7 June 2002 Internal T.I. 2002-0134537 - ACB Calculation in Subs. 86.1(3)

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: Subsection 86.1(3) provides for adjustments to the cost base of "an original share" and "a spin-off share". In the case of a spin-off where the ratio of original shares to spin-off shares is not 1:1 (for example, where the taxpayer receives 0.5 spin-off shares for every one original share that he or she holds), should the term "the spin-off share" as used in "B" and "C" of the calculation always mean a single, whole share or should it refer to that fraction of a whole spin-off share that is equal to a single, whole original share?

Position: The better position is that the distribution ratio (i.e., number of spin-off shares received per original share held) should be taken into account in calculating the ACB adjustments.

Reasons: To interpret "the spin-off share", for purposes of subsection 86.1(3), as meaning a single, whole share leads to absurd results. Also, "spin-off share" and "original share" are not defined as such; those terms are defined only as a collective (i.e., "spin-off shares" and "original shares"). The ACB adjustments in subsection 86.1(3) are consistent if made either by considering the shares collectively or by taking into account the distribution ratio. Also, the definition of "share" in subsection 248(1) includes a fraction of a share, therefore, it is not unreasonable to interpret "spin-off share" as meaning "the share, or fraction of a share" that is received on account of each original share held. See FITAC document # F 2002-0118937.

Mr. Phil Fortier

International Tax Directorate
344 Slater Street 2002-013453
Ottawa ON K1A 0L5 Eliza Erskine

June 7, 2002

Dear Mr. Fortier:

Re: Adjusted Cost Base ("ACB") Calculation in Subsection 86.1(3) of the Income Tax Act (the "Act") - Distributions in a Ratio that is not 1:1

This is in reply to your email letter to us of April 12, 2002 (the "Email Letter"), in which you asked us to consider the proper application of subsection 86.1(3) of the Act to a foreign spin-off where less than a single, whole "spin-off share" is received by a Canadian shareholder of a foreign corporation in respect of each "original share" held by that shareholder in the distributing corporation. The terms "spin-off shares" and "original shares" are defined in subsection 86.1(2) of the Act.

Issue

The ACB calculation set out in subsection 86.1(3) of the Act provides that there must be deducted from the pre-distribution ACB of each "original share", an amount equal to the formula

A x (B/C)

where A is the pre-distribution ACB of "the original share", B is the post-distribution fair market value ("FMV") of "the spin-off share", and C is the sum of the post-distribution FMV of "the original share" and the post-distribution FMV of "the spin-off share" (emphasis added to the actual words used in the Act). The post-distribution ACB of "the spin-off share" to the Canadian shareholder is equal to the amount by which the ACB of "the taxpayer's original share" was reduced. As noted by Stephen Betts in the Email Letter, the difficulty is that the language used in this ACB calculation appears to assume that one "spin-off share" is received for each "original share" held by the Canadian shareholder, which is rarely the case. The sample ACB calculation that was provided by the Department of Finance ("Finance") with the Technical Notes to section 86.1, described a situation where a Canadian shareholder with one share of a particular foreign corporation received one share of another foreign corporation from the particular foreign corporation in a "spin-off" scenario.

The problem that arises is best explained through a numerical example. As the numerical example provided by Mr. Betts in the Email Letter is based on an actual existing spin-off transaction involving specific taxpayers, we have used different numbers below.

Example

? Corporation X ("Xco") is a U.S. corporation that owns 10,000 shares of corporation Y ("Yco"), which is another U.S. corporation. The Yco shares have a total FMV of $100,000, or $10 per share (which we will assume remains the same after the spin-off transaction).

? Xco has 40,000 existing and outstanding shares.

? Xco decides to "spin-off" its interest in Yco to its shareholders by distributing to each of its shareholders 0.25 of a Yco share for each Xco share held.

? A particular Canadian resident shareholder, Ms. A, holds 400 shares of Xco with an ACB of $25 per share.

? She receives 100 shares of Yco as a stock dividend from Xco as a result of the spin-off transaction. Ms. A needs to calculate what her ACB is for both her Xco shares (the "original shares") and her Yco shares (the "spin-off shares") as a result of the spin-off transaction.

? The FMV of the Xco shares after the distribution is $40 per share.

If Ms. A calculates her ACB for her Xco and Yco shares on the assumption that "a spin-off share", for purposes of subsection 86.1(3) is a single, whole share of Yco, then she will reduce the ACB of her Xco shares by

$25 x ($10/$50) = $5

to $20 per share and her ACB for each Yco share will be $5. Thus, before the spin-off transaction, Ms. A had 400 Xco shares with a total ACB of $10,000. After the spin-off transaction, Ms. A will have 400 Xco shares with a total ACB of $8,000, and 100 Yco shares with a total ACB of $500. In other words, Ms. A will "lose" $1,500 worth of basis.

If, on the other hand, Ms. A calculates her ACB for her Xco and Yco shares on the assumption that "a spin-off share", for purposes of subsection 86.1(3) is equal to that fraction of a Yco share that she actually received per Xco share she held, then she will reduce the ACB of her Xco shares by only

$25 x ($2.50/$42.50) = $1.47

to $23.53 and the ACB of each of her one-quarter of a Yco share will be $1.47. This means that Ms. A's ACB of a single, whole Yco share will be $5.88. Thus, before the spin-off transaction, Ms. A had 400 Xco shares with a total ACB of $10,000 and after the spin-off transaction, Ms. A will have 400 Xco shares with a total ACB of $9,412 and 100 Yco shares with a total ACB of $588. In other words, the total ACB available to Ms. A is the same before and after the spin-off transaction ($9,412 + $588 = $10,000).

The issue is: what is the correct interpretation of "a spin-off share" for purposes of subsection 86.1(3) of the Act?

Our Comments

In our opinion, the better view is that "a spin-off share", for purposes of subsection 86.1(3) of the Act, is that fraction of a whole share of the corporation being spun-off that is received by a taxpayer in respect of one whole share in the distributing corporation. This interpretation is consistent with the apparent legislative intent of the provision, as it allocates a taxpayer's total basis available between his or her original shares and his or her acquired shares without actually altering it. We cannot see any policy reason for the total basis to be reduced just because the taxpayer receives shares pursuant to a spin-off transaction.

This interpretation is also consistent with the wording of subsections 86.1(2) and 86.1(3), and the definition of "share" in subsection 248(1) of the Act. Subsection 86.1(2) defines "original shares" as "all of the taxpayer's common shares of the capital stock of the [distributing] corporation", and "spin-off shares" as "common shares of the capital stock of another corporation that were owned by the [distributing] corporation immediately before their distribution to the taxpayer". The preamble to subsection 86.1(3) reads as follows: "Where a spin-off share is distributed by a corporation to a taxpayer pursuant to an eligible distribution with respect to an original share of the taxpayer, ..." In our view, the words "with respect to an original share" in the preamble to subsection 86.1(3) indicate that "spin-off share" in this context refers to the share or that fraction of a share that is received by the taxpayer with respect to a single share held by him or her in the distributing corporation. This is supported by the definition of "share" in subsection 248(1), which provides that for purposes of the Act "share" means a share or a fraction of a share. It is our view that for purposes of subsection 86.1(3), share must be given its full expanded meaning in order for the provision to operate in a manner that is consistent with both its object and wording. The definitions provided in subsection 86.1(2) do not conflict with this interpretation, as they only define the collective terms, without restricting the meaning to be given to the singular terms "original share" and "spin-off share".

We trust that our comments will be helpful to you. We attach a copy of our document # F 2002-0118937, dealing with the same issue in French, as you requested in our telephone conversation of June 6, 2002 (Betts/Erskine).

Yours truly,

Jim Wilson
for Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch

Enclosure

c.c.: Stephen Betts
International Tax Directorate