12 January 2005 External T.I. 2004-0106161E5 - Application of par. 84.1(1)(b) on a sale 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.

Principal Issues: Will a deemed dividend result under 84.1(1)(b) in the taxpayer's crystallization transactions

Position: Yes.

Reasons: Parties appear not to be dealing at arm's length.

XXXXXXXXXX 2004-010616
Michael Cooke
January 12, 2005

Dear XXXXXXXXXX:

Re: Sale of Shares

This is in reply to your letter of December 2, 2004 wherein you requested our comments with respect to the above provision of the Income Tax Act (the "Act") as it applies to the fact situation described in your letter. All statutory references, unless otherwise indicated, are to the Act.

The facts in your letter are briefly summarized as follows:

Mr. A owns all the issued and outstanding shares of the capital stock of a corporation ("Farmco"). Each share of Farmco would qualify as a "share of the capital stock of a family farm corporation" as that term is defined in subsection 110.6(1). The shares of Farmco have an aggregate fair market value that is significantly in excess of their aggregate adjusted cost base and aggregate paid-up capital. The adjusted cost base and paid-up capital of the Farmco shares is nominal. Mr. A would like to utilize the $500,000 capital gains deduction available for "qualified farm property" as that term is defined in subsection 110.6(1) by undertaking the following transactions.

Mr. X, a person who is not related to Mr. A, would incorporate a new corporation ("Xco") for the purpose of purchasing a number of Farmco shares having an aggregate fair market value of $500,000 from Mr. A. Xco would pay cash consideration of $500,000 for the Farmco shares. Mr. A would then loan the $500,000 cash proceeds he received from Xco to Farmco and Farmco would use these loan proceeds to redeem all the Farmco shares that were acquired by Xco. Mr. A and Mr. X would then "go their separate ways". Mr. A would claim the $500,000 capital gains deduction in respect of the capital gain that he realized on the sale of the Farmco shares to Xco.

Although not stated in your letter, presumably Xco will use the $500,000 redemption proceeds to replace the source of funds it used to acquire the original $500,000 investment in the Farmco shares.

It is your view, that subsection 55(2) will not apply to the deemed dividend received by Xco on the redemption by Farmco of Farmco shares held by Xco. This is because there has been no reduction in the amount of capital gain that otherwise would have been realized by Xco, but for the dividend, on a disposition of the Farmco shares so held by Xco. Moreover, it is also your view that paragraph 84.1(1)(b) will not apply to deem Mr. A to have received a dividend on the sale of his Farmco shares to Xco.

We are unable to respond to your request for a technical interpretation since your request appears to relate to either proposed transactions or completed transactions involving specific taxpayers. Confirmation of the income tax consequences of proposed transactions involving specific taxpayers will only be provided in response to a request for an advance income tax ruling that is submitted in accordance with the guidelines set out in Information Circular 70-6R5 ("IC-70-6R5") dated May 29, 2002. However, if the situation described in your letter relates to a completed transaction, any request for the Canada Revenue Agency's ("CRA") views should be made to your local Tax Services Office. Notwithstanding the above, we can provide the following comments.

While the CRA does not generally consider transactions that are undertaken to utilize a capital gains deduction ("crystallization transactions") to necessarily represent a misuse or abuse of the Act, it is also our view that the steps taken to crystallize such a gain must comply with the provisions of section 84.1. Section 84.1 will apply where an individual resident in Canada transfers shares of a corporation resident in Canada ("subject corporation") to another corporation ("purchaser corporation") with which the individual does not deal at arm's length and immediately after the disposition, the subject corporation would be connected with the purchaser corporation. Under paragraph 84.1(1)(b) the maximum amount of non-share consideration that can be received without triggering an immediate deemed dividend is an amount not exceeding the greater of the paid-up capital of the shares of the subject corporation so transferred and the particular individual's adjusted cost base of such shares, subject to paragraphs 84.1(2)(a) and (a.1), determined immediately before such transfer.

In the situation described above, it is our view that paragraph 84.1(1)(b) will apply to deem Mr. A to have received a dividend of approximately $500,000 since Mr. A, Mr. X, Xco and Farmco appear not to be dealing at arm's length in respect of the above described crystallization transactions. In addition, it is also our view that the above crystallization transactions could constitute avoidance transactions within the meaning of subsection 245(3) of the Act and thus be subject to the general anti-avoidance rule in subsection 245(2).

We trust our comments will be of assistance to you. However, as stated in paragraph 22 of IC-70-6R5, the opinion expressed in this letter is not a ruling and consequently is not binding.

Yours truly,

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