15 May 1987 Income Tax Severed Letter 5-3056 - [Subsection 85(1) of the Income Tax Act]

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.

PBA/397-4304 R.A. Primeau Tel. (613) 957-2122

May 15, 1987

Dear Sirs:

This is in reply to your letter of March 11, 1967 wherein you request clarification of the comments given in our two letters of January 29, 1987 concerning subsection 85(1) of the Income Tax Act (the "Act").

Your first question is whether the requirement in subsection 85(1) that the consideration for property transferred to a taxable Canadian corporation include shares of the capital stock of the corporation would be satisfied if such consideration consists of shares to be issued by the corporation after legal authorization to do so is obtained. That is, although the sales contract between the transferor and the corporation stipulates that the consideration for the property is shares of the corporation, such shares cannot be issued until the corporation obtains articles of amendment or supplementary letters patent authorizing their issuance. Your concern, as we understand it, is that the resultant delay in issuing the shares, even if reasonable, could invalidate a subsection 85(1) election.

It is our opinion that, technically speaking, the above-mentioned requirement in subsection 85(1) of the Act would not be satisfied where the transferee corporation cannot immediately issue shares as partial or full consideration for the property transferred to it. However, it is the Department's practice to accept a subsection 85(1) election as valid where all of the following conditions are met:

1. there is a binding agreement between the transferor and the transferee requiring the transferee to issue the shares in question,

2. the transferee takes immediate steps to issue the necessary shares (e.g. applies for supplementary letters patent or articles of amendment), and

3. the shares are issued without delay once the transferee is authorized to do so.

If for any reason the transferee does not receive authorization to issue the shares, the election will be treated as invalid.

With regard to your second question, it is our opinion that co- ownership in a single share of a corporation received as consideration for the transfer of property to the corporation would qualify as share consideration for purposes of a subsection 85(1) rollover.

With regard to your third question, we continue to be of the opinion that a prepaid expense is not a capital property as defined in paragraph 54(b) of the Act, and thus does not qualify for a subsection 85(1) rollover. Your earlier letter, dated November 21, 1986, indicates that it is your position that a prepaid expense could qualify for a subsection 85(1) rollover if it can be considered to be a right. In support of this position you give a hypothetical example in which Mr. A prepays $5,000 rent on a 5 year lease for his business premises. Rental values increase and at the end of year 4, the landlord buys out the remaining year in the lease for an amount which exceeds the $1,000 unamortized rent. We understand your position to be that since the portion of the amount so received which exceeds the $1,000 unamortized rent is a capital gain to Mr. A, then the $1,000 unamortized rent must be a capital asset which qualifies for subsection 85(1) rollover treatment.

As stated in paragraph 1 of Interpretation Bulletin IT-233R , it is necessary to determine with regard to a leasing agreement whether the payments thereunder are in substance payments of rent or are payments on account of the purchase price of property or, in the case of a sale-leaseback agreement, repayments of a loan. Where the payments are in substance payments of rent, it can be said that the tenant has acquired a leasehold interest which would be a capital property within the meaning of paragraph 54(b) of the Act. Capital cost allowance ("CCA") could be claimed by the tenant with respect to any cost incurred by him to acquire such leasehold interest, and a disposition of the leasehold interest could result in a terminal loss, CCA recapture, or a capital gain, as the case may be (see IT-464R ). However, payments under the leasing agreement which are in substance rental payments, whether prepaid or not, will not form part of the capital cost of the tenant's leasehold interest (see paragraph 6(b) of IT-464R ). Rather, such payments are simply claimed as rental expense (see IT-261R regarding the amortization of prepaid rental payments).

We understand that in your hypothetical example, the $5,000 paid by Mr. A is in substance a prepayment of rent rather than a payment on account of the purchase by him of the business premises. Mr. A would therefore have a leasehold interest in the business premises. He may or may not have incurred a capital cost with respect of the leasehold interest but, in any event, the $5,000 prepaid rent will not form part thereof (see paragraphs 3 to 6 of IT-464R ). Rather, the $5,000 will simply be claimed as rental expense over the term of the lease. Assuming that A has amortized $4,000 of the prepaid rent as of the end of year 4 in the lease, let us say that the landlord buys out the remaining one year of the lease from Mr. A for $1,500. We would consider $1,000 thereof to be a reimbursement of prepaid rent and the remaining $500 to be capital proceeds to Mr. A for the disposition of his leasehold interest (see paragraph 7 of IT- 359R2).

To summarize our position with respect to your third question, a leasehold interest is a capital property which qualifies for subsection 85(1) rollover treatment, but in our opinion neither the cost nor the fair market value thereof includes prepaid rent. To illustrate, let us assume that in your example, instead of being bought out by the landlord for $1,500 at the end of year 4, Mr. A assigns the lease to his corporation at that time and receives $1,500 in shares of the corporation. We would consider $1,000 of the shares to be in respect of the prepaid rent, for which there would be no tax consequences to Mr. A, and the remaining $500 to be the fair market value proceeds for the leasehold interest. Assuming the leasehold interest had no cost, the subsection 85(1) elected amount therefor could be any amount between $1 and $500, inclusive.

We hope that the above adequately explains our position on these matters.

Yours truly,

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

RP/da job-85(1) M8-18