5 September 1990 Income Tax Severed Letter AC59657 - Capital Gains Exemption - Prescribed Shares under Insufficient Dividend Test

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.

24(l)                                       5-9657
                                            L.A. McCarron-McGuire
                                            (613) 957-2092

19(1)

September 5, 1990

Dear Sirs:

Re: Subsections 110.6(8) and 110.6(9) of the Income Tax Act (the "Act") and Regulation 6205

We are writing in response to your letter dated February 20, 1990 in which you requested our views on the application of the above-referenced provisions to various hypothetical situations described by you in the manner set out below. In providing our response we have assumed in each case that the shares of all corporations involved are "qualified small business corporation shares" within the meaning assigned by subsection 110.6(l) of the Act, and that no dividends have been paid on any shares other than the common shares.

Situation 1

(i) An operating company (Opco) was incorporated to carry on an active business with Mr. X as the sole shareholder. Subsequently an estate freeze was carried out under subsection 86(l) whereby Mr. X took back freeze shares, and a trust (whose beneficiaries are all related to Mr. X) acquired the common shares. No other shares have ever been outstanding in Opco.

(ii) Subsequently Mr. X and the trust formed a holding company (Holdco) and transferred all shares of Opco to Holdco under subsection 85(1). This transfer was carried out for business planning and creditor-proofing purposes. During this rollover Mr. X took back preference shares of Holdco that were identical to his original freeze shares of Opco so that the freeze would be maintained. The trust acquired all common shares of Holdco so that the appreciation would continue to accrue to the trust. No other shares have ever been outstanding in Holdco.

(iii) Many years later the trust may wish to sell its common shares of Holdco.

In your view the preference shares of Holdco are prescribed shares
under Regulation 6205 on the basis that:
          (a)   the main purpose for the original estate freeze was
          to permit the increase in value of the company to accrue 
          to the common shares owned by the trust; and

          (b)   although the main purpose for the rollover to the 
          holding company was for creditor proofing and business 
          planning purposes, the main purpose for maintaining the 
          "freeze share structure" was to continue to permit the  
          increase in the value of the company to accrue to new   
          common shares held by the trust.

Our comments

It is our view that the arrangement, as a part of which the freeze shares of Holdco were issued, is the interposition of Holdco to hold the common and, freeze shares Opco.

While the main purpose of an arrangement is a question of fact, it appears that the main purpose of this arrangement was not to permit the increase in value of Holdco's property to accrue to the common shares, but, as you have stated, to satisfy the shareholders' creditor-proofing and business planning purposes.

Therefore, in our view, the freeze shares of Holdco would not be prescribed shares within the meaning of Regulation 6205(2) (a)

Situation 2 (i) Opco was incorporated by two unrelated individuals, X and Y, to carry on an active business. X and Y each acquired 500 common shares for $500.

(ii)  Some years later, X wished to carry out an estate freeze in
favour of a family trust.  Y did not need a trust or freeze but
agreed to the reorganization to accommodate X.  me capital of Opco
was reorganized under section 86 whereby each of X and Y received
500 special freeze shares in exchange for their original  common
shares.  New common shares were then subscribed for as follows:
          50 shares for $5,000 - by a trust for X's family        
          50 shares for $5,000 - by Y

(iii) Many years later Y may wish to sell his new common shares. In order for them to be eligible for the capital gains exemption it is necessary that Y's freeze shares be "prescribed shares".

In your view Y's freeze shares are prescribed shares, within the meaning of Regulation 6205(2)(a), because:

          (a)   the main purpose of the arrangement was to permit
          some of the increase in the value of the property of Opco
          to accrue to X's trust; and 

          b)   Y should be considered not to deal at arm's length
          with X's trust because X and Y acted in concert to allow 
          estate planning for the benefit of X's trust.

Our comments

We agree that, in these circumstances, the main purpose of the arrangement could be said to be to permit some of the increase in the value in the property of Opco to accrue to X's trust. However, 's freeze shares will not qualify as prescribed shares under Regulation 6205(2)(b) unless Mr. Y did not deal at arm's length with Mr. X's family trust at the time of the reorganization. Paragraph 251(1)(b) of the Act provides that it is a question of fact whether or not persons who are not related to each other are dealing at arm's length at a particular time. Please refer to paragraphs 10 to 14 of Interpretation Bulletin IT-419 , issued by Revenue Canada, Taxation dated July 10, 1978 for the Department's views on the criteria to be applied in determining whether unrelated persons are dealing at arm's length.

Situation 3

(i) Opco was incorporated by two unrelated individuals, X and Y, to carry on active business. Each of X and Y was an active employee who acquired 500 common shares for $500.

(ii)  Some years later, X wished to carry out an estate freeze in 
favour of a family trust.  Y did not need a trust but agreed      
to accommodate X.  On the freeze each of X and Y exchanged their
common shares for special freeze shares.  New common shares were
subscribed for as follows: 
         50 shares by a trust for X
         50 shares by Y

(iii) Many years later Y may wish to sell common shares.

In your view the freeze shares held by Y are prescribed shares because they were issued under an arrangement in which other shares were issued to employees of the company. You place emphasis on the fact that Regulation 6205(2)(b) has no requirement that the employee had to be someone other than the original shareholder or that his percentage interest in the corporation must change.

Our comments

It is our view that Y's freeze shares will not be prescribed shares within the meaning of Regulation 6205(2)(b) because not all of the common shares that were issued as part of the arrangement were issued to employees of the corporation since the trust for X is not an employee.

Situation 4

(i) Opco was incorporated with all of its shares hating been issued to one trust as follows: Shareholder No. and Class of Shares Subscription Price Trust 200,000 Class A preferred 200,000 Trust 1,000 common $ 1,000 The Class A preferred shares are redeemable and retractable for $l each and bear a 7% non-cumulative dividend. The Class A preferred shares were issued to the trust in order to give it the option of redeeming the shares for a tax-free return of capital.

(ii) The value of the Opco's assets has appreciated over the years, resulting in an increase in the value of its common shares. No dividends have been paid on any shares.

(iii) The trust has received an offer to sell the shares for proceeds of $200,000 for the 200,000 Class A preferred shares and $200,000 for the 1,000 common shares.

You request confirmation that if the trust were to sell its common shares of Opco the capital gains exemption would not be denied as a result of the application of subsections 110.6(8) and (9) of the Act.

In your view, subsection 110.6(8) of the Act should not apply because it is not reasonable to conclude that a significant part of a capital gain is attributable to the non-payment of dividends, since "the trust as sole shareholder did not care if it received dividends on common shares or preference shares".

You further contend that the Class A preferred shares are prescribed shares for purposes of subsection 110.6(8) of the Act, so that the failure to pay dividends on them would not result in denial of the capital gains exemption. In your view, the Class A shares satisfy the requirements of 6205(2) (a) since:

(a)       they were issued as part of an arrangement in which other
          shares were issued;

(b)       the main purpose of the arrangement was to permit any  
          increase in value of the company's property to accrue  
          to the common shares; and

(c)       all the common shares were issued to the trust which  
          does not deal with itself at arm's length.

Our comments

Whether a significant part of the capital gain realized on the disposition of the common shares is attributable to the fact that no dividends were paid on the Class A preferred shares is a question of fact that cannot be determined without a review of all of the relevant facts and circumstances. We are therefore not in a position to determine the factors to which the capital gain is attributable. If dividends were paid annually on the common shares rather than on the Class A preferred shares, it may not be reasonable to conclude, depending on the facts, that a significant part of the capital gain is attributable to the failure to pay dividends on the Class A preferred shares since, if they had been so paid, perhaps no dividends would have been paid on the common shares. However, if no dividends were paid on the common shares either, it might well be reasonable to attribute the gain to the non-payment of dividends on the Class A preferred shares.

We do not agree with your contention that the Class A preferred shares are prescribed shares within the meaning assigned by Regulation 6205(2) (a) for the following reasons.

First, it is not clear that the main purpose of the arrangement (the original issuance of shares) was to permit any increase in the value of the property of the corporation to accrue to the other shares. We suggest that the main purpose for the issuance of shares may have been to capitalize the corporation.

Secondly, the Class A preferred shares do not satisfy the requirement in Regulation 6205(2)(a)(ii) which is that:

"the other shares (i.e. the common shares) were issued to

          (A)   the person to whom the particular share was       
                issued (in this paragraph referred to as the      
                "original holder") and any combination of persons 
                described in clauses (B) or (C),

            (B)   another shareholder of the corporation who did  
                  not deal at arm's length with the original      
                  holder,

            (C)   a trust all the beneficiaries of which were     
                  either the original holder and persons who did  
                  not deal at arm's length with the original holder 
                  or those persons alone, or

            (D)   any combination of persons described in clauses 
                  (B) or (C);"  The common shares must satisfy the
                  requirements of one of clauses (A), (B) and (C)
                  above.  The requirement in clause (A) is not
                  satisfied because, although the common shares were
                  issued to the trust (the original holder), they
                  were not also issued to any combination of persons
                  described in clauses (B) or (C). The requirement in
                  clause (B) is not satisfied because "another
                  shareholder" refers to someone other than the
                  original holder, in this case, someone other than
                  the trust.

The requirement in clause (C) is also not satisfied because the trust that owns the common shares is not a trust whose beneficiaries include the original holder (i.e. the trust to which the Class A shares were issued), or persons who did not deal at arm's length with the original holder.

Situation 5

(i) Opco was incorporated to carry on an active business with Mr. X as sole shareholder. Subsequently, an estate freeze wascarried out whereby Mr. X transferred all of his shares of Opco to Holdco on a tax-deferred basis pursuant to subsection 85(1) and received special freeze shares as consideration therefor. A trust (all of the beneficiaries of which are related to Mr. X) subscribed for new common shares.

(ii) Several years later the two companies were amalgamated to reduce administration and paper work. The shares received by X and the trust in the amalgamated company ("Amalco") were identical to the original freeze shares and common shares of Holdco.

(iii) Many years later the trust may wish to sell its common shares of Amalco.

In your view the freeze shares of Amalco are prescribed shares under Regulation 6205(2) because:

          (a)   the main purpose for the original estate freeze was
          to permit the increase in value of the property of Holdco 
          to accrue to the common shares owned by the trust; and

          (b)   although the main purpose for the amalgamation was
          to reduce administrative paper work, the main purpose for 
          maintaining the "freeze share structure" was to continue
          to permit the increase in the value of the property of
          Amalco to accrue to common shares held by the trust.

Our comments

We understand that the purpose of the formation of Holdco and the transfer of the shares of Opco by Mr. X to Holdco was to permit any increase in the value of the property of Holdco to accrue to the trust. However, you state that the amalgamation of Holdco and Opco was done for other business reasons, namely to reduce administrative paper work.

It is our view that the arrangement as a part of which the shares of Amalco, were issued is the formation of Amalco to carry on the business of Opco. While the main purpose of any arrangement is a question of fact, it appears that the main purpose of this arrangement was not to permit any increase in the value of the property of the amalgamated corporation to accrue to its common shares, but to reduce the administrative burden of maintaining the existing structure.

Therefore the freeze shares of the amalgamated corporation would not, in our view, be prescribed shares within the meaning of Regulation 6205(2) (a). We have requested that the Department of Finance, consider the absence of substituted share provisions in Regulation 6205, which may sometimes lead to unintended results.

The foregoing expressions of opinion are given in accordance with the practice referred to in paragraph 24 of Information Circular 70-6R dated December 18, 1978 and are not binding on Revenue, Canada, Taxation.

Yours truly,

for Director Reorganizations and Non-resident Division Rulings Directorate Legislative and Intergovernmental Affairs Branch