24 April 1996 External T.I. 9604235 - ALLOCATION OF SAFE INCOME

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.

5-960423
XXXXXXXXXX J. Teixeira
(613) 957-8953

Attention: XXXXXXXXXX

April 24, 1996

Dear Sirs:

This is in reply to your letters dated January 24 and March 13, 1996 wherein you requested our interpretation of subsection 55(2) of the Income Tax Act (the "Act") in relation to the hypothetical situations described in your letters.

The hypothetical situations in your letter involve an individual holding qualified small business corporation shares, as defined in subsection 110.6(1) of the Act, of a corporation ("Opco"), who first transfers these shares to a holding company ("Holdco") before the shares are repurchased by Opco. The individual transfers the shares of Opco to Holdco pursuant to subsection 85(1) of the Act, electing an amount not to exceed the fair market value of the shares transferred. The transfer results in a capital gain in respect of which the individual will claim a capital gains deduction pursuant to subsection 110.6(2.1) of the Act. The purchase of the Opco shares held by Holdco results in a deemed dividend pursuant to subsection 84(3) of the Act. There is an amount of income earned or realized by Opco after 1971 which has not been distributed ("Safe Income") to which the gain on the Opco shares is attributable immediately before their transfer to Holdco.

You have requested our opinion as to whether Holdco retains the Safe Income attributable to the Opco shares immediately before their transfer to Holdco.

Our comments

In situations as outlined above, where a part of the capital gain inherent in the shares of Opco is crystallized on their transfer to Holdco by an individual, not all of the individual's potential gain on the transferred shares of Opco will become a potential gain of 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 the individual on the rollover of his 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.

When a portion of the capital gain inherent in the shares of Opco is crystallized, the reasonable approach, consistent with the principles outlined in 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, proportionately to each part of the gain. Therefore, the amount of Safe Income that would be attributable to the Opco shares immediately following the transfer to Holdco will be determined using the following formula:

A x B
C

where: Ais the Safe Income attributable to the shares of Opco held by the individual immediately before the transfer or commencement of the series of transactions which included the transfer

B is the potential gain on the shares of Opco held by Holdco

C is the potential gain on the shares of Opco immediately before their transfer to Holdco

In the situation where Opco's shares held by Holdco are repurchased by Opco for an amount that will not result in a capital gain, subsection 55(2) of the Act will not apply to the deemed dividend received by Holdco on the purchase. The result of the deemed dividend is not to effect a significant reduction in the portion of the capital gain that would have been realized by Holdco on the disposition of the Opco shares immediately before the dividend, in this case.

The foregoing comments are not rulings and, in accordance with the practice referred to in Information Circular 70-6R2, are not binding on Revenue Canada.

Yours truly,

for Director
Reorganization and International Division
Income Tax Rulings and Interpretations
Directorate
Policy and Legislation Branch