30 June 1986 Income Tax Severed Letter 5-0259 - [Part IV Tax]

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.

Revenue Canada Taxation

Head Office

XXXX

J.D. Brooks (613) 957-2118

Attention: XXXX

June 30, 1986

Dear Sirs:

Re: Part IV Tax

This is in reply to your letter of December 13, 1985 in which you described a series of transactions. It appears that the series of transactions probably relates to contemplated transactions involving specific taxpayers. If this is the case, it would be appropriate for you to request an advance income tax ruling on behalf of the taxpayers involved, following the guideline set out in our Information Circular 70-6R. Despite our concern that the issues you have raised relate to contemplated transactions, we have set out our views on these matters at pages 3 and 4 below. We regret the delay in replying to your letter.

The transactions which you described are as follows:

1. MCo is a Canadian-controlled private corporation.

2. K is an individual who holds 1% of the common shares in the capital of MCo. The fair market value of K's common shares exceeds their paid-up capital.

3. K will incorporate a personal holding company ("Holdco") and transfer his MCo shares to Holdco on a tax-deferred basis pursuant to section 85 of the Income Tax Act (the "Act").

4. A lawyer for MCo will incorporate a new corporation ("Newco"). The lawyer will hold all of the common shares of Newco for which he will pay $100.

5. Holdco will transfer its MCo shares to Newco pursuant to a section 85 election in exchange for preference shares in the capital of Newco. These preference shares will have the following attributes:

i) redeemable and retractable for an amount in aggregate equal to the fair market value of the MCo common shares purchased by Newco from Holdco;

ii) entitled to a preferential and cumulative annual dividend of 6%;

iii) full voting rights under all circumstances with more than 10% but less than 50% in aggregate of the total votes available to all classes of shares; and

iv) an aggregate paid-up capital equal to the aggregate paid-up capital of the MCo common shares purchased by Newco from Holdco.

6. The lawyer will sell his Newco common shares to MCo for $100 so that Newco becomes a subsidiary of MCo. The $100 sale price will be fair market value. After the sale, MCo will have voting control of Newco.

7. MCo will purchase for cancellation its common shares held by Newco at their fair market value for consideration which will include cash and a promissory note. This will result in a deemed dividend to Newco, pursuant to subsection 84(3) of the Act.

8. MCo has sufficient safe income to cover the deemed dividend on the purchase for cancellation of its common shares held by Newco. MCo does not have any refundable dividend tax on hand so that the deemed dividend will not result in a refund in MCo.

9. Newco will redeem the preference shares held by Holdco which will result in a deemed dividend to Holdco. As the paid-up capital of the Newco preference shares will be equal to the paid-up capital of the MCo common shares, the deemed dividend on the redemption of the preference shares will be equal to the deemed dividend on the purchase for cancellation of the MCo common shares.

It is your view that the deemed dividend arising on the purchase for cancellation by MCo of its common shares held by Newco will not be subject to subsection 55(2) because of the safe income available in MCo and will not be subject to Part IV tax because MCo controls Newco within the meaning of subsection 186(2).

You do not believe that the deemed dividend on the cancellation of the MCo common shares will be subject to the application of subsection 247(1) for several reasons. The common shares of MCo will be purchased for cancellation at their fair market value and the purchase price will be paid in the form of cash and a promissory note to Newco, another Canadian-controlled private corporation. In your view, it cannot be said that assets of MCo have disappeared in a manner such that tax otherwise payable has been avoided. You point out that this deemed dividend is subject to the anti-avoidance provision in subsection 55(2). As safe income is available and paragraphs 55(2)(a) and (b) do not apply, you do not believe that it is appropriate to consider the possible application of a further anti-avoidance provision.

Our comments

In order for Part IV tax not to be exigible pursuant to paragraph 186(l)(a) a dividend must be received by a particular corporation from a payer corporation connected with the particular corporation. The definition of the phrase "a payer corporation connected with a particular corporation" is set out in subsection 186(4). Paragraph 186(4)(a) states that a payer corporation will be connected with a particular corporation if the payer is controlled (otherwise than by virtue of a right referred to in paragraph 251(5)(b)) by the particular corporation at that time. Subsection 186(2) states that one corporation is controlled by another corporation if more than 50% of its issued share capital (having full voting rights under all circumstances) belongs to the other corporation, to persons with whom the other corporation does not deal at arm's length, or to the other corporation and persons with whom the other corporation does not deal at arm's length.

Upon the acquisition for cancellation of the MCo common shares, MCo (the payer corporation) is not controlled by Newco (the particular corporation) within the meaning of subsection 186(2), so MCo is not connected with Newco within the meaning of paragraph 186(4)(a). MCo is clearly not connected with Newco pursuant to paragraph 186(4)(b) as Newco owns only 1% of the common shares of MCo and no other shares of MCo. As MCo (the payer) is not connected with Newco (the particular corporation) the deemed dividend arising on the purchase for cancellation by MCo of its common shares held by Newco will be subject to Part IV tax pursuant to paragraph 186(1)(a) of the Act.

You also stated that it is your view that the deemed dividend received by Holdco on the redemption of the Newco preferred shares will not be subject to Part IV tax pursuant to paragraph 186(l)(a) of the Act. This will only be true if Newco as payer is connected with Holdco pursuant to subsection 186(4) of the Act. Newco is not connected with Holdco pursuant to paragraph 186(4)(a) of the Act, as Newco is controlled by MCo, not Holdco. If Holdco's preferred shares of Newco have a fair market value of more than 10% of the fair market value of all of the issued shares of the capital stock of Newco and if Holdco owns more than 10% of the issued share capital (having full voting rights under all circumstances) of Holdco, then Newco will be connected with Holdco pursuant to paragraph 186(4)(b) of the Act. Holdco will be subject to Part IV tax under 186(1)(b) to the extent that Newco is entitled to a dividend refund in respect of the deemed payment of a dividend to Holdco.

Subsection 55(2) would not be applicable to the acquisition for cancellation of MCo common shares held by Newco, provided that the potential gain on the cancelled MCo shares is attributable to income earned or realized by any corporation after 1971 and before the series of transactions. If this is the case the deemed dividend and the subsequent redemption of the Newco preferred shares held by Holdco would also not result in the application of subsection 55(2), as the safe income attributable to Newco's 1% holding of MCo shares was attributed to the Newco preference shares on a consolidated basis at the time of the rollover of the MCo shares from Holdco to Newco.

Subsection 247(1) of the Act probably would not be applied in respect of the series of transactions described, as the series is subject to the more specific provisions of subsection 55(2), as noted above. A close examination of the facts of a particular case could of course lead to the opposite conclusion.

Our comments are not rulings, but are expressions of opinions which are not binding on the Department, as explained in paragraph 24 of Information Circular 70-6R, published by Revenue Canada, Taxation on December 18, 1978.

Yours truly,

for Director Reorganizations and Non-Resident Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch