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) What is the tax policy behind the bump denial rule provided under subparagraph 88(1)(c)(vi)? 2) Whether the bump denial rule provided under subparagraph 88(1)(c)(vi) would apply in the particular situation.
Position: 1) and 2) General comments provided.
Reasons: Question of fact and law.
February 17, 2012
Re: 88(1)(c)(vi) Bump Denial Rule
This is in reply to your email dated November 18, 2011 in which you requested our comments on the application of the bump denial rule provided under subparagraph 88(1)(c)(vi) of the Income Tax Act (hereinafter the "Act") in a particular situation (hereinafter the "Particular Situation").
Unless otherwise stated, every reference herein to a part, section, subsection, paragraph or subparagraph is a reference to the relevant provision of the Act.
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 a request for an advance income tax ruling submitted in the manner set out in Information Circular 70-6R5, Advance Income Tax Rulings, dated May 17, 2002. The particular situation outlined in your email appears to be a factual one, involving specific taxpayers and completed transactions. We are, however, prepared to provide the following general comments.
Our understanding of the facts is as follows:
1. An individual (hereinafter "Mr. X") dies.
2. A spousal trust (hereinafter the "Trust") is created under the last will of Mr. X for the benefit of his spouse (hereinafter "Ms. X").
3. Under the terms of the Trust, following the death of Ms. X, the property of the Trust shall be distributed equally between three individuals: A, B and C.
4. A and B are Mr. X's children born from a first marriage. C is the son of Ms. X also born from a first marriage. Mr. X is not the father of C and Ms. X is not the mother of A and B.
5. The Trust property includes all of the issued and outstanding shares of the capital stock of a corporation (hereinafter "HOLDCO") which were held by Mr. X prior to his death. HOLDCO is a Canadian taxable corporation.
6. Ms. X dies. Thus, pursuant to paragraph 104(4)(a) the Trust is deemed to have disposed of each of its property at fair market value (hereinafter "FMV") at the end of the day of Ms. X's death and to have reacquired it immediately after that day for an amount equal to that FMV.
7. Following the death of Ms. X, the Trust distributes one third of the shares of the capital stock of HOLDCO to each of its beneficiaries A, B and C in satisfaction of all of their capital interest in the Trust. The adjusted cost base (hereinafter "ACB"), for each of A, B and C, of each share of the capital stock of HOLDCO is equal to its FMV at that time.
8. Subsequently, A, B and C create a new corporation (hereinafter "NEWCO"). Each of them holds one third of the common shares of NEWCO. NEWCO is also a taxable Canadian corporation.
9. Each of A, B and C transfers his shares of the capital stock of HOLDCO to NEWCO and jointly elects with NEWCO to have the provisions of subsection 85(1) apply to the transfers. The agreed amount is equal to the ACB, for each of A, B and C, of the shares of the capital stock of HOLDCO. As consideration for these transfers, each of A, B and C receives a promissory note and common or preferred shares of the capital stock of NEWCO. After these transfers, HOLDCO becomes NEWCO's wholly-owned subsidiary.
10. Then HOLDCO is wound-up into NEWCO, pursuant to subsection 88(1). The winding-up of HOLDCO is intended to bump the cost of the eligible property received by NEWCO to the extent allowable pursuant to paragraphs 88(1)(c) and (d) (hereinafter the "Bump").
11. Finally, NEWCO is wound-up and its assets are distributed to A, B and C as a return of capital.
You mention that pursuant to paragraph 88(1)(c), the property eligible for the Bump is a capital property owned by HOLDCO at the time NEWCO last acquired control of HOLDCO and that was owned by HOLDCO thereafter without interruption until such time as it was distributed to NEWCO on the winding-up.
You consider that the time where NEWCO last acquired control of HOLDCO is deemed to be the time immediately after the death of Ms. X pursuant to paragraphs 88(1)(d.2) and (d.3).
You explain that A and B are brother and sister so they are related. Accordingly, they constitute a related group controlling NEWCO and HOLDCO, so they are "specified persons" pursuant to paragraph 88(1)(c.2). However, C is not related to A and B since the death of Mr. X. C is a "specified shareholder" of the subsidiary, HOLDCO, as he owns more than 10 % of the voting shares of that corporation, pursuant to paragraph (a) of the definition of "specified shareholder" in subsection 248(1). Therefore, the Bump would be denied pursuant to subparagraph 88(1)(c)(vi) since property distributed by HOLDCO to NEWCO as part of the series of transactions including the winding-up of HOLDCO would be acquired by C.
You also point out that subparagraphs 88(1)(c)(iii), (iv) and (v) do not apply in the Particular Situation.
1. What is the policy purpose behind the anti-avoidance rule of subparagraph 88(1)(c)(vi) and is it appropriate to apply it to the abovementioned set of facts?
2. If C does not participate in incorporating NEWCO and sells his shares of the capital stock of HOLDCO to A and B at FMV in consideration for cash before the transfer of the shares of HOLDCO to NEWCO, could NEWCO bump the cost of eligible property received from HOLDCO on its winding-up, as C would not receive any of HOLDCO's property?
3. Would the answer in 2) be the same if C, instead of receiving cash, receives a promissory note from each of A and B and the promissory notes are repaid after the winding-up?
Answer to question 1)
Subparagraph 88(1)(c)(vi) was introduced in 1994 along with subsection 55(3.1) which was aimed at eliminating "purchase butterfly" transactions. More specifically, subparagraph 88(1)(c)(vi) was designed to eliminate the so-called "backdoor purchase butterfly". As stated in the 1994 Department of Finance technical notes:
The fourth type of property [88(1)(c)(vi)] is added in order to prevent taxpayers from circumventing the restrictions against purchase butterfly reorganizations set out in subsection 55(3.1) of the Act by means of a series of transactions that effectively result in a sale of part of a corporation's assets to an arm's-length corporate purchaser on a tax-deferred basis...
The new rules prevent the parent corporation from obtaining an increase in the adjusted cost base of a property distributed to it on the winding-up of its subsidiary where one or more persons (other than specified persons) who had a significant interest in the subsidiary before the parent last acquired control of the subsidiary acquire, directly or indirectly, a significant interest in the property after the winding-up.
However, it is recognized that the bump denial rule in subparagraph 88(1)(c)(vi) has been drafted in a very broad manner and can apply in situations other than those of a backdoor purchase butterfly.
We note that the Department of Finance issued a comfort letter to our Directorate in 2005 in a situation where the beneficiaries under the will were the children and grandchildren of the deceased individual and a "pipeline" strategy similar to the one in the Particular Situation was undertaken. The letter stated that the Department of Finance was prepared to recommend to the Minister of Finance that the Act be amended so that the meaning of "specified person" be expanded to include, in that particular scenario, the grandchildren of the deceased; and that the amendment be effective to windings-up that begin after 2004. In that regard, we refer you to documents E 2008-028822 and E 2004-008855.
Answer to questions 2) and 3)
In the Particular Situation, C would be a "specified shareholder" of HOLDCO at any time during the course of the series of transactions and before control of HOLDCO would be last acquired by NEWCO.
However, for the purposes of subparagraph 88(1)(c)(vi), if C receives from A and B property other than property distributed by HOLDCO to NEWCO or substituted property as consideration for the sale of his shares of the capital stock of HOLDCO then the bump denial rule in subparagraph 88(1)(c)(vi) should not be applicable in the Particular Situation. On this point, it is worth noting that money is excluded from the notion of "substituted property" pursuant to subparagraph 88(1)(c.3)(iii) but not from the notion of "distributed property".
Our comments are based on the information provided to us in your request and are limited to the questions submitted. We hope our comments will be of assistance to you, however they do not address all of the potential income tax implications that could arise in a situation similar to the one described above; for example, the application of subsection 84(2).
Maurice Bisson, CGA
Corporate Reorganization Section IV
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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