10 April 1995 External T.I. 9504695 - SAFE INCOME, FEB. 22, 1994 ELECTION

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:

Safe income and the election to "bump-up" the ACB of shares pursuant to the election to be filed on February 22, 1994

Position TAKEN:

Safe income attributable to the shares is reduced proportionally to the capital gain that is included in income when the election is filed

Reasons FOR POSITION TAKEN:

Consistent with our position in 5-913247 and the 1981 paper presented at the Canadian Tax Foundation

		950469
XXXXXXXXXX	A. Seidel

Attention: XXXXXXXXXX

April 10, 1995

Dear Sirs:

This is in reply to your letter dated February 20, 1995 wherein you requested our interpretation of subsection 55(2) of the Income Tax Act (the "Act") in relation to the hypothetical situation described below.

X owns 30% of the issued and outstanding shares (the "Shares") of Opco and her brother owns the remaining 70% of the issued and outstanding shares of Opco. The adjusted cost base ("ACB"), as defined in section 54 of the Act, of the Shares is $90,000, the paid-up capital ("PUC"), as defined in subsection 89(1) of the Act, of the Shares is $100 and the fair market value ("FMV") of the Shares is $375,000. On February 21, 1994 the income earned or realized ("safe income") of Opco which is attributable to the Shares is $185,000. X will elect, in the prescribed manner and form, to "bump up" the ACB of the Shares by $100,000 which will result in a $100,000 capital gain for tax purposes. Pursuant to subsection 110.6(3) of the Act, in computing her taxable income for 1994, X will deduct an amount equal to the taxable capital gain on the Shares.

Commencing in 1995, X will transfer the Shares to her holding company ("Holdco") pursuant to subsection 85(1) of the Act. The agreed amount will be $190,000 and the consideration received by X will consist of preferred shares of Holdco having a FMV of $375,000, an ACB of $190,000 and PUC of $100. Opco will then purchase for cancellation the Shares held by Holdco for $375,000 which will result in a deemed dividend pursuant to subsection 84(3) of the Act.

You have requested our opinion as to whether all or any part of the deemed dividend will be subject to the application of subsection 55(2) of the Act.

In the situation outlined above, since $100,000 of the capital gain will be crystallized at the time the election is made to increase the ACB of the Shares, not all of X's potential gain on the Shares of Opco transferred to Holdco will become a potential gain to Holdco. In addition, as there is no tracing provided for in subsection 55(2) of the Act, it is not reasonable to conclude that the gain that will be realized by X on the rollover of her Opco shares to Holdco is entirely attributable to something other than safe income and that the remaining gain inherent in Holdco's shares of Opco is attributable only to safe income.

Therefore it is our view that when a portion of the capital gain inherent in the Shares of Opco is crystallized on February 22, 1994 pursuant to the election described above, the only reasonable approach, consistent with the principles outlined in paragraph (d) on page 85 of the 1981 paper presented by John R. Robertson at the 1981 annual conference of the Canadian Tax Foundation, is to apportion the safe income, to which the entire gain is in part attributable, proportionally to each part of the gain. Therefore, the amount of safe income that would be attributable to the Shares immediately following the election to include $100,000 in income is made in 1994 will be determined using the following formula:

A - ( B * A )
C

where: A is the safe income of Opco attributable to the Shares on February 22, 1994,

B is the increase to the ACB of the Shares as a result of the February 22, 1994 election, and

C is the amount of the capital gain inherent in the Shares on February 22, 1994 before making the election referred to in B

Accordingly, in the situation where the capital gain attributable to the Shares on February 22, 1994 is $285,000 and the safe income attributable to the Shares on February 22, 1994 is $185,000, it is our view that the election to include $100,000 of the capital gain in income in 1994 would result in safe income of $120,087 being attributable to the Shares immediately following the election on February 22, 1994. Consequently, in the situation where Holdco has received a taxable dividend on the purchase for cancellation of the Shares by virtue of subsection 84(3) of the Act, the amount of the dividend exceeds the safe income attributable to the Shares at the time they are purchased for cancellation and Holdco has not made any designation(s) pursuant to subsection 55(5)(f) of the Act, the entire amount of the deemed dividend will be reclassified as a capital gain pursuant to subsection 55(2) of the Act.

The above comments are provided in accordance with the practice referred to in paragraph 21 of Information Circular 70-6R2.

Yours truly,

for Director
Reorganizations and Foreign Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch