13 February 1997 CTF Roundtable Q. 1, 9621950 - 1996 ONTARIO TAX CONFERENCE - QS & AS

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.

1996 ONTARIO TAX CONFERENCE

OCTOBER 8, 1996

COMPUTER SOFTWARE PAYMENTS TO RESIDENTS OF THE U.S. AND THE NETHERLANDS

Revenue Canada has said that royalty payments to a non-resident for distribution rights would be exempt from Canadian tax where the applicable tax treaty definition of "royalty" does not include payments of this kind (see Revenue Canada Document No. 9418695 dated July 29, 1994. CCH Tax Window Files). In these cases, the payments would generally be exempt from Canadian taxation pursuant to the business profits article unless attributable to a Canadian permanent establishment of the non-resident.

The definitions of "royalty" in the Canada-U.S. Income Tax Convention and in the Canada-Netherlands Income Tax Convention do not include payments for marketing and distribution rights.

U.S.

"The term "royalties" as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work (including motion pictures and works on film, videotape or other means of reproduction for use in connection with television), any patent, trade mark, design or model, plan, secret formula or process, or for the use of, or the right to use, tangible personal property or for information concerning industrial, commercial or scientific experience, and, notwithstanding the provisions of Article XIII (Gains), includes gains from the alienation of any intangible property or rights described in this paragraph to the extent that such gains are contingent on the productivity, use or subsequent disposition of such property or rights."

Netherlands

"The term "royalties" as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including motion picture films and works on film, videotape or other means of reproduction for use in connection with television, any patent, trade mark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific equipment or for information concerning industrial, commercial or scientific experience."

Question

Are payments to a U.S. or Netherlands resident for rights in respect of the use of custom computer software in Canada that would otherwise be subject to tax under Part XIII of the Income Tax Act exempt from Canadian tax in all cases on the basis of being either:

(a)a payment for the use of, or the right to use, computer software exempt under Article XII of the applicable treaty, or

(b)a payment in respect of the production or reproduction of the software exempt under paragraph 212(1)(d)(vi) of the Income Tax Act, or

(c)a payment for marketing or distribution rights which is not a royalty as defined in the applicable treaty and so is exempt by the business profits article of the applicable treaty?

If not, what kinds of payments to a resident of the U.S. or the Netherlands for rights in respect of the use of custom computer software would be subject to tax under Part XIII of the Income Tax Act?

Response

As preliminary comments, we note the following:

-Although you have asked about rights in respect of the use of software, Article XII of both the U.S. and Netherlands Conventions does not use the words "in respect of" before "the use of, or the right to use".

-It would be expected that payments for distribution rights would only be in respect of exclusive rights to distribute. Also, we assume that no part of the payment described in paragraph (c) of the question includes a payment for what is in fact the right to use the software. For example, an agreement may call for a Canadian distributor of custom computer software, who has an exclusive right to distribute by way of sublicense the right to use the software, to make periodic payments to a non-resident based on a certain percentage of the payments received by the distributor from the end-users to whom the distributor has sublicensed the right to use the software. Such payments would be considered to be blended payments, part of which would be allocated to the exclusive right to distribute the right to use the software, and the other part of which would be allocated to the property sublicensed, which is the right to use the software. The portion of the payment for the exclusive right to distribute would be a payment described in paragraph (c) of the question and the portion of the payment which is for the right to use the software would be a payment described in paragraph (a) of the question. If in the example the Canadian distributor had a non-exclusive right to sublicense the right to use the software, all of the payments to the non-resident would be considered to be for the right to use the software.

In response to your questions, while it should be recognized that all the facts of a particular case must be considered before a determination of the appropriate tax treatment is made, in general the types of payments described in paragraphs (a), (b) and (c) of the question would be exempt from tax in Canada unless the payments are attributable to a Canadian permanent establishment. We cannot comment with respect to other payments which might be subject to tax in Canada without more information as to what kinds of payments are at issue.

COMPUTER SOFTWARE PAYMENTS TO RESIDENTS OF TREATY JURISDICTIONS OTHER THAN THE U.S. AND THE NETHERLANDS

Question

What kinds of payments for rights in respect of the use of custom computer software in Canada made to residents of countries with which Canada has a tax treaty (other than the U.S. and the Netherlands), where the treaty contains a business profits article and a definition of "royalty" similar to the Canada-U.S. Income Tax Convention, will be subject to Canadian tax under Part XIII of the Income Tax Act?

Response

Whether or not a particular payment is subject to tax in Canada can only be determined after an examination of all of the facts. However, as we have indicated in a paper presented at the 1994 Canadian Tax Foundation Annual Conference, where payments are made by a Canadian resident to a non-resident and such payments are in respect of the use of, or the right to use software, it is Revenue Canada's view that the payments represent compensation for the right to use a secret formula or process and are considered to be royalties for the purpose of most, if not all, of Canada's income tax treaties. While the Department treats a transaction whereby a non-resident sells a Canadian resident "shrink-wrap computer software" as a sale of tangible goods and exempt from tax under Part XIII of the Act, all software is considered as being custom computer software where an end-user acquires the right to use any computer software program under a specific license agreement. It does not matter that copies of the particular software program may also be available to the end user and other end-users as shrink-wrap computer software.

Furthermore, for the purposes of determining whether a payment or a portion thereof is for the right to use computer software, it does not matter that the Canadian taxpayer does not use the software in its own computers to execute the functions the software was developed to perform. As we have indicated in our response to question #1, in the case of a distributorship agreement where the distributor acquires the exclusive right to sublicense the right to use the custom computer software to its customers, the right to use the software is the property being distributed albeit by way of licensing those rights to its customers. The right to use the property is a distinct and separate right from the exclusive right to actually distribute by way of sublicense (i.e., the distribution right) in a predetermined geographical area. Therefore, each distribution agreement and the surrounding circumstances will have to be examined to determine if a particular payment is for the exclusive right to sublicense or for the right to use the custom computer software or is a blended payment for both. As the right to use the custom computer software is the property being distributed, there should always be a reasonable allocation of a portion of the aggregate payments called for under the agreement to that right. Where the payee has no permanent establishment in Canada to which the portion of the payments for the right to use the property is attributable, that portion of the payments is subject to tax under Part XIII of the Act at the rates provided for in the royalty article of the treaties described in the question.

PAYMENTS TO U.S. RESIDENTS FOR INFORMATION RE INDUSTRIAL, COMMERCIAL OR SCIENTIFIC EXPERIENCE

Paragraph 212(1)(d) of the Income Tax Act imposes tax on payments to a non-resident for information concerning industrial, commercial or scientific experience where the amount payable is dependent in whole or in part on the use to be made of or the benefit to be derived from the information, on production or sales of goods or services, or on profits.

Paragraph 3(c) of Article XII of the Canada-U.S. Income Tax Convention exempts such payments made to a U.S. resident from Canadian withholding tax except where the information is provided in connection with a rental or franchise agreement.

The Technical Explanation to the Third Protocol says that a licence of a secret formula to manufacture a particular product together with the right to use a trade mark for the product and to market it at a non-retail level would not, by itself, constitute a franchise or rental agreement.

Questions

(a) Is the reference in the Technical Explanation to the right to market being at the non-retail level significant? In other words, if the right to market were for the retail level only or for retail and non-retail levels would the agreement described in the Technical Explanation be a rental or franchise agreement?

(b) Would a licence of information concerning industrial, commercial or scientific experience combined with a licence of computer software for use in dealing with the information be considered to be "in connection with a rental agreement"?

(c) What is Revenue Canada's understanding of the essential characteristics of a franchise agreement?

Response

As a preliminary comment, we note that it is Revenue Canada's position that subparagraph 212(1)(d)(i) of the Act may apply to payments for the use of information where subparagraph 212(1)(d)(ii) does not.

(a) It is a question of fact as to what constitutes a franchise or rental agreement. Therefore, the example in the Technical Explanation to the Protocol should stand on its own and each other situation will be considered based on its own facts.

(b) gain, it is a question of fact whether or not such an arrangement would be considered to be "in connection with a rental ...agreement". We cannot provide further comments because of the limited information given to us.

(c) To date Revenue Canada has not formulated a position on the essential characteristics of a franchise agreement for the purpose of subparagraph 3(c) of Article XII of the Canada-U.S. Income Tax Convention.

SAFE INCOME - CAPITAL GAINS EXEMPTION

Under existing income tax legislation, individuals who dispose of qualified small business corporation shares are eligible to claim a capital gains exemption of up to $500,000. Since the introduction of the capital gains exemption many taxpayers have entered into crystallization transactions either by a transfer of their shares of an operating company to a holding company or by way of an internal reorganization of capital of the operating company.

The Department has set out its views on the interaction of safe income and the capital gains exemption in a Technical Interpretation dated April 10, 1995, issued by the Reorganizations and Foreign Division of Revenue Canada. The Department indicated that where a taxpayer crystallizes a capital gains exemption by transferring shares of an operating company ("Opco") to a holding corporation ("Holdco"), there is a proportionate reduction in the safe income attributable to the Opco shares. In addition, the Department has indicated that a similar result will occur where the shareholder elects to realize a gain in order to use the capital gains exemption.

The situation considered by the Department was as follows:

1. X owns 30% of the shares (the "Shares") of Opco and her brother owns the remaining 70% of the issued and outstanding shares of Opco.

2. The adjusted cost base ("ACB") of the Shares is $90,000.

3. The paid-up capital ("PUC") of the Shares is $100.

4. The fair market value of the Shares is $375,000.

5. On February 21, 1995 the safe income of Opco that is attributable to the shares of $185,000.

6. X will elect in 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 tot he taxable capital gain on the Shares.

7. In 1995, X transferred her shares to her Holdco pursuant to subsection 85(1) of the Act. The elected amount was $190,000 and the consideration received by X was preferred shares of Holdco having a FMV of $375,000, an ACB of $190,000 and a PUC of $100.

8. Opco will then purchase for cancellation for Shares held by Holdco for $375,000 that will result in a deemed dividend pursuant to subsection 84(3) of the Act.

The Department's view is that the safe income attributable to the shares of Opco will be $120,087.

Question #1

What is the basis for the Department's position that a proportionate amount of safe income should be attributed to the capital gain realized on a crystallization plan?

Response

Subsection 55(2) requires that a determination be made of the portion of a capital gain on a share that is attributable to safe income and the portion that is attributable to something else.

The Department's long-standing position is that each share of a corporation represents only its proportionate share of the value of the company and therefore is entitled only to its proportionate share of the safe income of the corporation during the relevant holding period of that share.(1)

Accordingly, to the extent that a corporation has safe income, in our view, it is reasonable to consider that any gain realized on a share of that corporation will have both a safe-income and non-safe-income component, determined on the pro rata basis described in the technical interpretation above.

Question #2

Assume that Mr.Z owns all the shares of an operating company ("Opco"). The adjusted cost base ("ACB") of Mr. Z's investment is $1 and the fair market value ("FMV") of Opco today is $1,000,000. The after-tax income accumulated in Opco, which represents safe income to a corporate shareholder is $500,000. Opco has no refundable dividend tax on hand.

Mr. Z wishes to utilize his capital gains exemption and protect excess cash held by Opco from the risks of the business operations of Opco. As a result, Mr. Z transfers 50% of his shares of Opco to a new Holdco under subsection 85(1) of the Act. Mr. Z transfers the shares at an elected amount of $0.50 and Mr. Z receives only share consideration from Opco in order to avoid taxation under section 84.1.

Opco then purchases its shares held by Holdco for cancellation for redemption proceeds of $500,000. The redemption amount of $500,000 will be in excess of the PUC of the shares. The excess of the redemption amount over the PUC of the shares will be deemed by subsection 84(3) of the Act to be a dividend. The dividend received by Holdco would be deductible under section 112 of the Act and since Holdco and Opco are connected corporations, Holdco would pay no Part IV tax on the redemption.

Mr. Z then crystallizes his capital gains exemption through an internal reorganization of the capital of Opco. In particular, Mr. Z disposes of his remaining common shares of Opco in exchange for retractable/ redeemable preference shares of Opco with a FMV of $500,000 and new common shares with a nominal FMV. Mr. Z files a section 85 election with respect to the exchange of shares and elects at $500,000, thereby recognizing a gain of $500,000.

Two years later Mr. Z receives an unsolicited offer for his shares of Opco for $500,000 and sells both common and preferred shares of Opco. Mr. Z has no gain on the sale of his Opco shares. Mr. Z retains ownership of Holdco.

If instead of the above, Mr. Z had transferred 50% of his Opco shares to Holdco immediately before the sale and then Opco redeemed the shares with the full payment of $500,000 to Holdco, Holdco would be required to designate in its tax return separate dividends to isolate the safe income of $250,000. Holdco would then realize a capital gain of $250,000.

Does the Department agree with the tax consequences noted above?

Response

In the first situation, it is assumed that the deemed dividend arising on the purchase for cancellation of the Opco shares held by Holdco is not subject to subsection 55(2) because of the application of paragraph 55(3)(a), since the dividend is not part of a series of transactions or events that resulted in a disposition of property to a person to whom Holdco was not related.

In the second situation, the dividend received by Holdco is clearly part of the series of transactions that includes the sale to the unrelated person. Accordingly, paragraph 55(3)(a) would not apply to preclude the application of subsection 55(2).

Purpose Test in Subsection 55(2)

Subsection 55(2) of the Act deems a taxable dividend to be proceeds of disposition if one of the purposes of the dividend was to effect a significant reduction in the capital gain that, but for the dividend, would have been realized on a disposition at fair market value of any share of the capital stock of a corporation.

Question

In light of recent jurisprudence such as C.P.L. Holdings Limited (Plaintiff) v. Her Majesty the Queen (Defendant), can the Department clarify what is meant by the phrase "one of the purposes of which ... was to effect a significant reduction in the portion of the capital gain ..."

Response

In C.P.L. Holdings, the plaintiff owned 99 of the 100 issued and outstanding shares of Clem Industrial Machine Ltd.("Clem Industrial"). On January 1, 1987, Clem Industrial declared a $415,000 dividend to the plaintiff. The proceeds of the dividend were immediately loaned back to Clem Industrial and secured by a demand debenture in favour of the plaintiff against the assets of Clem Industrial. One month later, the plaintiff sold 49 of its Clem Industrial shares to an arm's-length party for one dollar a share. In deciding that subsection 55(2) had no application to the transactions, the Court relied on the evidence of the witnesses called by the plaintiff who testified that the payment of the dividend was unrelated to the subsequent sale by the plaintiff of its shares in Clem Industrial.

The Department considers that the decision in C.P.L. Holdings is based on its unique facts. In considering whether one of the purposes of a dividend was to significantly reduce the capital gain on the disposition of a share, the Department will examine all of the surrounding circumstances including the time elapsed between the payment of the dividend and the arm's-length sale. Ordinarily, if an arm's-length sale of shares occurs within a short time after a dividend was received on the shares, the Department will consider this to be strongly indicative that one of the purposes of the dividend was to reduce the capital gain that would otherwise have been realized on the share sale.

CREDITOR PROTECTION AND BUTTERFLY TRANSACTIONS

In a Technical Interpretation issued by Revenue Canada, the Department determined that subsection 55(2) of the Act would apply in circumstances where an asset was transferred from a corporation owned by A and B (unrelated persons) to a new corporation owned by the same shareholders in the same proportions. The fact situation set out in the Interpretation is as follows:

1. A and B are two unrelated individuals who each own 50% of OPCO.

2. A and B wish to transfer the land and buildings currently owned by Opco to another corporation to shield its assets from potential creditors.

3. A and B each purchase 50% of the common shares of Newco and each of them transfers an equal number of common shares in Opco to Newco in exchange for the common shares in Newco. The fair market value of the common shares in Opco that were transferred is equal to the fair market value of the land and buildings that were transferred.

4. Opco will transfer the land and buildings to Newco in exchange for preferred shares in Newco that have a redeemable value equal to the fair market value of the land and buildings. A rollover under subsection 85(1) of the Act will be carried out on the transfer.

5. OPCO will purchase and then cancel, at their fair market value, the common shares held by Newco in exchange for a note payable. Newco will then redeem at their fair market value all the preferred shares held by Opco in exchange for a note payable. The notes payable will then be set off.

The Department noted, however, that it does not regard subsection 55(2) of the Act as applicable when the shares in Opco are held through Holdco, which is owned equally by A and B. In such a situation, where the assets are segregated in Newco, which is a subsidiary of Holdco and a sister to Opco, the Department has indicated that the exception in paragraph 55(3)(a) could apply.

Question #1

Assume that A and B owned Opco directly and some time prior to the creditor protection transactions noted above, A and B transferred their shares to Holdco under section 85 of the Act. Holdco was also established for creditor protection purposes, as retained earnings (assume equal to safe income) are paid from Opco to Holdco in the form of a dividend on an annual basis. Would the exception in paragraph 55(3)(a) apply?

Response

Whether paragraph 55(3)(a) would apply to exempt the dividends arising on the purchase for cancellation of the Newco shares and the redemption of the Opco shares would depend on whether it could be considered that A and B acquired their interest in Holdco as part of the series of transactions that included the dividends. If the acquisition of A and B's interest in Holdco was part of the series, then paragraph 55(3)(a) would not provide relief from the application of subsection 55(2) because A and B are not related to Newco or Opco.

Question #2

If Mr. A and Mr. B held their interest in Opco directly and also owned an existing shell company ("Oldco") in the same proportions, and Opco transferred its land and buildings to Oldco would the exception in paragraph 55(3)(a) apply?

Response

Paragraph 55(3)(a) would not preclude the application of subsection 55(2) because as a result of the series of transactions there has been a significant increase in the value of the interest in Oldco of A and B - persons to whom the corporation receiving the dividend (Opco) is not related.

SECTION 112 STOP-LOSS AMENDMENTS

Question #1

The shares of Opco are held as follows:

Shareholder	ClassVotesFMVACBPUC
Mr. A	100 Class A common 50% $1,000,000nilnil
Mr. B	100 Class B
common 	50% 	$1,000,000nilnil

1.Mr. A and Mr. B deal with each other at arm's length.

2.Mr. A dies.

3.Opco holds $500,000 life insurance on Mr. A's life which is paid on Mr. A's death and added to Opco's capital dividend account. Opco's capital dividend account balance is then $500,000.

4.Opco either

(a)First Scenario

(i) first purchases 50 Class A common shares for cancellation from Mr. A's estate for $500,000 and files a capital dividend election for the full $500,000 deemed dividend, and

(ii) next purchases the remaining 50 Class A common shares for cancellation from Mr. A's estate giving rise to a $500,000 taxable dividend; or

(b)Second Scenario

(i) first pays a $500,000 capital dividend to Mr. A's estate on all 100 Class A common shares, and

(ii) next purchases all 100 Class A common shares for cancellation from Mr. A's estate for $500,000 giving rise to a $500,000 taxable dividend.

The estate's capital loss in each scenario appears to be as follows:

First Scenario$625,000
Second Scenario$750,000

Do you agree?

First Scenario

Purchase of First 50 Shares - capital dividend

capital loss500,000
s. 112(3.2) reduction*(375,000)
reduced loss125,000

* The subsection 112(3.2) reduction is:

		500,000 	-  capital dividend
		(125,000)	-  25% of capital gain on death on 50 Class A shares
		375,000 

Purchase of Second 50 Shares - taxable dividend

capital loss500,000
s. 112(3.2) reduction nil
loss500,000

Total Loss

	First 50 shares				125,000
	Second 50 shares				500,000
	Total						625,000 

Second Scenario

capital loss1,000,000
s. 112(3.2) reduction* (250,000)
reduced loss750,000

*The subsection 112(3.2) reduction is:

the lesser of

$500,000 (the capital dividend) and $1,000,000 (the loss otherwise determined)

minus

$250,000 (25% of the capital gain on death on 100 Class A shares)

Response

Yes. The Department of Finance has been made aware of this anomaly.

Question #2

1.A and B are both individuals.

2.A and B each owns 50% of the shares of Opco.

3.A, B and Opco entered into a unanimous shareholders agreement before April 27, 1995 (the "Shareholders Agreement") which provides, among other things, that Opco will purchase for cancellation all the shares of a deceased shareholder for fair market value at the date of death and that Opco will elect the resulting deemed dividend to be a capital dividend to the extent of life insurance proceeds received as a consequence of the shareholder's death.

4.The shareholders agreement also contains provisions as follows:

(a)requiring unanimous shareholder consent for certain corporate actions,

(b)shotgun buy-sell,

(c)providing that the agreement will be binding on all transferees of Opco shares.

5.Opco was not the beneficiary of any life insurance policy on April 26, 1995.

Which of the following post-April 26, 1995 changes would result in a loss of grandfathering and which would not?

(a)hange: Changes to or deletion of one or more of the provisions of the Shareholders Agreement other than the provision dealing with purchase for cancellation on death.

Disposition: Purchase for cancellation of A's shares by Opco on A's death.

(b)Changes: Changes to the price and/or payment terms that apply to a purchase for cancellation on death.

Disposition: Purchase for cancellation of A's shares by Opco on A's death.

(c)Change: Revision of all aspects of the Shareholders Agreement to reflect the addition of a third shareholder, C, so that the provisions of the agreement applicable to two 50% shareholders apply in a similar fashion to three 33_% shareholders.

Disposition: Purchase for cancellation of C's shares by Opco on C's death.

(d)Change: The sale by B of all B's shares to A.

Disposition: Purchase for cancellation of A's shares by Opco on A's death.

Response

(a) Generally, a material change to a written agreement will result in the agreement being considered to be a new agreement with the consequential loss of grandfathered status.

(b) The changes to price and or payment terms would be significant enough to result in loss of grandfathering status.

(c) The addition of a new shareholder would be significant enough to result in loss of grandfathering status.

(d) Since the disposition of B's shares is made pursuant to a written agreement entered into prior to April 27, 1995, the disposition of A's shares on his death would be grandfathered.

Question #3

The transitional rules with respect to the amendments to the stop-loss rules in section 112 provide grandfathering under paragraph 57(10)(b) of the June 20, 1996 Notice of Ways and Means Motion where:

(a) the taxpayer owned the relevant share (or a predecessor share) on April 26, 1995,

(b) a corporation was on April 26, 1995, the beneficiary of a life insurance policy on the life of the taxpayer or the taxpayer's spouse,

(c) it is reasonable to conclude, on April 26, 1995, that the proceeds of the life insurance policy were intended to be used directly or indirectly to fund, in whole or in part, the redemption, acquisition or cancellation of the relevant share (or a predecessor share), and

(d) the share is disposed of to the "particular corporation" pursuant to a written agreement entered into before 1997.

What factors will be considered in determining whether it is reasonable to conclude on April 26, 1995 that the proceeds of the life insurance proceeds were intended to be used, directly or indirectly, to fund in whole or in part the redemption, acquisition or cancellation of the share?

Response

As clause 10(b)(ii) of the coming-into-force provisions presently reads, all of the proceeds of the life insurance policy must be used to fund the redemption acquisition or cancellation of the share. The Department of Finance is currently considering whether it would be appropriate to allow the grandfathering provision to apply where it is reasonable to consider that the proceeds were primarily used to fund the redemption, acquisition or cancellation of the share.⁽²⁾

In applying the "reasonable to consider test", the circumstances surrounding the purchase of the life insurance would be relevant.

For example, if an agreement with a supplier or financial institution required life insurance be in place it would be reasonable to consider that the purpose of the life insurance was to ensure that indebtedness was repaid. Conversely, if insurance was put in place as part of an estate plan that would be a factor indicative of an intention to use the insurance proceeds to purchase shares. For example, the terms of a will could contemplate that life insurance proceeds be used to repurchase shares.

Question #4

The grandfathering rules with respect to the amendments to the stop-loss rules in section 112 provide grandfathering, in several circumstances, for a disposition of a share owned by the taxpayer on April 26, 1995. For this purpose, a share acquired in exchange for another share pursuant to a section 51 share conversion, a section 86 reorganization or a section 87 amalgamation is deemed to be the same share as the share exchanged.

How are grandfathered shares to be distinguished from non-grandfathered shares where the section 86 or section 87 transaction consolidates grandfathered and non-grandfathered shares? For example, A, an individual, owns all the shares of XCo on April 26, 1995, acquires all the shares of YCo in 1996 and then amalgamates XCo and YCo so that he holds 100 common shares of Amalco.

Response

We are presently consulting with the Department of Finance regarding the application of the grandfathering rules in this situation.

PURCHASE AND SALE OF COMPUTER SOFTWARE

Question #1

Where a taxpayer has purchased software for use in its business, the Department will allow a current deduction for the purchase if the software does not provide an enduring benefit. Given the rapid pace of change in the software industry, in many circumstances it is difficult to determine whether or not purchased computer software has an anticipated life beyond one year. Where a taxpayer acquires software with an initial payment, but is required to pay for annual updates, which provide additional features and enhancements, do the payments for the annual updates qualify as a current expense?

Response

As indicated in paragraph 10 of Interpretation Bulletin IT-283R2, in the case of computer software that has been acquired primarily for use in the taxpayer's business, its nature, purpose and anticipated life should be considered in determining whether the acquisition cost should be written off in the year the cost was incurred or, because the software is of an enduring nature, capitalized. For these purposes, software is considered to be of an enduring nature where its useful life is anticipated to last beyond one year. Although the estimated useful life of property is a question of fact, in our view, the fact that particular software may be upgraded regularly would indicate that its useful life will last beyond one year. Accordingly, annual upgrade fees incurred for computer software would in most cases be included in the capital cost of the property. In this regard, paragraph 8 of Interpretation Bulletin IT-285R2 states that the capital cost of property generally means the full cost to the taxpayer of acquiring the property.

Question #2

If a taxpayer develops computer software for use in the taxpayer's business (not for resale), using internal resources, and the expenditures do not qualify as Scientific Research & Development Expenditures ("SR&ED"), does the taxpayer have to capitalize these costs or can these costs be deducted on a current basis?

Response

Where computer software has been developed for use in the taxpayer's business, its nature, purpose and anticipated life should be considered in determining whether the development costs should be written off in the year they were incurred or, because the software is of an enduring nature, capitalized. As indicated in paragraph 10 of Interpretation Bulletin IT-283R2, software is considered to be of an enduring nature where its useful life is anticipated to last beyond one year.

The nature of the development costs that could be capitalized would, in keeping with the comments set out in paragraph 8 of Interpretation Bulletin IT-285R2, include such items as material, labour and overhead costs reasonably attributable to the software, but nothing in respect of profit which might have been earned had the software been sold.

Question #3

If the taxpayer is in the business of making and selling software how should the taxpayer treat all costs related to the development of a custom software program for a single customer where the entire interest in that program will be sold to that customer?

Response

As indicated in paragraph 13 of Interpretation Bulletin IT-283R2, ordinarily, a taxpayer in the business of producing and marketing software for sale should, except where section 37 (scientific research and experimental development) applies, include in inventory development and software production costs that are related to work in progress and completed software programs that are on hand at the end of a fiscal period.

Question#4

If a taxpayer develops software that will be licensed or sold to many customers how should such costs be treated assuming they do not qualify as SR&ED expenditures?

Response

Whether the costs are incurred to develop custom software for one client or software that will be sold to many customers, as indicated in the question above, the costs should be included in inventory.

Where the software developed will be licensed, as opposed to sold, to customers, the costs of developing the software should be capitalized as being costs incurred to acquire proprietary application software. As such, the costs would be included in the appropriate class in Schedule II of the Income Tax Regulations.

Question #5

Assume Ms. A incorporates a company ("Newco") to develop and ultimately sell a software program. The software program takes two years to develop and all development costs qualify as SR&ED expenditures. The only revenue of Newco during the two year development period is some miscellaneous consulting revenue. After the software is developed, all rights to the software are sold to an unrelated purchaser that will commercially exploit the product. After the sale of the software, Newco no longer continues to carry on an active business. Are the sale proceeds received by Newco on account of capital? Is the answer different if Newco continues to develop and sell software programs?

Response

Whether the outright sale of computer software where the software is the only or main asset of the business would be treated as an income or capital receipt is a question of fact which can only be resolved after analysing all of the facts of a particular situation. However, where, as in the situation described above, the development costs of computer software were claimed as SR&ED expenditures under paragraph 37(1)(b) of the Act, the proceeds of disposition in respect of the software would be on account of income as recaptured capital expenditures under subsection 37(6) of the Act, regardless of whether the company ceased to carry on business or continued to develop and sell computer software.

ENDNOTES

^_1. John R. Robertson,"Capital Gains Strips: A Revenue Canada Perspective", Report of Proceedings of the Thirty Third Tax Conference, Canadian Tax Foundation, p. 81 at page 85.

^2. This change is reflected in subparagraph 57(10)(b)(ii) of Bill C-69 which was given first reading in the House of Commons on December 2, 1996.