16 October 1990 External T.I. 9014515 F - Resource Industries - Prescribed Share Excluded from Meaning of Flow-through Share

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.

October 16, 1990

Dear Sirs:

Re:  Paragraph 6202.1(1)(d) of the Regulations to The Income Tax Act

We are writing in response to your letter of June 20, 1990, wherein you requested our views concerning the application of paragraph 6202.1(1)(d) of the Regulations to the Income Tax Act ("Regulation 6202.1(1)(d)").

For illustration purposes, you describe a hypothetical situation as follows:

1.     Pursuant to a "selling instrument", as defined in paragraph 66(15)(h.1) of the Income Tax Act (the "Act"), a newly formed Canadian corporation ("Drillco") offers to sell to the public "flow-through" common shares (the "Drillco Shares") and agrees to incur and renounce expenses to subscribers as specified in paragraph 66(15)(d.1) of the Act. Drillco is a taxable Canadian corporation and a principal business corporation within the meaning of the Act.

2.     The promoter of the offering is a junior or intermediate oil and gas corporation ("Oilco"). Oilco is a taxable Canadian corporation and a principal business corporation as defined in the Act. Oilco will own the initial outstanding shares of Drillco. Drillco and Oilco will have a number of senior officers in common, however, in all respects, after the issuance of the flow-through shares to the public, Drillco and Oilco will act at arm's length (i.e. there will be no common control).

3.     Drillco intends to explore for and develop oil and gas prospects generated internally and also to participate in prospects on a joint venture basis with other oil and gas companies. Drillco say also joint venture with Oilco.

4.     The selling instrument indicates as follows:

(a)     that investment in the shares is highly speculative;

(b)     that no market exists for the shares and that it may be difficult or even impossible for a subscriber to sell his securities.

     No reference is made in the selling instrument to a method of liquidity for a subscriber's investment except for a statement to the effect that the management of Drillco will consider options available to it, which may include raising additional monies by private offering or by an initial public offering, incurring debt, merging or amalgamating with other oil and gas companies or the acquisition or disposition of reserves.

5.     The selling instrument provides that Drillco has undertaken that it is, and at all material times will be, a principal business corporation and that its shares, when issued, will not be prescribed shares.

6.     Within 5 year (and possibly within 2 years) following the closing of the Drillco offering, Oilco may make an offer to acquire all of the Drillco shares in exchange for the listed securities of Oilco. This offering may take the form of a proposed amalgamation, share for share exchange or plan of arrangement. The consideration which Drillco shareholder would receive from. Oilco for, his Drillco shares would consist solely of common shares of Oilco which would not be prescribed shares under Regulation 6202.1. If the offer was to proceed by way of amalgamation, the amalgamation would have to be approved by the special resolution of the holders of Drillco common shares, being a majority of not less than two thirds of the votes of the Drillco shareholders as vote in person or by proxy at a Drillco shareholders meeting. Any dissenting shareholders of Drillco would have the right to be paid the fair value of his shares pursuant to the Alberta Business Corporations Act. Oilco will obtain an opinion from an independent appraiser that the amalgamation, share for share exchange or plan of arrangement, as the case may be, is fair and reasonable from a financial point of view to the shareholders of each of Drillco and Oilco.

     In any event there will be no requirement for Oilco to make such an offer nor will the investors be obliged to accept same.

7.     At the time the Drillco Shares are offered to the public and at the time the Drillco Shares are issued, neither Drillco or Oilco, either directly or through their agents, will make any representation, either written or oral, to investors, that Oilco would offer to acquire the Drillco Shares.

8.     Subscribers would, however, be aware of the following facts:

(a)     Oilco had previously acquired the shares of a public oil and gas company managed by Oilco by way of amalgamation. Oilco had been the Promoter of the initial offering of flow-through shares by this public oil and gas company, which company was formed to joint venture with Oilco.

(b)     Drillco may be considered a financing vehicle for Oilco in the sense that it is not commercially viable for Oilco to issue its own flow-through shares to the public given the disparity between Oilco's own net asset values and the trading price of its shares. There is "common management" between Drillco and Oilco and the Drillco properties will be complementary to the properties owned by Oilco.

Opinion Requested

You have requested our views on the following questions:

a)     Whose expectation is being referred to in Regulation 6202.1(1)(d) and how should the phrase "may reasonably be expected" be interpreted?

b)     In the above hypothetical fact situation, would the Drillco Shares be prescribed shares by virtue of Regulation 6202.1(1)(d) at the time they are issued?

c)     If your answer to question (b) above is no, does the type of consideration which a Drillco shareholder receives from Oilco have a significant impact on your view. In particular, what would be your view if a shareholder of Drillco received fixed value preferred shares of Oilco or a debenture of Oilco, neither of which were redeemable within five years from the date of issue of the original Drillco Shares? The redemption amount of each preferred share and the face amount of the debenture would be equal to the fair market value of the Drillco Share at the time of the exchange. All other terms of the preferred shares or debenture would be within normal commercial practice.

Your Conclusions

Your conclusions with regard to the three questions which you have posed to us are as follows:

a)     The words "reasonably be expected" in Regulation 6202.1(1)(d) refers to the expectation of the investor and establishes an objective test to be determined on a balance of probabilities. The Courts will determine "reasonableness" based on the information which an investor knew or ought to have known at the time of the acquisition of the Drillco Shares.

b)     The Drillco Shares would not be prescribed shares by virtue of Regulation 6202.1(1)(d) as an investor could not reasonably expect, at the time the Drillco Shares are issued, that Oilco would acquire the Drillco Shares and the transactions are within the object and spirit of the flow-through share and prescribed share rules.

c)     Provided that the type of security, which Oilco may offer for the Drillco Shares does not allow an investor to "liquidate" his investment within 5 years from the date of issue of the Drillco Share, then if the security consists of a preferred share or debenture, this should not offend the prescribed share rules because in your view, the 5 year holding period relates to the "permanent equity" requirement and does not impact upon whether or not the investor is at risk for his investment.

Rulings Opinions

Wether or not shares are prescribed shares at the time of their issuance, pursuant to Regulation 6202.1(1)(d), is a question of fact which can only be determined once all of the relevant facts in a particular situation are known. As your letter describes a hypothetical situation for which all of the facts are not known, we cannot provide definitive answers to each of your questions. However, we can give the following general comments which may be of assistance to you.

a)     We concur with your conclusion that the particular phrase "reasonably be expected" in Regulation 6202.1(1)(d) establishes an objective test based on a balance of probabilities. In our view the particular phrase has a broad application and should not be limited only to investors' expectations. It can also refer to the expectations of a informed party who has access to the available facts concerning this matter for the time at which the shares were issued.

         Ultimately, it is the responsibility of the Courts to determine the results of this objective test if they are asked to do so in the event of a dispute.

b)     Your conclusion on the second matter appears to be premised on the fact that at the time the Drillco Shares are issued it could not be reasonably expected that Oilco would acquire the Drillco Shares in such a manner that Regulation 6202.1(1)(d) would apply.

     In considering whether Regulation 6202.1(1)(d) would have application because of Oilco acquiring the Drillco Shares, we must determine if Oilco would be a "specified person" as defined in subsection 6202.1(5) of the Regulations in relation to Drillco (Oilco would have to be a person with whom Drillco does not deal at arm's length in order for Oilco to be a specified person in relation to Drillco).

     Although this determination is a question of fact, you have stated that after the issuance of the flow-through shares to the public, Drillco and Oilco will act at arm's length. Therefore, one could argue that Oilco is not a specified person in relation to Drillco at the time the flow-through shares are issued and we would not have to concern ourselves further with Regulation 6202.1(1)(d).

          However, in the event that Oilco does not operate at arm's length with Drillco at the time the flow-through shares are issued so that Oilco would be a specified person in relation to Drillco pursuant to subsection 6202.1(5) of the Regulations, then whether or not, at the time the Drillco Shares were issued, was reasonable to expect Oilco to acquire the Drillco Shares, is a question of fact that can only be determined after reviewing all the relevant facts in a live situation.

     We note that subparagraph 6202.1(1)(d)(i) of the Regulations provides an exception to a share being a prescribed share if the expected acquisition of the share meets the conditions set out in clauses 6202.1,(1)(a)(iii)(A) and (B).

     In your hypothetical example, the Drillco Shares are not being exchanged for shares in the same corporation (i.e. they may be exchanged for shares in Oilco). Therefore, notwithstanding that Oilco may be a specified person to Drillco, and barring an amendment to the legislation to provide for such non-arm's length exchanges, in your scenario the exceptions noted in subparagraph 6202.1(1)(d)(i) will not be met.

c)     Although we have some concerns about Drillco shareholders receiving such fixed value types of consideration from Oilco, as noted in your opinion request "c", once it has been determined that Oilco is a "specified person" to Drillco and that at the time the Drillco Shares are issued to investors, Oilco cannot reasonably be expected to acquire these shares within 5 years, then these types of consideration which a Drillco shareholder may ultimately receive from Oilco on such an acquisition would not alter our opinion in (b) above.

          However, if at the time the Drillco Shares are issued it was reasonable to assume that Oilco would acquire these shares, within 5 years, for fixed value preferred shares of Oilco or for a debenture of Oilco, as described in your letter, it is our opinion that the plain meaning of the words in Regulation 6202.1(1)(d) would result in the Drillco Shares being prescribed shares.

The above opinions are expressions of opinion only and are not binding on the Department.

Yours truly,

ChiefResource Industries SectionBilingual Services & Resource Industries Division