8 October 1993 External T.I. 3M09520 - APFF 1993

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.

TRANSLATION FROM FRENCHASSOCIATION DE PLANIFICATION FISCALE ET FINANCIÈRE

ROUND TABLE ON FEDERAL TAXATION1993 CONGRESS

Question 1

Associated corporations — non-arm's length

("the Partnerships").

shares of Opco.

In the opinion of Revenue Canada:

1)      Are Holdco I and Opco associated?

2)      Are Holdco II and Opco not at arm's length?

Revenue Canada response

Regarding the first question, we assume that Holdco II's share of the income and losses of the limited partnerships is always insufficient for it to be deemed, pursuant to paragraph 256(1.2)(e) of the Act, the owner of a sufficient number of shares to control Opco for the purposes of section 256 of the Act. Nevertheless, it would appear that Holdco II has "de jure" control of Opco. General partners are the sole persons authorized to administer and bind a limited partnership, and special partners may not negotiate any business on behalf of the partnership (Civil Code, articles 1876 and 1887). Since Holdco II is the only general partner in the three limited partnerships, we assume that it is able to vote in the members of Opco's board of directors.

Consequently, Holdco II and Opco would be associated within the meaning of paragraph 256(1)(a) of the Act. Furthermore, since Holdco I controls Holdco II and Holdco II controls Opco, Holdco I controls Opco indirectly and is therefore associated with it pursuant to paragraph 256(1)(a) of the Act.

In view of our conclusions above and paragraph 251(1)(a) and subparagraph 251(2)(b)(i) of the Act, Holdco II does not deal with Opco at arm's length.

Question 2

Tax Convention and application of general anti-avoidance rule

A non-resident owned investment corporation ("NRO") owns property that is not taxable Canadian property. The shares of NRO are owned by an entity resident in a country that has no tax convention with Canada. The shareholders in this entity wish to transfer the NRO shares to a Barbados corporation, purely to take advantage of the reduction in the dividend tax rate provided in the Canada-Barbados Tax Convention.

Does the GAAR apply to this transaction, since the tax benefit is limited to an exemption provided in the Convention rather than in the Income Tax Act.

Revenue Canada response

Whether the GAAR applies to a specific transaction is a question of fact. However, in a situation where a non-resident of Canada carries out a series of transactions whose purpose is to secure an exemption from or reduction of Canadian tax through a tax convention that Canada has concluded with another country, the Department will examine this type of situation closely in order to establish whether it results in an abuse. In the example submitted above, it should be noted that insofar as the Barbados corporation is not the beneficial owner of the dividends, Article X, paragraph 2 reducing the tax rate to 15% would not apply.

Question 3

Deductibility of interest

An individual borrows $100,000 to acquire common shares of a company. Some years later, the shares are worth $500,000 and the loan balance is still $100,000. The adjusted cost base of the shares for the individual is $100,000. The individual incorporates a holding company and transfers his shares to it in a tax rollover (subsection 85(1)). The amount elected is $100,000. As consideration for the property acquired, the holding company pays $100,000 cash and transfers common shares worth $400,000. The individual does not use the cash to repay his loan but continues to pay interest on it after the transfer to the holding company.

The question is therefore whether the interest paid on the loan remains deductible after the shares are transferred to the holding company. Specifically, is all the interest still deductible on the basis that the income source still exists. Would it be more correct to say that only 4/5 of the interest is still deductible, since 1/5 of the source has disappeared? Or alternatively, as some think, is none of the interest now deductible, since the cash payment by the holding company is equivalent to the adjusted cost base? Is there really a link between the adjusted cost base and deductibility of interest on a loan?

Would the interpretation be different if on the tax rollover the holding company issued consideration on the transfer consisting only of common shares worth $500,000 but with a paid-up capital of $100,000, and after the transaction the holding company reduced its paid-up capital by $100,000 by paying that amount to the taxpayer, assuming of course that the taxpayer does not use this amount to repay his loan? If the Department's interpretation is that the interest is no longer deductible, how would it view the situation just outlined if instead of a reduction of $100,000 in the paid-up capital, the holding company paid the taxpayer a dividend of $100,000.

Revenue Canada response

Whether interest is deductible in calculating an individual's income is a question of fact that can be determined only after reviewing all the relevant facts.

In the context of this question, it would seem that although the three series of transactions presented are different in form, they all have essentially the same objective, ie that the shareholder will receive new property as a result of the series of transactions--$100,000 cash (whose use by the taxpayer is not stated) and common shares worth $400,000--to replace old property wholly acquired by means of a loan. In the circumstances, the Department would apply the same tax treatment to the three series of transactions.

Where a source of income acquired with borrowed money is disposed of in exchange for property that is all used to earn income, the interest on the borrowed money that was used to acquire the original source of income will still be deductible, to the extent that the loan amount is reflected in the fair market value of the property received as consideration.

Where a source of income acquired with borrowed money is disposed of in exchange for cash and other income-generating company, and the cash is used by the taxpayer for personal expenses, normally only a part of the interest will still be deductible corresponding to the proportion of the value of the income-generating property to the value of all the property received in exchange for the original source of income. In the circumstances, this proportion would be 4/5.

Question 4

Section 84.1 — Meaning of "connected corporation"

I would like to know the position of Revenue Canada Taxation on an expression used in the preamble to subsection 84.1(1) of the Act.

The expression is as follows:

     and, immediately after the disposition, the subject corporation would be connected (within the meaning assigned by section 186(4) if the references therein to "payer corporation" and to "particular corporation" were read as "subject corporation" and "purchaser corporation" respectively) with the purchaser corporation.

This expression is an essential condition for application of subsection 84.1(1) of the Act. What is the Department's interpretation in light of the following observations:

1.      Is this condition satisfied if the corporations (the purchaser corporation and the subject corporation) were connected before the share disposition referred to in subsection 84.1(1) of the Act?

2.      Must the two corporations become connected following the share sale?

3.      The conditional is used in this expression. Does this mean that the corporations would not be otherwise connected before or after the transaction?

4.      The French version of Interpretation Bulletin IT-489, dated June 23, 1982, states: "immédiatement après la disposition, ladite corporation devient rattachée à l'acheteur...".

     In the French version if it becomes connected to the purchaser, does this mean that this was not connected before?

5.      The English version of the same paragraph uses the present tense ("is connected") instead of the conditional. Is there a reason for this?

     It would seem that the above condition is satisfied only if the subject corporation becomes connected to the purchaser following the share sale referred to in subsection 84.1(1) of the Act, and that if these two corporations were connected immediately before the share sale, this condition is not satisfied since they have not become connected because of the share sale. Accordingly subsection 84.1(1) of the Act would not apply.

Revenue Canada response

We disagree. The time of the above-mentioned connected corporation test is clearly the time immediately after the disposition and it is not necessary for the corporation to become connected following the share disposition. In our view, therefore, whether the subject corporation and the purchaser corporation were connected before the disposition in question is immaterial.

Use of the conditional is necessary because the subject corporation must be connected with the purchaser corporation, within the meaning of the word "connected" used in subsection 186(4) of the Act, but "subject corporation" and "purchaser corporation" are substituted for "payer corporation" and "particular corporation" respectively. Therefore, for subsection 84.1(1) to apply, it must be possible to conclude that the subject corporation would be connected with the purchaser corporation within the meaning of subsection 186(4) of the Act if the appropriate substitution were made.

With reference to the comments in Interpretation Bulletin IT-489 (quoted in your question at point 4 above), we must point out that these comments applied to section 84.1 as it stood before May 23, 1985. Section 84.1 was amended effective on that date with the introduction of the capital gains deduction; in the French version the expression "...et qu'immédiatement après la disposition, ladite corporation devient rattachée..." was replaced by the expression "...et que, immédiatement après la disposition, ladite corporation serait rattachée à l'acheteur...". Thus, Interpretation Bulletin IT-489 is no longer correct on this point and is currently being reviewed by Revenue Canada, partly because of the amendments to subsection 84.1(1) of the Act. It is expected that a revised version of the Interpretation Bulletin will be issued shortly. We should point out that Interpretation Bulletin IT-67R3, dated May 15 1992, explains the Department's interpretation of the amended section 84.1 as follows:

Also, a taxable dividend may be deemed under section 84.1 to have been paid to a shareholder (other than a corporation) resident in Canada where the shareholder disposes of shares in a corporation resident in Canada to another corporation with which the shareholder does not deal at arm's length and, immediately after the disposition, the two corporations are connected within the meaning assigned by subsection 186(4).

(Underlining added)

With regard to point No 5 — the fact that the English version of subsection 84.1(1) uses the present tense ("is connected") instead of the conditional — we wish to point out that the present English version uses the expression "would be connected" which in our opinion is the equivalent of "serait rattachée". The present tense was used in the previous version of subsection 84.1(1) applicable to dispositions before May 23, 1985.

Question 5

Winding-up of a subsidiary — farming business

What is the Department's position regarding the winding-up of a subsidiary in the following hypothetical situation:

1.      Company B is wholly-owned (100%) by company A.

2.      Companies A and B both carry on a farming business and both have made the election provided in section 28 of the Income Tax Act ("the Act") (cash basis).

3.      Company B proposes to wind up and distribute all its property to company A under the provisions of subsection 88(1) of the Act.

4.      Immediately before the winding-up, company B has receivables of $50,000 from the sale of property in the normal course of its farm business. Because of the section 28 election these receivables have not been included in income.

QUESTIONS:

1.      How does subparagraph 88(1)(a)(iii) of the Act apply when the receivables are distributed to company A?

     Does company B realize a capital gain or business income, since it is deemed to have disposed of its receivables at their cost amount? If so, what is the amount?

     In this situation is the cost amount, as defined in subsection 248(1) of the Act, equal to $50,000?

2.      Must company A (the parent company) include the amounts received from these receivables in its income pursuant to paragraph 87(2)(c), via paragraph 88(1)(e.2) of the Act?

3.      Must company A (the parent company) include in its income the same amounts received from these receivables pursuant to subparagraph 28(1)(a)(i) of the Act?

Revenue Canada response

The Department is aware of the difficulties in applying subparagraph 88(1)(a)(iii) to this type of situation. The matter has been submitted to the Department of Finance for its consideration. It is therefore not possible to offer an opinion at this time.

Question 6

Prescribed shares

Mr A has always owned 100% of the issued shares of Corporation A, an operating company using its assets principally in its active business:

-      100 common shares

-     2,000 rollover preferred shares

The rollover preferred shares (the "old preferred shares") have a redemption value of $2 million, equivalent to the fair market value of the consideration received when they were issued in 1987.

The market value of Corporation A fell significantly in 1993 as a result of the recession, so that the fair market value of the old preferred shares is $1.5 million and the fair market value of the common shares is nil.

In order to reduce income tax on his death, Mr A intends to undertake a capital reorganization under section 86 of the Act, by which he will dispose of the old preferred shares in exchange for shares of a new class of shares redeemable at $1.5 million.

The old preferred shares will be cancelled by Corporation A following the exchange.

In Revenue Canada's view:

1)      Does subsection 86(2) of the Act apply in the circumstances? In other words, will the Department consider that any benefit has been conferred on Corporation A, to which Mr A is related?

2)      If Mr A transfers his old preferred shares to Corporation A in a rollover under subsection 85(1) of the Act instead of in a capital reorganization, is paragraph 110.6(7)(b) applicable? In other words, will the Department take the position that Corporation A has acquired property for consideration significantly less than its fair market value at the time of acquisition?

3)      Are the new preferred shares redeemable at $1.5 million prescribed shares within the meaning of Regulation 6205(2)(a) on the same basis as the old preferred shares for which they are substituted, so that subsection 110.6(8) of the Act would not apply if Mr A disposed of the new preferred shares and the common shares?

Revenue Canada response

Since in the proposed situation the old preferred shares will be traded at their fair market value, either in a reorganization of the corporation's share capital or in a rollover under subsection 85(1) of the Act, in our view the provisions in subsections 86(2) and 110.6(7) of the Act should not apply.

The Department would not normally apply subsection 110.6(8) of the Act in a situation such as that presented where the shareholder disposing of the shares in an operating company has always been the sole shareholder in that corporation.

Question 7

Deductibility of interest and GAAR

Under the free trade arrangements, Canco has incorporated a new wholly-owned subsidiary ("USCO") in the United States in order to expand its operations. Canco will subscribe for a large number of the common shares of USCO through a bank loan bearing interest at the market rate. USCO will invest the proceeds of the share subscription in commercial paper and will use the funds (including the interest income from the commercial paper) over time to acquire part of its assets and fund the operating losses it anticipates for the first three years. From the tax point of view, the interest income from the commercial paper will absorb most of the start-up operating losses.

Is the interest on the bank loan deductible?

If so, what is the Department's position regarding application of subsection 245(2) of the Act?

Revenue Canada response

The Department normally considers that interest on money borrowed to acquire common shares is deductible since the potential return on the common shares may exceed the interest expense. However, it may be determined in specific situations that it is not reasonable to expect a potential return in excess of the interest, so that this interest would not be deductible in view of the current provisions of paragraph 20(1)(c) of the Act.

Whether common shares were acquired for the purpose of earning income is question of fact and each situation must be examined in light of its specific facts.

Question 8

Associated companies — use of loans

a)      P-C owns two subsidiaries, G Ltd and P. Ltd, that carry on manufacturing businesses. G Ltd operates a profitable business and owns class 29 equipment with a UCC of nil and a cost and FMV of $20M. P Ltd has incurred business losses of approximately $20M in the last two years. G Ltd rolls over its class 29 equipment to P Ltd in exchange for preferred shares redeemable for $20M. P Ltd transfers to G Ltd (not in a rollover) the same equipment for a price of $20M to pay for the redemption of the preferred shares issued on the purchase of this equipment. Through this series of transactions P Ltd has incurred a capital cost recapture of $20M enabling it to use its carried over losses of $20M. G Ltd has claimed CCA of $20M on the class 29 equipment acquired from P Ltd, thus reducing its tax otherwise payable.

     In the Department's opinion, is this series of transactions caught by section 245?

b)      What is the position regarding the following: Corporation A has incurred large business losses in the past. If it does not use these business losses in the current year, paragraph 111(1)(a) of the Act will prevent it from claiming them in future. Immediately before the year end, Corporation A incorporates a wholly-owned subsidiary (Corporation B) to which it transfers its assets in order to create the recapture to be included in Corporation A's income calculation. The business losses will be used to reduce Corporation A's income for the current year to nil. At the beginning of the next year, Corporation B is wound up into the parent corporation. Thus, Corporation A will have used its business losses and increased the cost of its property.

     In Revenue Canada's view, is this series of transactions caught by the general anti-avoidance rule? Would the answer be different if Corporation B carried on the business of Corporation A for some months?

Revenue Canada response

Since this issue is currently under review in the Department, it is not possible to answer at present.

Question 9

Part IV tax

F Ltd obtains a dividend refund following payment of a dividend on the shares held by its parent company, PC. F Ltd later sustains a business loss which it carries back, thus reducing the balance of its RDTOH and also the dividend refund it received on payment of the dividend to PC.

In these circumstances, is the Department prepared to refund to PC a portion of the Part IV tax on the dividend it received from F Ltd?

Revenue Canada response

Paragraph 186(1)(b) of the Act calculates the Part IV tax of a connected corporation based on the taxpayer's share in the dividend refund of the payer corporation. If the dividend refund of the payer corporation changes, the Part IV tax payable by the corporation receiving the dividend will be affected accordingly.

In the Department's view, therefore, PC would in these circumstances be entitled to a refund to the extent that it could reasonably be demonstrated that F Ltd's dividend refund has been changed and PC could be reassessed within the time limit allowed by subsection 152(4) of the Act. A reassessment would be issued to F Ltd pursuant to paragraph 152(6)(c) of the Act. As for PC, a reassessment could be issued under subparagraph 152(4)(b)(ii) and subsection 187(3) of the Act.

Question 10

Issue of Income Tax Rulings

Why is it that not all Rulings on the general anti-avoidance rule are published to enable taxpayers to better appreciate the scope of this provision?

Revenue Canada response

In most cases the general anti-avoidance rule does not apply in the Rulings issued by the Rulings Directorate. This in itself may be a major limitation for analysts who wish to be aware of the situations in which the Department applies the general anti-avoidance rule. This is why we believe that Information Circular 88-2 and its supplements represent a much more valuable tool for taxpayers who wish to better appreciate the scope of the general anti-avoidance rule. The examples explained there are directly related to application of the general anti-avoidance rule and explain the Department's position in detail.

The Department therefore proposes to publish regular supplements to Information Circular 88-2. A second supplement will be published in the near future.

Question 11

Rule of construction

We believe that the Department is placing great reliance on the decision by the Appeal Division of the Federal Court in The Queen v Placer DomeInc, 92 DTC 6402, in examining requests for rulings on transactions which the Department regards as "aggressive", in order to require justification of the envisaged transactions in terms of their form and substance. What is the Department's position here?

Revenue Canada response

The rule of substance as opposed to form is a long-standing principle of legal construction. This principle was in fact used in the Placer Dome Inc decision to determine the exact commercial nature of an employee stock purchase plan.

In its examination of requests for rulings, the Department seeks to determine the true economic and business effect of the proposed transactions, especially with regard to avoidance transactions.

Question 12

Meaning of "principally"

Under the definition of "qualified small business corporation share" in section 110.6 of the Act, more than 50% of the fair market value of the shares in a corporation must be attributable to assets used principally in an active business carried on by the corporation. We understand that Revenue Canada Taxation has adopted the position that "principally" means more than 50%.

Would it be possible to provide us with criteria to establish the situations in which this 50% test will be satisfied, in other words, is it necessary to consider the physical use of the asset or the economic value of the portion used in the active business of the corporation?

Revenue Canada response

Whether an asset is used principally in an active business is a question of fact. As stated in paragraph 5 of Interpretation Bulletin IT-486R dated December 31, 1987, the Department considers that the expression "used principally" means more than 50%. Normally, with respect to property such as land or a building for example, the Department considers initially the extent to which an asset is actually or physically used in an active business in order to establish its primary or principal use. However, the Department is ready to consider any other relevant criteria, depending on the specific circumstances of a given situation, in order to determine whether an asset is used principally in an active business.

Question 13

Scope of subsection 110.6(15)

Subsection 110.6(15) of the Act deals with the effect of an insurance policy owned by a corporation, specifically for the purposes of the definition "small business corporation". Subparagraph (b)(ii) provides that the proceeds of the policy must be used within the 24-month period commencing at the time of the death of the insured to redeem, acquire or cancel the subject shares owned by the insured immediately before his or her death. However, the subparagraph also provides that the 24-month period may be extended when the Minister considers this reasonable in the circumstances after considering a written application therefor made by the particular corporation within that period.

In what circumstances will the Minister consider it reasonable to grant an extension under this subparagraph? For example if the solvency tests in the corporation's instrument of incorporation prevent it from redeeming its shares, would this be a circumstance in which the Minister would grant an extension of the 24-month period? And what of a situation in which the life insurance policy proceeds are not paid within the 24-month period because of a dispute between the corporation and the insurer?

Revenue Canada response

The Department has not established criteria to determine the specific situations in which it would be reasonable to grant an extension of the period prescribed in subparagraph 110.6(15)(b)(ii) of the Act. In our view, the insolvency of a corporation or a dispute regarding the payment of life insurance proceeds could be valid considerations for requesting such an extension.

Question 14

Section 80 — Trade receivables

Can a taxpayer's trade receivables be subject to the application of section 80 of the Act in the case of a settlement of debts, ie would the Department take the position that these trade receivables are capital property whose cost would be reduced in a settlement of debts to an amount less than their principal amount?

Revenue Canada response

Subsection 80(1) of the Act may apply to reduce the cost of a trade receivable if at the time when a debt is settled or extinguished the trade receivable is a capital property.

For the purposes of the Act, the definition of "capital property" means any depreciable property and any property (other than depreciable property), any gain or loss from the disposition of which would, if the property were disposed of, be a capital gain or a capital loss, as the case may be, of the taxpayer.

Whether a trade receivable is a capital property at a given point in time is a question of fact that can be determined only after an examination of all the relevant facts.

The disposition of trade receivables does not normally result in a capital gain or loss. Instead, these are transactions on income account. For example, as stated in paragraph 1 of Interpretation Bulletin IT-442R, a loss incurred on the sale of trade receivables is deductible provided the disposition is made in the ordinary course of the business (for example under factoring agreements) or as part of trading in accounts receivable.

However, a taxpayer's trade receivables are normally capital property when they are disposed of as part of the sale of the taxpayer's business and are not subject to the rules in section 22 of the Act.

Question 15

Payments as inducement

The Department apparently takes the view that certain transactions in which public authorities subscribe for non-participating shares in corporations or grant them loans on advantageous conditions are within paragraph 12(1)(x) of the Act at the time of the subscription or loan.

1)      Does the Department maintain its position in circumstances where the shares are redeemed or the debt is repaid within a short time, either in cash or by converting the shares to a debt security?

2)      Does the Department nevertheless allow a deduction under paragraph 20(1)(hh) of the Act on the redemption or conversion of the shares or repayment of the debt?

3)      If a debt of this kind is assumed by a taxpayer in connection with the transfer of the assets for which the loan was contracted, will the Department allow a deduction under paragraph 20(1)(hh) of the Act to the original borrower on the transfer of the business or to the purchaser when it repays the loan?

Revenue Canada response

Whether a subscription for the capital stock of a corporation or a loan by a public authority is an inducement payment covered by the provisions of paragraph 12(1)(x) of the Act is a question of fact that can be determined only after a review of all the relevant facts. A subscription for capital stock or a loan by a public authority may in some circumstances constitute a payment within paragraph 12(1)(x) of the Act.

When the amount of a loan or a subscription for capital stock by a public authority is considered to be an amount that must be included in a taxpayer's income pursuant to paragraph 12(1)(x) of the Act, any amount repaid by the taxpayer in cash pursuant to a legal obligation to repay all or part of the amount included in the taxpayer's income is deductible under paragraph 20(1)(hh) of the Act. In the Department's view there is no repayment for the purposes of paragraph 20(1)(hh) of the Act when shares are converted to a debt security and the parties are in essentially the same situation before and after the conversion.

Where a debt is transferred by a taxpayer in connection with the transfer of the assets for which the loan was contracted, the taxpayer would not be eligible for a deduction since there is no repayment of the debt. The taxpayer assuming the debt would not be eligible for a deduction under paragraph 20(1)(hh) of the Act, since this taxpayer has not included an amount in income.

Question 16

Tax on large corporations

What is the Department's position regarding the effect of a reduction in the value of an asset in the following situations for the purposes of the tax on large corporations:

a)      The reduction in value relates to depreciable property. It is written off in the period and included in accumulated depreciation in accordance with generally accepted accounting principles (GAAP).

b)      The non-temporary reduction in value relates to capital property in the form of long-term investments (for example shares or debts of other corporations).

Revenue Canada response

The definition of "reserves" in subsection 181(1) of the Act excludes allowances in respect of depreciation or depletion. In the Department's view, the reduction in the value of a depreciable property is not a "reserve" for the purposes of Part I.3.

With respect to a reduction in the value of a long-term investment resulting from an non-temporary decline where the cost of the property has been written down in accordance with GAAP to reflect this lower value, the reduction in value is not considered a "reserve" within the meaning of subsection 181(1) of the Act. In addition, for the purpose of calculating the investment allowance of the corporation pursuant to subsection 181.2(4) of the Act, the revised book value of the specific investment after the write-down will be used.

Question 17

Benefit conferred on a shareholder

A taxpayer transfers certain assets to a corporation under subsection 85(1) of the Act. As consideration for this transfer the taxpayer receives preferred shares with a redemption value below the fair market value of the assets transferred. Paragraph 85(1)(e.2) of the Act does not apply since the other shareholder in the corporation is not related to the taxpayer.

Is it possible to conclude that there will be no tax consequences of this transfer, or will the Department seek to tax a benefit on the other shareholder under another provision of the Act (for example section 246 or subsection 56(2))?

Revenue Canada response

It does not seem possible to give an opinion on the tax consequences of a transfer without knowing all the facts associated with the situation, including the reasons for conferring the benefit, if any. On the assumption that paragraph 85(1)(e.2) does not apply since the corporation is not related to the taxpayer in the given situation, it still does not seem possible to rule out application of subsections 246(1) and 56(2) of the Act.

Question 19

Subsection 55(3.1)

On December 21, 1992, the Department of Finance introduced subsection 55(3.1), the purpose of which is to exclude inter-company dividends from the exemption provisions in paragraphs 55(3)(a) and (b) when a given corporation with a non- resident shareholder disposes of real estate or certain other assets tax free through a distribution of assets to a shareholder corporation resulting in a gain exempt under a tax convention. On May 4, 1993, the Department of Finance tabled a new version of subsection 55(3.1) whose purpose is to eliminate all buy/sell butterfly reorganizations in an international context.

1.      Does the Department of Finance intend to legislate the version of subsection 55(3.1) tabled on December 21, 1992, in view of the fact that the later version is wider in scope and covers most of the situations targeted in the proposal of December 21, 1992?

2.      The version of subsection 55(3.1) introduced on May 4, 1993, is a major change in tax policy, in that realization of the gain is forced at the corporation level instead of the non-resident shareholder level in the case of an arm's length transaction. Does the Department of Finance intend to extend this policy to domestic buy/sell butterfly reorganizations?

XXXXXXXXXX

Question 20

Foreign accrual property income

Canco has two wholly-owned foreign affiliates, USCO and AFCO, whose only income is active business income from a business carried on in a country listed in Regulation 5907(11). AFCO loaned an amount to USCO at a reasonable rate of interest. The interest paid or due by USCO in a year was not deducted from its income for American tax purposes because of the application of section 163(j) of the Code, the Earning Stripping Rule. However, this interest was taxed in the hands of AFCO.

Does the Department consider AFCO's interest income to be foreign accrual property income (FAPI), since the expense was not deducted by USCO (note that this disallowed expense can be carried forward indefinitely)?

Revenue Canada response

Subparagraph 95(2)(a)(ii) of the Act will apply to categorize the full amount of interest received by AFCO from USCO as active business income in the year it was received, despite the fact that the interest expense was not deducted by USCO, since this expense will eventually be deductible under the American Code, or whenever USCO ceases to be a foreign affiliate.

Question 21

Payment as inducement

A taxpayer purchases an eligible capital property for which it receives an inducement payment. Can the taxpayer make the election provided in subsection 53(2.1) of the Act, or can it consider that the cost of its property is the cost reduced by the inducement payment, in order to rule out application of paragraph 12(1)(x) of the Act?

Revenue Canada response

No. The election in subsection 53(2.1) of the Act may be made only in respect of capital property that is not depreciable property. In this connection, the June 1992 Explanatory Notes issued by the Department of Finance accompanying Bill C-92 (now enacted) are quite clear. The Department of Finance states on page 41 of these Explanatory Notes that:

     Subsection 53(2.1) of the Act permits a taxpayer to elect to reduce the adjusted cost base of a capital property by the amount of a related inducement, reimbursement, contribution or allowance received by the taxpayer that would otherwise be included in income pursuant to paragraph 12(1)(x). This subsection is amended to clarify that such an election may be made only in respect of capital property (other than depreciable property).

     (Underlining added)

This position is explained by the fact that the "adjusted cost base" concept is unrelated to eligible capital property. It would be impossible or illogical to allow reduction of the "adjusted cost base" of an eligible capital property, which would have no immediate or future tax consequence, and thereby allow the taxpayer to exclude from its income calculation pursuant to paragraph 12(1)(x) of the Act an inducement received by it relating to that eligible capital property. Furthermore, it should be noted that an election under subsection 53(2.1) of the Act in such circumstances, if accepted, would have no effect on the taxpayer's cumulative eligible capital, which would be unacceptable.

There is nothing in the Act that would allow a taxpayer to avoid application of paragraph 12(1)(x) by reducing the cost of an eligible capital property by the amount of an inducement received in respect of that property. As stated above, subsection 53(2.1) of the Act applies only to non-depreciable capital property. Subsection 13(7.4) of the Act applies only to depreciable property. Finally, subsection 12(2.2) of the Act applies only in respect of outlays or expenses other than those made or incurred by the taxpayer in respect of the cost of property.

Consequently, in our opinion a taxpayer in a situation such as that described in this question cannot use subsection 53(2.1) of the Act or otherwise reduce the cost of an eligible capital property to avoid application of paragraph 12(1)(x) of the Act.

The Department of Finance is aware of the situation described in this response.

Question 22

Small business corporation

Opco, a Canadian-controlled private corporation, carries on two activities, production of raw material and manufacture of a product using that raw material. The fair market value of Opco's assets break down as follows:

--      Assets related to manufacture of the product       80%      100%

In view of the adverse economic situation in this industrial sector, Opco decided to discontinue its goods manufacturing activity until market conditions improve. However, it continues to carry on its raw material production activity and the raw material is sold on the market at acceptable prices.

In this situation, can it be considered that all or substantially all of the fair market value of Opco's assets is attributable to assets used principally in an active business carried on by Opco, for the purposes of the definition of small business corporation?

Revenue Canada response

The Department does not normally interpret the term "used" strictly for the purposes of the definition of small business corporation. Whether an asset is used principally in an active business is a question of fact. In our opinion assets which, as in your situation, are not directly used in the active business carried on by the corporation because of unfavourable market conditions could nevertheless be considered to be "used principally" for the purposes of the definition of small business corporation, if it is clear that the discontinuance is only temporary and the company intends to use these assets in its business soon.

However, our position could be different if the assets were used for another purpose during this period of inactivity.

Question 23

Capital portion under a leasing contract

Income Tax Regulation 4302 prescribes an interest rate for the purposes of Regulation 1100(1.1). The effect of this prescribed rate is to determine the interest portion and by subtraction the capital portion of payments received under a leasing contract.

The capital portion thus deemed to be repaid is one of the limits used to calculate the capital cost allowance claimable by the lessor under Regulation 1100(1.1).

The prescribed rate is calculated on the basis of Canadian-dollar Government of Canada bonds with a remaining term to maturity of over 10 years.

As a result of the close trading relationship between Canada and the United States, Canadian lessors are often able to negotiate leasing contracts in American dollars. Since there is only one prescribed rate for the purposes of Regulation 4202, a disproportionate amount of the payments is deemed to be interest, thus reducing the capital portion that can be claimed for capital cost allowances. This increases the after-tax cost of these contracts for Canadian lessors and reduces their ability to compete internationally.

Is the Department of Finance willing to consider more than one prescribed rate based on different currencies, or at least a second prescribed rate based on US dollars, to help Canadian lessors compete?

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Question 24

Audit procedure

During the audit of unrelated Canadian-controlled private corporations, Revenue Canada auditors asked the shareholders controlling these corporations or with major interests to provide copies of their personal bank statements. This request is apparently part of normal audit procedures in this kind of situation.

a)     Is such a request indeed part of normal audit procedures?

b)      If the answer to question a) is in the negative, in what circumstances does the Department make such a request?

c)      Is the auditor required to discuss with the shareholder the reasons for such a request, so that the shareholder can respond to his concerns before having to make his bank statements available?

Revenue Canada response

As indicated in paragraph 16 of Information Circular 71-14R3 dated June 18, 1984, the Department frequently audits all the returns of a particular group of taxpayers. It is therefore to be expected that auditors will audit the tax returns of the principal shareholders in a private corporation when they audit the corporation's return; this is to avoid repeated visits to the shareholders and reduce the time required to audit transactions between the corporation and the shareholders. The scope of this audit is left to the discretion of the auditor and his immediate supervisor. Examination of the bank statements of persons subject to limited or detailed audits is a normal procedure.

Auditors are encouraged to discuss all matters relating to the audit with taxpayers or their representatives and to answer the questions put to them. However, they are not required to justify reasonable requests for documents whose examination is a normal and necessary audit procedure.

Question 25

Reduction of paid-up capital

The situation is as follows:

     subsidiary of USCO since 1960;

     $1,000,000, corresponding to the original amount subscribed by USCO;

     undistributed surplus on hand; as a result the adjusted cost base of the shares was reduced to $100,000 pursuant to subparagraph 53(2)(a)(i) of the Act;

     reducing the adjusted cost base of the shares to ($400,000) pursuant to subsection 53(2)(a)(ii) of the Act;

     be a capital gain from the disposition of property.

Questions:

1)      What is the Department's position on the deemed gain realized by Canco, in light of the Canada-United States Tax Convention. Specifically, does the Department consider that the gain is exempt pursuant to paragraph 4 of Article XIII of the Convention?

2)      If the gain is exempt pursuant to the Convention, is it necessary to request a certificate of disposition under section 116 of the Act?

Revenue Canada response

1)      In preparing a response we have assumed that Canco does not derive the value of its shares principally from real property situated in Canada for the purposes of Article XIII(3) of the Canada-United States Tax Convention (hereafter "the Convention") or from the alienation of personal property as indicated in Article XIII(2) of the Convention.

     Assuming that the share in question is a taxable Canadian property as defined in paragraph 115(1)(b) of the Act, in our opinion the gain would normally be exempt pursuant to Article XIII(4) of the Convention, provided that the gain is derived from the alienation of property other than property specified in Article XIII(1), (2) and (3) of the Convention.

2)      In our view, section 116 would not normally apply in situations of the above-described type.

Question 26

Fairness package — late elections

Under subsection 220(3.2) of the Act, the Minister may extend the time for making an election under a provision of the Act or a regulation that is a prescribed provision. Regulation 600 sets out a number of prescribed elections for the purposes of paragraph 220(3.2)(a) of the Act. It seems, however, that the Department accepts late elections in circumstances other than those listed in Regulation 600.

a)      Can Revenue Canada indicate what elections, other than those specified in Regulation 600, may be filed late?

b)      Does the Department of Finance intend to amend Regulation 600 in the near future to add additional prescribed provisions?

Revenue Canada response

Under paragraph 220(3.2)(a) of the Act, the Minister accepts the late elections prescribed by Regulation 600. In addition certain specific provisions of the Act, such as subsection 85(7.1), authorize the Minister to accept late elections.

The Department has no administrative policy regarding acceptance of late elections not covered by specific provisions of the Act or the Regulations. However, all requests for acceptance of late elections are reviewed by departmental officers. When there is no provision in the Act or the Regulations indicating that the election can be accepted, the matter is submitted to the Department of Finance to enable it to consider adding the election to the list of provisions in Regulation 600.

Question 27

Employee benefits

According to paragraph 42 of Interpretation Bulletin IT-470R, airline passes available to airline employees will become taxable only if certain conditions are satisfied. However, in Stevens v MNR, 93 DTC 291, the Tax Court of Canada decided that an airline pass was taxable in the case of a travel agency employee. Is it the view of Revenue Canada that the Stevens decision applies only to travel agency employees?

Revenue Canada response

The Court's decision in Stevens again confirms the generally broad scope of paragraph 6(1)(a) of the Act, and accordingly the Department does not consider that this decision is applicable only to travel agency employees. However, the decision does not change in any respect the tax treatment of passes available to airline employees in the circumstances described in paragraph 42 of Interpretation Bulletin IT-470R.

Question 28

Farm losses

The 1987 White Paper included proposals for profit and gross revenue tests. On April 19, 1989, the Department of Finance announced that introduction of these proposals had been postponed to allow consultations on the matter. What is the present position regarding these proposals?

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Question 30

Extinguishment of debt

May subsection 80(1) of the Act apply to redocumenting an advance as a promissory note in a situation where the debt is not extinguished in law, even though Interpretation Bulletin IT-448 indicates that there could be disposition.

Revenue Canada response

A debtor's gain is subject to the rules in section 80 of the Act when his debt is settled or extinguished without his making a payment, or by payment of a sum less than the principal.

If the debt is not extinguished or settled in law, subsection 80(1) will not apply.

The Department intends to review its position as stated in paragraph 7 of Interpretation Bulletin IT-448.

Question 31

Cumulative net investment loss

The definition of investment expense in subsection 110.6(1) of the Act includes in the calculation of the cumulative net investment loss (CNIL) the aggregate of all amounts deducted in computing the individual's income in respect of the individual's share of the amount of any loss of a partnership of which the individual was a specified member.

A specified member is a limited partner or a partner who is not actively engaged in the activities of the partnership business.

What is the Department's position regarding a business loss allocated to an individual by a partnership of which he is not a specified partner when this loss was itself allocated to the partnership by a limited partnership of which it is a specified partner. Is this loss to be included in calculating this individual's CNIL?

Revenue Canada response

In the Department's view, an individual is eligible for the capital gains deduction in respect of a capital gain allocated to him by a partnership of which he is a member even though, technically, he has not himself disposed of property in a given year as specified in subsections 110.6(2), (2.1) and (3) of the Act, assuming that the principle of "flow through" of sources of income or losses laid down in paragraphs 96(1)(f) and (g) of the Act also applies to the "disposition" of the property. The provisions of subsection 110.6(11) of the Act may also support this interpretation.

In the situation presented, we feel that the same reasoning applies and that accordingly the share of the partner who is a member in a general partnership in the loss derived from the limited partnership must be included in calculating his "investment expense".

Question 32

Advance rulings process

Revenue Canada Taxation has recently consulted with the tax community to identify improvements required to the advance ruling process. What are the main changes that will result from this process?

Revenue Canada response

Early in the year a customer satisfaction study relating to the services of the Rulings Directorate was conducted by an independent organization at the Department's request.

The services provided by the Directorate were generally rated highly. The main weakness revealed concerns the delay associated with issuance of rulings. However, overall, those consulted understood the situation and recognized the Directorate's efforts to meet urgent requests. We received suggestions designed to reduce the time required to process rulings to a period acceptable to respondents, ie between one and two months. The suggestions received covered a very broad range of possible actions; for example publication by the Department of checklists for certain types of transactions, use of standard presentation formats for requests submitted, increasing the Directorate's charges if this would really speed up service, hiring more staff, etc. The Department has noted these suggestions carefully and intends to continue its efforts to improve the Advance Rulings service to the extent that its budgets will allow.

Question 33

Disposition of shares of an insolvent corporation

Would Revenue Canada apply the anti-avoidance rule in a situation where a corporation subscribed for capital stock of a small business corporation in financial difficulty with which it does not deal at arm's length instead of making it a loan, in order to benefit from a business investment loss in the case of a disposition to which subsection 50(1) of the Act might apply?

Revenue Canada response

In our view, the general anti-avoidance rule would not normally apply to a situation like the one described.

We also think that if the acquisition cost of the shares of the corporation in financial difficulty for the subject corporation exceeds the fair market value of the shares as of the date they are acquired, paragraph 69(1)(a) of the Act could apply to reduce the acquisition cost of the shares to an amount equal to that fair market value. However, the Department considers that the reduction in the acquisition cost of the shares pursuant to paragraph 69(1)(a) of the Act would be a contribution of capital by the subject corporation to the corporation in financial difficulty for the purposes of application of paragraph 53(1)(c) of the Act. Consequently, to the extent that this contribution results in an increase (however small) in the fair market value of the shares of the corporation in financial difficulty, and no part of that contribution of capital could reasonably be regarded as a benefit conferred by the subject corporation on a person--other than the corporation in financial difficulty--related to the subject corporation, application of paragraph 53(1)(c) of the Act would increase the "adjusted cost base" of the capital stock of the corporation in financial difficulty owned by the subject corporation by an amount equivalent to the increase in the fair market value of those shares. Application of paragraph 53(1)(c) of the Act could therefore result in completely negating the effect of paragraph 69(1)(a) in a specific situation.

Question 35Lease agreement

Since Interpretation Bulletin IT-233R was issued, taxpayers have relied on it to establish whether a lease is to be considered a rent or a disposition/acquisition for income tax purposes. We know that this bulletin has been under revision since at least 1986 but has never been formally cancelled or replaced. At the annual conference of the Canadian Tax Foundation in 1988, Revenue Canada made certain observations which cast some doubt on the application of the Interpretation Bulletin. These observations can be summarized as follows:

     reflects the true relationship between the parties;

     own transactions by claiming that the form of transactions does not reflect the true legal relationship between the parties;

     that it does not reflect the true legal relationship existing between the parties.

Following these observations, many people have believed that leases were always rents and never dispositions/acquisitions. Subsequently, at the 1991 Annual Conference, Revenue Canada confirmed that it was not true to say that all leases are operating leases.

Over the years a number of cases have been heard by the courts in which the Department adopted a position different from the policies expressed in Interpretation Bulletin IT-233R.

In view of this situation there is real uncertainty in determining the tax status of leases. Can Revenue Canada indicate its position in this matter.

Revenue Canada response

The revision of the Interpretation Bulletin has been delayed several times. A number of recent decisions of the Tax Court of Canada heard in Quebec and elsewhere on lease agreements are currently being studied by the Department and this has contributed to the delay.

The fact remains that the guidelines in Interpretation Bulletin IT-233R, which describes situations in which a transaction structured as a lease might be considered an acquisition and disposition of property remain the Department's position. The general observations made in the report on the 1988 Conference merely clarify the application of the principles stated in Interpretation Bulletin IT-233R. Essentially, the Department stated that it will apply these principles only in situations where the parties claim that an agreement is a lease but is in substance a disposition.

In addition, the observations made at the 1991 Conference remain valid.

Question 36Non-residents — Income earned in Canada

When a non-resident carrying on a business in Canada receives amounts within Part XIII, there is some risk that they will be subject to tax under Parts I, XIII and XIV. Paragraph 214(13)(c) gives regulatory authority to determine the amounts taxable under Part XIII when a non-resident carries on business in Canada.

Regulation 802 applies specifically for the purposes of paragraph 214(13)(c) and provides that an amount taxable under Part I is not taxable under Part XIII. In this case, it is not necessary for the taxpayer to maintain a permanent establishment in Canada. Regulation 805 provides that amounts attributable to a business carried on in Canada through a permanent establishment are not subject to Part XIII tax.

Furthermore, the Trial Division of the Federal Court, in Twentieth CenturyFox Film Corporation v The Queen, [1985] 2 CTC 328, confirmed that Regulation 802 prevails over Regulation 805.

However, in paragraph 12 of Interpretation Bulletin IT-420R3, the Department takes the opposite position and states that a non-resident carrying on a business in Canada without maintaining a permanent establishment there will be subject to Part XIII tax and not Part I on amounts within Part XIII.

Could you explain Revenue Canada's position as stated in Interpretation Bulletin IT-420R3 concerning the application of Income Tax Regulations 802 and 805? Under what provision is there an exemption from Part I tax? How does Revenue Canada reconcile its position with the case law?

Revenue Canada response

Revenue Canada considers that Income Tax Regulation 802 applies only to registered non-resident insurers as defined in Regulation 804 and does not apply to "other non-resident persons".

The correctness of this interpretation could obviously be challenged, since Regulation 802 does not state that it applies only to insurers. However, if we look at Part VIII of the Regulations as a whole, it becomes obvious that this interpretation of Regulation 802 is appropriate. This Regulation is part of and in harmony with Regulations 800 to 804, which deal with non-resident insurers. If a broader scope is given to Income Tax Regulation 802, Regulation 805 would then be meaningless.

In our view, this interpretation accords with the modern rule of construction of tax legislation as stated by Mr E A Driedger in "Construction of Statutes", Toronto, Butterworths, 1974, and cited with approval by Mr Justice Estey of the Supreme Court of Canada in Stubart Investments Limited v The Queen, 84 DTC 6304 on page 6323. One stage in the method of construction using the modern rule is as follows:

     If, notwithstanding that the words are clear and unambiguous when read in their grammatical and ordinary sense, there is disharmony within the statute, statutes in pari materia, or the general law, then an unordinary meaning that will produce harmony is to be given the words, if they are reasonably capable of bearing that meaning.

It is also our opinion that the amendment to Regulation 802 in 1979 (elimination of the specific reference to insurers) did not (and was not intended to) broaden its scope.

Finally, we still think that the position adopted in paragraph 12 of Interpretation Bulletin IT-420R3 accords with Regulation 805, which states that a non-resident (other than a registered non-resident insurer) carrying on business in Canada without maintaining a permanent establishment in Canada will be subject to Part XIII tax. It should be noted that non-residents of Canada are subject to Part I tax on all their income from businesses carried on in Canada under subsection 2(3) ITA. However, as indicated in paragraph 12 of IT-420R3, the Department's practice is not to tax under Part I amounts already taxed under Part XIII of the Act.

With respect to the decision in Twentieth Century Fox Film Corporation vThe Queen, [1985] 2 CTC 328 by the Federal Court, Trial Division, once Mr Justice Addy concluded, based on the facts in the case, that the taxpayer's rental activities were an integral part of its business and the income derived from those activities was reasonably attributable to that business carried on in Canada, any reference to the primacy of Regulation 802 over Regulation 805 became as it were pointless, since the judge's conclusion was the same in any case. Although the judge stated as his opinion that Regulation 802 was applicable to the exclusion of Regulation 805, this was not fundamental to his decision. Mr Justice Addy did not deal with the primacy of Regulation 802 over Regulation 805 in reaching his decision. It was implied that even if his interpretation that Regulation 802 was applicable to the exclusion of Regulation 805 were incorrect, his conclusion would still be that the taxpayer was carrying on a business in Canada. We therefore consider that the decision is not to be interpreted as a precedent for the application of Regulation 802. In addition, Mr Justice Addy did not consider the possibility that Regulation 802 is applicable only to non-resident insurers.

Finally, this decision was not appealed by Revenue Canada, since it was considered that the Federal Court, Appeal Division, would also have concluded that Twentieth Century Fox Film Corporation was carrying on a business in Canada.

Question 37

Debts to specified non-residents

For the purposes of subsection 18(4), outstanding debts of a corporation to specified non-residents include a debt in respect of which any amount in respect of interest paid or payable by the corporation is deductible or would be deductible were it not for the existence of subsection 18(4).

Does the Department consider that this definition includes a debt that carries interest in a year but where the interest for the year in question has been waived by the payee so that the debtor does not claim any interest expense for tax purposes?

Revenue Canada response

Revenue Canada considers that the expression "outstanding debts to specified non-residents" of the corporation, defined in paragraph 18(5)(a) ITA, does not normally include a debt where the interest payable for the year by the corporation has been formally waived by the creditor (in a written, bilateral waiver binding on the parties) before the end of the taxation year. A debt in respect of which the interest has been waived is not considered to be an "outstanding debt to specified non-residents" of the corporation, in view of the fact that no interest relating to this debt is considered payable by the corporation and accordingly deductible in calculating the income of the corporation for the taxation year in question.