27 October 2020 CTF Roundtable Q. 1, 2020-0860991C6 - ACB increase due to misalignment of ACB

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: A reorganization where outside and inside ACB are misaligned could result in an inappropriate increase in ACB on a possible wind-up (or short-form amalgamation).

Position: GAAR could apply and favourable ruling cannot be provided in such situation.

Reasons: Inappropriate increase in ACB is against the scheme of the Act and particularly subsection 55(2).

2020 CTF Annual Conference
CRA Roundtable

Question 1: ACB increase in a reorganization caused by a misalignment of outside and inside ACB

Question 1: ACB increase in a reorganization caused by a misalignment of outside and inside ACB

Consider the following situation:

1. Parentco originally incorporated Subco1 and subscribed for shares of Subco1 with an ACB of $2,000 on incorporation.
2. Subco1 incorporated Subco2 and subscribed for shares of Subco2 with an ACB of $2,000 on incorporation.
3. Subco2’s value increased to $20,000. Subco2 did not realize any safe income.
4. The value of other assets in Subco1, which was nil on incorporation of Subco1, increased to $180,000. Subco1 did not realize any safe income.
5. Parentco, Subco1 and Subco2 are Canadian-controlled private corporations.
6. It is proposed that Subco1 transfers Subco2 to Newco, a wholly-owned subsidiary of Parentco, in a reorganization that qualifies under either paragraph 55(3)(a) or 55(3)(b) of the Act. The steps of the reorganization would be as follows:
   
   1. Parentco transfers shares of Subco1 having an ACB of $200 ($2,000 x $20,000/$200,000) and a FMV of $20,000 to Newco on a rollover basis in consideration for shares of Newco.
   2. Subco1 transfers shares of Subco2 to Newco on a rollover basis in consideration for shares of Newco.
   3. The shares held between Subco1 and Newco are cross-redeemed.
   4. Newco is subsequently wound-up into Parentco. Subsection 88(1) applies to the wind-up.

Before the reorganization, Parentco owned shares of Subco1 with an ACB of $2,000 and a FMV of $200,000. Subco1 owned assets with an aggregate ACB of $2,000 and an aggregate FMV of $200,000.

After the reorganization and the wind-up of Newco, Parentco will own shares of Subco1 with an ACB of $1,800 and a FMV of $180,000 and shares of Subco2 with an ACB of $2,000 and a FMV of $20,000. In aggregate, the assets owned by Parentco after the reorganization and wind-up of Newco will have an ACB of $3,800 and a FMV of $200,000. Subco1 will own assets having no ACB and a FMV of $180,000. Does the CRA have any concern with this situation?

CRA Response

We recently received a ruling request with respect to a similar reorganization and we were unable to issue a favourable ruling in that regard based on the following considerations:

1. Let’s consider the following distinct possibilities if there was no reorganization:
   
   1. If Subco1 sold all of its assets at FMV, a total capital gain of $198,000 would be realized by Subco1. Subco1 could then distribute the after-tax money to Parentco. Suppose the net tax to be paid by Subco1 (ignoring the RDTOH refund and Part IV tax mechanism) is $39,600, based on a hypothetical tax rate of 40%, Parentco would be entitled to receive $160,400 from Subco1 on a tax-free basis, i.e., as a return of capital of $2,000, a CDA dividend of $99,000 and a safe income dividend of $59,400.
   2. If Parentco sold Subco1 at FMV, a capital gain of $198,000 would be realized by Parentco. On an after-tax basis, it’s the same as if Subco1 sold the assets and distributed the after-tax money to Parentco, i.e., Parentco would retain $160,400 after tax.
   3. The results discussed in a. and b. above are due to the integration mechanism in the corporate tax system.
   4. If Subco1 only sold Subco2 and distributed the after-tax money to Parentco, it would realize a capital gain of $18,000. Assuming the same tax rate as above of 40% and ignoring the RDTOH and Part IV tax mechanism, Subco1 would pay $3,600 of tax and would be able to distribute to Parentco $9,000 of CDA dividend and $5,400 of safe income dividend. Subco1 could also reduce PUC on the shares held by Parentco for $2,000 tax-free. However, any payment of a taxable dividend by Subco1 to Parentco in excess of $5,400 would attract the scrutiny of subsection 55(2) since the latent gain on the remaining assets of Subco1 has not been realized.
2. Because Parentco has in fact exchanged shares of Subco1 having an ACB of $200 for shares of Subco2 having an ACB of $2,000 as part of the reorganization, Parentco has obtained an increase of $1,800 in ACB that is equivalent to a reduction of tax of $360. This result is a form of duplication of tax basis on assets held by Parentco. If Parentco were to sell Subco1 and Subco2 after the winding-up of Newco, it would realize a capital gain of $196,200 (instead of $198,000 as discussed above) and the applicable tax amount would be $39,240 (instead of $39,600 as discussed above).
3. If Newco was not wound-up and it disposed of the shares of Subco2 and then made a distribution to Parentco, the results are the same as discussed in 1.d. above. Newco would have an after-tax cash of $16,400. It would be able to make a tax-free distribution to Parentco of only $14,600, i.e., $9,000 of CDA dividend, $5,400 of safe income dividend and $200 of PUC reduction. The excess of $1,800 would attract the scrutiny of subsection 55(2) if distributed as a taxable dividend. If shares of Newco were redeemed to inappropriately take advantage of the paragraph 55(3)(a) exemption, the CRA would consider the application of GAAR.
4. Although the possible exchange of shares of Subco1 by Parentco prior to their transfer to Newco and the transfer itself may have complied with subsection 51(1), 86(1) or 85(1), a misalignment of outside ACB (i.e., ACB in the shares of Subco1 and Newco held by Parentco) and inside ACB (i.e., ACB in the assets held by Subco1 and Newco) on the reorganization followed by a winding-up of Newco provide an inappropriate result. In this type of situation, the CRA would not rule favourably and would consider the application of GAAR because there is an undue increase in ACB in the hands of Parentco that is against the scheme of the Act and particularly of subsection 55(2).
5. This winding-up under subsection 88(1) has to be distinguished from a “normal” winding-up under subsection 88(1) where a parent would have inherited assets of a subsidiary that have an ACB higher than the ACB of the shares of the subsidiary held by the parent and where the difference between the outside ACB and the inside ACB is not due to a bargain purchase. In those “normal” winding-ups, the ACB of the assets of the subsidiary would normally be supported by after-tax money earned by the subsidiary, i.e., safe income. In the situation discussed above, the subsidiary, Newco, has acquired assets in a tax-free reorganization in which high ACB is pushed into the subsidiary while the outside ACB is low.
6. A favourable ruling could be obtained in this situation if Parentco transferred enough ACB in the shares of Subco1 to Newco to cover the ACB (and any safe income that can be crystallized into ACB) of the assets to be transferred to Newco. This would result in an alignment of inside and outside ACB. The picture prior to the winding-up of Newco would be as follows: