Principal Issues: Whether subsection 55(2) would apply to a dividend in the situation described?
Position: Yes
Reasons: Significant increase in the total direct interest in Holdco.
XXXXXXXXXX 2005-011769
R. Gagnon
March 18, 2005
Dear Sir,
Subject: Section 55(2) of the Income Tax Act
This is in response to your email of February 22, 2005 in which you asked whether subsection 55(2) of the Income Tax Act would be applicable to the dividends referred to in the situation described below.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
Facts
1. Opco and Subco are "taxable Canadian corporations" as defined in subsection 89(1) and "Canadian-controlled private corporations" as defined in subsection 125(7).
2. The issued and outstanding shares of the capital stock of Opco consist of 100 common shares.
The principal rights, privileges, conditions and restrictions attaching to the common shares of the capital stock of Opco are as follows: no par value, voting, participating, entitled to receive dividends when declared by the board of directors. Upon liquidation or dissolution of the corporation, the holders of common shares are entitled to receive the remaining property of the corporation.
3. The paid-up capital ("PUC"), as defined in subsection 89(1), of the issued and outstanding common shares of the capital stock of Opco is $100. The fair market value ("FMV") of the 100 issued and outstanding common shares of the capital stock of Opco is $500,000.
4. Mr. X and Mr. Y are resident in Canada for the purposes of the Act. Mr. X is Mr. Y's brother.
5. Mr. X and Mr. Y each hold 50 common shares of the capital stock of Opco. The issued and outstanding shares of the capital stock of Opco are capital property, as defined in section 54, to the holders. Mr. X and Mr. Y have always been the sole shareholders of Opco. Mr. X and Mr. Y form a group of persons who have effective (de jure) control of Opco for the purposes of the Act.
6. The adjusted cost base ("ACB"), as defined in section 54, of the common shares of Opco held by Mr. X and Mr. Y is $50 each. The safe income on hand for the purposes of subsection 55(2) that is attributable to the 100 common shares of the capital stock of Opco held by Mr. X and Mr. Y is $125,000.
7. Opco holds 35 common shares of the capital stock of Subco, which represent 35% of the issued and outstanding common shares of the capital stock of Subco. The issued and outstanding shares of the capital stock of Subco are capital property as defined in section 54 for Opco. The FMV of the 35 common shares of the capital stock of Subco is $200,000. The PUC and ACB of the 35 common shares of the capital stock of Subco held by Opco are each $35.
There is no safe income on hand for the purposes of subsection 55(2) that is attributable to the 35 common shares of the capital stock of Subco held by Opco.
8. Mr. X and Mr. Y would like the 35 common shares of Subco to be held through a new holding company ("Holdco”), in order to protect this investment from the business risks of Opco. In order to meet this objective, the following transactions would be carried out by the parties in the order set out below. The transactions below would form part of a single series of transactions or events within the meaning of section 248(10).
9. Holdco would first be incorporated. Holdco would be a "taxable Canadian corporation" as defined in subsection 89(1) and a "Canadian-controlled private corporation" as defined in subsection 125(7). Mr. X and Mr. Y would be the incorporators of Holdco. Upon incorporation of Holdco, Mr. X and Mr. Y would each subscribe for 50 common shares in the capital stock of Holdco for $50 in cash. Mr. X and Mr. Y would form a group of persons who have legal control of Holdco for the purposes of the Act.
10. Mr. X and Mr. Y would transfer to Holdco all of their common shares of the capital stock of Opco, and would each receive as consideration only 50 preferred shares of the capital stock of Holdco. The FMV and redemption value of the 50 preferred shares of the capital stock of Holdco that would be received by Mr. X and Mr. Y would be $250,000 per shareholder.
Mr. X and Mr. Y would each make a subsection 85(1) election with Holdco, in the prescribed form and within the prescribed time set out in subsection 85(6), in respect of their 50 common shares of Opco. The agreed amount established by Mr. X, Mr. Y and Holdco would be the ACB of the Opco common shares, or $50.
As a result of these transactions, Opco would be a wholly-owned subsidiary of Holdco.
11. Opco would transfer to Holdco its 35 common shares of the capital stock of Subco, and would receive as consideration 200,000 Class C preferred shares of the capital stock of Holdco. The FMV and redemption value of those 200,000 Class C preferred shares of the capital stock of Holdco would be $200,000. We have assumed for the purposes of this letter that the issuance by Holdco of the 35 preferred shares of its capital stock to Opco would be valid under applicable corporate law.
Opco would make the subsection 85(1) election with Holdco, in the prescribed form and within the prescribed time set out in subsection 85(6), in respect of the 35 common shares of Subco. The amount agreed to by Opco and Holdco would be the ACB of the Subco common shares, or $35.
12. Holdco would redeem the 200,000 Class C preferred shares of its capital stock held by Opco, for an amount equal to their redemption value, i.e. $200,000. Holdco would pay for the redemption of the 200,000 Class C preferred shares of its capital stock by issuing to Opco a demand, non-interest bearing note payable ("Note Payable to Opco"), the principal amount of which would be $200,000.
Upon redemption of the 200,000 Class C preferred shares of its capital stock, Holdco would be deemed by subsection 84(3) to have paid a taxable dividend (as defined in subsection 89(1)) of $199,965 on the 200,000 Class C preferred shares held by Opco.
13. Opco would then pay a taxable dividend (as defined in subsection 89(1)) of $200,000 to Holdco. This dividend would be paid by Opco delivering the Note Payable to Opco to Holdco. The Note would then be extinguished by confusion [i.e., set-off] within the meaning of Article 1683 of the Civil Code of Québec.
Our Comments
It appears to us that the situation described in your letter may be an actual situation involving taxpayers. The Canada Revenue Agency ("CRA") does not generally provide written opinions on proposed transactions otherwise than by way of advance rulings. Furthermore, it is the responsibility of the relevant Tax Services Office to determine whether completed transactions have received appropriate tax treatment. We can, however, offer the following general comments which may not apply in full to the situation submitted.
In the situation described above, Mr. X and Mr. Y would be "unrelated persons" within the meaning of paragraph 55(3.01)(a), vis-à-vis the Holdco and Opco dividend recipients. Mr. X and Mr. Y would not be related to Holdco and Opco because of the application of subparagraph 55(5)(e)(i), which provides that for the purposes of section 55, persons are deemed not to be related to each other if one is the brother of the other.
It appears to us that in a series of transactions as described in the above situation, there would be, at the time of the acquisition by Mr. X and Mr. Y of the preferred shares of the capital stock of Holdco, a significant increase in the direct interest in a corporation (Holdco) of persons (Mr. X and Mr. Y) who were unrelated persons immediately before the particular time, which would come within paragraph 55(3)(a)(ii). Consequently, the exception in paragraph 55(3)(a) could not apply in respect of the two dividends described in the above situation.
Subsection 55(2) would apply in respect of the dividend resulting from Holdco's redemption of the 200,000 Class C preferred shares of its capital stock, because one of the results of the dividend would be to significantly reduce the portion of the capital gain that, but for the dividend, would have been realized on a disposition of the Class C shares at their FMV immediately before the dividend and that could reasonably be considered to be attributable to something other than income earned on hand attributable to the preferred shares.
Please note that this opinion is not an advance ruling and, as stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, is not binding on the CRA with respect to any particular factual situation.
Best regards,
Maurice Bisson, CGA
for the Director
Corporate Reorganizations and Industrial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch