4 October 1989 Income Tax Severed Letter RCT 5-8260

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 response to your letter of June 15, 1989 in which you requested our views on the interpretation of subparagraph (5)(a) of Article XIII of the Canada-U.K. Income Tax Convention (1978) (the "convention") in the context of the hypothetical fact situation described below.

Facts

• 1. Mr. X, a U.K. resident owns all the issued common shares in a Canadian holding company (Holdco). the shares of which do not trade on an approved stock exchange, within the meaning of paragraph XIII(5)(a) of the Convention. The only assets of Holdco consist of 100% of all the issued shares of Opco, an active manufacturing company, and 100% of Realco, a real estate holding and investment company. All of the assets of Opco constitute property other than immovable property. within the meaning of Article XIII of the Convention. All of the assets of Realco constitute immovable property.
• 2. At the time of the transactions referred to in paragraphs 3 and 4 below, the total fair market value of Holdco is $10 million. the underlying value of the Opco shares is $6 million and the underlying value of the Realco shares is $4 million. Thus at such time the common shares of Holdco do not derive the greater part of their value directly or indirectly from immovable property situated in Canada for purposes of subparagraph XIII(5)(a) of the Convention. The adjusted cost base, within the meaning of paragraph 54(a) of the Income Tax Act (the "Act"), to Mr. X of his Holdco shares is $1 million.
• 3. A "freeze" is effected by Holdco whereby the common shares of Opco held by Holdco are exchanged for preferred shares with a fair market value and redemption amount of $6 million and the common shares of Realco owned by Holdco are exchanged for preferred shares of Realco with a redemption amount and fair market value of $4 million. Common shares of Opco and Realco would be issued to members of Mr. X's family, who are not residents of Canada.
• 4. Immediately after the transactions referred to in paragraph 3 above, Mr. X effects a freeze of his Holdco common shares by exchanging such shares for preferred shares of Holdco with a fair market value and redemption amount of $10 million. The exchange occurs on a tax-deferred basis under the Act so that Mr. X's adjusted cost base of the Holdco preferred shares is $1 million. Common shares of Holdco are issued to family members of Mr. X.
• 5. Five years later, Mr. X sells his Holdco preferred shares for $10 million to Mr. Y, an arm's length third party. At this time the value of Opco is $8 million and the value of Realco is $12 million. All of the assets of Opco constitute property other than immovable property situated in Canada and all of the assets of Realco constitute immovable property situated in Canada.

Issue

Do the Holdco preferred shares derive the greater part of their value directly or indirectly from immovable property situated in Canada such that the gain realized by Mr. X on the sale of such shares to Mr. Y will be subject to tax in Canada?

You are of the view that subparagraph XIII(5)(a) of the Convention is unclear as to the time that the determination of whether shares derive their value from immovable-property situated in Canada is to be made. You suggest that in this case, such determination in respect of the Holdco preferred shares should be made at the time of the estate freeze referred to in paragraphs 3 and 4 above rather than at the time of the disposition of the Holdco preferred shares to Mr. Y. In support of this position you submit that the value of the Holdco preferred shares will effectively "track back" to the original frozen values of Opco and Realco at the time of the freeze.

Opinion

In our opinion, the gain realized by Mr. X on the disposition of his Holdco preferred shares would be exempt from tax under the Act by virtue of subparagraph XIII(5)(a) of the Convention. However, we are not in agreement with your views as to the interpretation of that provision of the Convention.

In our opinion, the time at which the determination under subparagraph XIII(5)(a) of the Convention is to be made is the time of the alienation of shares giving rise to the relevant capital gain.

Thus, in the hypothetical situation described herein, the issue to be determined is whether the Holdco preferred shares derive the greater part of their value primarily from immovable property situated in Canada at the time Mr. X sells such shares. In our view, as more than 50% of the value of Holdco is attributable to the value of the preferred shares of Opco and as none of the assets of Opco constitutes immovable property situated in Canada, the value of both the Holdco preferred shares and the Holdco common shares is not derived primarily from immovable property situated in Canada.

The fact that the Holdco preferred shares were issued in the course of an estate freeze at a time that the shares of Holdco did not derive their value primarily from immovable property situated in Canada is not relevant, in our opinion. In respect of a gain on the alienation of shares of a company, the determination of whether such shares derive their value primarily from immovable property must be made by reference to the assets underlying such shares which are on hand at the time of the alienation.

The opinions expressed herein are given in accordance with the procedure outlined in paragraph 24 of Information Circular 70-6R.