Opco has safe income of $2M, which equals the value of its net tangible assets. X does a s. 51 exchange of its Opco common shares (being the only issued and outstanding shares) in exchange for new preferred shares having a $2M value, and for new common shares, having a value of between $1M and $4M, given the uncertain value of Opco’s goodwill and intellectual property. Next:
- X transfers such preferred shares to Newco
- Opco transfers its tangible net assets to Newco in consideration for Newco common shares.
- The shareholdings between Opco and Newco are cross-redeemed.
- X sells its (new) common shares of Newco to a third party based on an earnout clause.
The correspondent submitted that “the safe income of $2M should be allocated to the preferred shares of the capital stock of Opco up to the value of the preferred shares on the basis that the new preferred shares represent the value of the tangible net assets, that they were created to represent the value of those tangible net assets and that the safe income is also represented by the value of the tangible net assets” and, conversely, the new common shares represent “the capital appreciation of the business, i.e., something other than safe income.”
In rejecting this submission, CRA stated:
Assuming that the adjusted cost base of the exchanged common shares was nominal … the value of each class of shares … received on the exchange … would generally represent both a share of income earned or realized by Opco and a share of income not earned or realized …. Accordingly … the new shares issued by Opco would generally share the safe income on hand attributable to the old common shares on the basis of the gain inherent in each of them at the time of the exchange.
The safe income on hand of Opco attributable to the former common shares would therefore … generally be allocated based on the proportion that the unrealized gain inherent in the Preferred Shares at the time of the exchange bears to the total unrealized gain, at the time of the exchange, inherent in the shares received on such exchange.