14 June 1996 CICA Roundtable Q. 1, 6M12570 - 1996CMTC

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

CANADIAN TAX FOUNDATION

CORPORATE MANAGEMENT TAX CONFERENCE
JUNE 13 - 14, 1996
___________________________________________

REVENUE CANADA FORUM

Question 1 - Interest Deductibility

Interpretation Bulletin IT-80 was cancelled shortly after the decision of the Supreme Court in The Queen v. Bronfman Trust, 87 DTC 5059. On December 20, 1991, the Department of Finance released draft legislation concerning the income tax treatment of interest on borrowed funds. The legislation dealt with, inter alia, the deductibility of interest on money borrowed by a corporation to make distributions by way of dividend, redemption or acquisition of shares or reduction of capital, and interest on money borrowed by a partnership to make a distribution of profits or capital. Proposed section 20.2 would govern the treatment of borrowed money used to make distributions at any time before the date on which the legislation is issued in final form and proposed section 20.1 would apply to borrowings after that time.

What rules is Revenue Canada currently applying: the rules as stated in Interpretation Bulletin IT-80, or the rules in draft section 20.2 ?

Department's Response

The Department continues to apply its administrative position as was presented in former Interpretation Bulletin IT-80. Briefly, the position with respect to the deductibility of interest on funds borrowed to redeem shares or make distributions of partnership capital is that, in order to be fully deductible, the borrowed funds cannot exceed the aggregate of the paid-up capital of the shares or capital of the partnership, as the particular case may be, to be redeemed plus the accumulated profits of the corporation or the partnership determined immediately before the distribution. Further, accumulated profits and paid-up capital or capital, as the case may be, are relevant only to the extent that they have been used to earn income and have not been used to acquire property the income from which is exempt or to acquire a life insurance policy. In the case of funds borrowed to pay dividends or make distributions of profits to partners, only the accumulated profits are relevant to the determination.

It is our understanding that the provisions of proposed section 20.2 were intended to codify the Department's administrative position. Also, representatives of the Department of Finance have publicly stated that, to the extent that the new provisions prove to be more restrictive than the existing administrative position, the new provisions will be modified to eliminate those discrepancies.

Question 2 - Paragraph 88(1)(d) and Pre-Change-of-Control Dividends

Corporation A acquires, in an arms's-length transaction, 100% of the issued and outstanding shares of Corporation B. Corporation B owns 100% of the issued and outstanding shares of Corporation C which owns shares in a number of subsidiary corporations. All of the corporations are taxable Canadian corporations. Corporation A wishes to wind-up Corporation B and step-up the cost base of the shares in Corporation C under paragraphs 88(1)(c) and (d) of the Income Tax Act (the "Act"), and then cause Corporation C to wind-up and step-up the cost base of the shares of the various subsidiaries. In the years prior to the acquisition, Corporation C paid dividends to Corporation B which paid dividends to its shareholders, and the dividends were deductible under section 112 of the Act.

Will subparagraph 88(1)(d)(i.1) apply to reduce the amount of the "step-up" available to Corporation A by the dividends paid from Corporation C to Corporation B?

Department's Response

Subparagraph 88(1)(d)(i.1) can operate to reduce the amount of the "step-up" otherwise available on the wind-up of a subsidiary corporation by the amount of dividends received, on the shares of the subsidiary corporation, by the parent corporation or a corporation with which the parent was not dealing at arm's length. The Department's policy is to apply the arm's-length test at the time the dividends are paid. In the situation in question, at the time the dividends are paid from Corporation C to Corporation B both corporations dealt at arm's length with Corporation A.

In some situations, the postamble of paragraph 88(1)(d) (the "Postamble") can deem a parent corporation to not be dealing at arm's length with another corporation but that provision has no application to corporations acquired by the parent from a person with whom the parent was dealing at arm's length. In this case the shares of Corporation C were not acquired directly by Corporation A from an arm's-length party. The Department's position is, however, that a corporation, the control of which was acquired from an arm's-length party, is considered to have been acquired from that party.

Problems can arise, however, if a new company is inserted in the chain. Assume, for example, that after the acquisition of Corporation B, Corporation A rolls the Corporation B shares to a newly incorporated company ("Holdco") and that Corporation B and Corporation C will be wound up into Holdco. In that case, the deeming provision in the Postamble will come into play because Holdco acquired the shares of Corporation B from Corporation A - a company with which it did not deal at arm's length. The result would be that Holdco would be deemed to have been in existence and not to have dealt at arm's length with Corporation B and C from the time of formation of those corporations. Accordingly the dividends paid from Corporation C to Corporation B would reduce the amount of the "step-up" available to Holdco on the wind-up of Corporation B.

Question 3 - Resident in a Designated Treaty Country - "Exempt Earnings"

Is it Revenue Canada's view that in order for a foreign affiliate to accumulate "exempt earnings" the foreign affiliate must be a resident of a particular "designated treaty country" both

A)under Canadian common law principles (mind and management test), and

B)under the terms of Canada's tax treaty with that particular country?

Department's Response

The term "resident in a designated treaty country" is not defined. Therefore general Canadian common law principles apply in determining whether a foreign affiliate is otherwise resident in a designated treaty country. Draft Regulation 5907(11.2) deems a foreign affiliate not to be resident in a designated treaty country unless one of paragraphs 5907(11.2)(a), (b), (c) or (d) is satisfied. The test is therefore a two-pronged test. As well, the references to "that country" found in draft Regulation 5907(11.2) are to the country that the affiliate is otherwise resident under Canadian common law. Therefore the affilate must be resident in the same country under both tests in order to be considered "resident in a designated treaty country".

Question 4 - Consolidated Group in United States - "Excluded Property"

Assume Canco owns 80% of the shares of U.S. Holdco which in turn owns 100% of the shares of four operating subsidiaries in the U.S., called S1 to S4.

Canco also owns 100% of the shares of Cansub which owns the other 20% of U.S. Holdco. Canco and Cansub also own 80% and 20% respectively of the shares of U.S. Limited Liability Company ("LLC") which has loaned money to U.S. Holdco to acquire shares in the four operating subsidiaries.

100% of the assets of S1 to S3 are used in an active business. However, 30% of the assets of S4 are passive assets not used to produce income from an active business and the passive income from these assets represents less than 5% of the total income of the U.S. consolidated group. Under subsection 95(1), "substantially all" the property of each of S1 to S4 must be used in an active business before the shares of that company are "excluded property". The shares of each of S1 to S4 must be excluded property before clause 95(2)(a)(ii)(D) can deem the interest income of LLC not to be Fapi.

Will the passive assets in S4 cause the shares of S4 not to be excluded property and thus cause the interest income paid from U.S. Holdco to LLC to be Fapi of LLC?

Department's Response

Where at least 90% of the property of a foreign affiliate is "excluded property" the "all or substantially all" test will generally be considered to have been met. This measurement may be either a cost or fair market value measurement unless the facts clearly indicate that one method of measurement is more appropriate than the other.

In this example the shares of S4 would not be considered excluded property. Clause 95(2)(a)(ii)(D) would therefore not apply to the interest received by LLC from U.S. Holdco as subclause 95(2)(a)(ii)(D)(V) requires that the shares of each member of the group of corporations be excluded property.

Question 5 - Interest on Funds Borrowed to Redeem Shares

A private corporation wishes to issue an interest-bearing promissory note to redeem some of its outstanding shares or to reduce capital thereon. The position of Revenue Canada is that interest would not be deductible because the debt would not constitute "borrowed money" nor would it constitute an amount payable for property acquired by the corporation to earn income from the property or a business.

To avoid this problem, the corporation's shareholders borrow funds and re-lend the funds to the corporation in exchange for an interest-bearing note. The corporation uses the cash to redeem the shares or reduce capital, and the shareholders retire their loan. The corporation has therefore borrowed from its shareholders to fund the redemption or reduction of capital.

Alternatively, the corporation borrows from its bank and redeems the shares or reduces the capital, the shareholders loan the funds back in exchange for an interest-bearing note, and the corporation pays out the bank. Again, even taking into account subsection 20(3), the corporation has borrowed to redeem or reduce capital.

In either case, subject to reasonableness of the rate of interest, would Revenue Canada respect the transaction and allow interest deductibility as if the note were owed to an arm's-length bank?

Department's Response

Yes, interest on the note payable to the shareholders would be deductible by the corporation pursuant to paragraph 20(1)(c) of the Act to the same extent that interest would have been deductible by the corporation on money borrowed by the corporation from an arm's-length lender and used by the corporation to redeem its shares or to pay an amount to its shareholders on a reduction of its capital.

The Department would not ordinarily seek to apply subsection 245(2) to such an arrangement.

Question 6 - GAAP Requirements to Re-Classify Shares as Debt

CICA Handbook Section 3860 contains new rules which require an issuer of a financial instrument to classify the instrument as a liability or as equity in accordance with the substance, rather than the legal form, of the contractual arrangement. The Handbook specifies that the reclassification requirement should be applied for fiscal periods ending December 31, 1996 or later.

For example, preferred shares that are mandatorily redeemable or are retractable at the option of the holder must be classified as debt rather than equity, and be shown at their redemption or retraction amount rather than at their legal stated capital amount (e.g., high-low shares). Dividends and interest on reclassified instruments may also have to be reclassified.

If these accounting reclassifications are respected for income tax purposes it could alter the tax results for a number of purposes including Large Corporations Tax (Part I.3), Financial Institutions Capital Tax (Part VI), the thin capitalization rules and deductibility under Part I.

Has Revenue Canada developed a policy on these new provisions?

Department's Response

The new reporting requirements set out in CICA Handbook Section 3860 are rather extensive and as suggested may have income tax implications that require consideration from a tax policy perspective. To the extent that you encounter such potential concerns they should be submitted to the Department of Finance for consideration. We will similarly refer any such potential policy concerns that we become aware of to the Department of Finance.

With regard to the new reporting requirements as they apply to preferred shares that are mandatorily redeemable, or are redeemable at the option of the holder as stated at the 1995 Tax Executive Institute Revenue Canada Round Table, it is the Department's position that the classification of a particular financial instrument as debt or equity for accounting purposes is generally not determinative of its treatment for income tax purposes since it is the legal form of the particular financial instrument, not its economic substance, that will usually determine its income tax treatment. By the same token payments of interest or dividends will derive their income tax consequences from the legal nature of the payment unless otherwise provided by the Income Tax Act.

Accordingly for purposes of the Tax on Large Corporations (Part I.3) the Department's position with regard to high-low preferred shares that are reclassified as debt for accounting purposes is that they will continue to be treated as equity. By virtue of subsection 181(3) the value to be assigned to these shares for the purpose of computing capital under paragraph 181.2(3)(a) is the amount reflected on the corporation's balance sheet prepared in accordance with generally accepted accounting principles (GAAP). Therefore where the high-low preferred shares are shown on the balance sheet at their redemption or retraction amount in accordance with GAAP, that same amount is to be used for Part I.3 purposes.

Similarly for purposes of the Financial Institutions Capital Tax (Part VI), notwithstanding that shares may be reclassified as debt for accounting purposes they will be regarded as capital stock the amount of which will be the amount recorded on the corporation's balance sheet prepared in accordance with GAAP.

Consistent with the above, for purposes of the thin capitalization rules (subsection 18(4)) the preferred shares would be treated as equity irrespective of their accounting classification. The relevant amount of such shares for purposes of subsection 18(4) is the paid-up capital thereof. The Department's position, as indicated in paragraph 8 of Interpretation Bulletin IT-59R3, is that the amount (positive) of retained earnings recorded on the balance sheet using GAAP is the amount to be used in the calculation of the corporation's "equity" for purposes of subsection 18(4). Accordingly the amount of the retained earnings that is reflected on the balance sheet is used for purposes of subsection 18(4) notwithstanding that retained earnings may have been reduced by the amount of the increase in the carrying value of the preferred shares.

Question 7 - Rollovers When Boot Exceeds ACB

Sometimes a full subsection 85(1) rollover appears to be impossible because debt payable that is to be assumed by the transferee corporation exceeds the ACB of the target assets to be transferred. Assumption of the debt as consideration for the assets would result in the agreed amount being deemed to be increased by paragraph 85(1)(b). It appears this can be solved by:

a) transferring the target assets as planned and having debt assumed up to the ACB of the target assets;

b) having the transferor issue a Note Payable to the transferee equal to the balance of the debt payable being assumed by the transferee; and

c) issuing shares of the transferee to the transferor for the remaining equity.

Shortly after this, the Note Payable by the transferor and an equal amount of share capital of the transferee are both cancelled by cross-redemptions.

A)Does Revenue Canada accept this as a valid method of avoiding the application of paragraph 85(1)(b) in this situation?

B)Would the answer be the same if the transferee only assumed the excess debt as consideration for redeeming some of its shares issued to acquire the target assets from the transferor?

C)Is the interest on all the debt assumed by the transferee corporation deductible under paragraph 20(1)(c)?

Department's Response

A)Yes. At the 1984 Round Table the Department indicated that paragraph 85(1)(b) of the Act would not be applied to this type of transaction. However, that position is presently under review by the Department. Once our review has been completed, our position will be announced publicly. In the meantime, our existing administrative position can still be relied on.

B)Yes.

C)Provided that:

(i) the target assets are acquired by the transferee for the purpose of gaining or producing income, and

(ii) interest on all the assumed debt was deductible by the transferor under paragraph 20(1)(c),

interest on all the assumed debt would ordinarily be deductible by the transferee. However, if any of the assumed debt is incurred by the transferor as part of the same series of transactions, the Department would have to review all the surrounding circumstances to determine whether the interest would be deductible to the transferee.

This position is also the subject of the review referred to above.

Question 8 - Interaction of Subsections 250(5) & 212(13.2)

A U.S. corporation wishes to acquire an existing business in Canada and decides, for U.S. tax reasons, to establish a wholly-owned U.S. subsidiary ("Subco") to purchase the business. Subco finances the acquisition with money borrowed from related parties and from banks in the United States. The operations of Subco are carried on solely in Canada. All directors of Subco reside in Canada and all directors meetings are in Canada. Subco would be regarded as resident both in Canada and the United States under their respective domestic laws. By virtue of Subco's incorporation in the United States, paragraph 3 of Article IV of the Canada - U.S. Income Tax Convention ("Convention") would deem Subco to be a resident of the United States for purposes of the Convention. As the Convention would then generally deny Canada the right to tax non-Canadian source income earned by Subco, subsection 250(5) of the Act would apply and deem Subco not to be resident in Canada for purposes of the Act.

A)Subsection 250(5) of the Act seems to conflict with subsection 212(13.2) of the Act which deems Subco to be a resident of Canada for purposes of Part XIII tax. Is subsection 212(13.2) of the Act effectively nullified by the interaction of paragraph 3 of Article IV of the Convention and subsection 250(5) of the Act?

B)If it is Revenue Canada's view that the interest paid by Subco is subject to Part XIII tax, can the interest be eligible for the 5 year arm's length exemption in subparagraph 212(1)(b)(vii) of the Act where one of the pre-requisites is that the payer be "a corporation resident in Canada"?

Department's Response

A)Subsection 212(13.2) of the Act is intended to apply to a non-resident, factual or deemed, so as to treat that non-resident, for purposes of Part XIII, as a person resident in Canada with respect to the payment or portion thereof that was deductible in computing that person's taxable income earned in Canada. The objective of this provision is to bring the transaction within the scope of the subsection 212(1) pre-amble which otherwise would only apply to those amounts "that a person resident in Canada pays or credits ...... to the non-resident person". It should be noted that the ultimate Part XIII tax is a tax on the non-resident recipient of the interest and not Subco.

Where subsection 250(5) of the Act applies to deem a corporation "to be not resident in Canada", that corporation will be considered a "non-resident person" as that term is used in paragraphs 212(13.2)(a) and (b) of the Act. Accordingly, interest payments made by Subco to a non-resident of Canada would be subject to Part XIII tax, subject to any exemptions that may otherwise be applicable. To interpret subsection 212(13.2) of the Act in the circular manner suggested above is clearly in contradiction with the spirit and object of the provision.

B)Where subsection 212(13.2) of the Act applies such that a non-resident payer of interest (eg. Subco) is deemed to be a person resident in Canada and that payer is a corporation, interest payable by the non-resident corporation will represent "interest payable by a corporation resident in Canada" for purposes of subparagraph 212(1)(b)(vii) of the Act. Accordingly, if all the other requirements of subparagraph 212(1)(b)(vii) of the Act are met, interest paid by Subco to the arm's length U.S. lender would be exempt from Part XIII tax.

Question 9 - Plan of Arrangement - What is it for Tax Purposes?

Many of today's more complex corporate takeovers and other reorganizations are given legal effect by virtue of an "arrangement" which essentially appears to collapse what might otherwise be several reorganization steps into one set of transactions that are stated to occur in a very short time frame. An arrangement can involve any combination of amalgamation, wind-up, division of a business into two corporate entities, reorganization of the share capital of a company, etc. (see section 192 of the CBCA, section 182 of the OBCA and similar sections of other governing statutes).

The tax consequences of a series of corporate manoeuvres often depend on the sequence of steps. This sequence is not always required to be spelled out for corporate law purposes but spelling out the sequence may be critical for tax purposes.

How does Revenue Canada determine the tax consequences of an arrangement?

Department's Response

Ordinarily, the Department will respect the ordering of a series of transactions where the order is specified in an arrangement. Where the order of a series of transactions is not set out in the arrangement, and the order is relevant for tax purposes, the Department will look to all of the relevant legal documentation in order to ascertain the tax consequences of the series. Of course, the tax consequences of a series of transactions effected by way of an arrangement can be recharacterized under section 245.

Question 10 - Sale of "All or Substantially All of the Property of a Business"

Under section 167 of the Excise Tax Act ("ETA"), a registrant who sells substantially all the property that can reasonably be regarded as being necessary for the purchaser to carry on a business can sign a joint election with a purchaser who is registered so that GST does not apply to the transaction (with some exclusions). The purchaser is required to file the election on or before the due date of the purchaser's next return.

How does the vendor determine that the assets sold constitute substantially all the property that can reasonably be regarded as being necessary for the purchaser to carry on a business? What are Revenue Canada's views concerning the application of section 167 in the following situations?

Question 10 a) - Sale of "Mothballed" Restaurant

A registered supplier will sell a "mothballed" restaurant to a registered purchaser. The restaurant had been operated by the supplier, but has not been used for a number of years and therefore needs to be renovated to modernize the building and equipment. The properties being supplied are land and building, equipment, and goodwill and all are priced at fair market value. The purchaser plans to spend more than 10% of the purchase price to equip the restaurant before it begins operation.

Department's Response 10 a)

In order to determine whether two parties are eligible to use the election under section 167 of the ETA, the parties to the transaction must meet certain conditions, including the two following tests. First, the supplier must be supplying a business or part of a business that was established or carried on. Second, under the agreement for the supply the recipient must acquire ownership, possession, or use of all or substantially all of the property that can reasonably be regarded as being necessary to be capable of carrying on the business or part as a business. The department's position is that the term "all or substantially all" generally means 90% or more. The Department has issued a policy statement, P-188 that provides guidelines to assist in determining whether a supply of property meets the above two conditions.

The election under section 167 is a joint election which means that both parties must agree that they meet their respective eligibility requirements. The effect of the election is that no GST is payable with respect to a supply of a property or service (with certain exclusions) made under the agreement.

With respect to this example, the sale of a "mothballed" restaurant, the purchaser needs to spend more than 10% of the purchase price to equip the restaurant prior to it beginning operations. Therefore under the agreement for the supply, the purchaser is not acquiring all or substantially all of the property that can reasonably be regarded as being necessary to be capable of carrying on the business as a business. Consequently section 167 of the ETA would not apply in this case and the supplier would collect GST on the supply. However, under subsection 221 (2) of the ETA the supplier would not be required to collect GST on the supply of the land and building used for the restaurant as the purchaser is registered. The purchaser would self-assess GST on the real property under subsection 228 (4) of the ETA and under subsection 228 (6) of the ETA offset that amount with input tax credits ("ITC") claimed under section 169 of the ETA. ITCs on the other business property would also be claimed pursuant to section 169 of the ETA.

Question 10 b) - Dividing one Business into Parts

A supplier may supply the assets of a business to more than one purchaser. For example, a receiver may sell the assets to three different purchasers as described below.

i) X will purchase the land, building, all the manufacturing equipment, all the related office equipment and goodwill,

ii) Y will purchase only the distribution vehicles, and

iii) Z will purchase only a motor vehicle and a lap top computer in order to operate as a commissioned sales representative.

Department's Response 10 b)

i) The nature of the business will generally determine the package of assets that would comprise a business or part of a business. Where a person purchases the land, building, all the manufacturing equipment, all the related office equipment and goodwill then generally the person is acquiring all or substantially all the property that can reasonably be regarded as being necessary to carry on the business as a business and section 167 of the ETA would apply.

ii) Where only the distribution vehicles are being supplied, the supply does not constitute a sale of a business or part of a business but is a sale of particular assets used in a business. Therefore section 167 of the ETA would not apply.

iii) Where only a motor vehicle and a lap top computer are being supplied, the supply is of certain assets used in a business and not of a business, and therefore section 167 of the ETA would not apply.

Question 10 c) - Joint Venture Interest

Would the sale of an undivided interest in an oil and gas joint venture constitute substantially all of the property that can reasonably be regarded as being necessary for the recipient to be capable of carrying on a business or part of a business?

Department's Response 10 c)

Where an arrangement described as an oil and gas joint venture has the following characteristics:

-a group of persons engaged in a specific business for a limited period;

-the business is not structured as a corporation, a partnership or a trust;

-each co-venturer or participant has a direct undivided interest in the joint venture property and in the commodity produced by the joint venture;

-each participant is a party to all the joint venture agreements such as the operating agreement and the ownership agreement;

-a right of mutual control and management of the business;

-contribution by the participants of money, property, effort, knowledge, skill and other assets to the joint venture,

the recipient generally will, to the extent it purchases an undivided interest in all the joint venture property and the rights and obligations attached to this interest, qualify as having acquired all or substantially all of the property that can reasonably be regarded as being necessary to be capable of carrying on the business as a business and qualify for the section 167 election.

Question 11 - Registration of a Newly Formed Corporation

A new corporation is formed for the purpose of acquiring the assets of a manufacturing business from a registrant. Will Revenue Canada accept a request for registration by the newly incorporated company before it has acquired the business and started operating?

Department's Response

An application for registration may be made by any person who is not required to be registered but who is engaged in a commercial activity in Canada pursuant to subsection 240 (3) of the ETA. Subsection 141.1 (3) of the ETA provides that to the extent that a person does anything (other than make a supply) in connection with the acquisition of a commercial activity of the person, the person shall be deemed to have done that thing in the course of its commercial activities. The election concerning the supply of a business or part of a business provided for in section 167 of the ETA does not apply where the supplier is a registrant and the purchaser is not a registrant. Therefore the new company must register prior to the acquisition of the business if it wants to elect under section 167.

Subsection 221 (2) of the ETA which relieves the supplier from collecting GST on the real property also requires the recipient be registered. If the person did not register prior to acquiring the business, then for the purpose of determining ITC eligibility, it would be subject to the rules concerning becoming a registrant under section 171 of the ETA as well as the general rules in section 169 of the ETA.

Question 12 - Up-Front Lump-Sum Franchise Fees

Revenue Canada's policy statement P-181 "Franchise Fees and the Subsection 167 (1) Election" states that up-front lump-sum payments under franchise agreements for use of trade marks and trade names are not tax-free because they come within the exclusions in subsection 167 (1.1).

In the Explanatory Notes to Bill C-112, the Department of Finance stated that the amendments to section 167 were intended to permit sales of businesses "under a turn-key arrangement". The position stated in P-181 seems to negate most of the benefit which appears to be intended by the amendment to section 167. Can Revenue Canada offer any further clarification here?

Department's Response

The Department recognizes the concern that the amendment to the preamble of section 167 of the ETA to provide for a business that was "established", is affected by the amendment to subparagraph 167 (1.1)(a)(ii) which excludes "a taxable supply of property by way of lease, licence or similar arrangement," from the election. However the words in subparagraph 167 (1.1)(a)(ii) are clear and would apply to up-front lump-sum payments under franchise agreements for the use of trade marks and trade names. This issue has been brought to the attention of the Department of Finance for their consideration. A legislative amendment by that department would be required in order for the up-front lump-sum payments to be covered by the section 167 election.

Question 13 - Convertible property

A)Does subsection 51(2) of the Act apply to a parent corporation in respect of its shares of a wholly-owned subsidiary? Unlike paragraphs 85(1)(e.2) and 53(1)(c), subsection 51(2) does not contain an exclusion for wholly owned corporations. Consider a parent corporation that holds preferred shares in a wholly-owned subsidiary which are exchanged for common shares with a fair market value that is less than the fair market value of the preferred shares. Would the Department apply subsection 51(2) to the conversion?

B)Assume the same facts except that section 86 applies to the exchange. Would the Department apply subsection 86(2) which also does not contain an exclusion for wholly owned corporations?

Department's Response

A)Subsection 51(2) has application where subsection 51(1) applies to an exchange, the fair market value of the exchanged property exceeds the fair market value of the shares received on the conversion and it is reasonable to regard any portion of the excess as a benefit that the taxpayer desired to have conferred on a related person. Ordinarily, the Department would not consider that it is reasonable to regard the excess in value, in a situation where no one other than the parent corporation owned shares of the subsidiary, as a benefit that the parent corporation desired to confer on the subsidiary.

B)No, for the same reasons the Department would not apply subsection 86(2).

Question 14

(Question withdrawn)

Question 15 - Related Person Test in Paragraph 55(3)(a)

Can Revenue Canada clarify the point in time when the related person test in paragraph 55(3)(a) of the Act should be determined:

a) when property is disposed of,

b) throughout the series of transactions in question, or

c) at the end of the series of transactions in question?

Department's Response

It is our view that the test should be applied at the time of the relevant disposition of property or increase in interest that is referred to in paragraph 55(3)(a).

Question 16 - Meaning of "Reorganization" for Butterfly Transaction

Paragraph 55(3)(b) of the Act applies where the dividend referred to therein is received "in the course of a reorganization". Paragraph 55(3)(b) is the "butterfly" exception to subsection 55(2). Questions that arise in many cases are:

-what constitutes a reorganization?

-when does a reorganization end (i.e. when are subsequent transactions considered part of the "reorganization" and when are they outside the "reorganization" or part of a second reorganization)?

Revenue Canada gave several examples in response to this issue in the 1989 Conference Report, specifically Questions 21 and 22.

Can Revenue Canada provide an update on this issue?

Department's Response

It is our view that the 1994 amendments to the butterfly provisions made it clear that the word "reorganization" as it is now used in the context of section 55 is intended to have a narrower meaning than elsewhere in the Act. The rules in subsection 55(3.1) now specify the transactions which may and may not be carried out in contemplation of or after a butterfly distribution. Accordingly, we are of the view that the "reorganization" referred to in section 55 would normally include only transfers of property by the distributing corporation to its shareholders (or corporations related to its shareholders) and the cross-redemption of shares or winding-up of the distributing corporation.

Thus the following transactions, occurring after a pro rata distribution and cross-redemption of shares, would normally not be considered to occur as part of the butterfly reorganization:

-an amalgamation of a transferee corporation with its parent

-a winding-up of a transferee corporation into its parent

-a transfer of butterflied property by a transferee corporation:

-to another shareholder of the distributing corporation

-back to the distributing corporation

-to its subsidiary

-to a third party

On the other hand, the reorganization would normally include all transfers of property by the distributing corporation to its corporate shareholders (or to corporations related to such shareholders), including taxable sales and dividends.

It should also be recognized that, while a transaction may not be viewed as occurring as part of the butterfly reorganization, it may nevertheless occur as part of the series of transactions. If so, the transaction would come under the scrutiny of the rules in subsection 55(3.1)

Question 17 - Post-Butterfly Transfers of Property

Post-butterfly sales are governed by paragraphs 55(3.1)(c) and (d) of the Act. Prior to the 1994 amendments, Revenue Canada had indicated that certain taxable transfers between shareholders of properties received on a butterfly distribution would not affect the pro rata distribution test. If two shareholders are related, the transfer of butterflied properties between them would not constitute a problem under paragraph 55(3.1)(c).

Could these related shareholders be amalgamated or one be wound up into the other without the amalgamation or winding-up being considered to be done in the course of the reorganization in which the butterfly distribution is made?

Department's Response

Applying the approach described in our response to question 16, a winding-up or amalgamation of a transferee corporation would not ordinarily be considered to occur as part of the butterfly reorganization, even where the corporation with which the transferee corporation is being merged is also a shareholder of the distributing corporation. Thus, the amalgamation or winding-up would not affect the prior pro rata distibution. However, the amalgamation or winding-up might nevertheless occur as part of the series of transactions, in which case the rules in subsection 55(3.1) would have to be considered.

Question 18 - Pre-Butterfly Transactions

What is Revenue Canada's view on the repayment of shareholders' loans with cash by the distributing corporation prior to a butterly distribution? Can Revenue Canada reconcile that view with the rules in section 55 of the Act which specifically permit the redemption of shares of a specified class prior to a butterfly distribution?

Department's Response

The repayment of a shareholder's loan with cash by the distributing corporation before a butterfly would ordinarily be viewed as occurring in contemplation of the butterfly distribution, and not as a transfer of property as part of the distribution. Accordingly, the cash paid to the shareholder would not have to be taken into account in determining whether there had been a pro rata distribution. The same view would ordinarily be taken with respect to cash paid to a shareholder on the redemption of its shares of a specified class.

However, where the butterfly is being carried out on a "net equity" basis, the repayment of a debt (whether owing to a third party or a shareholder) could be viewed as resulting in property becoming property of the distributing corporation in contemplation of the distribution, thus contravening paragraph 55(3.1)(a), where the repayment of the debt changes the mix of property of the distributing corporation. Our position in that regard was set out at the 1991 annual conference.

Question 19 - Net Butterfly

An administrative practice has been developed by Revenue Canada to deal with the butterfly rules in section 55 of the Act. Notwithstanding the 1994 amendments, there is still little guidance within the legislation as to the meaning of the concept of "type" of property, as to how debt should be dealt with, and to the concept of acquisition of property in contemplation of the butterfly. These issues are dealt with by administrative practice.

Regardless of whether the taxpayer applies for an advance ruling, what degree of tolerance is there should the executed transaction be offside the administrative guidelines but not by "a significant degree"?

The purpose of the question is to get some feel for the Department's tolerance level, taking into account the comments in John Robertson's 1981 paper:

"Where there is no attempt to use the butterfly transaction to disguise a sale or barter transaction or to achieve any undue tax advantage, an effort will be made to make the transactions work with an acceptable result to both the taxpayer and the Department." (1981 Conference Report, page 97.)

Department's Response

The Department's approach in this area was summarized in the introduction of a paper presented by Michael Hiltz at the 1989 annual conference. The 1989 statement was intended to clarify Mr. Robertson's general 1981 remarks quoted in the question. To summarize, we indicated that we take a "plain meaning" approach in interpreting the provisions of the Act, including the butterfly provisions. Where the words have a plain meaning, as in the case of the definition "distribution", which clearly requires a pro rata distribution to shareholders based on relative fair market value, the words are interpreted to give effect to that plain meaning. If, on the other hand, the words of a provision are unclear, as in the case of the "type of property" requirement, the Department has tried to adopt interpretations which are reasonable, taking into account the intent of the provision.

The definition "distribution" in section 55 requires that the property transferred to a shareholder be equal to or approximate that shareholder's pro rata share. The Department has consistently maintained that the word "approximate" provides limited scope for discrepancies. In the paragraph immediately preceding the above-quoted remarks in the 1981 Robertson paper, it was indicated that the distribution "must be very close to equal" to a pro rata distribution. In 1991 we indicated that, for purposes of advance rulings, we are prepared to accept a discrepancy of up to 1 percent.

Question 20 - Changes In Terms of Debt Obligations

Revenue Canada's Interpretation Bulletin IT-448, dealing with changes to the terms of securities, has been the subject of some controversy and confusion.

Can Revenue Canada provide any guidance as to whether IT-448 fully reflects the Department's current administrative and rulings practice?

Department's Response

Paragraph 7 of IT-448 as currently written provides examples which could or may result in a disposition of a debt obligation.

We are currently revising this bulletin to provide a clearer view on this issue, focusing on the fact that the settlement, extinguishment or disposition of a debt obligation is primarily a matter of law.

Question 21 - Article XXI Exemption

In certain circumstances, paragraph 3 of Article XXI of the Canada-U.S. Income Tax Convention (the "Convention") removes the basic withholding tax exemption granted under that Article where the income is derived from a "related person".

(a)For purposes of that Article, what does the term "related person" mean? Specifically, does it mean the same as defined under the Income Tax Act?

(b)Where the recipient of interest or dividends is a partnership of United States pension funds or other entities otherwise qualified for the benefits of Article XXI, the Department has previously confirmed that it will look through the partnership to each member and grant or withhold the exemption based on the member's proportionate interest in the partnership. Will a similar look-through be applied in determining a member's "related person" status under paragraph 3 of Article XXI of the Convention?

Department's Response

The term "related person" is not defined in the Convention. In accordance with paragraph 3 of the Income Tax Conventions Interpretation Act, that term has, except to the extent the context otherwise requires, the meaning it has for purposes of the Income Tax Act (the "Act"), as amended from time to time. The term "related persons" is defined, for purposes of the Act, in subsection 251(2) of the Act. In the context of Article XXI of the Convention "related person" has the meaning assigned in the Act.

Where a person is a member of a partnership, the Department will look through to the members in determining whether a particular member is related to the person from which the income is derived and whether paragraphs 1 or 2 of Article XXI of the Convention are applicable in respect of that member. It is a question of fact whether a partnership, and thereby its members, is considered to be carrying on a trade or business.

ENDNOTES

1.It should be noted that on June 20, 1996, after this forum was held, the Minister of Finance tabled in the House of Commons a Notice of Ways and Means Motion which included a new subsection 88(1.7), which would replace the existing paragraph 88(1)(d) Postamble and clarify that the test is whether control of the corporation is acquired from an arm's-length person, consistent with Revenue Canada's interpretation described above.

2.It should be noted that subsection 55(2) could apply to the deemed dividends arising on the redemptions, unless the exceptions in paragraph 55(3)(a) or (b) applied.

3."Revenue Canada Round Table", in Report of Proceedings of the Thirty-Sixth Tax Conference, 1984 Conference Report, question 47 at 819.

4.It should be noted that on June 20, 1996, after this forum was held, the Minister of Finance tabled in the House of Commons a Notice of Ways and Means Motion which included a proposed amendment to paragraph 55(3)(a). This amendment would, inter alia, set out explicitly the time at which the unrelated tests in amended paragraph 55(3)(a) are to be applied.

5.Ted Harris, "An Update of Revenue Canada's Approach to the Butterfly," in Report of Proceedings of the Forty-Third Tax Conference, 1991 Conference Report, 14:11-12.

6.Michael A. Hiltz, "The Butterfly Reorganization: Revenue Canada's Approach," in Report of Proceedings of the Forty-First Tax Conference, 1989 Conference Report, 20:32-33.

7.John R. Robertson, "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55," in Report of Proceedings of the Thirty-Third Tax Conference, 1981 Conference Report, 97.

8.Ted Harris, "An Update of Revenue Canada's Approach to the Butterfly," in Report of Proceedings of the Forty-Third Tax Conference, 1991 Conference Report, 14:8-9.