take into account the fact that the deduction was disallowed.

If an investor acquires what is believed to be flow-through shares and it is subsequently determined that these shares are not flow-through shares, the exploration expense deduction will be zero. Since the share is not a flow-through share, its cost is not deemed to be nil.

A share may not be a flow-through share if it is a prescribed share as defined in sections 6202 and 6202.1 of the Regulations.

Shouldn't the adjusted cost base of the shares in both situations be corrected?

Answer: Responses from the Income Tax Rulings and Interpretation Directorate:

There is no provision in the Act to increase the adjusted cost base of shares in the first situation described above. Determining whether the adjusted cost base of shares should be changed under specific circumstances is a tax policy issue, which is the responsibility of the Department of Finance. The Department of Finance has not found it necessary to amend the Act in order to require an adjustment to a taxpayer's adjusted cost base of flow-through shares in this situation. Consequently, the cost remains nil and the adjusted cost base of the shares will not change.

In the second situation, the cost of the shares will not be deemed to be nil.

Our position, as stated above and in our letter of August 21, 1992, has not changed. Our letter of August 21, 1992 referred to paragraphs (a) to (f) in subsection 6202.1(1) of the Regulations, however our position also applies to shares that are determined to be prescribed shares under subsection 6202.1(2) of the Regulations.

In your letter, you stated that the promoter suggested investors can sell their shares to an arm's length person for $1 and trigger an ABIL equal to the subscription price minus $1. Assuming that $1 is the fair market value of the share, the relevant provisions of the Act would be subparagraphs 39(1)(c)(ii) and (iii).

Generally, a shareholder of a small business corporation can only deduct an allowable business investment loss under paragraph 39(1)(c) when he or she disposes of the share to an arm's length third party. A shareholder may also deduct an unrealized loss under subparagraph 50(1)(b)(iii) in the year that the corporation is considered to be insolvent, does not carry on any business and can be expected to be dissolved provided the following conditions are met:

1. at the end of the year, the fair market value of the share is nil;

2. at the end of the year, it is reasonable to expect that the corporation will be dissolved (or wound up) and will not begin carrying on any business; and

3. the corporation in fact does not commence business in the year or within 24 months following the end of that year.

The date the ABIL is to be recognized will, therefore, depend on either the date the share was actually disposed of, or the date the conditions noted above have been or will be met. In our view, the fact that the shares are prescribed shares does not have a bearing on whether a capital loss on the disposition of those shares would be an ABIL. A capital loss on the shares would be an ABIL, provided the requirements of paragraph 39(1)(c) are otherwise met.

The inclusion rate that would be applicable to the ABIL under the proposed amendments to section 38 would be determined by considering all the investor's net capital gains and losses during the year, and depends on whether the taxation year of the investor straddles February 28, 2000 and/or October 18, 2000. The inclusion rate will be determined in accordance with the application rules relating to section 38 contained in the Legislative Proposals and Explanatory Notes Relating to Income Tax released by the Minister of Finance on December 21, 2000. According to the application rules, the inclusion rate will be either three-quarters, two-thirds, one-half, or some other fraction between one-half and three-quarters, and would differ from one investor to the next, depending on their particular circumstances.

In a telephone conversation on March 14, 2001 (Shugar/Mueller) you informed us that the loan agreements between the investors and Corporation B were separate from the flow-through share purchase agreements between the investors and Corporation A. You stated that you intend to treat the shares which were bought with funds loaned to the investor by Corporation B as prescribed shares, while shares purchased by investors who did not receive a loan from Corporation B will remain flow-through shares. The question of whether a given share is a prescribed share is a question of fact; determination of the facts rest not only on the characteristics of the share in a company's by-laws, but on any agreement in respect of the share. Flow-through shares purchased by persons who did not receive a loan, and which according to Audit, are not prescribed shares under any provision in section 6202.1, will be deemed to have been acquired by the person at a cost of nil, under subsection 66.3(3).

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