24 May 1989 Income Tax Severed Letter 5-7050 - Paragraph 15 of Information Circular 88-2

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.

Dear Sirs:

This is in reply to your letter, dated November 11, 1988, whereby you request our views concerning the application of subsection 245(2) of the Income Tax Act (the "Act") in the following hypothetical fact situations.

In the first situation, the fair market value of the assets of a corporation is estimated to be $2,000,000. The assets that are used in an active business carried on primarily in Canada by the corporation are estimated to have a fair market value of $1,200,000, while the assets not so used have an estimated fair market value of $800,000 and an adjusted cost base of a lower amount.

The corporation would declare a stock dividend of $1 that would be satisfied by the issue of special shares with a stated capital and paid-up capital of $1 and a redemption and retraction amount of $800,000. The shareholder would transfer these special shares to a new corporation using subsection 85(1) of the Act and would take back special shares of the new corporation with a fair market value of $800,000 as consideration.

The operating company would transfer the non-business assets to the new corporation using subsection 85(1) of the Act taking back shares of the new corporation with a fair market value of $800,000 as consideration.

The cross shareholdings would be redeemed in consideration for notes and the notes, which would be equal as to principal amount and fair market value, would then be offset.

In the second situation, prior to the purification, the fair market value of the total assets of the corporation is estimated to be $1,000,000, of which $600,000 is attributable to non-business assets. Steps similar to those mentioned in the first situation would be taken to transfer these assets to a new corporation.

In the third situation, the corporation has retained earnings of $1,000,000 and the fair market value of the non-business assets is equal to $800,000. The corporation declares a stock dividend of $1, which is satisfied by the issue of special shares with a paid-up capital of $1 and a redemption and retraction amount of $1,000,000. These shares are transferred to a new corporation in consideration for shares of the new corporation with a fair market value of $1,000,000. At the end of the share redemption and offset of the notes, the new corporation would be left with a $200,000 receivable from the operating corporation.

You requested our opinion as to whether we would consider any of these three series of transactions, undertaken to purify a corporation for the purposes of the definition of qualified small business corporation share in subsection 110.6(1) of the Act, as resulting directly or indirectly in a misuse of the provisions of the Act or an abuse having regard to the provisions of the Act read as a whole, for the purposes of subsection 245(4) of the Act.

Our Comments

Assurance as to the tax consequences of a contemplated transaction can only be given in response to a request for an advance income tax ruling. The procedure for requesting an advance income tax ruling is outlined in Information Circular 70-6R, published by Revenue Canada, Taxation on December 18, 1978. If you wish to obtain any binding commitment with respect to an actual case with facts similar to your examples, an advance income tax ruling application should be submitted. Although we are unable to provide any binding assurance here with respect to the queries you have raised, we have stated our observations below.

The expression "tax benefit" is defined in subsection 245(1) of the Act as including a deferral of tax. In determining whether a transaction is an avoidance transaction for purposes of subsection 245(3) of the Act, the question of whether the transaction would result in a tax benefit to any person must first be answered.

In the transactions described above, a tax benefit would occur upon the election under subsection 85(1) of the Act since the tax otherwise payable by the transferor would be deferred until a subsequent disposition of the shares received as consideration for the transfer of the non-business assets. Furthermore, the purification of the corporation ultimately would allow the shareholder to obtain a tax benefit in the form of a reduction of tax by virtue of the application of section 110.6 of the Act.

It is our opinion that each of these transactions could reasonably be considered to be undertaken primarily to obtain the tax benefits described and therefore these transfers would be avoidance transactions within the meaning assigned by subsection 245(3) of the Act.

The next question to consider is whether these transactions would result directly or indirectly in a misuse of the provisions of the Act or an abuse having regard to the provisions of the Act read as a whole, for the purposes of subsection 245(4) of the Act.

As stated in paragraph 15 of Information Circular 88-2,

• ...the formation of the new corporation and the transfer of the shares to the new corporation is not an abuse of the Act. The transfer of the non-business assets is governed by subsection 55(2) of the Act. Since the definition of a qualified small business corporation share does not require that all or substantially all of the assets be used in carrying on an active business in Canada for a particular period of time prior to the sale of the shares, the distribution of the non-business assets prior to the sale is acceptable. Therefore, in this case, the transactions undertaken to "purify" the corporation are in accordance with the scheme of the Act.

We are of the opinion that the quoted reasoning in the Circular would apply to your examples and consequently that the provisions of subsection 245(2) of the Act would not apply, even where the non-business assets represent more than 50% of the fair market value of the assets of the corporation or, as in the third situation, the new corporation would be left at the end of the series of transactions with a receivable of $200,000 from the operating corporation.

You also state that, in your situations, subsection 55(2) of the Act would not be applicable since there is no contemplated disposition of property to parties dealing at arm s length with the dividend recipients. We would only agree with your statement where a purification transaction cannot be considered to be part of a series of transactions or events that would result in a disposition of property to an arm's length party. A subsequent disposition of the shares of the corporation could be part of the same series of transactions as the purification step. Consequently, if such a disposition occurs in favour of an arm's length party as part of a series of transactions or events, within the extended meaning of subsection 248(10) of the Act, and that series also includes a "purification" transaction of one of the types described above, the relief from subsection 55(2) of the Act provided under paragraph 55(3)(c) of the Act would not be available. The determination of which transactions or events comprise a series of transactions or events, within the extended meaning of subsection 248(10) of the Act, is a question of fact.

The views expressed in this letter as previously mentioned do not constitute advance income tax rulings, but are provided pursuant to the practice referred to in paragraph 24 of Information Circular 70-6R.