4 April 1990 Income Tax Severed Letter RCT-0418D

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.

NOTES FOR USE BY BRYAN DATH RE. QUESTIONS SUBMITTED FOR DISCUSSION

OTHER PARTICIPANTS, PAUL LAILEY DEPT. OF FINANCE

XXX

FACT SITUATION 1

(A) IN MARCH, 1988, A STARTED UP BUSINESS IN A BUILDING WHICH HE BOUGHT FOR THAT PURPOSE.

(B) AS IT APPEARED THAT THE BUSINESS WOULD BE SUCCESSFUL AT THE OUTSET, HE DECIDED THAT HIS TWO YOUNGER BROTHERS, B AND C, WOULD HELP HIM TO RUN THE BUSINESS.

(C) IN AUGUST, 1988 A,B, AND C TRANSFERRED THE BUSINESS, OTHER THAN THE BUILDING WHICH WAS STILL OWNED BY A, INTO X CO, A NEW CORPORATION. A OWNED 60% OF THE SHARES AND EACH OF B AND C OWNED 2O%.

(D) THE THREE BROTHERS ENTERED INTO A BUY-SELL AGREEMENT UNDER WHICH THE SURVIVORS HAD THE OPTION TO BUY THE DECEASED'S SHARES AND THE DECEASED'S WIDOW HAD THE OPTION TO "PUT" HIS SHARES TO THE SURVIVORS. THEY ARRANGED FOR X CO. TO PURCHASE INSURANCE SO THAT FUNDS WOULD BE AVAILABLE FOR THE PURCHASE OF THE DECEASED'S SHARES.

(E) IN JULY, 1989, A WAS DIAGNOSED AS SUFFERING FROM A TERMINAL ILLNESS AND IN JULY OF 1990, HE DIED. UNDER A'S WILL ALLOF HIS ASSETS PASSED TO HIS WIDOW.

QUESTION 1 THE NORMAL RULE IS THAT TO QUALIFY FOR THE $400,
000 EXEMPTION IN RESPECT OF SHARES THEY CANNOT HAVE
BEEN OWNED BY AN UNRELATED PERSON WITHIN THE
PREVIOUS 24 MONTHS. NEW SHARES ISSUED BY A
CORPORATION ARE DEEMED TO HAVE BEEN OWNED BY AN
UNRELATED PERSON UNLESS THEY WERE ISSUED IN EXCHANGE
FOR SUBSTANTIALLY ALL OF THE ASSETS USED IN AN
ACTIVE BUSINESS. BY RETAINING THE BUILDING IN HIS
OWN NAME HAS A DENIED HIMSELF THE PROTECTION OF THIS
EXCLUSION?

RESPONSE IF THE BUILDING WAS NOT A PARTNERSHIP PROPERTY THEN
APPARENTLY SUBSTANTIALLY ALL OF THE ASSETS USED IN THE
PARTNERSHIP BUSINESS WOULD BE TRANSFERRED TO THE NEW CORP
AND A HAS NOT DENIED HIMSELF THE PROTECTION OF THE
EXCLUSION.

• IN THE ABOVE SITUATION, IT APPEARS THAT A PARTNERSHIP WAS CARRIED ON BY A, B, AND C AND THAT THE BUILDING WAS EITHER RENTED TO THE PARTNERSHIP OR USED ON A RENT-FREE BASIS BY THE PARTNERSHIP. IN OTHER WORDS, THE BUILDING WAS NOT PARTNERSHIP PROPERTY OR AN ASSET USED IN AN ACTIVE BUSINESS. IN THESE CIRCUMSTANCES, IT IS THE DEPARTMENT'S VIEW THAT THE ISSUED SHARES WOULD NOT BE DEEMED TO HAVE BEEN OWNED BY AN UNRELATED PERSON BECAUSE THE SHARES OF THE CORPORATION WERE ISSUED IN EXCHANGE FOR SUBSTANTIALLY ALL OF THE ASSETS USED IN THE PARTNERSHIPS ACTIVE BUSINESS.

QUESTION 3 OUR INTERPRETATION OF QUESTION AND RESPONSE
PART OF THE THIRD QUESTION CONCERNS WHETHER THE X
CO. SHARES HAVE BEEN "VESTED INDEFEASIBLY" IN MRS.
A FOR THE PURPOSES OF THE SUBSECTION 70(6) IN VIEW
OF THE BUY-SELL AGREEMENT.
IT DEPENDS WHETHER THE BUY SELL IS COMPULSORY IF THE
ESTATE HOST SELL TEEN THERE IS NO INDEFEASIBLE
VESTING AS PER PARKS. IF TEE AGREEMENT IS NOT
BINDING ON THE ESTATE AS IN VAN SON THEN
INDEFEASIBLE VESTING CAN TAKE PLACE

• IN RELATION TO THE "VESTED INDEFEASIBLY" REQUIREMENT, IT APPEARS THAT THE TERMS OF THE BUY- SELL MERELY GIVES B AND C THE OPTION TO ACQUIRE THE SHARES WITH THE RESULT THAT THE BUY-SELL AGREEMENT MAY OR MAY NOT BE EXERCISED. IN THESE CIRCUMSTANCES IT IS THE DEPARTMENT'S VIEW THAT THE BUY-SELL AGREEMENT WOULD NOT PREVENT THE X CO. SHARES FROM BEING VESTED INDEFEASIBLY IN THE SPOUSE. HOWEVER, IF THE TERMS OF THE BUY-SELL AGREEMENT MADE IT COMPULSORY FOR THE EXECUTOR OF A'S ESTATE TO SELL AND A AND C TO BUY THE X CO. SHARES, THE DEPARTMENT'S VIEW IS THAT THE SHARES WOULD NOT VEST INDEFEASIBLY IN THE SPOUSE AND NO ROLLOVER WOULD BE AVILABLE.
• I WOULD ALSO ADD THAT MY COMMENTS ARE CONSISTENT WITH THE PARKS ESTATES DECISION [[1986] 1 C.T.C. 2262] (86 DTC 1214) WHICH DEALT WITH A COMPULSORY SALE OF SHARES. A RECENT CASE IN THE FEDERAL COURT TRIAL DIVISION VAN SON ESTATE HELD THAT AS THERE WAS NO ENFORCEABLE OBLIGATION ON THE PART OF THE ESTATE TO SELL THE SHARES THE SHARES VESTED.
• THE SECOND PART OF THE THIRD QUESTION CONCERNS WHETHER A COULD USE THE $400,000 CAPITAL GAINS EXEMPTION IN THE YEAR OF DEATH ASSUMING THE ROLLOVER PROVISIONS OF SUBSECTION 70(6) DON'T APPLY. IN RELATION TO THIS POINT, THE ISSUE IS WHETHER "ALL OR SUBSTANTIALLY ALL" OF X CO.'S ASSETS WERE USED IN AN ACTIVE BUSINESS AT THE TIME OF THE DEEMED DISPOSITION UNDER SUBSECTION 70(S) IN VIEW OF THE LIFE INSURANCE POLICY. INSURANCE POLICY WILL NOT BE AN ACTIVE BUSINESS ASSET AND WILL BE INCLUDED IN THE CORP'S ASSETS AT ITS FAIR MARKET VALUE WHICH IN THIS CASE WILL BE CLOSE TO ITS FACE VALUE.
• AS IT APPEARS THAT THE LIFE INSURANCE PROCEEDS WILL BE PAID OUT AS DIVIDEND TO FUND THE BUY-SELL AGREEMENT, IT IS THE DEPARTMENT'S VIEW THAT THE LIFE INSURANCE POLICY WOULD NOT BE CONSIDERED TO BE AN ASSET USED IN AN ACTIVE BUSINESS. ACCORDINGLY, FAIR MARKET VALUE OF THE LIFE INSURANCE POLICY, ASSUMING IT REPRESENTS MORE THAN 10% OF THE FAIR MART VALUE OF X CO.'S ASSETS AT THE TIME OF THE DEEMED DISPOSITION, WOULD RESULT IN THE "ALL OR SUBSTANTIALLY ALL" REQUIREMENT NOT BEING SATISFIED AS A FURTHER COMMENT, IT WOULD APPEAR THAT IN VIEW OF MR. A'S STATE OF HEALTH PRIOR TO DEATH, THE INSURANCE POLICY WOULD BE VALUED AS AN AMOUNT CLOSE TO ITS VALUE AT MATURITY.

QUESTION 4 ASSUMING THAT MRS. A ACQUIRES THE X CO. SHARES UNDER
THE ROLLOVER PROVISIONS OF SUBSECTION 70(6). THE
ISSUE IS WHETHER MRS. A, IN VIEW OF THE LIFE
INSURANCE POLICY, CAN USE THE $400,000 CAPITAL GAINS
EXEMPTION WHEN SHE SELLS THE X CO. SHARES TO B AND C.

RESPONSE OBVIOUSLY TEE PROCEEDS OF THE INSURANCE WOULD NO
LONGER BE IN THE CORP TO PUT IT OFFSIDE HOWEVER THEY
WOULD HAVE BEEN DURING THE LAST 24 MONTHS AND
THEREFORE HAVE THE POTENTIAL OF PUTTING THE CORP
OFFSIDE.

• THE DEPARTMENT'S VIEW ON THIS ISSUE IS THAT THE LIFE INSURANCE PROCEEDS WERE RECEIVED AND PAID OUT AS A DIVIDEND PRIOR TO THE SALE, THEY WOULD HAVE NO EFFECT ON DETERMINING WHETHER X CO. WAS A SMALL BUSINESS CORPORATION AT THE TIME OF SALE.
• HOWEVER, IT IS POSSIBLE THAT X CO., AS A CONSEQUENCE OF HAVING RECEIVED THE PROCEEDS PRIOR TO THE SALE, WOULD FAIL TO HAVE USED MORE THAN 50% OF ITS ASSETS IN AN ACTIVE BUSINESS THROUGHOUT THE SPECIFIED TIME PERIOD PRIOR TO THE SALE. IF THIS WERE TO BE THE CASE, IT WOULD NOT BE POSSIBLE FOR A SHARE OF X CO. TO BE A QUALIFYING SMALL BUSINESS CORPORATION SHARE FOR AT LEAST TWO YEARS FROM THE TIME X CO. AGAIN COMMENCED TO MEET THAT 50% TEST.

QUESTION 5 THE INITIAL SCENARIO HAS BEEN MODIFIED AS THAT EACH
OF A, B AND C USED A HOLDING CORPORATION TO HOLD HIS
SHARES OF X CO. AND THE INSURANCE ON THE LIVES OF
THE OTHERS. THE QUESTION THEN BECOMES WHETHER A
SHARE IN A'S COMPANY (ACO) IS A QUALIFIED SMALL
BUSINESS CORPORATION SHARE.

RESPONSE INSURANCE PROCEEDS WOULD BE IN OTHER CORPS THEREFORE
NO PROBLEM THERE. INSURANCE POLICIES HELD BY A CO
WOULD BE OFFSIDE ASSETS

• IN THIS TYPE OF SITUATION IT IS THE DEPARTMENT'S VIEW THAT THE INSURANCE POLCIES ON A'S LIFE AND THE PROCEEDS THEREOF WOULD NOT BE A FACTOR IN DETERMINING WHETHER ACO WAS A SMALL BUSINESS CORPORATION AT THE TIME OF SALE BY MRS. A BECAUSE THOSE ASSETS WOULD BELONG TO THE HOLDING COMPANIES OF B AND C.
• HOWEVER, THE POLICIES ON THE LIVES OF B AND C HELD BY ACO WOULD HAVE TO BE VALUED, AS THESE WOULD NOT BE ASSETS USED IN AN ACTIVE BUSINESS. THE USUAL TESTS WOULD HAVE TO BE APPLIED TO DETERMINE WHETHER THE SHARES OF ACO WERE QUALIFIED SMALL BUSINESS CORPORATION SHARES AT THE RELEVANT TIME.

QUESTION 6 COULD BOTH MR. A AND MRS. A UTILIZE THE CAPITAL
GAINS EXEMPTION UTILIZING SUBSECTION 70(6.2). UNDER
THIS PROVISION, AN ELECTION CAN BE MADE IN RESPECT
OF ANY PROPERTY SO THAT THE PROVISIONS OF SUBSECTION
70(5) APPLY RATHER THAN THE ROLLOVER PROVISIONS OF
SUBSECTION 70(6).

RESPONSE EACH SHARE IS CONSIDERED TO BE A SEPARATE PROPERTY
SO IT IS POSSIBLE TO ELECT ON SOME AND NOT OTHERS
AND DOUBLE UP THE EXEMPTION.

• IN RELATION TO THE PROVISIONS OF SUBSECTIONS 70(6) AND 70(6.2), IT IS THE DEPARTMENT'S VIEW THAT MRS. A, AS A'S EXECUTOR, COULD ELECT OUT OF THE AUTOMATIC INTER-SPOUSAL ROLLOVER PROVISIONS PURSUANT TO SUBSECTION 70(6.2) IN RESPECT OF SOME OF MR. A'S X CO. SHARES AND NOT OTHERS AS EACH SHARE IS CONSIDERED TO BE A SEPARATE PROPERTY. THE EFFECT OF ACHIEVING THIS RESULT IS THAT IT MAY BE POSSIBLE FOR BOTH MR. A AND MRS. A TO UTILIZE THE $400,000 CAPITAL GAINS EXEMPTION.

FACT SITUATION II

SAME AS 1 EXCEPT THAT

• 1) A HAD TRANSFERRED THE BUILDING TO X CO AT THE BEGINNING BUT
• 11) NO INSURANCE OR BUY-SELL AGREEMENT WAS IN PLACE AT HIS DEATH B, C, AND MRS A AGREE THAT THEY WOULD LIKE TO DISTRIBUTE THE BUILDING TO MRS A IN SATISFACTION OF THE 60% INTEREST IN X CO WHICH SHE INHERITED FROM A. THE BUILDING REPRESENTS 60% OF X CO'S TOTAL ASSETS.

QUESTION 1 MAY THE BUILDING BE BUTTERFLIED TO A NEW CORP
CONTROLLED BY MRS A THE WIDOW?

OUR INTERPRETATION OF THE QUESTION

• • IF THE BUILDING IS TRANSFERRED BY WAY OF A SINGLE WINGED BUTTERFLY OF X CO TO A NEW HOLDING CO A CO TO WHICH MRS A HAS TRANSFERRED HER SHARES OF X CO WILL THE DIVIDENDS DEEMED TO BE PAID ON THE CROSS REDEMPTION OF SHARES OF X CO AND A CO BE EXEMPT FROM THE APPLICATION OF 55(2) BY VIRTUE OF 55(3)(B)

RESPONSE YES ASSUMING THAT THE BUILDING AND ALL OF THE OTHER
PROPERTY OF X CO CONSTITUTED BUSINESS PROPERTY FOR THE
PURPOSES OF 55(3)(B)

QUESTION 2 ASSUMING ANSWER TO QUESTION 1 IS YES BECAUSE THE
BUILDING AND OTHER ASSETS OF X CO WERE ALL BUSINESS
ASSETS WOULD THE ANSWER BE DIFFERENT IF TWO MONTHS
BEFORE A DIED X CO MOVED TO RENTAL PREMISES AND
LEASED THE BUILDING TO AN ARMS LENGTH TENANT? OR
WOULD THE BUTTERFLY RULES NOT APPLY HERE BECAUSE:

• • THE BUILDING IS NOW AN INVESTMENT PROPERTY AND A PRO RATA SHARE IS NOT BEING DISTRIBUTED TO EACH SHAREHOLDER AS REQUIRED TO MEET THE EXCLUSION UNDER 55(3)(B) AND
• • THE PARTIES CANNOT RELY ON THE NON ARMS LENGTH EXEMPTION IN 55(3)(A) SINCE THE BROTHERS ARE DEEMED TO DEAL WITH EACH OTHER AT ARMS LENGTH FOR PURPOSES OF THE BUTTERFLY RULES AND MRS A CEASES TO BE RELATED ONCE A DIES

RESPONSE YES THE ANSWER WOULD BE DIFFERENT FOR THE ABOVE

AS THE SERIES OF TRANSACTIONS THAT INCLUDES THE
DIVIDENDS WOULD RESULT IN AN INCREASE IN THE
PERCENTAGE INTEREST IN X CO BY B AND C WHO WOULD BE
DEEMED TO DEAL AT ARMS LENGTH BY 55(5)(E) THE
DIVIDENDS WOULD NOT QUALIFY FOR THE EXEMPTION IN
55(3)(A)

QUESTION 3 OUR INTERPRETATION OF THE QUESTION

WOULD THE RESPONSE TO QUESTION 2 BE DIFFERENT IF
A'S SHARES OF X CO WERE BEQUEATHED TO A SPOUSAL
TRUST FOR MRS A WITH A'S FATHER APPOINTED AS SOLE
TRUSTEE

RESPONSE YES THE ANSWER WOULD BE DIFFERENT

A'S FATHER IS RELATED TO A'S BROTHERS AND SUBJECT
TO THE TERMS OF THE TRUST CONTROLS BOTH A CO AND X
CO

THEREFORE (SUBJECT TO 55(4)) EACH OF THE BROTHERS
WOULD BE DEEMED NOT TO DEAL AT ARMS LENGTH WITH A
CO AND X CO
THUS DIVIDENDS WOULD QUALIFY FOR THE EXEMPTION IN
55(3)(A)

55(4) COULD BE APPLIED IF IT WAS CONSIDERED THAT
THE PRINCIPAL PURPOSE OF ESTABLISHING THE SPOUSAL
TRUST WITH A'S FATHER AS THE TRUSTEE WAS TO CAUSE
THE BROTHERS TO BE RELATED AND NOT DEAL AT ARMS
LENGTH. 55(4) DEEMS THEM TO DEAL AT ARMS LENGTH.
FUTURE EVENTS SUCH AS THE DISTRIBUTION OF THE TRUST
CAPITAL TO MRS. A COULD BE AN INDICATION ON INTENT.

CAUTION

BUTTERFLY TRANSACTIONS THAT RESULT IN THE DEEMED
DIVIDENDS ARE NOT PART OF A LARGER SERIES OF
TRANSACTIONS THAT RESULTS IN THE DISPOSITION OF
PROPERTY TO, OR AN INCREASE IN INTEREST IN ANY
CORPORATION BY, A THIRD PARTY WHO DEALS AT ARMS
LENGTH WITH A CO OR X CO

QUESTION 4 OUR INTERPRETATION OF THE QUESTION

WOULD ANY FUTURE SALE OF THE SHARES OR ASSETS OF A
CO TO AN ARMS LENGTH THIRD PARTY BE CONSIDERED TO
BE PART OF A SERIES OF TRANSACTIONS THAT INCLUDED
THE DEEMED DIVIDENDS OR WOULD SUCH A FUTURE SALE
HAVE TO BE SPECIFICALLY CONTEMPLATED AT THE TIME OF
SUCH DIVIDENDS IN ORDER TO BE CONSIDERED TO BE PART
OF THE SERIES

RESPONSE 48(10) DEEMS A SERIES OF TRANSACTIONS TO INCLUDE
TRANSACTIONS OR EVENTS COMPLETED IN CONTEMPLATION
OF THE SERIES.
OUR VIEW IS THAT A PRELIMINARY TRANSACTION WILL FORM
PART OF A SERIES IF AT THE TIME THE PRELIMINARY
TRANSACTION IS CARRIED OUT THE TAXPAYER INTENDS TO
IMPLEMENT SUBSEQUENT TRANSACTIONS AND THIS IN FACT
HAPPENS
THE FACT THAT THE TAXPAYER MAY NOT HAVE DETERMINED
ALL OF THE IMPORTANT ELEMENTS; FOR EXAMPLE
IDENTIFIED A THIRD PARTY, OF THE SUBSEQUENT
TRANSACTION WOULD NOT PREVENT THE PRELIMINARY
TRANSACTION FROM BEING PART OF A SERIES
A'S FATHER'S INTENTION IS THE KEY FACTOR

• 2. SALARIES, BONUSES, USE OF COPORATE ASSETS

QUESTION 1 SIZE OF BONUS A SOLE OWNER MANAGER MAY PAY
HIMSELF

RESPONSE - THE REASONABLENESS TEST OF SEC 67 COULD HAVE
APPLICATION TO ANY EXPENSE

• • GENERALLY WE WOULD NOT SEEK TO APPLY SEC 67 IN RESPECT OF A BONUS TO AN OWNER/EMPLOYEE WHERE HE IS ACTIVE IN THE BUSINESS

QUESTION 2 GUIDELINES FOR REASONABLENESS OF SALARIES PAID
TO FAMILY MEMBERS WHO ARE NOT ACTIVE IN THE
BUSINESS FOR EXAMPLE SPOUSES WHO COME IN ONCE
A WEEK TO SIGN CHEQUES OR CHILDREN WHO HAVE
SUMMER JOBS

RESPONSE - WE WOULD CONSIDER THAT AN AMOUNT THAT WOULD BE
PAID IN AN ARMS LENGTH TRANSACTION WOULD BE
REASONABLE

• • REFER TO MADUKE CASE [[1989] 2 C.T.C. 284] DTC 89 DTC 5458 FC TD

QUESTION 3 VALUATION OF BENEFIT FOR CORPORATE OWNED
PROPERTY USED BY SHAREHOLDER. WHERE THE
SHAREHOLDER CONTRIBUTES THE FUNDS TO
PURCHASE THE ASSET THAT IS USED COULD ONE LOOK
AT THE FINANCIAL ADVANTAGE THAT IS GAINED BY
THE SHAREHOLDER AS THE BENEFIT RATHER THAN
USING FAIR MARKET VALUE OR A RETURN ON
INVESTMENT VALUATION

RESPONSE -THERE ARE A NUMBER OF CASES ON THIS ISSUE, YOUNGMAN
AND WOODS BEING THE MOST RECENT. THESE HELD THAT
THERE IS A FMV BENEFIT OR A RETURN ON INVESTMENT
BENEFIT

• • THE U.S. CONDO POSITION WAS TAKEN IN 1980 IN RESPECT OF A SPECIFIC RULING AND WAS NOT MEANT TO BE ANY BROADER. IT IS ANTICIPATED THAT THE CANADA U.S. TAX AGREEMENT WILL BE AMENDED SOON TO RECOGNIZE CERTAIN TAXES PAID IN THE OTHER JURISDICTION. WHEN THIS HAPPENS THERE WILL NO LONGER BE A NEED FOR OUR ADMINISTRATIVE POSITION
• • OUR VIEW IS THAT THE SEPARATE CORPORATE ENTITY MUST BE RECOGNIZED AND THE VALUE OF A BENEFIT IS NOT RELATED TO HOW MUCH YOU HAVE INVESTED IN THE COMPANY. WHERE THE CORP IS OTHER THAN A SOLE PURPOSE CORP IT IS LIKELY DIFFICULT TO TRACK FUNDS
• • THIS QUESTION HAS BEEN RAISED IN ANOTHER FORUM AND THE DEPARTMENT HAS UNDERTAKE TO REVIEW THE ISSUE. ANY CHANGE IN POSITION WILL LIKELY BE ANNOUNCED IN AN IT BULLETIN

QUESTION 4 RE U.S. PERSONAL USE PROPERTY ADMINISTRATIVE
POSITION. AT 89 CTF REVENUE SAID THAT THERE WAS NO
CHANGE IN POSITION. HOWEVER WE UNDERSTAND THAT THE
POSITION WILL NOT APPLY IF THE PROPERTY IS ROLLED TO
THE CORP

PARTICULAR CASE AND INVOLVED THE PURCHASE OF A
PROPERTY AT FAIR MARKET VALUE

• • THE DEPARTMENT HAS NEVER CONSIDERED IT APPROPRIATE IN A SECTION 85 SITUATION
• • THE EXAMPLE OF PROTECTING THE PRINCIPAL RESIDENCE EXEMPTION IS ENOUGH REASON TO MAKE THIS EXTENSION OFFENSIVE

PENSION FUND INVESTMENTS

QUESTION IS EITHER THE DEPARTMENT OF FINANCE OR REVENUE
CANADA AWARE OF ANY SITUATION IN WHICH A SMALL
BUSINESS HAS ATTEMPTED TO ACCESS FUNDS IN RRSP'S OR
PENSION PLANS BY WAY OF SMALL BUSINESS INVESTMENT
CORPS, SMALL BUSINESS INVESTMENT TRUSTS, OR SMALL
BUSINESS INVESTMENT LIMITED PARTNERSHIPS? IT IS
POSSIBLE THAT MORE DIRECT ACCESS TO THESE FUNDS
COULD BE INTRODUCED?

RESPONSE WE HAVE ISSUED TWO RULINGS FOR SMALL BUSINESS
INVESTMENT LIMITED PARTNERSHIPS AND ONE FOR A SMALL
BUSINESS INVESTMENT CORP.
WE HAVE HAD A LARGE NUMBER OF GENERAL INQUIRIES

SUPPLEMENTARY QUESTIONS

QUESTION 1 WHERE AN INDIVIDUAL OR A CORPORATION TRANSFERS
PROPERTY TO A CORPORATION ALL OF WHOSE SHARES HE OR
IT ALREADY OWNS, WILL RCT INVOKE THE "BENEFIT"
PROVISIONS IF THE VALUE OF THE SPECIFIC SHARE OR
SHARES TAKEN BACK ON THE TRANSFER IS LESS THAN THE
VALUE OF THE TRANSFERRED ASSETS? THE VALUE OF THE
TRANSFEROR'S ASSETS HASN'T CHANGED.

RESPONSE THIS WAS RAISED AT THE 89 CTF

85(1)(E.2) APPLIES WHERE IT APPEARS REASONABLE TO
CONCLUDE THAT THE EXCESS IS A BENEFIT THAT THE
TAXPAYER WISHES TO CONFER ON THE CORPORATION.

IN OCTOBER 89 DEPT. OF FINANCE ANNOUNCED THAT THEY
WOULD RECOMMEND A CHANGE TO 85(1)(E.2) TO PERMIT
THIS TYPE OF TRANSACTION BETWEEN A PARENT AND
SUBSIDIARY CORP.

QUESTION 2 BEFORE IMPLEMENTING AN ESTATE FREEZE FATHER HAD A
VALUATION OF HIS SHARES PREPARED BY A FIRM OF
BUSINESS VALUATORS. ON THE CORP REORG HE TOOK BACK
SHARES HAVING A VALUE OF HIS OLD SHARES. IF
SUBSEQUENTLY IT IS DETERMINED THAT THE OLD SHARED
HAD A GREATER VALUE, IS IT "REASONABLE TO REGARD"
THE EXCESS AS A BENEFIT THAT FATHER "DESIRED TO HAVE
CONFERRED" ON HIS CHILDREN WHO ARE THE COMMON
SHAREHOLDERS?

RESPONSE WE HAVEN'T DEALT WITH THIS BEFORE

DEPENDING ON THE CIRCUMSTANCES IT MAY BE REASONABLE
TO REGARD THAT FATHER MAY HAVE WISHED TO CONFER A
BENEFIT DESPITE THE VALUATOR'S REPORT.

QUESTION 3 IT 169 [IT-169] STATES THAT REVENUE CANADA WILL ACCEPT A FORM
OF PRICE ADJUSTMENT CLAUSE UNDER WHICH THE PARTIES
AGREE TO ACCEPT RCT'S DETERMINATION OF VALUE. IS
THIS THE ONLY FORM OR PRICE ADJUSTMENT CLAUSE THAT
RCT WILL RECOGNIZE AS VALID.

RESPONSE WE WILL RECOGNIZE CLAUSED MEETING ALL THE
REQUIREMENTS SET OUT IN THE BULLETIN. IF THERE IS
SOME OTHER POSITION DESIRED IT SHOULD BE SUBMITTED
FOR OUR REVIEW.

P A R T II

Transfers for Inadequate Consideration

(85(1)(e.2); 86(2); 87(4) and 51(2))

The corporate reorganization sections in the Income Tax Act contain provisions which impose "penalties" for transfers to or share exchanges with corporations where the value of the property given up exceeds the value of the property received, and "it is reasonable to regard any part of such excess as a benefit that the taxpayer desired to have conferred on a person related to the taxpayer." These provisions give rise to the following questions:

• 1. Where an individual or a corporation transfers property to a corporation all of whose shares he or it already owns, will Revenue Canada invoke the "benefit" provisions if the value of the specific share or shares taken back on the transfer is less than the value of the transferred assets? The value of the transferor's assets hasn't changed.
• 2. Before implementing an estate freeze, Father had a valuation of his shares prepared by a firm of business valuators. On the corporate reorganization he took back shares having a value equal to the valuators opinion as to the value of his old shares. If subsequently it is determined that the old shares had a greater value, is it "reasonable to regard" the excess as a benefit that Father "desired to have conferred" on his children who are the common shareholders?
• 3. Interpretation Bulletin IT-169 states that Revenue Canada will accept a form of price adjustment clause under which the parties agree to accept Revenue Canada's determination of value. Is this the oily form of price adjustment clause which Revenue Canada will recognize as valid?
• 4. Consider the following fact situation. Father set up Old Opco many years ago and the adjusted cost base of his shares is $100. Old Opco prospered and financed itself by reinvesting its earnings. His sons wanted into the business so he caused Opco to transfer the business assets, worth $450,000 and with an ACB of $250,000, to New Opco. His sons subscribed for 2 common shares for $2.00. Old Opco received $450,000 worth of common shares. Sometime later New Opco reorganized its capital and Old Opco exchanged its New Opco commons for $250,000 worth of preference shares. The sons now owned all of the common shares. It appears that the effect of subsection 86(2) is that Old Opco is deemed to have disposed of its New Opco common shares for $200,000. Since the ACB of those shares was $250,000 Old Opco doesn't realize a capital gain. The adjusted cost base of the New Opco preference shares is deemed to be $50,000. The value of Father's shares of Old Opco is now reduced by $200,000 and the value of the sons' common shares is increased by $200,000. Is this analysis correct?
• 5. Suppose in this case immediately before a sale of New Opco, the preference shares were redeemed. Prior to the transfer of the business assets to New Opco, Old Opco had safe income of over $250,000. Will subsection 55(2) apply to the deemed dividend on the redemption?
• 6. When the reorganization of New Opco shares took place the sons were considering whether to sell the business or to continue to operate it. They tried for another 2 years to operate it but disagreements about policy matters finally made them decide to sell. Are the sons ineligible to claim the capital gains exemption by reason of subsection 110.6(7)?

"Taxation Issues of Family Companies"

• 1. Qualified Small Business Shares; Corporate Reorganizations; Life Insurance

Fact Situation I:

In March, 1988 A started up a business in a building which he bought for the purpose. The business immediately looked as if it would be successful and so he brought his two younger brothers, B and C, into it. In August, 1988 A, B and C transferred everything but the building (which was still owned by A) into a new corporation, X Co. in which A owned 60% of the shares and B and C owned 20% each. The three brothers entered into a buy-sell agreement under which the survivors had the option to buy the deceased's shares and the deceased's widow had the option to "put" his shares to the survivors. They arranged for X Co. to purchase the insurance necessary to fund this agreement.

In July, 1989 A was diagnosed as suffering from a terminal illness and died in July, 1990. Under his will all of his assets passed to his widow.

Questions:

• 1. The normal rule is that to qualify for the $400,000 exemption in respect of shares they cannot have been owned by an unrelated person within the previous 24 months. New shares issued by a corporation are deemed to have been owned by an unrelated person unless they were issued in exchange for substantially all of the assets used in an active business. By retaining the building in his own name, has A denied himself the protection of this exclusion?
• 2. Why isn't there an exception from the "2-year hold" rule in the case of death? Even the press couldn't consider this a loophole of which the rich would try to take advantage!
• 3a) Are the shares of X Co. rolled over to Mrs. A on A's death? If the buy-sell agreement required that A's Estate must sell his X Co. shares and B and C must buy them, would there be a rollover? In other words could it be said that the shares vested indefeasibly in the spouse? Or, does Revenue Canada still take the view that the Parkes Estate case was properly decided.
b) Had Mr. A died four months later, could his executors use his 5400,000 exemption in his year of death? The concern here is that while the insurance proceeds would not come into X Co. until after A's death the value of the insurance immediately prior to his death would exceed its cash surrender value with the result that it represents more than 10% of the assets in X Co. If the insurance policy is not considered to be an asset used in carrying on an active business, then substantially all of X Co.'s assets would not be used in the business, and it would no longer be a qualified small business corporation.
• 4. Assuming that the shares of X Co. do rollover on A's death to Mrs. A, can she use her $400,000 capital gains exemption when she sells the shares to 8 and C? Or will the insurance proceeds have put X Co. "off side"? Even if the proceeds were paid out before the sale, she would not get the $400,000 exemption for 2 years if the proceeds represented over 50% of the total assets in X Co.
• 5. If each of A, B and C had used a holding corporation to hold his shares of X Co. and also to hold his insurance on the lives of the others, could Mrs. A trigger a $400,000 capital gains exemption by transferring the holding corporation shares in September 1990 and only subsequently, having the holding corporation transfer the shares of X Co. to the other corporations?
• 6. It may be attractive to try to use both A's and Mrs. A's $400,000 exemption. Could Mrs. A, as A's executor, elect out of the rollover to her in respect of some of his X Co. shares and not others? Is each share a separate property for purposes of subsection 70(6.2)?

Fact Situation II:

The fact situation is the same as I, except that:

• (i) A had transferred the building to X Co. at the beginning, but
• (ii) no insurance or buy-sell agreement was in place at his death.

B, C and Mrs. A agree that they would like to distribute the building to Mrs. A in satisfaction of the 60% interest in X Co. which she inherited from A. The building represents 60% of X Co.'s total assets.

Questions:

• 1. May the building be "butterflied" to a new corporation controlled by Mrs. A?
2. If the answer to Q. 1 would be "yes", because the building and the other assets of X Co. were all business assets, would the answer be different if two months before A died, X Co. moved to rental premises and leased the building to an arm's length tenant? Or would the butterfly rules not apply here because:
• i) the building is now an investment property and a pro rata portion is not being distributed to each shareholder, as required to meet the exclusion under paragraph 55(3)(b), and
• ii) the parties cannot rely upon the non-arm's length exemption in paragraph 55(3)(a), since the brothers are deemed to deal with each other at arm's length for purposes of the butterfly rules and Mrs. A ceases to be related once A dies?
• 3. Suppose, faced with the fact that the reorganization described in Q. 2 could not be accomplished tax-free, A redrew his will before he died to name his father, F, as his executor and left his shares of X Co. to a spouse trust for his wife. Could F, who doesn't deal with B or C at arm's length, carry out a butterfly using the non-arm's length exemption?
• 4. A non-arm's length butterfly is not exempt under paragraph 55(3)(a) if it leads to the sale of assets to an arm's length person. Does this mean any sale in the future or simply one that was specifically contemplated when the butterfly began? In our facts, A's executor was not certain whether he would hold on to the building or sell it when the butterfly was carried out.
• 2. Salaries, Bonuses, Use of Corporate Assets

Questions:

• 1. Does Revenue Canada consider that there is any limit on the size of bonus which the sole owner/manager of a corporation may pay to himself?
• 2. Does Revenue Canada have any guidelines as to what is reasonable for salaries for members of the family, e.g. spouses who come in once a week to sign cheques or children who have summer jobs at the company?
• 3. Revenue Canada has said that, except in the case of a corporation used solely to hold a U.S. personal-use residence, when a corporation allows a shareholder to have the use of a corporate-owned asset, the shareholder must pay market rental. Where the market rental is not easily ascertainable, he must pay a percentage of value. This may be appropriate where the company bought the property with retained earnings. Where, though, the shareholder contributed the capital to acquire the asset, could one look at the advantage gained by the shareholder to determine the benefit and not to a return on the value of the property? In other words, compare the difference in the cost to the shareholder of owning the asset personally with the cost to him of having the corporation own it.
• 4. While Revenue Canada stated at the 1989 Round Table that there has been no change to the rules regarding corporations set up to hold U.S. personal-use real estate, we keep hearing rumors that Revenue Canada now takes the position that these rules do not apply where the Canadian previously owned the property and transferred it to his company. Is this rumor correct?
• 3. Pension Fund Investments

Questions

• 1. Is either the Department of Finance or Revenue Canada aware of any situation in which a small business has attempted to access funds in RRSPs or pension plans by way of Small Business Investment Corporations, Small Business Investment Trusts or Small Business Investment Limited Partnerships? Is it possible that more direct access to these funds could be introduced?

Fact Situation II

The facts are the same as in Fact Situation I except that:

• (a) A had transferred the building to X Co at the beginning; and
• (b) there was no corporate-owned insurance and no buy-sell agreement in place at his death.

B, C and Mrs. A agree that they would like to distribute the building to Mrs. A in satisfaction of her 605 interest in X Co which she inherited from A. The fair market value of the building represents 605 of the fair market value of all of X Co's property.

Question I:

If the building is transferred by way of a "single-winged butterfly" of X Co to a new holding corporation ("A Co") to which Mrs. A has transferred her shares of X Co, will the dividends deemed to be paid on the cross redemption of shares of X Co and A Co be exempt from the application of subsection 55(2) of the Act by virtue of paragraph 55(3)(b)?

Response:

Yes, assuming that the building and all of the other property of X Co constituted business property for the purposes of paragraph 55(3)(b).

Question 2:

Would the response to Question I be different if, before A's death, X Co ceased to use the building in its business and leased it instead to an arm's-length tenant, so that the building produced income from property rather than income from an active business?

Response:

Yes. The building would be classified as an investment property for the purposes of paragraph 55(3)(b) The exemption in paragraph 55(3)(b) would therefore not apply because A Co would not have received its pro rata share of each type of property of X Co.

As the series of transactions that includes the dividends would result in an increase in interest in X Co by B and C, both of whom would be considered to deal at arm's length with A Co and X Co by virtue of paragraph 55(5)(e), the dividends would not qualify for the exemption in paragraph 55(3) (a).

Question 3:

Would the response to Question 2 be different if A's shares of X Co were bequeathed not to Mrs. A but to a spousal trust for Mrs. A with A's father appointed as the sole trustee?

Response:

Yes. In this situation A's father, who is related to A's brothers, would ordinarily, subject to the terms of the trust, control both A Co and X Co. Subject to the application of subsection 55(4), each of the brothers would be deemed to be related to, and not to deal at arm's length with, A Co and X Co and the dividends would qualify for the exemption in paragraph 55(3)(a) provided that the "butterfly" transactions that result in the' deemed dividends are not part of a larger series of transactions that results in the disposition of property to, or an increase in interest in any corporation by, a third party who deals at arm's length with A Co or X Co. If the principal purpose of establishing the spousal trust with A's father as sole trustee could reasonably be considered to be to cause the brothers to be related to, or not to deal at arm's length with, A Co and X Co, subsection 55(4) would apply to deem them not to be related and to deal with each other at arm's length for the purposes of section 55.

Question 4:

Would any future sale of the shares or assets of A Co to an arm's length third party be considered to be part of the series of transactions that included the deemed dividends or would such a future sale have to be specifically contemplated at the time of such dividends in order to be considered part of the series?

Response:

Subsection 248(10) of the Act deems a series of transactions to include transactions or events completed in contemplation of the series. It is Revenue Canada's view that a preliminary transaction will form part of a series if, at the time the preliminary transaction is carried out, the taxpayer intends to implement the subsequent transactions constituting the series, and the subsequent transactions are eventually carried out. Thus the preliminary and subsequent transactions may form part of the same series even though at the time of the completion of the preliminary transaction the taxpayer may not have determined all of the important elements of the subsequent transactions -- such as, for example, the identity of other parties involved -- or lacked the ability to implement the subsequent transactions. In the present example, A's father would have to have formed the intention, at the time of the preliminary "butterfly" transactions, to sell the shares or assets of A Co in order for the subsequent sale to be considered to be part of a series that included the preliminary transactions.