1 December 1998 E9829500.txt - SAFE INCOME - ALLOCATION TO SHARES

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.

TEI Conference
December 1, 1998

Question XXIV

SAFE INCOME DETERMINATION

A. Holdco A and Holdco B each own 100 common shares in the capital stock of Opco, consisting of all of the issued and outstanding shares of Opco. On January 1, 1998 the fair market value of the 100 common shares of Opco held by Holdco A is $100,000. On that date, Opco and Holdco A enter into an agreement whereby Opco agrees to redeem, over a five year period, the 100 common shares of Opco held by Holdco A for a fixed amount of $1,000 per common share (“the redemption amount”). Hence, Opco will redeem 20 common shares per year for an amount of $20,000. Based on the terms of the agreement, the redemption amount will not be modified even though the fair market value of Opco may increase or decrease before all of the shares are redeemed. During the five-year period covered by the agreement, Opco earns a net income of $250,000, or $50,000 per year. Since Holdco A will not benefit from any increase in the fair market value of Opco after January 1, 1998, could a taxpayer allocate all of the safe income on hand attributable to the common shares after that time to the common shares held by Holdco B? If not, what would be the allocation method for the safe income on hand realized on the common shares of Opco after January 1, 1998?

B. Holdco owns all of the issued and outstanding shares of Opco, consisting of 100 common shares. These shares have an adjusted cost base of $100 and a fair market value of $950,000. On January 1, 1998 the safe income on hand attributable to those shares is $1,000,000. On that date, Holdco acquires from Opco, pursuant to the provisions of section 51 of the Act, 500,000 newly issued common shares of Opco and 500,000 non-voting, non-participating preferred shares (collectively, the “new shares”) in exchange for the 100 common shares previously owned in capital stock of Opco (the “old shares”). The preferred shares have a non-cumulative dividend calculated at the prescribed rate and a redemption value of $500,000. The adjusted cost base (determined pursuant to paragraph 51(1)(d) of the Act) of the 500,000 newly issued common shares is $47 whereas the adjusted cost base of the 500,000 preferred shares is $53.

According to Revenue Canada’s administrative policy, the safe income on hand attributable to the old shares will be allocated to the new shares in proportion to the inherent gain on each class of shares received by virtue of the exchange over the inherent gain of the old shares. Hence the safe income on hand attributable to the preferred shares would be equal to $526,315, whereas the safe income on hand attributable to the new common shares would be $473,685.

Since the fair market value of the preferred shares is $500,000, how should the portion of the safe income on hand attributable to those shares that exceeds their fair market value (i.e. $26,135) be allocated? Since the newly issued common shares will be entitled to any increase in the fair market value of Opco, can a taxpayer attribute this excess to the newly issued common shares held by Holdco?

Department's Position

A) The agreement to redeem Holdco A's common shares for specified redemption amounts at specified times is equivalent to Opco undergoing a reorganization of capital to convert such common shares into redeemable preferred shares. On page 85 of the paper presented at the 1981 Conference of the Canadian Tax Foundation, John Robertson stated:

"f) Where a common share is exchanged for a high-low preferred share such a preferred share is entitled to the same portion of the safe income that could have been paid as a safe dividend on a pro-rata basis on the common share immediately before the exchange. Otherwise such a preferred share (or for that matter any preferred share) is only entitled to share in the safe income of a corporation during its holding period to the extent of its dividend entitlement."

Consequently, the common shares which are the subject of the redemption agreement will, during the period that they remain outstanding, share in the safe income on hand of Opco only to the extent of their dividend entitlement. Any remaining safe income on hand will be attributable to the common shares held by the other shareholder.

B) As stated in our response to question 12 of the 1993 Revenue Canada Round Table at the 1993 annual conference of the Canadian Tax Foundation:

"Safe income on hand" with respect to a share of a corporation refers to the portion of the income earned or realized by the corporation during the relevant period of time that could reasonably be considered to contribute to the capital gain that would be realized on a disposition at fair market value of the share at that time.

In the example cited above we do not understand how common shares having a fair market value of $950,000 can be entitled to Safe Income on Hand of $1.0 million. Consequently, in our view the amount of safe income on hand which can be allocated to each of the common and preferred shares of Opco should not exceed the capital gain that would have been realized on a disposition at fair market value of such shares at the time of the conversion.

Author:	T. Harris
File:		982950
Date:		November 16, 1998