21 July 1998 External T.I. 9808565 - NO GRACE YR IN DETERMINING WHETHER INSUFF DIVIDEND

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 a grace year exists for 110.6(8) and if so, whether it applies when shares are issued in exchange for other shares (either prescribed or not and as part of a rollover or not)

Position: the definition of aveage annual rate of return does not create a grace year but one would normally expect that the lack of dividends in the part year following the issuance of the shares would not result in an increase in the capital gain on the ultimate disposition of those shares

Reasons: the average annual rate of return be paid each and every year in order for 110.6(8) to have no application whatsoever. normally, the lack of dividends in the first part year should not cause 110.6(8) to apply. However at the 92 CGA conference, we noted that the annual rate of return of the original shares is significant in determining the amount that a knowledgeable and prudent investor would expect from an investment in the exchanged shares. Similarly a knowledgable and prudent investor would not expect to lose a year's worth of dividends just because the shares were exchanged for new shares

XXXXXXXXXX 980856
A. Humenuk

Attention: XXXXXXXXXX

July 21, 1998

Dear Sir:

Re: The Determination of the Average Annual Rate of Return on
Certain Shares for the Purpose of the Capital Gains Exemption

This is in reply to your letter of April 1, 1998, concerning the definition in subsection 110.6(9) of the Income Tax Act (the "Act") of an “average annual rate of return” on a corporate share other than a prescribed share. You have raised certain questions about the expression: “other than the first year after the issue,” in this provision.

Subsection 110.6(8) of the Act is designed to prevent the conversion of dividend income into exempt capital gains of individuals in those cases where it is reasonable to conclude that, having regard to all the circumstances, a significant part of a capital gain is attributable to the fact that either dividends were not paid on a share (other than a prescribed share) of the capital stock of a corporation, or that dividends paid on such a share were less than 90% of the average annual rate of return thereon. Subsection 110.6(9) of the Act defines an average annual rate of return for a taxation year as:

“the annual rate of return by way of dividends that a knowledgeable and prudent investor who purchased the share on the day it was issued would expect to receive in that year, other than the first year after the issue, in respect of the share if:

(a) there was no delay or postponement of the payment of dividends and no failure to pay dividends in respect of the share;

(b) there was no variation from year to year in the amount of dividends payable in respect of the share (other than where the amount of dividends payable is expressed as an invariant percentage of or by reference to an invariant difference between the dividend expressed as a rate of interest and a generally quoted market interest rate); and

(c) the proceeds to be received by the investor on the disposition of the share are the same amount the corporation received as consideration on the issue of the share.”

It is your view that the reference in subsection 110.6(9) of the Act to “the first year after the issue” of a share provides a grace year in which subsection 110.6(8) will not apply even if the requisite amount of dividends is not paid in that year. You have asked whether this grace year will apply when the non-prescribed shares are issued in exchange for other shares of the same corporation. You also ask whether the application of the grace year to such a share is dependent on whether the original shares are prescribed shares or not, or on whether the exchanged shares are issued as part of a rollover transaction.

In our view, the reference in subsection 110.6(9) to “the first year after the issue” of a share does not create a grace year in which dividends need not be paid in order to avoid the application of subsection 110.6(8) of the Act. The “year” referred to in subsection 110.6(9) is the taxation year of the corporation which issued the shares and the “first year after the issue” is the portion of the taxation year in which the shares were issued that follows the issuance of the shares. The phrase "the fact that dividends were not paid on a share (other than a prescribed share) of a corporation or that dividends paid on such a share in the year or in any preceding taxation year were less than 90% of the average annual rate of return thereon for that year," as it appears in subsection 110.6(8) of the Act, means that if the requisite amount of dividends is not paid on all the outstanding non-prescribed shares in each and every year during the applicable period (generally the period throughout which the particular individual or a related person owns the property that is the subject of the disposition), subsection 110.6(8) may apply. On the other hand, the fact that a dividend is not paid in a particular year does not, in and of itself, mean that subsection 110.6(8) automatically applies to deny the capital gains deduction.

In defining an “average annual rate of return” for a share, the law recognizes that the expectation of return for the first year of issue may not be the same as for other years. The first taxation year after the issue of a share will be less than 12 months long if the share is issued after the beginning of a taxation year. Accordingly, it is reasonable to expect that the amount of dividends received in that taxation year may not be representative of an annual rate of return. For example, if a corporate share was issued on December 1, and the taxation year ended December 31, the dividend expectation for that year may not be the same as for the years following the issuance of the share. Accordingly, the “average annual rate of return” as determined by subsection 110.6(9) of the Act, is based on the expectations for years subsequent to the issue of the share and not on the year in which the share was issued.

As stated at the 1992 CGA Round Table, it is our view that 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 the share was acquired, is a question of fact. The expectations of a knowledgeable and prudent investor must be determined on the assumption that there will be no delay or postponement in the payment of dividends, no failure to pay dividends, the dividends will be paid each year at a predetermined rate, either fixed or variable and the share will be eventually sold for an amount equal to the amount received by the corporation when the share was issued. We are of the opinion that the average annual rate of return on the original shares is a factor to be taken into account in determining the average annual rate of return of the exchanged shares and that the average annual return is usually calculated on the basis of the amount invested by a knowledgeable and prudent investor who purchased the share on the day it was issued. Since the determination of whether a capital gain realized on the disposition of property is attributable to the lack of dividends on a non-prescribed share is based on all the surrounding circumstances, the fact that a non-prescribed share is issued in exchange for another share, prescribed or not, and whether or not it is issued as part of a rollover transaction, is relevant in determining whether subsection 110.6(8) of the Act applies to a particular capital gain.

We trust that these comments will be of assistance.

Yours truly,

J.F. Oulton, CA
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch