Principal Issues: A partnership is the sole shareholder of a corporation ("Subco"). An individual has transferred X's partnership interest to a holding corporation ("Holdco") in consideration for preferred shares of the capital stock of Holdco. Subsection 85(1) applied with respect to the transfer. The agreed amount was the adjusted cost base of the partnership interest and the fair market value of such interest was higher than the ACB. Before the transfer to Holdco, safe income could be attributed to the shares of the capital stock of Subco. Should the safe income attributable to the shares of the capital stock of Subco (at the time of the transfer of the interest of the partnership by the individual) be considered in computing the safe income attributable to the preferred shares of the capital stock of Holdco held by the individual?
Position: Based on the wording of subsection 55(2), the CRA applies a certain "consolidation approach" in the computation of safe income in situations similar to the one described above. In such a case, depending on the circumstances, the capital gain that would result from a disposition of the preferred shares of the capital stock of Holdco could reasonably be considered to be attributable in part to the safe income generated by Subco during the holding period by the individual of his partnership interest, provided that the income earned or realized by Subco was not received by the partnership before the transfer of the interest and that the fair market value of the interest at the time of the transfer is higher than its ACB. Therefore, it is possible that part of the safe income generated by Subco immediately before the time of the transfer of the interest in the partnership could be reasonably attributable to the preferred shares of the capital stock of Holdco received by the individual as consideration for the transfer of the partnership interest. Depending on the circumstances and the relevant facts occurring after the transfer of the interest in the partnership, that part of the safe income generated by Subco attributable to the preferred shares of the capital stock of Holdco could change over time and be replaced by safe income generated at Holdco's level. Double counting issues are also briefly mentioned.
Reasons: Wording of the Act and previous positions.
FEDERAL TAX ROUNDTABLE
APFF CONFERENCE 2010
Question 14
Computing safe income
Consider the following situation: a partnership ("SENC") was the sole shareholder of a corporation ("Subco"). As part of a reorganization of all the partners, the interest of an individual ("X") in the SENC was transferred to a corporation ("Holdco") in exchange for Class B preferred shares of the capital stock of Holdco. To do so, X and Holdco made an election under 85(1) and the agreed-upon amount was the ACB of the interest. At the same time, X subscribed for Class A shares of the capital stock of Holdco and a family trust subscribed for Class C shares of the capital stock of Holdco. X, the family trust and Holdco are not related, as defined in subsection 251(2), to the other members of the SENC. It can be demonstrated that Holdco exercises significant influence over the operations of Subco. Prior to the reorganization, an amount of safe income was attributable to the shares of the capital stock of Subco.
(a) Based on CRA's established positions, X, as a partner of the SENC, is deemed to hold a proportionate share of each of the assets held by the SENC, including a certain number of shares of Subco. It is also understood that where a share is exchanged for new shares pursuant to section 51, 85, 85.1, 86 or 87, the portion of safe income attributable to the exchanged share immediately before the exchange is transferred to the new shares, to the extent that the ACB of the new shares is equal to the ACB of the transferred share. Based on these two well-established CRA positions, in the current situation, given that the units of X in the SENC were exchanged for Class B shares ("freeze shares") as part of a rollover at ACB pursuant to subsection 85(1), we understand that the safe income attributable to the shares of Subco should be considered in computing the safe income attributable to the freeze shares of Holdco. Does the CRA agree with this interpretation?
(b) Considering that Holdco exercises significant influence over the operations of Subco, the safe income of Subco contributes to the value of the shares of Subco that are indirectly held by Holdco and, consequently, to the value of the shares of Holdco. Immediately after the freeze, in the event that the CRA does not agree with the foregoing interpretation, can the CRA advise us as to which Holdco shares should be allocated the earned income attributable to the shares of Subco?
- Class C shares, referred to as “participating shares" - even though the earned income attributable to the shares of Subco does not contribute to the gain on those shares;
- no shares?
(c) Consider the following intermediate-steps situation: as part of the reorganization, X's interest in the SENC was transferred to Holdco in exchange for common shares of Holdco, with an election under subsection 85(1) being made with an agreed-upon amount equal to the ACB of the interest.
Subsequently, X proceeded with a freeze under subsection 51(1) in which X received 100 Class B shares of the capital stock of Holdco in consideration for X’s 100 common shares of the capital stock of Holdco. At the same time, X subscribed for 100 Class A shares of the capital stock of Holdco and the family trust subscribed for 100 Class C shares of the capital stock of Holdco, to arrive at the current situation.
Given these intermediate steps, would the CRA like to make any changes or qualifications to its responses to the preceding questions?
CRA Response
Subsection 55(2) applies to a dividend one of the purposes of which (or, in the case of a dividend under subsection 84(3), one of the results of which) was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition of any share of capital stock that could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971 ("safe income on hand") and before the relevant safe-income determination time.
Since the terms used in subsection 55(2) are "income earned or realized by any corporation", safe income on hand could have been earned or realized by any corporation as long as some or all of the capital gain that would have been realized on the disposition of shares is attributable to income earned or realized by that corporation. Thus, the CRA applies a certain principle of "consolidation" in computing a corporation's safe income on hand in such a case.
In this situation, the capital gain that would result from the sale of the preferred shares of the capital stock of Holdco could reasonably be attributable in part to the safe income on hand generated by Subco during the period that the individual held the interest in the partnership if the income earned or realized by Subco was not received by the partnership as income, before the transfer of the interest, and if the FMV of the interest on the transfer exceeded the ACB of the interest. Indeed, where Subco earns or realizes income, that income is a component of the value of the interest in the partnership and, consequently, that income is also a component of the redemption value of the preferred shares of the capital stock of Holdco obtained by the individual on the transfer by the individual of the interest in the partnership. In addition, if the partnership did not receive such safe income on hand generated by Holdco as part of its own income, the ACB of the individual's interest in the partnership before the rollover will not have increased to reflect such safe income on hand generated by Holdco. The same will be true with respect to the ACB of the preferred shares of the capital stock of Holdco received on the rollover of the partnership interest if the amount agreed to on the rollover is equal to the ACB of the interest (assuming the FMV is greater).
In light of the foregoing comments, it is possible that a portion of the safe income on hand generated by Subco prior to the transfer of the interest held in the partnership may be allocated to the preferred shares of the capital stock of Holdco on a reasonable basis. Furthermore, it is possible that the amount of safe income on hand generated by Subco allocated to the preferred shares of the capital stock of Holdco may vary over time and be replaced by an amount of income earned or realized by Holdco.
For example, the amount of safe income on hand generated by Subco that is allocated to the preferred shares of the capital stock of Holdco at the time of the transfer by the individual could decrease after the transfer if the partnership receives a dividend from Subco in respect of that portion of the safe income on hand generated by Subco or if the partnership realizes a capital gain on the sale of the shares it holds in the capital stock of Subco. On the other hand, Holdco will add its share of the dividend or capital gain to its income by virtue of paragraph 96(1)(f). This income of Holdco will form part of its safe income on hand. We are of the view that any increase in Holdco's safe income on hand resulting from such dividend or capital gain that would arise from Subco's income previously allocated to the preferred shares of the capital stock of Holdco should be considered to form part of the safe income on hand of such preferred shares and should not be added to the safe income on hand in respect of the common shares of the capital stock of Holdco. As such, there would be no duplication of safe income in respect of the same income.
Similarly, if Holdco were to sell its interest in the partnership, Holdco may realize a capital gain and that capital gain would be part of its safe income on hand. It would then be necessary to take into account that a portion of the safe income on hand generated by Holdco would reflect the safe income on hand generated by Subco allocated to the preferred shares of the capital stock of Holdco and to ensure that there is no increase in that portion when computing the safe income on hand in respect of the common shares of the capital stock of Holdco so as to avoid duplication.
While the principles set out above may apply generally, it is possible that studying the specifics of a particular situation may lead us to a different conclusion.
Sylvie Labarre
(613) 946-5357
October 8, 2010
2010-037319.