30 June 1989 Income Tax Severed Letter 5-7939 - Purification of small business corporation

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 of April 20, 1989 in which you requested our comments concerning the application of subsection 55(2) of the Act to a hypothetical situation which can be summarized as follows:

• (1) The issued share capital of a corporation ("Opco") consists of 100 common shares all of which are owned by an individual resident in Canada ("Mr. X"), and which have nominal paid-up capital and adjusted cost base to Mr. X ("the Opco Shares"). The fair market value of the Opco Shares is $1 million. Opco is a Canadian-controlled private corporation within the meaning of paragraph 125(7)(b) of the Act.
• (2) The total assets of Opco have a fair market value of $1 million, consisting of the following:

Assets used directly in an active business
carried on primarily in Canada ("the Qualifying
Assets")                                          $800,000
Investment assets which are not incidental to
the active business ("the Non-Qualifying Assets")  200,000
TOTAL                                           $1,000,000

(3) Mr. X wishes to remove the Non-Qualifying Assets from Opco on a tax-deferred basis, if possible, so as to bring the Opco Shares within the definition of "qualified small business corporation share" ("QSBC Share") in subsection 110.6(1) of the Act for purposes of claiming a deduction under subsection 110.6(2.1) of the Act in the event of a sale of the Opco Shares. Accordingly, Mr. X causes the following transactions to be carried out:
• (a) Mr. X forms a new corporation ("Newco") of which he is the sole shareholder, holding 100 issued common shares.
• (b) Mr. X then transfers to Newco such number of Opco Shares as have an aggregate fair market value of $200,000 ("the Transferred Opco Shares"). In consideration for the Transferred Opco Shares, Newco issues to Mr. X preference shares with an aggregate fair market value of $200,000, and paid-up capital equal to the paid-up capital of the Transferred Opco Shares. An election under subsection 85(1) of the Act is filed, with the agreed amount being equal to the adjusted cost base to Mr. X of the Transferred Opco Shares.
• (c) Opco then sells to Newco the Non-Qualifying Assets at their fair market value of $200,000, and receives as consideration there for redeemable preference shares of Newco with an aggregate redemption amount and fair market value of $200,000 and having nominal paid-up capital. An election under subsection 85(1) of the Act is filed with the agreed amount in respect of each of the transferred assets being equal to its cost amount.
• (d) Newco then redeems its preference shares held by Opco at their aggregate redemption amount of $200,000, and Opco repurchases for cancellation the Transferred Opco Shares at their fair market value of $200,000 ("the Cross-Redemptions"). Promissory notes are issued in each case which are then offset and cancelled.
• (e) Some time subsequent to the completion of the above steps (subsequently referred to as "the Reorganization") the Opco Shares which are still owned by Mr. X are sold by him to an arms-length purchaser.

Your Questions:

(1) Would the subsection 84(3) deemed dividends which would arise on the Cross Redemptions ("the Deemed Dividends") be exempted from the application of subsection 55(2) by virtue of Paragraph 55(3)(a) of the Act where:
• (a) at the time of the Reorganization, Mr. X has not identified a potential purchaser of the Opco Shares and he has no intention of selling the Opco Shares ("Situation 1");
• (b) at the time of the Reorganization, the sale of the Opco Shares is not under consideration or negotiation, although there are several potential purchasers in the marketplace and an offer could be received or negotiations commenced soon after the Reorganization ("Situation 2"); or
• (c) at the time of the Reorganization Mr. X has identified a prospective purchaser who is prepared to purchase, and to whom Mr. X is prepared to sell, the Opco Shares ("Situation 3")?
• (2) Would subsection 245(2) be applied in respect of any of the transactions constituting the Reorganization?

Our Commments

• (1) The exemption from subsection 55(2) contained in paragraph 55(3)(a) of the Act would not apply where the disposition of the Opco Shares by Mr. X to the arm's-length purchaser is part of the same series of transactions in which the Deemed Dividends arise. Subsection 248(10) of the Act deems a series of transactions to include any related transactions or events completed in contemplation of the series. Whether two transactions are part of the same series of transactions determined with reference to subsection 248(10) is a question of fact which will depend upon the circumstances of each case. Accordingly we cannot provide any definitive comments with respect to whether the sale of the Opco Shares and the Deemed Dividends would be part of the same series of transactions. However, we can make the following general observations concerning that question.
• It is our view that a preliminary transaction will form part of a series determined with reference to subsection 248(10) if, at the time the preliminary transaction is carried out, the taxpayer intends to implement the subsequent transactions constituting the series, and the subsequent transactions are eventually' carried out. Thus, the preliminary and subsequent transactions will be part of a series even though at the time of the completion of the preliminary transactions the taxpayer either had not determined all the important elements of the subsequent transaction including, possibly, the identity of other taxpayers involved - or had lacked the ability to implement the subsequent transactions.
• Accordingly, in Situation 1 referred to above, if as hypothesized Mr. X has no intention at the time of the Reorganization of ever selling the Opco Shares, the Deemed Dividends and an eventual sale of the Opco Shares would generally not be part of the same series of transactions. It is in our view unlikely that such a situation would occur, however, since in most situations a shareholder who causes a reorganization to be carried out for the purpose of causing shares to qualify as QSBC shares does so in order that a deduction under subsection 110.6(2.1) of the Act will be available to him upon a disposition of the shares. In such cases the shareholder would have some intention at the time of the reorganization of eventually selling the shares.
• At the time of the Reorganization in Situation 2 referred to above, Mr. X intends to sell the Opco Shares. The Deemed Dividends and an eventual sale of the Opco Shares in such a situation would generally be considered to be part of the same series determined with reference to subsection 248(10) of the Act, notwithstanding the fact that Mr. X had not identified a purchaser of the Opco Shares at that time.
• In Situation 3 referred to above, because at the time of the Reorganization Mr. X intends to sell the Opco Shares and has identified a purchaser of such shares, the Deemed Dividends and the eventual sale of the Opco Shares would generally be considered to be part of the same series.
• (2) The views of the Department concerning the application of subsection 245(2) of the Act in this situation are set out in paragraph 15 of Information Circular 88-2, "General Anti-Avoidance Rule - Section 245 of the Income Tax Act".

The above comments are based only on the provisions of the Act referred to above and should not be interpreted as implying that any other provision of the Act would or would not apply to, or as a result of, any actual transactions or events similar to those described in the situation above.

The foregoing responses are opinions in accordance with the practice described in paragraph 24 of Information Circular 70-6R.