31 January 1990 Ruling 59233 F - Estate Freeze

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.

January 31, 1990

Dear Sirs:

Re: Subsections 110.6(8) and (9) of the Income Tax Act (the "Act")

We refer to your letter of December 6, 1989, wherein you requested our views on the application of subsections 110.6(8) and (9) of the Act to shares issued pursuant to an estate freeze. You have illustrated your request in the three hypothetical situations described below.

Situation 1

A Canadian-controlled private corporation ("Famco"), within the meaning assigned by paragraph 125(7)(b) of the Act, has issued share capital consisting solely of common shares, which are held as to 90% by a father (the "Father") and 10% by his son (the "Son"). Famco is also a small business corporation within the meaning assigned by subsection 248(l) of the Act.  The share capital of Famco is reorganized pursuant to subsection 86(1) of the Act, such that the Father exchanges all of his common shares of Famco for redeemable/retractable preference shares having a redemption amount equal to the fair market value of his common shares at the time of exchange.  The preference shares are entitled to a non-cumulative dividend of 9.5% on their redemption amount.  The Son does not participate in the reorganization of Famco's capital, but simply retains his existing common shares of Famco.

If the Father or the Son had disposed of their shares immediately prior to the reorganization, they would have realized a capital gain which would not be attributable to the fact that dividends were not paid on a share (other than a prescribed share) of a corporation, or that dividends paid on such a share in the year or in any preceding taxation year were less than 905 of the average annual rate of return (as defined by subsection 110.6(9) of the Act) thereon for that year.  The term "prescribed share" as referred Co here and subsequently has the meaning set out under section 6205 of the Income Tax Regulations ("ITR").  Prior to the reorganization, the common shares of Famco would be prescribed shares within the meaning assigned by paragraph 6205(l) (a) of the ITR.

It is your understanding that the preference shares issued to the Father would not qualify as prescribed shares pursuant to paragraph 6205(2) (a) of the ITR, since no prescribed shares were issued to the Son as part of the reorganization, even though the main purpose of the reorganization was to permit an increase in the value of the property of Famco to accrue to the existing common shares of Famco held by the Son.

It is also your understanding that subsection 110.6(8) of the Act would not apply to deny a deduction under subsection 110.6(2.1) of the Act in respect of a subsequent disposition by the Father of his preference shares for proceeds of disposition equal to the redemption amount of such shares, since the capital gain resulting from the disposition would not be attributable to insufficient dividends being paid on a share (other than a prescribed share) of Famco.

Situation 2

The assumed facts given in Situation 1 apply.  In addition, during the first taxation year following the reorganisation described in Situation 1, dividends paid on the preference shares of Famco equalled the "average annual rate of return as defined by subsection 110.6(9) of the Act.  However, during the second taxation year, dividends paid on the preference shares were less than 901 of such average annual rate of return.  As a result of the shortfall in dividends paid on the preference shares, the accrued value in respect of the common shares of Famco held by the Son increased by 1%.

It is your view that, should the Son dispose of his common shares in Famco's third taxation year following the reorganization, subsection 110.6(8) of the Act would not apply to deny a deduction under subsection 110.6(2.1) of the Act in respect of the disposition of the Son's common shares, since only an "insignificant part" of the capital gain realized by the Son would be attributable to the shortfall in dividends paid on the preference shares.

Situation 3

The assumed facts given in Situation 1 apply. In addition, in the third taxation year of Famco following the reorganization described in Situation 1, the Father exchanges all of his preference shares of Famco for new preference shares of Famco pursuant to a second reorganization of Famco's share capital to which subsection 86(l) of the Act would again apply.

The attributes of the new and old preference shares are the same except that the new preference shares are entitled to a non-cumulative dividend equal to 101 of their redemption amount, rather than 9.51 in respect of the old preference shares. Concurrently with the issue of the new preference shares, Famco also issues additional common shares to the Son in consideration for a subscription price equal to their fair market value (based on the fair market value of an existing common share of Famco held by the Son).  The object of this second reorganization is to permit any subsequent increase In the value of the property of Famco to accrue to the additional common shares of Famco so issued to the Son.

It is your opinion that the new preference shares Issued to the Father would qualify as prescribed shares pursuant to paragraphs 6205(2) (a) and 6205(4)(e) of the ITR.  In this regard, you understand that the purpose of paragraph 6205(4)(e) of the ITR is to permit the share capital of a corporation to be reorganized in a manner such that a share that is not a prescribed share may be converted into a prescribed share.  For the same reason, you are also of the opinion that subsection 245(2) of the Act would not apply to the second, reorganization referred to herein by virtue of subsection 245(4) thereof.

Comments

Your request appears to relate to a specific proposed transaction.  Confirmation of the tax consequences of a specific proposed transaction will only be provided in response to a request for an advance Income tax ruling.  The procedures for requesting an advance ruling are set out in Information Circular 70-6R.  Although we are unable to provide any opinion in response to the specific transactions described in your letter, we do provide the following general observations.

Situation 1

We agree that the preference shares issued to the Father would not qualify as prescribed shares pursuant to paragraph 6205(2) (a) of the ITR, since no prescribed shares were issued to the Son as part of the reorganization of the share capital of Famco.  However, we are unable to agree with your conclusion that subsection 110.6(8) of the Act would not apply to deny the capital gain arising on a subsequent disposition of the preference shares.  In this regard, whether or not a significant part of the capital gain would be attributable to the fact that insufficient dividends were paid on a share that was not a prescribed share is a question of fact on which we make no comment.  We would, however, point out that since the preference shares would not be prescribed shares, insufficient dividends paid on these shares could very well result in a significant part of any capital gain being realized on such shares, since it is certainly possible that, in certain situations, the payment of insufficient dividends would maintain the value of the preference shares, and this may not have been the case if a reasonable rate of return were to have been paid thereon.  What would be the average annual rate of return for the purposes of subsection 110.6(9) of the Act would require a valuation of the preference shares, and this is a question of fact on which we would not provide a ruling, as stated in paragraphs 14(h) and (1) of Information Circular 70-6R dated December 18, 1978.

Situation 2

We are unable to confirm your understanding that the payment of insufficient dividends on the preference shares of Famco, which results in an increase of 1% in value in respect of the common shares of Famco prior to their disposition by the Son, constitutes an "insignificant part" of the capital gain realized by the Son as a result of the disposition.  What constitutes an "insignificant part" is a question of fact, and in this respect, the Department has not established any guidelines on what is a significant part for the purposes of subsection 110.6(8) of the Act.  In this regard, the Department would not place reliance on a percentage test alone; the dollar value attached to that part of the capital gain attributable to the payment of insufficient dividends would also be taken into account.  This is consonant with the Department's position on what is a "significant reduction in the portion of the capital gain" (for the purposes of subsection 55(2) of the Act), as set out in the paper entitled "Capital Gains Strips:  A Revenue Canada Perspective on the Provisions of Section 55", presented by John R. Robertson in 1981.  This paper was published in the 1981 Conference Report, and the relevant passage referred to herein may be found on page 93 of the Report.

Situation 3

We do not agree that the new preference shares would be prescribed shares pursuant to the provisions of paragraphs 6205(2) (a) and 6205(4)(e) of the ITR.  In our view, the new preference shares would not meet the requirement of subparagraph 6205(2)(a)(i) of the ITR that

      "the main purpose of the arrangement was to permit any increase in the value of the property of the corporation to accrue to the other shares",

since such increase in value would not only benefit the additional common shares of, Famco issued to the Son (the "other shares"), but would also benefit the existing common shares of Famco held by the Son.  In Situation 3, it would appear that the main purpose of the arrangement is to convert preference shares that would not otherwise be prescribe shares into prescribed shares.

We also do not agree that the provisions of paragraph 6205(4)(e) of the ITR are pertinent to the issue of the new preference shares.  This paragraph operates only where the terms or conditions of an (existing) share are changed or any existing agreement in respect thereof is changed or a new agreement in respect of the (existing) share is entered into.  In either such case, the paragraph deems the (existing) share to have been issued at the particular time for the purposes of determining whether the (existing) share is a prescribed share.  The paragraph has no application to the factual issue of new shares.

We offer no opinion on the application of subsection 245(2) of the Act to the second reorganization described in Situation 3, since we are of the view that the provisions of subsection 110.6(8) of the Act and paragraph 6205(2)(a) of the ITR are adequate to deal with the Situation.

We trust our comments will be of assistance.

Yours truly,

for DirectorReorganizations and Non-Resident DivisionSpecialty Rulings DirectorateLegislative and Intergovernmental Affairs Branch