7 September 1991 Income Tax Severed Letter - Qualified Small Business Corporation Share

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 Sir:

Re: Request for Interpretation

We are writing in response to your letter, dated May 31, 1991, in which you request an interpretation of sections of the Income Tax Act (the "Act") in relation to the following fact situation:

XXX

Interpretation Requested

The principal interpretation you have requested is whether XXX would be considered by Revenue Canada to be a qualifying "bond" debenture, bill, note, mortgage, hypothec or similar obligation" within the meaning of subparagraph (c)(ii) of the definition of "qualified small business corporation share" in subsection 110.6(1) of the Act. If it would not be so considered, you also wish to know whether Revenue Canada's view would be otherwise if the XXX.

Our Comments

We must draw your attention to paragraph 21 of Information Circular 70-6R2, dated September 28, 1990, wherein it is stated that when a requested interpretation is related to a contemplated transaction, a taxpayer should request an advance ruling. Nevertheless, we can offer you our general comments.

The shares of a corporation ("the corporation") must qualify as shares of the capital stock of a "small business corporation" in order to meet the definition of "qualified small business corporation share" in subsection 110.6(1) of the Act. Paraphrasing that portion of the definition of "small business corporation" in subsection 248(1) of the Act which is germane to the interpretation you have requested, all or substantially all of the fair market value of the corporation's assets must be attributable to assets that are

• (a) used in an active business carried on primarily in Canada by it, or by a corporation related to it,
• (b) a bond, debenture, bill, note, mortgage, hypothec or similar obligation issued by a small business corporation ("the issuing corporation") which was at that time connected with the corporation (within the meaning of subsection 186(4) of the Act on the assumption that the issuing corporation was a "payer corporation" within the meaning of that subsection), or
• (c) assets described in paragraphs (a) and (b).

When two corporations are controlled by the same individual because of that individual's ownership of more than 50% of the voting shares of each corporation, the corporations are related to each other, by reason of the definitions of "related persons" and "person" in subparagraph 251(2)(c)(i) and subsection 248(1) of the Act.

In Revenue Canada's view the phrase "all or substantially all" refers to 90% or more of the fair market value of the assets of a corporation (see Revenue Canada Round Table, 1988 Conference Report 53:1, at p.53:7). Assuming, for example, that all or substantially all of the fair market value of the issuing corporation's assets is attributable to assets used in an active business carried on primarily in Canada by it or by a related corporation, the issuing corporation would be a "small business corporation", pursuant to paragraph (a) of the definition in subsection 248(1) of the Act.

The issuing corporation would also be connected to a related corporation if it was controlled by the related corporation, within the meaning of subsection 186(2) and paragraph 186(4)(a) of the Act, by reason of the fact that more than 50% of the issuing corporation's issued share capital (having full voting rights under all circumstances) belonged to an individual with whom the related corporation was not dealing at arm's length according to paragraph 251(1)(a) and subparagraph 251(2)(b)(i) of the Act.

However, in our opinion, having regard to the specific statutory requirement that forms of indebtedness not identified in paragraph (b) of the definition of "small business corporation" in subsection 248(1) of the Act must be "similar" to a bond, debenture, bill, note, mortgage or hypothec, and also, applying the ejusdem generis principle of statutory interpretation, an unsecured, non-interest bearing loan with no specific terms of repayment would not be a qualifying asset. This is because all of the forms of indebtedness identified in paragraph (b) of the definition would be, at the very least, evidenced in writing, and would also normally contain terms of, and security for, repayment.

In connection with your observation that the word "indebtedness" has been substituted for the words "bond, debenture, bill, note, mortgage, hypothec or similar obligation" in the definition of "qualified small business corporation share" and "small business corporation" in subsections 110.6(1) and 248(1) of draft legislation released by the Department of Finance on July 13, 1990 (now Bill C-18 which received First Reading on May 30, 1991), we agree that "indebtedness" has a more general meaning than the words it is replacing.

Regarding the matter of whether having the loan "documented" before the proposed transaction would qualify the debt, you have said that "documenting" the debt would not, in your opinion, amount to a disposition of the debt, within the meaning of subsection 54(c) of the Act, and that avoiding a disposition of the debt is necessary, in your view, in order to avoid violating the holding period prescribed in subsection 110.6(1) of the Act.

The determination of whether a change made in the terms of a debt obligation will cause a disposition to occur depends upon the particular facts of each case - see IT-448, dated June 6, 1980. The overall question which must be addressed, as per paragraph 4 of the Bulletin, is whether or not it is reasonable to regard an amended debt obligation as being the same property as that which underwent the change. While you do not say in your letter what steps would be taken to "document" the loan, you should also be aware that the Tax Court of Canada has recently said in Dorcas v. M.N.R. [[1991] 1 C.T.C. 2312] 91 D.T.C. 350, at p. 354, that past events cannot be altered ab initio by steps taken ex post facto (see also The Queen v. Neudorf [[1975] C.T.C. 192] 75 D.T.C. 5213, at p.5216 (F.C.T.D.)).

In any event, in our view, the matter of whether or not a disposition of the debt obligation would occur as a result of a change in the terms of the debt is not, in and of itself, significant in the context of the interpretation you have requested. The requirement in paragraph (c) of the subsection 110.6(1) definition of "qualified small business corporation share" is that more than 50% of the fair market value of a corporation's assets must be attributable to qualifying assets throughout the entire portion of the 24 month holding period while the individual owned the share. Prior to the documentation of the debt it would not be a qualifying asset (subject ot the proposed amendment in Bill C-18 which you have noted), and a new 24 month holding period would therefore be needed after the documentation.

In accordance with the practice outlined in Information Circular 70-6R2, the comments in this letter are not binding on Revenue Canada Taxation. Furthermore, nothing in this letter should be interpreted as our agreement with the terms or tax efficacy of the contemplated reorganization. In particular, we have insufficient information to enable us to determine how the capital gains will arise; however, in general, by virtue of paragraphs 86(1)(b) and (c) no capital gains will arise on a section 86 reorganization of capital where the only consideration received by the taxpayer is shares of another class of the capital stock of the corporation. Also, it appears to us that there is potential for a deemed dividend under subsection 84(1) of the Act, although this depends upon matters which were not canvassed in your letter, or in the subsequent (August 6th) telephone conversation. Generally, subsection 84(1) applies where the paid-up capital in respect of a particular class of the capital stock of a corporation is increased by an amount in excess of all reductions in the paid-up capital of the shares of all other classes of its capital stock and the transaction does not involve either the payment of a stock dividend, a net increase in the assets of the corporation or a net decrease in the liabilities of the corporation or certain conversions of contributed surplus into stated capital.

Should you wish to obtain an advance income tax ruling, the manner of submitting a request is set out in paragraph 15 of Information Circular 70-6R2.