17 August 1990 Internal T.I. 901529 F - Reorganizations - Butterflys

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 17, 1990

Dear Sirs:

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

We are writing in response to your letter dated July 6, 1990 wherein you requested our opinion regarding the application of paragraph 55(3)(b) of the Act to the hypothetical situation outlined hereunder.

Facts

1.     A owns 165 common shares, representing 50% of the issued voting capital, of Holdco, a Canadian-controlled private corporation a defined in paragraph 125(7)(b) of the Act. B, a child of A, owns the other 50% of the issued common shares of  Holdco.  In addition, A and 8 own 200 and 500 preferred shares of Holdco, respectively. It is assumed that the preferred shares of Holdco are non-voting.

2.     Holdco owns, in addition to other assets, 215 common shares of Opco, a Canadian-controlled private corporation.

3.     A owns 5 common shares and 2,000 preferred shares of Opco.  It  is assumed that the preferred shares of Opco held by A are non-voting.

4.     In addition to it's common shareholdings of Opco, Holdco has other assets which include cash and accounts receivable of $50,000.00 and a minority interest in a corporation represented by shares having a fair market value of $15,000.00.

5.     Opco carries on an active business in Canada. Its assets consist mainly of inventory and accounts receivable arising in connection with its business activities, land and building which it uses in carrying on its business and goodwill associated with the business.  Opco has liabilities associated with the foregoing assets, which consist primarily of bank financing of its inventory.  Opco's balance sheet is summarized as follows (with an additional column showing actual fair market values of assets):

Outline of the Proposed Transactions

6.     Opco will purchase for cancellation the five common shares held by A for $100,000 and will redeem the 2,000 preferred shares held by A for $200,000.  Payment, in full, will be by cheque and as a result of this transaction A will report, for tax purposes pursuant to subsection 84(3) and paragraph       82(1)(b) of the Act, a taxable deemed dividend of $124,375.00 on the disposition of the common shares.

7.     A new corporation ("Newco 1") will be incorporated.  No shares will be issued upon its initial incorporation.  Holdco will sell 60 common shares ($1,200,000.00 $4,300,000.00 x 215) of Opco to Newco and will receive in exchange 1,200 common shares of Newco 1 (representing all of the then issued shares of Newco 1).

     The paid-up capital of the common shares of Newco 1 will be equal to the paid-up capital of the 60 common shares of Opco.  A section 85 election will be filed and the elected amount will be equal to Holdco's adjusted cost base of the Opco shares.  The expressions "paid-up capital" and "adjusted cost base" ("ACB") as referred to here and subsequently have the meanings assigned by paragraphs 89(1)(c) and 54(a) of the Act respectively.

8.     Opco will sell, at fair market value, the land and building to Newco 1 for proceeds of $1,200,000.00 and will receive in exchange 1,200,000 preferred shares, with a redemption value and fair market value of $1.00 each.  The paid-up capital of  the preferred shares will be equal to Opco's aggregate cost   amount, as defined in subsection 248(1) of the Act, of the land and building.  A section 85 election will be filed and the elected amounts will be equal to Opco's cost amounts of the land and building.

9.     (a)  Newco 1 will redeem the 1,200,000 preferred shares held by Opco and will issue to Opco a promissory note in the amount of $1,200,000.00 in payment.

     (b)  Opco will purchase for cancellation the 60 common shares held by Newco I and will issue to Newco 1 a promissory note in the amount of $1,200,000.00 in payment.

     (c) The amounts payable pursuant to (a) and (b) above will be set off against each other in satisfaction of the amounts owing under the respective promissory notes.

10.     A new corporation ("Newco 2") will be incorporated.  A and B  will each sell to Newco 2 that number of common shares of Holdco which is equal in value to one half of the value of the  shares of Newco 1 owned by Holdco.  Newco 2 will issue to each  of A and B an equal number of common shares as consideration  for the shares of Holdco which it acquires from them.

     The aggregate paid-up capital of the common shares of Newco will be equal to the aggregate paid-up capital of the common shares of Holdco.  A section 85 election will be filed and the elected amounts will be equal to A's and B's respective adjusted cost bases of the Holdco shares.

11.     Holdco will sell the 1,200 common shares of Newco 1 to Newco 2 at fair market value.  Newco 2 will pay Holdco by the issuance of preferred shares equal in value to the value of the 1,200 common shares of Newco 1 which it has just acquired from Holdco. 

     The paid-up capital of the preferred shares will be equal to the paid-up capital of the 1,200 common shares of Newco 1. A section 85 election will be filed and the elected amount will be equal to Holdco's adjusted cost base of the Newco 1 shares.

12.     (a)  Newco 2 will redeem the preferred shares held by Holdco and will issue to Holdco a promissory note with a principal amount and fair market value equal to the fair market value of those shares.

     (b)  Holdco will purchase for cancellation the 60 common shares held by Newco 2 and will issue to Newco a promissory note with a principal amount and fair market  value equal to the fair market value of those shares.

     (c)  The amounts payable pursuant to (a) and (b) above will be set off against each other in satisfaction of the amounts owing under the respective promissory notes.

Purpose of the Proposed Transactions

You have indicated that under the new corporate structure the land and building presently held by Opco as described in paragraph 5 above would be owned by a newly formed corporation, Newco 1, whose parent company's shares would be beneficially owned by A and B while Opco would remain as a wholly-owned subsidiary of Holdco. However, you have not provided any information which would, in our view, indicate the purpose for creating this new structure.  This information is in our view essential to the proper review of a series of transactions to which the provisions of subsection 55(3) may apply.

In reviewing the above summarized series of transactions you have concluded that they can all be effected on a non-taxable basis with the exception of the tax payable by A upon the purchase for cancellation of the common shares of Opco as described in paragraph 6 above and have requested our views on this matter.  In addition, you have identified several areas which you believe may be of potential concern to the Department in connection with this particular series of transactions and have also requested our views concerning these areas.

Our Comments

Assurance as to the tax consequences of a contemplated transaction can only be given in response to a request for an advance income tax ruling.  In addition, several of the questions which you have raised can only be addressed in the context of an application for an advance ruling as they would require a careful review of all the relevant facts.  The procedure for requesting an advance income tax ruling is outlined in Information Circular 70-6R, dated December 18, 1978 and the related Special Release thereto.  If you wish to obtain a binding commitment with respect to an actual series of proposed transactions, an advance income tax ruling application should be submitted.  Nevertheless, we can offer the following general comments with regards to this matter.

The Department's views on the application of subsection 55(2) of the Act were expressed in Mr. J.R. Robertson's address to the 1981 Conference of the Canadian Tax Foundation.  These views were subsequently updated by Mr. M.A. Hiltz at the 1984 Corporate Management Tax Conference, as well as by Mr. R.J.L. Read and Mr. Hiltz at the 1988 and 1989 conferences of the Canadian Tax Foundation, respectively.

As indicated at pages 44 and 31 of Mr. Hiltz's 1984 and 1989 papers, respectively, subject to one administrative exception, any payment or transfer upon the redemption of preferred shares (or purchase for cancellation of common shares) occurring in the course of an intended butterfly reorganization is taken into account in determining whether each shareholder transferee, has received its proportionate share of each type of property transferred.  The Department has agreed to make an exception to it's position where a shareholder owns only preferred shares with a fixed redemption price and which were acquired in consideration for an amount of cash equal to the fixed redemption price.  In such a case, it is the Department's practice to accept the distribution of cash equal to the redemption price in satisfaction of such shares in the course of a butterfly reorganization. As the distribution of cash on the redemption by Opco of the preferred shares held by A and the purchase for cancellation by Opco of the common shares held by A as described in paragraph 6 above do not qualify for this administrative exception, it is our view that the proposed transaction will result in a disproportionate distribution of the cash or near cash property of the particular corporation such that the provisions of paragraph 55(3)(b) would not apply.

As an alternative to the redemption by Opco of preferred shares held by A and the purchase for cancellation by Opco of common shares held by A you suggested that the shares of Opco held by A could be transferred to Holdco pursuant to subsection 85(1) of the Act.  In our view, this alternative transaction would result in property becoming property of Holdco (the particular corporation with respect to the second butterfly) in contemplation of that reorganization and this transaction would not be an excepted transaction as described in subparagraphs (55)(3)(b)(iii) to 55(3)(b)(viii) inclusive such that the provisions of paragraph 55(3)(b) would not apply.

Your letter suggests that the inherent tax liability associated with a particular property should be considered when determining the fair market value of the said property.  It is our view that inherent tax liabilities generally do not constitute liabilities and as such are not considered when determining the fair market value, on the net equity basis, of a particular property for purposes of paragraph 55(3)(b) of the Act.

Your letter also suggests that once the reorganization as described above has been completed, A and B may sell the shares of Newco 2 or Holdco to a third party and may subsequently claim any available capital gain deduction pursuant to subsection 110.6(2), (2.1), or (3) of the Act.

We wish to point out that the provisions of paragraph 110.6(7)(a) of the Act will apply to deny a capital gains deduction that would otherwise be available to an individual pursuant to any of subsections 110.6(2), (2.1), or (3) of the Act, where the capital gain arises as part of the same series of transactions or events that also includes a reorganization described in paragraph 55(3)(b) of the Act.  Subsection 248(10) of the Act deems a series of transactions to include any related transactions or events completed in contemplation of the series.  It is the Department's view that a preliminary transaction will form part of a series determined with reference to subsection 248(10) if, at the time the preliminary transaction is carried out, the taxpayer intends to implement the subsequent transactions constituting the series, and the subsequent transactions are eventually carried out. Thus the preliminary transactions will be part of a series even though at the time of completion of the preliminary transaction the taxpayer either had not determined all the important elements of the subsequent transactions - including, possibly, the identity of other taxpayers involved - or had lacked the ability to implement the subsequent transactions.

In light of the above, and given that A and B are contemplating the sale of the shares of Newco 2 or Holdco the capital gains deduction that would otherwise be available to A and B may be denied by virtue of paragraph 110.6(7)(a) of the Act.

With regards to the other concerns outlined in your earlier mentioned letter, the Department, as previously stated, will only address such issues in the context of an application for an advance ruling where all of the relevant facts are available for review.

We trust our comments will be of assistance.

Yours truly,

for DirectorReorganization and Non-Resident DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch