20 May 1987 Income Tax Severed Letter 5-3142 - [870520]

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.

R.A. Primeau (613) 957-2122

Attention: XXXX

May 20, 1987

Dear Sirs:

This is in reply to your letter of March 24, 1987.

You have asked for our interpretation of subsections 55(2) and 247(1) of the Income Tax Act (the "Act") in the following hypothetical situations:

ASSUMPTIONS

1. Mr. A, a Canadian resident, owns 100% of the common shares of Aco which carries on an active business in Canada. The adjusted cost base ("ACB") of the Aco common shares is nominal. There are no other shares of Aco outstanding.

2. The retained earnings of Aco is $100,000, all of which is considered to be "safe income" for the purposes of subsection 55(2) of the Act.

3. The total fair market value of the Aco shares is $300,000.

4. Mr. A has received an offer from an arm's length party to sell his Aco shares for $300,000.

Mr. A proposes to structure the sale by using either of the two following methods:

ALTERNATIVE I

1. Mr. A will sell his shares of Aco to his personal holding company ("Holdco") in exchange for shares of Holdco the value of which will be equal to the fair market value of the Aco shares so transferred. This sale will be subject to an election under subsection 85(1) of the Act whereby Mr. A will elect that his proceeds of disposition will be $100,000.

2. Aco will declare and pay a taxable dividend of $100,000 to Holdco.

3. Holdco will then sell its shares of Aco to the arm's length party for $200,000.

In your view, the income tax consequences of alternative 1, ignoring the possible application of subsection 247(1) of the Act, will be as follows:

i) Mr. A will realize a capital gain of $100,000 (which is twice the "allowable exemption" within the meaning of paragraph 110.6(3)(a) of the Act as it reads for the 1987 taxation year),

ii) the dividend received by Holdco from Aco will be tax-free and not subject to the provisions of subsection 55(2) of the Act, and

iii) Holdco will realize a capital gain of $100,000.

ALTERNATIVE 2

1. Aco will declare a stock dividend of preference shares which will have a paid-up capital of $1 and which will be redeemable at $100,000. The stock dividend resolution will state that the ultimate redemption of the preference shares would represent a payment of Aco's safe income.

2. Mr. A will sell his preference shares of Aco to Holdco in exchange for shares of Holdco the value of which will be $100,000. The sale will be subject to an election under subsection 85(1) of the Act whereby Mr. A will elect that his proceeds of disposition will be $1.

3. Aco will purchase for cancellation the preference shares for $100,000.

4. Mr. A will sell his common shares of Aco for $200,000.

In your view, the income tax consequences of alternative 2, ignoring the possible application of subsection 247(1) of the Act, will be as follows:

i) the deemed dividend received by Holdco from Aco on the redemption of the preference shares will be tax-free and not subject to the provisions of subsection 55(2) of the Act, and

ii) Mr. A will realize a capital gain of $200,000 on the sale of the common shares of Aco ($100,000 of which is twice the "allowable exemption" within the meaning of paragraph 110.6(3)(a) of the Act as it reads for the 1987 taxation year).

It is also your view that both of the above alternatives are substantially the same and that subsection 247(1) of the Act would not apply in either case.

We do not agree that the dividend paid in either of the above situations would not be subject to the provisions of subsection 55(2) of the Act. There is initially a $300,000 capital gain inherent in Mr. A's common shares in Aco. $100,000 of this inherent gain is attributable to Aco's safe income and $200,000 thereof is attributable to something else - let us say, to the capital appreciation of Aco's fixed assets.

In alternative 1, Mr. A realizes $100,000 of this inherent gain as a result of the subsection 85(1) transfer of the Aco shares to Holdco at an elected amount of $100,000. In our opinion, $33,333 of this realised gain is attributable to safe income of Aco and $66,667 thereof to the capital appreciation of Aco's fixed assets. This leaves $66,667 of safe income in Aco. A $200,000 capital gain remains inherent in the Aco shares now held by Holdco (i.e. the $300,000 fair market value thereof less Holdco's $100,000 ACB therein), $66,667 of which is attributable to Aco's safe income and $133,333 of which is attributable to the capital appreciation of Aco's fixed assets. The $100,000 taxable dividend paid by Aco to Holdco then reduces the inherent gain from $200,000 to $100,000 (i.e. since the fair market value of the shares is reduced from $300,000 to $200,000). The dividend is considered to reduce or eliminate the portion of the gain that is attributable to safe income first - that is, in this case, from $66,667 to nil. However, since the total reduction to the gain caused by the dividend is $100,000, the $33,333 remainder is considered to be a reduction of the portion attributable to the capital appreciation of Aco's fixed assets from $133,000 to $100,000. It can thus be seen that the $100,000 dividend would be subject to subsection 55(2) of the Act.

In alternative 2, $100,000 of the $300,000 capital gain inherent in the Aco common shares owned by Mr. A is shifted to his new preference shares in Aco as a result of the stock dividend. In our opinion, the portions of the inherent gains in the two classes of shares that are then attributable to safe income of Aco and to the capital appreciation of Aco's fixed assets would be as follows:

                                                      Common     Preferred         Total

Portion attributable to 
Aco's safe income:                        $ 66,667       $ 33,333       $100,000

Portion attributable to 
capital appreciation in 
Aco's fixed assets                           133,333          66 667         200 000

Total inherent capital 
gain                                                 $200,000      $100,000       $300,000 

These portions would not change as a result of the subsection 85(1) transfer of the Aco preferred shares from Mr. A to Holdco at the elected amount of $1.00. The subsection 84(3) dividend on the redemption of the preferred shares by Aco would then reduce to nil the $100,000 gain inherent in the preferred shares, $66,667 of which was attributable to the capital appreciation in Aco's fixed assets. The dividend would therefore be subject to subsection 55(2) of the Act.

There are no factors in the two scenarios you have given which necessarily lead us to the conclusion that subsection 247(1) of the Act should be applied. However, as that subsection involves a tax avoidance purpose test, a more definitive response can be made only on a rulings basis where all of the relevant facts and proposed transactions of a particular case are known.

If either of the above two situations which you have outlined relate to contemplated transactions involving specific taxpayers, you may wish to request an advance income tax ruling following the guidelines set out in Information Circular 70-6R.

Yours truly,

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

RAP/jb