2002 Ruling 2002-0152183 - DEBT FORGIVENESS SHARES LOANS

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 GAAR applies to transactions

Position: No

Reasons: No misuse/abuse

XXXXXXXXXX 							2002-015218

XXXXXXXXXX, 2002

Re: Advance Income Tax Ruling - XXXXXXXXXX

We are writing in response to your letter of XXXXXXXXXX wherein you requested advance income tax rulings on behalf of the above taxpayer.

To the best of your knowledge, and that of the taxpayers involved, none of the issues contained herein is:

(i) dealt with in an earlier return of the taxpayers or a related person;

(ii) being considered by a tax services office or taxation centre in connection with a previously filed tax return of one or any of the taxpayers or a related person;

(iii) under objection by one or any of the taxpayers or a related person;

(iv) subject to a ruling previously issued by the Income Tax Rulings Directorate; or

(v) before the courts or, if a judgment has been issued, the time limit for appeal to a higher court has not expired.

In this letter, the following terms have the meanings specified:

(a) "A Co." means XXXXXXXXXX;

(b) "Act" means the Income Tax Act, R.S.C 1985 (5th Supp.) c.1, as amended to the date hereof, and, unless otherwise stated, every reference herein to a Part, section, subsection, paragraph or subparagraph is a reference to the relevant provision of the Act;

(c) "B Co." means XXXXXXXXXX;

(d) "Employee" means XXXXXXXXXX;

(e) "Public corporation" has the meaning assigned by subsection 89(1) of the Act;

(f) "Retiring allowance" has the meaning assigned by subsection 248(1) of the Act;

(g) "Taxable Canadian corporation" has the meaning assigned by subsection 89(1) of the Act;

FACTS

1. Each of A Co. and B Co. is a taxable Canadian corporation and a public corporation.

2. A Co. was formed by an amalgamation under the laws of the province of XXXXXXXXXX on XXXXXXXXXX (although its predecessor companies date back to XXXXXXXXXX). Its principal address is XXXXXXXXXX, its taxation year end is XXXXXXXXXX , its Business Number is XXXXXXXXXX, and its tax returns are filed in the XXXXXXXXXX Tax Services Office. A Co.'s XXXXXXXXXX shares ("A Co. shares") are listed for trading on the XXXXXXXXXX Stock Exchange XXXXXXXXXX.

3. B Co. was incorporated under the laws of the province of XXXXXXXXXX on XXXXXXXXXX. Its principal address is XXXXXXXXXX its taxation year end is XXXXXXXXXX, its Business Number is XXXXXXXXXX, and its tax returns are filed in the XXXXXXXXXX Tax Services Office. B Co.'s common shares ("B Co. shares") are listed for trading on the XXXXXXXXXX.

4. At the time of the formation of B Co., A Co. transferred a number of its operating entities to B Co. and generally acted as the promoter in connection with the initial public offering of B Co. shares in XXXXXXXXXX. As at XXXXXXXXXX A Co. held or controlled, directly or indirectly, approximately XXXXXXXXXX% of the issued and outstanding B Co. shares.

5. The Employee is a resident of Canada, residing at XXXXXXXXXX.

6. The Employee was originally employed by A Co. pursuant to an employment letter dated XXXXXXXXXX, with the title of President of A Co.'s XXXXXXXXXX division. As such, XXXXXXXXXX received a loan from A Co. in XXXXXXXXXX in the principal amount of $XXXXXXXXXX ("Loan No. 1") in order to acquire XXXXXXXXXX A Co. shares, which were pledged as security for Loan No. 1.

7. In connection with the initial public offering of B Co. Shares in XXXXXXXXXX, the Employee became employed for an indefinite term by B Co. as its President and CEO and entered into an Employment Contract dated as of XXXXXXXXXX, superseding the employment letter with A Co. (the "B Co. Employment Contract"). Under the B Co. Employment Contract, the Employee was entitled to receive compensation consisting of an annual base salary of $XXXXXXXXXX, a discretionary bonus up to XXXXXXXXXX% of the base salary, stock options, and other benefits including an automobile allowance of $XXXXXXXXXX per month.

8. Pursuant to section XXXXXXXXXX of the B Co. Employment Contract, the Employee was entitled to borrow up to $XXXXXXXXXX from B Co. in order to purchase B Co. shares as part of the initial public offering of B Co. shares. On XXXXXXXXXX, the Employee borrowed $XXXXXXXXXX from B Co. ("Loan No. 2") in order to acquire XXXXXXXXXX B Co. shares, which were pledged as security for Loan No. 2.

9. Also on XXXXXXXXXX, the Employee borrowed $XXXXXXXXXX from A Co. ("Loan No. 3") in order to acquire XXXXXXXXXX B Co. shares, which were pledged as security for Loan No. 3.

10. Each of Loan No. 1, Loan No. 2 and Loan No. 3 (hereinafter collectively referred to as the "Share Purchase Loans") is non-interest bearing except that, in the case of Loan No. 2 and Loan No.3, interest may be chargeable in the event that the pledged shares are sold prior to the XXXXXXXXXX anniversary date thereof, provided that such interest shall be no greater than the pre-tax gain on the sale of the shares. Each of the Share Purchase Loans was issued to Employee because of, or as a consequence of the previous, current or intended office or employment of Employee with A Co. or B Co.

11. The Employee has recognized a taxable benefit in connection with the Share Purchase Loans pursuant to subsection 80.4(1) of the Act, calculated by reference to the prescribed rates of interest under the Act applicable to taxable benefits in the form of non-interest bearing loans, in each of the XXXXXXXXXX taxation years. The amount of the benefit has also been deducted in calculating the Employee's income in each year, pursuant to paragraph 20(1)(c)of the Act, as interest deemed to be paid in the year under section 80.5 of the Act.

12. The Employee's employment with B Co. was terminated effective on XXXXXXXXXX. Under subparagraph 11(b)(ii) of the B Co. Employment Contract, if the Employee's employment is terminated without cause, XXXXXXXXXX is entitled to receive as severance 18 months of total compensation plus car allowance and benefits.

13. Loan No. 1 is due XXXXXXXXXX following the date of termination. Loan No. 2 is repayable in full XXXXXXXXXX following the date of termination. The promissory note evidencing Loan No. 3 states that it is due and payable in full XXXXXXXXXX after the termination of the Employee's employment.

14. At the present time, B Co. and the Employee are negotiating the settlement of their respective rights and obligations under the B Co. Employment Contract. Neither A Co. nor B Co. has issued a demand for payment in respect of the Share Purchase Loans, or taken any steps to realize on the security of the pledged shares which are held as security for the Share Purchase Loans.

15. As at the close of business on XXXXXXXXXX, the shares pledged as security for the Share Purchase Loans had an aggregate market value of $XXXXXXXXXX, based on a closing price for A Co. shares of $XXXXXXXXXX and a value for B Co. shares of $XXXXXXXXXX being the average of the bid and ask price on the XXXXXXXXX for that day. The principal amounts of the Share Purchase Loans in aggregate total $XXXXXXXXXX, leaving a potential shortfall upon realization of the security in the amount of $XXXXXXXXXX.

PROPOSED TRANSACTIONS

16. At such time or times as the parties mutually agree, the A Co. shares and B Co. shares which are held as security for the Share Purchase Loans, will be sold and the net proceeds thereof, net of any costs of disposition, will be applied to reduce the outstanding balance of the Share Purchase Loans. All such sales will be carried out at prevailing market prices and to arm's length purchasers. The remaining balance of the Share Purchase Loans, after all of the shares have been sold, is hereafter referred to as the "Deficiency".

17. A Co. and B Co. will enter into an agreement with the Employee to accept, in full satisfaction of the Deficiency, two new promissory notes issued by the Employee, one note evidencing the outstanding balance of Loan No. 1 and Loan No. 3 owing to A Co. ("Note 1") and the other evidencing the outstanding balance of Loan No. 2 owing to B Co. ("Note 2"). Each of Note 1 and Note 2 will be non-interest bearing, with the principal amount to be due and payable on the date which is XXXXXXXXXX following the date of the Employee's death (the "Maturity Date").

18. As part of the settlement of its obligations under the B Co. Employment Contract, B Co. will pay a retiring allowance to the Employee. The after-tax portion of the retiring allowance will be sufficient to enable the Employee to acquire, by payment of a single premium, a life insurance policy ensuring XXXXXXXXXX life (the "Life Policy") with a death benefit at least equal to the sum of the principal amounts of Note 1 and Note 2. In the context of the settlement of the rights of Employee under the employment contract with B Co., the payment by B Co. of amounts described in the Proposed Transactions (above and below) to Employee will be commercially reasonable and it is expected that the amount paid will not exceed the severance obligations which might have existed, in the absence of any concerns in respect of the Share Purchase Loans.

19. The Life Policy will be a universal life policy, fully paid by a single deposit, issued by an arm's length insurer, subject to normal underwriting requirements.

20. The Employee will execute a collateral assignment of the Life Policy in favour of A Co. and B Co., as security for the amounts owing under Note 1 and Note 2 respectively. As such, the Employee will not be entitled to surrender the policy without the consent of the assignee. Upon the death of the Employee, the insurer will pay the death benefit under the Life Policy, to the extent of the amount owing under Note 1 and Note 2, to A Co. and B Co. pursuant to the collateral assignment, and will pay any residual amount of the death benefit under the Life Policy to such beneficiary as may be designated by the Employee.

21. The Employee will irrevocably assign XXXXXXXXXX interest in the Life Policy and the death benefit payable thereunder to A Co. and B Co., as security for the amounts owing by XXXXXXXXXX under Note 1 and Note 2, respectively. An irrevocable assignment and direction will be given to the insurer, directing it to pay that death benefit to A Co. and B Co. as their interests appear, upon the death of the Employee.

22. As part of the overall settlement of their respective rights and obligations under the B Co. Employment Contract, B Co. has also agreed to make salary continuation payments to the Employee, based on XXXXXXXXXX base salary level, plus certain ancillary benefits including the automobile allowance and reimbursement of certain expenses, for a period of XXXXXXXXXX following the effective date of termination of the Employee's employment. Upon the completion of the said salary continuation payments, and the completion of the proposed transactions described herein, the parties will exchange mutual releases releasing any other claims arising out of the B Co. Employment Contract.

PURPOSES OF THE PROPOSED TRANSACTIONS

23. At the time of borrowing the Share Purchase Loans, it was never anticipated that the market value of the pledged shares would decline so precipitously, and that the Employee would be facing personal liability for the Deficiency, which XXXXXXXXXX has no means of satisfying.

24. Rather than forcing the Employee into personal bankruptcy, A Co. and B Co. have determined that it is in their best interests, as part of an overall settlement with the Employee, to accommodate XXXXXXXXXX by extending the terms of Note 1 and Note 2, effectively extending the term of the Share Purchase Loans, notwithstanding that the underlying collateral will have been sold and will no longer exist.

25. The extension of the term of the indebtedness, and securing of life insurance to provide a means of repayment, is a commercially reasonable arrangement between arm's length parties, which will ultimately make A Co. and B Co. whole. The Employee is otherwise lacking the financial means to repay the Deficiency.

26. In addition to satisfying the Employee's obligations in respect of the Share Purchase Loans, the parties wish to avoid triggering a taxable benefit in the Employee's hands, which could otherwise arise by virtue of a forgiveness of any portion of the Share Purchase Loans, which the Employee would also lack the financial means to satisfy.

RULINGS GIVEN

Provided that the statement of facts, the proposed transactions and the purposes thereof, all as described herein, are accurate and constitute complete disclosure of all of the representations, relevant facts, proposed transactions and the purposes thereof, and all of the proposed transactions are carried out as described above, our rulings are as set forth below:

A. No amount will be included in Employee's income under subsection 6(15) of the Act in respect of the transaction described in paragraph 17 above.

B. Subparagraphs 80(2)(h)(i) and (ii) of the Act will apply in respect of the transactions described in paragraph 17 above such that:

(i) an amount equal to the principal amount of the Note 1 shall be deemed to be paid by Employee at that time, because of the issue of the Note 1, in satisfaction of the principal amount of Loan #1 and Loan #3, and

(ii) Note #1 shall be deemed to have been issued for an amount equal to the amount, if any, by which

(A) the principal amount of Note #1 exceeds

(B) the amount, if any, by which the principal amount of Note #1 exceeds the amount for which Loan 1 and Loan 3 were issued;

C. Subparagraphs 80(2)(h)(i) and (ii) of the Act will apply in respect of the transactions described in paragraph 17 above such that:

(i) an amount equal to the principal amount of the Note 2 shall be deemed to be paid by Employee at that time, because of the issue of the Note 2, in satisfaction of the principal amount of Loan #2, and

(ii) Note #2 shall be deemed to have been issued for an amount equal to the amount, if any, by which

(A) the principal amount of Note #2 exceeds

(B) the amount, if any, by which the principal amount of Note #2 exceeds the amount for which Loan 2 was issued;

D. Subsection 20(3) of the Act will apply to the transactions described in paragraph 17 above to deem the borrowed money evidenced by Note 1 and Note 2, for the purposes of paragraphs 20(1)(c) and subsection 20.1(1) of the Act, to have been used for the purposes for which Loan #1, Loan #2 and Loan #3 were used or were deemed by this subsection to have been used, or to acquire the property in respect of which the amount was payable, as the case may be.

E. Paragraphs 20.1(1)(a) and (b) of the Act will apply to the transactions described in paragraph 17 above to deem the borrowed money evidenced by Note 1 and Note 2 to be used by Employee for the purpose of earning income from the shares described in paragraphs 6, 8 and 9 above.

F. In a taxation year, the provisions of subsections 6(9) and 80.4(1) will apply to include an amount in the income of Employee in respect of the Notes equal to the amount by which the amounts described in paragraphs 80.4(1)(a) and (b) for such taxation year exceed the amounts described in paragraphs 80.4(1)(c) or (d), if any, for such taxation year in respect of such Notes.

G. In a taxation year, section 80.5 of the Act will apply to the benefit deemed by section 80.4 of the Act to have been received in the taxation year by Employee (as described in Ruling F above) such that the amount of that benefit shall, for the purpose of paragraph 20(1)(c) of the Act, be deemed to be interest paid in, and payable in respect of, the year by the Employee pursuant to a legal obligation to pay interest on borrowed money.

H. The payment of the retiring allowance described in paragraph 18 above by B Co., subject to the general limitation contained in section 67 of the Act, will be deductible by B Co. in computing its income from its business for the taxation year in which such amount is paid, and such deduction will not be prohibited by subsections 18(1)(a) or 18(1)(b) of the Act.

I. The amount of the retiring allowance will be included in the Employee's income under subparagraph 56(1)(a)(ii) of the Act in the year in which it is received.

J. Subsection 245(2) of the Act will not be applicable as a result of the proposed transactions, in and by themselves, to redetermine the tax consequences confirmed in the rulings given.

CAVEAT

The above rulings are given subject to the general limitations and qualifications set out in Information Circular 70-6R5 (the "Circular") issued by the CCRA on May 17, 2002, and are binding provided that the Proposed Transactions described above have been carried out on or before XXXXXXXXXX.

These rulings are based on the Act in its present form and do not take into account the effect of any proposed amendments to the Act.

Nothing in this letter should be construed as implying that the CCRA has agreed to or accepted:

(a) the GST implications of any of the proposed transactions;

(b) any other tax consequences of the proposed transactions or of related transactions or events that are not described herein.

Yours truly,

XXXXXXXXXX
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch