29 June 2001 External T.I. 2001-0088145 - Capital gains deduction

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: Whether an individual can benefit of the enhanced capital gains deduction under 110.6(2.1) in a given fact situation ?

Position: No

Reasons: The redemption of the individual's shares result in an 84(3) deemed dividend not in a gain under 40(1).

XXXXXXXXXX 2001-008814
Marc LeBlond
June 29, 2001

Dear XXXXXXXXXX:

Re: Capital Gains Deduction for Qualified Small Business Corporation Shares

This is in response to your letter dated May 31, 2001, wherein you requested our opinion on the application of the capital gains deduction for qualified small business corporation shares under subsection 110.6(2.1) of the Income Tax Act (the "Act") in the following situation.

The Situation

In summary, the situation under consideration, as we understand it, is as follows:

XXXXXXXXXX (Mr. A), a resident of Canada, owns all the shares of XXXXXXXXXX (OPCO I) and of XXXXXXXXXX (OPCO II). Both corporations are private corporations and Canadian-controlled private corporations (CCPC), as defined under subsections 89(1) and 125(7) of the Act, respectively.

The capital stock of OPCO II consists of XXXXXXXXXX common shares. The total adjusted cost base (ACB) of the shares, as provided under section 54 of the Act, is $XXXXXXXXXX. We assume that the total paid-up capital (PUC) of the shares, as defined under section 89(1) of the Act, is also $XXXXXXXXXX.

OPCO II carries on an active business in Canada involving the rendering of services for a commission or a fee. In addition to assets related to its business (such as account receivables), OPCO II owns investments. The value of the investments has increased considerably since they were acquired and now represents more than 50 % of the fair market value (FMV) of all of OPCO II's assets. We assume that OPCO II does not carry on a specified investment business or a personal services business, as these expressions are defined under subsection 125(7) of the Act.

Your Questions

You asked us whether Mr. A could be entitled to the capital gains deduction, under subsection 110.6(2.1) of the Act, if the following transactions were carried out:

-i- OPCO II disposed of some of the investments to finance the purchase of other business assets -ii- Mr. A exchanged his OPCO II common shares for OPCO II preferred shares that are redeemable for $XXXXXXXXXX and OPCO II new common shares -iii- Mr. A transferred the OPCO II new common shares to OPCO I (we assume on a tax-free basis, pursuant to subsection 85(1) of the Act) and -iv- at least two years later, when the FMV of OPCO II's business assets represent more than 50% of the FMV of all of OPCO II's assets, Mr. A disposed of the OPCO II preferred shares by causing OPCO II to redeem the shares for their redemption value of $XXXXXXXXXX.

Our Comments

The particular circumstances in your letter on which you have asked for our views appear to be a factual situation involving specific taxpayers. As explained in Information Circular 70-6R4 dated January 29, 2001, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling. Should your situation involve a specific taxpayer and a completed transaction, 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 assistance.

An individual who realizes a gain on the disposition of a qualified small business corporation (QSBC) share, as defined in subsection 110.6(1) of the Act, may be entitled to a deduction in calculating his or her taxable income according to subsection 110.6(2.1) of the Act.

In order for a share to so qualify at the time of disposition, the corporation must be a small business corporation (SBC), as defined in subsection 248(1) of the Act, and among other requirements at any particular time, the corporation must be a CCPC, all or substantially all of the FMV 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, generally, "all or substantially all" means that at least 90% of the assets must be used principally in an active business of the corporation. Thus, if more than 10% of the assets are not principally used (in the normal sense of that word) in a business, the corporation is not a small business corporation and therefore is not a QSBC share for the purpose of the capital gains deduction under subsection 110.6(2.1) of the Act.

Another condition for a share to qualify as QSBC share is that throughout the 24 months immediately preceding the determination time (for example, at the time of disposition) the share must be a share of the capital stock of a CCPC more than 50% of the FMV of the assets of which was attributable to, generally, assets used principally in an active business carried on primarily in Canada or shares of the capital stock or indebtedness of other corporations connected with the corporation (within the meaning of subsection 186(4) of the Act).

However, in the situation you have described, in our view, the capital gain deduction under 110.6(2.1) of the Act would not apply because Mr. A does not realize a capital gain, pursuant to subsection 39(1) of the Act, on the redemption of the OPCO II preferred shares.

Generally, a capital gain on the disposition of any property, under subsection 39(1) of the Act, is a gain computed according to paragraph 40(1)(a) of the Act as the amount of the taxpayer's proceeds of disposition that exceeds the total adjusted cost base to the taxpayer of the property. Paragraph 54(j) of the definition of the expression "proceeds of disposition" specifically excludes an amount deemed to be a dividend received pursuant to subsections 84(2) and (3) of the Act. Paragraph 84(3)(a) of the Act applies to deem a shareholder to have received a dividend equal to the amount, if any, by which the amount paid by the corporation on the redemption, acquisition or cancellation, as the case may be, of those shares exceeds the PUC in respect of those shares immediately before that time.

In Mr. A's situation, there would be no gain on the disposition of the OPCO II preferred shares as the proceeds of disposition of the OPCO II preferred shares would be reduced to the amount of the total ACB of the shares ($XXXXXXXXXX) since the proceeds of disposition would exclude $XXXXXXXXXX, the amount of the dividend ($XXXXXXXXXX) Mr. A would be deemed to have received, pursuant to paragraph 84(3)(a) of the Act, that is the excess of the redemption value ($XXXXXXXXXX) over the PUC ($XXXXXXXXXX) of the OPCO II preferred shares.

We trust that our comments will be of assistance.

Yours truly,

Maurice Bisson, CGA
for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Legislation Branch