7 October 1991 Income Tax Severed Letter - Prescribed Flow-through Share Rules

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: Interpretation of Subparagraph 6202.1(1)(a)(ii) of the Income Tax Regulations (the "Regulations")

This is in reply to your letter dated September 26, 1991 wherein you requested a technical interpretation of the above-captioned provision pertaining to the prescribed flow-through share rules.

Facts

In summary, the facts which you provided are as follows:

• 1. A principal business corporation ("PBC") entered into a series of flow-through share ("FTS") agreements under paragraph 66(15)(d.1) of the Income Tax Act in 1988 and 1989.
• 2. Each time a FTS agreement was entered into, a parallel agreement was entered into among the investor, the PBC and a specified person (as defined in subsection 6202.1(5) of the Regulations) to provide the PBC or the specified person with the right to acquire any of the issued shares under certain circumstances. The agreement does not, however, obligate the PBC nor the specified person to acquire the FTS.
• 3. The parallel agreement provides that the purchase price at which each FTS may be acquired would be at the fair market value of the share determined as follows:

The purchase price shall consist of the amount determined at the sole discretion of the corporate accountant (subject to appeal by way of the provisions of the arbitration clause provided in this agreement) to be the fair market value of each share, based on an arm's length voluntary liquidation of the corporation's assets, held by the Selling party together with any outstanding amounts owed by the Company with respect to such shares, including declared but unpaid dividends and any accrued interest thereon and such amounts, if any, which may be owing pursuant to terms of this agreement or otherwise to the shareholder.

Your Question

Whether the determination of the purchase price described in item 3 of the Facts would cause the FTS to be prescribed FTS pursuant to subparagraph 6202.1(1)(a)(ii) of the Regulations.

Subparagraph 6202.1(1)(a)(ii) of the Regulations

This subparagraph provides that a new share of the capital stock of a corporation is a prescribed share if, at the time it is issued, under the terms or conditions of the share or any agreement in respect of the share or its issue

• (ii) the amount that the holder of the share is entitled to receive in respect of the share on the dissolution, liquidation or winding-up of the corporation, on a reduction of the paid-up capital of the share or on the redemption, acquisition or cancellation of the share by the corporation or by specified persons in relation to the corporation (in this section referred to as the "liquidation entitlement") may reasonably be considered to be, by way of a formula or otherwise, fixed, limited to a maximum or established to be not less than a minimum.

Our Comments

We understand that the general intent of the prescribed FTS regulations is to ensure that a share would qualify for treatment as a FTS only if the investor is truly at risk for the consideration for which the share was issued. Subsection 6202.1 of the Regulations therefore addresses specified types of guarantees and/or entitlements in relation to FTS.

An agreement entered into by a shareholder for the sale of its FTS to the PBC that issued the FTS, a specified person or any other person for its fair market value at the time of the sale does not, in our view, have any impact on the investor's cost of the share for which he is at risk. This view is consistent with subsection 6202.1(4) of the Regulations which allows agreements for the sale of FTS at fair market value for the purposes of determining whether paragraphs 6202.1(1)(c) and (e) apply.

Regarding the parallel agreement described in item 3 of the Facts, it is therefore our view that the right of the PBC or a specified person to acquire the shareholder's FTS at the fair market value of each share at that time would not fall within the ambit of subparagraph 6202.1(1)(a)(ii).

The parallel agreement states that the fair market value of each FTS, presumably at the time of its sale by the shareholder, would be determined on the basis of "an arm's length voluntary liquidation of the corporation's assets". It is your view that this constitutes a formula or otherwise that fixes the amount that the shareholder would be entitled to receive from the sale of the FTS to the PBC or specified person, i.e., fixing the purchase price of the share need not be in terms of absolute dollars at the time the share is issued, but rather the "formula or otherwise" used in determining the purchase price need only be fixed at that time. Alternatively, the use of a formula which establishes the liquidation entitlement on the fair market value of the corporation's assets on a voluntary arm's length liquidation basis could, in your view, be interpreted as limiting the price for the share to a maximum because the holder of the share could not dispose of the share at a going concern fair market value.

XXX, we are inclined to the view that the purchase price of the FTS determined at the time of the sale under the above circumstances would not be an amount that may, by way of a formula or otherwise, reasonably be considered to be fixed or limited to a maximum. It would be a question of fact, however, whether the purchase price so determined is fair market value, having due regard to a going concern fair market value among other acceptable valuation methods and principles.

XXX our comments are merely the expressions of opinion of those Revenue Canada officials named herein and as such should not be construed as advance income tax rulings, nor are they binding on the Department. Our practice is to make this specific disclaimer in all instances in which we provide an opinion.

If you have any questions or would like to discuss the above matter further, please contact the writer.