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.
Principal Issues: Whether additional proceeds determined under s. 69(1)(b) in respect of share redemption form part of dividend amount determined under 84(3).
Position: No.
Reasons: Additional proceeds recognized under s. 69(1)(b) are not an amount paid on the redemption of shares for the purposes of s. 84(3).
December 31, 2004
XXXXXXXXXX Tax Services Office Income Tax Rulings Directorate
XXXXXXXXXX Reorganizations and
XXXXXXXXXX Resources Division
J. MacGillivray
Attention: XXXXXXXXXX (613) 948-5274
2004-009178
Redemption of Shares for Less than Fair Market Value
This is in reply to your facsimile of August 19, 2004 and your memorandum of September 9, 2004 in which you requested our views regarding the application of s. 69(1)(b) of the Income Tax Act (Canada) (the "Act") to the transactions described below. We understand that the transactions are being reviewed in the context of an audit of the XXXXXXXXXX taxation year of XXXXXXXXXX, a taxable Canadian corporation and a private corporation for the purposes of the Act.
Background
1. XXXXXXXXXX had 4 classes of issued and outstanding shares: Class A Common Shares, Class A Preferred Shares, Class B Preferred Shares and Common Shares. In addition, XXXXXXXXXX had authorized Class C Preferred Shares, but none were issued.
2. The Class A Common Shares were non-voting, entitled their holders to dividends as and when declared by the board of directors of XXXXXXXXXX , ranked rateably with the Common Shares and were convertible at the option of XXXXXXXXXX into Common Shares on a one-for-one basis.
3. The Common Shares were voting, entitled their holders to dividends as and when declared by the board of directors of XXXXXXXXXX, ranked rateably with the Class A Common Shares and, at the option of the holder (except for Holdco), were redeemable by XXXXXXXXXX for Common Shares of XXXXXXXXXX's parent, Holdco, for a redemption price equal to the fair market value of the number of Common Shares of Holdco equal to the number of Common Shares of XXXXXXXXXX being redeemed, plus a cash amount to reflect any declared and unpaid dividends on the Common Shares of XXXXXXXXXX (net of required withholdings). Alternatively, holders of the Common Shares of XXXXXXXXXX (except for Holdco) had the option to sell such shares to Holdco in exchange for a like number of Common Shares of Holdco, plus a cash amount to reflect any declared and unpaid dividends on the Common Shares of XXXXXXXXXX (net of required withholdings).
4. The Class A Preferred Shares were voting, entitled their holders to fixed, non-cumulative dividends as and when declared by the board of directors of XXXXXXXXXX and in priority to Class B Preferred Shares, Class C Preferred Shares, the Common Shares and the Class A Common Shares, ranked in priority to Class B Preferred Shares, Class C Preferred Shares, the Common Shares and the Class A Common Shares and were redeemable by XXXXXXXXXX at a price of $XXXXXXXXXX per share.
5. The Class B Preferred Shares were non-voting, entitled their holders to fixed, non-cumulative dividends as and when declared by the board of directors of XXXXXXXXXX and in priority to Class C Preferred Shares, the Common Shares and the Class A Common Shares, ranked in priority to Class C Preferred Shares, the Common Shares and the Class A Common Shares and were redeemable by XXXXXXXXXX at a price of $XXXXXXXXXX per share.
6. The Class C Preferred Shares were issuable in one or more series, were non-voting and entitled their holders to receive fixed non-cumulative dividends as and when declared by the directors in priority to Common Shares and Class A Common Shares. Each series of Class C Preferred Shares ranked rateably with each other series and in priority to the Common Shares and Class A Common Shares. XXXXXXXXXX was authorized to issue XXXXXXXXXX First Series Class C Preferred Shares, which were redeemable by XXXXXXXXXX and retractable by their holder at an amount equal to the fair market value of the property for which the First Series Class C Preferred Shares were issued.
7. Prior to the commencement of the transactions described below, XXXXXXXXXX Class A Common Shares were issued and outstanding and were held by various employees of XXXXXXXXXX. All of the issued and outstanding Class A Preferred Shares, Class B Preferred Shares and Common Shares were held by Holdco.
8. Holdco was controlled by Canco, which held XXXXXXXXXX% of Holdco's Common Shares. Another XXXXXXXXXX% of the Common Shares of Holdco were held by XXXXXXXXXX, a party unrelated to Canco, with the remaining Common Shares of Holdco held by XXXXXXXXXX minority shareholders. Holdco and XXXXXXXXXX were resident in Canada for the purposes of the Act throughout the course of the transactions described below.
9. XXXXXXXXXX was controlled by Mr. X, a resident of Canada for the purposes of the Act. Mr. X held all of the common shares of XXXXXXXXXX. Canco held XXXXXXXXXX Class A Preferred Shares of XXXXXXXXXX with a fair market value of $XXXXXXXXXX.
10. In addition to Mr. X's holdings in XXXXXXXXXX, Mr. X held all of the issued and outstanding shares of PurchaserCo, a corporation resident in Canada for the purposes of the Act.
11. Canco was an indirect wholly-owned subsidiary of a XXXXXXXXXX Trust ("Trust"). The Trust also held all of the issued and outstanding shares of XXXXXXXXXX, which in turn held all of the issued and outstanding shares of XXXXXXXXXX.
12. The Trust, Canco, XXXXXXXXXX and XXXXXXXXXX were resident in Canada for the purposes of the Act throughout the course of the transactions described below.
13. XXXXXXXXXX held XXXXXXXXXX ordinary shares of XXXXXXXXXX, a XXXXXXXXXX corporation.
14. As a consequence of the shareholdings described above, XXXXXXXXXX and XXXXXXXXXX were related to each other at all relevant times pursuant to s. 251(2)(c)(i) and were therefore not dealing at arm's length with each other.
On XXXXXXXXXX, Mr. X utilized PurchaserCo to facilitate a management buy-out of XXXXXXXXXX. On that date, XXXXXXXXXX purchased all of the issued and outstanding Common Shares of XXXXXXXXXX from Holdco. As a result of the transactions described below, the Common Shares of XXXXXXXXXX were the only shares of XXXXXXXXXX issued and outstanding at that time. The transaction resulted in a change of control of XXXXXXXXXX . In the days leading up to that acquisition of control, the corporate entities controlled by the Trust engaged in and caused XXXXXXXXXX to engage in certain tax-planning transactions, which are the subject of your inquiry.
Relevant Transactions
1. On XXXXXXXXXX, XXXXXXXXXX sold the XXXXXXXXXX Shares to XXXXXXXXXX in exchange for XXXXXXXXXX First Series Class C Preferred Shares. XXXXXXXXXX and XXXXXXXXXX elected the XXXXXXXXXX Shares to be disposed of for proceeds of disposition equal to $XXXXXXXXXX pursuant to s. 85(1) of the Act. The fair market value of the XXXXXXXXXX Shares was $XXXXXXXXXX at the time of the sale. As a consequence, the First Series Class C Preferred Shares had a redemption and retraction price of $XXXXXXXXXX. XXXXXXXXXX realized a capital gain of $XXXXXXXXXX on the sale of the XXXXXXXXXX Shares to XXXXXXXXXX.
2. XXXXXXXXXX then sold the XXXXXXXXXX Shares to XXXXXXXXXX on XXXXXXXXXX in exchange for a demand promissory note with a fair market value equal to the fair market value of the XXXXXXXXXX Shares. As a consequence, XXXXXXXXXX realized a capital gain of $XXXXXXXXXX. An amount in respect of the non-taxable portion of the capital gain was added to the capital dividend account of XXXXXXXXXX.
3. On XXXXXXXXXX, XXXXXXXXXX received a loan from a limited partnership controlled by the Trust ("LP") in an amount equal to the $XXXXXXXXXX face amount of the note XXXXXXXXXX issued to XXXXXXXXXX. XXXXXXXXXX used the proceeds from the loan to pay the face amount of the note owing to XXXXXXXXXX.
4. On XXXXXXXXXX, XXXXXXXXXX purchased for cancellation the XXXXXXXXXX First Series Class C Preferred Shares from XXXXXXXXXX in exchange for a promissory note of XXXXXXXXXX with a face amount and fair market value of $XXXXXXXXXX, which was $XXXXXXXXXX less than the redemption price of $XXXXXXXXXX. As a consequence of this transaction, XXXXXXXXXX reported that it received a dividend from XXXXXXXXXX in the amount of $XXXXXXXXXX under s. 84(3), being the amount by which the fair market value of the promissory note of XXXXXXXXXX exceeded the paid-up capital of the XXXXXXXXXX First Series Class C Preferred Shares. No capital gain or loss was reported in respect of this transaction. The full amount of the $XXXXXXXXXX dividend was elected to have been paid from XXXXXXXXXX's capital dividend account such that XXXXXXXXXX did not include any part of the dividend in its income for the XXXXXXXXXX taxation year.
5. On XXXXXXXXXX, XXXXXXXXXX redeemed the Class B Preferred Shares of XXXXXXXXXX held by Holdco for a price of $XXXXXXXXXX. As a consequence of the redemption, XXXXXXXXXX was deemed to have paid a dividend to Holdco in the amount of $XXXXXXXXXX. The full amount of the dividend was elected to be a capital dividend.
6. On XXXXXXXXXX, XXXXXXXXXX redeemed all of the issued and outstanding Class A Common Shares of XXXXXXXXXX at an aggregate price of $XXXXXXXXXX.
7. On XXXXXXXXXX, XXXXXXXXXX paid a taxable dividend to Holdco in the amount of $XXXXXXXXXX.
8. On XXXXXXXXXX, XXXXXXXXXX paid a capital dividend to Holdco in the amount of $XXXXXXXXXX.
9. On XXXXXXXXXX, Holdco purchased for cancellation XXXXXXXXXX Common Shares of Holdco held by XXXXXXXXXX for $XXXXXXXXXX.
10. On XXXXXXXXXX, Holdco purchased for cancellation all of the Common Shares of Holdco held by XXXXXXXXXX for $XXXXXXXXXX. As a result, XXXXXXXXXX was deemed to receive a dividend under s. 84(3) in the amount of $XXXXXXXXXX. The full amount of the dividend was elected to be a capital dividend.
11. On XXXXXXXXXX, Holdco purchased for cancellation all of the Class A Preferred Shares of Holdco held by XXXXXXXXXX for $XXXXXXXXXX. The proceeds received by XXXXXXXXXX were used to redeem all of the preferred shares of XXXXXXXXXX held by Canco.
12. On XXXXXXXXXX, XXXXXXXXXX purchased for cancellation all of the issued and outstanding Class A Preferred Shares of XXXXXXXXXX held by Holdco for a price of $XXXXXXXXXX, which was partially paid by XXXXXXXXXX in cash, with the remainder paid by XXXXXXXXXX through the issuance of two promissory notes. Holdco was deemed to receive a dividend from XXXXXXXXXX pursuant to s. 84(3) of the Act.
13. On XXXXXXXXXX, PurchaserCo acquired all of the issued and outstanding Common Shares of XXXXXXXXXX from Holdco for $XXXXXXXXXX.
14. A number of loans owing by XXXXXXXXXX as a consequence of the payment of dividends and the purchases for cancellation of shares of XXXXXXXXXX described above were transferred to the account of LP. XXXXXXXXXX repaid these loans to LP subsequent to the purchase of the Common Shares of XXXXXXXXXX by Purchaser.
Issue
As a consequence of the redemption of the First Series Class C Preferred Shares held by XXXXXXXXXX, you have taken the position that XXXXXXXXXX redeemed such shares for proceeds of disposition that were less than their fair market value at the time of the redemption. Having determined that XXXXXXXXXX and XXXXXXXXXX were related and did not deal at arm's length with each other at the time of the redemption, you have inquired as to whether s. 69(1)(b) would apply to the disposition of such shares so as to deem XXXXXXXXXX to have an additional $XXXXXXXXXX capital gain.
Taxpayer's Position
The taxpayer argued that the reduced proceeds of $XXXXXXXXXX was reflective of the fair market value of the First Series Class C Preferred Shares since the proceeds were negotiated by XXXXXXXXXX and the minority shareholders of XXXXXXXXXX. In the taxpayer's opinion, the reduced proceeds reflected the fact that XXXXXXXXXX was to receive a $XXXXXXXXXX capital dividend that would deplete XXXXXXXXXX's capital dividend account to the detriment of its minority shareholders. Accordingly, by discounting the redemption price by $XXXXXXXXXX, it was submitted that XXXXXXXXXX was compensating the minority shareholders of XXXXXXXXXX for the reduction to XXXXXXXXXX's capital dividend account. It was emphasized that there had been a number of disputes between the minority shareholders of XXXXXXXXXX and the shareholders of XXXXXXXXXX and Canco, so it was necessary to carry out the transactions preceding the XXXXXXXXXX sale of the remaining shares of XXXXXXXXXX to Purchaser having regard to the interests of the minority shareholders. In light of this context, it was submitted that XXXXXXXXXX was not about to bestow a benefit on the minority shareholders of XXXXXXXXXX by accepting a redemption price less than the fair market value of the First Series Class C Preferred Shares. As such, the redemption price of $XXXXXXXXXX was established in an arm's length negotiation between a willing buyer and a willing seller with due regard being had to what was fair and reasonable to the minority shareholders.
The taxpayer argued that even if the fair market value of the First Series Class C Preferred Shares was equal to the original redemption price, s. 69(1)(b) would not apply because the amount of any additional proceeds would be added to the amount of the dividend that XXXXXXXXXX would be deemed to receive under s. 84(3). In addition, the taxpayer argued that s. 69(1)(b) is a punitive provision that should only be invoked with discretion and is typically invoked in intergenerational asset transfers to prohibit parties from transacting below fair market value in order to achieve a long-term tax deferral. Given that the transactions in question occurred only a few days before an arm's length management buy-out in which all of the remaining shares of XXXXXXXXXX were sold at fair market value, it is suggested that there is no need to invoke s. 69(1)(b).
Furthermore, it was suggested that the discounted redemption price would primarily benefit Canco, the majority shareholder of Holdco, although it is not clear why this suggestion bears upon the application of s. 69(1)(b). Similarly, the taxpayer referred to a lawsuit initiated against the family of certain persons beneficially interested in the Trust by minority shareholders of another corporate group relating to a transaction where a minority shareholder sold his interest in the corporate group to the family. It appears to have been suggested that the significant expense of successfully defending the claim would justify a flexible approach under s. 69(1)(b) in determining the fair market value of the First Series Class C Preferred Shares.
As you are aware, the Income Tax Rulings Directorate does not make any comment on the calculation of fair market value. The following comments are based on the assumption that the fair market value of the First Series Class C Preferred Shares was in fact greater than the amount paid on the redemption of such shares. It is pivotal that a reliable valuation be obtained which will stand up to court scrutiny if necessary.
However, based upon our review of the Articles of Incorporation of XXXXXXXXXX, it would appear that the fair market value of the First Series Class C Preferred Shares, determined immediately before their redemption, would have been $XXXXXXXXXX, since those shares ranked senior to the Common Shares and Class A Common Shares. As the Common Shares and Class A Common Shares were disposed of by Holdco shortly after the redemption of the First Series Class C Preferred Shares for a substantial amount of proceeds, it seems reasonable to conclude that BCO could have obtained $XXXXXXXXXX for the First Series Class C Preferred Shares in an open and unrestricted market, from a willing buyer who was acting independently of BCO. Instead, BCO took advantage of its non-arm's-length position vis-à-vis XXXXXXXXXX to receive proceeds of disposition on the redemption that were less than the fair market value of the First Series Class C Preferred Shares, which provided indirect compensation to the other shareholders of XXXXXXXXXX for streaming XXXXXXXXXX's capital dividend account to BCO.
We agree with your comments regarding the application of s. 69(1)(b) and s. 84(3). Our position is that where, in a non-arm's-length situation, the fair market value of the shares exceeds the redemption amount, the difference will be taxed as a capital gain rather than as a deemed dividend. Paragraph 84(3)(a) speaks only of the "amount paid" where shares are redeemed. It does not stipulate fair market value payment or the lack of fair market value payment or even the necessity for one as opposed to the other; only that the amount paid in excess of the paid-up capital of the shares redeemed shall create a deemed dividend. Furthermore, although paragraph 69(1)(b) deems a taxpayer to have received proceeds of disposition equal to the fair market value of the property transferred in a non-arm's length situation, it does not apply to adjust the "amount paid".
For your information, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your clients request a copy of this memorandum, they can be provided with the electronic library version, or they may request a copy severed using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
for Division Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Planning Branch
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