29 September 1998 External T.I. 9814245 - QSBC - SUBSTITUTED SHARES

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:

Individual transfers shares of a QSBC (the “transferred shares”) to a newly formed corporation under subsection 85(1), in exchange for shares of the new corporation (the “new shares”) having a FMV equal to the FMV of the transferred shares. The agreed amount with respect to the subsection 85(1) transfer equalled the adjusted cost base of the transferred shares, which was significantly less than their FMV. The new shares will be sold, within 24 months of issue, resulting in a capital gain.

1. Do the new shares fall within the ambit of subparagraph 110.6(14)(f)(i)?

2. Will the capital gains exemption be denied by virtue of paragraph 110.6(7)(b)?

Position TAKEN:

1. Based on the limited information provided, yes. While, as a result, the individual may not be required, for purposes of the definition of “qualified small business corporation share”, to own the new shares throughout the 24-month period immediately preceding their disposition, the new shares will, nonetheless, generally not meet this definition, by virtue of paragraph (e) of the definition, if the transferred shares did not meet the ownership and asset tests of the definition, for that part of the said 24-month period ending at the time of substitution (i.e., at the time of transfer, in this particular case).

2. No.

Reasons FOR POSITION TAKEN:

1. The new shares were issued by the new corporation as consideration for the transferred shares, as part of the subsection 85(1) transfer of the transferred shares.

2. The term “consideration” as used in paragraph 110.6(7)(b) of the Act does not mean the agreed amount referred to in subsection 85(1). In this particular situation, the FMV of the consideration received by the individual (i.e., the FMV of the new shares) equalled the FMV of the property acquired by the new corporation (i.e., the FMV of the transferred shares).

XXXXXXXXXX 				5-981424
M. Azzi
September 29, 1998

Dear Sir:

Re: Capital Gains Exemption - Substituted Shares

This is in reply to your letter of May 22, 1998, wherein you requested our views on the application of subparagraph 110.6(14)(f)(i) and paragraph 110.6(7)(b) of the Income Tax Act (the “Act”).

We understand that an individual who owned all the shares of an operating corporation, which met the definition of “qualified small business corporation share” in subsection 110.6(1) of the Act, transferred the shares (the “transferred shares”) to a newly formed corporation under subsection 85(1) of the Act, in exchange for shares of the new corporation (the “new shares”) having a fair market value (“FMV”) equal to the FMV of the transferred shares. The agreed amount with respect to the subsection 85(1) transfer equalled the adjusted cost base of the transferred shares, which was significantly less than their FMV. No other consideration was received by the individual in respect of the transfer, and the individual is the sole shareholder of the new corporation. You indicate that the new shares will be sold, within 24 months of issue, to an arm’s length purchaser at FMV, resulting in a capital gain to the individual. In establishing whether this gain will qualify for the capital gains exemption in respect of qualified small business corporation shares, you enquire whether the new shares will be exempt from the application of paragraph 110.6(14)(f) of the Act, by virtue of the exception contained in subparagraph 110.6(14)(f)(i) of the Act. You also enquire whether the capital gains exemption would be denied by virtue of paragraph 110.6(7)(b) of the Act because the agreed amount was less than the FMV of the transferred shares, even though the total consideration received by the individual was equal to that FMV.

Our Comments

Written confirmation of the tax implications inherent in particular transactions is given by this directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular 70-6R3, dated December 30, 1996. Where the particular transactions are completed, the enquiry should be addressed to the relevant tax services office. However, we are prepared to offer the following comments which are not binding on the Department.

The determination of whether a particular share meets the definition of “qualified small business corporation share” in subsection 110.6(1) of the Act is a question of fact which can only be established after a review of all relevant facts of each particular case. We are therefore not in position to comment on whether the transferred shares or the new shares met, at any time, the definition of “qualified small business corporation share”. However, based on the limited information provided, it appears that the new shares would fall within the ambit of subparagraph 110.6(14)(f)(i) of the Act, provided they were in fact issued to the individual as consideration for the transferred shares. Consequently, the new shares would not be deemed to have been owned, immediately before their issue, by a person not related to the individual. While, as a result, the individual may not be required, for purposes of the definition of “qualified small business corporation share”, to own the new shares throughout the 24-month period immediately preceding their disposition, the new shares will, nonetheless, generally not meet this definition, by virtue of paragraph (e) of the definition, if the transferred shares did not meet the ownership and asset tests of the definition, for that part of the said 24-month period ending at the time of substitution (i.e., at the time of transfer, in this particular case). Consequently, in general terms, in the above circumstances, in order for the new shares to meet the definition of “qualified small business corporation share”, throughout the 24-month period immediately preceding their disposition, the individual must, inter alia, first have owned the transferred shares up to the time of transfer, then the new shares up to their disposition.

As a general rule, paragraph 110.6(7)(b) of the Act denies a capital gains exemption where property is disposed of as part of a series of transactions or events in which any property is acquired by a corporation for consideration that is significantly less than the FMV of the property at the time of acquisition. In our view, the term “consideration” as used in paragraph 110.6(7)(b) of the Act does not mean the agreed amount referred to in subsection 85(1) of the Act. Accordingly, in the above described situation, the fact that the agreed amount may be less than the FMV of the transferred shares, would not, in and by itself, trigger the application of paragraph 110.6(7)(b) of the Act. Since the FMV of the consideration received by the individual (i.e., the FMV of the new shares) equalled the FMV of the property acquired by the new corporation (i.e., the FMV of the transferred shares), in our view, paragraph 110.6(7)(b) should not apply to the above described transactions.

We trust that these comments will be of assistance.

Jim Wilson
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch