10 October 1989 Income Tax Severed Letter RCT 5-7863

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 April 6, 1989, wherein you requested our interpretation of paragraph 66(15)(d.i) of the Act in the context of a "flow-through share agreement" (the "agreement") which contains a termination clause.

Your request is also in reference to section 6202.1 of the Draft Income Tax Regulations issued July 18, 1988 (the "draft regulations") in the context of (1) the possible termination of the agreement prior to the resource company actually incurring and renouncing the promised amounts, and (2) a cancellation of the shares and a return of the shareholder's consideration.

You describe a termination clause as one which provides that the agreement will terminate on the occurrence of certain events such as upon (i) the appointment of a trustee, receiver or liquidator following a bankruptcy, insolvency, liquidation or dissolution of the resource company, (ii) an act of God, (iii) the enactment of any law or regulation that would prevent the resource company from renouncing expenses in favour of the investor, and (iv) the receipt by the resource company of an opinion from qualified experts that its exploration program will not yield the described results, and so on.

For purposes of rendering our comments herein, we are obliged to add that we would expect that the termination clause would also provide that the occurrence of termination would not have any effect on any action taken or performed by the resource company before such occurrence; and would not negate the obligation of the resource company (1) to renounce the maximum amount of expenses that it would otherwise be entitled to renounce by reason of the expenses being incurred before the occurrence, (2) to issue shares pursuant to the agreement, or (3) to flow-through any incentive payments to which the resource company would otherwise be entitled.

COMMENTS

For the purposes of paragraph 66(15)(d.1) of the Act, section 6202.1 of the draft regulations provides that a share will be a prescribed share if, at the time it is issued, certain conditions exist. Prescribed shares are specifically excluded from flow-through shares by virtue of paragraph 66(15)(d.1).

Whether or not a termination clause in a share agreement would render any share issued thereunder as being a flow-through share or prescribed share is a question of fact that can only be determined after examination of all of the relevant facts of the situation. However, we offer the following general comments which may be of assistance to you.

Paragraph 6202.1(1)(b)

Your stated opinion is that ". . . shares issued pursuant to a flow-through share agreement which contains a termination clause would be flow-through shares as defined by paragraph 66(15)(d.1), notwithstanding that the agreement could terminate prior to the fulfillment of the conditions in that paragraph."

We do not object to your opinion as such because the mere existence of a termination clause in an agreement or even the act of invoking the termination clause, thereby ending the agreement, would not, in and by themselves, cause an issued share to be prescribed under section 6202.1 of the draft regulations.

Furthermore, provision in the flow-through share agreement for (1) the possible termination of the agreement prior to the company actually incurring and renouncing the promised amounts, and (2) a cancellation of the share would not, in and by themselves, in our view, cause the issued share to be prescribed for the purposes of paragraph 66(15)(d.1) of the Act.

We respectfully submit however that a share issued under an agreement which provided for a return of a shareholder's consideration after the share had been issued would be a prescribed share at the time of issuance by virtue of paragraph 6202.1(1)(b) of the draft regulations which would apply where "(b) any person or partnership has, either absolutely or contingently, an obligation . . .

• (i) to provide assistance, (ii) to make a loan or payment, (iii) to transfer property, or (iv) otherwise to confer a benefit by any means whatever, including the payment of a dividend,

either immediately or in the future, that may reasonably be considered to be. directly or indirectly. a repayment or return by the corporation of all or cart of the consideration for which the share was issued...".

In our view, a share issued under a flow-through share agreement which provided for the return of the shareholder's consideration after the share had been issued would fall within the ambit of paragraph 6202.1(1)(b) of the draft regulations, thereby precipitating treatment of the issued share as a prescribed share at the time of its issuance.

Paragraph 6202.1(1)(c)

Notwithstanding that paragraph 6202.1(1)(b) of the draft regulations could apply, paragraph 6202.1(1)(c) provides that a new share (as defined in paragraph 6202.1(5)) would be a prescribed share at the time it is issued where "(c) any person or partnership has, either absolutely or contingently, an obligation... to effect any undertaking... either immediately or in the future, with respect to the share or the agreement under which the share is issued... that may reasonably be considered to have been given to ensure, directly or indirectly, that

• (i) any loss that the holder of the share... may sustain by reason of holding, ownership or disposition of the share or any other property is limited in any respect, or
• (ii) the holder of the share... will derive earnings by reason of the holding, ownership or disposition of the share or any property;".

A share issued under an agreement which provided for (1) the possible termination of the agreement prior to the company actually incurring and renouncing the promised amounts, (2) a cancellation of the issued share, and (3) a return of the shareholder's consideration in respect of the issued share would appear to fall within the ambit of paragraph 6202.1(1)(c) because these provisions impose a contingent obligation to effect an undertaking, i.e. the return of the shareholder's consideration, in order to limit a loss that the shareholder may sustain. In the absence of information that indicates otherwise, our view is that the return of the shareholder's consideration could reasonably be considered to have been given to limit the shareholder's "loss" of the amount of consideration paid for the issued share.

With respect to the aforementioned loss, you state your contention as being that "A shareholder who does not receive certain expected tax benefits just because the agreement has prematurely terminated has not suffered a "loss".

We do not share your interpretation of the phrase "any loss" used in subparagraph 6202.1(1)(c)(i). Our view is that the phrase refers to an economic loss. An economic loss would be sustained in an amount of the consideration paid for the issued share to which is attached an entitlement to certain income tax deductions that would not otherwise exist but for the payment of consideration. The loss would be realized upon the expected income tax deductions becoming unavailable.

Our view is manifest in the exclusion from the ambit of paragraph 6202.1(1)(c) of an undertaking to indemnify the shareholder for the amount of any tax payable which arises as a consequence of a reduction pursuant to subsection 66(12.73) of the Act. This exclusion contemplates situations involving indemnification for "lost tax benefits" by virtue of the reduction of tax deductions (in respect of amounts renounced to the holder of the share) under subsection 66(12.73) of the Act.

Clearly, the draft regulations recognize that a loss may be sustained both in the course of ownership of a share and on its disposition. A loss for purposes of subparagraph 6202.1(1)(c)(i) of the draft regulations could therefore be sustained in the form of realized or unrealized adjustments to the value of the share resulting from expected tax benefits actually becoming unavailable. Moreover, the presence of subparagraph 6202.1(1)(c)(ii) of the draft regulations suggests that a loss sustained in the period of ownership of the share may be something other than a lost dividend.

Consequently, provision in the flow-through share agreement for possible termination of the agreement, cancellation of the issued shares and return of the shareholder's consideration upon invoking a termination clause would, in our view, satisfy the requirements for subparagraph 6202.1(1)(c) to apply.

CONCLUSION

Our interpretation therefore is a flow-through share agreement which contains the provisions described above would result in a share issued thereunder being a prescribed share under paragraphs 6202.1(1)(b) and (c) of the draft regulations and, consequently, would be excluded from flow-through shares by virtue of the exclusion of prescribed shares in paragraph 66(15)(d.1) of the Act.

The above comments are only expressions of opinion and as such should not be construed as advance income tax rulings, nor are they binding on the Department.