7 October 2016 APFF Roundtable Q. 16, 2016-0653001C6 F - Safe income and freeze preferred shares

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55(2); 55(2.1)(c)

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This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.

PRINCIPAL ISSUES: An estate freeze would happen when the safe income on hand is $700,000. Freeze preferred shares would be issued and their redemption value would be $1,000,000. The ACB of the freeze preferred shares would be $100. Each year, a dividend would be paid on the freeze preferred shares. What would be the safe income on hand that contributes to the capital gain of the freeze preferred shares immediately before the annual dividend?

POSITION: The safe income on hand of the corporation at the time of the estate freeze would be transferred to the freeze preferred shares. With respect to additional safe income on hand, it would depend, inter alia, on the value of the freeze preferred shares immediately before the dividend as computed pursuant to paragraph 55(2.1)(c) and on the safe income accumulated by the corporation since the estate freeze, if any. If the hypothetical capital gain is $999,900 ($1,000,000 - $100), which may mean that the safe income accumulated by the corporation since the estate freeze would not contribute to the hypothetical capital gain on the freeze preferred shares. Therefore, the safe income on hand of $700,000 less any previous reduction would contribute to the hypothetical capital gain. In such a case, the annual dividend would reduce the amount of $700,000 less any previous reduction. If the annual dividend is greater than $700,000 less any previous reduction, subsection 55(2) may apply if the other conditions are met.

If the hypothetical capital gain was equal to an amount of $999,900 + the annual dividend, it would be necessary to determine the safe income on hand accumulated since the estate freeze. If such an amount of safe income on hand was equal to or greater than the annual dividend on the freeze preferred shares, the amount of the annual dividend would not be greater than the safe income on hand that contributes to the hypothetical capital gain. Subsection 55(2) would not apply. In such a case, the safe income accumulated by the corporation since the estate freeze would be reduced by the annual dividend on the freeze preferred shares.

REASONS: Wording of the Act.

7 OCTOBER 2016 APFF FEDERAL ROUNDTABLE - 2016 CONFERENCE

QUESTION 16

INTERRELATION BETWEEN SAFE INCOME ON FREEZE SHARES AND SUBSECTION 55(2)

Opco is a corporation resident in Canada. Opco's shares have a FMV of $2,500,000 and an aggregate safe income of $1,700,000. This aggregate safe income includes safe income of $700,000 attributable to the freeze preferred shares held by Holdco A.

Holdco A holds 100 common shares with a PUC and ACB of $100. The common shares have voting rights and are participating.

Holdco A also holds 100 freeze preferred shares with a PUC and ACB of $100. The FMV (redemption value) of these freeze preferred shares is $1,000,000 and the safe income of the shares exchanged at the time of the freeze was $700,000. The preferred shares are not entitled to a discretionary dividend. The attributes of the freeze preferred shares are:

Non-participating
No voting rights
Pre-determined dividends (8% of the redemption value)
Pre-determined value ($1,000,000, i.e., the consideration received on issue + unpaid dividends)

Questions to the CRA

(a) If Opco generates safe income in the year of $150,000 and declares a dividend of $80,000 on the freeze preferred shares: - What portion of the dividend will covered by the aggregate safe income?

What will be the safe income of the freeze preferred shares following the dividend’s payment?
What will be the aggregate safe income of Opco after the payment of the dividend?

(b) If Opco generates nil safe income in the year and declares a dividend of $80,000 on the freeze preferred shares:

What portion of the dividend will be covered by the aggregate safe income?
What will be the safe income of the freeze preferred shares after payment of the dividend?
What will be the aggregate safe income of Opco after the payment of the dividend?

CRA response

The answer to your question will depend on the FMV that could be attributed to the freeze preferred shares in the capital stock of Opco held by Holdco A. This FMV will be determined immediately before the dividend payment but taking into account that such shares would be entitled to an additional amount equal to the dividend declared in respect of these shares. This permits the calculation of what would be the hypothetical capital gain that would have been realized on a disposition of the shares at FMV immediately before the dividend but taking into account the assumptions referred to in paragraph 55(2.1)(c) of the Act. This is a valuation question on which the CRA cannot pronounce in a hypothetical situation.

According to the facts stated above, the safe income on hand of the shares exchanged in the estate freeze was $700,000 and the estate freeze was carried out on a rollover basis. Thus, according to the longstanding position of the CRA, the SIOH of $700,000 attributable to the exchanged shares was transferred to the freeze preferred shares.

In addition to the $700,000 of safe income on hand contributing to the hypothetical capital gain on the freeze preferred shares (in accordance with the assumptions under paragraph 55(2.1)(c)), it must be established if there is SIOH earned or realized by the corporation subsequent to the freeze and up to the safe income determination time that would contribute to the hypothetical capital gain on the freeze preferred shares. To this end, it is not sufficient to establish the amount of safe income generated in the year of the dividend since, for example, this amount could be reduced due to a loss in years prior to the freeze or could be increased by safe income earned or realized in years prior to the freeze. Likewise, the amount of safe income earned in the year and earned or realized in prior years subsequent to the freeze might not contribute to the hypothetical capital gain on the freeze preferred shares (based on the assumptions in paragraph 55(2.1)(c)).

The question of whether an amount of SIOH contributes to the hypothetical capital gain on freeze preferred shares, calculated using assumptions of paragraph 55(2.1)(c), is a question of fact. If the dividend of $80,000 was not greater than the SIOH of the corporation which contributed to the hypothetical capital gain on freeze preferred shares (the amount of $700,000 transferred at the time of the freeze could have been reduced due to previous dividends as well as SIOH that accumulated since the freeze if it contributed to the hypothetical capital gain on preferred shares), paragraph 55(2.1)(c) and subsection 55(2) would not apply. The dividend of $80,000 would firstly reduce the SIOH of the corporation from the time of the freeze if it contributed to the hypothetical capital gain on the freeze preferred shares and up to the lesser of safe income that contributed to the hypothetical capital gain on the freeze preferred shares and the dividend amount. Any difference between the amount of the dividend and this reduction in the post-freeze SIOH of the corporation would reduce the SIOH of $700,000 that is specifically attached to the freeze preferred shares freeze (less any prior reduction).

Depending on circumstances, it may be that the only SIOH contributing to the hypothetical capital gain on the freeze preferred shares was the amount of $700,000 less any previous reduction of such safe income. If the dividend amount of $80,000 was not greater than such SIOH, paragraph 55(2.1)(c) and subsection 55(2) would not apply. In such case, the SIOH of $700,000 (less any previous reduction) would be reduced by the amount of the dividend.

Sylvie Labarre
(613) 670-9014
October 7, 2016
2016-065300

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Text of Severed Letter

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.

POSITION: The safe income on hand of the corporation at the time of the estate freeze would be transferred to the freeze preferred shares. With respect to additional safe income on hand, it would depend, inter alia, on the value of the freeze preferred shares immediately before the dividend as computed pursuant to paragraph 55(2.1)(c) and on the safe income accumulated by the corporation since the estate freeze, if any. If the hypothetical capital gain is $999,900 ($1,000,000 - $100), that may mean that the safe income accumulated by the corporation since the estate freeze would not contribute to the hypothetical capital gain on the freeze preferred shares. Therefore, the safe income on hand of $700,000 less any previous reduction would contribute to the hypothetical capital gain. In such a case, the annual dividend would reduce the amount of $700,000 less any previous reduction. If the annual dividend is greater than $700,000 less any previous reduction, subsection 55(2) may apply if the other conditions are met.

REASONS: Wording of the Act.

TABLE RONDE SUR LA FISCALITÉ FÉDÉRALE DU 7 OCTOBRE 2016 APFF - CONGRÈS 2016

QUESTION 16

INTERRELATION ENTRE LE REVENU PROTÉGÉ SUR DES ACTIONS DE GEL ET LE PARAGRAPHE 55(2) L.I.R.

Opco est une société résidente du Canada. Les actions d’Opco ont une JVM de 2 500 000 $ et un revenu protégé global de 1 700 000 $. Ce revenu protégé global comprend le revenu protégé de 700 000 $ attribuable aux actions privilégiées de gel détenues par Gesco A.

Gesco A détiendrait 100 actions ordinaires dont le CV et le PBR seraient de 100 $. Les actions ordinaires comporteraient des droits de vote et seraient participantes.

Gesco A détiendrait aussi 100 actions privilégiées de gel dont le CV et le PBR sont de 100 $. La JVM (valeur de rachat) de ces actions privilégiées de gel est de 1 000 000 $ et le revenu protégé des actions échangées au moment du gel était de 700 000 $. Les actions privilégiées de gel ne comporteraient pas de droit à un dividende discrétionnaire. Les caractéristiques des actions privilégiées de gel seraient les suivantes :

Non participantes
Sans droit de vote
Dividende prédéterminé (8 % de la valeur de rachat)
Valeur prédéterminée (1 000 000 $, soit la contrepartie reçue à l’émission + dividende impayé)

Questions à l’ARC

a) Si Opco génère du revenu protégé dans l’année de 150 000 $ et déclare un dividende de 80 000 $ sur les actions privilégiées de gel : - Quelle sera la portion du dividende couvert par le revenu protégé global?

Quel sera le revenu protégé des actions privilégiées de gel après le versement du dividende?
Quel sera le revenu protégé global d’Opco après le versement du dividende?

b) Si Opco génère un revenu protégé nul dans l’année et déclare un dividende de 80 000 $ sur les actions privilégiées de gel :

Quelle sera la portion du dividende couvert par le revenu protégé global?
Quel sera le revenu protégé des actions privilégiées de gel après le versement du dividende?
Quel sera le revenu protégé global d’Opco après le versement du dividende?

Réponse de l’ARC

La réponse à vos questions dépendra de la JVM qui pourrait être attribuée aux actions privilégiées de gel du capital-actions d’Opco détenues par Gesco A. Cette JVM sera établie immédiatement avant le paiement du dividende mais en sachant que lesdites actions auront droit à un montant supplémentaire égal au dividende déclaré à l’égard de ces actions. Ceci permettrait de calculer quel serait le gain en capital hypothétique qui aurait été réalisé lors d’une disposition de l’action à la JVM immédiatement avant le dividende en tenant compte des hypothèses mentionnées à l’alinéa 55(2.1)c) L.I.R. Ceci est une question d’évaluation sur laquelle l’ARC ne se prononce pas dans une situation hypothétique.

Selon les faits mentionnés ci-dessus, le revenu protégé en main (« RPEM ») des actions échangées lors du gel était de 700 000 $ et le gel s’est effectué sur une base de roulement. Ainsi, selon la position de longue date de l’ARC, le RPEM de 700 000 $ attribuable aux actions échangées serait transféré aux actions privilégiées de gel.

En plus du 700 000 $ de RPEM qui contribue au gain en capital hypothétique sur les actions privilégiées de gel (selon les hypothèses de l’alinéa 55(2.1)c) L.I.R.), il faudrait établir s’il y a du RPEM gagné ou réalisé par la société depuis le gel et jusqu’avant le moment de détermination du revenu protégé qui contribuerait au gain en capital hypothétique sur les actions privilégiées de gel. À cette fin, il n’est pas suffisant d’établir le montant de revenu protégé généré dans l’année du dividende puisque, par exemple, ce montant pourrait être réduit en raison d’une perte subie au cours d’années antérieures depuis le gel ou pourrait être augmenté du revenu protégé gagné ou réalisé au cours d’années antérieures depuis le gel. De même, ce montant de revenu protégé gagné dans l’année et celui gagné ou réalisé depuis le gel au cours d’années antérieures pourraient ne pas contribuer au gain en capital hypothétique sur les actions privilégiées de gel (selon les hypothèses de l’alinéa 55(2.1)c) L.I.R.).

La question de déterminer si un montant de RPEM contribue au gain en capital hypothétique sur les actions privilégiées de gel, calculé selon les hypothèses de l’alinéa 55(2.1)c) L.I.R., est une question de fait. Si le dividende de 80 000 $ n’était pas supérieur au RPEM de la société qui contribue au gain en capital hypothétique sur les actions privilégiées de gel (le montant de 700 000 $ transféré au moment du gel qui pourrait avoir été réduit en raison de dividendes antérieurs ainsi que le RPEM qui s’est accumulé depuis le gel s’il contribue au gain en capital hypothétique sur les actions privilégiées), l’alinéa 55(2.1)c) L.I.R. et le paragraphe 55(2) L.I.R. ne s’appliqueraient pas. Le dividende de 80 000 $ réduirait d’abord le RPEM de la société depuis le moment du gel s’il contribuait au gain en capital hypothétique sur les actions privilégiées de gel et ce, jusqu’à concurrence du moindre de ce revenu protégé qui contribue au gain en capital hypothétique sur les actions privilégiées de gel ou du montant du dividende. La différence entre le montant du dividende et ce montant de réduction du RPEM de la société depuis le moment du gel, s’il y lieu, réduirait le RPEM de 700 000 $ qui est rattaché spécifiquement aux actions privilégiées de gel (moins toute réduction antérieure).

Selon les circonstances, il se pourrait que le seul RPEM qui contribue au gain en capital hypothétique sur les actions privilégiées de gel soit le montant du 700 000 $ moins toute réduction antérieure de ce revenu protégé. Si le montant du dividende de 80 000 $ n’était pas supérieur audit RPEM, l’alinéa 55(2.1)c) L.I.R. et le paragraphe 55(2) L.I.R. ne s’appliqueraient pas. Dans un tel cas, le RPEM de 700 000 $ (moins toute réduction antérieure) serait diminué du montant de dividende.

Sylvie Labarre
(613) 670-9014
Le 7 octobre 2016
2016-065300

Summaries

Summary Under

Tax Topics - Income Tax Act - Section 55 - Subsection 55(2.1) - Paragraph 55(2.1)(c)

application of safe income on hand to dividends paid on estate freeze prefs

Holdco A holds 100 voting common shares of Opco with a paid-up capital and adjusted cost base of $100, as well as 100 estate freeze non-participating, non-voting preferred shares bearing a pre-determined dividend of 8% on their redemption amount of $1,000,000, having an ACB of $100 and having safe income of $700,000 traceable to the shares for which they had been exchanged. The shares of Opco have an aggregate fair market value of $2,500,000 and its global safe income is $1,700,000. (a) If Opco generates safe income in the year of $150,000 and declares a dividend of $80,000 on its preferred shares, what portion of the dividend will be covered by the global safe income and, following the dividend’s payment, what will be the preferred shares’ safe income? (b) What if Opco did not generate any safe income in the year before that dividend was declared?

CRA responded:

If the dividend of $80,000 was not greater than the SIOH of the corporation which contributed to the hypothetical capital gain on frozen preferred shares (the amount of $700,000 transferred at the time of the freeze could have been reduced due to previous dividends as well as SIOH that accumulated since the freeze if it contributed to the hypothetical capital gain on preferred shares), paragraph 55(2.1)(c) and subsection 55(2) would not apply. The dividend of $80,000 would firstly reduce the SIOH of the corporation from the time of the freeze if it contributed to the hypothetical capital gain on the freeze preferred shares and up to the lesser of safe income that contributed to the hypothetical capital gain on the freeze preferred shares and the dividend amount. Any difference between the amount of the dividend and this reduction in the post-freeze SIOH of the corporation would reduce the SIOH of $700,000 that is specifically attached to the freeze preferred shares freeze (less any prior reduction).

Depending on circumstances, it may be that the only SIOH contributing to the hypothetical capital gain on the frozen preferred shares was the amount of $700,000 less any previous reduction of such safe income. If the dividend amount of $80,000 was not greater than such SIOH, paragraph 55(2.1)(c) and subsection 55(2) would not apply. In such case, the SIOH of $700,000 (less any previous reduction) would be reduced by the amount of the dividend.

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7 October 2016 APFF Roundtable Q. 16, 2016-0653001C6 F - Safe income and freeze preferred shares

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