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: How to allocate safe income and ACB in a reorganization involving several tiers of corporations.
Position: see document.
Reasons: see document.
XXXXXXXXXX
2021-088961
Marc Ton-That
May 28, 2021
Dear XXXXXXXXXX
Re: ACB and Safe income allocation on corporate reorganization
This is in response to your letter of April 14th, 2021 in which you requested our views on the situations described below.
Unless otherwise stated, all statutory references herein are to the Income Tax Act (Canada).
Assume that Parentco owns 100% of Holdco 1 which owns 100% of Holdco 2 which owns 100% of Opco. The group intends to transfer one of Opco’s existing business assets (“Property 1”) to Holdco 1 on a tax-deferred basis. Holdco 1 owns assets in addition to the shares of Holdco 2. Holdco 2 owns assets in addition to the shares of Opco. Opco owns assets in addition to Property 1.
Assume further the following to represent complete facts with respect to this hypothetical situation:
- Shares owned by Parentco in Holdco 1 have a cost of nil and a FMV of $2,100.
- Holdco 1 owns shares of Holdco 2 with a cost of $75 and a FMV of $1,200.
- Holdco 1 owns other assets with a cost of $925 and a FMV of $900.
- Holdco 1 has realized safe income of $1,000.
- Holdco 2 owns shares of Opco with a cost of $65 and a FMV of $1,100.
- Holdco 2 owns other assets with a cost of $20 and a FMV of $100.
- Holdco 2 has realized safe income of $10.
- Opco owns Property 1 with a cost of $100 and a FMV of $400.
- Opco owns other assets with a cost of $135 and a FMV of $700.
- Opco has realized safe income of $170.
- No safe income will be capitalized prior to the reorganization.
Alternative A
1. Holdco 1 forms Newco and subscribes for nominal common shares.
2. The following steps are taken to transfer Property 1 to Newco.
(a) Opco transfers Property 1 to Newco in exchange for preferred shares of Newco (the “Newco Class A Preferred Shares”) on a tax-deferred basis pursuant to subsection 85(1). The Newco Class A Preferred Shares have a redemption/retraction value and fair market value equal to the fair market value of Property 1.
(b) Holdco 2 exchanges all of its shares of Opco for a class of preferred shares of Opco (the “Opco Preferred Shares”) with a redemption/retraction value and fair market value equal to fair market value of Property 1, and new common shares on a tax deferred basis pursuant to subsection 85(1). In accordance with paragraph 85(1)(g), this will result in the streaming of the pre-existing ACB (i.e., elected amount) to the Opco Preferred Shares to the extent of their value, i.e., up to $65 according to the above assumptions.
(c) Holdco 2 transfers the Opco Preferred Shares to Newco in exchange for preferred shares of Newco (the “Newco Class B Preferred Shares”) on a tax deferred basis pursuant to subsection 85(1). The Newco Class B Preferred Shares have redemption/retraction value and fair market value equal to fair market value of the Opco Preferred Shares.
(d) The Opco Preferred Shares held by Newco are redeemed with redemption price paid by Opco’s promissory note (the “Opco Promissory Note”). The Newco Class A Preferred Shares held by Opco are redeemed with redemption price paid by Newco’s promissory note (the “Newco A Promissory Note”).
(e) The Opco Promissory Note and the Newco A Promissory Note are set off and cancelled.
3. The steps in paragraph 2 above result in Holdco 2 owning the Newco Class B Preferred Shares of Newco. To eliminate this ownership link between Newco and Holdco 2, the following steps (similar to those in the preceding paragraph but now involving Holdco 1) are taken:
(a) Holdco 1 exchanges all of its shares of Holdco 2 for a class of preferred shares of Holdco 2 (the “Holdco 2 Preferred Shares”) with a redemption/retraction value and fair market value equal to fair market value of the Newco Class B Preferred Shares, and new common shares on a tax deferred basis pursuant to subsection 85(1). In accordance with paragraph 85(1)(g), this will result in the streaming of the pre-existing ACB (i.e., elected amount) to the Holdco 2 Preferred Shares to the extent of their value, i.e. up to $75 according to the above assumptions.
(b) Holdco 1 transfers the Holdco 2 Preferred Shares to Newco in exchange for common shares of Newco on a tax deferred basis pursuant to subsection 85(1).
(c) The Holdco 2 Preferred Shares held by Newco are redeemed with redemption price paid by Holdco 2’s promissory note (the “Holdco 2 Promissory Note”). The Newco Class B Preferred Shares held by Holdco 2 are redeemed with redemption price paid by Newco’s promissory note (the “Newco B Promissory Note”).
(d) The Holdco 2 Promissory Note and the Newco B Promissory Note are set off and cancelled.
4. As a result of the above steps, Property 1 is owned by Newco which is wholly-owned by Holdco 1. Newco winds up in accordance with subsection 88(1) and Property 1 is owned by Holdco 1.
Alternative B
5. Holdco 1 forms Newco and subscribes for nominal common shares.
6. Opco transfers Property 1 to Newco in exchange for preferred shares of Newco (the “Newco Class A Preferred Shares”) on a tax-deferred basis pursuant to subsection 85(1). The Newco Class A Preferred Shares have a redemption/retraction value and fair market value equal to fair market value of Property 1.
7. Holdco 2 exchanges all of its shares of Opco for a class of preferred shares of Opco (the “Opco Preferred Shares”) with a redemption/retraction value and fair market value equal to fair market value of Property 1, and new common shares on a tax deferred basis pursuant to subsection 85(1). In accordance with paragraph 85(l)(g), this will result in the streaming of the pre-existing ACB (i.e., elected amount) to the Opco Preferred Shares to the extent of their value, i.e., $65 under the above assumptions.
8. The Newco Class A Preferred Shares held by Opco are redeemed with redemption price paid by Newco’s promissory note (the “Newco A Promissory Note”).
9. The Opco Preferred Shares held by Holdco 2 are redeemed with redemption price paid by Opco’s assignment of the Newco A Promissory Note.
10. Holdco 1 exchanges all of its shares of Holdco 2 for a class of preferred shares of Holdco 2 (the “Holdco 2 Preferred Shares”) with a redemption/retraction value and fair market value equal to fair market value of Property 1, and new common shares on a tax deferred basis pursuant to subsection 85(1). In accordance with paragraph 85(l)(g), this will result in the streaming of the pre-existing ACB (i.e., elected amount) to the Holdco 2 Preferred Shares to the extent of their value, i.e., $75 under the above assumptions.
11. The Holdco 2 Preferred Shares held by Holdco 1 are redeemed. As Holdco 2 holds the Newco A Promissory Note as a result of the assignment in paragraph 9 above, Holdco 2 will pay the redemption price by assignment of the Newco A Promissory Note.
12. As a result of the foregoing steps, Property 1 is owned by Newco which is wholly owned by Holdco 1. Also. Holdco 1 holds the Newco A Promissory Note. Newco winds up in accordance with subsection 88(1) and Property 1 is owned by Holdco 1. An election is made pursuant to subsection 80.01(4) such that Newco A Promissory Note is deemed settled at cost amount and is thereby cancelled.
Your comments were as follows:
13. Alternative B does not involve cross-redemptions. Where Opco and Holdco 2 have refundable tax balances (whether ERDTOH or NERDTOH), cross-redemptions will result in Part IV tax circularity unless different steps are taken.
14. At the end of the series of transactions in Alternative B, the Newco A Promissory Note is cancelled. There is no purpose to increase the cost of property upon receipt of the note where there is a cross-redemption as part of the series. The Newco A Promissory Note is not contributed to capital of Newco and not “used” to create cost. Nor is the promissory note held in abeyance for any future “use”. It is cancelled.
15. As described above, the use of a subsection 85(1) share transfer rather than a section 86 share capital reorganization will result in the streaming of pre-existing cost to the class of preferred shares created in such step, to the extent of their value. In each case, the preferred shares to which cost is streamed, are later redeemed and cancelled (whether Alternative A or B). This should address any concern about misalignment of outside and inside basis as described in Question 1 of the 2020 CRA Roundtable. At the end of Alternative A or B, Holdco 1 will own Property 1 with an ACB equal to the amount which was Opco’s ACB of Property 1 prior to the reorganization. Also, Holdco 1 will continue to own shares of Holdco 2, but the ACB of such shares shall be reduced as a result of the prior streaming and share redemption/cancellation.
16. Questions 3 and 4 of the 2020 Roundtable provided guidance on the impact of reorganizations on safe income, an issue not previously addressed by CRA. If steps are taken as referred to in paragraph 15 above to address the misalignment of outside and inside basis, does CRA require representations regarding direct safe income and indirect safe income of each corporation, both prior to the reorganization and following the reorganization as a prerequisite to a favourable ruling?
OUR COMMENTS
This technical interpretation provides general comments about the provisions of the Act and related legislation. It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R10 – Advance Income Tax Rulings and Technical Interpretations.
Regardless of the form of the transactions, the CRA’s views on the impact of the reorganization on the safe income of each corporation and on the required elimination of ACB on shares held in the corporations are as follows:
- Prior to the reorganization, the cost on the shares of Opco held by Holdco 2 ($65) and the safe income realized by Opco ($170) have contributed to the acquisition of property held by Opco with a total cost of $235 (cost in Property 1 of $100 and cost in other assets of $135).
- As explained in documents 2020-0861031C6 and 2021-0876441E5, when Opco has transferred Property 1 out on a tax-free basis, its direct safe income (DSI) should be reduced.
- Because of the chain of corporations involved, in the situation where Property 1 is transferred by Opco up the chain to Holdco 1 on a tax-free basis, the CRA will consider that Opco has transferred Property 1 to Holdco 2 and Holdco 2 has in turn transferred Property 1 to Holdco 1 for purposes of the calculations described below. Therefore, Opco is considered to have transferred a portion of its DSI to Holdco 2 and Holdco 2 is considered to have transferred a portion of its DSI to Holdco 1.
- The DSI and indirect safe income (ISI) of each corporation and the required ACB transfer to avoid misalignment of outside and inside cost would be calculated as follows:
1. DSI on the shares of Opco after reorg: DSI of Opco prior to reorg ($170 x net cost amount of assets retained by Opco ($135) / total cost amount of assets of Opco prior to reorg ($235) = $98.
2. DSI of Opco considered to be transferred to Holdco 2: $170 - $98= $72.
3. The ACB of shares of Opco held by Holdco 2 that is required to be eliminated on the reorg is $28, resulting in a remaining ACB in the shares of Opco held by Holdco 2 after the reorg of (65-28) $37. In the current situation, this ACB of $37, combined with the remaining safe income of Opco of $98 would be the correct amount required to support the cost of the remaining assets of Opco of $135.
4. DSI of Holdco 2 after reorg: (DSI of Holdco 2 prior to reorg ($10) + amount considered to have been received from Opco ($72)) x net cost amount of assets considered retained by Holdco 2 ($57) / (net cost amount of assets of Holdco 2 prior to reorg ($57) + net cost amount of assets considered to have been received from Opco ($100)) = 82 x 57 / 157 = $30.
5. DSI of Holdco 2 considered to be transferred to Holdco 1: 82 – 30 = $52.
6. ISI of Holdco 2 after reorg: equal to DSI of Opco after reorg = $98.
7. The ACB of shares of Holdco 2 held by Holdco 1 that is required to be eliminated on the reorg is $48, resulting in a remaining ACB in the shares of Holdco 2 held by Holdco 1 after the reorg of (75-48) $27. In the current situation, this ACB of $27, combined with the remaining safe income of Holdco 2 of $30 would be the correct amount required to support the cost of the remaining assets of Opco of $57 ($37 in the cost of the shares of Opco and $20 in the cost of other assets).
8. DSI of Holdco 1 after reorg: DSI of Holdco 1 prior to reorg ($1,000) + amount considered to have been received from Holdco 1 ($52) = $1,052. The DSI of Holdco 1 of $1,052, combined with the cost on the shares of Holdco 1 held by Parentco of nil, would be the correct amount required to support the cost of the assets held by Holdco 1 after the reorg of $1,052 (being the aggregate of $100 of cost on Property 1, remaining ACB in the shares of Holdco 2 of $27 and cost of other assets of $925).
9. The ISI of Holdco 1 after reorg would be $98 + $30= $128.
Alternatives A and B:
As explained above, the safe income at each level below Holdco 1 will be reduced and the ACB of the shares held by a direct parent in each corporation does not need to be totally eliminated in order to avoid a misalignment of inside and outside ACB. As the calculations above demonstrated, each parent corporation can preserve a certain amount of ACB in the shares of its subsidiary. On the other hand, the full elimination of ACB on the shares of a corporation in a reorganization does not necessarily address the issue of misalignment of ACB, especially when the corporations involved have a significant amount of safe income that was not capitalized. In the hypothetical situation described above, the full elimination of ACB on the shares at each level does not seem to result in a misalignment of ACB that would be concerning to the CRA. This exercise will be very much fact-driven and judgement will be exercised to determine whether a reorganization will result in a misalignment of ACB to which the CRA would consider applying the GAAR.
Regarding the question whether representations regarding safe income of each corporation is a prerequisite to a favourable ruling, it is our view that an estimate of such safe income is always necessary to fully assess the situation being ruled upon since it represents one of the key elements in the appreciation of such situation. On a going-forward basis, a comment will be added to the ruling letter regarding the allocation of safe income that is required on a tax-free reorganization.
We trust the above comments to be of assistance.
Yours truly,
Stephane Prud’homme
Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
UNCLASSIFIED
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