19 October 1988 Income Tax Severed Letter RCT 5-6463 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 Sirs:

RE:     Subsection 55(2) of the Income Tax Act

This is in reply to your letter of August 19, 1988 wherein you requested our opinion on the application of the provisions of subsection 55(2) of the Income Tax Act ("the Act") to the following scenario.

We are to assume that a corporation, Opco, the shares of which have a fair market value of $2,000,000, has redundant cash on hand of $500,000. For the purposes of subsection 55(2) of the Act, the corporation has earned or realized income ("safe income") of $500,000. The issued share capital of Opco consists of 100 Class A Common Shares. A sale of these shares is contemplated and the shareholder wishes to remove the safe income to the extent possible and then sell the shares, thereby availing himself of the capital gains deduction under subsection 110.6(3) of the Act.

The following steps are proposed:

1. The shareholder forms a new corporation ("Newco") and subscribes for 100% of the issued shares.

2. Opco issues 300 Class B Common Shares to the shareholder for consideration of $1.

3. The shareholder transfers his Class A Common Shares to Newco and both the shareholder and Newco elect under subsection 85(1) of the Act with respect to the shares so transferred. The agreed amount will be equal to the adjusted cost base of the Class A Common Shares. As consideration for the shares, the shareholder will receive one additional common share of Newco which will have an adjusted cost base and paid-up capital identical to that of the shares being transferred. Adjusted cost base and paid-up capital have the meanings assigned by paragraphs 54(a) and 89(1)(c) of the Act.

4. The Class A Common Shares held by Newco are redeemed by Opco for $500,000.

5. The shareholder sells the Class B Common Shares to an arm's length purchaser for $1.5 million.

You have asked us to provide our opinion as to whether the safe income remains with the Class A Common Shares in the above series of transactions. You have also asked for our opinion as to whether certain other provisions of the Act would apply to this series of transactions.

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 and advance ruling are set out in Information Circular 70-6R. Although we are unable to provide any opinion in response to the specific transactions described in your letter, we do provide the following general observations.

The Department's views on the principles employed in the calculation of safe income can be found in a paper by J.R. Robertson presented in the Report of Proceedings of the Thirty-third Tax Conference in the 1981 Canadian Tax Foundation Conference Report.

Generally, the Department is of the view that safe income during the holding period of a share is made up of taxable income plus certain adjustments, less the sum of losses incurred, dividends paid and provincial and federal income taxes paid or payable in respect of that income. The holding period is the time which commences from the later of January 1, 1972 or the acquisition of the particular share to the time immediately before the transaction or event or the commencement of the series of transactions or events referred to in paragraph 55(3)(a) of the Act.

The issue of whether safe income would remain with shares transferred to a corporation under a rollover provision was covered in the aforementioned paper by Mr. Robertson as follows:

"When a corporation acquires a share as a result of a section 85 rollover such a transferred share will retain its share of safe income that could have been paid as a safe dividend immediately before the transfer. In effect the transferee's holding period in respect of such a transferred share includes the transferor's holding period. This is reasonable because the transferor's potential gain on those shares becomes the transferee's potential gain."

A determination of whether the provisions of the other sections of the Act referred to in your request would be applicable could only be made after a review of all of the facts surrounding the transaction. Such a determination is not possible in a hypothetical situation. Should your concerns relate to an actual completed transaction, we suggest that you approach officials of your local District Taxation Office, who should be able to provide you with an opinion on the applicability of these sections to your transaction once all of the relevant facts have been examined.

We do, however, wish to provide some general comments about the potential application of paragraph 85(1)(e.2) of the Act, as amended by S.C. 1986-87-88, c.55, to the type of scenario described in your letter. In step 1 above, the shares issued upon the incorporation of Newco have a certain value. When the Class A Common Shares of Opco are transferred to Newco for one additional common share thereof, this share will not have a fair market value equal to the fair market value of the Opco shares transferred. Paragraph 85(1)(e.2) of the Act, as it read prior to its amendment, would not have applied to this situation, since it referred to a gift that benefits "any other shareholder of the corporation". The amended version of paragraph 85(1)(e.2) of the Act, which is applicable with respect to dispositions after June, 1988, applies where a benefit has been conferred on a person related to the taxpayer. In your scenario, that person would be Newco and the benefit would arise from the fact that Newco has received property which has a fair market value greater than the value of the consideration paid for it. For example, assume that one common share of Newco was issued to the shareholder upon incorporation. In step 3 above, one additional common share is issued as consideration for the Class A Common Shares. By virtue of the one common share outstanding prior to the transfer, the one additional common share issued in step 3 would have a value equal to one-half of the value of the property transferred. A benefit has been conferred upon Newco, a person related to the shareholder, and paragraph 85(1)(e.2) of the Act would apply to this transaction.