14 August 1981 Income Tax Severed Letter RCT 5-2662 F

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 XXX:

RE:     Rollover of Contractors Holdbacks under Subsection 85(1)

This is in reply to your letter of May 1, 1981 wherein you request our opinion on the above-noted subject. Your question relates to the treatment of contractors' holdbacks (as described in paragraph 3 of IT-92R) for the purposes of subsection 85(1) of the Act. You are of the opinion that such holdbacks should be considered as inventory. Inventory is defined under section 248 of the Income Tax Act to be property the cost or value of which is relevant in computing a taxpayer's income from a business for a taxation year. IT-291R specifies that inventory includes work in progress of a professional who has elected under paragraph 34(1)(d) of the Act. Since holdbacks are of the same nature as work in progress, they could be transferred as inventory.

Technically the holdbacks are not inventory but are rights to receive amounts in the future. The Department is nevertheless, prepared to consider the holdbacks as being inventory for the purposes of subsection 85(1) of the Act provided that:

1. The reduction in capital will not result in a disposition of the shareholder's shares.

2. A deemed dividend under subsection 84(4) of the Act will not result as the amount paid on the reduction of paid-up capital is not in excess of the paid-up capital so reduced.

3. Under subparagraph 53(2)(a)(ii) of the Act, the adjusted cost base of the shareholder's shares will be reduced by an amount equal to the amount received on the reduction of paid-up capital. As the adjusted cost base is nominal, this will result in a negative cost base and consequently a capital gain under subsection 40(3) of the Act.

4. The taxpayer individual will be entitled to claim an exemption under subsection 110.6(3) of the Act to the extent of the limits provided by that provision.

5. The anti-avoidance measures provided under section 245(1.1) of the Act will not apply as no conversion of income to capital gain has resulted.

You request our confirmation of the income tax consequences described above. However, as the fact situations in your letter would appear to relate to proposed transactions involving identifiable taxpayers we are unable to comment in specific reference thereto other than by way of advanced income tax ruling requests. We note that several of your questions require determinations of fact. Thus, we will consider the matter on a ruling basis if all relevant facts are determinable at the advanced rulings stage. In the alternative, we are prepared to provide the following general comments concerning the provisions of the Act and the Regulations that are the subject of your inquiries.

In our view, there is nothing in the Act to preclude subparagraph 69(1)(b)(i) of the Act from applying to a redemption of shares in which the provisions of subsection 84(3) of the Act might also apply. Subsection 84(9) of the Act provides that a redemption of shares is a disposition to the corporation for purposes of the Act. Where the taxpayer is the sole shareholder of the corporation the disposition is to a non-arm's length party. Thus, if the fair market value of the shares at the time of redemption exceeds the redemption price, subparagraph 69(1)(b)(i) of the Act in our view operates to deem the taxpayer to receive proceeds equal to fair market value. In our view the application of subparagraph 69(1)(b)(i) of the Act does not affect the application of subsection 84(3) of the Act. The latter provision applies to actual proceeds by virtue of the words "... the amount paid by the corporation on the redemption"... and not to proceeds deemed to have been received under subparagraph 69(1)(b)(i) of the Act. Thus, to the extent that the actual proceeds on the redemption exceed the paid-up capital of the shares, subsection 84(3) of the Act deems the shareholder to have received a dividend of an amount equal to that excess. This deemed dividend would be deducted from the deemed proceeds of disposition pursuant to subparagraph 54(h)(g) of the Act thereby reducing the gain computed under subsection 40(1) of the Act on redemption.

It is a question of fact as to whether shares that have been redeemed are prescribed shares within the meaning of section 6205 of the Regulations. Where the terms or conditions of the shares permit the corporation unilaterally to redeem the shares or permit the holder to cause the corporation to exercise a redemption, clauses 6205(1)(a)(i)(G) or (D) of the Regulations generally preclude the shares from being prescribed shares. With regard to a redemption of shares under section 123.56 of the Quèbec Companies Act, in our view, clauses 6205(1)(a)(1)(G) or (D) of the Regulations do not apply because such a redemption, in and of itself, is not carried out pursuant to the terms or conditions of the shares or an agreement in respect of the shares or their issue.

In connection with the possible application of subsection 110.6(8) of the Act, even if shares are not prescribed shares it may be that any capital gain on their disposition is not attributable to the fact that dividends were not paid on the shares and thus subsection 110.6(8) may not apply. This is another determination that can only be made after a complete examination of all the relevant facts.

With respect to a reduction of capital not accompanied by a redemption or cancellation of the shares, assuming there is no obligation to reduce paid-up capital pursuant to the terms or conditions of the shares or any agreement in respect of the shares or their issue, at the time of their issue, the provisions of clause 6205(1)(a)(i)(F) Regulations will not preclude the shares from being prescribed shares.

As discussed in the Special Release to Interpretation Bulletin IT-448 dated June 21, 1982, a reduction in paid-up capital that involves the redemption or cancellation of a share is a disposition in the hands of the holder by virtue of clause 54(c)(ii)(A) of the Act. However, a reduction in the paid-up capital in respect of a share, not accompanied by a redemption or cancellation of that share, will not constitute a disposition of that share.

Where the amount paid on the reduction in paid-up capital is not in excess of the paid-up capital before reduction, a deemed dividend under subsection 84(4) of the Act will not occur. However, pursuant to subparagraph 53(2)(a)(ii) of the Act, the adjusted cost base of the shareholder's shares is reduced by an amount equal to the amount received on the reduction in capital except to the extent that the amount is deemed by subsection 84(4) of the Act to be a dividend. This may result in a gain under subsection 40(3) of the Act.

With respect to our above comments we would like to point out that we have not addressed the effects of the possible application of section 84.1 or subsection 85(2.1) of the Act, as the result of a transfer of property sometime after 1983 to the holding company pursuant to the provisions of section 85 of the Act, on the adjusted cost base or the paid-up capital of the shares in the holding company. In addition should the holding company redeem its shares for less than their fair market value it is our view that the provisions of subsection 110.6(7) of Act may apply to deny the capital gains deduction under subsection 110.6(3) of the Act.

Regarding subsection 245(1.1) of the Act, in our view the intention of this provision is to prevent the conversion of ordinary income into a capital gain. Whether or not subsection 245(1.1) of the Act applies in any particular case can only be determined after reviewing all of the relevant facts. Among other factors we would consider are the following: the purpose of the transaction, the type of property transferred on a tax-deferred basis, the type of gain that would be realized on a sale at fair market value, whether the subsequent disposition of the shares received in consideration of the transfer was contemplated at the time of the transfer, and whether the purpose of the rollover was to facilitate a conversion of ordinary income into a capital gain. If the transfer on a tax deferred basis occurred prior to November 22, 1985, section 245(1.1) of the Act does not apply due to its coming into force provisions. For further discussion of the intent and prerequisites of section 245(1.1) of the Act we refer you to the comments at pages 138 to 140 of the November 22, 1985 "Technical Notes to a Bill Amending the Income Tax Act and Related Statutes" (the "Technical Notes").

We cannot say that subsection 247(1) of the Act would not apply as this is also a question of fact. A paper entitled "Subsection 247(1) and the 1985 Amendments to the Income Tax Act" presented at the 1986 Canadian Tax Foundation Conference provides a background discussion of subsection 247(1) of the Act from the Department's perspective. We also refer you to pages 140 to 142 of the Technical Notes.

We trust this will be of some assistance.