This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.
Principal Issues: 1. Would paragraph 55(3)(a) of the Act apply to the hypothetical situation described in the letter to exclude, from the application of subsection 55(2) of the Act, the deemed dividend resulting from the cross-redemptions of shares between Corporation A and Newco?
2. Would the CRA apply subsection 55(4) of the Act in the hypothetical situation?
3. Would the interests, payable on another person's indebtedness assumed by the taxpayer to acquire the preferred shares and the common shares of the capital stock of an operating corporation, be deductible?
4. Would the interests, payable on a debt assumed by the taxpayer to acquire the shares of an operating corporation, be deductible by the amalgamated corporation after the amalgamation of the taxpayer and the operating corporation?
5. Would subsection 84.1(1) of the Act apply on the transfer by the children of the shares of the capital stock of their operating corporation to their holding corporation?
Position: 1. It would depend on whether we would apply subsection 55(4) of the Act and on the identity of the beneficiaries of the trust holding the common shares of a dividend recipient at a particular time.
2. General comments provided. It would depend on the facts of the particular situation.
3. The answer is subject to the legislation that may be proposed by the Department of Finance and the date of enactment. Without such a proposed legislation, the answer would depend on whether the preferred shares carries a stated dividend rate and on whether there is a reasonable expectation, at the time the common shares are acquired, that the common shareholder will receive dividends.
4. The position taken in paragraph 21 of IT-533 in relation to a deduction under subparagraph 20(1)(c)(i) of the Act would also be applicable in relation to a deduction under subparagraph 20(1)(c)(ii) of the Act. After the amalgamation, we would consider that the debt has been assumed for the acquisition of the assets of the acquired corporation that has been amalgamated and that are now held by the continuing corporation after the amalgamation. These assets would have to be acquired for purpose of gaining or producing income from the property or from a business.
5. It would depend on the consideration received for each class of shares.
Reasons: 1. Provisions of the Act.
2. The question of determining whether it is reasonable to consider that one of the main purposes for the issuance of the voting shares of the capital stock of the dividend recipients to A would be to cause 2 or more persons to be related to each other, is a question of fact.
3. Paragraphs 10 and 31 of IT-533. Statement of the Department of Finance which was published on February 23, 2005, as part of the presentation of the Federal Budget.
4. Previous positions. Paragraph 21 of IT-533.
5. Provisions of the Act.
Sylvie Labarre, CA
November 2, 2009
Subject: Issues related to transactions resulting in a transfer of businesses to two corporations owned by brothers
This is in response to your email of April 9, 2009, in which you asked our opinion regarding certain provisions of the Income Tax Act (the "Act") in relation to the following hypothetical situation. We apologize for the delay in responding to your request.
Unless otherwise stated, all statutory references herein are to provisions of the Act.
1. Corporation A is owned by the following persons:
- A holds 2,000 Class B preferred shares with a paid-up capital, adjusted cost base ("ACB") and fair market value ("FMV") of $100, $500,000 and $500,000, respectively, and whose high ACB resulted from a previous "crystallization" of the capital gains deduction under subsection 110.6(2.1);
- Holdco A (all of whose issued shares belong to A) holds all of the Class C preferred shares with a paid-up capital, ACB and FMV of $1,000, $1,000 and $4,000,000, respectively;
- Trust A which holds 100 common shares with a paid-up capital, ACB and FMV of $100, $100 and $3,000,000 respectively.
2. Corporation A operates six restaurants and A wants each of his children, through the operating companies Corporation A and Newco, respectively, to operate three restaurants each.
3. To do so, A incorporates Newco and subscribes for 1,000 preferred shares, carrying voting control, for $100. Thus, A has de jure control of Newco at all relevant times and for the purposes of the Act. We also understand that A is the founder of Newco for the purposes of applicable corporate law.
4. Subsequently, Corporation A sells the assets of three of its restaurants to Newco in consideration for which Newco assumes the debts related to those three restaurants and issues rollover preferred shares having a FMV of $3,000,000, corresponding to the excess of the FMV of the assets transferred over the amount of the debts assumed. Subsection 85(1) is utilized and the agreed amount is the cost amount of the assets sold.
5. The shareholders of Corporation A sell a portion of their shares of Corporation A to Newco and receive shares of Newco's capital stock in consideration. As a result, A sells half of the Class B preferred shares that he holds in Corporation A and receives in consideration 1,000 Class B preferred shares of the capital stock of Newco having a paid-up capital, ACB and FMV of $50, $250,000 and $250,000 respectively. Holdco A sells, using subsection 85(1), 1/2 of its Class C preferred shares in consideration for Class C preferred shares of the capital stock of Newco having a paid-up capital, ACB and FMV of $500, $500 and $2,000,000 respectively. Trust A sells, using subsection 85(1), 1/4 of its common shares to Newco and receives in consideration therefor 25 common shares of the capital stock of Newco having a paid-up capital and ACB of $25 and an FMV of $750,000.
6. Following this share transfer, A subscribes for 1,000 voting preferred shares of Corporation A for $100. Accordingly, we understand that A would have de jure control of Corporation A commencing from that time for the purposes of the Act.
7. There is a cross-repurchase of the Newco shares held by Corporation A, on the one hand, and then of the Corporation A shares held by Newco, on the other hand, for an amount of $3,000,000, reciprocally payable by the issuance of non-interest bearing demand promissory notes.
8. Corporation A and Newco set-off their $3,000,000 reciprocal notes.
9. As a result of these transactions to separate the restaurants into two corporations, the shareholders of Corporation A sell their shares of the capital stock of that corporation, except for the controlling voting preferred shares held by A, to Child X. The sale price of the shares correspond to the FMV of the shares and are paid in cash using the amounts obtained by X under the loans he contracted with a financial institution ($4,000,000) and with A ($500,000).
10. Similarly, the Newco shareholders sell their shares of the capital stock of Newco, with the exception of the controlling voting preferred shares held by A, to Child Y. The sale price of the shares corresponds to the FMV of the shares and is paid in cash using the amounts obtained by Y under the loans he contracted with a financial institution ($2,500,000) and with A ($500,000).
11. Trust A realizes a capital gain of approximately $3,000,000 on the sale of the common shares and taxes itself accordingly or chooses to distribute all or a portion of the taxable capital gain, together with the remainder of the capital of the Trust to A, who is one of Trust A's discretionary beneficiaries as permitted by the Trust Indenture. A deducts the final $250,000 of capital gains deduction against the taxable capital gain allocated to him by Trust A.
12. Following the acquisition by Child X and Child Y of the shares of the capital stock of Corporation A and Newco, they incorporate their own holding corporations (Holdco X and Holdco Y) of which they are the sole respective shareholders.
13. Each of the children repays, from their own assets, a portion of the $750,000 loan from the financial institution.
14. X and Y sell to Holdco X and Holdco Y, respectively, all the preferred and common shares held in Corporation A (for X) and in Newco (for Y) for a sale price equal to the price paid to acquire those shares, namely $4,500,000 for X and $3,000,000 for Y. In consideration, Holdco X assumes X's loans from A and the financial institution and issues preferred shares having a minimal legal and tax paid-up capital, but being redeemable for $750,000, an amount representing the excess of the FMV of the shares over the amount of the assumed debts. Holdco Y does the same, by assuming Y's debts and issuing preferred shares with the same paid-up capital and redemption value characteristics.
15. Finally, it is possible for Corporation A to be merged with Holdco X to form Amalco X and for Newco to be merged with Holdco Y to form Amalco Y.
1. You wish to know whether paragraph 55(3)(a) would apply to this hypothetical situation so that the deemed dividends resulting from the cross share repurchases between Corporation A and Newco would not be subject to subsection 55(2).
2. You asked whether the Canada Revenue Agency ("CRA") would apply subsection 55(4) so that control by A for each of Corporation A and Newco would be deemed not to exist. You stated that control by A is necessary to ensure the repayment to A of the loan that he initially made to X and Y and that was assumed by Holdco X or Holdco Y, as the case may be. Control by A would also be necessary to ensure a healthy transition between administration by him and by his children.
3. You also inquired as to the deductibility of interest payable on the loans assumed by Holdco X and Holdco Y upon the acquisition of the preferred and common shares of the capital stock of Corporation A and Newco, respectively.
4. You wish to know our opinion on the impact, if any, that the possible mergers of Corporation A with Holdco X and of Newco with Holdco Y could have on the deductibility of interest paid on the loans originally assumed by Holdco X and Holdco Y.
5. In addition, you wish to confirm that subsection 84.1(1) would not apply on the sale by X of the shares of the capital stock of Corporation A to Holdco X or on the sale by Y of the shares of the capital stock of Newco to Holdco Y.
It appears to us that the situation described in your letter may constitute an actual situation involving taxpayers. As explained in Information Circular 70-6R5, it is not the practice of this Directorate to provide comments on proposed transactions involving specific taxpayers otherwise than in the form of an advance income tax ruling. If your situation involved specific taxpayers and one or more completed transactions, you should submit all relevant facts and documents to the appropriate Tax Services Office for its opinion. However, we are able to offer the following general comments that may be of assistance. It should be noted that the application of one or more provisions of the Act generally requires an analysis of all the facts relating to a particular situation. As a result, and given that your letter only briefly describes a hypothetical situation, the comments we make below may not apply in full in a particular situation.
For the purposes hereof, we have assumed that the common shares of the capital stock of Corporation A are the only voting shares of Corporation A prior to the issuance of the controlling voting preferred shares subscribed for by A. Thereafter, we have assumed that A controls Corporation A.
Furthermore, for the purposes of this analysis, we have assumed, first, that all transactions referred to in the Facts would be part of the series of transactions or events and, second, that all transactions forming part of the series of transactions or events have been disclosed.
It can be seen from the Facts that there are a number of transactions involving dispositions of property or involving a significant increase in interest that would fall within subparagraphs 55(3)(a)(i) to (v) if, in the case of a disposition, it was made to an unrelated person immediately before the time of the disposition or, in the case of a significant increase in interest, if it was a significant increase of one or more persons who were unrelated persons immediately before the time of the significant increase.
Consequently, the question is whether such dispositions or significant increases in shareholdings were made in favour of unrelated persons immediately before the time of the disposition or significant increase, as the case may be.
Pursuant to paragraph 55(3.01)(a), a person, other than the dividend recipient, to whom the dividend recipient is not related is an unrelated person for the purposes of paragraph 55(3)(a).
According to the Facts of the situation you described to us, the dividend recipients are Corporation A and Newco.
Subject to the application of subsection 55(4), Newco was controlled by A immediately prior to each transaction. In addition, subject to the application of subsection 55(4) and taking into account the assumptions stated at the beginning of our comments, Corporation A was controlled by Trust A until the issuance of the controlling voting preferred shares to A, and by A thereafter.
In determining whether persons are related to each other, subparagraph 55(5)(e)(iii) provides that a trust and a person shall be deemed not to be related to each other unless they are deemed by paragraph 55(3.2)(d) or subparagraph 55(5)(e)(ii) to be related to each other or the person is a corporation that is controlled by the trust. In this situation, paragraph 55(3.2)(d) can be disregarded. Subparagraph 55(5)(e)(ii) provides that where at any time a person is related to each beneficiary (other than a registered charity) under a trust who is entitled to share in the income or capital of the trust, the person and the trust shall be deemed to be related at that time to each other and, for this purpose, a person shall be deemed to be related to himself, herself or itself.
For the purposes of this analysis, we will consider all increases in ownership interests resulting from the transactions described in the Facts to be significant increases in ownership interests.
Generally and based on the facts set forth in your hypothetical situation, the exception in subsection 55(3)(a) would apply with respect to the deemed dividends resulting from the cross-redemptions between Corporation A and Newco, but only to the extent that subsection 55(4) did not apply and to the extent that each of A, Newco and Corporation A was related to all of the beneficiaries of Trust A described in subparagraph 55(5)(e)(ii) at the relevant times.
In the present situation, A's acquisition of the voting preferred shares controlling the capital stock of Newco and the capital stock of Corporation A resulted in persons becoming related to each other and could result in subsection 55(2) not applying to the dividends but for subsection 55(4).
The question is whether it is reasonable to consider that one of the main reasons for these acquisitions of preferred voting shares was to cause persons to become related to each other so that subsection 55(2) did not apply to the dividends. This is a question of fact.
We cannot answer your question with respect to the hypothetical situation described above because we do not have all the relevant facts to make this determination. In connection with a request for an advance ruling, we would require additional information such as, inter alia, the age of the parent and children, the involvement of the parent and children in the businesses prior to the reorganization and thereafter, the experience and training of the children to operate such businesses, the identity of the trustee or trustees of Trust A, the length of time that A has held voting shares of the capital stock of Newco and Corporation A, etc.
Furthermore, although we have previously issued advance rulings that subsection 55(4) did not apply where the principal reason was to protect the economic interests of the person holding the voting shares, we were satisfied that in those cases there was not another principal reason that corresponded to the one set out in s. 55(4). Although you indicated in your letter that one of the main reasons would be to protect the economic interests of A because of the loans it would have made to X and Y, which loans would ultimately be assumed by Holdco X/Amalco X and Holdco Y/Amalco Y respectively, it cannot be precluded that we could come to the conclusion that one of the main reasons corresponded to the one indicated in subsection 55(4) considering a set of factors including, inter alia, the identity of the persons who control Corporation A prior to the described reorganization. In this regard, we note that A's economic interest in the businesses would amount to $4.5 million before the described reorganization and only $1 million after the reorganization. In addition, as a result of the transactions, each of the children would have a greater economic interest in Corporation A or Newco, as the case may be, than their father.
Holdco X would acquire the preferred shares and common shares of Corporation A held by X and would assume the loans owing by X to a financial institution and to A as the consideration for the purchase price of those shares. Holdco Y would acquire the preferred and common shares of Newco held by Y and would assume the loans owed by Y to a financial institution and to A as the consideration for the purchase price of those shares.
As stated in paragraph 27 of Interpretation Bulletin IT-533, dated October 31, 2003 (the "Bulletin"), subparagraph 20(1)(c)(ii) applies to interest on an amount payable for property acquired for the purpose of gaining or producing income. This would include situations where a taxpayer has assumed another person's indebtedness as part of the purchase price of an asset acquired by the taxpayer.
Thus, in this hypothetical situation, the conditions for the application of subparagraph 20(1)(c)(ii) would have to be examined to determine whether the interest would be deductible to Holdco X or Holdco Y, as the case may be. As stated in paragraph 27 of the Bulletin, unlike subparagraph 20(1)(c)(i), there is no "use" test in subparagraph 20(1)(c)(ii). Consequently, for the purposes of subparagraph 20(1)(c)(ii), the "for the purpose of gaining or producing income" test will have to be considered in relation to the property acquired specifically with the assumed loan from which interest is sought to be deducted. If, for example, the Class B preferred shares had not been acquired for the purpose of gaining or producing income or from a business, the interest on the assumed debt incurred to acquire the Class B preferred shares would not be deductible even if Holdco X or Holdco Y, as the case may be, acquired all of the shares of the capital stock of the corporation, including the common shares.
On the other hand, where a property referred to in subparagraph 20(1)(c)(ii) is disposed of, the replacement property is taken into account in determining the continued application of that subparagraph.
In this situation, you have not disclosed to us the details of the consideration given for the acquisition of each class of shares (the portion of the consideration that consists of the assumption of debt and the portion that consists of the issuance of preferred shares). You also did not indicate whether the preferred shares acquired carried a dividend rate. Therefore, we cannot make a final determination as to the deductibility of interest without all relevant facts.
Paragraph 31 of the Bulletin states that where an investment (e.g., interest-bearing instrument or preferred shares) carries a stated interest or dividend rate, the purpose of earning income test will be met "absent a sham or window dressing or similar vitiating circumstances" (Ludco). Further, assuming all of the other requisite tests are met, interest will neither be denied in full nor restricted to the amount of income from the investment where the income does not exceed the interest expense, given the meaning of the term income as discussed in ¶ 10 of the Bulletin.
Consequently, the interest on the loan assumed to acquire the Class B preferred shares would not be deductible if those shares did not bear dividends. The same is true for the Class C preferred shares.
With respect to interest on the loan assumed to acquire the common shares, paragraph 31 of the Bulletin states that "[w]here an investment does not carry a stated interest or dividend rate such as some common shares, the determination of the reasonable expectation of income at the time the investment is made is less clear. Normally, however, the CCRA considers interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation, at the time the shares are acquired, that the common shareholder will receive dividends. Nonetheless, each situation must be dealt with on the basis of the particular facts involved.”
However, what was stated by the Department of Finance in the February 23, 2005 Budget, which provided an update on the consultation that followed the October 31, 2003 legislative proposals, may have an impact on our comments above as well as on certain paragraphs of the Bulletin. We remind you of that statement:
“In October 2003, the Department of Finance released for public consultation a package of legislative proposals regarding the deductibility, for income tax purposes, of interest and other expenses. The proposals responded to certain court decisions that departed significantly from what had been the accepted understanding of the law in this area.
In computing income from a business or property, a taxpayer can deduct many kinds of expenses, provided they were incurred in order to earn the income. A familiar example is interest on borrowed money, which is deductible only if the borrowed money is used for the purpose of earning income from a business or property.
In this context, “income” had been understood to be a net amount comparable to profit, and to exclude capital gains. The court decisions, however, took a different view: income was read as the equivalent of gross revenue, and the distinction between income and capital gains was blurred.
The 2003 proposals were intended to restore the law on these points to its more familiar and more appropriate state.
An extended period of public consultation on the proposals ended in August 2004. Many commentators expressed concerns with the proposals’ structure: in particular, that the proposals’ codification of an objective “reasonable expectation of profit” test might inadvertently limit the deductibility of a wide variety of ordinary commercial expenses. The Department of Finance has sought to respond by developing a more modest legislative initiative that would respond to those concerns while still achieving the Government’s objectives. The Department will, at an early opportunity, release that alternative proposal for comment. This will be combined with a Canada Revenue Agency publication that addresses, in the context of the alternative proposal, certain administrative questions relating to deductibility.”
Consequently, we cannot provide you with our final comments in this regard until such legislative proposal is announced. It should be noted, however, that it is possible that the new legislative proposal, once adopted, may apply to years prior to its adoption or announcement.
It is our view that the position taken in paragraph 21 of the Bulletin would also apply in the context of a deduction claimed pursuant to subparagraph 20(1)(c)(ii). Thus, after the amalgamation, we consider the debt to have been assumed for the acquisition of the assets from the predecessor companies Corporation A or Newco, as the case may be, in lieu of the acquisition of the shares. If the assets from the predecessor companies Corporation A or Newco, as the case may be, were acquired for the purpose of gaining or producing income from an income or business and all other conditions required for interest deductibility were satisfied, interest on the assumed debt would be deductible to the new corporations resulting from the amalgamations.
In order to answer your question, it is necessary to know, for each class of shares transferred to Holdco X (or Holdco Y, as the case may be), the details of the debts assumed and the preferred shares issued by that corporation received in consideration for that class of shares. Indeed, we would review the application of subsection 84.1(1) by considering each class of shares transferred and the consideration received for that class.
It appears to us that X and Holdco X (or Y and Holdco Y, as the case may be) may determine property or debt consideration for each class of shares transferred so that subsection 84.1(1) does not result in any reduction in the paid-up capital of shares received as consideration or in a deemed dividend.
Please note that this opinion is not an advance income tax ruling and, as stated in paragraph 22 of Information Circular 70-6R5 of May 17, 2002, is not binding on the CRA in respect of any particular factual situation.
We hope that our comments are of assistance.
Stéphane Prud'Homme, Notary, M. Fisc.
Mergers and Acquisitions Section
Corporate Reorganizations and Resource Industry Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.
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