29 July 1992 Income Tax Severed Letter 2M01530 - 1991 Round Table

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.

The following are notes prepared by T. Harris for a panel discussion titled INSIGHTS INTO THE 1991 REVENUE CANADA ROUND TABLE DISCUSSION which was sponsored by the Institute of Chartered Accountants of Ontario and which was held as part of the Bottom Line Trade Show in Toronto on July 29, 1992.

QUESTION 34
CONTROL OF A CORPORATION

In the first part of this question the Department was asked whether two unrelated individuals, A and B, who each holds 50% of the only class of issued shares of a corporation will automatically be considered to act in concert to control the corporation simply because the consent of both is required in order for the corporation to undertake any action.

In the Department's view the mere fact that it is necessary for 2 or more shareholders to agree before the corporation can undertake any course of action is not sufficient, in and by itself, to conclude that those shareholders are acting in concert or together to control the corporation. As stated in paragraph 19 of IT-419 "...acting in concert generally means a predetermined agreement to act in a certain manner." This suggests that it would be necessary to show that there is some arrangement whereby the shareholders have agreed to vote their shares in the same manner or to have their nominees to the board of directors vote together on most matters. Alternatively, it would be necessary to establish that they have common interests such that it would be reasonable to conclude that they will vote their shares together. In other words, the concept of acting in concert generally requires the parties to act in a highly interdependent manner and without separate interests. Acting in an interdependent manner, however, is not necessarily equivalent to sharing a common goal. For example, if each shareholder will agree to a given course of action only if it judges that that course of action is in its own respective interest, then generally it cannot be said that the shareholders are acting together or acting in concert to control the corporation.

With respect to the second part of this question, the Department confirmed that the fact that the chairperson of a shareholders' meeting may have a deciding vote would not give that person control of the corporation, since the deciding vote is by reason of the position as chairperson and not by virtue of voting shares. Where, however, the extended concept of control found in subsection 256(5.1) is relevant then the existence of this deciding vote would have to be considered in determining whether or not the person who holds this power can be considered to have some direct or indirect influence that, if exercised, would result in control in fact of the corporation. In the situation described, that is two 50% shareholders, we confirmed that the existence of the deciding vote would generally give the person holding such vote factual control over the corporation. In any other situation it would be necessary to review all of the facts to determine whether this right gives the holder factual control over the corporation.

QUESTION 22
LOSS DEEMED ON TRANSFER TO A CORPORATION

In our response to the first part of this question the Department confirmed that where an estate disposes of property, in this case being some of its shares in a corporation, to a corporation and immediately following the disposition the estate controls the corporation, then subsection 85(4) will apply to deny any capital loss which would otherwise arise as a result of the disposition. As stated in our response, it is the Department's view that subsection 164(6) does not override subsection 85(4) or any other similar provision of the Income Tax Act for purposes of determining whether a capital loss has occurred.

With respect to the second part of this question, the Department indicated that subsection 85(4) will not apply where all of the shares of a corporation held by an estate are disposed of to a corporation which, immediately following the disposition, is controlled by the estate's legal representative in his or her personal capacity unless, immediately following the disposition, the corporation is controlled, directly or indirectly in any manner whatever, by the estate. At first glance, this response may seem somewhat contradictory in that you may ask yourself how the corporation can be controlled by both the executor of the estate in his or her personal capacity and also by the estate. It must be remembered that we are dealing with two concepts of control. The executor may have de jure control by virtue of owning more than 50% of the voting shares of the corporation. However, subsection 85(4) refers to the corporation being controlled, directly or indirectly in any manner whatever. You will recall from our discussion of the previous question that this is a factual control test. Although the estate may not own any voting shares of the corporation, it could still be in a position to exercise some influence over the corporation which would result in it having factual control over the corporation. For example, if the shares owned by the estate are repurchased for consideration consisting of a demand promissory note and the calling of the note by the estate would have an adverse impact on the operations of the corporation, then the estate could be considered to have some influence which could result in factual control of the corporation. The determination of whether the estate has any such influence over the corporation can only be made following a consideration of all of the facts related to a particular situation.

QUESTION 48
SECTION 85 ELECTIONS - V-DAY DISPUTES

At the time that the administrative position outlined in paragraph 14 of former Information Circular 76-19R was adopted in 1978 there was no provision in the Income Tax Act which permitted a taxpayer to amend a validly filed election made under section 85 of the Act. This administrative position was discontinued with the release of the revised circular IC 76-19R2 [Information Circular 76-19R2] dated June 15, 1990 as subsection 85(7.1) had been enacted setting out the circumstances in which amended elections would be permissible and required that a penalty of up to $8000 be paid before the amended election was valid.

I have been asked to comment on whether the penalty could be avoided by the use of a price adjustment clause which provides that the valuation day value, and consequently the agreed amount stipulated in the election, would be retroactively amended in the event that the valuation value is finally determined to be different from that set out in the election.

The Department's views with respect to price adjustment clauses and their effect on section 85 elections is described in paragraph 25 of IC 76-19R2 [Information Circular 76-19R2] which states that "in order to give effect to a price adjustment clause, an amended election must be filed under subsection 85(7.1)." Since an amended election will only be valid where the stipulated penalty is paid, it follows that the use of such price adjustment mechanisms will not be effective for purposes of avoiding the penalty provisions.

In the Department's view the agreed amount set out in a section 85 election is a key term of the election. Consequently, any change to the agreed amount, whether subject to a price adjustment clause or not, will result in an amended election.

As a final comment, I would like to point out that the penalty provisions found in section 85 are similar to those contained in the recently enacted "Fairness Package".

QUESTION 49
INVENTORY WRITE-DOWN - SINGLE VENTURE

The Weatherhead case is one of several cases heard by the courts over the past few years dealing with the issue of whether a taxpayer which holds property as an adventure in the nature of trade is entitled to follow the lower of cost or market rule found in subsection 10(1) of the Income Tax Act. The Department's first public pronouncement on this issue was made at the 1988 Revenue Canada Round Table of the Canadian Tax Foundation where it was stated that where property is acquired as an adventure in the nature of trade and not for the purpose of trading in that type of property it is the Department's view that one does not compute income or loss from that source until the year in which the property is sold. Consequently, in our view subsection 10(1) does not apply in this situation. The Department's position is based on the decisions of the Supreme Court in MNR v. Joseph Irwin [[1964] C.T.C. 362] (64 DTC 5227) and MNR v. Shofar Investments Corporation [[1979] C.T.C. 433] (79 DTC 5347), of the Federal Court of Appeal in Oryx Realty Corporation v. MNR [[1974] C.T.C. 430] (74 DTC 6352) and of the Tax Court in Jellaczyc v. MNR [[1985] 1 C.T.C. 2158] (85 DTC 184).

In the Irwin case Abbot J. stated that "This appeal has raised the question of whether the inventory provisions of the Act and the Regulations have effected a change in the settled concept of profit. I doubt whether the combined effect of s. 14 (now s. 10) of the Act and Regulation 1800 of the Income Tax Regulations, to which I shall refer in a moment, has made any such change, and I am also doubtful whether, in any event, the inventory provisions referred to are applicable in the circumstances of a case such as this where the actual cost and sale price of each particular piece of property are well established."

Since the Department's response to this question was given last November, another case on the same issue ( Friesen v. MNR ) was decided in the Department's favour by Justice Rouleau of the Federal Court Trial Division. Relying in part on the Supreme Court's decision in the Shofar Investments case, Justice Rouleau found that "in a business of few transactions, the value of its inventory is not relevant in computing income until disposition. As a result, in a year when property is not sold, it would not be included in the computation of income for tax purposes and, therefore, subsection 10(1) would not apply."

The final word on this issue remains to be heard as the taxpayer has appealed this decision to the Federal Court of Appeal.

QUESTION 14
SALES OF ASSETS

This question essentially deals with the determination of when a disposition of property will be regarded as being effective for income tax purposes. In the Department's view the date of disposition of property sold is the date on which the beneficial ownership is intended to pass to the purchaser and the vendor has an absolute but not necessarily immediate right to be paid. Where the transfer of beneficial ownership is subject to a "condition precedent" the vendor does not have an absolute right to be paid until the condition is either satisfied or waived.

As stated in Interpretation Bulletin IT-170R, a condition precedent is an event which is beyond the direct control of the vendor and which suspends completion of the contract until the condition is met or waived. If the condition precedent is not met or waived the contract will, in most instances, be void ab initio. In other words, until the condition is met or waived there is no binding contract. Some examples of conditions precedent are:

• i) a condition in a contract which provides that the transfer is subject to the approval of some regulatory agency, such as Investment Canada or the CRTC;
• ii) a condition in a contract for the sale of land which provides that the sale is subject to the purchaser's ability to obtain certain zoning changes; and
• iii) a condition in a contract for the sale of a restaurant business which provides that the sale is subject to the purchaser being issued a liquor permit.

In any of these cases the transfer of ownership is not effective until the relevant condition has been satisfied. Consequently, any income which arises prior to the satisfaction of the condition precedent is taxable in the hands of the vendor. Any agreement which purports to give retroactive effect to the transfer will not be effective for tax purposes.

A "condition precedent" should be distinguished from a "condition subsequent". Where a condition subsequent exists the contract will be legally binding at the time it is entered into but upon the happening of certain prescribed events the agreement may cease to be binding on one or more of the parties. Where an agreement is subject to a condition subsequent, beneficial ownership will be transferred at its effective date; however, in the event of one of the prescribed events happening, the property would be reconveyed to the vendor. In such circumstances one does not ignore the original transfer. Instead the property will be subject to two transfers of beneficial ownership.

In the final part of our response, the Department has stated that where the contract is not subject to a condition precedent and beneficial ownership has passed with the result that the vendor has an absolute right to receive payment, the income earned between the effective date and closing will be income of the vendor. To determine whether these conditions have been met it would be necessary to review the terms of the agreement between the vendor and the purchaser; however, they will generally be met where there is no condition which suspends the completion of the contract and the parties have agreed that it is to be effective as of a certain date notwithstanding that the transaction may not close until some later date.

QUESTION 21
BUSINESS INVESTMENT LOSS

In order for a debt receivable owing to a taxpayer to qualify as a business investment loss paragraph 39(1)(c) requires either that the debt must have become bad in the year or must be disposed of to a person with whom the creditor is dealing at arm's length. In addition, with respect to intercorporate debts subparagraph 39(1)(c)(iv) requires that the debt owed to the creditor must be a debt owed by a Canadian-controlled private corporation. Although there is nothing in subparagraph 39(1)(c)(iv) which specifically addresses when this non-arm's length test is to be applied, the fact that the question of whether a capital loss is a business investment loss only arises at the time there is a disposition of the debt indicates that the test must be applied at the time of the disposition that gives rise to the application of paragraph 39(1)(c). By virtue of clause 54(c)(ii)(B) of the Act, a disposition is defined as including any transaction or event by which "...any debt owing to a taxpayer or any other right of a taxpayer to receive an amount is settled or cancelled...". The fact that the debtor and creditor may not have been dealing at arm's length when the debt was incurred or at some other time prior to its disposition, will not , in and of itself, prevent any capital loss suffered as a result of the disposition of such debt from being a business investment loss.

In the example provided, although Opco and Gesco may not be related at the time that the debt owing by Opco to Gesco is settled, the existence of the agreement and the fact that they were related at the time that the agreement was entered into could be viewed as evidence that they were not factually dealing at arm's length with respect to the settlement of the debt at the time of its settlement. Another factor to be considered is whether the debt had become bad at some time prior to the sale of the shares in which case the disposition may have taken place while Opco and Gesco are still related. Furthermore, since the debt is interest-free, the conditions described in paragraphs 6 and 10 of Interpretation Bulletin IT-239R2 must be met or the loss arising on the settlement of the debt will be deemed to be nil by virtue of subparagraph 40(2)(g)(ii) of the Act. The conditions specified in IT-239R2 are that:

• i) the corporation to which the money was lent must use the funds, or have loaned the funds to its Canadian subsidiary, for the purpose of earning income;
• ii) the corporation must have made every effort to have borrowed the funds itself through the normal commercial markets;the loan can not result in any undue tax advantage; and
• iii) where the loan is settled as a result of an arm's length sale of the corporation's shares, the agreement of the shareholder to accept an amount less than the face amount of the debt must be a condition of the sale of shares.

QUESTION 24
CCPC STATUS - OWNERSHIP BY A TRUST

The person who asked this question appears to have been concerned that paragraph 256(1.2)(f) may be relevant for purposes of determining whether a company is a Canadian-controlled private corporation. Paragraph 256(1.2)(f) provides rules for determining who is deemed to own shares of a corporation held by a trust and the rules depend on whether the trustee has discretion as to the allocation of income and capital of the trust. However, the rules in paragraph 256(1.2)(f) apply for purposes of determining whether two corporations are associated, not whether a corporation is a CCPC.

With respect to the first part of our response, paragraph 251(5)(b) provides that for purposes of determining whether a corporation is a CCPC, a taxpayer who has a right under a contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently, to acquire shares of a corporation will be treated as being in the same position as if that person owned the shares. Where shares of a corporation are owned by a trust the Department's general position is that paragraph 251(5)(b) will only apply where the beneficiaries have an absolute, though not necessarily immediate, right to the shares under the terms of the trust. It will not generally be applied where the trustees have absolute discretion to deal with the trust property, including the right to sell the shares owned by the trust to a third party.

The second part of our response to this question is intended to make it clear that for the purpose of determining whether a corporation is a Canadian-controlled private corporation it is necessary to determine whether ANY non-resident has any direct or indirect influence that, if exercised, would result in control in fact of the corporation. It is not sufficient to look only to the beneficiaries of the trust.

Finally, where a trust is established with non-resident beneficiaries and Canadian trustees to hold shares of a private corporation and it is apparent that the sole reason for this ownership structure is to attempt to have the company qualify as a CCPC, the Department will look very closely at the arrangement to determine whether there is any non-resident who has factual control over the corporation or whether the provisions of paragraph 251(5)(b) apply to deem the non-resident beneficiaries to own the shares of the company.

QUESTIONS 42 & 46
MANAGEMENT FEES AND BONUSES

The Department has a long standing practice not to challenge the reasonableness of salaries or bonuses paid to a principal shareholder who is active in the corporation's business and the corporation has either established a practice of distributing profits to such employee\shareholder in this manner or a policy of declaring bonuses to shareholders to remunerate them for the profits the corporation has earned that in fact are attributable to special know-how or skills of the shareholder. This position, however, does not extend to remuneration paid to spouses or other family members of the principal shareholder or to principal shareholders who are non-residents. This position was adopted largely for administrative ease and because the overall tax effect did not vary significantly whether the corporate profits were drawn out as salaries or as dividends.

However, the Department is not prepared to extend this general administrative position to bonuses paid out of a corporation's investment income or to inter-corporate management fees since to do so could lead to inappropriate tax planning. The acceptance of excessive intercorporate management fees could, for example, enable taxpayers to multiply their access to the small business deduction or could facilitate intercorporate loss transfers. You may question why the Department would be concerned with the use of inter corporate management fees to transfer losses within a corporate group when the Department of Finance has indicated that the transferring of losses within a group of related corporations is not offensive in terms of tax policy. In the Department's view any method used to transfer losses within a corporate group will only be effective provided that it complies with the provisions of the Act, including section 67 which requires that any amount deducted in computing income will only be allowable to the extent that the amount is reasonable. Consequently, the Department's general position is that in order for bonuses paid out of the investment income of a corporation or for management fees paid from one corporation to another to be deductible, such fees must have been incurred by the payer for the purpose of earning income and the amount of such fees must be reasonable in the circumstances after considering the services rendered by the recipient or its employees.

The determination of whether an inter corporate management fee is reasonable can only be made on a case by case basis following a review of all of the facts of a particular case.

QUESTION 41
COLLATERAL SECURITY GIVEN BY A CORPORATION

With respect to this question I have been asked to address whether the Department's response given at the 1991 Round Table represents a change in the position which was stated in response to question 62 at the 1986 Round Table. At the 1986 Round Table, the Department indicated in response to a similar question that it would not normally assess a benefit in respect of a guarantee unless there was some evidence that the shareholder or employee whose loan was being guaranteed was not from the outset able to repay the loan.

Although the question addressed at the 1986 Round Table was somewhat similar to question 41 of the 1991 Round Table, there is one important difference. The 1986 question was restricted to whether a benefit would be assessed where the recipient was a minority shareholder or an employee. The 1991 question related to any shareholder. Consequently, the response does not represent a change in the Department's assessing practice.

The Department's position can be summarized as follows: where the shareholder or employee is dealing at arm's length with the corporation we will not generally assess a benefit unless there is evidence that the shareholder or employee is, at the time the guarantee is granted, unable to repay the loan. In any other case, to the extent that a benefit has been conferred on the shareholder or employee the amount of the benefit will generally be assessed. The determination of whether or not a benefit has been conferred and the amount of such benefit can only be made following a review of all of the circumstances of a particular situation.

QUESTION 40
BENEFIT ON INTEREST-FREE LOANS TO BENEFICIARIES

In our response to this question the Department confirmed that the Cooper decision will be followed in other similar situations. In Cooper the court found that an interest-free loan made by a trust to a beneficiary does not result in a taxable benefit under subsection 105(1) of the Act. The court's conclusion was based largely on the fact that section 80.4 was enacted in 1979 to set out the manner in which interest-free or low interest loans to employees or shareholders were to be taxed. The court , therefore, concluded that prior to the enactment of section 80.4 such benefits were not taxable under paragraph 6(1)(a) or subsection 15(1), respectively, of the Act and by analogy subsection 105(1) of the Act. I have been asked to comment on whether the ratio in Cooper is being extended to other benefits received by beneficiaries under trusts, with particular reference to respect the rent-free use of real property owned by the trust. In the Department's view the judge's analysis in the Cooper case makes it quite clear that the decision is limited to interest- free or low-interest loans received from a trust. The types of benefits which are taxable under paragraph 6(1)(a) or subsection 15(1) will also be taxable under subsection 105(1) of the Act.

With respect to real property owned by a trust it is the Department's general position that a subsection 105(1) benefit will arise where the fair market rental of a real property owned by a trust exceeds the aggregate amount of payments by its beneficiaries for such things as maintenance, taxes, etc. in respect of the property. However, as indicated in our response to question 31 of the 1989 Revenue Canada Round Table of the Canadian Tax Foundation, where the property is personal use property of an individual, such as a residence or cottage, the Department will not generally seek to assess a benefit for the use of the property where the trust is effectively standing in the place of the individual and no benefit or advantage would have arisen if the individual, instead of the trust, had allowed the use of the property. However, a benefit under subsection 105(2) of the Act may arise in respect of the upkeep, maintenance or taxes of such property where such amounts are paid by the trust.

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