7 February 1991 Income Tax Severed Letter - Redemption of Preferred Shares

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.

Subject: Redemption of Preferred Shares

The purpose of this memorandum is to respond to your memorandum of November 20, 1990 in respect of the above matter, and in particular, to discuss the three issues which you have raised.

Facts

It is our understanding that the material facts may be summarized as follows:

XXX

The issues in respect of which you have requested our comments are as follows:

XXX

In determining whether the XXX constitute separate classes, a useful discussion of the nature of a class is found in the recent decision of the Supreme Court of Canada in The Queen v. McClurg, [[1991] 1 C.T.C. 169] 91 DTC 5001, wherein Dickson, C.J. states the following at pages 5007-5008:
• The concept of share “classes” is not technical in nature, but rather is simply the accepted means by which differential treatment of shares is recognized in the articles of incorporation of a company. As Professor Welling [Corporate Law in Canada -The Governing Principles (Toronto: Butterworths, 1984)] succinctly explains, “a class is simply a sub-group of shares with rights and conditions in common which distinguish them from other shares” (at p. 583). Indeed, the use of the share class is recognized in the [Saskatchewan Business Corporations Act] as the means by which derogation from the principle of equality [i.e., the principle that all shares of a corporation are equal and have equal entitlements] is to be achieved. The statute thus explicitly requires that “the rights, privileges, restrictions and conditions attaching to the shares of each class” must be expressly stated in the articles of incorporation: s. 24(4)(a).

The first and last sentences of the above quotation suggest that separate classes of shares will exist only where the particular corporation's articles expressly so provide.

A compilation of some of the relevant general principles is found in the Federal Court of Appeal's decision in McClurg, [1988] 1 C.T.C. 75 at 82, wherein Desjardins, J. quotes from two leading text books on corporate law, as follows (although Desjardins, J. wrote dissenting reasons, the justices in the majority, as well as those in the Supreme Court, do not appear to have disagreed with her recitation of the applicable corporate law principles):

F.W. Wegenast, The Law of Canadian Companies, (Toronto: Carswell, 1979) at 320 notes:
• Apart from provisions, duly adopted, for preferences as between different classes of shares, and, where there are such preferences, then as amongst the members in each respective class, shareholders are entitled to be treated on a basis of equality. [Emphasis added by Desjardins, J.]

C.M. Schmithoff, Palmer's Company Law, vol. 1, 23rd ed. (London: Stevens & Sons, 1982) c. 33, no 33-06 at 387 states in brief:
• ... It is only when a company divides its share capital into different classes with different rights attached to them that the prima facie presumption of equality of shares may be displaced.
• Speaking generally, a separate class of shares is constituted when the principal rights carried by the shares differ from those carried by other shares; e.g. some shares carry preferential or deferred rights as to dividend or capital, or more votes than other shares. But differentiation between other rights may suffice to create a different class of shares, e.g. differences as to freedom of transferability, or redeemability ... [Emphasis added by Desjardins, J.]

XXX

The provisions of one governing corporate statute, the CBCA, are more important than judicial and academic authorities to a resolution of this issue. The relevant portion of paragraph 6(1)(c) of the CBCA reads as follows:
• 6(1) Articles of incorporation shall ... set out, in respect of the proposed corporation, ...
(c) the classes ... of shares that the corporation is authorized to issue, and
• (i) if there will be two or more classes of shares, the rights, privileges, restrictions and conditions attaching to each class of shares. ...

(See also subsection 24(4) of the CBCA.) The foregoing suggests that a corporation's share capital may be segregated into more than one class only where the articles set out the particular classes and the terms of each class.

XXX

The reference by Wegenast (as quoted above by Desjardins, J.) to “provisions, duly adopted” emphasizes the importance, when creating classes of shares subsequent to incorporation, of following the formalities required by the applicable corporate law. In this regard, paragraph 173(1)(e) of the CBCA provides that a corporation may, by special resolution, amend its articles to create new classes of shares, thus recognizing that the creation of a new class of shares is a fundamental change, and suggesting that a separate class of shares cannot be created without a formal amendment. Thus, even if XXX

To provide for a meaningful discussion of the remaining two issues, we will assume, throughout the balance of this memorandum, that, for corporate law purposes, the XXX comprise a single class of shares.

Issue 2: Interpretation of Subsection 84(3)

For purposes of this analysis, the relevant portion of subsection 84(3) of the ITA reads as follows:
Where at any time ... a corporation ... has redeemed ... any of the shares of any class of its capital stock,
• (a) the corporation shall be deemed to have paid at that time a dividend on a separate class of shares comprising the shares so redeemed ... equal to the amount ... by which the amount paid by the corporation on the redemption ... of those shares exceeds the paid-up capital in respect of those shares immediately before that time; and
• (b) a dividend shall be deemed to have been received at that time by each person who held any of the shares of that separate class at that time. ...

It is our view that the reference in subsection 84(3) to a separate class is intended to ensure that the deemed dividend is included only in the income of those shareholders whose shares were redeemed, and not in the income of any other shareholders who may have held shares of the same class (for corporate law purposes). The amount of the deemed dividend is calculated by reference to the paid-up capital in respect of the redeemed shares immediately before the time of the redemption. Since the paid-up capital is to be calculated as at a time that precedes the redemption of the shares (and thus also precedes the deemed creation of a separate class of shares), it is our view that the paid-up capital of the redeemed shares is to be calculated in the conventional manner, i.e., by ascertaining the average paid-up capital of all the shares of the entire class (for corporate law purposes)

XXX

Issue 3: Reduction and Return of Paid-Up Capital

Paid-up capital for purposes of the ITA is, subject to a few exceptions which are not relevant here, equal to paid-up or stated capital for corporate law purposes, with the result that there is a reduction in paid-up capital under the ITA only where there is a reduction in paid-up or stated capital under corporate law.

Insofar as corporate law is concerned, subsection 39(1) of the CBCA provides that, upon redeeming a share of a particular class, a corporation is required to deduct a proportionate amount from its stated capital account for that class. The CBCA does not provide a means for reducing the stated capital by a greater amount in the context of a share redemption, other than to utilize subsection 38(1), which provides that, subject to the applicable solvency test, a corporation may be special resolution reduce its stated capital.

XXX

We make no comment as to whether such a resolution could have retroactive effect for corporate law purposes; however, insofar as income tax purposes are concerned, the following was stated in Wood v. MNR [1988] 1 C.T.C. 2312 at 2316 (TCC):
• I find unacceptable the notion that a company and its shareholder are entitled, for purposes affecting the rights of third parties, to rewrite history, that is to say, to treat imaginary events as having happened.

Accordingly, it is our XXX

It is our view that, based on a strict reading and application of the CBCA XXX

It is our further view that the ITA and the relevant jurisprudence do not support XXX