Principal Issues: An individual ("A") owns all of the issued and outstanding shares of the capital stock of a holding corporation ("Holdco"). More specifically, A owns Holdco common shares having a fair market value ("FMV") of $0,5 million, a nominal adjusted cost base ("ACB") and a nominal paid-up capital ("PUC"). A also owns Holdco preferred shares having a FMV and an ACB of $0,5 million, and a nominal PUC. The high ACB would be the result of a previous crystallization of the capital gains deduction by A. Holdco owns all of the issued and outstanding shares of the capital stock of an operating corporation ("Opco"). More specifically, Holdco owns Opco common shares having nominal FMV, ACB and PUC. Holdco also owns Opco preferred shares having a FMV and ACB of $1 million, and nominal PUC. A would first dispose of his or her Holdco common shares in favour of his or her children for FMV consideration. The children would then dispose of the Holdco common shares in favour of another corporation ("Newco") in consideration for a promissory note. The children would be the only shareholders of Newco. Holdco would then redeem its preferred shares owned by A. Opco would redeem its preferred shares owned by Holdco, in order to allow Holdco to repay the note issued to A. Holdco would pay dividends to Newco in order to allow Newco to repay the notes issued to the children. Whether section 84.1 or 245 would apply in the given fact situation.
Position: General comments provided. Section 84.1 would apply if, for legal purposes, it is established that A disposed of his or her Holdco common shares directly to Newco. Based on the proposed transactions, the children should be able to establish a "nil" amount, pursuant to subparagraph 84.1(2)(a.1)(ii) of the Act, as being the amount in respect of which a deduction under section 110.6 was claimed. It is the CRA's practice to comment on the application of subsection 245(2) of the Act only after reviewing all the facts and circumstances of a transaction in the context of an advance tax ruling. However, it is noted that the loss realized by A on the redemption of the Holdco preferred shares is the result of the crystallization of A's capital gains deduction. This capital loss could be applied to offset the capital gain apparently realized by A on the disposition of the Holdco common shares. These elements should be considered in examining the purpose of section 84.1. This provision is designed to prevent the removal of corporate surpluses as a tax-free return of capital through a non arm's length transfer of shares and the utilization of the capital gains deduction. Furthermore, transactions or series of transactions similar to those described in this letter could, depending on the facts and circumstances surrounding a particular situation, involve surplus stripping. The loss sustained by A on the redemption of the Holdco preferred shares would be denied under subsection 40(3.6) of the Act if, immediately after the redemption of such shares, it is established that A controlled, directly or indirectly in any manner whatever, Holdco.
Reasons: Wording of the Act and previous positions.
2005-011860
XXXXXXXXXX S. Prud'Homme
(613) 957-8975
March 17, 2005Dear Madam,
Subject: Request for technical interpretation - Transfer of a family business - Non-arm's length sale of shares
This is in response to your letter of February 18, 2005 in which you requested our opinion regarding the potential application of sections 84.1 and 245 of the Income Tax Act (the "Act") in a particular situation.
Unless otherwise indicated, all statutory references herein are to provisions of the Act.
It appears to us that the situation described in your letter and summarized below may be 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 completed transactions, you should submit all relevant facts and documentation to the appropriate Tax Services Office for its opinion. However, we are able to offer the following general comments that may be helpful. It should be noted that the application of one or more provisions of the Act generally requires an analysis of all the facts relating to a particular situation. Accordingly, and given that your letter only briefly describes a hypothetical situation, the comments we provide below may not be fully applicable in a particular situation.
(1) Particular Situation
You have presented us with the situation described below (the "Particular Situation") as part of your request for a technical interpretation.
Background
(a) An individual resident in Canada ("A") held all of the issued and outstanding shares of the capital stock of a corporation ("Holdco"). Specifically, A held common shares of the capital stock of Holdco with a nominal fair market value ("FMV"), adjusted cost base ("ACB") and paid up capital ("PUC"). A also held preferred shares of the capital stock of Holdco with a FMV of approximately $1 million, an ACB of $0.5 million and a PUC of a nominal amount.
(b) Holdco held all of the issued and outstanding shares of the capital stock of an operating company ("Opco"). Specifically, Holdco held common shares of the capital stock of Opco with a nominal FMV, ACB and PUC. Holdco also held preferred shares of the capital stock of Opco with an FMV and ACB of approximately $1 million, as well as a PUC of a nominal amount.
(c) The capital gains deduction in respect of qualified small business corporation shares was crystallized by A through Holdco. A high ACB to A in respect of the preferred shares of the capital stock of Holdco resulted from this crystallization transaction.
(d) At the time of the above-mentioned crystallization transaction, A held 50% of the issued and outstanding common shares of the capital stock of Opco. The other 50% of those shares were held by A's brother ("B"). B also crystallized the capital gains deduction in respect of qualified small business corporation shares through Holdco at the same time as A.
(e) A few years after the crystallization transactions described above, Opco experienced significant financial difficulties. A then acquired all the shares of the capital stock of Holdco held by B. The price agreed between the parties corresponded to the FMV of those shares at that time, and was nominal.
(f) A's children have been involved in the family business for a number of years and wish to take over from A. A would like to withdraw completely from the business.
Proposed Transactions
In the context of A's complete withdrawal from the family business, the following steps would be considered:
(g) A would dispose of all of the preferred shares of the capital stock of Holdco held by A in consideration for Holdco issuing non-voting preferred shares of another class and voting common shares, with the shares of each such class having a FMV of $0.5 million. A and Holdco would make an election pursuant to subsection 85(1) in the prescribed form and within the time period set out in subsection 85(6). The agreed amount in this regard would be $0.5 million. By operation of paragraph 85(1)(g), the cost and ACB of the preferred shares of the capital stock of Holdco received by A would be $0.5 million. The PUC of those preference shares would be nominal. By operation of paragraph 85(1)(h), the cost and ACB of the common shares in the capital stock of Holdco received by A would be nominal. The PUC of those preference shares would also be nominal.
(h) A would then dispose of all of the common shares of the capital stock of Holdco then held by him to his children for a price equal to the FMV of those common shares, i.e. $0.5 million. We understand that in return, the children would issue to A a note with a principal amount equal to the purchase price of the Holdco shares. The acquisition by the children of the common shares of the capital stock of Holdco would be made in proportion to their respective level of involvement in the business. Under the terms of this transaction, A would realize a capital gain of approximately $0.5 million, for which no capital gains deduction pursuant to subsection 110.6(2.1) would be claimed. The "total ACB" to the children of the Holdco common shares would be $0.5 million and their PUC would be nominal. We have assumed for present purposes that these shares would constitute "capital property" to the children within the meaning of the definition in section 54.
(i) The children, who reside in Canada, would then dispose of all of the common shares of the capital stock of Holdco to another corporation of which they are the sole shareholders ("Newco") for a price corresponding to the FMV of such common shares, i.e. $0.5 million. We understand that in return, Newco would issue to the children term notes with a principal amount equal to the purchase price of the Holdco shares. We understand that immediately after this share disposition, Holdco would be connected to Newco. We also understand that pursuant to subparagraph 84.1(2)(a.1)(ii), the children would report an amount of nil as the amount in respect of which a deduction was claimed pursuant to section 110.6.
(j) Holdco would then redeem all of the preferred shares of its capital stock held by A. In exchange, Holdco would issue a term note to A with a principal amount equal to the redemption value of the preferred shares, i.e. $0.5 million. This term note would be secured by the assets of Holdco. Upon redemption of those shares, Holdco would be deemed to have paid and A would be deemed to have received a dividend of approximately $0.5 million pursuant to subsection 84(3). As a result of such redemption of shares, A would, in your view, sustain a capital loss of approximately $0.5 million.
As a result of the share redemption described above, A would no longer hold any shares of the capital stock of Holdco and, according to you, would no longer have any control over Holdco and Opco. Furthermore, A would never have held any shares of the capital stock of Newco and would never have controlled it.
(k) Opco would then redeem the preferred shares of its capital stock held by Holdco, which would enable Holdco, inter alia, to repay the term note issued to A.
(l) Holdco would then pay dividends on the common shares of its capital stock held by Newco, enabling Newco to repay the term notes issued to A's children.
(m) Finally, Newco and Holdco would eventually be amalgamated.
(2) Your Questions regarding the Particular Situation
You wish to know whether section 84.1 or subsection 245(2) applies in the context of the Particular Situation. You also wish to know whether the answer differs to the extent that the proposed transaction described in (1) (g) above were not be carried out. Finally, you wish to know whether the answer is different to the extent that the proposed transaction described in (1)(i) above were not carried out immediately, nor planned, but would occur at a later date for various reasons.
(3) Our Comments on the Particular Situation
First, it should be noted that your letter only briefly describes a hypothetical situation. Among other things, your letter does not provide any information with respect to the nature of Opco's business, the shareholders' equity of Holdco and Opco, the exact nature of the assets owned by Holdco and Opco, the tax attributes of those assets, and the use that would be made of those assets in connection with and following the transactions described. Your letter provides little detail as to the characteristics of the various promissory notes issued in connection with the Particular Situation, and the guarantee that would be granted by Holdco to A. Furthermore, your letter does not indicate precisely over what period the redemption of the shares in the capital stock of Opco, the dividend payments by Holdco to Newco and the repayments of the various promissory notes would take place.
In the absence of such information, it is therefore impossible for us to give a definitive opinion on the potential application of section 84.1 or subsections 84(2) and 245(2) in the particular situation. However, we can make the following general comments.
First, it should be noted that to the extent that it was determined that, as a matter of law, A sold his common shares of the capital stock of Holdco directly to Newco for non-share consideration, a dividend of approximately $0.5 million would be deemed to have been paid by Newco to A and received by A pursuant to paragraph 84.1(1)(b).
However, under the proposed transactions as described above in (1)(h) and (i), A would first dispose of his common shares of the capital stock of Holdco to his children. The children would then dispose of those same shares to Newco. In this regard, we are of the view that for purposes of paragraph 84.1(1)(b), the aggregate ACB to the children of the Holdco common shares acquired from A would technically be deemed to be $0.5 million since the children should be able to indicate, pursuant to subparagraph 84.1(2)(a.1)(ii), an amount of nil as the amount in respect of which a deduction had been claimed pursuant to section 110.6. Indeed, it should be possible to consider in the circumstances that no part of the aggregate ACB to the children of the common shares of the capital stock of Holdco would be attributable to the capital gains deduction claimed by A in respect of the capital gain realized on the crystallization transactions. Our position in this regard is based, inter alia, on the fact that, by the application of paragraph 85(1)(g), the entire amount of the capital gain realized by A and in respect of which he would have claimed a capital gains deduction pursuant to section 110.6 would have been attributed to the preferred shares of the capital stock of Holdco. Consequently, the transaction described in (1)(i) above should not technically result in a deemed dividend paid by Newco and received by the children pursuant to subsection 84.1(1)(b).
However, to the extent that the contemplated transaction described in (1)(g) above is not carried out, the answer to the preceding paragraph would be different. This is because, in such circumstances, the ACB to A of the preferred shares of the capital stock of Holdco would be high as a result of the capital gains crystallization transactions that had taken place. Consequently, where A disposes of a portion of those Holdco preferred shares to the children, the aggregate ACB to the children of the Holdco preferred shares acquired from A would be less than $0.5 million for purposes of paragraph 84.1(1)(b). This is because the children would not be able to designate, pursuant to subparagraph 84.1(2)(a.1)(ii), an amount of nil as the amount in respect of which a deduction had been claimed pursuant to section 110.6. This would be because part of the aggregate ACB to the children of the Holdco preferred shares would then be attributable to the capital gains deduction claimed by A in respect of the capital gain realized on the crystallization transactions. In such circumstances, the transaction described in (1)(i) above would result in a deemed dividend paid by Newco and received by the children pursuant to subsection 84.1(1)(b). Assuming that, in these circumstances, A would dispose of one-half of his preferred shares of the capital stock of Holdco to the children, the amount of the deemed dividend would be approximately $250,000.
With respect to the potential application of subsection 84(2), it would be necessary to determine whether, in the context of the particular situation, any funds or property of Holdco were distributed or otherwise appropriated in any manner whatever to A on the winding-up, discontinuance or reorganization of Holdco's business. To the extent that subsection 84(2) was applicable in the particular situation, a dividend would be deemed to be paid by Holdco to A on the shares of the capital stock of Holdco.
Furthermore, the practice of the Income Tax Rulings Directorate is generally to rule on the application of subsection 245(2) only after reviewing all the facts and circumstances of transactions in the context of an advance ruling request. We note, however, that the crystallization of A's capital gains deduction would directly contribute to a capital loss of approximately $0.5 million being realized upon Holdco's redemption of the preferred shares of its capital stock. This capital loss could then be applied against the capital gain that would appear, on its face, to arise from A's disposition of the common shares of Holdco's capital stock to the children. These factors should be considered in light of the purpose of section 84.1, which is to prevent the withdrawal of corporate surpluses as a tax-free return of capital by way of a non-arm's length transfer of shares and through the use of the capital gains deduction. In addition, we are of the view that transactions or series of transactions of the type described above could, depending on the facts and circumstances of a particular situation, give rise to surplus stripping situations for a particular corporation, which could also trigger the application of subsection 245(2). To the extent that subsection 245(2) was determined to be applicable in the particular situation, this legislative provision would redetermine the tax consequences of the transactions described above and recharacterize the proceeds received by A from his children as a dividend.
It would also be necessary to determine whether subsection 40(3.6) applies in the Present Situation to deem the capital loss sustained by A on the redemption of the preferred shares of the capital stock of Holdco to be nil. This would be the case if it is determined that immediately after the disposition of those preferred shares, A directly or indirectly controlled Holdco in any manner whatsoever. In this regard, we refer you to paragraph 40(3.6)(a), subparagraph 251.1(1)(b)(i), the definition of "controlled" in subsection 251.1(3) and subsection 256(5.1).
In conclusion, and due to the fact that your letter does not contain several essential pieces of information, we are unable to comment on other tax implications that may result from the Particular Situation.
We hope that our comments will be of assistance.
Best regards,
Stéphane Prud'Homme, Notary, M. Fisc.
For the Director
Corporate Reorganizations and Resource Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch