30 April 1990 Income Tax Severed Letter AC59276 - Avoidance of Tax on Capital Gains - Intercorporate Dividends

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)                                    S. Shinerock
                                         (613) 957-2108

Dear Sirs:

Re: Subsection 55(2) of the Income Tax Act (the "Act")

We are writing in response to your letter dated December 14, 1989 in which you asked for our opinion regarding the application of subsection 55(2) and certain other provisions of the Act to the two hypothetical situations described below.

Situation #1

All of the issued shares of a Canadian-controlled private corporation ("OPCO") that carries on an active business in Canada are owned by employees of OPCO who deal at arm's length with each other and with OPCO. Canadian-controlled private corporation ("CCPC") has the meaning assigned by paragraph 125(7)(b) of the Act. The shareholders of OPCO wish to create a holding corporation to hold all of the issued shares of OPCO to facilitate estate planning by the shareholders and to protect any of OPCO's assets that are not used in its active business from any claims by creditors that may arise in respect of its active business. Accordingly, the transactions described below will be implemented.

A new corporation ("NEWCO") will be incorporated to be the holding corporation. Each shareholder of OPCO will transfer his shares of OPCO to NEWCO for consideration comprising shares of NEWCO having a fair market value equal to the fair market value of the shares of OPCO so disposed of by him and will elect, jointly with NEWCO, to have the provisions of subsection 85(1) of the Act apply to the transfer. The amount agreed upon by a shareholder and NEWCO in their election may result in a shareholder realizing a capital gain on the disposition of his shares of OPCO to NEWCO, and the shareholder intends to claim an amount in respect of any such capital gain pursuant to either subsection 110.6(2.1) or (3) of the Act. OPCO will then declare and pay a taxable dividend to NEWCO equal to "income earned or realized by OPCO after 1971" ("Safe Income") on hand prior to the transfer of shares described above.

Situation #2

All of the issued shares of a CCPC ("OPCO") that carries on an active business in Canada are owned in equal proportions by three holding corporations (individually referred to as a "HOLDCO").

Each of the three HOLDCOs and OPCO is governed by the Company Act of the Province of British Columbia (the "Company Act") and is a taxable Canadian corporation, within the meaning assigned by paragraph 89(1)(i) of the Act. The shares. of OPCO owned by a HOLDCO are the only asset of that HOLDCO. Each HOLDCO is owned by an individual who is an employee of OPCO and who deals at arm's length with OPCO and with the other two individuals who own the other two HOLDCOs. The three individuals would like to be able to dispose of the issued shares of OPCO to an arm's length purchaser so that they may each claim an amount in respect of any capital gain realized on such disposition pursuant to either subsection 110.6(2.1) or (3) of the Act. Accordingly, it is proposed that the transactions described below will be implemented.

Each of the three individuals will transfer the shares of the HOLDCO owned by him to OPCO for sole consideration comprising shares of OPCO having a fair market value equal to the fair market value of the shares of the HOLDCO so disposed of by him and will elect, jointly with OPCO, to have the provisions of subsection 85(1) of the Act apply to the transfer. The amount agreed upon by an individual and OPCO in their election may result in the individual realizing a capital gain on the disposition of his shares of a HOLDCO to OPCO, and the individual intends to claim an amount in respect of any such capital gain pursuant to either subsection 110.6(2.1) or (3) of the Act. Under the Company Act, combining two corporations by winding up one corporation into the other corporation is simpler than amalgamating them, because the Company Act does not provide for a "short-form" amalgamation procedure. Each HOLDCO will therefore be wound up into OPCO in a winding-up to which subsection 88(1) of the Act will apply. The shares of OPCO owned by each HOLDCO will be distributed to OPCO on such winding-up and will be cancelled upon being so acquired by OPCO. Each of the three individuals will, at some time after the three HOLDCOs have been wound up, dispose of the shares of OPCO issued to each of them to an arm's length purchaser.

Comments

The two situations described by you seem to relate to specific proposed transactions. Confirmation of the tax consequences of specific proposed transactions will only be provided in response to a request for an advance income tax ruling. The procedures for requesting an advance ruling are set out in Information Circular 70-6R. If you wish to submit such a request, we would be pleased to consider it. Having said this, we are able to offer the following general comments on your two situations.

Situation #l

You have asked whether or not subsection 55(2) of the Act will apply to the dividend paid by OPCO to NEWCO. It is your view that there is no reduction in Safe Income as a result of the shareholders realizing a capital gain on the disposition of their shares of OPCO, as the time at which Safe Income would be determined would be immediately before the commencement of the series of transactions referred to above.

It is also your view that subsection 55(2) of the Act will not, by virtue of paragraph 55(3)(a) of the Act, apply to the dividend paid by OPCO to NEWCO because the series of transactions will not result in any disposition of any property to a person with whom NEWCO deals at arm's length or in any increase in the interest in any corporation of any person with whom NEWCO, the corporation that will receive the dividend, deals at arm's length.

Initially, we would point out that subsection 55(2) of the Act would apply to the dividend paid by OPCO to NEWCO where one of the purposes of OPCO paying the dividend is to effect a significant reduction in the capital gain that would, but for the dividend, be realized by NEWCO on a disposition at fair market value of the shares of OPCO. Whether or not one of the purposes of OPCO paying the dividend to NEWCO is to effect such a reduction is a question of fact that can only be determined by reference to all of the facts and circumstances of a particular case.

However, we do not agree with your view that subsection 55(2) of the Act will not apply to the dividend paid by OPCO to NEWCO because there is no reduction in Safe Income of OPCO as a result of the capital gains realized by the shareholders of OPCO. Assuming that the full amount of the unrealized gain on the shares of OPCO is greater that OPCO's Safe Income, and if a portion of this gain is realized, then a proportionate part of this portion is attributable to Safe Income and the remaining part may reasonably be considered to be attributable to something other than Safe Income. Similarly, a proportionate part of the balance of the unrealized portion of the gain would be attributable to residual Safe Income of OPCO and the remaining part may reasonably be considered to be attributable to something other than Safe Income.

In other words, a proportionate share of the Safe Income of OPCO has been capitalized in the adjusted cost base of the OPCO shares held by Newco. Hence, it is our view that a dividend paid by OPCO to NEWCO equal to the Safe Income of OPCO on hand immediately before the commencement of the series of transactions referred to above, to the extent that such dividend has not been designated as a separate taxable dividend under paragraph 55(5)(f) of the Act which is attributable solely to the residual Safe Income of Opco, old be subject to the application of subsection 55(2) of the Act.

We also do not agree with your view that subsection 55(2) of the Act will not, by virtue of paragraph 55(3)(a) of the Act, apply to the dividend. While we agree that the series of transactions may not, for the purposes of subparagraph 55(3)(a)(i) of the Act, result in a disposition of any property to a person with whom NEWCO deals at arm's length, it is our opinion that the series of transactions will, for the purposes of subparagraph 55(3)(a)(ii) of the Act, result in a significant increase in the interest in any corporation of any person with whom the corporation that received the dividend was dealing at arm's length". In your situation, it is our view that there will be a significant Increase in the interest in a corporation (i.e. NEWCO) of a person (i.e. a shareholder of NEWCO) with whom NEWCO, the corporation that receives the dividend, would be dealing at arm's length.

Situation #2

You have asked whether or not subparagraph 88(1) (a) (iii) of the Act will apply to deem the shares of OPCO that will be distributed to OPCO on the winding-up of each HOLDCO to have been disposed of by the HOLDCO for proceeds equal to the cost amount, within the meaning assigned under subsection 248(1) of the Act, of such shares to the HOLDCO immediately before the winding-up of the HOLDCO. You have also asked whether or not subsection 84(3) of the Act will apply to the acquisition and cancellation by OPCO of its shares on the winding-up of a HOLDCO to deem OPCO to have paid a dividend on a separate class of shares comprising such shares and whether or not subsection 55(2) of the Act will apply to any such dividend.

It is our view that, notwithstanding that any shares of OPCO that will be acquired by OPCO on the winding-up of a HOLDCO will be cancelled, those shares will, for the purposes of paragraph 88(1) (a) of the Act, be property of the HOLDCO that is distributed to OPCO on the winding-up of the HOLDCO. Consequently, subparagraph 88(1)(a)(iii) of the Act will apply to deem the shares of OPCO to have been disposed of by the HOLDCO for proceeds equal to the cost amount of such shares to the HOLDCO immediately before the winding-up. It is also our view that OPCO will not have paid any amount to a HOLDCO on the acquisition or cancellation by OPCO of its shares held by the particular HOLDCO. Consequently, there is no amount to which subsection 84(3) of the Act would apply and the subsection has no application. Therefore, subsection 55(2) of the Act will be of no consequence. We agree that subsection 84(2) of the Act would not, by virtue of paragraph 88(1)(d.1) of the Act, apply to the winding-up of a Holdco.

However, we wish to point out that the provisions of subsections 9(5) and 84(2) of the Act, which otherwise would have applied on the winding-up of the HOLDCO's, are avoided in this type of situation. Consequently, the subsection 85(1) transfers and the, winding-up of the Holdcos may be avoidance transactions within the meaning of subsection 245(3) of the Act, with the result that the provisions of subsection 245(2) of the Act may have application.

Your letter does not state whether or not an amount may be claimed, pursuant to either subsection 110.6(2.1) or (3) of the Act, in respect of any capital gain that may be realized by any of the three individuals on the disposition of the shares of OPCO by such individuals to a purchaser. We would note, however, that any shares of OPCO that may be disposed of by an individual to the purchaser may not, at the time of such disposition, be qualified small business corporation shares ("QSBCS") of the individual within the meaning of subsection 110.6(1) of the Act. In this regard, we understand that, by virtue of section 183 of the Company Act, a HOLDCO will not be entitled to vote its shares of OPCO or to permit its shares of OPCO to be voted at any meeting of OPCO. Consequently, for the purposes of the preamble in subparagraph (c)(ii) of the QSBCS definition, in determining whether the shares of the HOLDCOS will be assets of OPCO that are described in clause (c)(ii)(B), it would appear that OPCO will not be connected with a HOLDCO throughout the period referred to therein, because OPCO will not be controlled, within the meaning of paragraph 186(4) (a) of the Act, by that HOLDCO, and no HOLDCO will, for the purposes of paragraph 186(4)(b) of the Act, own more than 10% of the issued share capital of OPCO having full voting rights under all circumstances. Therefore, the fair market value of the assets of a HOLDCO will be wholly attributable to shares of the capital stock of a corporation that will not be connected with the HOLDCO.

Hence, throughout the period referred to in paragraph (c) of the QSBCS definition, the shares of a HOLDCO will not be assets of OPCO that are described in clause (c)(ii)(B) of the definition.

These comments represent our general views with respect to the subject matter of your letter and are expressed in accordance with the guidelines set out in Information Circular 70-6R dated December 18, 1978.

Yours truly,

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