Principal Issue: [TaxInterpretations translation] Must a replacement share continue, after its issuance, to be a share of an eligible small business corporation in order for the capital gain deferral under section 44.1 to continue to apply?
Position: No.
Reasons: The definition "eligible small business corporation share" provides, among other things, that the determination of a corporation's status is made at the time the share is issued.
XXXXXXXXXX 2009-033915 J. Gibbons May 11, 2010
Dear Madam,
Subject: Application of section 44.1 of the Income Tax Act (the "Act").
This is in response to your fax of September 1, 2009, in which you requested our opinion on the above subject.
Unless otherwise indicated, all legislative references herein are to the provisions of the Act.
In particular, your questions relate to the impact of the disposition of "replacement shares" acquired by an individual, assuming that the anti-avoidance rules in subsection 44.1(12) do not apply. For example, you wish to know when and where the deferred capital gain on the replacement shares that were subject to the section 44.1 election will be taxed.
Specifically, your questions are as follows:
1. Does the Act require that a "replacement share", as defined in subsection 44(1), must continue to be a share of an eligible small business corporation after its issue in order for the capital gain deferral under section 44.1 to continue to apply?
2. Does the capital gain deferral under section 44.1 continue to apply in future reorganizations of the corporation where the rollover rules are used? For example, can replacement shares be rolled over under subsection 85(1) with an agreed-upon amount equal to the adjusted cost base without any capital gain?
3. Using the above example, must the shares received on the rollover be shares of an eligible small business corporation in order for the capital gain deferral under section 44.1 to continue to apply?
Our Comments
It appears to us that the situation described in your letter may 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 documentation to the appropriate Tax Services Office for its opinion. However, we can offer the following general comments that may be helpful.
Section 44.1 permits the deferral of capital gains realized on a disposition of eligible small business corporation shares that is followed by the acquisition of replacement shares of an eligible small business corporation. Generally, the adjusted cost base of the replacement shares is reduced by the amount of the capital gain that is deferred. To benefit from the deferral, the shares that are sold must have been common shares and generally must have been held for at least 185 days. In addition, the taxpayer must designate the new shares as replacement shares on the taxpayer's return of income for the year.
The provisions of subsection 44.1(2) apply where an individual has made a "qualifying disposition". Where that subsection applies, paragraph 44.1(2)(a) provides that the individual's gain is deemed to be the amount by which the individual's capital gain exceeds the individual's "permitted deferral", while paragraph 44.1(2)(b) provides that the adjusted cost base of a "replacement share" in respect of the qualifying disposition at any time after the acquisition of the share is reduced by the amount of the "ACB reduction". As for the second amount, it is equal to that portion of the permitted deferral that is equal to the ratio of the cost of the replacement share to the cost of all of the replacement shares.
The definitions "qualifying disposition" and "replacement share" require, among other things, that each share that has been disposed of or acquired, as the case may be, is an "eligible small business corporation share". That expression provides, among other things, that "at the time the share was issued, the corporation was an eligible small business corporation”. The words in bold emphasize that the determination of a corporation's status is made at the time the shares are issued. Therefore, regardless of whether a corporation's status changed after the time of issuance of the eligible small business corporation share, the effect of subsection 44.1 remains.
For the reasons stated above, we agree with your interpretations above. Thus, the deferred gain, which results in a reduction in the adjusted cost base, will be realized when the taxpayer sells the replacement shares, to the extent that the proceeds of disposition exceed the adjusted cost base.
Best regards,
François Bordeleau, Advocate
Manager
Business and Partnerships Section
Income Tax Rulings Directorate.