12 November 1998 External T.I. E9822855 - ANTI-AVOIDANCE - 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:

A taxpayer receives shares, which do not meet the definition of prescribed shares for the purposes of section 6205 of the Regulations and dividends are not paid on these shares. The taxpayer exchanges all outstanding shares (special and common) of the corporation in exchange for new special shares. The new special shares would be prescribed shares. The taxpayer then subscribes for new common shares of the corporation at nominal value. Immediately following the share subscription, the taxpayer gifts the common shares to his adult children.

1. Would the gain, if any, realized on the new special shares be eligible for the capital gains deduction since a significant portion of the gain attributable to those shares was attributable to the fact that dividends were not paid on non-prescribed shares?

2. Would subsection 110.6(8) of the Act apply to deny the capital gains deduction in respect of any capital gains realized by the children in the future on the sale of their common share?.

Position:

1. Question of fact but subsection 110.6(8) of the Act would apply.

2. Question of fact but likely subsection 110.6(8) would not apply.

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

XXXXXXXXXX 5-982285
G. Moore
November 12, 1998

Dear XXXXXXXXXX:

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

This in reply to your letter of August 25, 1998 in which you requested our comments regarding subsection 110.6(8) of the Income Tax Act (the “Act”) in the following hypothetical situation:

A taxpayer owns all the common and preferred shares of a corporation. The preferred shares do not meet the definition of prescribed shares for the purposes of section 6205 of the Income Tax Regulations (the “Regulations”) and dividends are not paid on these shares. As part of an estate freeze, the taxpayer exchanges all outstanding shares (preferred and common) of the corporation in exchange for new special shares. The new special shares would be prescribed shares pursuant to subsection 6205(2) of the Regulations, which have a redemption amount and fair market value equal to the value of the preferred and common shares exchanged. The taxpayer then subscribes for new common shares of the corporation at nominal value. Immediately following the share subscription, the taxpayer gifts the common shares to his adult children. The common shares would be of nominal value at the time they were gifted to the adult children and the purpose of gifting the shares, as opposed to having the adult children subscribe for the common shares, is that gifting the shares is more advantageous for family law purposes.

It is your view that any gain realized on the new special shares would not be eligible for the capital gains deduction since a significant portion of the gain attributable to those shares was attributable to the fact that dividends were not paid on non-prescribed shares. However, you believe that since, at the time of the issue of the new common shares, only prescribed shares are outstanding, any future gains accrued to the common shares should not be affected by subsection 110.6(8) of the Act. You are enquiring whether subsection 110.6(8) of the Income Tax Act (the “Act”) would apply to deny the capital gains deduction in respect of any capital gains realized by the children in the future on the sale of their common shares.

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.

Paragraph 6205(2)(a) of the Regulations provides that, for purposes of subsections 110.6(8) and (9) of the Act and subject to subsection 6205(3) of the Regulations, a prescribed share is a share of the capital stock of a particular corporation if, amongst other things, the main purpose of the arrangement is to permit any increase in the value of the property of the corporation to accrue to other shares that would, at the time of their issue, be prescribed shares under section 6205 of the Regulations.

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.

In the situation you have described, we would generally agree with your comments that since a significant part of the unrealized capital gain on the new special shares is attributable to the failure to pay dividends on the preferred shares (i.e. the “non-prescribed shares”), subsection 110.6(8) would likely apply to deny the capital gains deduction in respect of any gain that may be realized on a dispostion of the new special shares. Since the value of the new special shares is frozen, we are of the view that any future gains accrued to the common shares owned by the adult children would generally not be affected by subsection 110.6(8) of the Act provided that only prescribed shares are outstanding.

We 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