Section 51

2004-0092561E5 indicated that an exchange of 100 common shares for 500,000 preferred shares and 100 common shares of the same corporation (with the same attributes), followed by the cancellation of the “old” common shares, would not constitute a disposition of the 100 common shares, so that the s. 85(1) election would not be available. Would s. 51(1) apply to the exchange? CRA responded:

[S]ection 51 should apply only where the exchange results in a disposition of the convertible property.

Furthermore, an exchange of shares that does not result in a disposition of the convertible property would not result in a capital gain or loss for the taxpayer.

Bco will transfer to a newly-incorporated subsidiary (Newco) all its shares of a wholly-owned subsidiary (Cco) on a s. 85(1) rollover basis in consideration for common shares and a demand non-interest bearing promissory note (the "Bco-Newco Note"), which is convertible after a specified period at the holder’s option into Newco common shares with an FMV equaling that of the note. Following a short-form amalgamation of Newco and Cco, Bco will exercise its right to convert the Bco-Newco Note to common shares of Amalco.

Rulings include the application of s. 51(1) and non-application of s. 51(2).

The described preliminary transactions (on which CRA did not rule) included the estate exchanging its Class A shares of Opco under s. 51(1) for non-voting non-cumulative retractable Class F shares of Opco and Class A shares of Opco.

Canco indirectly controlled ULC which was the sole member (holding common membership units) of LLC. ULC also held non-interest-bearing Notes which were convertible into "Shares" (membership interests) at a specified price per share. The Notes were converted into "Preferred Shares" of LLC having a fair market value equal to the "fair market value of LLC as a whole (i.e., the remaining equity interests in LLC had no value at that time)."

The Directorate found that the exchange did not occur pursuant to the terms of the Notes given the number of Preferred Shares which were issued. Accordingly, s. 51 did not apply, so that the loss which otherwise was realized on the exchange was denied. It also stated: "We have not considered the application of GAAR to the conversion, but you may wish to consider it further."

The Directorate further noted that "in 58563 [see below]… CRA stated that subsection 51(1)… applied to a conversion made pursuant to the holder's right to convert even if the issuer had the option to repurchase the shares in the meantime."

After being asked whether "the right of exchange must be absolute for purposes of subsection 51(1)," a specific example was described. Preferred shares were redeemable at the option of the company upon giving at least 30 days' notice to the holder and were convertible by the holder into common shares upon 30 days' notice by the holder. In addition, the corporation, without a requirement to give a notice, could during the 30-day period preceding a redemption [sic], proceed with a redemption of shares which were the subject of a conversion notice.

CRA stated (TaxInterpretations translation):

Subsection 51(1)...is applicable when a taxpayer has acquired shares of the capital stock of a corporation in exchange for capital property of the taxpayer which was a share, an obligation or note of the corporation, the terms of which conferred on the holder such right of exchange. We are of the view that the provisions of section 51 of the Act are applicable when the taxpayer has received shares in exchange for a convertible security after having required such exchange in accordance with the right of exchange attached to the convertible security - even if the corporation had the opportunity to redeem such security before such exchange was effected.

Q.B.C.A. s. 91 of the new Q.B.C.A. permits a corporation to convert the shares of a particular class into shares of a new class, through a simple resolution of the board of directors, and with no filing of articles of amendment being required unless this is necessary to change the authorized share capital.

After finding that s 86 would not apply given its general view “that capital will be reorganized for the purposes of section 86 in the situation where the provisions of the corporation's incorporating act require an amendment of its articles,” whereas here there was none, CRA went on to state:

[W]here, for tax purposes, there is a disposition of a share held by a taxpayer resulting from a conversion permitted by Q.B.C.A. section 91, we believe that such a transaction would normally come within subsection 51(1) … .

...[B]y virtue of subsection 51(4), section 86 takes precedence over subsection 51(1). Thus, an interpretation that would enable the application of section 86 to transactions permitted by Q.B.C.A. section 91would significantly restricts the scope of subsection 51(1). That does not seem appropriate or desirable.

CRA's position in IT-291R3, that an election under s. 85(1) potentially is available even if the shares to be issued are not yet part of the transferee's authorized capital, is inapplicable to s. 51(1) because the wording of s. 51(1) is clear as to the simultaneous nature of the exchange.

Where a shareholder exchanged all its Class A shares for Class B shares of the same corporation pursuant to what CRA accepted as being a s. 51 exchange, CRA characterized the Class B shares as having been issued, for purposes of the test in s. 256(1.1)(e), for consideration equalling the FMV of the exchanged Class A shares.

CCo and GCo will agree to amend the terms of the "Tier 2 Debt" owing to CCo to accord it with the right to convert the Tier 2 Debt into common shares of GCo with an aggregate fair market value at the time of conversion equal to the principal amount of the Tier 2 Debt. This amendment will not, pursuant to the governing law result in novation of Tier 2 Debt the creation of a new obligation in its place. CCo will then exercise the conversion right.

Rulings inter alia respecting the addition of the conversion right not giving rise to a disposition and respecting the application of s. 51(1) to the conversion

After indicating that ticking the box on any prescribed rollover election form is sufficient notification to it of the existence of a price adjustment clause, CRA went on to state:

[W]here no form is required (for example, with respect to a transfer of property by pursuant to section 86 or 51), the CRA considers that the mere failure of the parties to notify the CRA of the transaction does not preclude the application of the provisions of … IT-169, provided that all other conditions set out in that Bulletin are satisfied.

A shareholder of a mutual fund corporation redeems his shares in accordance with their terms in exchange for shares of another class of the same corporation. CRA stated:

Subject to the application of subsections 51(4) and 245(2), subsection 51(1) would apply to deem the exchange not to be a disposition of the convertible shares and …there would not be an "amount paid by the corporation in the year on the redemption of shares of its capital stock" for the purposes of factor A in the definition "capital gains redemptions" in subsection 131(6).

Where a debt obligation provides that it is convertible at the option of the holder into another debt obligation of the same issuer provided that the issuer has first given notice to the holders allowing them to make such a conversion, the rollover will be available on such a conversation because s. 51.1 applies at the point of conversion and, at that time, the terms of the debt obligation provides that the rollover is available. CRA stated:

Section 51.1...applies at a point in time, namely at the time of conversion. So long as the right to make the exchange is part of the terms of the debt obligation at that time the rollover will be available provided, of course, that the conditions in paragraphs 51.1(a) and (c) are also satisfied. Thus, a right of exchange which is part of the terms of the obligation from its inception or which becomes a term of the obligation at any time prior to the moment of exchange will satisfy paragraph 51.1(b)... .

A non-resident exchanged pursuant to s. 51(1) his common shares (which were taxable Canadian property) of a Canadian private corporation for preferred shares of the corporation. Although agreeing that, under s. 51(1)(c), “the exchange would be deemed not to be a disposition of the common shares,” CRA went on to state that “subsection 51(1) of the Act does not deem that there is no acquisition of the common shares acquired by the corporation for cancellation,” so that s. 116(5) would apply to the “purchaser” (the corporation) if the conditions in ss. 116(5)(a) and (b) had not been satisfied.

An employee, who holds 100 common shares of an employer corporation (the "Old Shares") with an adjusted cost base and paid-up capital of $500 ($5 per share) and a fair market value of $1,500 ($15 per share), will satisfy the exercise price of $10 per share ($300 in aggregate) for an employee stock option to acquire 30 treasury common shares (the "New Shares") of the employer corporation by exchanging 20 Old Shares having an aggregate fair market value of $300. Will such exchange be considered a disposition? CRA stated:

Subject to subsection 51(4) of the Act, section 51 will apply to any situation where a share of the capital stock of a corporation is acquired by a taxpayer in exchange for a capital property that is another share of the particular corporation and no other consideration is received for the old shares.

An estate freeze entailed the exchange by Mr. A of his common shares of Opco by way of purchase for cancellation for Class A preferred shares with a redemption value of $1 million, followed by a common share subscription by his two adult children for nominal consideration. The exchange agreement contained a price-adjustment clause providing that in the event of a CRA challenge to the FMV of the Class A preferred shares received by Mr. A as consideration, Mr. A and Opco would agree to exchange the those Class A preferred shares for an equal number of Class B preferred shares.

After noting that in such a situation “it is not subsection 15(1) that the CRA would consider applying if the FMV of the freeze preferred shares was less than the FMV of the exchanged common shares, but rather subsection 51(2),” and that the price adjustment clause was not one described in IT-169 as it addressed adjusting the consideration received rather than the purchase price, and that the clause as described “would not be acceptable because … it did not provide for the necessary measures to settle any difference between the FMV of the consideration in relation to the transferred assets, should the preferred shares be redeemed before the CRA contests the FMV of the preferred shares,” CRA stated:

The CRA would generally agree to recognize a clause for adjustment to the consideration and not apply subsection 51(2), where the facts (including the contract) evinced that the parties actually intended to deal in the shares at their FMV and established the FMV of the preferred shares for the purposes of the arrangement, by a fair and reasonable method, and the relevant adjustments provided for in the adjustment clause were effected by the parties where the FMV of the preferred shares was less than the FMV of the common shares. …