Principal Issues: [TaxInterpretations translation] In a particular situation, were the term preferred shares of the capital stock of a corporation (Bco) acquired in the ordinary course of business operated by a specified financial institution (Aco)?
Position: Question of fact.
Reasons: To the extent that it was shown that Aco's investment in Bco was not exceptional in relation to other investments it had made, we would be of the view that the shares of the capital stock of Bco would have been acquired in the ordinary course of the business carried on by Aco and that subsection 112(2.1) would apply to the particular situation.
May 3, 2006
XXXXXXXXXX TSO HEADQUARTERS
XXXXXXXXXX Income Tax Rulings Directorate
Specialty Section
Validation & Enforcement Division Guy Goulet, CA, M.Fisc.
(819) 986-80982005-013334
Request for interpretation - XXXXXXXXXX
This is in response to your letter of May 25, 2005, requesting our comments on the application of subsection 112(2.1) in the situation described below. Also, we acknowledge receipt of the information provided during our various telephone conversations regarding your request (G. Goulet/XXXXXXXXXX), as well as that in your fax of November 22, 2005, and your letter of June 27, 2005.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act ("Act").
Designation of parties:
For the purposes hereof, the names of the taxpayers are replaced by the following names:
(a) "Aco" means XXXXXXXXXX. In particular, the corporation can:
(i) Acquire securities and any debt or equity securities;
(ii) Establish, provide and hire technical, management and research services for itself or for others;
(iii) Make a loan or guarantee the repayment of all or part of a financial obligation.
Aco is a specified financial institution and a private corporation.
(b) "Bco" means XXXXXXXXXX. For the purposes of this section, Bco also means any "predecessor corporation" as defined in subsection 87(1) that was amalgamated to form Bco. Bco is a taxable Canadian corporation. It carries on a business in the XXXXXXXXXX field.
(c) "Cco" means XXXXXXXXXX, a wholly owned subsidiary of Aco.
(d) "Dco" means XXXXXXXXXX.
(e) "Eco" means XXXXXXXXXX.
(f) "Fco" means XXXXXXXXXX.
(g) "Gco" means XXXXXXXXXX.
(h) "Trust" means XXXXXXXXXX.
(i) "Hco" means XXXXXXXXXX.
(j) XXXXXXXXXX
(k) "USco" means XXXXXXXXXX, an American corporation.
(l) " specified financial institution" has the same meaning as in subsection 248(1);
(m) "affiliated persons" has the same meaning as in subsection 251.1(1);
(n) "taxable Canadian corporation" has the same meaning as in subsection 89(1);
(o) "private corporation" has the same meaning as in subsection 89(1);
(p) "series of transactions" has the same meaning as in subsection 248(10).
Facts:
The relevant facts which have been submitted to us, as we understand them and on which this opinion is based, are as follows:
1. On XXXXXXXXXX, the Trust acquired XXXXXXXXXX% of the common shares in the capital stock of Bco as agent for Hco.
2. XXXXXXXXXX acquired the block of common shares held by the Trust in the capital stock of Bco.
3. XXXXXXXXXX
4. On XXXXXXXXXX, Aco made an offer to purchase the shares of the capital stock of Bco held by all shareholders. The transaction closed on XXXXXXXXXX. The Government of Quebec authorized Eco to acquire from Aco not less than XXXXXXXXXX% and not more than XXXXXXXXXX% of the common shares of the capital stock of Bco, from the shares offered under the Aco offer to purchase. After this transaction, Aco and Eco held XXXXXXXXXX% and XXXXXXXXXX% respectively of the common shares of the capital stock of Bco.
5. At the beginning of XXXXXXXXXX, Aco held XXXXXXXXXX common shares of the capital stock of Bco, representing just over XXXXXXXXXX% of the issued and outstanding voting shares at that time. Those shares had been acquired by Aco in several different lots. XXXXXXXXXX
6. XXXXXXXXXX
7. On XXXXXXXXXX, Aco transferred all of its shares of the capital stock of Bco, i.e. XXXXXXXXXX common shares, to XXXXXXXXXX on a tax-free basis in exchange for shares.
8. XXXXXXXXXX acquired XXXXXXXXXX common shares in the capital stock of Bco, increasing its ownership balance from XXXXXXXXXX to XXXXXXXXXX% and the total number of common shares it held in the capital stock of Bco to XXXXXXXXXX.
9. On XXXXXXXXXX and Eco entered into a shareholders' agreement (the "Agreement") including, inter alia, a standard right of first refusal clause stating that no transfer of Bco shares may be made by one party to a third party without first offering such shares to the other party.
10. On XXXXXXXXXX held notes receivable from Bco for a total amount of $XXXXXXX.
11. The XXXXXXXXXX held XXXXXXXXXX in the form of debentures convertible into common shares of Bco.
12. In XXXXXXXXXX, Aco sold to Dco XXXXXXXXXX common shares of the capital stock of Bco. After that sale, Aco held XXXXXXXXXX common shares of the capital stock of Bco, representing XXXXXXXXXX% of the issued and outstanding common shares.
13. On XXXXXXXXXX, a confidentiality agreement was concluded between USco and Bco.
14. On XXXXXXXXXX, an offer was made by a wholly owned subsidiary of USco, to purchase all of the shares of Bco, to XXXXXXXXXX and all other shareholders of Bco and its option holders. That offer was duly accepted by XXXXXXXXXX on XXXXXXXXXX. However, in view of the terms of the shareholders' agreement between XXXXXXXXXX and Eco, the latter could exercise its right of first refusal. If that right was exercised, the offer became null and void. The offer was valid until XXXXXXXXXX.
15. On XXXXXXXXXX, at a special meeting of the Board of Directors of Aco, it was resolved to authorize the general partner of XXXXXXXXXX to accept the offer described in the preceding item, to authorize Cco to pay XXXXXXXXXX dollars as amounts for breach of contract in the event that Eco exercised its right of first refusal, and to guarantee total borrowings of XXXXXXXXXX dollars in order to allow XXXXXXXXXX executives of Bco to exercise their stock options in the corporation immediately prior to the sale.
16. The XXXXXXXXXX offered Eco its shares in Bco in accordance with the terms of their shareholders' agreement. Eco requested a response period and then exercised its right of first refusal in XXXXXXXXXX. The sale was completed on XXXXXXXXXX.
17. On XXXXXXXXXX, Aco held, through XXXXXXXXXX, a XXXXXXXXXX% interest in the voting shares of Bco. On XXXXXXXXXX, the options held by Bco's officers over Bco's common shares were exercised such that on a fully diluted basis, Aco through XXXXXXXXXX held only XXXXXXXXXX% of Bco's common shares. The share sale materialized on XXXXXXXXXX.
18. From XXXXXXXXXX to XXXXXXXXXX, the following transactions were carried out:
a. XXXXXXXXXX incorporated Gco under Part 1A of the Companies Act. XXXXXXXXXX subscribed for one Class A common share of Gco for $XXXXXXXXXX. Gco is a specified financial institution.
b. XXXXXXXXXX assigned all of its XXXXXXXXXX common shares of the capital stock of Bco to Gco in exchange for XXXXXXXXXX Class A common shares of the capital stock of Gco. The parties availed themselves of the provisions of subsection 85(2) so that no tax consequences would result from that transaction. In that regard, an amount of $XXXXXXXXXX has been credited to the issued and paid-up capital stock of Gco and an amount of $XXXXXXXXXX has been credited to its contributed surplus.
c. On XXXXXXXXXX, Aco took out a one-day loan of $XXXXXXXXXX from a related financial institution.
d. Subsequently, Aco subscribed for additional shares in the capital stock of XXXXXXXXXX for an amount of $XXXXXXXXXX.
e. With the proceeds from the issuance of the additional shares in its capital, XXXXXXXXXX subscribed for XXXXXXXXXX preferred shares in the capital stock of Gco for $XXXXXXXXXX.
f. On XXXXXXXXXX, Gco declared and paid the following dividends:
i. a dividend of $XXXXXXXXXX on its preferred shares held by XXXXXXXXXX.
ii. the following dividends on its Class A common shares held by XXXXXXXXXX:
- one dividend of XXXXXXXXXX dollars;
- XXXXXXXXXX dividends of XXXXXXXXXX dollars;
- XXXXXXXXXX dividends of XXXXXXXXXX dollars;
- XXXXXXXXXX dividends of XXXXXXXXXX dollars;
- XXXXXXXXXX dividends of XXXXXXXXXX dollars,
representing a total amount of XXXXXXXXXX dollars.
g. Upon receipt of dividends totalling $XXXXXXXXXX, XXXXXXXXXX made a return of capital to Aco in the same amount.
h. Upon receipt of the principal repayment amount, Aco repaid the loan of $XXXXXXXXXX plus interest of $XXXXXXXXXX XXXXXXXXXX to the related financial institution.
19. On XXXXXXXXXX, Eco sold its XXXXXXXXXX Class A common shares of Gco for $XXXXXXXXXX and its Class B preferred shares for $XXXXXXXXXX, for a total consideration of $XXXXXXXXXX. Eco immediately thereafter sold the Gco shares to Fco for a consideration of $XXXXXXXXXX. Eco also sold all of its shares of the capital stock of Bco to Gco.
Your Position:
You are of the view that the shares of the capital stock of Gco held by Aco through XXXXXXXXXX were term preferred shares at the time of the payment of dividends totalling $XXXXXXXXXX on XXXXXXXXXX. You are also of the view that those shares were acquired in the ordinary course of the business carried on by Aco. Consequently, you propose to apply subsection 112(2.1) to deny the deduction claimed by virtue of subsection 112(1) by Aco in respect of those dividends.
In particular, you are of the view that the shares of the capital stock of Gco held by Aco through XXXXXXXXXX were acquired in the course of the disposition of an investment of Aco. You add that the disposition of an investment is part of Aco's ordinary business cycle. In your view, each of the steps between the acquisition and the sale of an investment falls within the phrase "in the ordinary course of business", even though the acquisition of the shares of the capital stock of Gco may appear to be an isolated transaction. You refer to Regner Blok-Andersen v. M.N.R. ([1972] C.T.C. 338 (F.C.T.D.)) where it was stated that:
"The position taken by counsel for the appellant was that the words "in the course of business" necessarily imply a continuing process of sales rather than an isolated sale.
In my opinion such substitution is both permissible and logical and does no violence to the section so as to render it repugnant to the general scheme of the Income Tax Act or leading to an absurdity. The phrase "in the course of" contemplates a succession of events in a regular order. It also contemplates a result which follows from an event being set in motion. Such a result will arise in the case of an isolated sale as well as in a continuous number of sales."
Also, you refer to the case of D. Morgan Firestone v. The Queen (87 DTC 5237 (F.C.A.)) where it was established that the activities of a corporation investing in venture capital constituted a business. You stated that in that case the judge defined the business activity of the corporation as the supervision of those companies and the income derived from them as the dividends received:
"If the only possible profit from the appellant's supervision expenses were to have been an accretion in the market value of the appellant's shares of capital stock in the operating companies, then his failure to charge management fees to those companies might have been fatal to his claim to deduct them as running expenses. But there were always intended to be operating profits, and ultimately (i.e., from 1979) there were. The appellant's business was in no sense solely or even principally share management. It was rather the profitable management of his operating companies, even though that was achieved at one remove from and without direct involvement in their day-to-day operations. It was in fact skilful indirect business management of a high order."
To further support your position, you cited the arguments made by the appellant in Société d'Investissement Desjardins v. M.R.N. (91 DTC 373 (T.C.C.)) (section 4.03.3(1)) in describing its business:
“What was the ordinary course of the business carried on by SID? SID is a venture capital corporation, the business of which is to acquire minority holdings of voting and participating shares in Quebec businesses. Thanks to the management and financing expertise it provides, which was acknowledged by the witness Paul Parent of Sico, SID acts as a partner in a business, not in respect of the management and everyday operations of this business but rather in respect of its general orientation. It is allowed to do this by the positions held by its managers in the business's Board of Directors. SID invests for the medium and long term. Since 1976 SID had carried on no money-lending business; it no longer carried on a business of purchasing and selling shares. It held and still holds 'investments in businesses.”
Finally, you consider that Aco acquired the shares of the capital stock of Bco that it held in the ordinary course of business of the corporation it operated.
The Position of the Taxpayer:
In his letter of February 1, 2005, the taxpayer's representative states that he is of the view that the common shares of the capital stock of Bco conferring control on Aco were acquired prior to XXXXXXXXXX and were not term preferred shares. He also argues that the common shares of Bco's capital stock were not acquired in the ordinary course of the business carried on by Aco or Gco and that the common shares of Gco's capital stock were not acquired in the ordinary course of the business carried on by XXXXXXXXXX.
In paragraph 47 of his letter, he stated that that acquisition of shares was a one-time transaction that allowed the provisions of subsection 55(2) and the CRA's policy for calculating safe income to be used. In paragraph 48, he cites two advance income tax rulings (E-9526693 and E-99905543) in which favourable rulings were issued by the CRA on this issue in the context of a loss utilization in an affiliated group and a reorganization involving a reallocation of paid-up capital among different classes of shares for the purpose of a capital distribution. Finally, in paragraph 49, he stated that the shares of Gco's capital stock were acquired for the purpose of receiving tax relief on the subsequent sale of the Bco shares and that, although there is no precedent, it appears to him that the method used in this case is consistent with tax policy.
Our Comments:
Subsection 112(2.1) provides that no deduction may be made under subsection 112(1) or 112(2) in computing the taxable income of a specified financial institution in respect of a dividend received by the institution on a share that was, at the time the dividend was paid, a term preferred share, other than a dividend paid on a share of the capital stock of a corporation that was not acquired in the ordinary course of the business carried on by the institution.
Did Aco receive dividends totalling $ XXXXXXXXXX?
The CRA has had to rule on several occasions in the past regarding the application of section 112 to a dividend received on a share held by a partnership where one of its members was a corporation. The CRA's long-standing position has been that, for the purposes of section 112, the corporation received the dividend to the extent of its share of the dividend.
Consequently, we are of the view that for the purposes of section 112, the dividends totalling $XXXXXXXXXX paid by Gco to XXXXXXXXXX were received by Aco.
Were the shares in Gco's capital stock term preferred shares?
We are of the view that the shares of the capital stock of Gco were, at the time of the payment of the dividends totalling $XXXXXXXXXX, term preferred shares within the meaning of subsection 248(1).
Were the shares of the capital stock of Gco acquired in the ordinary course of the business carried on by Aco?
Generally, the CRA has in the past narrowly interpreted the exception in subsection 112(2.1) for shares acquired otherwise than in the ordinary course of business. The CRA's long-standing position has been to consider that an investment in a term preferred share would be acquired by a specified financial institution in circumstances other than in the ordinary course of business carried on by the institution where the investment is in a subsidiary and is of a permanent nature or is received as consideration on the sale of a business or a substantial part thereof.
In addition, we are of the view that where a specified financial institution invests in term preferred shares of a related corporation, those shares will generally be considered to have been acquired in the ordinary course of the business carried on by the institution unless the shares were acquired in the course of a reorganization of the institution in which the shares were redeemed quickly (a butterfly transaction) or in the course of the incorporation of a wholly-owned subsidiary as permanent capital.
In Société d'Investissement Desjardins (paragraph 4.03.3(4)(b) of the judgment), Justice Tremblay indicated that the exception found in subsection 112(2.1) concerning shares acquired otherwise than in the ordinary course of business is intended to exclude exceptional situations from the application of that subsection:
"This Court is accordingly of the opinion that the circumstances surrounding this case and the particular status of SID make it possible to state that the acquisition of the term preferred shares in Sico met the intention behind the exception in subsection 112(2.21) of the Act. In fact, this provision was clearly enacted to avoid the improper use by lending institutions of shares similar to loans the dividends on which were tax-free while the interest on the sums loaned had to be included in the income of these corporations, The malice rule that emerges from this provision is accordingly the abuse of this tax-free transaction. However, an exceptional situation that might at a pinch be described as accidental should not suffer from application of the principle in subsection 112(2.1) of the Act." (emphasis added)
In Bastion Management Ltd v The Queen, (FCA) 95 DTC 5238, the court ruled on the meaning of "in the ordinary course of the business" for the purposes of s.20(1)(gg) as follows:
"In my view, the Trial Judge's approach was the correct one. The phrase used is "in the ordinary course of the business," not "in the ordinary course of business." This means that the relevant business is that of the taxpayer, not of some abstract business organization.
(...)
This bullion transaction was correctly found not to be in the ordinary course of the taxpayer's business. It was something extraordinary, not something commonly or normally done by the taxpayer. On this one occasion only, it purchased the bullion six days before the year end and sold it three days after the year end. There being no risk of loss, in the words of its President, the deal was "a perfect hedge" (see Appeal Book at p.258). It was not part of the "common flow of the company's business"; in these circumstances, it did call for some remark because it arose out of a "special or particular situation." (emphasis added)
Section 112(2.1) also uses the expression "in the ordinary course of the business" and it seems to us that those comments are relevant.
In Singh v. The Queen (TCC) 2000 DTC 2031, Bonner J. stated that the transactions at issue were in the ordinary course of the appellant's business since there were no circumstances that would lead to the conclusion that the transactions were not in the ordinary course of his business. In that case, the judge had to consider whether the taxpayer was in the business of lending money for the purposes of paragraph 20(1)(p). The taxpayer was a professional engineer working as a project manager through companies controlled by and employing him. During six years, the taxpayer had made only four loans. In addition, for the purposes of his money lending activities, the taxpayer did not have a business card or printed letterhead, nor did he have a separate business telephone line. At page 2033, Judge Bonner stated:
In Morflot Freightliners Limited v. The Queen, at 5185 Strayer J. (as he then was) noted that "... in cases of this nature ... one must try to characterize a situation from a practical business point of view ...". As I see it, when the facts are viewed in this manner it is clear that the appellant in making the loans entered into the business of lending money. He evaluated the lending opportunities and considered both the potential gain for himself and the ability of the borrowers to repay. He obtained security when possible. The loans appear to have been made at ordinary commercial rates of interest. The loans though few in number, were not remarkable for any feature which distinguished them from the operations of an ordinary commercial money-lender. The 1992 and 1993 loans were not investments of the appellant's own capital. Rather, they were made with money borrowed at an interest cost expected to be lower than the interest earned. In short, the appellant expected to earn money on the spread between the two rates and thus to mimic the operations of other commercial lenders. Neither the fact that the operation eventually failed nor the fact that it was short-lived can support a conclusion that the operation was not an ordinary commercial venture. The use of borrowed money to make the last three loans negates any suggestion that the loans were simple investments of accumulated capital. A business is nonetheless a business because it is in its initial stages. The appellant therefore meets the first branch of the paragraph 20(1)(p) test.
[…]
In my opinion, the Pancella loan was made in the ordinary course of business. The terms of the loan were not affected by any circumstance which might take it out of the ordinary course. The subsequent transactions are relevant to show a course of conduct. The appellant therefore meets the second branch of the paragraph 20(1)(p) test.
In this case, Aco as a venture capital corporation is not a passive investor. It operates a business for which it has been set up. It does not participate in the day-to-day management of the corporations in which it invests, but it does participate in the decision-making process concerning the financing, management and growth strategies of those corporations. This is where its expertise lies. The holding period of its investments is relatively long as one of its mandates is XXXXXXXXXX. However, when the time is right, Aco realizes its investments and profits from them. We are of the view that these facts alone demonstrate that generally Aco's share acquisitions would be made in the ordinary course of business of the corporation it operates. However, that determination is one of fact and it is the particular facts of each share acquisition that must be considered for this purpose.
The acquisition of the shares of the Capital stock of Gco was part of the series of transactions prior to the sale of the shares of the capital stock of Bco held by XXXXXXXXXX to Eco. In fact, Gco was only formed to be used in the process of disposing of Aco's interest (via XXXXXXXXXX) in the capital stock of Bco. Consequently, we are of the view that in order to conclude that the shares of the capital stock of Gco were acquired in the ordinary course of business of the business carried on by Aco, it must be shown that Aco acquired the shares of the capital stock of Bco in the ordinary course of business of the business it carried on.
Such a demonstration requires a comparative analysis of the investments Aco has made in the ordinary course of its business over the years in order to identify what is ordinary and what is exceptional. For example, the circumstances that ordinarily surround share acquisitions, Aco's conduct and involvement in the management of the businesses, the business relationships with the managers and corporations, the manner in which the shares are acquired and held, the source of the funds invested, the length of time the shares have been held, the field of activity of the businesses, and any other relevant factors could form part of such an analysis. In addition, it should be determined whether Aco's conduct in relation to its investment in Bco is similar and analogous to its conduct in relation to its other investments. To the extent that, based on such an analysis, it was demonstrated that Aco's investment in Bco was not exceptional in relation to its other investments, we would be of the view that the shares of the capital stock of Gco would have been acquired in the ordinary course of the business carried on by Aco and/or XXXXXXXXXX and that subsection 112(2.1) would apply as you have proposed.
Access to Information
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
We hope that our comments are of assistance.
Best regards,
Ghislain Martineau
for the Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch