28 March 2003 External T.I. 2002-0166655 - Sale of shares to co-owners

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: The application of section 84.1 to a group of shareholders who transfer their shares of Opco to a holding corporation, Xyco.

Position: Section 84.1 may apply.

Reasons: It appears that the shareholders are acting in concert and therefore do not factually deal at arm's length with Xyco.

XXXXXXXXXX 2002-016665
F. Francis
March 28, 2003

Dear XXXXXXXXXX:

This is in reply to your letter of October 4, 2002, and further to a telephone conversation on March 21, 2003, wherein you requested our comments with respect to the application of section 84.1 of the Income Tax Act (the "Act") to the following situation:

- Opco is a "Canadian-controlled private corporation" and a "small business corporation" as defined under subsection 248(1).

- The shares of Opco are held as follows:

Mr. A 26%

Mrs. A 12%

Mr. B 26%

Mrs. B 12%

Mr. X 12%

Mr. Y 12%

- The adjusted cost base of the shares of Opco held by the shareholders is a nominal amount. The shares of Opco meet the definition of "qualified small business corporation share" in subsection 110.6(1).

- The paid-up capital of the class of shares of Opco is a nominal amount.

- Mr. and Mrs. A are married to each other. Mr. B and Mrs. B are married to each other.

- Mr. A and Mrs. A are not related to Mr. B and Mrs. B.

- Mr. X and Mr. Y deal at arm's length with each other and are not related to Mr. A and Mrs. A and Mr. B and Mrs. B.

Since Mr. X and Mr. Y want to purchase the shares of Opco that are held by Mrs. A and Mrs. B, they contemplate the following transactions:

- Mr. X and Mr. Y incorporate a new corporation ("Xyco") and transfer their shares of Opco to Xyco;

- Xyco purchases the shares of Opco held by Mrs. A and Mrs. B at fair market value for non-share consideration. Mrs. A and Mrs. B will claim a deduction under subsection 110.6(2.1) in respect of the capital gains realized on the sale.

- Xyco finances the purchase of shares by borrowing money from an arm's length financial institution bearing interest at the commercial rate; and

- Xyco and Opco may amalgamate to form Amalco, and, accordingly, Xyco's debt will become interest-bearing debt of Amalco. If Xyco and Opco do not amalgamate, Xyco will use the cash received from Opco as payment for dividends to make the payments of interest on the debt.

It is your view that section 84.1 should not apply to the transfer of Opco shares held by Mr. X and Mr. Y to Xyco since X and Y are unrelated persons who deal with each other at arm's length and therefore deal at arm's length with Xyco. You state that paragraph 84.1(2)(b) would not be applicable since X and Y as a group do not control Opco before the transfer of shares. You further state that section 84.1 should not apply to the transfer of Opco shares by Mrs. A and Mrs. B to Xyco since each of Mrs. A and Mrs. B is not related to Xyco.

You further enquire as to whether section 84.1 would be applicable if the shareholdings of Opco were varied such that Mrs. A, Mrs. B, Mr. X and Mr. Y each held 13% of the issued share capital of Opco. In that situation the proposed transactions would result in an acquisition of control of Opco.

OUR COMMENTS

We agree that paragraph 84.1(2)(b) will not apply to deem Mr. X and Mr. Y to deal at arm's length with Xyco. However, we note that, pursuant to paragraph 251(1)(c), it is a question of fact as to whether persons not related to each other are, at a particular time, dealing with each other at arm's length. In this particular situation, Mr. A, Mrs. A, Mr. B, Mrs. B, Mr. X and Mr. Y appear to be acting in concert to direct Xyco in connection with the sale of the shares of Opco. While there may be arm's length bargaining concerning the price to be paid for the shares of Opco, the shareholders appear to be acting in a highly interdependent manner to avoid tax on the transactions. In our view, Xyco may be viewed as merely accommodating the shareholders by structuring the transactions in this manner, since it does not appear to have any independent interest in acquiring the shares of Opco. Consequently, section 84.1 may apply to the above-described situation. Further, if it is determined that Xyco is acting as an agent for Opco, subsection 84(3) may apply to the purchase of the shares owned by Mrs. A and Mrs. B by Xyco. In our view, the same comments would be applicable in the second factual situation described in your letter.

The above comments are an expression of opinion and, as noted in Information Circular 70-6R5 issued on May 17, 2003, are not binding on the Canada Customs and Revenue Agency.

Yours truly,

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate