7 July 1991 Income Tax Severed Letter - Interpretation of subsection 110.6(8) involving the capital gains deduction in a particular situation

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 110.6(8)

We are writing in response to your letter, dated May 24, 1991, in which you request an interpretation of subsection 110.6(8) of the Income Tax Act (the "Act") in the following hypothetical fact situation:

A company issues common shares, and preferred shares with a fixed annual dividend entitlement, at the time of incorporation. As the company becomes profitable it will redeem all of the preferred shares. No dividends will be paid on the preferred shares. The common shares are qualified small business corporation shares as defined in subsection 110.6(1) of the Act. The preferred shares are not prescribed shares within the meaning of Regulation 6205.

Your letter requests the following interpretations:

• (1) whether subsection 110.6(8) would apply on the disposition of the common shares to deny the capital gains deduction under subsection 110.6(2.1) of the Act;
• (2) whether Revenue Canada Taxation has developed any guidelines as to what constitutes "a significant part of the capital gain"; and,
• (3) if the preferred shares remained outstanding and a "catch-up dividend" representing the present value of all unpaid dividends was paid to the preferred shareholders, whether subsection 110.6(8) would apply on the disposition of the common shares to deny the capital gains deduction under subsection 110.6(2.1) of the Act.

Our Comments

It would be reasonable to conclude that at least a portion of the capital gain arising on the disposition of the common shares would be attributable to the fact that dividends were not paid on the preferred shares. This is because the common shares would presumably increase in value by virtue of their participation in retained earnings of the company which were not used to pay dividends on the preferred shares. The matter of whether a significant part of the capital gain realized on the disposition of the common shares would be attributable to the fact dividends were not paid on the preferred shares is a question of fact that could not be determined without "... having regard to all the circumstances" [ss. 110.6(8)].

As each case must be judged on its particular facts, the Department has not developed any guidelines as to what constitutes "a significant part of the capital gain" for the purposes of subsection 110.6(8) of the Act. In this regard, however, the Department would not place reliance on a percentage test alone; the dollar value attached to that part of the capital gain attributable to the payment of insufficient dividends would also be taken into account. This is consonant with the Department's position as set out in the paper entitled "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55", presented by John R. Robertson (see Robert of Proceedings of the Thirty-third Tax Conference: Canadian Tax Foundation, 1981, p. 81, at p. 93).

The payment of a "catch-up dividend" representing the present value of all unpaid dividends on the preferred shares would not, in and of itself, resolve the matter of whether subsection 110.6(8) would deny the capital gains deduction under subsection 110.6(2.1) of the Act, having regard to the possibility that, depending on all of the circumstances, it might nevertheless be reasonable to conclude that a significant portion of the capital gain was attributable to the fact that the payment of dividends on the shares was deferred.

The expressions of opinion in this letter are given in accordance with the practice referred to in paragraph 21 of Information Circular 70-6R2 and are not binding on Revenue Canada Taxation.