7 December 1988 Income Tax Severed Letter 5-6991 - [Paragraph 85(1)(e.2) 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.

S. Leung (613) 957-2116

DEC - 7 1988

Dear Sirs:

Re: Paragraph 85(1)(e.2) of the Income Tax Act (the Act)

This is in reply to your letter of November 4, 1988 in which you requested our comment on the application of paragraph 85(1)(e.2) of the Act with respect to the following hypothetical situation.

1. Taxpayer A, an individual, owns 100% of the shares of a taxable Canadian corporation ("Canco").

2. The assets of Canco are significantly less than its liabilities. Canco has a significant amount of non-capital loss carry forwards. One of Canco's major liabilities includes a loan payable to Taxpayer A.

3. Taxpayer A owns property with an unrealized capital gain that he desires to sell to an arm's length party.

4. Taxpayer A transfers the property to Canco at its adjusted cost base pursuant to section 85 of the Act in exchange for preferred shares having a redemption amount equal to the fair market value of the property so transferred.

5. Subsequently, Canco sells the property to an arm's length person.

6. Since Canco is technically insolvent, the preferred shares received by Taxpayer A in exchange for the property transferred would have a fair market value of nil immediately after the transfer.

In your opinion, paragraph 85(1)(e.2) of the Act would not apply to the above hypothetical situation.

We do not concur with your interpretation of paragraph 85(1)(e.2) of the Act. Taxpayer A would be considered to have conferred a benefit on Canco, to the extent that the fair market value of the transferred property exceeds the greater of the fair market value of the consideration received and the elected amounts determined without reference to paragraph 85(1)(e.2) of the Act.

In order for the provisions of paragraph 85(1)(e.2) of the Act not to apply, the transferee corporation must be able to meet the corporate law solvency tests so that after the preferred shares have been issued they can be redeemed. In your hypothetical situation, the fair market value of the preferred shares issued is nil because, immediately after the transfer, Canco is still insolvent. Hence, paragraph 85(1)(e.2) of the Act would apply.

The foregoing represents our general views with respect to the subject matter of 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