Principal Issues: How should the safe income on hand attributable to the old common shares be allocated between preferred shares and common shares received in exchange for the old common shares pursuant to section 51 of the Act?
Position: The safe income on hand attributable to the old common shares should be allocated to the new preferred shares and to the new common shares on a pro rata basis based on the relative amounts of the gain inherent in the preferred shares and in the new common shares at the time of the exchange.
Reasons: In our view, as the preferred shares and the new common shares would be issued as a consequence of the exchange of the old common shares and assuming that the ACB of the old common shares would be low, the gain inherent in the preferred shares and in the new common shares would include a share of the income earned or realized by the corporation and a share of the unrealized income of the corporation.
XXXXXXXXXX 2010-037423 Sylvie Labarre, CA August 25, 2010
Dear Sir,
Subject: Allocation of Safe Income on Hand
This is in response to your email of July 8, 2010 in which you asked our views on the allocation of safe income on hand when common shares are exchanged for preferred shares and new common shares.
Unless otherwise stated, all statutory references herein are to provisions of the Income Tax Act.
Background
X, a Canadian resident, holds all of the common shares of the capital stock of Opco which carries on an active business in Canada. These are the only issued and outstanding shares of the capital stock of Opco.
Opco's assets consist of net tangible assets with a value of $2M, contracts that Opco has with its customers and intellectual property that Opco has developed over the years. The value of the latter two categories of assets is difficult to determine and could range between $1M and $4M.
Opco's safe income is $2M.
X is interested in selling its common shares in the capital stock of Opco, and Acquisitionco is interested in purchasing them provided that the only assets of Opco are the contracts that Opco has with its customers and the intellectual property. The sale price of the shares would vary depending on the achievement of financial objectives, but the maximum amount would be $4 million. At the closing, an amount of $1M would be paid to X and the balance, if any, would be paid over the next five years.
Prior to effecting the sale of the shares of the capital stock of Opco, X would receive preferred shares and new common shares in the capital stock of Opco in exchange for the common shares it holds in the capital stock of Opco. The redemption value of the preferred shares would be equal to the value of the tangible net assets, i.e. $2M. You indicated that section 51 would apply to the exchange.
Subsequently, X would transfer the preferred shares in the capital stock of Opco to Newco. Opco would transfer its tangible net assets to Newco and would receive the preferred shares of the capital stock of Newco in consideration.
Opco would redeem the preferred shares of its capital stock held by Newco. Newco would redeem the preferred shares of its share capital held by Opco.
Question
You wish to know how the safe income of $2 million would be allocated between the preferred shares and the common shares of the capital stock of Opco that would be received by X on the exchange of the former common shares, made in accordance with section 51.
Your Opinion
You believe that, in this situation, 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.
In addition, in your view it makes sense to allocate safe income first to the preferred shares of the capital stock of Opco because the common shares of that capital stock represent the value of the intangible assets and the capital appreciation of the business, i.e., something other than safe income.
In your view, allocating safe income to the preferred shares of the capital stock of Opco would avoid double taxation of Opco's income.
Our Comments
As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, it is the practice of the Canada Revenue Agency (the "CRA") not to issue a written opinion regarding proposed transactions otherwise than through advance income tax rulings. Furthermore, when it comes to determining whether a completed transaction has received adequate tax treatment, that determination is made first by our Tax Services Offices as a result of their review of all facts and documents, which is usually performed as part of an audit engagement. However, we can offer the following general comments that we hope may be helpful to you. These comments, however, may not apply to your particular situation in certain circumstances.
We are not in agreement with your opinion. Assuming that the adjusted cost base of the exchanged common shares was nominal, we are of the view that the value of each class of shares of the capital stock of Opco received on the exchange of such common shares would generally represent both a share of income earned or realized by Opco and a share of income not earned or realized, as was the case with the common shares given in exchange, and that the gain inherent in each class of shares would be derived from both. Accordingly, we believe that, on the exchange, 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 not be allocated solely to the preferred shares of the capital stock of Opco. It would 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.
The amount of the unrealized gain inherent in the classes of shares received on the exchange will be calculated by taking into account the fair market value of such shares at that time. The determination of the fair market value of a class of shares is a question of fact. Since the determination of fair market value is not the responsibility of the Income Tax Rulings Directorate, we cannot provide general commentary on the fair market value of a class of shares.
The Compliance Programs Branch is now accepting requests from taxpayers regarding complex valuation matters. These requests can be made to the CRA where a taxpayer plans to complete one or more specific transactions or, when transactions are completed, before filing an income tax return.
The purpose of the service is to assist taxpayers by answering their questions about the methods or approaches used. However, this Directorate does not provide an opinion on the value of a property or on estimates or statements that a taxpayer proposes. The CRA also does not discuss specific elements involved in determining the FMV of a particular property. The comments provided do not constitute an advance income tax ruling and are not binding on the CRA. In addition, this Directorate limits comments where the information provided is incomplete or inadequate.
Once the transaction has been completed, it may be audited in the same way as if no request for an opinion had been made. Any such request may be made directly, in writing, to the following address:
Director
Technical Applications and Valuations Division
112 Kent Street
Place de Ville, Tower B, 13th floor
Ottawa, Ontario K1A 0L5
These comments are not advance income tax rulings and are not binding on the CRA in respect of any particular situation.
Best regards,
Stéphane Prud'Homme, Notary, M.Fisc.
for the Director
Corporate Reorganizations and Resource Industries Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.