27 April 1988 Income Tax Severed Letter 7-2426 - [Capital Gains Exemption on Small Business Corporations]

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.

TO - SAINT JOHN DISTRICT OFFICE

FROM - HEAD OFFICE Specialty Rulings Directorate A.A. Cameron (613) 957-2116

ATTENTION B. Lynch Audit Division

RE. Capital Gains Exemption on Small Business Corporations

This is in reply to your round trip memorandum,of December 16, 1987 in which you requested our comments regarding XXXX letter to you of December 14, 1987 concerning "purifying" a corporation in order to qualify it as a small business corporation as defined in subsection 248(1) of the Income Tax Act (the "Act"). The purpose for "purifying" the corporation is to make it eligible for the $500,000 capital gains exemption proposed in the Notice of Ways and Means Motion to Amend the Income Tax Act which was tabled by the Minister of Finance in the House of Commons during December of 1987.

Assurances as to the income tax consequences of proposed transactions are only provided in response to requests for advance income tax rulings. The procedures for requesting an advance income tax ruling are as stated in Information Circular 70-6R, and the Special Release thereto. Although we are unable to issue rulings in respect of proposed amendments to the Act which are not yet law, and cannot offer opinions until there is draft legislation reflecting the intent of a Ways and Means Motion, we are able to rule or opine on other provisions such as subsection 110.6(7) of the Act.

Although we cannot provide a comprehensive response to the questions submitted we offer the following general comments on the four alternative proposals presented by XXXX.

Situation A

The situation was presented by XXXX as follows:

"Taxpayer sets up a holdco and transfers (under Sec. 85) sufficient common shares of the operating company to it. The value of these common shares equals the value of the redundant assets. The redundant assets are immediately used to redeem the common shares held by holdco. Since taxpayer has given up a proportion of acb and the operating company must recognize any gains involved, this transaction does not appear to violate any specific section of the Income Tax Act. Sec. 55(2) does not appear to apply. Since the common shares would be transferred at fair market value in an exchange for common shares on a one-for-one basis, it appears that Sec. 110.6(7)(b) would not operate to deny a capital gains exemption."

Response

The provisions of subsection 55(2) of the Act will not apply to the transactions described above, in and by themselves, by virtue of paragraph 55(3)(a) of the Act. However, subsection 55(2) of the Act may apply upon a subsequent disposition of property to a person who deals at arm's length with the corporation, or upon a subsequent increase in the interest in any corporation by such a person, that is part of a series of transactions or events which includes the transactions described above. For this purpose a series of transactions or events has the extended meaning assigned by subsection 248(10) of the Act.

As the stated purpose of the transactions described above is to "purify" the corporation for purposes of the capital gains deduction, the provisions of subsection 248(10) of the Act may be applicable upon a future sale of shares. If that is the case, the future series of transactions or events which includes the sale of the shares may also include the transactions described above.

The provisions of paragraph 110.6(7)(b) of the Act would not apply as property has not been acquired by a corporation for consideration that does not approximate the fair market value of the property. In addition, if a subsequent disposition of property to a person who deals at arm's length with the corporation, or a subsequent increase in the interest in any corporation by such a person, were determined to be part of the same series of transaction or events described above, paragraph 110.6(7)(a) of the Act would not appear to be applicable as the transactions are not, nor would they be, exempt from the provisions of subsection 55(2) of the Act by virtue of paragraph 55(3)(b) of the Act.

Situation B

The second alternative was presented as follows:

"Taxpayer does not wish to recognize the inherent gain in redundant assets. Therefore, the transaction is modified to redeem the common shares for a note equal to the value of the common shares. Would Revenue Canada consider that the note offsets the value of the redundant assets to bring the operating company within the 10% de minimas rule?"

Response

In our view this will not result in the corporation qualifying as a small business corporation. The gross assets owned by Opco, rather than "net assets", are relevant when determining the percentage of assets used in an active business carried on primarily in Canada for the purposes of the definition of a small business corporation contained in subsection 248(1) of the Act.

Situation C

The third alternative was presented as follows:

"Taxpayer modifies the transaction in the following way:

i) He does not transfer any shares to holdco.

ii) Instead, he causes operating company to transfer the redundant assets to holdco in exchange for a note representing acb and a $1.00 preferred share.

iii) The preferred share is redeemed for $1.00.

iv) The note is paid by holdco.

Would Revenue Canada consider this transaction one which meets the conditions of Sec. 110.6(7)(b) and would Revenue Canada consequently deny a claim for a capital gains exemption on the subsequent sale of the operating company shares?"

Response

The transfer of the redundant assets for consideration less than fair market value could be subject to the provisions of subsection 69(1) of the Act or, if an election is filed pursuant to subsection 85(1) of the Act, may be subject to the provisions of paragraph 85(1)(e.2) of the Act. Where a subsection 85(1) election has been filed, Revenue Canada is prepared on an administrative basis to consider not applying paragraph 85(1)(e.2) in its current form or subsection 15(1) of the Act, provided the fair market value of the consideration received by the transferor at least equals the cost amount of the property transferred and the property transferred was acquired by the transferor after the shareholder of the transferor acquired the shares of the transferor. If the transferred property was owned by the transferor when the shareholder of the transferor acquired the shares of the transferor, favourable rulings would be given only if the consideration received was equal to the fair market value of the transferred property at the time the shareholder of the transferor acquired the shares. Similarly, if the adjusted cost base of the property to be transferred is based on a V-day valuation, then the appropriate minimum amount of the consideration should be equal to the V-day value of the property. If the property to be transferred is depreciable property and the transferor had unexpired non-capital losses at the time of the rollover, these losses would affect the amount of consideration that would be acceptable. It should also be noted that the draft legislation released by the Department of Finance on April 13, 1988 proposes to change paragraph 85(1)(e.2) of the Act. If enacted, this change would be effective for transactions occurring after June 1988.

It is our view that paragraph 110.6(7)(b) of the Act will apply on a subsequent sale of the shares of either Opco or Holdco if the sale is part of a series of transactions or events which includes the transfer of the redundant assets as described in the above situation. For this purpose a series of transactions or events has the extended meaning assigned by subsection 248(10) of the Act, as described in more detail under Situation A above.

Situation D

The fourth alternative was presented as follows:

"Taxpayer butterflies the redundant assets to holdco by:

i) transferring a portion of common shares to holdco equal to value of redundant assets,

ii) transferring redundant assets to holdco in exchange for shares with a redemption value equal to redundant asset value,

iii) having the common shares redeemed and transferring the proceeds back to operating company with a redemption of the special shares issued to operating company for its redundant assets.

Assume that post '71 retained earnings are sufficient in this case to allow for inter-corporate dividends on a tax free basis. Would Revenue Canada consider allowing this type of transaction to "purify" a corporation to access capital gains exemption without applying the provision of Sec. 110.6(7)(a)?"

Response

In your example, Opco and Holdco do not deal at arm's length. Accordingly any taxable dividends received by Holdco and Opco would not be subject to the provisions of subsection 55(2) of the Act by virtue of paragraph 55(3)(a) of the Act.

However, subsection 55(2) of the Act may apply upon a subsequent disposition of property to a person who deals at arm's length with the corporation, or upon a subsequent increase in the interest in any corporation by such a person, that is part of a series of transactions or events which includes the transactions described above. For this purpose a series of transactions or events has the extended meaning assigned by subsection 248(10) of the Act as discussed in more detail under Situation A above.

The provisions of paragraph 110.6(7)(a) of the Act would not be applicable unless subsection 55(2) did not apply by virtue of the exception in paragraph 55(3)(b) of the Act. However, upon a subsequent disposition of property to a person who deals at arm's length with the corporation, or upon a subsequent increase in the interest in any corporation by such a person, that is part of a series of transactions or events which includes the transactions above, we would not expect that the dividends would be exempt from the provisions of subsection 55(2) of the Act by virtue of paragraph 55(3)(b) of the Act as the redundant assets transferred would appear to be a different type of asset than those retained by the corporation. Consequently, the "pro- rata test" in paragraph 55(3)(b) of the Act would not be met.

In addition, all of the deemed dividends could not be considered to have been paid from "income earned or realized" as Holdco would not have any "income earned or realized" prior to the commencement of the series of transactions or events for purposes of subsection 55(2) of the Act.

We trust the above comments will help you reply to the concerns of XXXX. If any other related queries arise, please do not hesitate to call us

for Director Reorganizations and Non-Resident Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch