9 January 1986 Income Tax Severed Letter RCT 5-2025A

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 Sirs:

This is in reply to your letter of August 7, 1986 in which you requested our opinion on the application of subsections 70(5), 85(2.1), 164(6) and section 84.1 of the Income Tax Act (the "Act") in the situation described below.

• 1. Father and Son are residents of Ontario, Canada.
• 2. Father owns all of the outstanding, redeemable, non-voting, preference shares of Subject Co., a Canadian-controlled private corporation. The preference shares are capital property to the Father. They have the following characteristics:

Cost equal to paid-up capital ("PUC") $ 1

Adjusted cost base ("ACB") equal to
valuation day amount $1,000,000

Redemption value and fair market value,
immediately before Father's death $3,000,000

• Those shares were received on the freeze of Father's interest in an operating company.
• 3. Son owns all of the outstanding voting common shares of Subject Co.
• 4. Subject Co. owns all of the outstanding shares of an operating company.
• 5. Father dies on January 1, 1987.
• 6. Son is the executor, trustee, and sole beneficiary of Father's estate ("the Estate").
• 7. In 1987, the Estate incorporates Purchaser Co. under the laws of Ontario. The Estate owns all the common shares of Purchaser Co., the only class of shares issued and outstanding prior to the transaction described in paragraph 8 below.
• 8. The Estate transfers the preference shares of Subject Co. to Purchaser Co. in exchange for shares ("new shares") of Purchaser Co. which are redeemable on demand of holder and elects under subsection 85(1) of the Act to effect the transfer at fair value, i.e. $3,000,000, with the following results:

Proceeds to Estate $3,000,000

ACB of Subject Co. shares to Purchaser Co. $3,000,000

ACB of new shares to the Estate $3,000,000

• 9. The legal PUC and redemption value of the new shares is set at $3,000,000.
• 10. The Subject Co. preference shares are redeemed in 1987.
• 11. The new shares of Purchaser Co. are redeemed in 1987 and an election is made under subsection 164(6) of the Act with respect to any resulting capital loss realized by the Estate.
• 12. It is assumed that Father realized other capital gains prior to the year of death sufficient to fully utilize his available capital gains exemption and that Father had no other income in the year of death.
• 13. It further is assumed Subject Co. has no preferred earnings amount or Refundable Part I taxes on hand.

As we agreed in our telephone conversation, we will address only certain issues raised in your letter. In the first scenario the Estate and the Father do not deal at arm's length. In that situation it is our opinion that certain tax consequences would be as follows:

• (a) subsection 70(5) of the Act would apply to deem Father to have disposed of his preference shares for $3,000,000 so that a $1,000,000 taxable capital gain would be realized and the Estate would be deemed to acquire the preference shares for $3,000,000,
• (b) on the redemption of the preference shares of Subject Co. held by Purchaser Co. a deemed dividend would be realized pursuant to subsection 84(3) of the Act and a capital loss would be denied pursuant to subsection 112(3) of the Act:
• (c) paragraph 84.1(1)(a) of the Act would apply to reduce the paid-up capital of the new shares by $1,000,000 so that on the redemption of new shares by Purchaser Co. a deemed dividend of $1,000,000 will be realized by the Estate pursuant to subsection 84(3) of the Act, and
• (d) an allowable capital loss of $500,000 to the Estate created as a result of the redemption referred to in (c) above will be denied by virtue of subsection 85(4) of the Act but the adjusted cost base of the common shares of Purchaser Co. owned by the Estate will increase by $1,000,000 pursuant to paragraph 85(4) of the Act.

In the second scenario the Estate and the Father do deal at arm's length. In that situation it is our opinion that certain tax consequences would be as follows:

• (a) same as (a) in the first scenario;
• (b) same as (b) in the first scenario, and
• (c) subsection 84.1(1) of the Act would not reduce the paid-up capital of the new shares because paragraph 84.1(2)(a.1) of the Act would not reduce the adjusted cost base of the preference shares for purposes of section 84.1 of the Act.

Where the trust (i.e. Estate) is created on the death of the Father as a result of a will it is the Department's position that the notion of dealing at arm's length is not applicable where the Estate acquired shares by virtue of the death of the Father. Therefore, in the situation described above paragraph 84.1(2)(a.1) of the Act would not reduce the adjusted cost base of the preference shares.

We trust this information will be of assistance to you.