22 December 1992 External T.I. 9033545 F - Capital Gains Deduction

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.

24(1)

Attention:   19(1)

December 22, 1992

Dear Sirs:

Re:     Subsection 110.6(8) of the Income Tax Act (the"Act") Section 6205 of the Income Tax Regulations under the Act (the "Regulations")

We are responding to your letter, dated November 12, 1990, in which you requested our views regarding the application of subsection 110.6(8) of the Act (all statutory references, unless specifically otherwise stated, are to the Act) in the following hypothetical situation. We apologize for the lengthy delay in our response.

Hypothetical Situation:

1.     Opco was incorporated forty years ago and operates an active business in Canada. Each of its shares is a "qualified small business corporation share" within the meaning of subsection 110.6(1).

2.     Opco has three wholly-owned subsidiaries, Subco 1, Subco 2, and Subco 3. The only issued shares of Subco 1 and Subco 2 are common shares. The only issued shares of Subco 3 are common shares and fixed-value, 8% non-cumulative, redeemable preferred shares on which no dividend has ever been paid.

3.     In 1980, Opco underwent a share reorganization to which subsection 86(1) applied. The details of the reorganization are as follows:

(a)     Each common share of Opco, which had a fair market value at the time of $170, was exchanged for one Class B common share and 2 Class C preferred shares redeemable for $85.00 per share. In addition, a separate class of common shares, Class A common, was authorized for issuance to employees.

(b)     The reason for the reorganization was to enable employees to become shareholders of Opco.

(c)     The Class C preferred shares have an annual dividend (non-cumulative) rate of 8% of the redemption value and have a liquidation entitlement equal to such redemption value.

4.     Dividends of 8% per annum have been paid on the Class C preferred shares of Opco since 1980, except for the 1987 fiscal year.

5.     None of the Class A common shares of Opco was ever issued to any employee of Opco or to anyone else. Consequently, any increase in value of the property of Opco after the reorganization accrued to the Class B common shares.

6.     All of the shareholders of Opco deal at arm's length with each other.

7.     The Class B common shares of Opco and the common shares of Subco 1, Subco 2, and Subco 3 are not subject to any restrictions other than, in the case of Opco and Subco 3, the prior rights and privileges attaching to the preferred shares of those corporations.

Your views:

It is your view that all of the shares of Opco, Subco 1, Subco 2 and Subco 3 are "prescribed shares", within the meaning of section 6205 of the Regulations, for the following reasons:

1.     The common shares of Opco, Subco 1, Subco 2 and Subco 3, not being subject to any restrictions, satisfy the requirements of subsection 6205(1) of the Regulations by virtue of subparagraph (a)(i) thereof.

2.     The Class C preferred shares of Opco are prescribed shares within the meaning of subsection 6205(2) of the Regulations because they were issued as part of an arrangement to permit any increase in value of the property of Opco to accrue to other shares (the Class A and Class B common shares) and, at the end of the arrangement, all such other shares that were issued as part of the reorganization were held by the original shareholders.

3.     The preferred shares in Subco 3 held by Opco are prescribed shares because the dividends on the preferred shares are deemed not to be limited to a maximum amount by virtue of paragraph 6205(4)(a) of the Regulations.

Further, it is your opinion that, even if the preferred shares in Subco 3 held by Opco are not prescribed shares, subsection 110.6(8) would not be applicable to any gain realized on a sale of shares of Opco because it is not reasonable to conclude that a significant part of any gain arising on a sale of such shares would be attributable to the fact that dividends were not paid on the preferred shares of Subco 3.

Our comments:

The situation outlined in your letter appears to relate to actual proposed transactions involving identifiable taxpayers. Confirmation as to the income tax consequences of proposed transactions can only be given in the context of an advance income tax ruling. We can, however, offer the following general comments.

While common shares often qualify as prescribed shares for purposes of subsection 110.6(8), we cannot confirm that the common shares of Opco, Subco 1, Subco 2 and Subco 3 would be prescribed shares because we do not have sufficient information about the shares to enable us to determine whether they satisfy all of the requirements in subsection 6205(1) of the Regulations.

With regard to the Class C preferred shares of Opco, you have concluded that because the Class B common shares of Opco (the "other shares" for purposes of clause 6205(2)(a)(ii)(A) of the Regulations) were owned at the end of the arrangement by the original holders of the common shares, the requirement in subclause (I) is satisfied.

In our view, in order for a particular share to satisfy the requirements of clause 6205(2)(a)(ii)(A), all of such "other shares" must be owned, at the time of issue of the particular share or at the end of the arrangement, by one or more of the persons described in subclauses (I), (II) and (III) of that clause. In your hypothetical situation, it cannot be said that in respect of any particular Class C preferred share all of the "other shares" are owned by the person to whom the particular share was issued (the "original holder") or by persons who did not deal at arm's length with the original holder. The "other shares" are owned by the original holder and the other shareholders of Opco who deal at arm's length with the original holder.

It is not clear whether it was intended that shares should qualify as prescribed shares for purposes of subsections 110.6(8) and (9) where, as in your hypothetical situation, arm's-length shareholders "freeze" their common shares and, as part of the arrangement, acquire new common shares in proportion to their original shareholdings. We will be bringing this matter to the attention of the Department of Finance for consideration.

In our view, the preferred shares of Subco 3 would not be prescribed shares. They would not satisfy the requirements of subsection 6205(1) of the Regulations because both the liquidation entitlement and the dividend entitlement of such shares are limited to a maximum amount. Further, subparagraph 6205(4)(a)(ii) would not apply to deem the dividend entitlement of such shares not to be limited to a maximum amount or fixed at a minimum amount because Subco 3 has no shares that meet the requirements of paragraph 6205(2)(a) of the Regulations. Accordingly, the Subco 3 preferred shares are not prescribed shares because they do not meet the requirements of clauses 6205(1)(a)(i)(A) and (B) of the Regulations.

Although the preferred shares of Subco 3 would not be prescribed shares, as Subco 3 is a wholly-owned subsidiary of Opco, we agree that it may not be reasonable to conclude, having regard to all the circumstances, that a significant portion of any gain realized on the disposition of a share of Opco would be attributable to the fact that dividends were not paid on the preferred shares of Subco 3.

The foregoing expressions of opinion are given in accordance with the practice referred to in paragraph 21 of Information Circular 70-6R2 dated September 28, 1990 and are not binding on Revenue Canada, Taxation. If you have any further questions, please contact David Palamar at (613) 957-8953.

Yours truly,

for DirectorReorganizations and Foreign DivisionRulings DirectorateLegislative and IntergovernmentalAffairs Branch

b.c.c. Gilles Pelletier     Current Amendments and Regulations Division