11 September 1989 Income Tax Severed Letter AC58075 - Capital Gains Deduction - Insufficient Dividend Test

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.

5-8075
19(1)                                        Claude Tremblay
                                             (613) 957-2095
Dear Sirs:

Re: Subsections 110.6(8) and (9) of the Income Tax Act (the "Act")

This is in reply to your letter of Hay 10, 1989, requesting our opinion and interpretation in relation to the application of subsection 110.6(8) and 110.6(9) of the Act in the hypothetical fact situation you describe.

Hypothetical Facts

1. X Co. is a Canadian-controlled private corporation, within the meaning of paragraph 125(7)(b) of the Act incorporated under the laws of Ontario on February 11,1975.

2. At the inception of its incorporation in 1975, X Co.'s share capital consisted of one class of 100 common shares owned 51% by F and 49% by A. F is the father of A. The common shares had nominal adjusted cost base and paid-up capital.

3. On March 29,1979, X Co. amended its Articles of Incorporation, and under subsection 86(1) of the Act, exchanged the previously issued 100 common shares for 10,000 new special shares. The special shares were voting shares with total par value of $100 and a preferred non-cumulative dividend at $1.60 per share. They are redeemable by the company, at the option of the holders, at a fixed amount equal to the fair market value as at March 29, 1979 of the 100 common shares exchanged for them. The market value of the cancelled 100 common shares was determined to be $199,665 and, therefore, the special shares have a redemption value of $19.97 per share.

150 new common shares were issued equally to F, A and B, where B is the son of F and the brother of A. The new common shares have nominal adjusted cost base and paid-up capital. The shareholding structure, after the exchange and issue of new common shares, was as follows:

                                           Number of Shares

                              Special              Common 

     F                         5,100                  50
     A                         4,900                  50
     C                                                50
                              10.000                 150

4. In 1984, F took advantage of the now-repealed subsection 73(5) election and transferred his 5,100 special shares and 50 common shares to A and 8. Form T2211 was filed at that time to defer most of the capital gains as permitted under subsection 73(5) of the Act.

The shareholding structure, after the transfer, has not changed since then and is as follows:

                                        Number of Shares

                         Special              Common

     A                    5,000                  76
     B                    5.000                  74
                         10.000                 150

Both the special shares and the common shares have nominal adjusted cost base.

5. Dividends were paid only once on the special shares for the taxation year ended January 2, 1986. No dividends were paid on the special shares in any other taxation year. Dividends were paid on common shares for the taxation years ending in 1980 to 1986.

With these hypothetical facts in mind, we have provided comments to your questions in the same order as you have posed them.

Question 1

There is no special distinction in Regulation 6205 for shares issued prior to the introduction of the capital gains exemption for the purposes of defining prescribed shares. Does the provision 110.6(8) apply "retroactively" to pre-1985 shares which were issued using provisions of the Income Tax Act at that time?

Our Comments

In order to be eligible for the capital gain exemption, an individual must comply with the provisions of section 110.6 which includes 110.6(8). These statutory provisions apply at any time an individual wishes to avail himself of the deduction, thus a share is or is not a prescribed share regardless of the issue date; the characteristics of the share will determine whether it is prescribed or not. The relevant date is the one where the individual has a capital gain from a disposition. In that taxation year, he must comply with all of subsection 110.6(8) which specifies that where a significant part of the capital gain is attributable to the fact that dividends were not paid on a share in the year (other than prescribed shares) 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 thereof for that year, no amount of that capital gain shall be deducted under section 110.6 in computing his taxable income for the year.

Question 2

What constitutes a "significant part" of a capital gain attributable to inadequate dividends? Does the circumstance chat the dividend entitlement attached to the special shares is non-cumulative affect the "average annual rate of return" on the special shares? You have asked for our comments as to a practical and acceptable way of determining a "significant part" of a capital gain attributable to inadequate dividends.

Our Comments

It is our position that the question of whether or not a significant portion of a capital gain is attributable to the fact that dividends were not paid on a share (other than a prescribed share), or that dividends paid on such a share in the year or in any preceding year were less than 90% of the average annual rate of return thereon for that year, is a question of fact which must be decided in each particular case having regard, as subsection 110.6(8) states, to all the circumstances.

The average annual rate of return on a share for a year is based on an objective standard, that is, the rate of return that a knowledgeable and prudent investor would expect to receive based on certain assumptions. By virtue of these assumptions, any delay, postponement or variation in the amount of dividends is generally ignored. Also ignored are any proceeds the investor might expect on the redemption or disposition of the share that differs from the original issue price. Consequently, the circumstance that the special shares have non-cumulative dividends would not affect the "average annual rate of return" on the special shares.

Question 3

In your view, the. special shares in question do not qualify as prescribed shares under section 6205 of the..Regulations. The dividend rate subscribed to the special shares is 8%. Would Revenue Canada accept the 8% dividend rate as reasonable because this was the rate of return the shareholders expected on the date of issue?

Our Comments

It is our opinion that the average annual rate of return is a -constructed yield based on market yields prevailing on the date the share was issued. Thus if a "knowledgeable and prudent investor" who purchased the share on the date it was originally issued would expect to receive that rate of dividends, the dividend rate would be considered reasonable. The expectation of the knowledgeable and prudent investor is based on the assumption there is no delay or postponement or failure to pay the dividends , that dividends are paid each year at the previously set fixed or floating rate and that the share will ultimately be sold at its original issue price. This is an objective test, rather than a test based on the subjective expectations of the actual shareholders.

Question 4

Where dividends are not paid on the special shares in each and every year, would Revenue Canada allow a catch-up dividend to be paid in one year to relieve the application of subsection 110.6(8)? If so allowed, would Revenue Canada require interest to be compounded on unpaid dividends of the prior years to determine the size of the catch-up dividends?

Our Comments

In our opinion, where at least one dividend was paid on a particular share after the date where property sold was originally acquired (the starting date) or at some earlier date (where the property was acquired in a non-arm's length or tax deferred transaction), the determination of whether sufficient dividends were paid on that share requires a separate calculation for each year, or part of a year during the relevant period. The relevant period consists of the starting date mentioned above and the ending date which is the date the property is sold.

Since the analysis of dividends paid is based on considering the tests in subsection 110.6(8) each and every year, a catch-up dividend to be paid in one year would, in our opinion, not relieve the application of subsection 110.6(8).

Question 5

Subsection 110.6(8) also requires that the dividends paid were not less than 90% of the average annual rate of return. You seek our opinion that, if Revenue Canada accepts the 8% dividend rate as a reasonable rate of return for the special shares in question, would the acceptable dividend payment be 90% of the 8% for the special shares?

Our Comments

If the "average annual rate of return" expected in the year of issue was 8%, a dividend payment of 90% of the 8% for the special shares would be considered acceptable.

Question 6

It appears that the definition "average annual rate of return" under 110.6(9) excludes the dividends which may be received in "the first year after issue". You are not clear whether this refers to the first full taxation year after the year of issue, the balance of the year in which the share was issued or one full year commencing with the day after the issuance. You seek our clarification.

Our Comments

It is our opinion that the analysis of dividends paid in each year is based on the taxation year of the individual claiming the exemption, which will generally be the calendar year or a portion thereof. Thus the exclusion in subsection 110.6(9) refers to the first calendar year or portion thereof. It is our view that the rate is zero for that year or portion thereof.

Question 7

Paragraph 110.6(9)(c) requires, for the definition of the average rate of return, the proceeds to be received by the shareholder on the disposition of the share to be the same amount the corporation received as consideration on the issue of the share. The special shares in question were issued by the corporation for a nominal amount. They, however have an aggregate redemption value of $199,665.

You question whether this fact would cause 110.6(9) to be inapplicable to your special client situation and if so what would be an alternative definition of an average annual rate of return for the special shares? Would your suggestion of an 8% dividend rate described above be considered reasonable in the circumstances?

Our Comments

The fact that the special shares were issued for nominal consideration and have an aggregate redemption value of $ 199,665 does not mean that subsection 110.6(9) does not apply. The paragraphs in subsection 110.6(9) are assumptions to be made in calculating an average annual rate of return for purposes of subsection 110.6(8), not conditions to be met before the subsection has application.

Question 8

The special shares in question have a fixed redemption value. As you have outlined previously, dividends have been paid only once on the special shares. You advise that deemed dividends will result in deemed dividends taxable in the hands of the shareholders. The deemed dividends may or may not be large enough to cover the unpaid dividends. If the shareholders choose to redeem these special shares prior to the sale of their common shares without catching up any unpaid dividends on the special shares, you ask if they will be allowed the capital gains deduction for the resulting gains on the common shares?

Our Comments

Yes, provided the common shares are prescribed shares. In the hypothetical example given, it appears that the common shares may be prescribed shares.

question 9

If the shareholders sell the special shares to an arm's length party, you ask if they would be allowed the capital gain deduction for the sale of the special shares even though inadequate dividends may have been paid on the shares in the prior years? You advise that the special shares have a fixed redemption value and, therefore their value does not vary from year to year. It is your view, that the capital gain from the sale of these shares cannot be attributed to inadequate dividends as required under subsection 110.6(8).

Our Comments

The facts of each case would have to be examined to determine whether or not a significant portion of the gain is attributable to the fact that sufficient dividends were not paid on a non-prescribed share. The fact that the redemption price of the special shares is pre-determined does not necessarily lead to the conclusion that no part of the capital gain is attributable to the fact that dividends were not paid or that dividends paid were less tan 90% of the average annual rate of return. For example, if the company did not pay dividends on the special shares in order to be in a position to redeem them at the pre-determined redemption price, we think that subsection 110.6(8) could apply.

We trust our comments will be of assistance

Yours truly,

for Director Small business and General Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch