18 April 1990 External T.I. 59665 F - Butterfly Reorganizations - Exception to Deemed Capital Gain Provision

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.

April 16, 1990

Dear Sirs

Re:  Paragraph 55(3)(b) of the Income Tax Act (the "Act")

We are writing in response to your letter of February 22, 1990 in which you have requested a technical interpretation concerning the above provision of the Act.

The Department's views concerning the requirements of paragraph 55(3)(b) of the Act were expressed by Mr. J.R. Robertson at the 1981 annual conference of the Canadian Tax Foundation.  These views were updated by Mr. M.A. Hiltz at the 1984 Corporate Management Tax Conference, as well as, by Mr. R.J.L. Read and Mr. M.A. Hiltz, respectively, at the 1988 and 1989 annual conferences of the Canadian Tax Foundation.

The determination of whether or not the requirements of paragraph 55(3)(b) of the Act have been satisfied, such that the provisions of subsection 55(2) will not be applied in a particular situation, can only be made once all the relevant facts have been determined. However, we can provide certain general comments in response to your questions concerning the classification of the assets, and the allocation of the liabilities, of the particular corporation for the purposes of paragraph 55(3)(b) of the Act. 

The provisions of paragraph 55(3)(b) of the Act require a classification, by type, of the property of a particular corporation and a determination of the fair market value of each type of property, immediately before the transfer of property referred to in that paragraph.  In our view a particular corporation may have three types of property:

i)     Cash or near cash property - generally consisting of current assets and similar assets including cash, short term deposits, marketable securities (other than portfolio investments) and advances to other corporations within a corporate group.

ii)     Business property - generally property, other than cash or near cash, used by that corporation to earn business income; and

iii)     Investment property - generally property, other than cash or near cash property or property which will be converted into such property, which is not used to earn business income reported by that corporation.

Where a particular corporation has property consisting of shares of another corporation in which it has some significant influence (within the meaning given that term in the CICA Handbook) it is our view that it is appropriate to "look through" these shares and determine the types of property of the particular corporation on a consolidated basis.  The shares held in the other corporation are not classified as a particular type of property per se, but are seen as representing their pro rata portion of each type of property owned by that corporation.  In addition, it is the fair market value of the assets owned by that corporation, rather than the fair market value of the shares of that corporation, which is relevant for purposes of the pro-rata test contained in paragraph 55(3)(b) of the Act.

Shares of a corporation in which the particular corporation does not have a significant influence will generally be classified as investment assets but could represent cash or near cash or business property depending upon all the facts of a particular situation.

The "look-through" approach described in the previous paragraph will also be applied where a particular corporation has property which is an interest in a limited partnership as a general partner (this approach will apply whether the particular corporation has a majority or a minority interest in the partnership).

Where the transfer of property referred to in paragraph 55(3)(b) of the Act is to proceed under the net equity method, the liabilities of the particular corporation (determined on a consolidated basis where appropriate) are allocated to property of each type of the particular corporation (determined on a consolidated basis where appropriate) and are deducted in the calculation of the net fair market value of the property of each type of the particular corporation, as follows:

(i)     current liabilities are allocated to cash and near cash property, including accounts receivable, inventory and prepaid expenses, on a proportionate basis, to the extent of the fair market value of such property;

(ii)     liabilities, other than current liabilities, that relate to a particular property will be allocated to the type of property to which the particular property belongs to the extent of the fair market value of all property of that type; and

(iii)     remaining liabilities, which have not been allocated in steps (i) and (ii), will be allocated on a proportionate basis to the net value of each type of property of the particular corporation, as determined after step (i) and (ii).

You have asked for our views on the proper treatment of obligations that a particular corporation may have under a "take-or-pay" contract. Pursuant to such contract the particular corporation would be required to deliver natural gas to the other party to the contract upon its demand (subject to certain restrictions) for same, however, no payment would be made at the time of such demand since the other party would have paid the particular corporation (or a predecessor thereof) for the natural gas at an earlier time. In our view the nature of any obligation arising under such a contract, and the proper allocation of same for the purposes of paragraph 55(3)(b) of the Act, would have to be determined based upon a review of the terms of the contract and all other relevant facts of a particular situation.  Where a corporation carrying on the business of producing, processing, etc. natural gas has a liability under such a contract, it may be appropriate to deduct same in determining the net fair market value of the corporation's business assets.  However, the final decision would be made on the basis described above.  It would also be a question of fact as to whether such a liability related to a particular asset of the corporation.

It should be noted that a problem may arise where it was a predecessor of the particular corporation which received the amounts paid pursuant to the "take-or-pay" contract described in the preceding paragraph.  If, as part of the transactions, an amount is paid by the particular corporation to another corporation in consideration for that corporation assuming the obligations under the "take-or-pay" contract, the requirements of subsection 20(24) of the Act will not be satisfied since the particular corporation would not have included in its income the amounts previously received under that contract.  Where the proposed transactions otherwise meet the requirements of paragraph 55(3)(b) of the Act and the above result is unintended based upon the facts of the particular situation, the Department is prepared to consider the acceptance of an otherwise valid election under subsection 20(24) of the Act.

You have also asked for our views regarding the effect of certain adjustments where the shares of a transferee corporation (as defined in paragraph 55(3)(b) of the Act) are sold to a third party with whom it deals at arm's length for the purposes of the Act after completion of the transfer of property to that corporation. In our opinion, the sale of the shares of the transferee corporation would not normally be considered to have occurred in the course of the reorganization referred to in paragraph 55(3)(b) of the Act.  The fact that the agreements concerning such sales contain provisions to adjust the purchase price for reasonable amounts concerning income and expenses relating to the transferred property up until the date of closing of the sale would generally not be of concern.

In determining whether or not the requirements of paragraph 55(3)(b) of the Act are satisfied in a particular situation, transactions occurring before and after the transfer of property referred to in that paragraph which are "in the course of " the "reorganization" referred to therein will have to be considered. Such transactions would be included in the determination of whether a transferee corporation has received its pro-rata portion of each type of property of the particular corporation.  If a particular corporation undertakes multiple transfers over a period of time, all such transfers may be part of a single reorganization for purposes of paragraph 55(3)(b) of the Act.  If such is the case, the pro-rata test for each such transfer is determined as at the point in time immediately before the first transfer.  It may be that all transferees are not shareholders at that time.

It will also be necessary to review the facts of the particular situation to determine whether "property has become property", as described in the mid-amble of paragraph 55(3)(b) of the Act, "in contemplation of and before the transfer" of property referred to therein.  Where that is the case the provisions of paragraph 55(3)(b) of the Act will not apply unless one of the specific exceptions detailed therein is met.

As explained in paragraph 24 of Information Circular 70-6R, the opinions expressed above are not rulings and are not binding upon Revenue Canada, Taxation in respect of any taxpayers.

Yours truly,

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