23 August 1990 Ruling 59731 F - Purification of 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.

August 23, 1990

Dear Sirs:

Re:   Subsection 55(2) of the Income Tax Act (Canada) (the "Act")

We are responding to your letter, dated February 23, 1990, regarding the application of subsection 55(2) of the Act to two situations described below.

Scenario 1

1.     The shares of an operating company ("Opco") are owned as follows:

(a)     as to 50% thereof, by three companies ("Brother Xco", "Son1 Xco" and "Son2 Xco") which are in turn owned by Mr. X and his two sons, respectively; and

(b)     as to the remaining 50% thereof, by three companies ("Brother Yco", "Son1 Yco" and "Son2 Yco") which are in turn owned by Mr. Y (who is a brother of Mr. X) and his two sons, respectively.

2.     Brother Xco and Brother Yco each own other assets in addition to their shares of Opco.

3.     For estate planning purposes, it is desired that each of Brother Xco and Brother Yco segregate its shareholding in Opco from its other assets.  It is proposed that this be done as follows:

(a)     Mr. X will incorporate a new holding corporation ("New Xco") and transfer a portion of his common shares of Brother Xco to New Xco, on a tax-deferred basis pursuant to subsection 85(1) of the Act, in exchange for common shares of New Xco that have the same value and paid-up capital as the transferred shares.  The value of the transferred shares will be equal to the value of Brother Xco's shares of Opco.

(b)     Brother Xco will then transfer its shares of Opco to New Xco, on a tax-deferred basis pursuant to subsection 85(1) of the Act, in exchange for non-voting preferred shares of New Xco having the same adjusted cost base, paid-up capital and redemption value as the transferred Opco shares.

(c)     New Xco will then redeem its preferred shares held by Brother Xco, the consideration being a demand promissory note having a value equal to the redemption amount.

(d)     Brother Xco will then purchase for cancellation its common shares held by Newco and, in payment of the  purchase price therefore, will return the promissory note delivered in step (c) to New Xco for cancellation.

(e)     Transactions similar to those described in steps (a) to (d) above will be implemented by Mr. Y and Brother Yco.

In your view, the deemed dividends arising on the redemptions of shares described in steps (c) and (d) above, and similar dividends arising on the share redemptions in Mr. Y's transactions should not be subject to the application of subsection 55(2) of the Act, by virtue of paragraph 55(3)(a).  You state, as a fact, that the transactions contemplated by the two brothers will occur independently of each other.  Thus, in your view, they will not form part of the same series of transactions or events, with the result that no event described in subparagraph 55(3)(a)(i) or (ii) will have occurred.

Scenario 2

1.     Before proceeding with the transactions described in Scenario 1, Mr. X and Mr. Y would like to undergo certain transactions that would effectively crystallize their capital gains exemption under subsection 110.6(2.1) of the Act.

2.     The shares of Brother Xco and Brother Yco satisfy the tests in paragraphs (b) and (c) of the definition of "qualified small business corporation share" in subsection 110.6(1) of  the Act.  However, in order to satisfy the test in paragraph (a) of the definition, each of the two companies and, in these circumstances Opco, must be a "small business corporation" immediately before the crystallization occurs.  Opco owns term deposits, the value of which exceeds 10% of the fair market value of all of Opco's assets, which are not used in any active business.

3.     The following transactions would be implemented in order to "purify" the corporations:

(a)     Opco would pay the term deposits pro rata to its shareholders as a dividend in kind.

(b)     Mr. X would transfer a portion of his common shares of Brother Xco, the value of which would equal the value of the term deposits received by Brother Xco, to a newly incorporated corporation ("NewcoX"), on a tax-deferred basis pursuant to subsection 85(1) of the Act, in exchange for common shares of NewcoX having the same value and paid-up capital as the transferred shares.

(c)     Brother Xco would then purchase for cancellation its common shares held by NewcoX and, in payment of the purchase price therefor, would transfer its term deposits to NewcoX.

(d)     Transactions similar to those described in paragraphs (b) and (c) above would be implemented by Mr. Y and Brother Yco.

4.     As a result of the foregoing transactions, Opco, Brother Xco  and Brother Yco would be small business corporations within   the meaning assigned by subsection 248(1) of the Act.  The transactions described above in paragraph 3 of Scenario I would then be implemented, with the only difference being that, in respect of the transfer of his shares of Brother Xco  to New Xco, Mr. X will elect at an amount that would be  $400,000 in excess of his adjusted cost base of such shares.  Mr. X would claim a deduction under subsection 110.6(2.1) of  the Act in respect of the resulting capital gain.

It is your view that the application of subsection 55(2) of the Act to any dividends paid or deemed to be paid in Scenario 2 would not be in accordance with the spirit of the provision as there has been no increase in the percentage ownership in Opco by any of the indirect shareholders.  The only change that has taken place is that Mr. X and Mr. Y have changed their investment vehicles for holding their shares in Opco.

Our Comments

You have requested confirmation as to the tax consequences of specifically proposed transactions, namely, the transactions described in paragraph 3 of Scenario 1 and in paragraph 3 of Scenario 2.  As explained in Information Circular 70-6R issued by Revenue Canada, Taxation dated December 18, 1978 (the "Circular"), assurance as to the tax consequences of specifically proposed transactions will not be provided except in response to a request for an advance income tax ruling submitted in accordance with the guidelines set out in the Circular.

Further, if you are considering whether or not to apply for an advance income tax ruling, you should bear in mind that the determination of whether two or more transactions form part of the same series, having regard to the extended definition of "series of transactions or events" in subsection 248(10) of the Act, is primarily a question of fact and, as explained in paragraph 14(1) of the Circular, we would be unable to rule where the matter on which a determination is requested is primarily one of fact and the circumstances are such that all of the relevant facts cannot be established at the time of the ruling request.

Although we cannot provide you with any assurance as to the tax consequences of the proposed transactions, you may find the following general comments to be of some assistance.

In circumstances such as those described in Scenario 1, it is possible that, depending on the facts, the estate planning transactions implemented by one brother would not be considered to form part of the same series of transactions that included the estate planning transactions implemented by the other brother. The fact that they happen to coincide would not, in and by itself, lead to the conclusion that they were part of the same series.  If in fact they were not part of the same series of transactions, but two separate series, then each series of transactions, in and by itself, would not result in a disposition of property to, or an increase in interest in any corporation by, any person with whom a corporate recipient of a dividend in the series dealt with at arm's length.  Paragraph 55(3)(a) of the Act would therefore apply to exempt any dividend received in the series from the application of subsection 55(2).

In the circumstances described in Scenario 2, the two brothers, Mr. X and Mr. Y, would be deemed by paragraph 55(5)(e) to be unrelated and not to deal at arm's length for the purposes of section 55.  We would thus consider their two holding companies to deal with each other at arm's length. Similarly, although each brother's company would be deemed not to deal at arm's length with his respective sons' companies, his sons' companies would be considered to deal at arm's length with each other and, with their uncle's company and their cousins' companies.

While the determination of which transactions or events form part of a series for the purposes of paragraph 55(3)(a) is a question of fact that cannot be determined without a review of all of the relevant facts, based on the facts and proposed transaction described in Scenario 2, the initial dividend by Opco would, in our view, be part of the same series of transactions that included the transactions described in paragraphs 3(b), (c) and (d) and the estate planning transactions described in paragraph 3 of Scenario 1.

The initial dividend by Opco to its shareholders would result in a distribution of property to persons with whom the corporate recipients of dividends in the series would be considered, for the purposes of section 55 of the Act, to deal at arm's length.  Thus all dividends received or deemed to be received by any corporation in the series of transactions that includes such initial dividend would not be exempted by paragraph 55(3) (a) of the Act from the application of subsection 55(2).

The above comments reflect our position only with respect to subsection 55(2) and paragraph 55(3)(a) of the Act and should not be interpreted as implying that any other provision of the Act would or would not apply to any actual transactions similar to those described herein.

The foregoing expressions of opinion are given in accordance with the practice referred to in paragraph 24 of Information Circular 70-6R dated December 18, 1978 and are not binding on Revenue Canada, Taxation.

Yours truly,

for DirectorReorganizations and Non-resident DivisionRulings DirectorateLegislative and IntergovernmentalAffairs Branch