7 June 1991 Income Tax Severed Letter - Implications of Non-alienation Clause in a Shareholders' Agreement

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: Subsections 86(2) and 15(1) of the Income Tax Act (the "Act")

This is in reply to your letter dated October 9, 1990 whereby you requested our opinion with respect to the application of subsections 86(2) and 15(1) of the Act to the following hypothetical situation.

The common shares of a company ("OPCO") are owned by Mr. A and his three sons B, C and D. Mr. A holds 70% of the common shares and each of his three sons holds 10% of the common shares. The sons are all over 18 years of age.

In order to permit all of the future growth of OPCO to accrue to son B, who plays a dominant role in the operations of the business carried on by OPCO, Mr. A and his sons effect a reorganization of capital, to which section 86 of the Act applies, whereby all of the existing common shares are converted into retractable preferred shares having an aggregate redemption price equal to the fair market value of the common shares. A new class of class A common shares is then issued solely to son B such that son B holds 100% of the Class A common shares and Mr. A holds 70% of the preferred shares and each of the sons holds 10% of the preferred shares.

Immediately after the reorganization, the parties thereto enter into a shareholders' agreement which provides, inter alia, that no shareholder may alienate, dispose, sell, transfer or assign any of the preferred shares without the consent of the other preferred shareholders. The effect of the non-alienation clause in respect of the preferred shares is that no preferred shareholder may retract his preferred shares without the consent of the other preferred shareholders.

You asked us to confirm that the insertion of such a clause in a shareholders' agreement would not, in and of itself, cause the provisions of subsection 86(2) or 15(1) to apply to the estate freeze on the basis that the preferred shares were not retractable.

OUR COMMENTS

Your query raises issues related to the determination of the fair market value of the particular property, which is a question of fact, to be reviewed by the relevant district taxation office. However, we can provide you with the following general comments.

Subsection 86(2) of the Act does not apply if the fair market value of the preferred shares received as consideration for the disposition of the common shares, referred to as the "old shares" for purposes of section 86, is equal to the fair market value of the new shares. In our view, a feature which affects the retractability of the new shares, such as the one described above, would affect the value of the new shares and subsection 86(2) could apply. However, this may not be the result if other terms of the shares maintain the appropriate fair market value. Such might be the case if, for instance, the preferred shares carry a cumulative dividend entitlement at an appropriate rate.

We are of the opinion that subsection 15(1) of the Act would not ordinarily be applied in circumstances such as those described above.

The foregoing response is an opinion provided in accordance with the practice described in paragraph 21 of Information Circular 70-6R2, and is not binding on the Department.