20 October 1998 External T.I. 9818705 - CAPITAL GAINS DEDUCTION

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: The taxpayer has been the sole shareholder of Holdco since Holdco was incorporated. Soon after its incorporation, Holdco acquired at fair market value from an arm’s length party, all of the issued shares of an ongoing corporation, Opco. The shares of Opco that were acquired by Holdco were comprised of both common shares and fixed value preferred shares bearing non-cumulative dividends of Opco. The Holdco common shares and the Opco common shares are prescribed shares but the Opco preferred shares are not prescribed shares. Holdco has owned no assets other than Opco shares. Opco has not paid any dividends on its preferred shares.

Does subsection 110.6(8) apply to deny the capital gains exemption in respect of a taxpayer’s capital gain on a disposition of shares of Holdco.

Position: Question of fact but likely subsection 110.6(8) will not apply.

Reasons: See files # 5M08340, 58311, 9225415, 941399, 9816165, 9700935, 931860, 9306161, 9309051, and 9309041.

XXXXXXXXXX 5-981870
G. Moore
October 20, 1998

Dear XXXXXXXXXX:

Re: Subsection 110.6(8) of the Income Tax Act

I am replying to your letter of July 20, 1998, in which you requested our comments regarding subsection 110.6(8) of the Income Tax Act (the “Act”).

You have asked for our comments regarding the application of subsection 110.6(8) of the Act in the following hypothetical situation:

The taxpayer has been the sole shareholder of Holdco since Holdco was incorporated. Soon after its incorporation, Holdco acquired at fair market value from an arm’s length party, all of the issued shares of an ongoing corporation, Opco. The shares of Opco that were acquired by Holdco were comprised of both common shares and fixed value preferred shares bearing non-cumulative dividend entitlements. The Holdco common shares and the Opco common shares are prescribed shares but the Opco preferred shares are not prescribed shares. Holdco has owned no assets other than Opco shares. Opco has not paid any dividends on its preferred shares. The taxpayer sells his common shares in Holdco and realizes a capital gain which, subject to subsection 110.6(8) of the Act, would be eligible for the capital gains deduction.

It is your opinion that even though the unrealized gain on the Opco common shares might be considered to be attributable to the failure to pay dividends on the Opco preferred shares, that should not affect the applicability of subsection 110.6(8) of the Act to the taxpayer’s disposition of the Holdco common shares. Your reasoning that subsection 110.6(8) of the Act should not apply is that even if Opco had paid to Holdco dividends on its preferred shares, those dividends would have formed part of Holdco’s equity in any event.

Our Comments

Subsections 110.6(8) and (9) of the Act are anti-avoidance rules enacted to prevent the conversion of dividend income into exempt capital gains of individuals. Subsection 110.6(8) of the Act applies to deny a capital gain deduction where a significant part of the capital gain is attributable to 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 a year or in a preceding taxation year were less than 90% of the average annual rate of return thereon for that year.

Whether it can reasonably be concluded that a significant part of a capital gain is attributable to the non-payment of dividends is a question of fact which can only be determined upon a complete review of all of the relevant circumstances surrounding a particular capital gain. However, as stated in Question 2.3 of the 1994 APFF (Association de planification fiscale et financière), the Department would not usually apply subsection 110.6(8) of the Act to a capital gain arising from the disposition of prescribed shares where the shareholder disposing of the shares of an active corporation carrying on a small business has always been the sole shareholder of the corporation. The Department’s position will generally stand whether the sole shareholder held all the shares of the active corporation directly or through a holding corporation.

In the situation you have described, we would generally expect, for the reason you provided above, that it would not be reasonable to consider that a significant part of the capital gain realized on the disposition of Holdco shares is attributable to the fact that dividends were not paid on the Opco preferred shares. In other words, the gain on the Holdco shares will be attributable to both retained earnings and unrealized gains on underlying assets of Holdco. The failure by Opco to pay dividends on its preferred shares would increase the unrealized gain on the Opco common shares but at the same time, reduce what would have been Holdco’s retained earnings, thus having a nil effect on the value of the Holdco common shares.

As the application of subsection 110.6(8) of the Act can only be determined once we have reviewed all the facts, and because subsection 110.6(8) is worded very broadly, we would encourage a request for an advance income tax ruling should this hypothetical situation ever become a proposed transaction. The above comments are not binding on the Department.

I trust our comments will be of assistance to you.

Yours truly,

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