5 December 1996 Roundtable Q. 2, 9639160 - APPLICATION OF 85(1)(E.2)

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.

Revenue Canada Roundtable
Tax Executives Institute
1996 Annual Conference

XXIV. PARAGRAPH 85(1)(e.2)ISSUES

Consider the following situation. Company A owns 75 percent of the issued and outstanding share capital of Company B and 80 percent of the issued and outstanding share capital of Company C. Company C owns the remaining 25 percent of the share capital of Company B. Company B owns the remaining 20 percent of the issued and outstanding share capital of Company C.

Company A transfers to Company B a capital property in exchange for preferred shares of Company. The fair market value of the capital property of $1 million significantly exceeds the adjusted cost base of $100. Company A and B intend that the property be transferred at fair market value. Hence, a valuation of Company B is undertaken to determine the proper number of shares to issue to A in the exchange. Moreover, the asset transfer agreement between A and B includes a provision requiring an adjustment of the value of shares to be issued to A should the fair value of the contributed property vary significantly (up or down) from the appraised value determined by A and B. Company A and B jointly elect to have the provisions of subsection 85(1) of the Act apply to the transfer. The agreed amount of the joint election is the adjusted cost base of the property at the time of the transfer.

Please comment on the following questions concerning the transaction:

1.Does Revenue Canada consider Company B to be a "wholly owned corporation" of Company A so that paragraph 85(1)(e.2) will not apply?

2.If Company B is not considered a "wholly owned corporation" within the meaning of subsection 85(1.3) and Revenue Canada subsequently determines that the preferred shares of Company B issued on the initial transfer of the property had insufficient value, would Revenue Canada consider that a benefit has not been conferred on a related person (as contemplated in paragraph 85(1)(e.2)) solely on the basis of the companies' intentions in undertaking the transaction?

3.If the answer to question 2 is no, could the taxable transaction be remedied by Company B adjusting the value of the shares issued to A pursuant to the price adjustment clause in the asset transfer agreement?

Department's Response

1.In order for Company B to be a wholly owned corporation of Company A all the shares of Company B must be held by Company A or a wholly owned corporation of Company A. Accordingly, unless Company C, which owns 25% of the shares of Company B, is a wholly owned corporation of Company A, Company B will not be a wholly owned corporation with respect to Company A. In turn, Company C will not be a wholly owned corporation of Company A unless Company B, which owns 20% of Company C is a wholly owned corporation of Company A. Since both of Company C's and B's status as wholly owned corporations with respect to Company A depends on whether each is a wholly owned corporation with respect to Company A, a circular analysis ensues. In our view, since, because of this circularity, it cannot be conclusively determined that Company C is a wholly owned corporation with respect to Company A, Company B is not a wholly owned corporation with respect to Company A.

2.Whether a taxpayer desires to confer a benefit on a related party is a question of fact that can be determined only after consideration of all the facts and circumstances. Generally, where the facts show that the parties to the transaction intended to transfer the property at its fair market value and their efforts to establish that value are based on a fair and reasonable method the Department will not consider that a taxpayer desired to confer a benefit. The existence of a price adjustment clause, in and of itself, will not be enough to negate the conclusion that a benefit was desired to be conferred.

3.As set out in paragraph 26 of IC76-19R3, the Department will accept the operation of a price adjustment clause in the context of a transaction subject to section 85 of the Act where the conditions set out in IT-169 are complied with and where an amended election is filed pursuant to subsection 85(7.1). IT-169 sets out a number of criteria which must be met before the Department will recognize a price adjustment clause including the requirement that the method for valuing the property be fair and reasonable and the requirement that the Department be notified, by way of a letter attached to the tax return of each of the parties to the transaction, of the existence of the price adjustment clause.

D.A. Palamar
File #963916
5/12/96