4 June 1986 Income Tax Severed Letter RCT 5-1024

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.

Dear Sir:

This is in reply to your letters of February 6, 1986 and February 26, 1986 concerning the above-captioned matter. In this connection you have asked us to consider the following factual situation:

• 1. A and B are individual taxpayers resident to Canada who are deemed not to deal with each other at arm's length by virtue of paragraph 251(1)(a) of the Income Tax Act (Canada) (the "Act");
• 2. A and B each owns 50% of the issued and outstanding common shares of an operating company ("Opco"). The common shares are fully paid and non-assessable, and there are no other shares outstanding in Opco's capital stock;
• 3. The adjusted cost base ("ACB") and fair market value ("FMV") of each shareholder's interest in Opco is $1.00 and $1 million, respectively. Opco is a Canadian-controlled private corporation carrying on business in Canada and earning active business income. It was incorporated in Ontario in 1974 and has carried on business in that jurisdiction since that date;
• 4. In 1980, A and B entered into a Shareholder Agreement (the "Agreement") which provided, inter alia, that Opco would acquire a term life insurance policy (no cash surrender value) in the amount of $) million on the life of each shareholder. The Agreement further provided that on the death of a shareholder, Opco would collect the proceeds and credit the proceeds to its capital dividend account within the meaning of paragraph 89(1)(b) of the Act ("CDA"). Concurrently, the surviving shareholder would purchase shares of the deceased shareholder for FMV. The Agreement provides that FMV for the purposes of the buy and sell obligation in FMV determined in accordance with generally accepted accounting principles immediately before the death of the shareholder;
• 5. The purchase and sale of the deceased shareholder's shares would take place as follows: on the death of the shareholder, the surviving shareholder would purchase the deceased shareholder's common shares from his estate for a promissory note in the amount of $1 million. Opco would then declare a dividend on its common shares, which dividend would be elected to be paid out of the CDA in the amount of $1 million. The amount received by the surviving shareholder would then be used to pay the promissory note owing to the estate of the deceased shareholder;
• 6. The common shares represent capital properties to the shareholders;

With regard to the foregoing, you wish to know whether the policy proceeds received by Opco will inflate the FMV of Opco's shares such that on a disposition of the shares by the estate to B, the proceeds of disposition to the estate will be adjusted to $1,500,000 as a result of the application of paragraph 69(1)(b) of the Act.

Generally, as is evident from the provisions of paragraph 4 of Interpretation Bulletin IT-14052, the Department will closely scrutinise option and buy-sell agreements entered into by parties who do not deal at arm's length. It is understood that in all cases in which non-arm's length agreements represent colourable attempts designed artifically to reduce the value of capital assets for capital gains tax purposes, the Department may disregard such agreements in determining the fair market value of property in connection with deemed dispositions on death. With regard to property transfers by estates to survivors and to dispositions inter vivos, it is the Department's view that the provisions of subsection 55(1) of the Act may properly be invoked to increase a gain or reduce a loss to a non-arm's length transferor may be required to include an amount in income parsuant to paragraph 245(2)(a) or may be regarded as a donce for the purpose of paragraph 245(1)(c) of the Act. Where paragraph 245(2)(c) is applicable, paragraphs 69(1)(b) and 69(1)(c) will be applied to the donor and the donee respectively, and in this connection the fair market value will be determined without regard to the existence of a non-arm's length option or buy-sell agreement.

In a situation such as you have described, the onus would be on the taxpayers to establish that their transactions were entirely consistent with the commercial norm and such as would have been entered into by parties dealing at arm's length. In Besment v. M.H.R., 70 DTC, 6130 the Supreme Court of Canada, in recognising the effect of a non-arm's length agreement upon the valuation of shares relied upon the following comments of the President of the Exchequer Court:

... No attack has been made on the bona fida of the arrangements. No resort has been made by the respondent to any provision designed to deal with tax avoidance schemes where closely related persons are involved. It follows therefore, as I appreciate the matter, that it must be appraised in the same way as it would be appraised if the Class "A" shares had been taken up by persons who were dealing with the deceased at arm's length and who subscribed very substantial sums for a relatively small annual dividend and a covenant by the deceased that the company would be wound up on his death so that they would then receive any capital gains that had been acquired by the company.

The Department accordingly accepts that in circumstances where the transactions concluded pursuant to a non-arm's length buy-sell agreement does not result in any undue tax advantages to either of the parties or to the company, the buy-sell agreement will effectively bear upon the fair market value of the shares held by the estate and paragraph 69(1)(b) will not be invoked to deem the estate to have received proceeds of disposition for the shares which include all or a portion of the value of insurance proceeds received by the company in order to fund the transfer.

We would point out that the foregoing opinion is a general comment upon a hypothetical situation and is not binding upon the Department. In view of the many difficulties which can arise in connection with non-arm's length buy-sell agreements, actual transactions would seem to be best dealt with on an advance ruling basis.

We trust that the above is of assistance.