14 April 1989 Income Tax Severed Letter

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.

XXXX

April 14, 1989

XXXXXXXX

Thank you for your letter of April 7, 1989, concerning the items which you are intending to include in the book which you are writing on butterfly reorganizations.

We have no objection to you including reproductions of the Revenue Canada papers on this subject that were presented in 1981, 1984 and 1988 as an interpretation of the law as it applied on those dates.

There will be one minor change to the 1988 paper in your possession. This is indicated on the attached extract from your summary.

Yours sincerely,

Acting Assistant Deputy Minister Legislative and Intergovernmental Affairs Branch

Attached is a summary of a paper given by Mr. R.J.L. Read, Director General, Specialty Rulings Directorate of Revenue Canada Taxation at the Canadian Tax Foundation Annual Conference in Vancouver on November 29, 1988. The paper was entitled Section 55: A Review of Current Issues. This summary only deals with that part of the paper relating to butterfly reorganizations and the interpretation of paragraph 55(3)(b).

Types of Butterflies

There are four types of butterflies as follows:

1. Each shareholder receives its share of each type of property (a full double-wing butterfly). 2. Each shareholder receives its share of one type of property (partial double-wing butterfly). 3. Some, but not all, shareholders receive their share of each type of property (full single-wing butterfly). 4. Some, but not all, shareholders receive their share of one type of property (partial single wing butterfly).

Favourable rulings will not be granted where partial single-wing butterflies are preceded or followed by other divisions of corporate property which, in aggregate, would not result in compliance with the requirements of paragraph 55(3)(b).

Partial butterflies should be followed by appropriate reductions in the adjusted cost base of the shares of the particular corporation held by the shareholder to whom property was distributed.

In the Course of a Reorganization

This is a question of fact to be determined on a case-by-case basis. Any form of distribution of property of the particular corporation referred to in paragraph 55(3) (b) will ordinarily be considered to occur ". . . in the course of a reorganization in which property or a particular corporation was transferred . . .".

The payment of a safe dividend will be taken into account in determining whether each transferee has received his pro rata share of each type of property for purposes of paragraph 55(3)(b).

Example 1

Holdco owns 100% of OPCO. OPCO pays a cash dividend to Holdco. Holdco then transfers 50% of the shares of OPOD to Newco, a newly incorporated wholly owned subsidiary of Holdco. Following this transfer OPCO distributes 50% of each of its types of property to Newco in a butterfly-type transaction. Holdco plans to sell the shares of Newco to an arm's length person.

For purposes of paragraph 55(3)(b) the reorganization will include both the dividend paid by OPCO to Holdco and the transfer of assets to Newco. Since, in the course of the reorganization, OPCO has transferred each of its types of property and since Holdco owns 100% of the shares of OPCO immediately before payment of the initial dividend, in order for paragraph 55(3) (b) to apply Holdco must have received 100% of each of OPCO's types of property. Since this was not the case, paragraph 55(3)(b) will not apply to this reorganization.

Example 2

This example is similar to example 1 except that the distribution of cash to Holdco is made on a reduction of the paid-up capital of the shares of OPCO held by Holdco. Nevertheless, the result would be the same as in example 1. In addition, it would not matter whether the cash payment on the PUC reduction was made before or after the transfer of property to Newco.

Example 3

Parentco owns all of the shares of A and B. A owns 10% of the shares of OPCO. The other 90% are owned by persons with whom A deals at arm's length. OPCO has only business property. B wishes to acquire 10% of the property of OPCO and to resell such property to an arm's length purchaser. A transfers its shares of OPCO to B on a rollover basis for shares of B with nominal paid-up capital and fair market value redemption amount. B redeems these shares. OPCO transfers 10% of its property to B in a single-wing butterfly reorganization. The deemed dividends arising in the course of the butterfly occur ". . . in the course of a reorganization in which property of a particular corporation was transferred . . ." and therefore paragraph 55(3)(b) would apply. However, the deemed dividends arising on the redemption of the shares of B held by A do not occur ". . . in the course of a reorganization in which property of a particular corporation was transferred . . ." and therefore would not benefit from the paragraph 55(3)(b) exemption.

Property Transferred Directly or Indirectly

Property received on a butterfly by a shareholder corporation may be sold on a taxable basis by that corporation to another shareholder corporation that received property on the butterfly where the property sold is to be used in the same business as the other assets acquired by the purchasing shareholder on the butterfly.

As indicated in Information Circular 88-2 subsection 245(2) may apply in respect of a butterfly in which real property inventory is transferred by use of a partnership.

A transfer of property by a particular corporation to a wholly owned subsidiary of a shareholder corporation followed by a winding-up of the subsidiary into that shareholder corporation would constitute an indirect transfer of property by the particular corporation to the shareholder corporation for the purposes of paragraph 55(3)(b). On the other hand, if the subsidiary and the shareholder corporation amalgamated within the meaning of subsection 87(1), the property would have been indirectly transferred to the new corporation resulting from the amalgamation which was not a shareholder of the particular corporation immediately before the transfer.

Each Type of Property So Transferred

In 1981 Revenue Canada described three types of property for purposes of paragraph 55(3)(b) as follows:

1. Cash or near cash 2. Business assets 3. Investments

Since 1981 Revenue Canada's experience has been that different groupings than these have not been appropriate.

Cash generated in the course of operating a business, even though related to the business, is not a business asset for purposes of paragraph 55(3) (b). Since the main reason for the inclusion of the types-of-property test in paragraph 55(3)(b) was to prevent a tax-free cashing out of a shareholder, including property which is cash or near cash in the business property category would defeat the purpose for which the types-of-property test was enacted.

Cash or near cash generally consists of current assets and, subject to the following comments relating to business property, also includes accounts receivable, inventory and prepaid expenses. Advances to other corporations within a corporate group are generally considered to be cash or near cash. In addition, property that will be converted to cash or near cash as part of the series of transactions described in subsection 55(2) may also be considered as cash or near cash.

Accounts receivable, inventory and prepaid expenses may, in appropriate circumstances, be classified as business property where the holder will operate the business to which they relate and they will be collected, sold or consumed, as the case may be, in the ordinary course of that business. This categorization would be unacceptable if it facilitates a significantly disproportionate allocation of such property to a particular shareholder.

Pursuant to the look-through approach described below, shares in a subsidiary may be classified as investment, cash or near cash, or business property or some combination of these types, depending on the nature of the underlying property of the subsidiary and other circumstances.

Cash proceeds received upon the sale of a business property which are to be used for the purchase of another business property will not be considered to be a business property.

It is not reasonable to consider each type of property to be a separate type of property for the purposes of paragraph 55(3)(b).

When a particular corporation has some significant influence (within the meaning of section 3050 of the CICA Handbook) with respect to another corporation in which it owns shares, the look-through approach will be used in determining types of property for purposes of paragraph 55(3)(b).

In the context of a butterfly, the look-through approach will be used to determine the types of property on hand before the butterfly and after the butterfly, in order to determine whether the pro-rata test has been satisfied with respect to each type of property. Using this approach, a transferee who receives a share of a corporation would receive part of each type of property owned by such corporation.

The look-through approach will not be used where there are no changes in the indirect interest of any shareholders in any properties as a result of a butterfly reorganization.

Fair Market Value of Property Received

The value of each type of property may be reduced by related liabilities. If such liabilities exceed the value of the type of property to which they relate, or if debts do not relate to any type of property, the excess or the debts, as the case may be, should be allocated among the remaining types of property on the basis of the relative net fair market values of those other types of properties as otherwise determined.

Where certain current assets are categorized as business properties, a proportionate amount of current liabilities should, in most instances, be netted against the value of such property. Otherwise, current liabilities should, in most instances, be netted against cash or near cash property.

Shares of the Transferor Held by the Transferee

In a situation similar to that in example 1 under the heading "In the Course of a Reorganization", if Newco was wound up into Holdco instead of being sold, OPCO's property will be considered to have been indirectly transferred to Holdco. The pro-rata test in paragraph 55(3) (b) is not met in respect of this indirect transfer. If Newco continues to hold the property and is not wound up, no indirect transfer of property to Holdco arises.

Acquisition of Property in Contemplation of the Transfer

If a particular corporation transfers property to a wholly owned subsidiary in consideration for shares and then transfers such shares to a shareholder corporation as part of a butterfly, Revenue Canada Taxation considers that the transfer to the subsidiary is part of an indirect transfer of the property of the particular corporation to a transferee and that paragraph 55(3)(b) would not apply unless the subsidiary is wound up following the transfer of its shares to the shareholder corporation. Where the shares of the subsidiary are not transferred to a shareholder corporation, the look-through approach will be used to determine the types of property that the shares of the subsidiary represent.

Incurring a debt in contemplation of a butterfly will involve an acquisition of cash. Nevertheless, subject to the comments with respect to net asset value basis butterflies, incurring a new debt to pay an existing debt according to its tenor would not normally be considered by RCT to be an acquisition of property.

When the value of a type of property is determined on a net basis, the repayment of long-term debt will result in an increase in the net value of the type of property to which the debt relates. This increase, in the context of a net asset value butterfly, could be viewed as an acquisition of property in contemplation of a butterfly. This would be the case where the repayment was clearly made to facilitate the property distribution as part of the butterfly, such as in a case where a particular corporation uses existing cash to make a large unscheduled repayment of a debt associated with a business asset. In such as case, the increase in the net value of the business asset would be considered a prohibited acquisition of net assets in contemplation of the intended butterfly. This would not be so where the repayment was made on the due date pursuant to a long-standing legal obligation.