6 December 2005 Internal T.I. 2005-0147401I7 - Grandfathering-Stop Loss Rules

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:

1. Whether a redemption agreement entered into after April 26, 1995 without other supporting evidence is sufficient to satisfy the "main purpose" test referred to in paragraph 131(11)(b) of the Income Tax Amendments Act, referred to as the grandfathering rules to the stop loss provisions in subsection 112(3) of the Income Tax Act.

2. Where the conditions of paragraph 131(11)(b) are met, whether new shares issued pursuant to section 85 of the Income Tax Act are grandfathered.

Position:

1. No
2.Yes

Reasons:

1. Where the only document provided by the taxpayer to support the main purpose of the insurance policy in existence on April 26, 1995 is a redemption agreement entered into after April 26, 1995, the taxpayer has not established that it was reasonable to conclude that the main purpose of the insurance policy in existence on April 26, 1995 was to fund, in whole or in part the redemption of shares held by the taxpayer on April 26, 1995.

2. In accordance with the deeming rule in subsection 131(12), where new shares are issued pursuant to a section 85 the new shares will be deemed to be the same as the grandfathered shares.

December 6, 2005

VANCOUVER ISLAND TSO HEADQUARTERS
Income Tax Rulings
Attention: Calvin Poon Directorate
M. Vethanayagam
(613) 957-922

2005-014740

Grandfathering of Shares - Stop Loss Rules (ss. 112(3) to (3.2) of the Income Tax Act)

We are writing in response to the issues raised in your memorandum dated August 15, 2005. Our comments are based on the relevant facts as summarised below:

Facts

1. In XXXXXXXXXX, the taxpayer acquired XXXXXXXXXX Class A Common Share, XXXXXXXXXX Class D Preferred Shares, and XXXXXXXXXX Class E Preferred Shares in XXXXXXXXXX

2. On XXXXXXXXXX, the taxpayer transferred the XXXXXXXXXX Class A Common Share, XXXXXXXXXX of the Class D Preferred Shares and XXXXXXXXXX Class E Preferred Shares of XXXXXXXXXX to XXXXXXXXXX pursuant to section 85 of the Income Tax Act (the "Act") and received XXXXXXXXXX Class D preferred shares of XXXXXXXXXX with a redemption value of $XXXXXXXXXX each. The taxpayer retained XXXXXXXXXX Class D Preferred Shares of XXXXXXXXXX.

3. On XXXXXXXXXX acquired an insurance policy (First Insurance Policy), which provided for a benefit of $XXXXXXXXXX payable on the death of the taxpayer. XXXXXXXXXX was both the owner and beneficiary of the policy.

4. On XXXXXXXXXX acquired a second policy (Second Insurance Policy), which also provided for a benefit of $XXXXXXXXXX payable on the death of the taxpayer. XXXXXXXXXX was both the owner and beneficiary of the Second Insurance Policy.

5. On XXXXXXXXXX, the taxpayer entered into a Redemption Agreement with XXXXXXXXXX (Redemption Agreement) for the redemption of XXXXXXXXXX Class D preferred shares of XXXXXXXXXX owned by the taxpayer immediately before death. The Redemption Agreement confirmed that the First Insurance Policy in existence on April 26, 1995 was purchased to redeem the XXXXXXXXXX Class D preferred shares, which would be held by the estate subsequent to the taxpayer's death. Paragraph XXXXXXXXXX of the Redemption Agreement described the process for the redemption of the XXXXXXXXXX Class D preferred shares held by the estate on the death of the taxpayer.

6. A Unanimous Shareholders Agreement, effective XXXXXXXXXX (Shareholders Agreement) between the shareholders of XXXXXXXXXX indicates that the main purpose of the Second Insurance policy was to redeem the XXXXXXXXXX shares. Clause XXXXXXXXXX of the Shareholders Agreement provided for the redemption of the Class C and Class D preferred shares of XXXXXXXXXX, which would be held by the taxpayer's estate subsequent to the taxpayer's death.

7. In XXXXXXXXXX the taxpayer passed away and all XXXXXXXXXX and XXXXXXXXXX shares owned by the taxpayer immediately before his death became the property of his estate.

Issues and Comments

1. Whether the taxpayer has established that on April 26, 1995 the "main purpose" of the First Insurance Policy was to fund, the redemption of the shares held by the taxpayer on April 26, 1995 as referred to in paragraph 131(11)(b) of the Income Tax Amendments Act, 1998, S.C. 1998, c.19 (grandfathering rules).

As the taxpayer owned the XXXXXXXXXX shares on April 26, 1995 and XXXXXXXXXX was the beneficiary of a life insurance policy on April 26, 1995 paragraphs (i) and (ii) of paragraph 131(11)(b) are satisfied. However, the evidence presented by the taxpayer does not appear to be conclusive for the purposes of subparagraph 131(11)(b)(iii).

The taxpayer bears the onus of proving that it was reasonable to conclude that "a main purpose" of the life insurance policy was to redeem the shares held by the taxpayer on April 26, 1995. As described in Income Tax Technical Newsletter, Issue No. 12 dated February 11, 1998 (ITTN -12) documents like the minutes of meetings held by a corporation or correspondence from legal advisors could be used to support the "main purpose" test referred to in paragraph 131(11)(b). We recognise that as suggested in ITTN-12, subsequent actions may be relevant in supporting the "main purpose" test. However, subsequent actions without other evidence that existed on April 26, 1995 may not be sufficient to satisfy the main purpose test.

The Redemption Agreement may be damaging to the taxpayer's case as it was entered into to redeem the XXXXXXXXXX Class D preferred shares retained by the taxpayer rather than all the XXXXXXXXXX shares. Although the phrase "directly or indirectly, in whole or in part" referred to in subparagraph 131(11)(b)(iii) is broad this phrase refers to a whole or a part of the value of "a" share and not necessarily all of the shares held by the taxpayer. Therefore, the grandfathering rule in paragraph 131(11)(b) could apply to a portion of the shares held by the taxpayer on April 26, 1995.

Where the only document provided by the taxpayer is a Redemption Agreement, the taxpayer has not established that it was reasonable to conclude that on April 26, 1995, a main purpose of the First Insurance Policy was to fund, in whole or in part the redemption of any XXXXXXXXXX shares owned by the taxpayer in XXXXXXXXXX. At best, if it is assumed that the Redemption Agreement is the only evidence available, the Redemptions Agreement may suggest that the main purpose of the First Insurance Policy was to redeem only a portion of the class D preferred shares of XXXXXXXXXX, being the XXXXXXXXXX class D preferred shares retained by the taxpayer. Therefore, the Redemption Agreement does not provide a basis to conclude that the main purpose of the First Insurance Policy was to redeem all the XXXXXXXXXX shares owned by the taxpayer on April 26, 1995.

2. If the taxpayer has satisfied the "main purpose" test referred to above, does subsection 131(12) of the Income Tax Amendments Act deem the shares issued as part of a transfer under section 85 of the Income Tax Act to be the same as the grandfathered shares.

If the taxpayer provides evidence indicating that a "main purpose" of the First Insurance Policy was to redeem all of the shares held by the taxpayer on April 26, 1995, the next issue is whether shares of XXXXXXXXXX received under section 85 in exchange for XXXXXXXXXX shares are deemed to be grandfathered shares. We note that the Shareholders Agreement refers to Class C Preferred shares, however the XXXXXXXXXX shares received on the transfer pursuant to section 85 were Class D Preferred shares. We have assumed that the XXXXXXXXXX shares received on the transfer of the XXXXXXXXXX shares are redeemed pursuant to the Shareholders Agreement.

Subsection 131(12) indicates that, where the conditions of paragraph 131(11)(b) are met, and the XXXXXXXXXX shares are transferred to XXXXXXXXXX pursuant to section 85, the XXXXXXXXXX shares are deemed to be the "same share as the other share" for the purposes of the grandfathering rules. Therefore, the grandfathering rules apply to these new shares after the transfer pursuant to section 85.

The focus of the grandfathering rule referred to in paragraph 131(11)(b) is to establish the main purpose of the insurance policy that existed on April 26, 1995. If the taxpayer provides satisfactory evidence and it is established that the "main purpose" of the First Insurance Policy was to grandfather all the XXXXXXXXXX shares, the Second Insurance policy and the manner in which the XXXXXXXXXX share are redeemed is not relevant, and paragraph 131(11)(b) will apply and the XXXXXXXXXX shares will be grandfathered. Therefore, subsection 112(3) will not reduce the amount of the loss otherwise calculated on the disposition of the grandfathered shares.

For your information a copy 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 client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (613) 994-2898. A copy will be sent to you for delivery to the client.

F. Lee Workman
Manager
Charitable and Financial Institution Sectors
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate