Principal Issues: Whether, under section 51, the ACB of the preferred shares, received in exchange for common shares having no value, would be nil?
Position: Technically yes. An identical technical result would occur pursuant to paragraph 86(1)(b). However, where the exchanged shares have a nominal value, the ACB of the new preferred shares would be the ACB to the taxpayer of the convertible property immediately before the exchange. Finally, the taxpayer could elect to have the provisions of section 85 apply, precluding the application of sections 51 and 86 (pursuant to subsections 51(4) and 86(3)). Pursuant to paragraph 85(1)(c), a capital loss would be triggered, subject to the potential application of the stop loss rules.
Reasons: Wording of the Act.
Tax Executive Institute/CRA Liaison Meeting
December 9, 2008
Question 17 Section 51 - Convertible Property
Where common shares are exchanged for preferred shares under section 51, and where, prior to the exchange, the common shares clearly have no value (because the amount of the company's debt substantially exceeds the enterprise's value), the formula in paragraph 51(1)(d) will cause the preferred shares to have a nil adjusted cost base ("ACB"). Under paragraph 51(1)(d), the ACB of the preferred shares is equal to the ACB of the common shares multiplied by the fair market value ("FMV") of the preferred shares divided by the FMV of all shares received (the preferred shares in this example since there would only be one class). If the numerator in the second part of the formula is equal to zero, the result is that the ACB of the preferred shares is also equal to zero. We believe that this is likely an unintended result and that the ACB of the preferred shares should be equal to the ACB of the common shares even if the common shares have no value. We invite CRA's views on this issue.
CRA Response
To our knowledge, your question has not previously been submitted for our consideration. Further, we note that the facts described in the question are very limited. Consequently, we find it difficult to understand the context in which a taxpayer would require an exchange of shares that have no value.
Based on our review, we agree that, where the FMV of the common shares is nil as stated in the facts presented, the result of the application of paragraph 51(1)(d) would be that the preferred shares would have a nil ACB. We further note that an identical technical result would occur with the application of paragraph 86(1)(b), should the provisions of section 86 apply.
However, we have also considered the circumstance where, all other facts remaining the same, the convertible property (common shares) has a nominal value. In this case, the ACB of the new preferred shares would be the ACB to the taxpayer of the convertible property immediately before the exchange.
We conclude by noting that, alternatively, the taxpayer could elect to have the provisions of section 85 apply, precluding the application of sections 51 and 86 (pursuant to subsections 51(4) and 86(3)). Assuming that the common shares have a nil FMV, paragraph 85(1)(c) would deem the agreed amount (and consequently the proceeds of disposition) to also be nil, resulting in a capital loss to the extent of the ACB of the transferred shares. Note that this capital loss could be subject to the application of the stop loss rules.