7 February 1995 External T.I. 9421745 - DEALING AT ARM'S LENGTH

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:

Whether two individuals are dealing at arm's length for purposes of paragraph 84.1(1)(b).

Position TAKEN:

No. They are acting in concert and therefore not dealing at arm's length.

Reasons FOR POSITION TAKEN:

The series of transactions is designed to create a capital gain which thwarts the purpose of paragraph 84.1(1)(b). The series of transactions would not be entered into unless both parties acted together to achieve the desired result. The parties are therefore acting in concert and not dealing at arm's length. In addition, subsection 245(2) would apply to deny the tax benefit and to treat each individual as having received a dividend rather than proceeds of disposition.

		942174
XXXXXXXXXX	A. Seidel

Attention: XXXXXXXXXX

February 7, 1995

Dear Sirs:

This is in reply to your letter dated August 5, 1994 with respect to the application of section 84.1 and subsection 245(2) ("GAAR") of the Income Tax Act (the "Act") in the following circumstances:

1.Mr. X owns 55% and Mr. Y owns 45% of the issued and outstanding common shares of Aco. Mr. X has owned his shares since the incorporation of Aco and Mr. Y has owned his shares since 1992.

2.The fair market value of the common shares held by each of Mr. X and Mr. Y exceeds the paid-up capital and adjusted cost base thereof. The common shares of Aco are held as capital property by Mr. X and Mr. Y and are "qualified small business corporation shares" within the meaning of subsection 110.6(1) of the Act.

The expression "paid-up capital" has the meaning assigned by subsection 89(1) of the Act and the expressions "adjusted cost base" and "capital property" have the meanings assigned by section 54 of the Act.

3.Mr. X owns 100% of the shares of Xco and Mr. Y owns 100% of the shares of Yco. Mr. X and Mr. Y are not related.

4.Mr. X sells 45% of his common shares in Aco to Yco and Mr. Y sells all of his common shares of Aco to Xco. The two sales will be at fair market value and Yco and Xco will each issue interest-bearing demand promissory notes as sole consideration for the Aco shares they purchased.

5.Mr. X and Mr. Y will each claim a $500,000 capital gains deduction pursuant to subsection 110.6(2.1) of the Act.

Issue

Will paragraph 84.1(1)(b) of the Act apply to the disposition of the Aco shares by Mr. X and Mr. Y such that they will each be deemed to have received a dividend equal to the excess of the fair market value of the promissory note received by each of them and the adjusted cost base of the common shares of Aco disposed of by each of them and therefore the capital gains deduction would not be available to Mr. X and Mr. Y? If paragraph 84.1(1)(b) of the Act does not apply, will GAAR apply to deny the capital gains deduction claimed by Mr. X and Mr. Y?

Our Position

In paragraph 19 of Interpretation Bulletin IT-419 it states that "even when there are two distinct parties (or minds) to a transaction, but these parties act in a highly interdependent manner (in respect of a transaction of mutual interest) then it can be assumed that the parties are acting in concert, and hence not at arm's length."

In the situation described above, we believe that Mr. X and Mr.Y could be considered to be acting in concert with the result that Mr. X's sale of his Aco shares to Yco and Mr. Y's sale of his Aco shares to Xco will not be at arm's length. It is therefore our view that the provisions of paragraph 84.1(1)(b) of the Act would apply to the disposition of the common shares of Aco by each of Mr. X and Mr. Y.

In addition, paragraph 25 of Information Circular 88-2 discusses the situation where as a result of a series of transactions a shareholder realizes a capital gain on the disposition of property that should have been accounted for as a dividend. Where one of the transactions in the series of transactions is an avoidance transaction, subsection 245(2) of the Act will be applied to the transaction if it is determined that the series of transactions was carried out to thwart the purpose of the provision in question. In the situation outlined above, it is our view that these transactions are being completed in an attempt to thwart the purpose of paragraph 84.1(1)(b) of the Act. Accordingly, subsection 245(2) of the Act would be applied to the series of transactions to deny the tax benefit and to treat the individuals as having received a dividend equal to the excess of the fair market value of the promissory note received by each of them over the adjusted cost base, as determined under paragraph 84.1(2)(a) or (a.1) of the Act as the case may be, of the common shares of Aco disposed of by each of them. Accordingly, the capital gains deduction would not be available to Mr. X and Mr. Y.

These comments are provided in accordance with the guidelines set out in paragraph 21 of Information Circular 70-6R2.

Yours truly,

for Director
Reorganizations and Foreign Division
Rulings Directorate
Policy and Legislation Branch