7 July 1994 External T.I. 9413315 - INTERNAL CRYSTALLIZATION

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

internal crystallization- deemed dividend and puc grind

Position TAKEN:

if PUC is set high, a dividend could result and no PUC grind

Reasons FOR POSITION TAKEN:

-wording of 85(2.1)

XXXXXXXXXX			941331

Attention: XXXXXXXXXX

July 7, 1994

Dear Sirs:

Re: Internal crystallizations

This is in reply to your letter of May 13, 1994 in which you ask our opinion regarding the application of subsection 85(2.1) of the Income Tax Act to a hypothetical situation. Unless otherwise stated, all references to a statute are to the Income Tax Act S.C. 1970-71-72, c.63, as amended, consolidated to June 10, 1993 (the "Act"). You have described the following facts and assumptions:

i)two unrelated persons each own 50% of the issued and outstanding common shares of an operating company ("Opco");

ii)the common shares are the only issued and outstanding shares of Opco;

iii)the common shares of Opco of each shareholder have a fair market value of $500,000, and adjusted cost base and paid-up capital of $100,000;

iv)in order to crystallize the $500,000 capital gain deduction, each shareholder exchanges his or her common shares of Opco for preferred shares of Opco which are redeemable by the company and retractable by the shareholders and have a redemption value equal to the fair market value of the common shares for which they were exchanged;

v)the shareholders file elections under section 85 of the Act indicating an elected amount of $500,000 with respect to the exchange.

Your comments

You have indicated that in the example in question, it is arguable whether each shareholder is dealing at arm's length with the other and with Opco for the purposes of the crystallization. On the assumption that each shareholder is in fact dealing at arm's length with Opco, you explain that the paid-up capital for corporate law purposes of the preferred shares received by each shareholder upon the exchange would be equal to the fair market value of the common shares, ie. $500,000.

You have analyzed the reduction to paid-up capital provided for in subsection 85(2.1) of the Act, where the reduction is determined by the formula

(A-B) x C/A

You are of the opinion that where, as in this situation, common shares of a corporation are cancelled upon acquisition by the issuing corporation, in calculating "B" of the formula, there would be no cost of the "property" to Opco immediately after the acquisition, since the property no longer exists, and therefore the reduction of paid-up capital determined by the above formula would be $400,000.

You have discussed an alternative interpretation of "B" in the above formula as being the elected amount less any non-share consideration. You believe that this would unduly penalize arm's length parties, since it would mean that non-arm's length parties could carry out an internal crystallization without any adverse tax consequences whereas arm's length parties could not. You believe that this would be contrary to the intended result of the legislation.

You have suggested that if the second interpretation of "B" is correct, then arm's length shareholders could avoid the application of subsection 85(2.1) of the Act simply by transferring their shares to a shell corporation which would avoid the application of subsection 84(3) of the Act and would result in the application of section 84.1 which results in the correct reduction of paid-up capital. The shell company and Opco could then be amalgamated.

Our comments

As you have stated, it is a question of fact whether persons not related to each other were at a particular time dealing with each other at arm's length, and as such we do not offer any guidelines on such a factual determination.

We refer you to question 20 of the 1992 Revenue Canada Round Table, where the Department responded as follows, regarding a similar fact pattern:

"Changing the common shares into preferred shares results in a disposition of the common shares to Opco for the purposes of subsection 85(1) of the Act so that the subsection 85(1) election can be made. Provided that an election pursuant to subsection 85(1) is made with respect to the disposition of the common shares, subsections 86(1) and (2) will not apply to the disposition of these common shares, pursuant to subsection 86(3)."

We would add to this response that in order for the internal crystallizations to produce the desired results, the paid-up capital of the "new" shares must be restricted to that of the "old" shares. If this is done, subsection 84(1) of the Act will not apply and paragraph 84(5)(d) of the Act will apply to deem the amount paid, for purposes of subsection 84(3) of the Act, to be the paid-up capital of the "new" shares.

The Department's interpretation of the formula provided in subsection 85(2.1) of the Act is as follows:

A =the stated capital of the new shares less the paid-up capital of the old shares

B =the agreed amount less the fair market value of non-share consideration

C =the stated capital of the preferred shares issued.

Therefore, applying the formula to the numbers in your example:

A = $500,000 - $100,000 = $400,000

B = $500,000 - 0 = $500,000

C = $500,000

(400,000 - 500,000) X 500,000/400,000 = NIL

There is therefore no PUC reduction to the preferred shares occurring under subsection 85(2.1) of the Act. The result, as you point out under your second interpretation of the formula, is a deemed dividend under subsection 84(3) of the Act, equal to the new PUC of $500,000 less the old PUC of $100,000, or $400,000. This deemed dividend would reduce the proceeds of disposition of the common shares by virtue of paragraph 54(h)(x) so that no capital gain would result.

We do not think that your interpretation of "B" in the formula is correct, since paragraph 85(1)(a) of the Act specifically deems the elected amount to be the corporation's cost of the property. The fact that the common shares may subsequently be cancelled does not change the fact that their cost to the corporation for purposes of "B" is deemed to be the elected amount.

You have also mentioned that you are of the opinion that there is a problem with either "A" or "C" in the formula, in that the paid-up capital reduction is not properly allocated between the classes of shares, since "C" does not take into account the previously existing paid-up capital associated with the common shares, whereas "A" does take the previously existing paid-up capital into account. We would agree that the formula does not appear to grind the full amount of the paid-up capital increase in a situation where shares of a corporation have been transferred to the corporation under subsection 85(1) of the Act. We have referred this problem to the Department of Finance for their consideration.

You have suggested that arm's length shareholders could structure their transactions such that section 84.1 of the Act would apply to give an appropriate PUC adjustment. We are not commenting on this alternative since we do not have the facts necessary to determine whether the desired result would be obtained.

We hope that you will find our comments helpful.

Yours truly,

for Director
Reorganizations and Foreign Division
Rulings Directorate
Legislative and Intergovernmental
Affairs Branch