17 March 1988 Income Tax Severed Letter RCT 5-5799

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 March 17, 1988 wherein you requested a technical interpretation of the application of subsections 55(2) and 55(3) of the Act in the following hypothetical situation. We apologize for the delay in our reply.

1. (a) Mr. A currently owns 300 common shares in A Co., being all the outstanding shares in the capital stock of A Co. The adjusted cost base ("A.C.B.") and the paid-up capital of the shares is $300 and the fair market value ("F.M.V.") of the shares is $3,000. ACB and paid-up capital have the meanings assigned by paragraphs 54(a) and 89(1)(c), respectively, of the Act.

(b) A Co. currently owns two types of assets that have the following attributes:

Asset 1  Asset 2
A.C.B.                              $    50  $   250
F.M.V.                              $   500  $ 2,500

2.
• (a) Mr. B.deals at arm's length with Mr. A and A Co.
• (b) Mr. A, A Co. and C Co. are resident in Canada.
• (c) Mr. A, A Co. and C Co. (identified below) are related to each other within the meaning of subsection 251(2) of the Act.

3. Mr. A and Mr. B agreed to the following:
• (a) Mr. B will acquire 100% of A Co. from Mr. A for a purchase price of $2,500 after A Co. divests itself of its interest in the $500 asset.
• (b) Mr. A is to arrange the affairs of A Co. such that the only asset in A Co. prior to the sale of shares to Mr. B is the $2,500 asset.

4. Mr. A proceeds to arrange the affairs of A Co. as follows:
• (a) Step 1

Mr. A incorporates C Co. and transfers 50 common shares in A Co. to C Co. in exchange for 50 common shares in C Co.

The parties elect to have the provisions of subsection 85(1) of the Act apply to the transfer and agree to the following:

Amount elected under subsection 85(1)                 $  50
Fair market value of shares                             500
Paid-up capital of shares issued by C Co.                50

• (b) Step 2

A Co. transfers the $500 asset to C Co. in exchange for 500 redeemable, retractable preferred shares in C Co.

The parties elect to have the provisions of subsection 85(1) of the Act apply to the transfer and agree to the following:

Amount elected under subsection 85(1)                 $  50
Fair market value of property transferred               500
Paid-up capital of preferred shares                      50
Redemption price of preferred shares                    500

• (c) Step 3

A Co.redeems the 50 common shares held b y C Co. in A Co. for $500.

C Co. redeems the 500 preferred shares held by A Co. in C Co. for $500.

• (d) Step 4

Mr. A sells his remaining 250 common shares in A Co. to Mr. B for $2,500.

You have asked us to confirm and comment upon your understanding of the tax consequences of the transaction as set out above. Your request appears to relate to a specific proposed transaction. Confirmation of the tax consequences of a specific proposed transaction will only be provided in response to a request for an advance income tax ruling. The procedures for requesting an advance ruling are as set out in Information Circular 70-6R. Although we are unable to provide any confirmation of your views in response to your request, we do provide the following general observations.

It is your opinion that subsection 55(2) of the Act will not apply in respect of the $500 deemed dividends received by A Co. and C Co. on the basis that these dividends were received as part of a transaction or event or a series of transactions that resulted in a disposition of property to a person who was not dealing at arm's length with the corporation. It is your view that the sale of shares by Mr. A to Mr. B will have no implication to the inter-corporate dividends deemed by subsection 84(3) to be paid by A Co. and C Co.

We do not agree with your interpretation of the provisions of subsection 55(2) and 55(3) of the Act in this situation. Subparagraph 55(3)(a)(i) of the Act provides that subsection 55(2) of the Act will not apply to any dividend received by the corporation unless the receipt of the dividend was part of a series of transactions that resulted in a disposition of any property to a person with whom the corporation which received the dividend was dealing at arm's length. In the example provided, the intercorporate dividends received by A Co. and C Co. are part of a series of transactions that results in the disposition of shares of A Co. by Mr. A to Mr. B, an individual dealing at arm's length with both A Co. and C Co. It is our opinion, therefore, that since the series of transactions in your letter is described in subparagraph 55(3)(a)(i) of the Act, the exception contained in paragraph 55(3)(a) would not apply and subsection 55(2) would be applicable in such a situation.

It is also your opinion that the reference to "... a disposition at fair market value of any share of capital stock immediately before the dividend..." in subsection 55(2) of the Act refers only to a share disposed of by a corporation. This interpretation is in your view consistent with the intent of subsection 55(2) of the Act, which you believe is to prevent corporations from converting proceeds which otherwise might result in capital gains to tax-free inter-corporate dividends.

We do not agree with your interpretation in this regard. If the intention of the legislators had been to restrict the application of subsection 55(2) of the Act to those situations in which shares are disposed of by a corporation, this could have been accomplished by adding the words "by a corporation" after the word "stock" in the aforementioned phrase. In view of the absence of such a restriction, it is our opinion that subsection 55(2) can have application if there has been a significant reduction in the portion of the capital gain that, but for the inter-corporate dividend, would have been realized on the disposition at fair market value of any share of the capital stock held by any shareholder immediately before the dividend.

Our comments herein are provided in accordance with the practice referred to in paragraph 24 of Information Circular 70-6R.