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: In a situation, Opco may issue three classes of shares that are voting, participating equally in the distribution of the corporation's property in the process of dissolution and having a right to discretionary dividends. Class A common shares would be issued by Opco to Holdco A eight years after the other classes of common shares were issued. A common shares would be equal to $70,000. Opco for the period that would be paid on the basis of a dividend would be paid on a Class A common shares would be $20,000. A discretionary dividend of $35,000 would be paid on Class A common shares. (2.1)(c) (a) (b) (b) (b) (c) and (c) of the Act is replaced by the following: If Opco is wound up and dissolved immediately after the discretionary dividends, how would the safe income of Opco be allocated?
(2.1) (c) is more than $20,000, safe income on hand of $ 20,000 would be considered To contribute to the hypothetical capital gain on Class A common shares, which is the safe income accumulated by Opco.
POSITION: In the particular situation described below, if a winding-up and dissolution of Opco follows the discretionary dividend on Class A common shares and Opco has no other safe income on hand, Class B common shares would be equal to $ 35,000 and the safe income on hand would contribute to the hypothetical capital gain on the Class C common shares would be equal to $ 35,000. There would be no safe income on hand that would contribute to the hypothetical capital gain on the Class A common shares.
REASONS: Wording of that Act and previous positions with respect to the holding period.
7 OCTOBER 2016 APFF FEDERAL ROUNDTABLE - 2016 CONFERENCE
DIFFERENT PERIODS AND AGGREGATE SAFE INCOME
Three unrelated shareholders hold all of the shares in the capital stock of Opco. The shareholders are corporations resident in Canada.
Each shareholder holds a separate class of voting and participating shares in the capital stock of Opco (HA holds 100 Class "A" common shares, HB holds 100 Class "B" common shares and HC holds 100 class "C" common shares ). The shares in the capital stock of Opco carry the right to a discretionary dividend.
In Year 1, HB and HC form Opco by investing $100 each.
In Year 8, Opco's global safe income is $70,000 and its FMV is $100,000.
In Year 8, HA subscribes for 100 Class "A" common shares for $50,000.
In Year 10, Opco's aggregate safe income is $90,000 and its FMV is $170,300.
Opco pays a dividend of $35,000 to HA in Year 10.
Question to the CRA:
How should the aggregate safe income be allocated among the different classes given their different holding periods?
The answer to this question will depend on the FMV that could be attributed to the Class "A" shares in the capital stock of Opco held by HA. The FMV will be determined immediately before the dividend payment but taking into account that such shares will be entitled to an additional amount equal to the dividend declared in respect of those shares. This permits a calculation of what the hypothetical capital gain would be that would have been realized on a disposition of the share at FMV immediately before the dividend taking into account the assumptions referred to in paragraph 55(2.1)(c). This is a valuation question on which the CRA cannot pronounce in a hypothetical situation.
To determine whether paragraph 55(2.1)(c) applies, it is necessary to compare the dividend paid to the safe income on hand ("SIOH") earned or realized before the safe income determination time that could reasonably be considered to contribute to the hypothetical capital gain (based on the assumptions of this paragraph). In the current situation, the SIOH that it could reasonably be considered to contribute to the hypothetical capital gain on the Class "A" shares held by HA could not exceed the income earned or realized by the corporation after the issuance of Class "A" shares to HA. In the current situation, the composition of the $20,000 of such SIOH indicated by you must be examined. For example, a gain on assets of Opco had accrued to the date of the issue of the Class "A" shares to HA (which is reflected in the cost of the shares to HA), which had been realized since the issue of the Class "A" shares to HA and before the safe income determination time and was part of the $20,000 amount, could not be included in the amount that could reasonably be considered to contribute to the hypothetical capital gain on the Class "A" shares held by HA - since it was reflected in the cost of the shares to HA. Thus, such a gain would be subtracted from the $20,000 amount for the purposes of paragraph 55(2.1)(c).
If, on the facts described above, the income earned or realized by Opco after the date of issuance of the Class "A" shares in the capital stock of Opco HA represented business income, the SIOH which contributed to the hypothetical capital gain on the Class "A" shares could not exceed $20,000. All SIOH before the subscription (or, for instance, gain accrued prior to that subscription and subsequently realized) should generally be reflected in the shares’ ACB and, therefore, does not contribute to the hypothetical capital gain in accordance with the assumptions of paragraph 55(2.1)(c).
Under the assumptions indicated by you, there was an increase in the FMV of the corporation from the time of the shares subscription by an amount which was somewhat greater than the income earned or realized by Opco. In particular, the value of the corporation increased from $150,000 immediately after the subscription for the Class "A" shares to $170,300, while the income earned or realized subsequently to the share subscription was $20,000.
If the CRA considered that the dividend of $35,000 declared on the Class "A" shares in the capital stock of Opco was part of the FMV of the Class "A shares immediately before the dividend payment, the hypothetical FMV of the Class "A" shares held by HA is $80,100 ([($170,300 - $35,000) / 3] + $35,000). The hypothetical capital gain on the Class "A" shares held by HA is equal to $30,100. Assuming that the SIOH amount of $20,000 is derived from business income, it could be reasonable to consider that the SIOH from the date of issue of the Class "A" shares in the capital stock of Opco up to the safe income determination time ($20,000 according to the indicated facts) contributes to the hypothetical capital gain of $30,100 on the Class "A" shares of Opco.
The amount of $20,000 would represent a separate taxable dividend pursuant to paragraph 55(5)(f) and would not be subject to subsection 55(2). In contrast, if one of the purpose tests under paragraph 55(2.1)(b) was satisfied as well as the other conditions for the application of subsection 55(2), this provision would apply in respect of an amount of $15,000 (the excess of the $35,000 dividend over $20,000).
The CRA would accept that the amount of a dividend which is subject to subsection 55(2) does not reduce SIOH. In contrast, the SIOH of the corporation would be reduced by the portion of the dividend in respect of which subsection 55(2) does not apply.
If no other dividends were declared and paid, if there was no increase in SIOH of the corporation (following its reduction by a portion of the dividend paid to HA), if the value of the corporation changed from $170,300 to $135,300 ($170,300 minus $35,000) if Opco was liquidated and if the remaining property was distributed equally to each shareholder, the hypothetical capital gain on the Class "A" shares would be nil ($45,100 less $50,000). The hypothetical capital gain on the shares of the Class "B" and Class "C" shares would be $45,000 ($45,100 minus $100). Using these values, no SIOH could be attributed to the Class "A" shares held by HA, and the SIOH that could reasonably be considered to contribute to the hypothetical capital gain on the Class "B" and "C" shares held, respectively, by HB and HC would equal $35,000.
Our conclusion might be different if it were determined that the dividend of $35,000 was not part of the FMV of the Class "A" shares immediately before the dividend since the hypothetical capital gain would be reduced.
In a situation such as the one you mention, it is equally necessary to ensure that there is no other legislative provision which would result in tax consequences to one of the shareholders. Indeed, there should be a consideration inter alia what the effect is of the transfer of part of the value of the "B" and "C" shares by HB and HC to HA, which is accomplished by paying a discretionary dividend which is greater than the income earned or realized by Opco subsequently to the issuance of the Class "A" shares. Such a transfer of value or waiver of a portion of the accumulated value by one shareholder, having joined the corporation subsequently, to another appears unlikely where shareholders are dealing at arm’s length and it would be necessary to examine what motivated such an transfer or waiver.
Similarly, the answer to this question is not intended to give our general approval for the use of discretionary dividend shares. Indeed, the issuing and holding of shares as discretionary dividends could result in other tax consequences that may be adverse to certain taxpayers. For example, there may be situations where some provisions could apply such as subsections 15(1), 56(2), 69(1) and 246(1). Similarly, there may be abusive situations where the CRA would consider the use of the general anti-avoidance rule ("GAAR") in subsection 245(2).
It should also be noted that the use of discretionary dividend shares could have an adverse impact if a butterfly transaction was envisaged in a particular situation. Indeed, given the uncertainty in the valuation of discretionary dividend shares, it may make it more difficult to meet the conditions for considering that there is a distribution, as defined in subsection 55(1), for the purposes of paragraph 55(3)(b) in this situation. Similarly, the use of discretionary dividend shares could result in unintended consequences due to the difficulty connected to calculating the FMV of the shares where a reorganization under paragraph 55(3)(a) is envisaged.
Sylvie Labarre (613) 670-9014
October 7, 2016
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