Subsection 55(4) - Avoidance of subsection (2)

Background

PC1, whose only undertaking was investing in marketable securities was held by Father (through voting common shares and super-voting shares, giving him de jure control), PC2 (holding non-voting common shares) and a discretionary family trust (“Trust 2), holding voting common shares. PC2 is controlled by Father through his voting shares, with his three adult children holding voting common shares.

Proposed transactions

1. TC1, TC2 and TC3 will be incorporated with each being controlled by Father through holding a special share, and with a child holding a common share.
2. PC2 will be continued, then amalgamated with PC1 to form DC, with Father continuing to control DC.
3. Each child will transfer special C shares of DC (whose number will be affected somewhat by the trading price of certain shares held by DC so as to ensure only a whole number of such shares are transferred in 3 below) pursuant to s. 85(1) to their respective TCs in consideration for common shares of that TC.
4. DC will contemporaneously transfer shares to each of the TCs pursuant to s. 85(1) in consideration for Class A preferred shares of the TC.
5. Each TC will redeem its Class A preferred shares owned by DC, and DC will simultaneously redeem the special shares owned by each TC, in each case for a note.
6. The notes owing each way will be paid by set-off.

Additional information

[T]here is no intention by any person to dispose of the shares of any of the corporations referred to herein to a person or partnership that was not a related person to DC or any of the TCs, as the case may be, immediately prior to such disposition. ...

The Children have had very limited, if any, involvement in the investment decisions made by PC1, the predecessor to DC. Father has had de jure control of PC1 and PC2, the predecessors to DC, since incorporation and has made all the decisions relating to the investment of PC1’s assets. The organization of the TCs will simply mirror and continue the existing decision making structure of PC1/DC after the assets are split. ...

Under the terms of Trust 2, the trustees have the authority to appoint an eligible person [including any person or class of persons (other than Father)] as a beneficiary, however, that authority has not been exercised such that all the existing beneficiaries of Trust 2 will be related to DC and will be related to TC1, TC2 and TC3 following the creation of these corporations. In addition, Trust 2 has not acquired property, directly or indirectly, in any manner whatever, from any eligible persons or a person with whom any of the eligible persons does not deal at arm’s length or a person with whom the latter does not deal with at arm’s length.

Purpose of proposed transactions

The purpose of the Proposed Transactions is to divide a portion of the assets of DC among Child 1, Child 2 and Child 3 so that each such person has direct and separate ownership of those assets through a holding company controlled by Father. This will allow the Children to increase their involvement and invest such assets in accordance with Father’s leveraged investment philosophy, in a way that will be subject to the guidance and ultimate voting control of Father, while allowing each Child to make investment decisions independently of his/her siblings.

Rulings

Re application of s. 55(3)(a) exception and non-application of s. 55(4).

A DC which holds a rental property and an investment portfolio and is owned by Parent and his four children will spin off its investment portfolio in reliance on the s. 55(3)(a) exception to four TCs mostly owned by each of the four children. However, parent will have control of each TC by being issued special voting shares on their incorporation.

The CRA tags mention s. 55(4) as a provision that it considered relevant: access to the s. 55(3)(a) exception was assisted by or depended on Parent controlling all the corporations involved in the transactions; the special voting shares of Parent likely had minimal economic attributes; and Parent’s will bequeathed them to the respective children. In this regard, the ruling letter indicates that:

• Parent will control DC and each TC in order to retain control over the property currently owned by DC and the investment decisions related thereto in the same manner as before and to protect his economic interest in the Parent Note and Parent Note 2.
• Parent has no intention of ceasing to control the TCs, is in good health and expects to continue to be fully involved in the day-to-day management of DC.

[N]one of the purposes of Parent acquiring and maintaining voting control of the [TCs] is to cause his children to be related to the [TCs] so that subsection 55(2) would not apply to any of the deemed dividends resulting from the Proposed Transactions since Parent intends to exercise the same degree of control over each of the [TCs] that he currently exercises over DC.

CRA has ruled on a s. 55(3)(a) split-up of a real estate rental corporation (Canco) whose common shares were held by Son Holdco and Daughter Holdco and whose prefs were held by a Holdco for the father and mother of Son and Daughter (Holdco 1). Before the split up of the real estate between Newco 1 (whose common shares and prefs were acquired on the spin-off by Son Holdco and Holdco 1, respectively) and Newco 2 (whose common shares and prefs were acquired on the spin-off by Daughter Holdco and Holdco 1, respectively), Holdco 1 subscribed (presumably a nominal amount) for “super” voting shares of Canco and of Newco 1 and 2, so that at all relevant times, Canco, Newco 1 and Newco 2 were controlled by the two parents. The Additional Information states:

The reason that Holdco 1 will acquire super-voting shares and redeemable, preferred shares of Newco 1 and Newco 2 as part of the Proposed Transactions is to preserve Holdco 1’s economic interest in the underlying assets as it was before the Proposed Transactions.

Parent holds all of the (controlling) special voting shares of Holdco as well as wholly-owning Parent Holdco which, in turn, owns more than half of the common shares and preferred shares of Opco. The balance (under 50%) of the common and preferred shares of Holdco is held by Child Holdco whose preferred shares and (controlling) special voting shares are hold by Child and whose common shares are held by Child Trust, whose beneficiaries include not only Child but also an unrelated beneficiary, so that Child Trust is an unrelated person.

The wholly-owned subsidiary of Holdco (Opco) redeems preferred shares, following which Holdco redeemed preferred shares held by Child Holdco, following which Child Holdco redeemed preferred shares of Child. There otherwise would have been a resulting significant increase in the direct interest of an unrelated person (Child Trust) in the dividend recipient (e.g., Child Holdco). In order to avoid this result, at the beginning of the above series of transactions, Child Trust distributes its common shares of Child Holdco to Child qua beneficiary (i.e., to a person related to the dividend recipients). In finding that s. 55(4) does not apply, CRA stated:

[T]he purpose of the transaction was not to have people become related to each other. In fact, despite the transaction, Child Trust would continue to be an unrelated person for the purposes of section 55 respecting the other taxpayers in the situation described. In addition, all taxpayers in the described situation, other than Child Trust, would continue to be related to each other for the purposes of section 55. …

Thus, subsection 55(2) would not apply in the situation described above to the extent that none of the occurrences set out in subparagraphs 55(3)(a)(i) to 55(3)(a)(v ) occurred as part of a transaction or event or a series of transactions or events as a part of which the dividend was received.

If a butterfly split-up of a distributing corporation (DC) between the two corporations of the two children of a deceased parent had instead been effected during the lifetime of the parent (controlling DC), would it have been necessary to deal with the proportionality test in the division of the property?

CRA indicated that it accepted that the s. 55(3)(a) exemption may apply where the share ownership includes siblings, as long as the presence of their parents as shareholders allows the s. 55(3)(a) exemption to apply. However, this exemption will not be available under s. 55(4) where one of the purposes of the transactions was to cause persons to be related or a corporation to control a corporation so that s. 55(2) did not apply. In this regard, it stated:

[T]he CRA has already taken the position that subsection 55(4) should not apply where the primary reason for a shareholder to hold a sufficient number of shares of the capital stock of a corporation to control it was to protect its economic interests.

Son Inc. and Daughter Inc. (wholly-owned by Son and Daughter) and Father Inc. (owned by Father, Son and Daughter and a family trust with them as the beneficiaries) wholly-owns Holdco Inc. which, in turn, wholly-owns Opco 1 Inc. and a portion of the shares of Opco 2 Inc. (with the balance held by a third party). Son Inc. and Daughter Inc. are not related for s. 55(3)(a) purposes (and similarly for their shareholders), but are related to Holdco Inc. and Holdco 2 Inc.

• Father Inc., Son Inc. and Daughter Inc. will transfer their preferred shares of Holdco Inc. on a s. 85(1) rollover basis to corporation incorporated by Father Inc. (“Holdco 2 Inc.”) in exchange for the issuance of preferred shares
• [T]his Directorate has previously taken the position that subsection 55(4) should not apply where the principal reason for a shareholder holding a sufficient number of shares of the capital stock of a corporation to control it was to protect the economic interests of the shareholder.
• Holdco Inc. will transfer a rental property and its shares of Opco 1 Inc. to Holdco 2 Inc. on a s. 85(1) rollover basis in consideration for the issuance of preferred shares

and the resulting cross preferred shareholdings will be redeemed and the resulting notes settled.

After finding that the s. 55(3)(a) exceptions otherwise applied respecting the deemed dividends arising on the cross-redemptions, CRA turned to s. 55(4) and stated:

… Father controls Father Inc., Holdco Inc., Holdco 2 Inc. as well as Opco 1 Inc.

… .Under [s. 55(4)] it must be demonstrated that none of the main reasons for the events or transactions is to cause persons to become related to each other so that subsection 55(2) would not apply to a dividend.

… Based solely on the information provided in your request, it is not possible for us to determine whether subsection 55(4) could be applicable in the Particular Situation. ...

[T]his Directorate has previously taken the position that subsection 55(4) should not apply where the principal reason for a shareholder holding a sufficient number of shares of the capital stock of a corporation to control it was to protect the economic interests of the shareholder.

A holds preferred shares of Corporation A directly (Class B shares with a redemption amount and ACB (reflecting a previous crystallization transaction) of $500,000 and nominal PUC and, through Holdco A, holds Class C preferred shares with an FMV of $3,000,000 and nominal ACB and PUC. Corporation A’s common shares, having an FMV of $3,000,000 and nominal ACB and PUC, are held by Trust A.

In order that the six restaurants operated by Corporation A can be held by corporations (Corporation A and Newco) for the respective benefit of A’s two children (X and Y):

1. A incorporates and subscribes a nominal amount for special voting shares of Newco that give him control at all times.
2. Corporation A sells the assets of three of its restaurants to Newco under s. 85(1) in consideration for the assumption of debt and Newco preferred shares.
3. A, Holdco A and Trust A sell ½. ½ and ¼, respectively, of their shares of Corporation A on a s. 85(1) rollover basis in exchange for similar-attribute shares of Newco.
4. A subscribes a nominal amount for special voting preferred shares of Corporation A, giving him de jure control.
5. There is a cross-redemption of the shareholdings between Corporation A and Newco for notes for $3,000,000, followed by their set-off.
6. With the exception of the special voting shares (retained by A), the shares of Corporation A and Newco are sold for their FMV to the respective children for cash purchase prices that are funded with loans from a financial institution and A to the children.
7. The resulting capital gain realized by Trust A may be distributed to A as a discretionary beneficiary, with A utilizing the balance of the capital gains exemption.
8. After having repaid a portion of their bank loans, the children transfer their shares of Holdco A and Corporation A, as the case may be, to a newly-formed holding company for each child (Holdco X and Holdco Y) in consideration for the assumption of the debt remaining from 6 above and for high-low preferred shares.
9. Holdco X and Corporation A, and Holdco Y and Newco, may amalgamate.

In discussing whether the s. 55(3)(a) exemption would be available for the dividends deemed to arise in 5 above in light of the s. 55(4) exclusion, and after noting that it had insufficient information to answer this question, CRA stated:

In connection with a request for an advance ruling, we would require additional information such as, inter alia, the age of the parent and children, the involvement of the parent and children in the businesses prior to the reorganization and thereafter, the experience and training of the children to operate such businesses, the identity of the trustee or trustees of Trust A, the length of time that A has held voting shares of the capital stock of Newco and Corporation A, etc.

Furthermore, although we have previously issued advance rulings that subsection 55(4) did not apply where the principal reason was to protect the economic interests of the person holding the voting shares, we were satisfied that in those cases there was not another principal reason that corresponded to the one set out in s. 55(4). Although you indicated in your letter that one of the main reasons would be to protect the economic interests of A because of the loans it would have made to X and Y, which loans would ultimately be assumed by Holdco X/Amalco X and Holdco Y/Amalco Y respectively, it cannot be precluded that we could come to the conclusion that one of the main reasons corresponded to the one indicated in subsection 55(4) considering a set of factors including, inter alia, the identity of the persons who control Corporation A prior to the described reorganization. In this regard, we note that A's economic interest in the businesses would amount to $4.5 million before the described reorganization and only $1 million after the reorganization. In addition, as a result of the transactions, each of the children would have a greater economic interest in Corporation A or Newco, as the case may be, than their father.

The children shareholders of two corporations (S1 and S2) that have been controlled for a number of years by their parents, transfer a portion of their S1 common shares to S2 under s. 85(1) for preferred shares, S1 transfers a portion of its assets under s. 85(1) to S2 for preferred shares, and the two cross- shareholdings are cross-redeemed for notes, which are set-off. Some of the child shareholders of S1 then acquired shares of S1 from other child shareholders.

After indicating that, assuming that s. 55(4) did not apply, the s. 55(3)(a) exception applied, CRA noted:

[T]his Directorate has previously taken the position that subsection 55(4) does not apply where it is shown that a parent retained de jure control of a corporation newly-formed by one of the parent’s children primarily for the purpose of protecting the parent's economic interest in the newly-formed corporation, and that none of the primary purposes of the transactions were to cause persons to become related to each other … .

The only shareholders of A Inc. were Mr. A, who had de jure control, and his children, who held all the participating shares. A Inc. transferred the assets related to a particular business to a new corporation ("Son Inc."), all the participating shares of which were held by Son, and which was controlled de jure by Mr. A at all relevant times. In addition, Son disposed of his interest in A Inc. as part of the proposed series of transactions.

A Inc. and Son Inc. were the only "dividend recipients" under the series of transactions within the meaning of s. 55(3) and at all relevant times during the series, Mr. A, each of his children and each of the corporations were related to each of the dividend recipients.

Regarding s. 55(4), CCRA stated:

This Directorate has already taken the position that subsection 55(4) does not apply where it is shown that a father (or mother) retained de jure control of a corporation newly-formed by one of his (or her) children primarily to protect the father's (or mother's) economic interest in the newly-formed corporation, and that none of the main purposes of the transactions was to cause persons to become related to each other, so that subsection 55(2) does not apply to a dividend.