Regulation 6205

Where the share capital of a corporation is divided into several classes of common shares, and the dividends that may be declared and paid on each class are limited to the surplus of the corporation allocated to the class, shares of any such class will not qualify as a prescribed share even if only one class of such shares has been issued by the corporation.

A right of acquisition set out in the articles will not ipso facto disqualify the share as a prescribed share if such provision in the articles merely describes an acquisition procedure that is set out in the governing companies legislation.

Mr. X holds all 100 of Opco's Class A shares with a fair market value of $1,000,000 and nominal ACB and PUC. Opco pays a stock dividend comprising Class B shares which have a retraction right for $900,000; the 100 Class shares are exchanged for estate freeze Class C preferred shares; and the family trust subscribes for Class A shares for $10. Would the Class B shares issued on the stock dividend be issued as part of an arrangement the main purpose of which was to permit any increase in the value of the property of the corporation to accrue to other shares that would, at the time of their issue, be prescribed shares, so that ITR subparagraph 6205(2)(a) is satisfied? CRA responded (Tax Interpretations translation):

…"[A]rrangement"…has a broad meaning. An arrangement can encompass more than one transaction. Thus, if several transactions are effected in the context of a freeze in favour of persons contemplated by ITR subparagraph 6205(2)(a), the CRA could consider that the arrangement includes these transactions if it appears to it that they are planned together to achieve the targeted purpose, being the freeze. For example, the payment of a stock dividend of Class B Shares…in order to lower the value of the Class A Shares …followed by an exchange of all of such CLass A Shares in order to receive Class C Shares…being transactions effected so as to be followed by the issuance of new participating shares to the family trust, could form part of the same arrangement in the circumstances. In such a case, the Class B and C shares of Opco would be issued as part of the arrangement.

The question of whether the main purpose of the arrangement is to permit any increase in the value of property of a corporation to accrue to other shares that would, at the time of their issue, be prescribed shares, is a question of fact. An arrangement could have been put in place mainly for purposes other than those described in ITR subparagraph 6205(2)(a), such as realizing certain financial, structural or other objectives, or for obtaining certain tax advantages.

…[I]t would be necessary in the current situation to determine if the test provided in ITR subparagraph 6205(2)(a) is satisfied at the completion of the arrangement, being when the Class A shares…are issued (assuming that these were prescribed shares at the date of their issue) to the family trust.

Situation 1

Opco is controlled by three brothers and its shares are held also by four minority shareholders (the "First Shareholders") who deal at arm's length with each other and the three brothers, and are later assumed by CRA not to be employees. Each shareholder (an "Original Shareholder") implements an estate freeze under which the Original Shareholder's shares of Opco are exchanged for preferred shares of Opco and a family trust subscribes for Opco participating shares. Are the preferred shares prescribed shares?

Response

In indicating that the preferred shares did not qualify as prescribed shares, CRA stated (Tax Interpretations translation):

Under clause 6205(2)(a)(ii)(A) ... in order for Opco preferred shares, issued to each Original Holder, to be Prescribed Shares, it is in particular necessary that the participating shares issued by Opco be owned by a person who did not deal at arm's length with each Original Holder or a trust none of whose beneficiaries were other than an Original Holder or persons who did not deal at arm's length with each Original Holder.

...[Instead] the trusts that hold Opco's participating shares do not deal on a non-arm's length basis with each Original Holder. The same applies for the beneficiaries of each of the trusts, who do not deal on a non-at arm's length basis with each of Opco's Original Holders.

Situation 2

The estate freeze of each Original Holder implemented differently.

Each Original Holder transfers its Opco shares to a Newco of which he or she is the sole shareholder in consideration for Newco shares, exchanges its shares of Newco for Newco preferred shares and the family trust subscribes for Newco participating shares. The four Newcos and Opco then amalgamate with the Original Holders and trusts receiving replacement preferred and participating shares, respectively, from Amalco (the "New Corporation"). Are the preferred shares prescribed shares?

Response

After summarizing the purpose requirement in Reg. 6205(2)(a)(i), and the requirement in Reg. 6205(2)(a)(i)(III) that each beneficiary not deal at arm's length with the Original Holder , and noting that each participating share would be required to satisfy Reg. 6205(1), and before noting the requirements of Reg. 6205(4)(c)(i) and (ii), CRA noted (Tax Interpretations translation) that, respecting the amalgamation, Reg. 6205(4)(c) " creates a presumption under which preferred shares issued by the New Corporation to each Original Holder qualify as a Prescribed Share."

CRA went on to state that although "there is some uncertainty ... it is possible that the presumption provided in paragraph 6205(4)(c) ITR may apply to the preferred shares of the capital stock of the New Corporation issued to each Original Holder so that they qualified as Prescribed Shares." In a live case, CRA would consult with Finance.

An employee who subscribed directly for treasury shares, and subsequently transferred them to a new corporation could benefit from the Reg 6205(2) exclusion from ITA s. 110.6(8) to the extent that that transaction did not occur under the same arrangement. In this context, what is an "arrangement" and when is it can be considered to end? After referring to dictionary definitions of arrangement, CRA stated

[T]he purpose of the provisions of ITR subsection 6205(2) is to grant the status of "prescribed shares", for purposes of ITA subsection 110.6(8), to shares issued pursuant to an arrangement the primary purpose of which is to effect a total or partial freeze in favour of persons not dealing at arm's length with the shareholder effecting the freeze, employees of the corporation or a corporation controlled by it, or a combination of such persons and employees. The question of whether the primary purpose of an arrangement is to ensure that the increase in the value of a corporation's property is attributed to "other shares" is a question of fact. An arrangement could have been put in place primarily for purposes other than those provided in paragraph 6205(2)(a), including to achieve certain financial, structural or other objectives, or to obtain certain tax benefits.

The questions of what constitutes an arrangement in a particular situation and, secondly, when that arrangement ends, are ones of fact.

The word "person" in Regulation 6205(2)(a) does not include a partnership.

The test in Regulation 6205(2)(a)(ii)(A) would not be met where two individuals each owning ½ of the common shares of a corporation exchange their common shares of the corporation for preferred shares and have the corporation issue common shares to individuals related to one or other of the two shareholders, because "all" of the common shares would not be owned by non-arm's length persons.

Re application of Regulation 6205(2) where an individual exchanges his common shares for preferred shares under an s. 86(1) reorganization, then he and his son subscribe for new common shares.

Where an individual transferred the common shares of Opco to Newco in consideration for preferred shares with the intention of having Newco issue common shares to his son but instead receives the common shares himself because this transaction is frustrated, the preferred shares of Holdco will be prescribed shares on the basis that increases in the value of the property of Holdco will accrue to the common shares owned by him.

The exemption in Regulation 6205(2)(a) was not available where increases in the value of the corporation were intended to accrue to shares previously issued in connection with an estate freeze where those shares were redeemable for a fixed amount.

Three examples of situations where the exception in Regulation 6205(2)(a) is not satisfied.

Where the share capital of Opco is reorganized under s. 86 by Father exchanging all his common shares for redeemable preference shares, the preference shares issued to him will not be prescribed shares because no prescribed shares are issued to Son who held 10% of the common shares of Opco prior to the s. 86 reorganization.

Following a reorganization described in s. 6205(2), a transfer of the preferred shares to another corporation would disqualify the shares of prescribed shares.