7 March 2007 External T.I. 2005-0157381E5 - Regulation 6204

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 a covenant made pursuant to a loan arrangement would cause a share not to be a prescribed share under subparagraph 6204(1)(a)(i) of the Regulations?

Position: Generally yes but question of fact.

Reasons: The preamble of paragraph 6204(1)(a) of the Regulation indicates that the restrictions apply to the terms and conditions of the share or any agreement in respect of the share or its issue. Accordingly, we must consider whether the terms and conditions of the shares and all of the agreements, both written and implied, that pertain to the shares or their issue.

XXXXXXXXXX 								2005-015738
S. Chua LLB(Hons), FCA
March 7, 2007

Dear XXXXXXXXXX:

Re: Income Tax Regulation 6204(1)(a)(i)

This is in reply to your letter of October 24, 2005, wherein you requested an interpretation of the above provision in the Income Tax Regulations (the "Regulations"). In particular, you asked for our opinion on whether a covenant made pursuant to a loan arrangement, not to declare a dividend of greater than 50% of cumulative net income of the borrower corporation in certain circumstances, would cause a share not to be a prescribed share under Regulation 6204(1)(a)(i). You make the argument that there is no agreement in respect of the share or its issue, within the meaning of the preamble to Regulation 6204(1)(a), because there is no privity of contract between the shareholders of the corporation and the bank. You also argue that suppressing the dividend entitlement in the manner described is not offensive in policy terms to the prescribed share rules.

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 submitted in the manner set out in Information Circular 70-6R5, Advanced Income Tax Rulings, dated May 17, 2002. Where the particular transactions are completed, the inquiry should be addressed to the relevant tax services office. The following comments are, therefore, of a general nature only and are not binding on the Canada Revenue Agency ("CRA").

Regulation 6204 sets out certain conditions that must be met in order for an employee who has acquired a stock option, to be eligible for the stock option deduction under paragraph 110(1)(d) of the Income Tax Act. One of the conditions contained in Regulation 6204(1)(a) is that under the terms or conditions of the share or any agreement in respect of the share or its issue, the amount of the dividends that the corporation may declare or pay on the share is not limited to a maximum amount or fixed at a minimum amount at that time or at any time thereafter by way of a formula or otherwise.

In the example you provided, the corporation may not declare a dividend of greater than 50% of cumulative net income under the terms of a loan agreement. The preamble of paragraph 6204(1)(a) of the Regulation indicates that the restrictions apply under the terms and conditions of the share or any agreement in respect of the share or its issue. Accordingly, in the present case, we are of the view that we must consider whether the terms and conditions of the shares and all of the agreements, both written and implied, that pertain to the shares or their issue, satisfy the conditions set out in the Regulation. As the share in question is a share upon which a dividend limitation has been imposed, the agreement between the borrower corporation and the lender is within the meaning of the phrase "any agreement in respect of the share", as stated in the preamble to paragraph (a). In essence, the covenant, as described, limited the amount of the dividends that the borrower corporation may declare or pay, to a maximum amount by way of a formula. Accordingly, in our view, it appears that the conditions in Regulation 6204(1)(a)(i) have not been met.

However, we are aware of the following CRA response to the 1989 Tax Executives Institute's ("TEI") Meeting question concerning "Dividends Limited to a Maximum Amount of Retained Earnings":

"Where as a consequence of a lending agreement dividends are restricted to a percentage of normally computed retained earnings, for purposes of regulation 6204 we would not generally consider that the amount of dividends that can be declared or paid would be limited to a maximum amount or fixed at a minimum amount by formula or otherwise. However, each determination would be made on the basis of the particular facts."

We would, accordingly, be prepared to deal conclusively with your issue in the context of an advance ruling request where all the facts and definitions of terms are known. Further, it should be noted that the above TEI response only applies to Regulation 6204 and would not apply to, inter alia, the definition of "taxable preferred shares" in subsection 248(1) of the Act.

Lastly, as you raised considerations that should relate to tax policy, you may wish to contact the Department of Finance, Attention: Brian Ernewin, General Director, Tax Legislation Division, L'Esplanade Laurier, 140 O'Connor St., Ottawa, ON, K1A 0G5.

We trust that these comments will be of assistance.

Yours truly,

Roberta Albert, C.A.

for Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch