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 CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principal Issues: Whether subsection 258(4) applies in the particular situation described in the letter so as to deny the application of subsection 258(3) of the Act?
Position: Question of fact. Generally, term preferred share acquired by a specified financial institution would be considered to have been acquired in the ordinary course of business.
Reasons: All the factors surrounding the situation must be examined.
XXXXXXXXXX 2001-007998
S. Leung
November 13, 2001
Dear XXXXXXXXXX:
Re: Subsections 258(3) and 258(4) of the Income Tax Act (the "Act")
We are writing in reply to your letter of April 12, 2001 in which you requested our view whether subsection 258(4) of the Act would apply to the situation described below so to deny the application of subsection 258(3) of the Act.
The Situation
1. USco is a financial institution incorporated and headquartered in the U.S.
2. USco owns all the shares of an operating subsidiary in Canada ("Cansub") which is a "specified financial institution" within the meaning assigned under subsection 248(1) of the Act.
3. USco also owns all the shares of another Canadian corporation ("Cansub2") which was recently incorporated in Canada. Cansub2 is also a "specified financial institution" within the meaning assigned under subsection 248(1) of the Act.
4. Cansub2 has received funds on deposit from, and thereby became indebted to, a corporation ("Clientco") with which it deals at arm's length. The deposit/indebtedness is for a term of two years. One of the terms of the indebtedness requires that Cansub2 is to remain relatively liquid and solvent over the term of indebtedness.
5. Cansub2 invested the proceeds of the borrowing in cumulative preferred shares of a subsidiary of USco which is a U.S operating corporation ("USsub"). The preferred shares bear a market coupon dividend rate and are retractable by Cansub2 at such time as Cansub2's debt is required to be repaid to Clientco. At that time, it is expected that Cansub2 will retract the preferred shares of USsub, obtain cash, and repay its indebtedness to Clientco.
The situation described in your letter appears to involve seriously contemplated transactions and identifiable taxpayers. Consequently, we would like to bring your attention to paragraph 22 of Information Circular 70-6R4, dated January 29, 2001, issued by the Canada Customs and Revenue Agency wherein it is stated that when a requested interpretation relates to a specific proposed transaction, a taxpayer should request an advance income tax ruling rather than an opinion. The procedures for requesting an advance income tax ruling are set out in paragraph 16 of the said circular. We are, however, able to provide you with the following general comments.
Whether the preferred shares of USsub were acquired by Cansub2 in the ordinary course of business carried on by Cansub2 is a question of fact that has to be determined by examining all the facts in the circumstances. Facts to be examined include, among other things, the purpose of incorporating Cansub2 by USco, the reason Cansub2 instead of Cansub took on the deposit/indebtedness from Clientco, the reason Cansub2 did not loan the money to USsub but rather invested in the retractable preferred shares of USsub, and the potential of Cansub2 to earn a profit at the dividend rate on the preferred shares of USsub when compared with the rate of interest paid by Cansub2 to Clientco.
Furthermore, all the factors described in our response to Question 62 of the Revenue Canada Round Table in the 1984 Canadian Tax Foundation Conference Report should also be considered. In view of the fact that it is expected that the preferred shares of USsub will be retracted in two years, it is clear that the funds involved in acquiring the preferred shares of USsub do not represent the initial capitalization of a new subsidiary or the provision of additional operating capital to a subsidiary, both of which would normally indicate permanent capitalization. As to the nature of Cansub2's activities, since Cansub2's only activity is the borrowing of funds to invest in the retractable preferred shares of USsub, it may be perceived that the acquisition of the preferred shares to earn dividend income is in the ordinary course of business of Cansub2. In addition, even though the acquisition of the preferred shares of USsub is an isolated event, it does not preclude that it is "in the course of" as noted by the judge in Regner Blok-Andersen v. M.N.R. ([1972] C.T.C. 338 (F.C.T.D.)) who stated:
"The position taken by counsel for the appellant was that the words "in the course of business" necessarily imply a continuing process of sales rather than an isolated sale.
In my opinion such substitution is both permissible and logical and does no violence to the section so as to render it repugnant to the general scheme of the Income Tax Act or leading to an absurdity. The phrase "in the course of" contemplates a succession of events in a regular order. It also contemplates a result which follows from an event being set in motion. Such a result will arise in the case of an isolated sale as well as in a continuous number of sales." (Emphasis added)
It should also be noted that in Societe d'Investissement Desjardins v. M.N.R. ([1991] 1 CTC 2214) the Tax Court of Canada, in discussing the purpose of subsection 112(2.1) of the Act, stated at page 2238:
"... In fact, this provision was clearly enacted to avoid the improper use by lending institutions of shares similar to loans the dividends on which were tax-free while the interest on the sums loaned had to be included in the income of these corporations. The malice that emerges from this provision is accordingly the abuse of this tax-free transaction. However, an exceptional situation that might at a pinch be described as accidental should not suffer from application of the principle in subsection 112(2.1) of the Act."
We agree fully with the view expressed by the Tax Court of Canada. The exception in subsection 112(2.1) of the Act which permits a specified financial institution to deduct, under subsection 112(2.1) of the Act, dividends received by it on term preferred shares is intended to encompass only exceptional situations. Similarly, the exception to the application of subsection 258(3) of the Act provided for in subsection 258(4) of the Act will only have application in exceptional situations. The use of the phrase "... in the ordinary course of business ..." is designed to distinguish the exceptional situations where subsections 112(2.1) and 258(3) should not be applied from those where these subsections of the Act should be applied. Accordingly, all the factors mentioned above need to be examined in determining what situations may be considered exceptional.
We are concerned that the primary purpose, if not the only purpose, of many of the transactions described in subsection 258(3) of the Act is to transfer taxable income from Canada to the U.S. For example, in the situation outlined in your letter, if subsection 258(3) of the Act does not apply, a large interest expense will be created in Canada which could be used by Cansub2 to offset other sources of income because dividends received from USsub would be deductible by Cansub2 under paragraph 113(1)(a) of the Act.
Even if there is no other source of income in Cansub2, the resulting loss may be able to be transferred to another Canadian company related to Cansub2. Hence, it is our position that where a specified financial institution invests in term preferred shares of a related corporation, the shares will generally be considered to have been acquired in the ordinary course of business, unless those shares are acquired in the course of a reorganization of the specified financial institution and are redeemed quickly or unless those shares are issued on the incorporation of a wholly-owned subsidiary where the proceeds of the sale of the shares constitute permanent capital of the subsidiary.
Yours truly,
for Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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