29 July 1997 Internal T.I. 9702107 - QSBCS - EMPLOYEE SHARE PURCHASE AGRREEMENT

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 the shares of a corporation that are owned by employees would be prescribed shares for the purposes of subsection 110.6(8).

Position:

Question of fact to be determined in accordance with the rules in section 6205 of the Regulations. In this case, they do not appear to be prescribed shares, since the exceptions provided in paragraphs 6205(4)(d) and (f) do not apply.

Reasons:

Absence of an employee share purchase agreement and no written shareholder agreement.

		July 29, 1997

	Vancouver Tax Services Office	HEADQUARTERS
	Business Enquiries	B. Kerr
(613) 957-2139
	Attention: Brian Kennedy
		970210

Income Tax Regulation 6205 - Prescribed Shares

This is in response to your memorandum of January 21, 1997, concerning paragraphs 6205(4)(d) and (f) of the Income Tax Regulations (the "Regulations") as they relate to subsection 110.6(8) of the Income Tax Act (the "Act").

The situation described in the letter attached to your memorandum involves a small business corporation that was incorporated prior to 1985. The corporation is employee-owned, in that the acquisition of shares is restricted to employees and no shareholder is permitted to own more than one share. The corporation has only one class of share capital. The rights attached to the shares include the right to employment with the corporation. The articles of the corporation provide that the corporation may purchase or redeem its shares by a resolution of the directors. The maximum number of shares that may be purchased in any year must be set by a special resolution of the shareholders. Transfer of shares are generally arranged between the parties after the satisfactory completion of a probationary period on the job. The shares trade at a significant premium to the original issue price. The company has not paid dividends for six years and has a significant amount of retained earnings on hand. There are no written shareholder agreements or separate employee share purchase agreements in existence.

You have been asked if the Department would apply the provisions of subsection 110.6(8) of the Act to deny the capital gains deduction in respect of the disposition of these qualified small business corporation shares. In your view, the shares would not be considered to be prescribed shares within the meaning of section 6205 of the Regulations, and therefore subsection 110.6(8) of the Act would apply.

Our Comments

Subsection 110.6(8) of the Act is an anti-avoidance rule enacted to prevent the conversion of dividend income into exempt capital gains. Subsection 110.6(8) of the Act will apply 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 a prescribed amount.

Whether a particular share is a prescribed share is a question of fact to be determined in accordance with the rules in section 6205 of the Regulations. Generally, where a corporation has the right or obligation to redeem, acquire or cancel its shares, the shares would not be "prescribed shares" by virtue of clause 6205(1)(a)(i)(G) of the Regulations. However, paragraphs 6205(4)(d) and (f) of the Regulations provide exceptions to this rule.

Paragraph 6205(4)(d) provides that the reference in clause 6205(1)(a)(ii)(G) of the Regulations to a right or obligation to redeem, acquire or cancel shares does not include such a right or obligation provided in a written agreement among shareholders of a private corporation owning more than 50% of its issued and outstanding share capital. In our view, the absence of a "written agreement" between the shareholders would make this provision inapplicable in your particular situation.

Paragraph 6205(4)(f) provides that the determination of whether a share is a prescribed share shall be made without reference to a right or obligation to redeem, acquire or cancel the share or to cause the share to be redeemed, acquired or cancelled where: (1) the share was issued pursuant to an employee share purchase agreement to an employee (the "holder") of the corporation, (2) the holder was dealing at arm's length with the corporation at the time the share was issued, and (3) having regard to all the circumstances including the terms of the agreement, it may reasonably be considered that the amount payable on the redemption, acquisition or cancellation (the "acquisition") of the share will not exceed the adjusted cost base to the holder, where the acquisition was provided for in the agreement and the principal purpose for its provision was to protect the holder against any loss, or the fair market value of the share, where the acquisition was provided for in the agreement and the principal purpose for its provision was to provide the holder with a market for the share.

In our view, a share issued pursuant to an employee share purchase agreement is a share acquired by an employee under a plan, trust or program of the employer that provides for the acquisition of shares by employees. Although the employee share purchase agreement may be set out in a corporation's articles of incorporation, in our opinion, a statement in the articles to the effect that all shareholders must be employees would not constitute such an agreement. Furthermore, it does not appear that the Articles indicate the purpose of the provision regarding the acquisition or redemption of the shares. Accordingly, it is unlikely that the conditions of paragraph 6205(4)(f) of the Regulations would be met.

You should note, however, that the fact that the shares of a corporation do not qualify as prescribed shares does not, in and by itself, cause subsection 110.6(8) of the Act to apply to deny the capital gains deduction in respect of a gain realized on those shares. As we indicated above, all the circumstances of a particular situation must be considered in determining whether a significant part of a capital gain is attributable to insufficient dividends. In order to make such a determination, it may be necessary to obtain additional facts and information, however, your office is in a better position to obtain that information.

C. Chouinard
for Director
Business and General Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch