12 May 1989 Income Tax Severed Letter 5-7449 - [Subsections 55(2) and 245(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.

XXXX

M. Vallée (613) 957-2093

MAY 12 1989

Dear Sirs:

Re: Subsections 55(2) and 245(2) of the Income Tax Act (the "Act")

This is in reply to your letter, dated January 19, 1989, whereby you request our views regarding the application of subsections 55(2) and 245(2) of the Act in the following hypothetical situation.

Assumed Facts

1. All outstanding shares of Holdco are owned by Mr. X., a Canadian resident.

2. Holdco's assets are as follows:

                                                 Fair      
                                                 Market         Adjusted
                                                 Value          Cost Base
                                                ---------      ----------
Shares in ACo which are shares      
  in a "qualified small business 
  corporation" for the purpose of 
  Subsection 110.6(2.1) of the Act              $ 400,000       $   3,430
Marketable securities                             132,000         132,000
                                                ---------      ---------
                                                $ 532,000       $ 135,430
                                                =========       =========

Mr. X and Holdco deal at arm's length with ACo.

3. An arm's length party has offered to purchase the ACo. shares from Holdco for $400,000.

4. Mr. X wishes to take advantage of the capital gains exemption provisions of subsection 110.6(2.1) of the Act. However, he cannot do so by selling the Holdco shares because the Holdco shares do not meet the definition of "qualified small business corporation shares" in subsection 110.6(1) of the Act. Further, he will not "purify" Holdco as set out in paragraph 15 of Information Circular 88-2 because Holdco has no "safe income", and the Department's position is that subsection 55(2) of the Act would apply (paragraph 15).

5. Mr. X proposes to take the following steps:

(a) he incorporates Newco;

(b) he transfers to Newco shares of Holdco with a fair market value of $400,000. In return, he receives common shares of Newco. Mr. X and Newco jointly elect under subsection 85(1) of the Act a transfer price for tax purposes that is equal to the adjusted cost base to Mr. X of the Holdco shares;

(c) Holdco transfers all of its shares in ACo to Newco. In exchange, Newco issues preference shares which are redeemable and retractable on demand for $400,000. Newco and Holdco jointly elect under subsection 85(1) of the Act a transfer price for tax purposes that is equal to the adjusted cost base to Holdco of the ACo shares;

(d) Holdco retracts its preferred shares in Newco for a $400,000 promissory note issued by Newco;

(e) Holdco repurchases its common shares held by Newco for $400,000. Consideration is cancellation of the $400,000 promissory note; and

(f) Mr. X sells his shares in Newco to the arm's length third party for $400,000, triggering a capital gain which is eligible for the exemption under subsection 110.6(2.1) of the Act.

You submit that subsection 55(2) of the Act should not apply to the transaction since there is no significant reduction in the potential capital gain to be realized on the disposition of the ACo shares, the capital gain being fully recognized in the hands of Mr. X. You also argue that there is no "step-up" in the adjusted cost base to Mr. X of his Newco shares, and that there is no other reduction to potential capital gains associated with other assets of Holdco because those other assets have not been sold to an arm's length party.

You also argue that the general anti-avoidance rule of section 245 of the Act should not apply to the transactions because no attempt is made to artificially alter the status of a corporation to that of a "small business corporation", the reorganization of assets within corporate groups of common and/or related control without incidence of tax is assisted by specific provisions of the Income Tax Act and has been historically acceptable to Revenue Canada and because Mr. X is not attempting to take advantage of preferences that are not expressly provided by the Act.

Our Comments

You specifically mention that your query relates to a proposed transaction involving a specific taxpayer. Assurance as to the tax consequences of proposed transactions will only be provided in response to a request for an advance income tax ruling. The procedures for requesting a ruling are as stated in Information Circular 70-6R, and the Special Release thereto. We can, however, provide some general comments, as set out below.

We are of the opinion that subsection 55(2) of the Act will apply to deem the dividend deemed to have been received by Newco pursuant to subsection 84(3) of the Act, upon the redemption by Holdco of its common shares, to be a capital gain, since the stated result of the series of transactions is the disposition of the shares of ACo to a third party. Subsection 55(2) of the Act would also apply for the same reasons to the dividend deemed received by Holdco upon the redemption of the Newco preferred shares.

Furthermore, we do not agree with your submission to the effect that subsection 55(2) of the Act should not apply to the transaction since there is no reduction in the capital gain to be realized on the disposition of the ACo shares. We are of the opinion that there is a significant reduction in the portion of the capital gain that would have been realized by Newco and Holdco if the shares that they owned had been sold at their fair market value. The potential realization of a capital gain by another taxpayer, Mr. X, does not prevent the application of subsection 55(2) of the Act, even though that event is part of the same series of transactions.

The above comments are provided in accordance with the guidelines described in paragraph 24 of Information Circular 70-6R.

Yours truly,

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