21 October 1991 Administrative Letter 911806 F - Subsection 55 (2)

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.

Dear sirs:

Re: Subsection 55 (2)

We are writing in response to your letter, dated June 26, 1991, in which you request an interpretation of subsection 55(2) of the Income Tax Act("the Act") in the following hypothetical fact situation:

    Mr. A and Mr. B, two unrelated individuals, each own 50% of the common shares of AB Co.  No other shares are outstanding in AB Co.  The only assets owned by AB Co. are: (1) a building with a tax cost of $1 and a fair market value of $100,000; and (2) a business having shareholder's equity of $1 and a fair market value of $100,000 made up of goodwill with a value of $100,000 and no tax cost.

    In order to creditor-proof the building, Mr. A and Mr. B. wish to transfer it to Newco.  They will be the only shareholders of Newco, each owning 50% of the common shares.  No other shares of Newco will be issued, except for preferred shares with a paid-up capital of $1 and a redemption value of $100,000 to be issued to AB Co.to complete the transfer of the building to Newco on a tax- deferred basis under section 85 of the Act.

    Mr. A and Mr. B will each transfer 50% of their common shares of AB Co. to Newco on a tax deferred-basis under section 85 of the Act for common shares of Newco.  The redemption of the preferred shares issued by Newco to AB Co. will result in a $99,999 deemed dividend to AB Co. pursuant to subsection 84(3) of the Act.  The cancellation of the common shares of AB Co. held by Newco for $100, 000 will result in a $99,999 deemed dividend to Newco pursuant to subsection 84(3) of the Act. Your question is whether subsection 55(2) of the Act would apply to either of the deemed dividends arising in the series of transactions.  It appears to you that subsection 55(2) could apply because the deemed dividends result in a significant reduction in the portions of the capital gains that would have been realized on the dispositions at fair market value of the common shares of AB Co. and the preferred shares of Newco immediately before the dividends that could reasonably be considered attributable to anything other than income earned or realized by the corporations after 1971 and before the series of transactions commenced.  You also point out in your letter that Newco acquired a significant interest in AB Co. during the series of transactions.

Paragraph 55(3)(a) of the Act provides, in general terms, that subsection 55(2) will not apply to a dividend received by a corporation if the dividend was received as part of a series of transactions or events that did not result in

    (i) a disposition of any property to a person with whom the corporation which received the dividend was dealing at arm's length,

    or

    (ii) a significant increase in the interest in any corporation of any person with whom the corporation which received the dividend was dealing at arm's length.

Paragraph 12 of IT-419 states that it is a question of fact as to whether unrelated persons are dealing at non-arm's length.  The matter of whether Mr. A and Mr. B are dealing at arm's length with AB Co. and Newco could therefore not be determined without a review of all relevant facts; however, the balance of our response will be predicated on the assumption that Mr. A and Mr. B are dealing at arm's length with AB Co. and Newco. 

The Department's views on what constitutes an "increase in the interest in any corporation" for the purposes of subparagraph 55(3)(a)(ii) of the Act were presented by Mr. John Robertson of Revenue Canada Taxation at the 1981 Canadian Tax Foundation Conference:

    "Where a person or persons incorporate new companies and the incorporation of these companies is involved in the series of transactions that include the payment of dividends, their interest in the new corporation will be considered as an interest in any corporation. (see pages 93-94 and 108 of the 1981 Conference Report).

Accordingly, the acquisition by Mr. A and Mr. B of the shares of Newco is a significant increase in their interest in Newco.   Paragraph 55(3)(a) would therefore not apply to exempt the dividends deemed to have been received by AB Co. and Newco from the application of subsection 55(2) of the Act, assuming that Mr. A and Mr. B deal at arm's length with AB Co. and Newco.

Nevertheless, depending on the facts of a particular situation, it is possible that the butterfly exception in paragraph 55(3)(b) of the Act could apply to except a deemed dividend from the application of subsection 55(2) provided that Newco receives its proportionate share of each type of property owned by AB Co. immediately before the transfers of property to Newco.

The expressions of opinion in this letter are given in accordance with the practice referred to in paragraph 21 of Information Circular 70-6R2 and are not binding on Revenue Taxation.

Yours truly,

for DirectorReorganizations and Foreign DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch