15 November 1989 Income Tax Severed Letter AC58272 - Inter-generational Share Transfers

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.

19(1)                                        M. Vallée
                                             (613) 957-2093

Dear Sirs:

Re: Request for Technical Interpretation Inter-Generational Share Transfers Sections 55, 84.1 and 245 of the Income Tax Act (the "Act")

This is in reply to your letter dated June 8, 1989, wherein you requested a technical interpretation regarding the tax consequences of two alternative reorganizations in the following hypothetical situation.

A corporation ("Opco") is owned by brothers and sisters and possibly third parties. The brothers and sisters received their shares from their parents. The brothers and sisters are contemplating a transfer of shares to their children, using one of the following corporate reorganizations, in order to realize the value of their shares on a tax-free basis. Another objective of each of the two reorganizations would be that children of each of the brothers and sisters would acquire shares providing them (as a group)-with equity participation equal to that formerly held by their parents.

A. Surplus Distribution

          In this form of reorganization, which you described as
          a "Surplus Distribution", the following steps would be
          carried out:

     1)   Each shareholder of Opco would transfer his common
          shares to a Holdco pursuant to section 85 of the Act. 
          No assumptions were stated in your example as to the
          characteristics of the share consideration or the value
          of any non-share consideration to be received by the
          transferring shareholders.

     2)   A freeze of all the common shares of Opco would be
          implemented whereby all of the existing common shares
          would be exchanged for redeemable, retractable
          preferred shares of Opco of equivalent value.

     3)   New common shares of Opco would be issued such that the
          children of each shareholder would receive an
          equivalent equity percentage to that of their parents. 
          For example, if one shareholder had 305 of the existing
          common shares of Opco, his children would receive 305
          of the new common shares.

          Your primary concern with this form of reorganization
          is the potential application of subsection 55(2) of the
          Act to dividends.  We have assumed that your concern
          pertains to the dividend that would be deemed by
          subsection 84(3) of the Act to be paid by Opco to each
          Holdco upon a redemption of the Opco preferred shares
          which would be held by each Holdco.

B.        Cross Share Sale

          In this form of reorganization, which you described as
          a "Cross Share Sale", each brother and sister would
          sell his or her shares in Opco, not to his or her own
          children, but to his or her nieces or nephews, in the
          following manner:

     1)   Each purchaser child would incorporate a holding
          company.

     2)   Each vendor parent would sell his shares to the holding
          company of a niece or nephew, claiming a deduction
          under the provisions of section 110.6 of the Act and
          perhaps claiming a reserve under subparagraph
          40(1)(a)(iii) of the Act, subject to various provisions
          which might deny a reserve, such as subparagraph
          40(2)(a)(ii) of the Act.  You are of the opinion that
          the holding companies would generally be "connected
          corporations" within the meaning of subsection 186(4)
          of the Act.

     3)   In each case, the vendor would take back from the
          purchasing holding company a note and/or preferred
          shares as consideration on the sale.

     4)   The purchase price would be funded by intercorporate
          dividends paid by Opco to the Holdcos.

Our Comments

Assurance as to the tax consequence of a contemplated transaction can only be given in response to a request for an advance income tax ruling. The procedure for requesting an advance income tax ruling is outlined in Information Circular 70-6R, published by Revenue Canada, Taxation on December 18, 1978. If you wish to obtain any binding commitment with respect to an actual case involving proposed transactions, an advance income tax ruling application should be submitted. Although we are unable to provide any binding assurance with respect to the query you have raised, we have stated our observations below.

We are of the opinion that the provisions of subsection 55(2) of the Act would ordinarily apply in the transaction entitled "Surplus Distribution" to the dividends which would be deemed by subsection 84(3) of the Act to be paid upon a redemption of the Opco preferred shares, on the assumption that a capital gain would have been realized if the preferred shares had been disposed at their fair market value immediately before the time when they were redeemed.

The exception provided in paragraph 55(3)(a) of the Act would ordinarily not apply to transactions of the type described, since nephews and nieces are not deemed by paragraph 251(1)(a) of the Act not to deal at arm's length with their uncles and aunts and the interest of each original shareholder's nephews and nieces in Opco would have increased as a result of the transactions. Where the preferred shares of Opco were not redeemed, the application of subsection 55(2) to any cash dividends paid thereon would be subject to the satisfaction of the purpose test in subsection 55(2), rather than to the results test which applies to subsection 84(3) deemed dividends.

The portion, if any, of the income earned or realized after 1971 ("safe income") of Opco attributable to the unrealized gain in the common shares of Opco immediately before they were changed to preferred shares would normally be considered to be reflected in the unrealized gain on the Opco preferred shares prior to their redemption. In order to avoid having subsection 55(2) of the Act apply to the full amount of the deemed dividend arising on the redemption of the Opco preferred shares, a Holdco receiving such a deemed dividend could make a designation under paragraph 55(5)(f) of the Act in respect of that deemed dividend.

An updated summary of our views on section 55 was presented in a conference paper entitled "Section 55: A Review of Current Issues" given by Robert J.L. Read at the 1988 Canadian Tax Foundation Conference.

Depending on the consideration for the transferred Opco shares received by an individual from Holdco in the Surplus Distribution example, subsection 84.1(1) of the Act might apply to that transfer. Depending on the facts of a particular transfer, the application of subsection 84.1(1) of the Act could result in a reduction of the paid-up capital of the Holdco shares and, in certain cases, a deemed receipt of a dividend.

In your second example, the avoidance of the application of section 84.1 of the Act, if it were achieved, and the utilization by the vendor of the deduction provided by section 110.6 of the Act would be tax benefits, within the meaning of subsection 245(1) of the Act. A sale of shares by a shareholder to a corporation controlled by a niece or a nephew in such circumstances would, in our opinion, be an avoidance transaction, within the meaning of subsection 245(3) of the Act, designed to thwart the operation of section 84.1 of the Act. As mentioned in paragraph 25 of Information Circular 88-2, any arrangement designed to thwart the operation of section 84.1 of the Act would not be eligible for the exemption from the application of subsection 245(2) contained in subsection 245(4). Therefore, subject to the application of section 84.1 of the Act on the basis of paragraph 251(1)(b) of the Act, it is our opinion that the provisions of subsection 245(2) of the Act would apply to a transaction similar to the one described as a Cross Share Sale.

The opinions expressed herein are provided pursuant to the practice referred to in paragraph 24 of Information Circular 70-6R.

Yours truly,

for Director Reorganizations and Non-Resident Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch