29 January 1990 Ruling 59333 F - Non-Arm's Length Sale of Shares

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 29, 1990

Dear Sir:

Re:  Subsection 84.1(l) of the Income Tax Act (the "Act")

We are writing in response to your letter of December 12, 1989, wherein you requested our view as to whether subsection 84.1(1) of the Act would apply to the following hypothetical situation described in your letter.

Situation

1.     Mr. and Mrs. 5 own 905 and 105, respectively, of all of the 100 issued common shares of Holdco which were issued to them as sole consideration for the recent transfer of their common shares of Sin Inc. to Holdco pursuant to subsection 85(1) of the Act.  Immediately before their transfer the common shares of Sin Inc. had a nominal adjusted cost base, within the meaning of paragraph 54(a) of the Act to each of Mr. and Mrs. S Holdco added to its stated capital account in respect of the 100 common shares issued to Mr. and Mrs. S an amount equal to the paid-up capital of the shares of Sin Inc. transferred by them to Holdco.

2.     As a result of the transfer, Sin Inc. became a wholly-owned subsidiary of Holdco.

3.     Also as a result of the transfer, Mr. and Mrs. 5 realized capital gains in the aggregate amount of $500,000 and claimed capital gains deductions in respect of their proportionate shares of that amount pursuant to subsection 110.6(2.1) of the Act.

4.     Mr. and Mrs. S now wish to sell the shares of Holdco to a corporation ("Purchaseco") to be incorporated by their daughter and son-in-law for $500,000 which approximates the fair market value of the shares of Holdco.  Purchaseco will be owned 50% by their daughter and 505 by their son-in-law.  Purchaseco will issue, to each of Mr. and Mrs. S as consideration for the purchase price, a promissory note payable over 7 years with an annual interest rate of 10%.

5.     Immediately after the transfer described in paragraph 4, Holdco, SW Inc. and Purchaseco will amalgamate to form a new corporation ("Amalco").  As a result of the amalgamation, Amalco will issue to each of Mr. and Mrs. S a promissory note identical in terms and maturity date to the promissory note that will have been issued by Purchaseco as described in paragraph 4 above.

Comments

The situation outlined in your letter appears to involve actual proposed transactions with identifiable taxpayers.  Confirmation as to the tax consequences of proposed transactions can only be given in the context of a request for an advance income tax ruling.  The procedures for requesting an advance income tax ruling are outlined in Information Circular 70-6R dated December 1978 issued by Revenue Canada, Taxation and the related Special Release thereto. However, we are prepared to offer the following general comments.

It is our view that paragraph 84.1(1)(b) of the Act will apply to the transfer of the shares of Holdco by Mr. and Mrs. S to Purchaseco as described in paragraph 4 above such that a dividend will be deemed to have been paid by Purchaseco to each of Mr. and Mrs. S.  The amount of the deemed dividend will be equal to the amount by which the principal amount of the promissory note that will be issued by Purchaseco to Mr. S or Mrs. S, as the case may be, exceeds the greater of the paid-up capital of the shares of Holdco and the adjusted cost base thereof to him or her, as the case may be.  "Adjusted cost base" has the meaning assigned by paragraphs 84.1(2) (a) and (a.1) of the Act.

In the situation described in your letter, the adjusted cost base of the shares of Holdco to Mr. and Mrs. S will be determined in accordance with subparagraph 84.1(2)(a.1)(ii) of the Act.  That is, the adjusted cost base of the shares of Holdco to each of Mr. S and Mrs. S for the purposes of section 84.1, is the adjusted cost base thereof otherwise determined less the amount of the capital gain in respect of which a capital gains deduction was claimed by each of them pursuant to section 110.6 of the Act with respect to their disposition of the shares of SW Inc. to Holdco.

In your letter of December 12, 1989, you also asked us why should Mr. and Mrs. S be penalized for the type of transaction described above where, if the parties involved were dealing at arm's length, subsection 84.1(1) of the Act would not have applied.

As the subject matter of your question relates to a matter of tax policy, your question should be directed to the Department of Finance which is responsible for the formulation of tax policy. Nevertheless, we can offer the following general comments.

As stated in the Technical Notes to a Bill Amending the Income Tax Act and Related Statutes issued by the Department of Finance in November 1985, section 84.1 of the Act was originally intended as an anti-avoidance rule to prevent the removal of taxable corporate surplus as a tax-free return of capital where there was a non-arm's length transfer of shares by an individual resident in' Canada to a corporation.  As a result of the enactment of the capital gains deduction, section 84.1 was amended effective after May 22, 1985 to prevent the removal of taxable corporate surplus as tax-exempt capital gains of an individual in a non-arm's length transfer of shares to a corporation.  Without the provisions of section 84.1, it would be easy for a taxpayer to convert amounts which would otherwise be received as dividend income into capital gains in respect of which a capital gains deduction pursuant to subsection 110.6(2), (2.1) or (3) of the Act could be claimed.  Section 84.1 of the Act applies to all non-arm's transactions where all of the conditions described in that subsection have been met.

We trust the above comments will be of assistance.

Yours truly,

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