27 January 1999 Internal T.I. E9833717 - STOP-LOSS RULES - DIVIDENDS

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

APPLICATION OF 112 STOP LOSS RULES WHERE THE CHARACTER OF SHARES HELD BY A FINANCIAL INSTITUTION CHANGES FROM MARK-TO-MARKET PROPERTY TO CAPITAL PROPERTY OR INVENTORY & VICE VERSA

Position:

PROVISIONS APPEAR TO PROVIDE FOR CORRECT CALCULATION OF AMOUNTS (248(28) WILL NEED TO BE APPLIED IN SOME CASES) BUT THE CHARACTER OF THE GAIN OR LOSS WILL NOT ALWAYS BE APPROPRIATE

Reasons:

RE: CHARACTER - THERE IS NO DISPOSITION RULE WHICH WOULD CRYSTALIZE THE GAIN OR LOSS AT THE TIME THE CHARACTER OF THE SHARES TO THE HOLDER CHANGES

		January 27, 1999

	TORONTO NORTH TSO	HEADQUARTERS
F. L. Workman
	Attention;  D.W. Mitchell	(613)957-3497
	                 Banking Specialist
	                 Industry Specialist Services
		983371

Section 112 Stop Loss Rules

This is in reply to your memorandum dated December 15, 1998 with regard to the stop-loss rules provided for in subsections 112(3), (4) and (5.2) of the Income Tax Act ("Act"). All references to statute in this memorandum are to the Act. The concern you have raised is whether the aforementioned stop-loss rules provide for the appropriate tax result where the character, for income tax purposes, of shares held by a financial institution changes. In this regard, with respect to one particular set of facts, you set forth in your memorandum four situations which could occur which are summarized as follows:

- mark-to-market ("mtm") property becomes capital property;

- mtm property becomes inventory;

- capital property becomes mtm property;

- inventory becomes mtm property.

Based on the calculations which are set forth in the appendix to this memorandum, although it is necessary to rely on subsection 248(28) in two cases, the stop-loss rules in subsections 112(3), (4) and (5.2) appear to provide for the correct amount of loss (ie 17 in each case). The character of loss (or gain) will not necessarily reflect the fact that a portion thereof accrued while the scharacter of the shares to the taxpayer was capital property or inventory.

XXXXXXXXXX

With regard to the interpretative issues raised in your memorandum the following comments will hopefully be of assistance:

• there is no deemed disposition of the shares held by a financial institution at the time the character of the shares to the financial institution changes for tax purposes (e.g. shares held as capital become mtm property). In this regard subsection 45(1) would not apply since the shares would at all times be held by the taxpayer for the purpose of gaining or producing income;
• subsection 112(5.5) provides that the stop-loss rules that would otherwise apply to shares that are capital property or inventory will not apply where subsection 112(5.2) applies to a disposition of shares. The reference to subsection 112(5.5) in the preamble to subsections 112(3) and (4), while reinforcing this, makes it clear that these provisions can apply in a year when shares that were mtm property and have ceased to be such are disposed of;
• in applying subsections 112(3),(4) and (5.2) all dividends received by the taxpayer, other than "excluded dividends" as defined in subsections 112(3.01), (4.01) or (5.21), are taken into account without reference to the character of the shares at the time the dividends were received;
• paragraph (b) of the description of C of the formula provided for in subsection 112(5.2) applies with respect to deemed dispositions and with regard to subsections 112(3)( and (4) mainly will have application with regard to the deemed dispositions arising either as a consequence of the application of subsection 142.5(2) in a taxation year that includes October 31, 1994 in or after October 30, 1994 by virtue of paragraph 142.6(1)(b) This paragraph provides an adjustment that corresponds to the adjustment to proceeds that would have been provided for under paragraph (a) of C had the shares been mtm property when the deemed disposition occurred;
• paragraph 112(5.1)(c) can apply in a situation where a financial institution acquires shares that are mtm property and within 365 days first ceases to be a financial institution and then disposes of the shares. This is the case that the Finance technical notes refer to with regard to subsection 112(5.2) applying to a taxpayer that is not a financial institution.

As indicated IT-328R3 is currently being revised and it is intended that the revised IT deal with the application of the stop-loss rules to shares held by financial institutions.

If I have not addressed all of your concerns do not hesitate to contact me.

F. Lee Workman
Manager
Financial Institutions Section
Income Tax Rulings and
Interpretations Directorate

APPENDIX

Common Facts

Cost of shares 100

FMV at the end of year 1 95
FMV at the end of year 2 100
Sales price - year 3 50

Dividends received - year 1 25
- year 2 5
- year 3 3

Change of character of the shares to the financial institution occurs in year 2.

The minimum shareholding at all times is 5% and all shares are held more that 365 days prior to being disposed of in year 3.

SITUATION 1

Shares that were held as mtm property become capital property in year 2 (more than 10% of the shares of the company are held at some point during each of years 2 and 3).

TAX IMPLICATIONS

Year 1

As a consequence of the deemed disposition pursuant to 142.5(2) the shares are deemed to be disposed of and acquired for an amount equal to FMV (i.e. 95). Therefore the loss otherwise determined would be 5 (95 - 100).

Application of 112(5.2)

Deemed proceeds = A + B - (C - D)

A = 95
B = lesser of i) 5 (95 - 100) and
ii) 25
= 5
C = 0
D=0

therefore deemed proceeds are 100 (95 + 5)

Therefore the allowable loss for year 1 is 0 (100 - 100)

Year 2

Since the shares are not mtm property and there has been no disposition of the shares there is no loss otherwise determined to which 112(3) or (5.2) could apply.

Year 3

The loss otherwise determined would be 45 (50 - 95 (deemed cost at the end of year 1)).

Application of 112(3)

	Loss otherwise determined  	45
	Less: dividends received (years 1 to 3)	28*
	Revised loss  	17

* Given that 5 of the dividends served to reduce the loss in year 1 subsection 248(28) should be applied to prevent the deduction of these dividend twice - therefore 28 rather than 33.

SITUATION 2

Shares that were held as mtm property become inventory in year 2 (more than 10% of the shares of the company are held at some point during each of years 2 and 3).

TAX IMPLICATIONS

Year 1

As a consequence of the deemed disposition pursuant to 142.5(2) the shares are deemed to be disposed of and acquired for an amount equal to FMV (i.e. 95). Therefore the loss otherwise determined would be 5 (95 - 100).

Application of 112(5.2)

Deemed proceeds = A + B - (C - D)

A = 95
B = lesser of i) 5 (95 - 100) and
ii) 25
= 5
C = 0
D=0

therefore deemed proceeds are 100 (95 + 5)

Therefore the allowable loss for year 1 is 0 (100 - 100)

Year 2

Since the shares are not mtm property and there has been no disposition of the shares there is no loss otherwise determined to which 112(4) or (5.2) could apply.

Year 3

The loss otherwise determined would be 45 (50 - 95 (deemed cost at the end of year 1)).

Application of 112(4)

	Loss otherwise determined  	45
	Less: dividends received (years 1 to 3)	28*
	Revised loss  	17

* Given that 5 of the dividends served to reduce the loss in year 1 subsection 248(28) should be applied to prevent the deduction of these dividend twice - therefore 28 rather than 33.

SITUATION 3

Shares that were held as capital property become mtm property in year 2 (more than 10% of the shares of the company are held at some point during each of years 1 and 2).

Note that notwithstanding the taxpayer's holdings in the shares of the company falls below 10% in year 2 because it has a significant interest in the compnay at some time in year 2 the shares will not be mtm for year 2.

TAX IMPLICATIONS

Years 1 & 2

Since the shares are not mtm property and there has been no disposition of the shares there is no loss otherwise determined to which 112(3) or (5.2) could apply.

Year 3

The loss otherwise determined would be 50 (50 - 100).

Application of 112(5.2)

Deemed proceeds = A + B - (C - D)

A = 50
B = lesser of i) 50 (50 - 100) and
ii) 33
= 33
C = 0
D=0

therefore deemed proceeds are 83 (50 + 33)

Therefore the allowable loss for year 3 is 17 (83 - 100)

SITUATION 4

Shares that were held as inventory become mtm property in year 2 (more than 10% of the shares of the company are held at some point during each of years 1 and 2).

Note that notwithstanding the taxpayer's holdings in the shares of the company falls below 10% in year 2 because it has a significant interest in the company at some time in year 2 the shares will not be mtm for year 2.

TAX IMPLICATIONS

Years 1 & 2

Since the shares are not mtm property and there has been no disposition of the shares there is no loss otherwise determined to which 112(4) or (5.2) could apply. No write-down is available under section 10 in year 1 due to the application of subsection 112(4.1). The cost of the shares is not adjusted.

Year 3

The loss otherwise determined would be 50 (50 - 100).

Application of 112(5.2)

Deemed proceeds = A + B - (C - D)

A = 50
B = lesser of i) 50 (50 - 100) and
ii) 33
= 33
C = 0
D=0

therefore deemed proceeds are 83 (50 + 33)

Therefore the allowable loss for year 3 is 17 (83 - 100)