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:

CCPC stock options exercised by employee after CCPC purchased by US publicly traded firm & CCPC options were exchanged for options in US co; Employee now wishing to dispose of US co shares and wants to know if section 44.1 capital gains deferral is available

Position: No

Reasons: US co shares are not eligible small business corporation shares and ss.44.1 (6) & ss.44.1 (7) are only available for shares not options.

2002-013145
XXXXXXXXXX Lena Holloway
613-957-2104
June 4, 2002

Re: Technical Interpretation Request - Section 44.1

This is in reply to your letter dated March 20, 2002, regarding the application of section 44.1 of the Income Tax Act to a specific hypothetical situation. All references hereunder are to the Income Tax Act (Canada) (the "Act") unless otherwise indicated.

The scenario described in your letter was as follows.

Background

An employee of a Canadian-controlled private corporation ("CCPC1") was granted employee stock options within the meaning of and subject to section 7. CCPC1 was subsequently purchased by a US based publicly traded company ("USco") who assumed the old options and converted them to options to purchase USco shares.

You indicate that the employee exercised his options and acquired USco shares which he has held for more than 185 days. You also indicate that the fair market value of these shares has increased since their acquisition by the employee. Your letter stated that the employee would like to take advantage of the new rollover provisions under section 44.1 by selling the USco shares acquired via the exercise of the options and using some of the proceeds to establish a new small business. You had asked whether such an undertaking would qualify for capital gains deferral under section 44.1 and if so, what would be the amount of the deferral? You had also asked whether the incentive under section 44.1 was available in respect to a completely different business from that one being replaced provided the new business meets the definition of an eligible small business corporation.

While the particular circumstances, on which you have asked for our views, have been described in your letter as a hypothetical situation we would like to highlight, that this Directorate does not comment on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling. If you wish to obtain a binding commitment with respect to an actual case similar to that outlined in your letter, an advance income tax ruling application should be submitted as explained in Information Circular 70-6R4 issued by Canada Customs and Revenue Agency ("CCRA") on January 29, 2001. We are willing, however, to provide you with some general comments on the subject of the capital gain deferral for investments in small businesses.

Our Comments

The technical notes accompanying the introduction of the capital gains deferral for eligible small business investments offered the following explanation of this tax incentive:

New subsection 44.1(2) of the Act permits an individual that has a capital gain, determined without reference to section 44.1, from a qualifying disposition in a taxation year to claim the permitted deferral of the individual in determining the individual's capital gain for the year from the disposition. Where the individual has a permitted deferral in respect of a qualifying disposition, the capital gain from the disposition is deemed to be the amount by which the individual's capital gain (determined without reference to section 44.1) exceeds the permitted deferral. The individual can establish a permitted deferral less than the maximum amount available by designating a lesser amount of replacement shares.

There are many restrictions and conditions to be met before one can avail themselves of the deferral of all or a portion of a gain from a qualifying disposition under subsection 44.1(2). For example a "qualifying disposition" is defined in subsection 44.1(1) and refers to the disposition of a share that was an "eligible small business corporation share"("ESBC share") of an individual, and a common share of an "active business corporation". The shares must have been owned by the individual throughout the 185-day period that ended immediately before the disposition.

ESBC shares are common shares issued by a corporation to the individual, if at the time of the issue the corporation was an "eligible small business corporation", and the total carrying value of the assets (valued as per generally accepted accounting principles) of the corporation and corporations related to it did not exceed $50 million either immediately before or after the issuance. Under subsection 44.1(1), an "eligible small business corporation" must be a Canadian-controlled private corporation (as defined in subsection 125(7)) where all or substantially all of the fair market value of the assets is attributable to assets that are:

- used principally in an active business carried on primarily in Canada by the corporation or a related eligible small business corporation;

- shares or debt of other related eligible small business corporations; or

- a combination thereof.

In the hypothetical scenario presented in your letter, the employee did not acquire ESBC shares at the time the options were exercised. While subsections 44.1(6) and 44.1(7) can preserve one's eligibility to claim the small business investment deferral in certain rollover transactions, they would not apply in your situation. Under subsection 44.1(6), where an individual receives ESBC shares (the "new shares") as the sole consideration for the disposition of shares issued by another corporation that were ESBC shares ("exchanged shares"), the individual is deemed to own the new shares throughout the period that he or she owned the exchanged shares provided that certain conditions are met. As the exchange described in your letter is not an exchange of ESBC shares subsection 44.1(6) is not applicable. Similarly, under subsection 44.1(7) where an individual disposes of common shares of a corporation ("exchanged shares") and receives as consideration only common shares of another corporation ("new shares"), the new shares are deemed to be ESBC shares and shares of an active business corporation that were owned by the individual throughout the period that the exchanged shares were owned by the individual provided again that certain conditions are met. Again, under the scenario outlined in your letter there is no exchange of shares, but rather an exchange of options, making subsection 44.1(7) inapplicable. Accordingly, the deferral in section 44.1 would not be available in the scenario presented in your letter.

Finally, it is not a precondition for the application of section 44.1 that the business of the corporation whose shares qualify as replacement shares, be similar to the former business. Subsection 44.1(1) describes the type of share that qualifies as a "replacement share" as an ESBC share that is:

- acquired by the individual in the year or within 60 days after the year-end but not later than 120 days after the qualifying disposition; and

- designated by the individual to be a replacement share in the individual's tax return for the year.

As indicated in paragraph 22 of Information Circular 70-6R4, the above comments do not constitute an income tax ruling and accordingly are not binding on the CCRA. The foregoing comments represent our general views with respect to the subject matter and are not an exhaustive explanation of the many details of the small business investment capital gains deferral.

With respect to your comments concerning the possible revision of IT-259R3 in order to deal with new section 44.1, please note that there is no plan to make such a revision at this time, however we have forwarded your suggestion to our Technical Publications and Projects Section for their consideration.

We trust the above comments are of assistance to you.

Yours truly,

Milled Azzi, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch

c.c. Roxane Brazeau-Leblond

Manager, Technical Publications and Projects Section
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