17 October 1989 Ministerial Letter 58268 F - Associated Corporation Rules

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.

October 17, 1989

Dear Sirs:

Re:  Subsections 256(3) and (6) of Income Tax Act (the "Act")

This is in reply to your letter of June 21, 1989 in which you asked for our opinion concerning the application of the provisions of subsections 256(3) and (6) of the Act in the hypothetical situation described below:

A corporation (the "Lender") provides funds to a second corporation (the "Debtor") by way of a secured term loan on commercial terms repayable over a period of-three to seven years, depending on the nature of the Debtor.  In addition, the Lender subscribes for less than 50% of the issued common shares Of the debtor for a nominal sum.  In conjunction with the loan and issued common shares, the Lender is granted an option to acquire additional common shares of the Debtor.  If this option were exercised, the Lender would own more than 50% of the common shares of the Debtor.  You have concluded that, subject to subsections 256(3) and (6) of the Act, the Lender and the Debtor would be associated pursuant to paragraph 256(1)(a) of the Act.

The option agreement would provide that it expires on the date the loan is repaid in full in accordance with its terms.  In addition, the parties would agree that if the option is exercised before it expires, and the loan is later repaid in full in accordance with its terms, the Lender would be required to sell the shares acquired pursuant to the option to a third party with which the Lender deals at arm's length.  In most cases, this third party would be a manager of the Debtor or an existing shareholder of the Debtor.

We are unable to provide a definitive response to the question of whether the provisions of subsection 256(6) of the Act will be applicable in the situation described above as the determination of whether all of the conditions necessary for its application are satisfied is a question of fact that can only be answered based on an examination of all of the relevant circumstances of a particular real case.  We can, however, provide you with the following general comments explaining our views off the application of subsection 256(6).

In order for subsection 256(6) of the Act to apply, both of the following conditions must be satisfied:

(a)      there must be in effect an enforceable arrangement under which, upon the satisfaction of a condition or the happening of an event that it is reasonable to expect will be satisfied or happen, control of the corporation will pass from the controller to a person or group of persons dealing at arm's length with the controller; and

(b)      the controller must hold control solely for the purpose of safeguarding his rights or interests in respect of debt or shares described in subparagraphs 256(6)(b)(i) or (ii) of the Act.

In the situation described above, it will be a question of fact at any particular time whether:

(a)      it is reasonable to expect that the loan from the Debtor to the Lender will be repaid; and

(b)      the Lender holds control of the second corporation solely for the purpose of safeguarding its rights or interests in respect of the loan.

Since the tests in paragraphs 256(6)(a) and (b) of the Act apply as of the particular time when control is being determined, i.e. not solely at the time that the particular arrangement is entered into, the circumstances must be examined at that determination time to ascertain whether the provisions of these paragraphs are satisfied. The tests in these paragraphs may be satisfied at one time but not at a later time due to a change in circumstances.  Therefore, even though, for example, there may be a reasonable expectation that the loan will be repaid at the time that the loan is made, circumstances nay change so that it will no longer be reasonable to expect that the loan will be repaid.  The conditions set out in paragraphs 256(6)(a) of the Act would consequently not be satisfied at any time during the period throughout which such changed circumstances exist.

With respect to subsection 256(3) of the Act, taxpayers who believe they would be eligible for the relief described in subsection 256(3) of the Act should file their returns on that basis.  However, they should be ready and able to establish to the satisfaction of the Minister that, throughout the taxation year in question, the conditions set out in paragraphs 256(3)(a) and (b) were satisfied if called upon to do so by Revenue Canada, Taxation ("RCT").  It is clear that the provisions of subsection 256(3) of the Act would not apply if the corporations seeking to benefit from its application were unable to establish to the satisfaction of the Minister that the conditions set out in paragraphs 256(3)(a) and (b) of the Act were satisfied at any particular time.

Finally, you requested oar views as to the application of subsection 256(3) of the Act to the situation described herein.  In our view, subsection 256(6) and not subsection 256(3) is the provision which may be applicable in these circumstances.  The determination of whether the conditions for the application of subsection 256(3) are satisfied in any case would be a question of fact which would depend upon the relevant circumstances. Our comments set out above as to the satisfaction of the requirements of subsection 256(6) of the Act are also applicable for subsection 256(3) of the Act.

Our comments herein are provided in accordance with the practice referred to in paragraph 24 of Information Circular 70-6R.

Yours truly,

for DirectorReorganizations and Non-Resident DivisionSpecialty Rulings DirectorateLegislative and IntergovernmentalAffairs Branch