2003 Ruling 2003-0181713 - XXXXXXXXXX

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: Application of 84.1 and GAAR to the creation of a special corporation that is set-up to acquire the shares of the employer corporation from its employee.

Position: Favourable rulings provided.

Reasons: The law.

XXXXXXXXXX 2003-018171

XXXXXXXXXX, 2003

Dear XXXXXXXXXX:

Re: XXXXXXXXXX

Advance Income Tax Ruling Request

This is in reply to your letter of XXXXXXXXXX, and your subsequent correspondence, wherein you requested an advance income tax ruling on behalf of the above-noted taxpayer. You have advised us that to the best of your knowledge and that of the taxpayers involved none of the issues involved in this ruling request is:

(i) in an earlier return of the taxpayer or a related person;

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

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

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

(v) the subject of a ruling previously issued by the Income Tax Rulings Directorate.

The taxpayer has also represented that the proposed transactions described herein will not result in any taxpayer described herein being unable to pay its existing outstanding tax liabilities.

DEFINITIONS

In this letter all monetary amounts are expressed in Canadian dollars and the following terms have the meanings specified:

(a) "Act" means the Income Tax Act (Canada), R.S.C. 1985 (5th Supp.) c.1, as amended from time to time and consolidated to the date of this letter and, unless otherwise expressly stated, every reference herein to a part, section or subsection, paragraph or subparagraph and clause or subclause is a reference to the relevant provision of the Act and the Income Tax Regulations thereunder are referred to as the "Regulations";

(b) "arm's length" has the meaning assigned by section 251;

(c) "Canadian corporation" has the meaning assigned by subsection 89(1);

(d) "Canadian-controlled private corporation" has the meaning assigned by subsection 125(7);

(e) "CCRA" means the Canada Customs and Revenue Agency;

(f) "Employees" means the Canadian-resident directors, officers and employees of Employerco and "Employee" means any one of them;

(g) "Employerco" means XXXXXXXXXX and is more fully described in Paragraphs 1 and 2;

(h) "fair market value" means the highest price available in an open an unrestricted market between informed, prudent parties acting at arm's length and under no compulsion to act;

(i) XXXXXXXXXX;

(j) "paid-up capital" has the meaning assigned by subsection 89(1);

(k) "Paragraph" refers to a numbered paragraph in this advance income tax ruling;

(l) "prescribed stock exchange" has the meaning assigned by section 3200 of the Regulations;

(m) "Proposed Transactions" means the transactions described in Paragraphs 10 to 17;

(n) "Pubco" means XXXXXXXXXX, a taxable Canadian corporation and a public corporation whose shares are traded on prescribed stock exchanges;

(o) "public corporation" has the meaning assigned by subsection 89(1);

(p) "refundable dividend tax on hand" has the meaning assigned by subsection 129(3);

(q) "Shareholder 1" means one particular employee of Pubco who will be chosen before the Proposed Transactions are entered into;

(r) "Shareholder 2" means a newly incorporated corporation of a particular law firm that will be chosen before the Proposed Transactions are entered into;

(s) "stated capital" shall be computed in accordance with the XXXXXXXXXX;

(t) "specified financial institution" has the meaning assigned by subsection 248(1);

(u) "taxable Canadian corporation" has the meaning assigned by subsection 89(1);

(v) "taxable dividend" has the meaning assigned by subsection 89(1);

(w) "taxable preferred share" has the meaning assigned by subsection 248(1); and

(x) "Xco" means the corporation to be incorporated as described in Paragraph 10.

FACTS

1. Employerco was incorporated under the XXXXXXXXXX. Employerco's corporate head office is located at XXXXXXXXXX. Employerco is a taxable Canadian corporation and a Canadian-controlled private corporation with a taxation year ending XXXXXXXXXX. Employerco's CCRA business number is XXXXXXXXXX and it files its federal corporate income tax returns with the XXXXXXXXXX TC but otherwise deals with the XXXXXXXXXX TSO.

2. Employerco carries on an active business in Canada. Employerco's principal business includes XXXXXXXXXX . Employerco is not a specified financial institution XXXXXXXXXX.

3. The authorized share capital of Employerco consists of an unlimited number of common shares without nominal or par value. The common shares of Employerco are not convertible or exchangeable. There are approximately XXXXXXXXXX common shares of Employerco issued and outstanding, which are held as follows:

Shareholder
# Shares
% Held

XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX

XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX

XXXXXXXXXX

4. The total paid-up capital attributable to all the issued and outstanding common shares of Employerco is currently $XXXXXXXXXX.

5. As noted above, Pubco owns XXXXXXXXXX% of Employerco's issued and outstanding common shares. XXXXXXXXXX.

6. While Pubco is Employerco's largest single shareholder, it is not entitled to any additional rights in any regard with respect to the control or management of Employerco apart from the rights associated with the shares that it owns in Employerco and, for greater certainty, Pubco does not control Employerco directly or indirectly within the meaning assigned by subsection 256(5.1). Pubco deals at arm's length with Employerco. XXXXXXXXXX.

7. The common shares of Employerco that are owned by the Employees as described in Paragraph 3 have generally been acquired under various stock incentive plans or from other shareholders of Employerco. Each Employee and Employerco have entered into a separate agreement (the "Agreement") that provides that upon the cessation of employment with Employerco (whether due to termination, death or disability) such Employee's common shares of Employerco must be sold. Under the terms of the Agreement, an Employee ceasing employment must first offer their Employerco common shares to other Employees and shareholders of Employerco. However, where the particular Employee's shares are not purchased by other Employees or shareholders of Employerco within 1 year such shares will be repurchased by Employerco subject to the terms of the Agreement. Employerco is authorized (and committed) to use at least XXXXXXXXXX% of its net free annual cash flow to repurchase its shares.

The purchase price for a selling Employee's common shares is based on a formula that is set out in the Agreement. The purchase price is intended to reflect the fair market value of the particular Employee's shares at the time they are sold.

8. Employerco is not currently and has never been a public corporation. Employerco's common shares are not currently, and have never been, purchased and sold in the manner in which shares are normally purchased and sold by any member of the public in the open market.

9. All of the Employees deal at arm's length with Employerco and Pubco and will deal at arm's length with Xco. All of the Employees hold their shares of Employerco as capital property.

PROPOSED TRANSACTIONS

10. Shareholder 1, Shareholder 2 and Employerco will incorporate Xco pursuant to the XXXXXXXXXX. Xco will be authorized to issue two classes of shares. The first class of shares ("Common Shares") will be entitled to one vote each, will entitle a holder to dividends on a discretionary basis, and will entitle a holder, subject to the rights of holders of other classes of shares, to receive the remaining property of Xco in the event of a liquidation, dissolution or winding up of Xco.

The terms of the second class of shares ("Preferred Shares") provide that they will be non-voting and redeemable and retractable for an amount per share (the "Redemption Amount") equal to the fair market value of the consideration received by Xco for the issue of such share. The Redemption Amount for a Preferred Share will be fixed at a specific dollar amount by a resolution of the board of directors of Xco upon the issuance of such share such that the Redemption Amount will be a specified amount for the purposes of subsection 191(4). For greater certainty, the Redemption Amount will not be described by reference to a formula or subject to change thereafter.

11. Shareholder 1, Shareholder 2 and Employerco will each subscribe for an equal number of Common Shares of Xco. As consideration for the Common Shares so issued, each of Shareholder 1, Shareholder 2 and Employerco will pay an equal nominal amount to Xco. Initially, the Common Shares will be the only class of shares issued and outstanding of Xco.

12. Shareholder 1 and Shareholder 2 will deal at arm's length with Pubco and will not own any shares of Employerco.

13. Each Agreement described in Paragraph 7 will be amended (the "Amended Agreement") to continue to allow for the purchase of the Employee's common shares of Employerco by Employerco and to also provide for the purchase of the Employee's common shares of Employerco by Xco in circumstances where Employerco would otherwise have been required to repurchase such shares. Each Amended Agreement will give the particular Employee the option of selecting either Xco or Employerco as the purchaser of the particular Employee's common shares of Employerco. Accordingly, under the terms of each Amended Agreement, at such time when Xco becomes obligated to repurchase the particular Employee's common shares of Employerco, Employerco will subscribe for a number of Preferred Shares of Xco for an aggregate subscription price that will equal the aggregate fair market value of the number of Employerco common shares to be sold by the particular Employee. The sole consideration to be paid by Employerco for the Preferred Shares issued by Xco will be cash.

The addition to the stated capital account maintained for the Preferred Shares of Xco under the XXXXXXXXXX will be equal to the aggregate subscription price paid by Employerco for such shares. However, immediately after the Preferred Shares of Xco are issued a shareholders' resolution will be passed to reduce the amount of the stated capital of such shares, without payment, to an amount that will be equal to the paid-up capital attributable the particular Employee's common shares of Employerco that are to be acquired by Xco as described in Paragraph 14. The Preferred Shares of Xco acquired by Employerco will be capital property to Employerco.

14. Xco will use the cash proceeds it receives from Employerco's subscription for Xco's Preferred Shares to purchase the common shares of Employerco from the particular selling Employee. The amount paid by Xco to a selling Employee for the Employee's common shares of Employerco will be equal to the price determined for those shares as set out in the formula in the Amended Agreement and which is intended to reflect the fair market value of those shares at that time. For greater certainty, the amount paid for a selling Employee's common shares of Employerco by Xco will not exceed the fair market value of such shares at the time they are acquired by Xco. The common shares of Employerco acquired by Xco will be capital property to Xco.

15. Immediately after the Proposed Transactions described in Paragraphs 13 and 14 are completed, Employerco will purchase its common shares held by Xco for cancellation. The purchase price will equal the aggregate fair market value of the number of Employerco common shares so purchased for cancellation. As consideration for such purchase, Employerco will issue a non-interest bearing demand promissory note to Xco (the "Xco Note") with a principal amount and fair market value equal to the aggregate fair market value of the common shares of Employerco so purchased for cancellation at that time.

Xco will also redeem its Preferred Shares held by Employerco. The redemption price will equal the aggregate Redemption Amount of the number of Preferred Shares so redeemed. As consideration for such purchase, Xco will issue a non-interest bearing demand promissory note to Employerco (the "Employerco Note") with a principal amount and fair market value equal to the aggregate fair market value of the Preferred Shares so redeemed.

16. The principal amount owing on the Xco Note will be set-off against the principal amount owing on the corresponding Employerco Note and the respective notes will be cancelled. For greater certainty, the principal amount and fair market value of the corresponding notes will be identical.

17. Xco will acquire the common shares of Employerco from the Employees as principal and will not act as an agent for Pubco or Employerco. At no time will Xco own more than XXXXXXXXXX% of the common shares of Employerco.

PURPOSE OF THE PROPOSED TRANSACTIONS

18. The purpose of the Proposed Transactions is to allow the Employees of Employerco to obtain capital gains treatment on the sale of their common shares of Employerco in the circumstances where Employerco would otherwise be required to repurchase such shares for cancellation as described in Paragraph 7. The purpose of the stated capital reduction of the Preferred Shares described in Paragraph 13 is to ensure that Xco is deemed to pay a dividend on the redemption of such shares to allow it to obtain a refund of any Part IV tax it may be required to pay as a result of the Proposed Transactions.

RULINGS

Provided that the preceding statements constitute a complete and accurate disclosure of all of the relevant facts, proposed transactions and the purpose of the Proposed Transactions, and provided that the Proposed Transactions are completed in the manner described above, our rulings are as set forth below.

A. Subsection 84(3) will not apply to deem an Employee to have received a dividend as a result of Xco's purchase of the particular Employee's common shares of Employerco described in Paragraph 14.

B. Xco's purchase of the particular Employee's common shares of Employerco described in Paragraph 14 shall not give rise to an employment benefit to the particular Employee under section 6, but such purchase by Xco shall not preclude any employment benefit which might arise by virtue of section 7.

C. Xco will be subject to Part IV tax under paragraph 186(1)(a) in respect of any taxable dividend that Xco is deemed to receive as a result of Employerco's purchase for cancellation of its common shares described in Paragraph 15.

D. Employerco will be subject to Part IV tax under paragraph 186(1)(b) in respect of any taxable dividend that Employerco is deemed to receive as a result of Xco's redemption of its Preferred Shares described in Paragraph 15, to the extent that Xco is entitled to a dividend refund (within the meaning of subsection 129(1)) in respect of any such dividend.

E. To the extent that a deemed dividend arises as a result of Xco's redemption of its Preferred Shares held by Employerco described in Paragraph 15, such deemed dividend will not be subject to Part IV.1 tax under section 187.2 or Part VI.1 tax under subsection 191.1.

F. Provided that the amount paid by Xco for a selling Employee's common shares of Employerco, pursuant to the formula in the Amended Agreement as described in Paragraph 14, does not exceed the fair market value of such shares at that time, determined without reference to the Amended Agreement, Xco's obligation to purchase such shares under the terms of the Amended Agreement, will not, in and by itself, cause the common shares of Employerco to be taxable preferred shares.

G. The amount of any deemed dividend received by Xco that is described in Ruling C and the amount of any deemed dividend received by Employerco that is described in Ruling D will be excluded from the proceeds of disposition of the particular shares of such person by virtue of paragraph (j) of the definition of "proceeds of disposition" in section 54 and any loss arising from such disposition will be reduced by the amount of any such dividends pursuant to subsection 112(3).

H. Section 84.1 will not apply to deem an Employee to have received a dividend on the sale of the particular Employee's Employerco common shares to Xco in the circumstances described in Paragraph 14.

I. Provided that the aggregate fair market value of the Preferred Shares does not exceed the aggregate adjusted cost base of such shares at the time such shares are redeemed by Xco as described in Paragraph 15, subsection 55(2) will not apply to any dividend deemed to be received by Employerco by subsection 84(3) in respect of that redemption.

J. Provided that the aggregate fair market value of the Employerco common shares does not exceed the aggregate adjusted cost base of such shares at the time such shares are purchased for cancellation by Employerco as described in Paragraph 15, subsection 55(2) will not apply to any dividend deemed to be received by Xco by subsection 84(3) in respect of that purchase for cancellation.

K. Provided that Employerco does not become a corporation described in subsection 183.1(1), subsection 183.1(2) will not apply to impose a tax on Employerco in respect of (i) all or any part of the amount paid by Xco to purchase the Employerco common shares from the Employees as described in Paragraph 14 or (ii) all or any part of the amount paid by Employerco to Xco to purchase the Employerco common shares from Xco as described in Paragraph 15.

L. Subsection 245(2) will not apply to the Proposed Transactions, in and by themselves, to re-determine the tax consequences confirmed in the rulings given.

The above rulings are given subject to the limitations and qualifications set out in IC 70-6R5 and are binding on the CCRA provided that the proposed transactions are completed by XXXXXXXXXX. These rulings are based on the law as it presently reads and do not take into account any proposed amendments to the Act which, if enacted into law, could have an effect on the rulings provided herein.

OTHER COMMENTS

Nothing in this letter should be construed as implying that the CCRA has confirmed, reviewed or has made any determination in respect of:

(a) the paid-up capital of any share or the adjusted cost base or fair market value of any property referred to herein including whether the purchase price of any share as determined by the formula in the Agreement or Amended Agreement actually represents the true fair market value of those shares;

(b) the amount of any non-capital loss or any other amount of any person referred to herein;

(c) whether Pubco controls Employerco directly or indirectly within the meaning assigned by subsection 256(5.1) or whether Pubco deals at arm's length with Employerco; or

(d) any other tax consequence relating to the facts, Proposed Transactions or any transaction or event taking place either prior to the Proposed Transactions or subsequent to the Proposed Transactions, whether described in this letter or not other than those specifically described in the rulings given above.

Yours truly,

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Legislation Branch