23 August 1991 Administrative Letter 911846 F - Subsection 55(2) and 55(3)(a)(ii)

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.

Aug 23 1991

Dear Sirs:

Re: Subsection 55(2) and subparagraph 55(3)(a)(ii) of the Income Tax Act

This is in reply to your letter of June 28, 1991 in which you requested our opinion as to the application of subsection 55(2) and subparagraph 55(3)(a)(ii) of the Income Tax Act (the "Act") to the hypothetical facts and transactions described below.

1.      Opco, Aco and Bco are Canadian-controlled private corporations within the meaning assigned by paragraph 125(7)(b) of the Act.

2.      The common shares of Opco are owned 89% by Aco and 11% by Bco. Aco is owned lOO% by Mr. A and Bco is owned lOO% by Mr. B. Mr. A and Mr. B are individuals resident in Canada and are not related, within the meaning of subsection 251(2) of the Act, to each other.

3.      The aggregate adjusted cost base, within the meaning of paragraph 54(a) of the Act, of the common shares of Opco held by Aco and Bco is $100.  The aggregate fair market value of these shares is $5,000,000.

4.      Opco is engaged in the promotion business and owns the real estate from which it operates such business.  This real estate has a cost amount of $100,000 and a fair market value of $2,000,000.  The shareholders of Opco wish to creditor-proof this real estate.

5.      Aco and Bco will each transfer all of their shares ln Opco to a newly incorporated company (Holdco) in exchange for common shares of Holdco.  Elections under subsection 85(1) of the Act will be filed in respect of such transfers so that they will occur on a tax-deferred basis.

6.      Holdco will then transfer $2,000,000 worth of shares in Opco (the "Opco Shares) to a newly incorporated company (Newco) in exchange for common shares of Newco.  An election under subsection 85(1) of the Act will be filed in respect of such transfer so that it will occur on a tax-deferred basis.  Holdco will at all times hold all of the issued and outstanding shares of Newco.

7.      Opco will then transfer its real estate to Newco in exchange for voting preferred shares with an aggregate redemption amount of $2,000,000 (the "Newco Preferred Shares).  An election under subsection 85(1) of the Act will be filed in respect of such transfer so that it will occur on a tax-deferred basis.

8.        Newco would then redeem the Newco Preferred Shares in consideration for Opco purchasing for cancellation the Opco Shares (the "cross-cancellation").

Our Comments

On the cross-cancellation, Newco would be deemed by paragraph 84(3)(b) of the Act to have received a dividend equal to the amount by which the amount of the purchase for cancellation of the Opco Shares exceeds their paid-up capital, within the meaning of paragraph 89(1)(c) of the Act.  Similarly, Opco would be deemed to receive a dividend equal to the amount by which the redemption amount of the Newco Preferred Shares exceeds their paid-up capital. If either deemed dividend exceeds the "income earned or realized" by the corporation redeeming the shares in respect of such shares redeemed (the "safe income"), paragraph 55(2)(b) of the Act would apply to deem such dividend to be proceeds of disposition for the Newco Preferred Shares to Opco or proceeds of disposition of the Opco Shares to Newco, as the case may be, unless either exemption from the application of that provision contained in paragraph 55(3)(a) or (b) of the Act applied.  We have assumed that both dividends are in excess of safe income and that the provisions of paragraph 55(3)(b) are not applicable.

In general terms, paragraph 55(3)(a) of the Act provides that subsection 55(2) of the Act will not apply to a dividend received by a corporation (the "dividend recipient") 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   corporate recipient of 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 corporate recipient of the dividend was dealing at arm's length.

Assuming that the proposed transactions described herein comprise the complete series of transactions or events, read with reference to subsection 248(10) of the Act, such series would not result in a disposition of property to any person with whom either dividend recipient, Newco or Opco, dealt at arm's length.  As Newco and Opco would both be controlled by Aco, they would be related by virtue of subparagraph 251(2)(c)(i) of the Act and thus be deemed not to deal at arm's length with each other by virtue of paragraph 251(1)(a) of the Act.  If the transactions described were undertaken in contemplation of any disposition of shares or property to a person with whom either of Opco or Newco would deal at arm's length, the series would be described in subparagraph 55(3)(a)(i) of the Act and subsection 55(2) of the Act would have application.

With respect to subparagraph 55(3)(a)(ii) of the Act, in our view the proposed transactions would result in a significant increase in interest in Holdco by both Aco and Bco.  This view is consistent with the following comments contained on page 94 of the paper presented by 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 increase in the interest in any corporation.

Therefore, in this case, since it would appear that Bco in fact deals at arm's length with Newco and Opco, the series of transactions or events which includes the deemed receipt of dividends by Newco and Opco would result in an increase in the interest in a corporation of a person with whom a dividend recipient dealt at arm's length.  Consequently, paragraph 55(3)(a) of the Act would not apply to exempt the dividends deemed to be received by Newco and Opco from the application of subsection 55(2) of the Act.

These comments represent our general views with respect to the subject matter of your letter and are given in accordance with the practice referred to in paragraph 21 of Information  Circular 70-6R2 dated September 28, 1990.

Yours truly,

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