19 July 2007 Internal T.I. 2006-0194571I7 - section 44.1

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: In a series of transactions undertaken by the taxpayer and spouse which resulted in a disposition of shares to a third party, can section 44.1 be used to designate a replacement share? Does subsection 44.1(12) apply? Does GAAR apply?

Position: 1. Yes, a replacement share can be designated. 2. No subsection 44.1(12) does not apply. 3. No GAAR does not apply.

Reasons: 1. Section 44.1 permits the taxpayer and spouse to designate a replacement share. 2. The law 3. There is no misuse or abuse of the Act.

 								July 19, 2007

	XXXXXXXXXX  TSO					HEADQUARTERS
								Income Tax Rulings
	Attention:  XXXXXXXXXX 	  			Directorate
G. Moore
(613) 957-2141

								2006-019457

Section 44.1 of the Income Tax Act
XXXXXXXXXX
XXXXXXXXXX

We are writing in response to your memorandum of June 30, 2006, in which you requested our comments regarding the application of subsection 44.1(12) to deny the deferral of capital gains deferred under section 44.1 of the Income Tax Act with respect to the above-mentioned taxpayers.

Our understanding of the situation is as follows:

XXXXXXXXXX (the "Taxpayer") and XXXXXXXXXX (the "Spouse") were approached by a third party, XXXXXXXXXX. ("Purchaser"), who wished to purchase part of the business of XXXXXXXXXX. ("Opco") through a purchase of shares of Opco. The Taxpayer owned XXXXXXXXXX% and the Spouse owned XXXXXXXXXX% of the common shares of Opco. However, Purchaser did not want all of the assets owned by Opco. The unwanted assets had a total fair market value ("FMV") of $XXXXXXXXXX and consisted of XXXXXXXXXX. The Taxpayer and Spouse have undertaken a series of transactions in order to first transfer the unwanted assets from Opco to a new corporation, XXXXXXXXXX. ("Newco"), and then sell the shares of Opco, which owned the remaining assets, to Purchaser for FMV consideration of $XXXXXXXXXX. In the series of transactions, capital gains accrued on the shares of Opco were triggered on a section 85 rollover to Opco for consideration of Class D common shares and Class B preferred shares of Opco. These Class B preferred shares were then transferred to Opco in exchange for Class C common shares of Opco. The effective result of the series of transactions is that the Taxpayer and Spouse used section 44.1 to designate the Class C common shares of Opco as replacement shares in order to defer the gains triggered on the shares of Opco but reported the gains related to the shares disposed of to Purchaser. The Taxpayer and Spouse have claimed a deferred gain of $XXXXXXXXXX and $XXXXXXXXXX, respectively, on the disposition of Opco common shares on their XXXXXXXXXX income tax returns.

The following is a summary of the series of transactions undertaken by the Taxpayer and Spouse.

Step 1: Amendment to Articles of Incorporation of Opco

Articles of amendment were registered on XXXXXXXXXX, amending the share capital of Opco by redesignating the existing class of common shares to Class A common shares; deleting the existing Class A preference shares, creating four new classes of common shares (voting Class B common shares, voting Class C common shares, non-voting Class D common shares and non-voting Class E common shares, all in an unlimited number; and creating five new additional classes of preferred shares namely voting Class A preferred shares, voting Class B preferred shares, voting Class C preferred shares, non-voting Class D preferred shares and non-voting Class E preferred shares, all in unlimited number. The existing XXXXXXXXXX common shares registered in the name of the Taxpayer were redeemed back into the treasury and XXXXXXXXXX new Class A common shares were issued from the treasury to the Taxpayer. The existing XXXXXXXXXX common shares registered in the name of the Spouse were redeemed back into treasury and XXXXXXXXXX new Class A common shares were issued from the treasury to the Spouse.

Step 2: Subscription for Shares

XXXXXXXXXX Class A preferred shares were issued to the Taxpayer at a price of $XXXXXXXXXX and XXXXXXXXXX Class A preferred shares were issued to the Spouse at a price of $XXXXXXXXXX.

Steps 3 and 4: Section 85 transfer between the Taxpayer, the Spouse and Opco

A Share Transfer Agreement was entered into between the Taxpayer and Opco and between the Spouse and Opco, where the Taxpayer and the Spouse transferred their XXXXXXXXXX, respectively, Class A common shares of Opco to Opco in exchange for XXXXXXXXXX, respectively, Class D common shares and XXXXXXXXXX, respectively, of Class B preferred shares of Opco. The redemption amount of the Class B preferred shares is $XXXXXXXXXX per share [total redemption amount: (XXXXXXXXXX) and the shares have a non-cumulative dividend of XXXXXXXXXX% of the redemption amount per share per month.

As a result of the disposition of the Class A common shares of Opco, the Taxpayer and the Spouse realized a capital gain of $XXXXXXXXXX and $XXXXXXXXXX, respectively (total $XXXXXXXXXX). This is a "qualifying disposition" as defined in subsection 44.1(1).

Steps 5 and 6: Section 85 transfer between the Taxpayer, the Spouse and Opco

A Share Transfer Agreement was entered into between the Taxpayer and Opco and the Spouse and Opco. The Taxpayer exchanged his XXXXXXXXXX Class D common shares of Opco for XXXXXXXXXX Class B common shares and XXXXXXXXXX Class D preferred shares. The Spouse exchanged her XXXXXXXXXX Class D common shares of Opco for XXXXXXXXXX Class B common shares and XXXXXXXXXX Class D preferred shares.

Step 7: Incorproation of Newco and Transfer of Assets from Opco to Newco

Newco was incorporated and an Asset Purchase Agreement was entered into between Opco and Newco wherein Opco sold some of its assets to Newco in return for a non-interest bearing promissory note equal to the fair market value of the assets in the amount of $XXXXXXXXXX.

Step 8: Capital Dividend

Opco declared a capital dividend of $XXXXXXXXXX to the Taxpayer and $XXXXXXXXXX to the Spouse on outstanding Class B common shares.

Steps 9 and 10: Sale of Preferred Shares of Opco to Newco by Taxpayer and Spouse

The Taxpayer sold his XXXXXXXXXX Class B preferred shares of Opco to Newco and also transferred to Newco his ownership of a promissory note for $XXXXXXXXXX in return for consideration of XXXXXXXXXX Class C common shares of Newco. The fair market value of the XXXXXXXXXX Class B preferred shares and the promissory note was $XXXXXXXXXX. The Spouse sold her XXXXXXXXXX Class B preferred shares of Opco and transferred her ownership of a promissory note for $XXXXXXXXXX to Newco in return for consideration of XXXXXXXXXX Class C common shares of Newco. The fair market value of the XXXXXXXXXX Class B preferred shares and the promissory note was $XXXXXXXXXX. The total fair market value of the Class B preferred shares and notes transferred by the Taxpayer and the Spouse total $XXXXXXXXXX.

The Taxpayer and the Spouse designated the Class C common shares of Newco as replacement shares for the Class A common shares of Opco disposed in Step 3 and 4 above.

Step 11: Redemption of Class B preferred shares by Opco

The Opco XXXXXXXXXX Class B preferred shares owned by Newco were redeemed for $XXXXXXXXXX. A promissory note was issued by Opco to Newco for that amount.

Step 12: Set-Off and Cancellation of Promissory Notes

A Set-Off and Cancellation Agreement were entered into between Opco and Newco where the promissory notes of $XXXXXXXXXX issued to Newco were offset by the amount due under the promissory note of $XXXXXXXXXX given to Opco. The promissory notes were cancelled.

Step 13: Sale of Common and Preferred Shares of Opco by Taxpayer and Spouse to Purchaser

An Agreement of Purchase and Sale was entered into on XXXXXXXXXX, between Purchaser and the Taxpayer and Spouse to sell all of the issued and outstanding shares of Opco and shareholder loans to Purchaser for $XXXXXXXXXX. The issued and outstanding shares of Opco were XXXXXXXXXX Class B common shares, XXXXXXXXXX Class A preferred shares and XXXXXXXXXX Class D preferred shares. A non-competition agreement was entered into between Purchaser and the Taxpayer and Spouse such that the Taxpayer and Spouse agreed not to operate a XXXXXXXXXX business in competition with Purchaser for XXXXXXXXXX years within Ontario. The amount of $XXXXXXXXXX was allocated to the non-competition covenant.

Step 14: Consultation Agreement and Leasing Agreement Between Opco and Newco

A Consulting Agreement was entered into between Newco and Opco XXXXXXXXXX.

Our Comments:

Application of Subsection 44.1(12) (Anti-Avoidance Rule)

Subsection 44.1(12) of the Act states:

"The permitted deferral of an individual in respect of a qualifying disposition of shares issued by a corporation (in this subsection referred to as "new shares") is deemed to be nil where

(a) the new shares (or shares for which the new shares are substituted property) were issued to the individual or a person related to the individual as part of a series of transactions or events in which
(b) the new shares (or shares for which the new shares are substituted property) were issued by the corporation that issued the old shares or were issued by a corporation that, at or immediately after the time of issue of those shares, was a corporation that was not dealing at arm's length with the corporation that issued the old shares; and
(c) it is reasonable to conclude that one of the main reasons for the series of transactions or events or a transaction in the series was to permit the individual, persons related to the individual, or the individual and persons related to the individual to become eligible to deduct under subsection (2) permitted deferrals in respect of qualifying dispositions of new shares (or shares substituted for the new shares) the total of which would exceed the total that those persons would have been eligible to deduct under subsection (2) in respect of permitted deferrals in respect of qualifying dispositions of old shares."

Subsection 44.1(12) of the Act is an anti-avoidance rule. It applies where an individual or persons related to the individual dispose of shares of a particular corporation (which would normally result in the use of the corporate reorganization rules or a return of paid-up capital of shares of the corporation) and acquire new shares of the particular corporation or a corporation that does not deal at arm's length with the particular corporation principally for the purpose of increasing the total amount of permitted deferrals with respect to qualifying dispositions of the individual and the related persons. Where the rule applies, the permitted deferral with respect to qualifying dispositions of the new shares is deemed to be nil.

A review of the situation indicates that the existing XXXXXXXXXX common shares ("Old Shares") of Opco registered in the name of the Taxpayer and the Spouse (XXXXXXXXXX% and XXXXXXXXXX%, respectively) were redeemed back into the treasury and XXXXXXXXXX new Class A common shares ("New Shares") were issued from the treasury of Opco to the Taxpayer and the Spouse. Subsequently, the Taxpayer and the Spouse claimed a deferral of the gain arising from the disposition of these Class A common shares to Opco in consideration (part) of Class B preferred shares. In Steps 9 and 10 of the series of transactions, the Taxpayer and the Spouse sold their Class B preferred shares of Opco and transferred their ownership of two promissory notes to Newco in return for consideration of XXXXXXXXXX Class C common shares of Newco. The fair market value of the Taxpayer's XXXXXXXXXX Class B preferred shares and promissory note was $XXXXXXXXXX. The fair market value of the Spouse's XXXXXXXXXX Class B preferred shares and promissory note was $XXXXXXXXXX . The Taxpayer and the Spouse designated these Newco Class C common shares as their "replacement shares" as that term is defined in subsection 44.1(1) of the Act.

For subsection 44.1(12) to apply, all of the following conditions have to be met:

(a) the New Shares were issued to the Taxpayer/Spouse as part of a series of transactions or events in which the Old Shares were disposed of by the Taxpayer/Spouse;

(b) the New Shares were issued by the corporation which issued the Old Shares; and.

(c) it is reasonable to conclude that one of the main reasons for the series of transactions or events or a transaction in the series was to permit the Taxpayer/Spouse to become eligible to deduct under subsection 44.1(2) a permitted deferral in respect of qualifying dispositions of the New Shares (or shares substituted for the new shares) the total of which would exceed the total that the Taxpayer/Spouse would have been eligible to deduct under subsection 44.1(2) in respect of a permitted deferral in respect of qualifying dispositions of the Old Shares.

When the Taxpayer and the Spouse disposed of their Old Shares in Step 1, they acquired New Shares. The resulting capital gain on this disposition was nil and the permitted deferral was therefore nil. In Step 3, the Taxpayer and the Spouse disposed of their New Shares and claimed a permitted deferral on the capital gain which arose. The adjusted cost base and paid-up capital of the Old Shares and the New Shares are the same and nominal in amount. Therefore, the result of the permitted deferral formula [(G/H x I] for the New Shares would nil because the numerator (G) would be a nominal amount and the capital gain (I) and proceeds of disposition (H) would be essentially the same amounts. Accordingly, the permitted deferral calculation would have been the same whether the Old Shares or the New Shares were transferred under section 85. Subsection 44.1(12) would not apply in such a case.

XXXXXXXXXX

Application of General Anti-Avoidance Rule ("GAAR")

In our view and in the view of the GAAR and Technical Support Section, Aggressive Tax Planning Division, Compliance Programs Branch, GAAR is not applicable to this situation. The Taxpayer and his Spouse are getting a tax benefit from the series of transactions because they are deferring the recognition of over $XXXXXXXXXX in capital gains. These transactions could be viewed as avoidance transactions as they have been made to fit within the wording of section 44.1 of the Act. However, there is no abuse of section 44.1 of the Act or an abuse of the Act as a whole. In the case at hand, the transactions do not appear to be any more abusive than capital gains crystallization transactions, which are generally not considered to offend tax policy. In crystallization transactions, section 85 internal rollovers are used to trigger capital gains that will be sheltered from tax using the capital gains exemption in section 110.6. In the deferral transaction at hand, a section 85 internal rollover is used to trigger capital gains on shares that are then deferred by acquiring replacement shares.

The Taxpayer and Spouse have sold a small business corporation's shares at arm's length and utiltized their capital gains deferral from qualifying dispositions of eligible small business corporation shares. They retained the shares of another small business corporation with a low cost base. They are now in approximately the same position as if two corporations had been set up initially and then one was sold.

In conclusion, it is our view that neither section 44.1(12) nor GAAR would be applicable in the situation described.

We trust our comments will be of assistance and we appreciate the assistance you provided in the file.

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 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. 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.

S. Parnanzone
For Director
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch