Principal Issues: In a situation where a corporation (SoOp) has always had 100 class A (held by Mr. A) and 900 class B shares (held by a corporation (Gesco) wholly-owned by Mr. A) of its capital stock issued and outstanding, the class A shares having all the usual rights of a common share and the class B shares being non voting, non participating in the distribution of the corporation`s property in the process of dissolution and having the right to discretionary dividends: how safe income on hand should be allocated between the two classes of shares
Position: The amount of safe income on hand allocatable to a share is a question of fact which requires a review of all facts and circumstances. In this particular situation, it is possible that all the safe income on hand may be allocated to the class A shares.
Reasons: Position in document 2002-0158885 involving a similar situation.
XXXXXXXXXX Marc LeBlond 2010-038882
January 12, 2011
Dear Sir,
Subject: Discretionary dividends
This is in response to your letter of November 15, 2010, in which you have asked for our comments on the above subject regarding the situation described below.
Unless otherwise indicated, all statutory references herein are to the provisions of the Income Tax Act (the "Act").
It appears to us that the situation described in your letter and hereinafter summarized could constitute an actual situation involving taxpayers. As explained in Information Circular 70-6R5, it is not the practice of this Directorate to provide comments on proposed transactions involving specific taxpayers otherwise than in the form of an advance income tax ruling. If your situation involved specific taxpayers and one or more transactions, you should submit all relevant facts and documents to the appropriate Tax Services Office for their opinion. However, we are able to offer the following general comments that may be helpful to you. It should be noted that the application of one or more provisions of the Act generally requires an analysis of all facts relating to a particular situation. Accordingly, and in light of the fact that your letter only briefly describes a given hypothetical situation, our comments below may not be fully applicable in a particular situation.
The Situation
- Mr. A was the sole shareholder of a holding corporation ("Holdco") that was resident in Canada.
- On January 1 of Year 1, a corporation ("Opco") was incorporated in Canada. Opco was resident in Canada.
- The authorized capital stock of Opco consisted of two classes of shares whose principal rights, privileges, conditions and restrictions were as follows:
- The Class A Shares are voting, participating and entitled to receive dividends as determined by the Board of Directors ("Discretionary Dividends").
- The Class B preferred shares were non-voting, non-participating with respect to remaining assets in the event of liquidation, were entitled to receive Discretionary Dividends and were redeemable at the option of the corporation for the amount of stated capital of the shares.
- The directors had the discretionary right to declare and pay a dividend to the holders of Class A shares without declaring any dividend to the holders of the Class B preferred shares, and vice versa.
- Also on January 1 of Year 1, Mr. A and Holdco subscribed, respectively, for 100 Class A Shares and 900 Class B Preferred Shares of the capital stock of Opco. The "adjusted cost base" ("ACB"), as defined in section 54, of the 100 Class A shares to Mr. A and the "paid-up capital" ("PUC”), as defined in subsection 89(1), of those shares was $100. The ACB of the 900 Class B preferred shares to Holdco and the PUC of those shares was $900.
- In its first five years of operation, Opco realized an annual after-tax profit of $200,000.
- At the end of each of those five years, Opco was purified by paying Holdco a cash dividend of $200,000 so that the outstanding shares of its capital stock were "qualified small business corporation shares" ("QSBCS"), as defined in subsection 110.6(1). Thus, after five years, Opco had paid to Holdco dividends totalling $1 million.
- We have assumed that such dividends received by Holdco were "taxable dividends" as defined in subsection 89(1) and that Holdco would be entitled to a deduction under subsection 112(1) in respect of such dividends.
- At the beginning of Year 6, Mr. A plans to sell his Opco shares to an individual ("Buyer") with whom he is dealing at arm's length, as defined in subsection 251(1). At that time, Opco’s fair market value ("FMV") was $500,000 (represented by the unrealized appreciation in Opco’s assets).
- Before Mr. A sells his shares of Opco to Buyer, Opco redeems the Class B preferred shares in its capital stock, owned by Holdco, for their stated capital and PUC of $900.
Your Questions
You are asking us to confirm that:
(1) Holdco is not required under subsection 186(1) to pay Part IV tax for each of its first five taxation years respecting the dividends it received in those years; and,
(2) the amount of $900 that Opco pays to Holdco to redeem the Class B preferred shares in its capital stock is the FMV of those shares given the respective attributes of each class of its capital stock.
Furthermore, you asked, in the situation you submitted to us:
(3) how Opco’s safe income on hand should be allocated between the different classes of outstanding shares of the capital stock of Opco;
(4) assuming Opco is a "small business corporation" ("SBC"), as defined in subsection 248(1), is Mr. A entitled to the capital gains deduction, pursuant to subsection 110.6(2.1), in respect of the sale, to a person with whom he deals at arm’s length, of the 100 Class A shares of the capital stock of Opco owned by him; and,
(5) if the answer to Question 4 would be the same if, in each of its first five years of operation, Opco had paid, out of the total declared dividend amount of $200,000, 10% ($20,000) on the Class A Shares and 90% ($180,000) on the Class B Shares.
With respect to the third question, based on your understanding of some CRA technical interpretations, you believe that the CRA recommends two methods of allocating safe income on hand. In your opinion, one of those methods is to allocate safe income on a pro rata basis according to the number of shares of a particular corporation held by a shareholder out of the total number of outstanding shares of the corporation, whereas under the other method, the allocation is made according to the proportion of the cumulative amount of dividends received by a shareholder of a particular corporation out of all dividends paid by the corporation. In this regard, you referred to the CRA Technical Interpretation 2003-0006305 as well as the answer to Question 38 of the Federal Roundtable at the 2002 APFF Conference. In your view, in this particular situation, under the first allocation method, the proportion of Opco’s safe income on hand that should be allocated to the Class A shares and Class B shares is 10% ($20,000) and 90% ($180,000), respectively, whereas under the second allocation method, all of Opco’s safe income on hand ($200,000) should be allocated to the Class B shares.
Our Comments
Response to Question 1 respecting Part IV Tax
We are of the view that, in the particular situation, Holdco would not be required to pay Part IV tax on the dividends it receives from Opco in its first five taxation years since, when it receives them, Opco would be "connected", within the meaning of paragraph 186(4)(a), to Holdco and that, on the facts, Opco would not be entitled to a "dividend refund" within the meaning of 129(1)(a) in respect of them.
Opco would be “connected”, as defined in paragraph 186(4)(a), to Holdco when Holdco receives Opco’s dividends because Opco is controlled (otherwise than by means of a right described in paragraph 251(5)(b)) by Holdco at that time, by virtue of 186(2). That would be so since more than 50% of the issued shares of the capital stock (with full voting rights in all circumstances) of Opco would belong to Mr. A with whom Holdco “does not deal at arm's length" by virtue of paragraph 251(1)(a).
Response to Question 2 respecting the FMV of the Class B Preferred Shares
The question of whether the amount paid by Opco to Holdco to redeem its Class B preferred shares represents the FMV of the shares of that class at that particular time is a question of fact. Since the determination of that value is not the responsibility of the Income Tax Rulings Directorate, we cannot comment generally on that FMV.
Consequently, we cannot confirm that the FMV of the Class B Shares of the capital stock of Opco would be $900 at the time of their acquisition by Opco.
However, the Technical Applications and Valuations Division of the Audit Professional Services Directorate of the Compliance Programs Branch of the CRA agrees to review taxpayer inquiries on complex valuation issues. Those requests may be made to them when a taxpayer plans to carry out one or more specific transactions or, when the transactions are completed, before filing an income tax return. The service aims to help taxpayers by answering their questions about the methods or approaches used. If you wish to avail yourself of this service, we invite you to follow the guidelines contained in the answer to Question 5 of the "Financial Strategies and Financial Instruments Roundtable” of the 2008 APFF Conference (our document number 2008-0286151C6).
Response to Question 3 respecting the Allocation of Safe Income on Hand
In our opinion, CRA Technical Interpretation 2003-0006305 and the response to Question 38 of the Federal Roundtable at the 2002 APFF Conference do not indicate that the CRA accepts two methods of allocating safe income on hand between shares of different classes of the capital stock of a corporation.
Technical Interpretation 2003-0006305 describes the method of allocating safe income on hand endorsed by the CRA if all classes of shares of the capital stock of a corporation participate in the remaining assets on a winding-up. That method of allocation is described in that document as follows:
The determination of the safe income on hand in respect of shares of different classes of the capital stock of a corporation is based on the right of those shares to participate in the safe income of the corporation and is a function of the "holding period" of such shares.
At the 1988 Canadian Tax Foundation Conference, the CCRA took the position, in the answer to Question 9 of the conference, "Section 55: A Review of Current Issues," that the allocation of safe income on hand between shares of different categories, should be done as follows (page 18:27):
Our view is that income will be attributable to a particular class of shares in the same proportion in which each class of shares would be entitled to earnings of the corporation if all earnings were to be distributed in the process of dissolution. Once the income earned or realized is allocated among the various classes of shares, the extent to which the income allocated to a particular share is reflected in a gain on that share must be determined. The comments in this paper on stock options, stock dividends, and stock splits should also be considered.
[emphasis added]
The determination of safe income on hand attributable to shares of a corporation is a question of fact that cannot be determined without taking into account all the facts and circumstances of a particular situation, especially where the capital stock involved includes discretionary dividend shares. In this respect, the situation you presented to us only briefly describes a hypothetical particular situation. In the absence of an analysis of all the facts and circumstances pertaining to a particular situation, it is difficult for us to make a final determination on an issue relating to the application of subsection 55(2). However, we are able to offer the following general comments.
The division or allocation of safe income on hand between shares of various classes in a particular given situation would require, in particular, an analysis of all the rights, privileges, conditions and restrictions attached to the issued and outstanding classes of shares, as well as an analysis of the relevant clauses of a unanimous shareholder agreement, if any, and applicable corporate law.
That said, based on the summary description of the situation that you have submitted to us, the position stated in Technical Interpretation 2003-0006305 described above and the rights, privileges, conditions and restrictions attaching to the Class B Opco shares (and taking into account in particular that the right to dividends of such Class B shares would be subject to the discretion of the board of directors and that such shares would not give rise to the right to share in the remainder of Opco's assets in the event of liquidation), it is possible that the safe income on hand realized by Opco from the time of the issuance of the Class B Opco shares may be fully allocated to the Class A shares of the capital stock of Opco. This is the position that we took in a similar situation. We refer you in this regard to Technical Interpretation 2002-0158885.
Response to Questions 4 and 5 respecting the Capital Gains Deduction
Whether an individual may deduct, in computing the individual’s taxable income for a particular year, an amount pursuant to subsection 110.6(2.1) for the "capital gains deduction" in respect of the disposition of a QSBCS, is a question of fact and law that can only be determined by taking into account all relevant facts and legal documents relating to a particular given situation.
In this regard, the situation you presented to us only briefly describes a hypothetical particular situation. In the absence of an analysis of all the facts and circumstances pertaining to a particular situation, we find it difficult to make a final determination of an issue relating to the application of subsection 110.6(2.1), considering, among other things, subsections 110.6(7), 110.6(8) and 110.6(9) as well as section 6205 of the Income Tax Regulations.
In particular, the question of whether subsection 110.6(7) could apply in the situation you have submitted to us appears relevant to your question regarding the FMV of Class B shares of the capital stock of Opco at the time of their acquisition by Opco. Indeed, Mr. A would not be entitled to the capital gains deduction in subsection 110.6(2.1) in computing his taxable income for a taxation year under paragraph 110.6(7)(b) if the gain from the disposition of the Class A shares that Mr. A disposed of was part of a series of transactions or events in which Opco acquired its Class B shares held by Holdco for a consideration well below their FMV at the time of acquisition.
We hope that our comments will be of assistance.
Best regards,
Maurice Bisson, CGA
Manager
Corporate Reorganizations and Resource Industry Section
Corporate Reorganizations and Resource Industry Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch