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 Does the calculation of the average annual rate of return take into consideration the paid-up capital of the shares initially acquired or the commuted value of the preferred shares in a freeze?
Position: See letter below.
Reasons: See letter below.
(Veuillez noter que le document ACC9311 fait référence au 9014615 et le document FE91_147.149 fait référence au 9031715.)
APFF FEDERAL TAX ROUNDTABLE 11 OCTOBER 2013
APFF CONFERENCE 2013
Application of subsection 110.6(8)
To be able to utilize the capital gains deduction when selling qualified small business shares, certain conditions must be satisfied. Among others, by virtue of subsection 110.6(8) no deduction is allowed in the case where the value of the shares is attributable to dividends not being paid on a share or to dividends paid on such a share being less than 90% of the average annual rate of return on that share for the year. However, this provision does not apply if the share is a prescribed share under section 6205 of the Income Tax Regulations (the "ITR").
In the definition under subsection 110.6(9) of average annual rate of return, it is stated that, for the purposes of subsection 110.6(8), the average annual rate of return is that which a knowledgeable and prudent investor who purchased the share on the day it was issued would expect to receive in that year in respect of the share.
In a 1990 Technical Interpretation (ACC9311), the CRA stated that the average annual rate of return test would not take into account the proceeds that an investor could expect to receive on the disposition of the shares, which may differ from the price of the initial issue. A 1991 interpretation (FE91_147.149) also stated that it must be assumed, for the purposes of the average annual rate of return test, that the prudent investor would receive, at the time of disposition, the same amount as the corporation received at the time of its issue. These two interpretations suggest that the average annual rate of return test must be based on the paid-up capital of the shares, which appears to be disputed in a 1998 interpretation (9726375).
For example, Mr. X and Mr. Y, who deal with each other at arm's length, each subscribed for 50 common shares in a new corporation, Opco, with a total legal paid-up capital of $100. Several years later, they decided to effect an estate freeze, while the total value of Opco's common shares was now $2,000,000. On the estate freeze, Mr. X and Mr. Y exchanged their common shares of Opco for preferred shares with a redemption value of $2,000,000 and their respective trusts, Trust X and Trust Y, subscribed for 50 new common shares of Opco. The preferred shares provided for the payment of an annual dividend of between 0% and 10%. The preferred shares of Opco received by Mr. X and Mr. Y were not prescribed shares since the new common shares were held by trusts with whom both of those two shareholders did not have a non-arm’s length relationship (Trust X deals not at arm’s length only with Mr. X and Trust Y deals not at arm’s length only with Mr. Y) as required by subsection 6205(2) RIR. In order to be able to utilize the capital gain deduction each year, a dividend that satisfies the definition of average annual rate of return must be paid on the preferred shares.
Question to the CRA
In order to satisfy the definition of average annual rate of return in subsection 110.6(9), should the average annual rate of return be calculated using the paid-up capital of the shares originally acquired ($100) or using the redemption amount of the preferred shares issued during the freeze ($2,000,000)?
In determining the average annual rate of return for the purposes of subsection 110.6(8), paragraph 110.6(9)(c) requires that this rate of return be determined on the assumption that a knowledgeable and prudent investor, who purchased the share on the day it was issued, would receive, on the disposition of the share, the same amount received as consideration on the issue of the share.
In such a case, we are of the view that a knowledgeable and prudent investor would normally seek to obtain a dividend rate as a function of the amount paid by the investor to acquire the share. We are of the opinion that this rate is based on an objective standard. The expectations of a knowledgeable and prudent investor should be determined on the assumption that there would be no delay, postponement or default in the payment of dividends, that the dividends would be paid each year at a predetermined fixed or floating rate and that the proceeds to be received by the investor on the disposition of the share are the same amount the corporation received as consideration on the issue of the share.
Upon the issuance of a share, if it were expected that the corporation’s cash would be reinvested and the dividend rate would be lower due to this need for cash, the CRA is of the opinion that it would be necessary to take this fact into account in determining the annual rate of return that a knowledgeable and prudent investor would expect to receive in the form of a dividend.
In the situation described above, we are of the view that the average annual rate of return that should be paid on the preferred shares held by Mr. X and Mr. Y should be based on the amount that these taxpayers will have paid to acquire those shares, namely, $2,000,000.
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