10 June 1987 Income Tax Severed Letter RCT 5-2848

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 January 23, 1987 in which you requested our view on the meaning of the phrase "capital gain... that could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971" in subsection 55(2) of the Income Tax Act of Canada (the "Act"). The situation described in your letter is as follows:

• 1. Opco carries on an active business in Canada.
• 2. Holdco acquired all the shares of Opco in (1960) and held them continuously until 1980.
• 3. In 1980 Holdco sold the shares of Opco to three employees of Opco for a nominal amount of cash plus debt. The Opco shares were pledged to Holdco as security for the debt. Holdco realized a capital gain on the sale and claimed a reserve pursuant to subparagraph 40(1)(a)(iii) of the Act in respect of the proceeds of disposition which were not due until after the end of the year.
• 4. In subsequent years further payments were received and Holdco recognized the amounts as capital gains in respect of the disposition.
• 5. In 1984 as a result of the purchasers' failure to make payments required under the purchase and sale agreement, Holdco reacquired the Opco shares. Holdco's cost of the shares was deemed by paragraph 79(f) of the Act to equal the amount by which the cost of the remaining debt owing to Holdco exceeded the amount of the reserve claimed in the preceeding year. As a result, Holdco's cost of the Opco shares is less than than its cost prior to the sale in 1980.
• 6. Two current employees of Opco have approached Holdco with respect to the purchase of the Opco shares. It is proposed that the Opco common shares will be converted to preferred shares under section 86 of the Act, and that such shares will be redeemed at a future date. Presumably the purchasers will acquire new Opco common shares. The redemption price of the Opco preferred shares will exceed the paid-up capital of the shares, and accordingly the redemption will give rise to a deemed dividend under subsection 84(3) of the Act to the extent of such excess.

You have requested our views on the application of subsection 55(2) of the Act to the deemed dividend arising on redemption of the Opco preferred shares. The situation described in your letter appears to relate to an actual proposed transaction. A request for our opinion in respect of a proposed transaction should be submitted in the form of an advance income tax ruling request as described in Information Circular 70-6R, dated December 18, 1978. Nevertheless, we will provide you with our general comments on the situation you described. Our comments are not rulings and are not binding on the Department of National Revenue, Taxation.

Subsection 55(2) will apply to the deemed dividend arising on redemption of the Opco preferred shares if the deemed dividend results in a significant reduction in the capital gain on the shares attributable to anything other than income earned or realized by Opco (or its subsidiaries, if any) after 1971 (the "safe income"). Ordinarily, the safe income of a corporation with respect to a share will equal the prorata portion of the corporation's post-1971 income for the purposes of the Act which was earned during the shareholder's holding period and which is on hand at the time of the safe income determination. Certain adjustments to taxable income may be made to take various items into account. These adjustments are not germane to your request.

There are four relevant holding periods with respect to the Opco shares. The first holding period is the period following the conversion of the Opco common shares to preferred shares under section 86 of the Act. In our view the Opco preferred shares will only be entitled to share in Opco's safe income earned after the conversion to the extent of the cumulative dividend entitlement attached to the preferred shares.

The second holding period is the period from the date of reacquisition of the Opco common shares in 1984 to the date of conversion. Generally speaking, where shares are exchanged for new shares on a rollover basis (such as under section 86 of the Act) it is our opinion that the safe income entitlement of the exchanged shares flows through to the new shares. Therefore, the Opco preferred shares will share in the safe income earned by Opco during this second holding period.

The third holding period is the period from the date of sale in 1980 to the date of reacquisition in 1984. The fourth holding period is the period after 1971 to the date of sale in 1980. You have expressed the view that the Opco preferred shares should share in the safe income earned by Opco during both these holding periods. We agree with your view, subject to the following comments.

During the third holding period, Holdco held the Opco shares as a secured creditor. Holdco had the right to realize on the shares upon the debtor's default. This right is analogous to a contingent option exercisable on the occurrence of an uncertain event. The debt secured by the pledge of Opco shares is analogous to the option price. In our view, a shareholder who acquired shares on exercise of an option will generally be entitled to share in the safe income of the corporation earned during the period after the option was granted and during which the fair market value of the shares exceeded the option price. Accordingly, if the fair market value of the Opco shares exceeded the debt secured by the shares during the third holding period, Holdco will be entitled to share in the safe income earned by Opco during this period.

Another analogy can be drawn which links the safe income earned by Opco during the fourth holding period to the reacquisition of Opco shares in 1984. As a result of the application of section 79, Holdco's cost of the reacquired Opco shares is deemed to equal the unpaid purchase price less the prior year reserve. This deemed cost equals Holdco's original cost of the Opco shares at the time of sale in 1980 less the proportion of such cost recovered out of the paid purchase price, plus the gain, if any, in respect of the unpaid purchase price which was not offset by a reserve. In other words, Holdco's deemed cost equals its original cost adjusted for the recovered portion of such cost and any tax-paid gain in respect of the unpaid purchase price. Accordingly, it is our view that where section 79 applies to a vendor who reacquires shares as a result of a purchaser's default, the safe income earned by the corporation prior to the original sale will flow through the reacquisition.

We note that to the extent a vendor has reported a gain in respect of the unpaid purchase price which was not offset by a reserve, the application of section 79 will result in an equivalent increase in the vendor's deemed cost of the property on reacquisition. This increase is analogous to the increase in cost to a transferee on a rollover under subsection 85(1) where the transferor and transferee have elected at an agreed amount in excess of the cost of the transferred shares to the transferor.

In our view, such increase in cost results in a proportionate reduction in the amount of the remaining accrued gain on the shares attributable to safe income. In the case of a vendor who reacquires shares under section 79, the proportionate reduction in safe income will equal the proportion of the safe income at the time of the original sale that the amount of increase in the cost (as a result of reporting a gain in respect of unpaid purchase price which is not offset by a reserve) is of the total gain at the time of the original sale. This situation can arise even if the deemed cost of the shares on reacquisition is less than the cost at the time of the original sale because the proportion of the original cost recovered out of the paid purchase price (which results in a reduction in the deemed cost on reacquisition) may more than offset the taxed unrecovered gain. It is not clear from your example whether Holdco reported any gain in respect of the unpaid purchase price which was not offset by a reserve.

In summary, in our opinion the Opco preferred shares held by Holdco will share in the safe income earned by Opco for the period after 1971 to the date of sale in 1980 (subject to any proportionate reduction related to an increase in the deemed cost of the shares to Holdco on reacquisition), for the period after the date of reacquisition in 1984 to the date of conversion, and for the period after the date of redemption (to the extent of any cumulative dividend entitlement). The Opco preferred shares will be entitled to share in the safe income earned by Opco during the period after the date of sale in 1980 to the date of reacquisition only if the fair market value of the pledged Opco shares exceeded the amount of debt secured by the pledged shares during this period.

A final point to emphasize is that if the deemed dividend arising on redemption of the Opco preferred shares results in a significant reduction of "the capital gain... that could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971", the whole amount of the dividend will be deemed by paragraphs 55(2) and (b) to be proceeds of disposition. Consequently, it would be prudent to ensure that the amount of the deemed dividend which would result in the "significant reduction" referred to in subsection 55(2) is a separate dividend from the balance of the deemed dividend as a result of a designation under paragraph 55(5)(f).

As stated above, our foregoing comments are not rulings and are not binding on the Department of National Revenue, Taxation.