17 February 2003 External T.I. 2002-0176455 - Amount Added to Paid-up Capital of Shares

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 s. 84(1) deems the payment of a dividend in a particular reorganization scenario.

Position: Not likely.

Reasons: The increase to the value of the corporation's assets could offset the increase to its paid-up capital and therefore the exception in s. 84(1)(b)(i) would apply. However, s. 84(2), s. 84.1 and s. 245(2) could be applicable in such circumstances.

XXXXXXXXXX 2002-017645
J. MacGillivray
February 17, 2003

Dear XXXXXXXXXX,

Re: Amount Added to Paid-Up Capital of Shares Under a Particular Reorganization

This is in reply to your facsimile of November 28, 2002 wherein you requested a technical interpretation with respect to the amount to be added to the paid-up capital of shares of a corporation and the possible application of s. 84(1) of the Income Tax Act (Canada) (the "Act") under the following reorganization scenario:

1. Opco is a "taxable Canadian corporation", as defined pursuant to s. 89 of the Act. Opco has two shareholders, Aco and Bco, which are also taxable Canadian corporations. Aco holds 30 common shares of Opco ("Opco Shares"). Bco holds 70 Opco Shares. There are no other issued and outstanding shares of Opco.

2. The "adjusted cost base" and "paid-up capital" of Aco's Opco Shares is $30. The fair market value of Aco's Opco Shares is $300.

3. A, an individual, is the sole shareholder of Aco. A holds 30 common shares of Aco, which have an aggregate fair market value of $300 and adjusted cost base and paid-up capital of $30. Aco has no liabilities and its sole asset is the 30 Opco Shares indicated above. It is assumed that A holds the Aco common shares as capital property for the purposes of the Act.

4. Opco owns assets having a fair market value of $1,000. It has no liabilities.

5. A wishes to hold his 30 Opco Shares directly to facilitate a subsequent disposition. To do so, A transfers the 30 common shares of Aco to Opco in exchange for 30 Opco Shares, which are issued from treasury.

6. A will recognize a capital gain of $270 on this transaction and will claim a deduction under s. 110.6 of the Act to shelter the gain from tax.

7. It is assumed that A deals at arm's length with Opco such that s. 84.1 of the Act will not apply to this transfer.

8. Immediately following the transfer of the 30 Aco common shares to Opco by A, Aco will be wound-up into Opco.

You asked us to confirm that the increase to the "paid-up capital" of the Opco Shares on the issuance of the 30 Opco Shares to A is $300 and that the increase to paid-up capital of the Opco Shares will not give rise to a deemed dividend under s. 84(1) of the Act by reason of s. 84(1)(b)(i) since the value of Opco's assets less its liabilities will also increase by $300. Furthermore, you asked us to consider whether our response to these points would differ if the paid-up capital of the 30 Aco common shares held by A is $300 instead of $30.

Our Comments

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an Advance Income Tax Ruling request. 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 its views. However, we are prepared to offer the following comments to the scenario described above.

Generally speaking, the increase to the paid-up capital of a class of shares of a corporation resulting from an issuance of shares by the corporation is initially determined without reference to the Act, but with reference to applicable corporate laws. In this regard, paragraphs 2 and 3 of Interpretation Bulletin IT-463R2 "Paid-up Capital" state the following:

2. Since subparagraph (b)(iii) of the definition of "paid-up capital" provides that the amount of the paid-up capital of a class of shares is initially determined without reference to the provisions of the Income Tax Act, the calculation is based on the relevant corporate law rather than tax law. The amount calculated under corporate law is usually referred to as the "stated capital" of the class of shares. The stated capital is subject to adjustment by specific provisions (see 7 below) of the Income Tax Act in order to determine the paid-up capital of the class of shares. The amount of the stated capital for a particular class of shares is often indicated on a corporation's financial statements.

3. In regard to the issuance of shares, the stated capital account reflects

(a) the par value of shares issued with a par value,

(b) the amount ascribed by the directors for shares issued without par value or, in some jurisdictions, the fair market value of the consideration received for shares issued without par value,

(c) a reduction for discounts granted (where permitted) for par value shares, and

(d) a reduction for unpaid amounts (where permitted) for any issue.

In addition, certain actions that a corporation takes after issuing shares may affect stated capital as determined under applicable corporate law.

Accordingly, the amount that Opco adds to the stated capital of the Opco Shares under applicable corporate law on the issuance of the 30 Opco Shares to A will initially determine the addition to the paid-up capital of the Opco Shares for the purposes of the Act. Canadian corporate law statutes generally provide that a corporation shall add the full amount of consideration it receives for any shares it issues to the appropriate stated capital account,¹ but shall not add an amount greater than the full amount of the consideration so received.² In addition, the corporate law statutes generally provide that a share shall not be issued until the consideration for the share is fully paid in money or in property or past services that are not less in value than the fair equivalent of money that the corporation would have received if the share had been issued for money.³

Assuming that Opco is governed by similar corporate laws, Opco will not be permitted to issue the 30 Opco Shares to A unless the 30 Aco common shares to be received by Opco as consideration have a value of $300, being the fair equivalent of money that Opco could receive if it issued 30 Opco Shares for cash. If 30 Opco Shares are issued for cash, Opco should be able to receive $300 from an arm's length purchaser in an open market. This is because the 30 Opco Shares issued for $300 of cash consideration should have a fair market value of $300 immediately after their issuance as those 30 Opco Shares will in substance represent a 30/130 share in Opco's assets, which should have a fair market value of $1,300. It therefore seems reasonable to conclude that Opco could issue the 30 Opco Shares in exchange for the 30 Aco common shares under such corporate laws since the Aco common shares should have a fair market value of $300 and are thus equivalent in value to the amount of money that Opco would have received if it had issued the 30 Opco Shares for cash.

Accordingly, we expect that Opco would add $300 to the stated capital of the Opco Shares upon the issuance of 30 Opco Shares to Aco, which would appear to comply with the corporate law provisions described above.⁴

Provided that A and Opco jointly elect pursuant to s. 85(1) of the Act within the time limit set forth in s. 85(6) to deem that A has disposed of the 30 Aco common shares for proceeds of disposition of $300, the paid-up capital of the Opco Shares will increase by $300 upon the issuance of the 30 Opco Shares to A. If A and Opco do not jointly elect under s. 85(1) of the Act and A and Opco deal with each other at arm's length, s. 85.1(2.1)(a) of the Act would apply, thereby reducing the addition to the paid-up capital of the Opco Shares otherwise determined by an amount equal to the amount otherwise determined less the paid-up capital of the Aco common shares received by Opco on the exchange. We also note that s. 85.1(2.1)(a) of the Act would apply in this manner even if A chose to include a $270 capital gain in computing A's income from the disposition of the Aco common shares occurring on the share exchange, but did not jointly elect with Opco under s. 85(1) of the Act in respect of that transaction. Should s. 85.1 of the Act be applicable to the exchange of the 30 Aco common shares for the 30 Opco Shares, the $300 addition to the paid-up capital of the Opco Shares otherwise determined would be reduced by $270 under s. 85.1(2.1)(a), thus resulting in a net addition of $30 to the paid-up capital of the Opco Shares arising from the issuance of the 30 Opco Shares to A.

As regards the application of s. 84(1) of the Act to the above scenario, we are of the view that, for the purposes of s. 84(1)(b)(i) of the Act, the value of Opco's assets less its liabilities could increase by $300 when Opco acquires the Aco common shares. If so, s. 84(1) of the Act will not deem that Opco has paid a dividend to its shareholders as a consequence of the increase to the paid-up capital of the Opco Shares. Subparagraph 84(1)(b)(i) of the Act requires a valuation of each asset held by the corporation whose paid-up capital has increased and that the corporation's liabilities be subtracted from the aggregate of the asset values to determine if there has been any increase in "net asset value" of the corporation. Although the value of the Aco common shares held by Opco is wholly derived from the value of Opco's other assets in the above scenario, the Aco common shares are distinct from those other assets and could presumably be sold by Opco to an arm's length purchaser immediately after the share exchange for fair market value proceeds of $300. While it is clear that Opco's other assets are in substance being double-counted in this particular scenario, we are of the view that the wording of s. 84(1)(b)(i) requires that the calculation of the increase to asset value be done on an asset-by-asset basis and any property held by the corporation would be an asset for this purpose. Therefore, the fact that the Aco common shares derive value from Opco's other assets should not permit any departure from the method of calculation that is required by the wording of the provision.

The above comments are equally applicable if the paid-up capital of the Aco common shares was $300, except that s. 85.1(2.1)(a) of the Act would not reduce the addition to the paid-up capital of the Opco Shares otherwise determined if A and Opco did not file a joint election under s. 85(1) of the Act within the time limit set forth in s. 85(6).

Although we are of the view that s. 84(1) may not deem the payment of a dividend by Opco in the above scenario, we believe that the type of reorganization described therein could be utilized in certain situations to strip corporate surplus or to artificially increase the paid-up capital of a class of shares of a corporation. In such situations, we believe that the application of s. 84(2) or the general anti-avoidance rule ("GAAR") in s. 245 of the Act may be warranted. The Tax Court of Canada decisions in RMM Canadian Enterprises Inc. v. R., [1998] 1 C.T.C. 2300, 97 D.T.C. 302, McNichol v. R., [1997] 2 C.T.C. 2088, 97 D.T.C. 111 and Nadeau v. R., [1999] 3 C.T.C. 2235, 99 D.T.C. 324 demonstrate that GAAR can be applied to series of transactions which are primarily intended to either distribute corporate surplus as a capital gain that would otherwise be taxed as a dividend or artificially increase the paid-up capital of shares of a corporation.

Furthermore, s. 84.1 of the Act could apply to similar transactions if the parties to the share exchange transaction do not deal at arm's length. While it was assumed that A is dealing at arm's length with Opco at all relevant times in the above scenario, it is a ultimately a question of fact as to whether A deals at arm's length with Opco, which requires an examination of all of the facts and circumstances surrounding the reorganization transactions. The Tax Court of Canada's reasoning in the RMM Canadian Enterprises Inc. case, referred to above, may support the view that A would not be considered to deal at arm's length with Opco with respect to the acquisition by Opco of the Aco common shares. For a more detailed discussion of whether persons deal at arm's length, we refer you to Interpretation Bulletin IT-419R "Meaning of Arm's Length".

Having regard to the potential application of s. 84(2), s. 84.1 and s. 245 of the Act, it is advisable to apply for an advance income tax ruling before carrying out this type of reorganization.

We trust our comments will be of assistance to you. These comments are provided in accordance with the practice outlined in paragraph 22 of Information Circular 70-6R5 issued on May 17, 2002.

Yours truly,

Mark Symes
Section Manager
for Division Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Legislation Branch

ENDNOTES

¹ See for example s. 26(2) of the Canada Business Corporations Act ("CBCA") and s. 24(2) of the Ontario Business Corporations Act ("OBCA").

² Subsection 26(4) of the CBCA and s. 24(4) of the OBCA.

³ Subsection 25(3) of the CBCA and s. 23(3) of the OBCA.

⁴ We also note that Aco will generally be required to dispose of its Opco Shares within 5 years after the share exchange in order to comply with corporate law rules (for example, s. 30 of the CBCA and s. 28 of the OBCA) that restrict the ability of a subsidiary corporation to hold shares in its parent. In this regard, you have indicated in the hypothetical scenario that Aco will be wound-up into Opco after the share exchange, which would result in the cancellation of the 30 Opco Shares held by Aco.