19 August 1996 Internal T.I. 9611787 - PREFERRED SHARES WITH NO DIVIDEND ENTITLEMENT

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 subsection 110.6(8) would apply to deny the capital gains exemption on the exchange of shares for other shares.

Position:

Question of fact.

Reasons:

The question of whether there is an abuse, in the sense that the transaction constitutes an attempt to convert dividend income into exempt capital gains, is a question of fact.

		August 19, 1996

	Calgary Tax Services Office	HEADQUARTERS
	Business Enquiries		C. Chouinard
		957-8953
Attention: Tony Wong
		7-961178

Capital Gains Exemption - Subsections 110.6(8) and (9) of the Income Tax Act

This is further to a letter dated January 10, 1996, which you referred to us for our reply, wherein the taxpayer's representative inquired about the application of subsections 110.6(8) and (9) of the Income Tax Act (the "Act") in a particular situation.

In the situation described by the representative, the corporation was incorporated in XXXXXXXXXX. At that time, the corporation issued to the taxpayer XXXXXXXXXX common shares (the "Original Shares"). In XXXXXXXXXX, the corporation issued XXXXXXXXXX preferred shares to a numbered corporation of which the taxpayer's father is the controlling shareholder. The preferred shares entitle the holder to a non-cumulative dividend at a rate to be determined by the board of directors. In XXXXXXXXXX, the corporation issued XXXXXXXXXX common shares to the taxpayer and XXXXXXXXXX preferred shares to the numbered corporation. On XXXXXXXXXX, the corporation redeemed all of the preferred shares held by the numbered corporation, for an amount equal to their redemption value. In XXXXXXXXXX, the taxpayer exchanged her Original Shares for a new class of shares of the corporation (the "New Shares"), using a section 85 rollover. Immediately after the exchange, the taxpayer and her siblings subscribed for new common shares.

Since no dividend has ever been paid on the preferred and the common shares, the taxpayer has inquired whether subsection 110.6(8) of the Act would apply in respect of the exchange of the Original Shares for the New Shares, such that the capital gain exemption in respect of the capital gain, if any, arising from this transaction would be denied.

Taxpayer's Position

In the representative's view, neither of subsections 110.6(8) or (9) of the Act would apply in the situation described above, as the corporation could not have paid dividends during the years in question without being in breach of the provisions of the Alberta Business Corporations Act regarding liquidity and solvency. In addition, the representative argues that had dividends been paid, the corporation would not have been able to redeem the preferred shares. It is also the representative's view that subsections 110.6(8) and (9) of the Act would not apply because the holder of the preferred shares never expected any return on the shares, which were but a source of financing for the corporation. Alternatively, the representative argues that the preferred shares constitute "prescribed shares" within the meaning of subsection 6205(2) of the Income Tax Regulations (the "Regulations").

Our Comments

Although you asked us to respond to the taxpayer directly, as the transaction outlined in the representative's letter has already taken place, it would be more appropriate for the Audit Division of the Tax Services Office to handle the query. Accordingly, we will not be responding to the representative's letter. However, we offer the following general comments which may be of assistance.

Subsection 110.6(8) of the Act will apply to deny a capital gains exemption deduction 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 or, if paid, were less than 90% of the average annual rate of return thereon for that year.

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. 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.

The annual rate of return by way of dividends that a knowledgeable and prudent investor who purchased the shares would expect to receive on the day he or she acquired them is a question of fact. The expectations of a knowledgeable and prudent investor must be determined by assuming that there will be no delay or postponement in the payment of dividends and no failure to pay dividends, that the dividends will be paid each year at a predetermined rate, either fixed or variable and that the share will be eventually sold for an amount equal to that received by the corporation when the share was issued. We are of the view that the return on the shares that are substituted with new shares must be taken into account in determining the annual rate of return and that the average annual rate of return is usually calculated on the basis of the amount invested by a knowledgeable and prudent investor who purchased the shares on the day they were issued.

As regards corporate law liquidity and solvency tests that must be met before dividends can be declared, in our view, the fact that such tests may prevent the payment of dividends should be considered in determining whether subsection 110.6(8) of the Act would apply in a particular circumstance. However, these tests are not, in and by themselves, sufficient to conclude that subsection 110.6(8) of the Act would not apply.

With respect to the preferred shares, we do not share the representative's view that these shares are "prescribed shares" within the meaning of subsection 6205(2) of the Regulations. As indicated in paragraph 6205(2)(a) of the Regulations, in order for a share to be a prescribed share, it must have been issued pursuant to an arrangement, the main purpose of which was to permit any increase in the value of the property to accrue to prescribed shares that are "other shares" described in paragraph 6205(2)(a) of the Regulations. In the situation described in the letter, in our view, the preferred shares would not be considered to have been issued as part of an arrangement to permit any increase in the value of property of the corporation to accrue to the common shares, as they were issued 16 months after the common shares were issued. Therefore, they were not issued as part of an arrangement that involved the issue of other shares, as required by subsection 6205(2) of the Regulations.

R. Albert
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch