4 December 1992 Income Tax Severed Letter 9219615 - Capital Gains - Significant Amount

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.

921961
XXXXXXXXXX
Glen Thornley
(613) 957-2101

Attention: XXXXXXXXXX

December 4, 1992

Dear Sirs:

Re: Subsection 110.6(8) and "the significant amount"

This is in reply to your letter of June 15, 1992, and further to our conversation (Thornley/XXXXXXXXXX) of September 22, 1992, concerning the above and related matters.

You request a non-binding opinion related to a number of facts and proposed transactions which you have supported with a number of reasons. The gist of your enquiry relates to an attempt by a taxpayer corporation to "purify" non- business assets which represent, in your view, the "significant amount" attributable to the non-payment of dividends on previously owned preferred shares. Common shares of the existing company will be transferred into a Newco under the rules in subsection 85(1) of the Income Tax Act. These shares will be redeemed, creating a deemed dividend under subsection 84(3) of the Act. The amount of the dividend will approximate the value of the non-business assets, thus, in your view, the remaining shares of the taxpayer corporation will be qualifying small business shares for purposes of section 110.6 of the Act.

You then ask the following two questions:

1. Does the payment of a dividend to remove "the
significant part of the capital gain" referred to in
subsection 110.6(8) of the Act, so that the
preconditions of that subsection are not met, have to
be paid on the preferred shares that gave rise to "the
significant amount" or could a dividend be paid on any
class of shares to remove the significant amount?
2. On the assumption that the deemed dividend paid on the
redemption of the common shares owned by Newco removed
the "significant amount" attributable to the non-
payment of dividends on the preferred shares, will the
sale or transfer of the remaining common shares of the
taxpayer be subject to the provisions of subsection
110.6(8) of the Act.

As discussed during our telephone conversation, the scenario outlined in your letter appears to relate to actual proposed transactions involving identifiable taxpayers which, as reflected in paragraph 3 of Information Circular 70-6R2, should be the subject of an advance income tax ruling request. The Department will rule on the application of subsection 110.6(8) of the Act on a case by case basis when all the facts can be determined at the time of the request. Notwithstanding the above, we offer the following general comments.

Our comments

Subsection 110.6(8) of the Act is an anti-avoidance rule enacted to prevent the conversion of dividend income into exempt capital gains. Subsection 110.6(8) of the Act will apply if it may reasonably be concluded, having regard to all the circumstances, that a significant part of a capital gain is attributable to the fact that dividends were not paid on a share (other than a prescribed share) of a corporation.

In interpreting the phrase "a significant part of the capital gain" it is our view that the determination of what constitutes a significant part of the capital gain is a question of fact which must be decided in each particular case having regard, as the subsection states, to all the circumstances. Accordingly, the Department has not developed detailed or specific guidelines in respect of this issue. While we are of the view that in many cases this question is appropriately answered by ascertaining the proportion or percentage of the capital gain that is attributable to the non-payment of adequate dividends, we are also of the view that there may be circumstances where it is appropriate to consider the amount or magnitude, expressed in dollars, of the capital gain that is so attributable. Whether the shares of a company are held by arm's length or non-arm's length parties does not affect the application of the subsection.

It is our view that the phrase "the fact that dividends were not paid on a share (other than a prescribed share) of a corporation or that dividends paid on such a share in the year or in any preceding taxation year were less than 90% of the average annual rate of return thereon for that year", as it appears in subsection 110.6(8) of the Act, requires that the stipulated quantum of dividends must be paid on any relevant share (other than a prescribed share) in each and every year during the applicable period (generally the period throughout which the particular individual or a related person owns the property that is the subject of the disposition). If this is not done, it is not possible, after the end of a particular year, to pay a "catch-up" dividend so as to comply retroactively with this particular requirement.

Subsection 110.6(8) of the Act may apply in any situation where a significant part of the capital gain of a property is attributable to the non-payment of dividends on shares regardless of whether other parts of the capital gain arose prior to or subsequent to the period of non-payment of dividends.

In addition to the foregoing the answer to question 5 at the Prairie Provinces tax conference has a bearing on this matter. Question 5 and the answer read as follows:

• "For the purposes of Section 110.6(8), will shares qualify as prescribed shares under regulation 6205 (which came into force for 1985) even though such shares have ceased to exist prior to 1985 by virtue of their redemption or conversion into other shares by virtue of a section 86 reorganization or amalgamation, etc.?"

Response

• "Subsection 110.6(8) applies with respect to dispositions after November 21, 1985. Nevertheless, to determine whether it applies, consideration must be given to the fact that dividends were not paid on shares in preceding taxation years, other than prescribed shares. It is necessary to consider whether the share that is no longer issued and outstanding, in respect of which dividends were not paid, would have been prescribed under Regulation 6205. If the share that is no longer issued and outstanding would have been a prescribed share if it had been outstanding after 1984, then the fact that dividends were not paid on such shares will not cause subsection 110.6(8) to apply. Also, the Department would not generally seek to apply subsection 110.6(8) to deny a capital gains deduction in circumstances where a non-prescribed share ceased to exist prior to 1985."

With respect to your two questions, we can agree that the payment of a dividend arising on the redemption of the common shares, in the context of your example would remove a proportionate share of the "significant part" of the capital gain that is attributable to the non-payment of dividends on the preferred shares but not all of it. Subsection 110.6(8) of the Act refers to a "property" and a "share", thus, each share would bear a proportionate amount of capital gain attributable to the fact that dividends were not paid and capital gains attributable to other factors. Therefore the remaining 800 common shares in your example would bear a portion of gain attributable to the non-payment of dividends. As such, on a subsequent disposition they would likely be subject to the provisions of subsection 110.6(8) of the Act.

With regard to your assertion that subsection 55(2) will not apply to the deemed dividend in your example, in our view if the purification transactions and the ultimate sale to a third party form part of the same series, the dividend arising on the redemption of the common shares may not qualify for the exemption in paragraph 55(3)(a) of the Act.

We trust our comments will be of assistance to you.

Yours truly,

E. Wheeler
for Director
Business and General Division
Rulings Directorate
Legislative and Intergovernmental
Affairs Branch