1 December 1988 Income Tax Severed Letter 5-6989 - [Section 7, Subsection 51(1) and paragraph 110(1)(d)]

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.

S. Leung (613) 957-2116

DEC 1 1988

Dear Sirs:

Re: Section 7, Subsection 51(1) and paragraph 110(1)(d) of the Income Tax Act (Canada) (the "Act")

This is in reply to your letter of November 2, 1988 in which you requested our confirmation of your interpretation of section 7, subsection 51(1) and paragraph 110(1)(d) of the Act in the following two hypothetical situations.

Situation I

1. A group of U.S. investors subscribe for common shares of a newly incorporated U.S. corporation ("Newco") for U.S. $10 per share.

2. They also invest in unsecured convertible notes of Newco. Each U.S. $10 of principal of the notes can be converted into one common share of Newco within a specified period of time and under certain terms and conditions at the discretion of the holder of the note.

3. Five Canadian resident executives who will be employed in the business to be acquired by Newco's Canadian subsidiary wholly-owned corporation are given the opportunity to invest in the shares and debt of Newco under the same terms and conditions that apply to the U.S. investors, and with the same relative proportions of their investment being represented by the shares and notes.

4. The exchange rate between the U.S. and Canadian currencies at the time the investment is made is U.S. $1 equals Cdn $1.20.

5. Five years after the investment is made, Newco completes an initial public offering of shares in its capital stock for an issue price of U.S. $15 per share. At that time all the initial holders of the convertible notes of Newco cause them to be converted into common shares of Newco. As a result, each holder receives one common share of Newco for every U.S. $10 of the principal of the notes.

Your interpretation of the Act is that:

6. By virtue of the application of subsection 51(1) of the Act, the executives are deemed not to have disposed of the notes and therefore realize no capital gain or loss on their conversion of the notes into common shares of Newco. The cost of the common shares to the executives in exchange for their notes is Cdn $12 per share.

7. The acquisition of the shares and notes of Newco by the executives on the same terms and conditions as the non-employee investors precludes the application of subsection 7(1) of the Act with respect to their conversion of the notes into common shares of Newco, by virtue of subsection 7(5) of the Act.

Situation II

8. An employee is granted an option to buy shares of the U.S. parent corporation ("P Co.") of the Canadian corporation that employs him. The shares of P Co. are publicly traded at U.S. $1 per share at the time the option is granted. The exchange rate at that time between the U.S. and Canadian currencies is U.S. $1 equals Cdn $1.20.

9. At the time the employee exercises his option to purchase the shares, their trading price is U.S. $2.50 per share, and the exchange rate between the two currencies is U.S. $1 equals Cdn $1.10.

Your interpretation of the Act is that:

10. The employee's stock option benefit pursuant to subsection 7(1) is as follows:

  Value per share at time of acquisition     U.S.     $2.50
  Amount per share paid by employee          U.S.     $1.00
                                                      -----
  Stock option benefit per share             U.S.     $1.50
                                                      -----
  Translate into Canadian funds      @ $1.10 Cdn      $1.65
                                                      =====

11. Since the amount payable by the employee to acquire the share under the option agreement is U.S. $1, which is equal to the U.S. $1 fair market value of the share at the time the agreement is made, the requirement of subparagraph 110(1)(d)(iii) of the Act is met.

The situations outlined in your letter appear to involve actual situations which should be subject of a request for an advance income tax ruling, or alternatively, should be referred to the appropriate District Office.

With respect to Situation I it is our opinion that the provisions of subsection 51(1) of the Act would apply provided that the convertible notes are capital property to the holders. Generally we would not expect the provisions of subsection 7(1) of the Act to apply by virtue of subsection 7(5) of the Act as the benefit is not received in respect of, in the course of, or by virtue of the employment of the executives but rather in their capacity as a shareholder/creditor.

With respect to Situation II, the benefit described in paragraph 7(1)(a) is to be computed as follows:

  Value per share at time of acquisition    U.S.  $2.50
                                                  -----
  Translate to Canadian funds   @ $1.10                  Cdn   $2.75
  Amount per share paid by employee         U.S.  $1.00
                                                  -----
  Translate to Canadian funds   @ $1.10                  Cdn   $1.10
                                                               -----
  Stock option benefit per share                         Cdn   $1.65
                                                               =====

The requirement stipulated in subparagraph 110(1)(d)(iii) of the Act is not met because the amount payable (Cdn $1.10 per share) at the time the shares are acquired is lees than the fair market value (Cdn $1.20 per share) at the time the agreement was made. For purposes of subparagraph 110(1)(d)(iii) of the Act both the "amount payable" and the "fair market value" are expressed in Canadian funds using the exchange rate at the relevant time. With the application of different exchange rates at different times, the value of the amount payable would be less than the fair market value of the shares in your hypothetical situation. Consequently, the provisions of paragraph 110(1)(d) would not apply.

The foregoing represent our general views with respect to the subject matter in your letter. The facts of a particular situation may result in a different conclusion. The foregoing opinion is not a ruling and in accordance with the guidelines explained in Information Circular 70-6R dated December 18, 1978, is not binding on the Department.

Yours truly,

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