2006 Ruling 2006-0171291R3 - Loss Utilization

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: A loss utilization within an affiliated group of corporations

Position: Acceptable

Reasons: Paragraph 32 of IT-533

XXXXXXXXXX 								2006-017129

XXXXXXXXXX, 2006

Dear XXXXXXXXXX:

Re: Advance Income Tax Ruling
XXXXXXXXXX ("Amalco")
XXXXXXXXXX ("Opco") BN XXXXXXXXXX
Lossco
Newco

This is in reply to your letters of XXXXXXXXXX, wherein you request an advance income tax ruling on behalf of the above-named taxpayers. In general terms, the transactions described herein involve the use of losses within an affiliated group of corporations. We acknowledge information provided during numerous telephone conversations and electronic correspondences from XXXXXXXXXX.

We understand that, to the best of your knowledge and that of the taxpayers involved, none of the issues contained in this ruling request herein is:

(i) dealt with in an earlier return of Amalco, Opco, Lossco, Newco or a related person;

(ii) being considered by a tax services office or a taxation centre in connection with a tax return already filed by Amalco, Opco, Lossco, Newco or a related person;

(iii) under objection by Amalco, Opco, Lossco, Newco 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 expired, or

(v) the subject of a previous ruling issued by the Income Tax Rulings Directorate to the taxpayers or a related person.

DEFINITIONS

In this letter, the following terms have the meanings specified:

(a) "ACB" has the meaning assigned to "adjusted cost base" by section 54 of the Act;

(b) "Act" means the Income Tax Act, R.S.C. 1985 (5th Supp.) c.1, as amended to the date hereof, and unless otherwise stated, every reference herein to a part, section, subsection, paragraph, subparagraph or clause is a reference to the relevant provision of the Act;

(c) "Affiliated Person" has the meaning of affiliated person assigned by subsection 251.1(1) of the Act;

(d) "Amalco" means the corporation that resulted from the amalgamation of Parent and Holdings as stated in 2 below and is a TCC. Amalco became XXXXXXXXXX;

(e) "Arm's Length" has the meaning assigned to arm's length by subsection 251(1) of the Act;

(f) "Canadian corporation" has the meaning assigned by subsection 89(1) of the Act;

(g) "CRA" means Canada Revenue Agency;

(h) XXXXXXXXXX;

(i) "FMV" means fair market value;

(j) "Holdings" means XXXXXXXXXX, a corporation incorporated under the OBCA. On XXXXXXXXXX, Holdings was amalgamated with Parent as stated in 2 below to form Amalco;

(k) "Lossco" means a Subsidiary Wholly-owned Corporation to be formed by Amalco. Lossco will be incorporated under the XXXXXXXXXX as part of the Proposed Transactions. Lossco will be a TCC;

(l) "Newco" means a Subsidiary Wholly-owned Corporation to be formed by Amalco. Newco will be incorporated under the XXXXXXXXXX as part of the Proposed Transactions. Newco will be a TCC;

(m) "Non-capital Loss" has the meaning assigned by subsection 111(8) of the Act;

(n) XXXXXXXXXX;

(o) "Opco" means XXXXXXXXXX, a corporation incorporated under the Corporations Act (XXXXXXXXXX). Opco is a XXXXXXXXXX corporation that is a TCC;

(p) "Parent" means XXXXXXXXXX, a corporation incorporated by X under the XXXXXXXXXX. On XXXXXXXXXX, Parent was amalgamated with Holdings as stated in 2 below to form Amalco;

(q) "Proposed Transactions" means the transactions described in 11 to 30 below;

(r) "PUC" means "paid-up capital" and has the meaning assigned to that term by subsection 89(1) of the Act;

(s) "Subsidiary Wholly-owned Corporation" has the meaning assigned by subsection 248(1) of the Act;

(t) "TCC" means taxable Canadian corporation as defined by subsection 89(1) of the Act;

(u) "X" means the XXXXXXXXXX; and

(v) "Z" means XXXXXXXXXX, the President and Chief Executive Officer ("CEO") of Opco.

FACTS

1. Parent was incorporated for the purpose of purchasing all the shares of Holdings. On XXXXXXXXXX, Parent borrowed $XXXXXXXXXX at approximately XXXXXXXXXX% interest from X (the "X Loan") and acquired, from Arm's Length parties, all the XXXXXXXXXX common shares of Holdings for a consideration of approximately $XXXXXXXXXX. The acquisition was financed by the proceeds of the issuance of shares and the X Loan.

2. On XXXXXXXXXX, Parent and Holdings amalgamated to form Amalco.

3. Amalco has XXXXXXXXXX XXXXXXXXXX common shares issued and outstanding. X owns XXXXXXXXXX common shares (XXXXXXXXXX%), Z owns XXXXXXXXXX common shares (XXXXXXXXXX%) and a group of employees, together, owns XXXXXXXXXX common shares (XXXXXXXXXX%). The common shares were issued for a consideration of $XXXXXXXXXX per share for a total consideration of $XXXXXXXXXX .

4. XXXXXXXXXX.

5. XXXXXXXXXX

6. Prior to the amalgamation indicated in 2 above, Parent owned XXXXXXXXXX% of the XXXXXXXXXX common shares of Holdings. On the amalgamation of Holdings and Parent, the XXXXXXXXXX common shares of Holdings were cancelled.

7. Opco has XXXXXXXXXX common shares issued and outstanding. Amalco owns XXXXXXXXXX common shares (XXXXXXXXXX%), Z owns XXXXXXXXXX common shares XXXXXXXXXX and XXXXXXXXXX owns XXXXXXXXXX common shares XXXXXXXXXX of Opco. XXXXXXXXXX.

8. As of XXXXXXXXXX, Opco issued XXXXXXXXXX Class C shares to Z. XXXXXXXXXX.

9. XXXXXXXXXX.

10. Amalco expects to generate non-capital losses of approximately $XXXXXXXXXX in XXXXXXXXXX and further non-capital losses in subsequent taxation years as a result of the interest payable on the X Loan if the proposed transactions are not carried out. Opco reported taxable income of $XXXXXXXXXX in the taxation year ended XXXXXXXXXX and expects to generate further taxable income for subsequent taxation years.

Proposed Transactions

11. X will subscribe toXXXXXXXXXX an unsecured, subordinated convertible debenture of Amalco for $XXXXXXXXXX (the "Debenture"). The Debenture will be convertible into one common share for each $XXXXXXXXXX of principal amount of the Debenture. The Debenture will bear interest at a rate of XXXXXXXXXX%, payable either in cash or by the issuance of a promissory note. The promissory notes, if any, issued in payment for the interest will not bear interest and will be payable on demand.

12. Amalco will use the proceeds received on the issuance of the Debenture to purchase for cancellation XXXXXXXXXX common shares owned by X at a price of $XXXXXXXXXX a share for a total of $XXXXXXXXXX. Immediately after the cancellation, X will own XXXXXXXXXX% of all the issued and outstanding common shares of Amalco.

13. Amalco will incorporate Newco. The taxation year-end of Newco will be XXXXXXXXXX. The activities of Newco will be limited to investing of the proceeds received from the issuance of its preferred shares to Lossco, which will be loaned on a non-interest bearing basis to Amalco as described in 20 below.

The authorized share capital of Newco will consist of an unlimited number of common shares, Class A shares and Class C preferred shares (the "Newco Preferred Shares").

The common shares of Newco will be without par value and voting (XXXXXXXXXX vote per share). The holders of common shares will be entitled to dividends at the discretion of the directors, and will be entitled to receive the remaining property of Newco upon its winding-up or dissolution.

The Class A shares will be voting (XXXXXXXXXX votes per share). XXXXXXXXXX.

The Newco Preferred Shares will be without par value and non-voting. The Newco Preferred Shares will be redeemable and retractable for a redemption price equal to the FMV of the consideration for which the shares are issued, plus any accrued but unpaid dividends. The holders of Newco Preferred Shares will be entitled to cumulative dividends, calculated daily by reference to the redemption/retraction price of the Newco Preferred Shares at a rate equal to the interest rate on the Lossco Loan (as defined in 18 below) plus a small spread of approximately XXXXXXXXXX%. The dividends on the Newco Preferred Shares will be payable annually.

14. Newco will issue XXXXXXXXXX common shares of its capital stock to Amalco and XXXXXXXXXX Class A shares to Z for nominal consideration.

15. Amalco will incorporate Lossco. The taxation year-end of Lossco will be XXXXXXXXXX. The activities of Lossco will be essentially limited to the investing in preferred shares of Newco, as described in 19 below and will include repaying the Lossco Loan to Amalco (as described in 18 below). The authorized share capital of Lossco will consist of an unlimited number of common shares and Class A shares.

The common shares of Lossco will be without par value and voting (XXXXXXXXXX vote per share). The holders of common shares will be entitled to dividends at the discretion of the directors, and will be entitled to receive the remaining property of the corporation upon its winding-up or dissolution.

The Class A shares will be voting (XXXXXXXXXX votes per share). XXXXXXXXXX.

16. Lossco will issue XXXXXXXXXX common shares of its capital stock to Amalco and XXXXXXXXXX Class A shares to Z for nominal consideration.

17. Amalco will borrow an amount of $XXXXXXXXXX on a "daylight loan" basis from an Arm's-Length financial institution or from X (the "Daylight Loan"). The interest rate on the Daylight Loan will be a commercial Arm's Length rate.

18. Amalco will use the proceeds of the Daylight Loan to make a loan of $XXXXXXXXXX to Lossco (the "Lossco Loan"). Simple interest will accrue on the Lossco Loan and will be calculated at a rate slightly higher than the average weighted rate of the X Loan and the Debentures. The interest rate is estimated to be XXXXXXXXXX%. The Lossco Loan will be payable on demand. The interest on the Lossco Loan will be paid periodically.

19. Lossco will use the proceeds of the Lossco Loan to subscribe for Newco Preferred Shares having an aggregate redemption/retraction price equal to the amount contributed ($XXXXXXXXXX). The PUC and the FMV of the Newco Preferred Shares will be $XXXXXXXXXX. Lossco will be entitled to cumulative dividends on the Newco Preferred Shares, calculated daily by reference to the redemption/retraction price of the Newco Preferred Shares at XXXXXXXXXX% (a rate equal to the interest rate on the Lossco Loan plus a small spread of approximately XXXXXXXXXX%).

The amount of dividends on the Newco Preferred Shares held by Lossco will be sufficient to permit Lossco to realize a profit on its investment activity, after the deduction of all its expenses (not only its interest expenses).

20. Newco will use the proceeds ($XXXXXXXXXX) received from the Newco Preferred Shares subscription to make a demand, interest-free loan to Amalco in an amount equal to $XXXXXXXXXX (the "Amalco Loan"). The Amalco Loan will be payable on demand.

21. Amalco will use the proceeds ($XXXXXXXXXX ) received from the Amalco Loan to repay the Daylight Loan of $XXXXXXXXXX.

22. While the Lossco Loan is outstanding, Amalco will, at least annually, make a contribution of capital to Newco in an amount equal to the dividend payable by Newco on the Newco Preferred Shares held by Lossco. No shares will be issued by Newco with respect to these contributions of capital and no amount will be added to Newco's stated capital accounts or to its PUC. The amount of each contribution of capital will be recorded by Newco as contributed surplus for accounting purposes. The contributions of capital will not be treated as income of Newco pursuant to generally accepted accounting principles.

23. Upon receipt of the contributions of capital described in 22 above, Newco will use the amounts received to pay dividends to Lossco equal to the amount of the dividends payable on the Newco Preferred Shares.

24. Lossco will use the amounts received as dividends from Newco to pay to Amalco the interest on the Lossco Loan.

25. The following transactions will occur prior to XXXXXXXXXX, in order to unwind the loss consolidation arrangement:

(a) Amalco will make a contribution of capital to Newco in an amount equal to the amount of any accrued and unpaid dividends on the Newco Preferred Shares held by Lossco. No shares will be issued by Newco and no amount will be added to its PUC in respect of the contribution. The amount of this contribution of capital, if any, will be recorded as contributed surplus for accounting purposes. The contribution of capital, if any, will not be income of Newco pursuant to generally accepted accounting principles.

(b) Amalco will borrow $XXXXXXXXXX on a "daylight loan" basis from an Arm's-Length financial institution or from X (the "New Daylight Loan"). Amalco will use these funds to repay the Amalco Loan to Newco.

(c) Newco will use the funds received through 25 (a) and (b) above to redeem the issued and outstanding Newco Preferred Shares held by Lossco.

(d) Lossco will use the proceeds of the redemption of the Newco Preferred Shares received in 25 (c) above to repay the Lossco Loan and any unpaid interest thereon.

(e) Amalco will use the funds received from Lossco on the repayment of the Lossco Loan to repay the New Daylight Loan.

26. Immediately after the proposed transaction described in 25 above, Amalco will transfer to Opco all of its common shares of Lossco in exchange for one common share of Opco.

Opco will add to its account of issued and paid-up share capital, in respect of the common share issued to Amalco, an amount equal to the ACB to Amalco of the common shares of Lossco. The ACB to Amalco of the common shares of Lossco should be nominal. Amalco and Opco will file a joint election, in prescribed form and within the time limits referred to in subsection 85(6), to have subsection 85(1) apply to the transfer of the common shares of Lossco to Opco. The amount agreed in the election will be equal to the ACB to Amalco of the common shares of Lossco. The ACB of the common shares of Lossco will be less than their FMV at the time of the disposition. The FMV of the common shares of Lossco will be determined by taking into consideration the funds available in Lossco (i.e. some funds will have accumulated in Lossco given the spread between the yield on the Newco Preferred Shares versus the interest paid on the Lossco Loan), the estimated time of utilization of the Non-capital Losses of Lossco and other factors.

27. Z will sell all of the Class A shares of Lossco owned by Z to Opco for cash consideration equal to the PUC of the Class A shares.

28. Shortly after the transaction described in 26 and 27 above, Opco will cause Lossco to be wound-up. The assets of Lossco will be distributed to Opco and its liabilities, if any, will be assumed by Opco. Lossco will be dissolved within a short period of time.

29. After the wind-up of Lossco, the above transactions, other than the transactions described in 11 to 14 above, will be repeated until the X Loan and the Debenture have been repaid.

30. At the end of the cycle, after the repayment of the X Loan and the Debenture, Amalco will acquire all of the issued Class A shares of Newco for a cash consideration equal to the PUC of the issued Class A shares and will cause Newco to be wound-up.

Purpose of the Proposed Transactions

31. In general terms, the transactions described herein involve a loss utilization transaction within an affiliated group of companies which will permit Opco to indirectly deduct the losses that would otherwise be incurred by Amalco in respect of interest payable on borrowed money, the proceeds of which were used to partly finance the acquisition of the shares of Opco's parent. The purpose of the Proposed Transactions is to allow for the consolidation of the Non-capital Losses of Amalco that would have been created by the interest expense, if it were not for the loss utilization transaction described above, with the taxable income of Opco. XXXXXXXXXX In a typical loss transfer arrangement, Amalco would have lent to Opco at a stated rate of interest and Opco would in turn have used the borrowed funds to invest in the Newco Preferred Shares.

Additional Information

32. Each of the corporations involved in the Proposed Transactions is a "specified financial institution" as defined under subsection 248(1) XXXXXXXXXX.

33. Newco will not be used for any purposes other than those described in the Proposed Transactions. Amalco will not elect, at any time, to claim a capital loss in respect of its investment in Newco. Also, as Newco will not have any debt, it should never be insolvent.

34. As part of the reorganization of the share capital of Amalco described in 11 and 12 above, Amalco will put in place a dividend policy in respect of its common shares in order to ensure fairness between the holder of the Debenture and the holders of the common shares. Dividends will be declared, subsequent to director discretion, to create an after-tax yield on the common shares equivalent to an after-tax yield on interest on the Debenture. The dividends would only be paid when interest on the Debenture would be paid in cash.

35. In addition, holders of Amalco options would be entitled to a cash bonus equal to the after-tax equivalent of any dividend that would have been declared on the optioned shares in respect of a period before their issuance and on the assumption that the options had been exercised as of the date they were granted. The bonus would only be paid if the options are to be exercised and only to the extent that the corresponding dividends would have been paid by Amalco had the optioned shares been issued and outstanding.

36. None of the corporations involved in the Proposed Transactions has or will have entered into a "dividend rental arrangement" as defined by subsection 248(1) of the Act.

37. In the Proposed Transactions, there is no refreshing of losses. In fact, there will be a delay in using the losses but they will be used within the limitation as specified in paragraph 111(1)(a) of the Act.

Rulings Given

Provided that the preceding statements constitute complete and accurate disclosure of all the relevant facts, Proposed Transactions and purpose of the Proposed Transactions, and provided that the Proposed Transactions are completed in the manner described above, we rule as follows:

A. Provided that the interest paid or payable by Amalco on the X Loan is reasonable and that Amalco continues to hold the shares in Opco for the purpose of gaining or producing income from property, Amalco will not be precluded from deducting the interest paid or payable on the X Loan, pursuant to paragraph 20(1)(c) of the Act, solely because of the implementation of the Proposed Transactions.

B. Provided that the interest paid or payable by Amalco on the Debenture is reasonable and continues to be used for the purpose of gaining or producing income from property, and is paid pursuant to a legal obligation to pay interest, the interest paid or payable on the Debenture will be deductible by Amalco pursuant to paragraph 20(1)(c) of the Act.

C. To the extent interest paid or payable by Lossco on the Lossco Loan is reasonable and is paid pursuant to a legal obligation and that the Newco Preferred Shares continue to be held by Lossco for the purpose of gaining or producing income from property, pursuant to paragraph 20(1)(c) of the Act, Lossco will be entitled to deduct in a taxation year the interest paid or payable on the Lossco Loan in respect of the taxation year to the extent such amount does not exceed a reasonable amount in respect thereof.

D. In respect of the contributions of capital made by Amalco as described in 22 and 25(a) above, no amount will be included in the income of Newco pursuant to section 9 or paragraphs 12(1)(c) or 12(1)(x) of the Act.

E. The dividends (or deemed dividends, if any) received by Lossco on the Newco Preferred Shares, as described in 23 above (or 25(c) above), will be taxable dividends that will be deductible pursuant to subsection 112(1) of the Act in computing the taxable income of Lossco for the taxation year in which the dividends are received, and, for greater certainty, such deduction will not be precluded by any of subsections 112(2.1), 112(2.2) or 112(2.4) of the Act.

F. The provisions of paragraph 85(1)(e.2) of the Act will not apply with respect to the transfer of Lossco shares to Opco as described in 26 above.

G. After the winding-up of Lossco into Opco is completed, as described in 28 above, the provisions of subsection 88(1.1) of the Act will apply to permit Opco to deduct the Non-capital Losses of Lossco in computing its taxable income for any taxation year commencing after the commencement of the winding-up, to the extent that the requirements in paragraph 88(1.1)(a) and (b) of the Act are satisfied and subject to the limitations in paragraph 88(1.1)(e) and section 111 of the Act.

H. The provisions of subsections 15(1), 56(2), and 246(1) of the Act, in and by themselves, will not apply to the Proposed Transactions.

I. Subsection 245(2) of the Act will not be applicable as a result of the Proposed Transactions to redetermine the tax consequences confirmed in the rulings given above.

The above rulings are given subject to the limitations and qualifications set out in Information Circular 70-6R5 dated May 17, 2002 and are binding on the CRA provided that the Proposed Transactions, excluding 25 to 30 above, are completed by XXXXXXXXXX.

The above 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, could have an effect on the rulings provided herein.

COMMENTS

Nothing in this ruling should be construed as implying that the CRA has agreed to, reviewed or has made any determination in respect of:

(a) the fair market value or adjusted cost base of any property or the paid-up capital of any shares referred to herein;

(b) the unique share structure of Amalco, Opco, Newco and Lossco that is in place XXXXXXXXXX ;

(c) the amount of any non-capital loss, net capital loss or any other amount of any corporation referred to herein;

(d) the provincial income tax implications relating to the allocation of income and expenses under the Proposed Transactions;

(e) the application or non-application of the general anti-avoidance provisions of any province; nor

(f) any tax consequences relating to the facts and Proposed Transactions described herein other than those specifically described in the rulings given above.

Yours truly,

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