Principal Issues: Whether the CRA would accept not to apply subsection 15(1) because of a particular price adjustment clause?
Position: General comments.
Reasons: Question of fact. Subsection 15(1) is not relevant in the situation described. It is subsection 51(2) that is relevant.
XXXXXXXXXX 2005-011232
April 11, 2005
Dear Sir,
Subject: Price adjustment clause
This is in response to your letter of January 13, 2005, in which you asked whether the Canada Revenue Agency ("CRA") would agree not to apply subsection 15(1) of the Act in the situation described below because of the application of a price adjustment clause.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act ("Act").
Facts
1. Opco was a "taxable Canadian corporation" as defined in subsection 89(1) and a "Canadian-controlled private corporation" as defined in subsection 125(7).
2. The authorized share capital of Opco consisted of three classes of shares, namely, one class of common shares and two classes (A and B) of preferred shares.
The principal rights, privileges, conditions and restrictions of the common shares of the capital stock of Opco were as follows: no par value, voting, participating, and entitled to receive dividends when declared by the board of directors. Upon liquidation or dissolution of the corporation, the holders of common shares were entitled to receive the remaining property of the corporation.
Class A and B preferred shares were preferred shares with certain rights, privileges, conditions and restrictions, which were necessary to effect an estate freeze.
The features of the Class A Preferred Shares included a price adjustment clause in the form that is typically used in the case of an estate freeze, i.e. the redemption value of the shares must be adjusted in the event that the redemption value set by the corporation does not correspond to the fair market value ("FMV") of the property received by the corporation as consideration for the shares.
The characteristics of the Class A preferred shares also included the possible exchange by the corporation of the Class A shares into Class B shares.
3. The issued and outstanding shares of the capital stock of Opco consisted of only 100 common shares. The FMV of the 100 common shares was $1 million.
4. Mr. A held the 100 issued and outstanding common shares of the capital stock of Opco. The adjusted cost base as defined in section 54 and the paid-up capital ("PUC") as defined in subsection 89(1) of the 100 common shares were each $100.
5. Mr. A was an individual who was resident in Canada for the purposes of the Act. The 100 common shares of Opco were capital property, as defined in section 54, to Mr. A.
6. Opco held cash, term deposits and public corporation securities.
7. Mr. A wished to implement an estate freeze in favour of his two children. Mr. A's children were over the age of 18. The 100 common shares of Opco held by Mr. A were exchanged, by way of purchase for cancellation, for 200 Class A preferred shares. The PUC of the 200 Class A preferred shares was $100. The redemption value assigned by Opco to the 200 Class A preferred shares was $1 million.
8. Section 51 applied to the share exchange described in paragraph 6 above. Mr. A and Opco did not make the election under subsection 85(1). In addition, subsection 86(1) did not apply to the share exchange.
9. A contract was entered into between Mr. A and Opco for the exchange of the 100 common shares of the capital stock of Opco for 200 Class A preferred shares. The agreement included a price adjustment clause. The price adjustment clause provided, inter alia, that in the event that the CRA challenged the FMV of the 200 Class A preferred shares received by Mr. A as consideration, because of the attributes of the 100 [sic] Class A preferred shares other than the amount ($1 million) specified as their redemption value, Mr. A and Opco would agree to exchange the 200 Class A preferred shares for 200 Class B preferred shares.
10. Opco issued 100 new common shares of its capital stock to Mr. A's two children for consideration of $100.
11. Following an audit, the CRA concluded that the FMV of the 200 Class A preferred shares of the capital stock of Opco was less than their redemption value of $1 million.
12. Mr. A and Opco were then willing to apply the price adjustment clause in the agreement, and therefore exchange the 200 Class A preferred shares in the capital stock of Opco for 200 Class B preferred shares in the capital stock of Opco. The redemption value that was attributed to the 200 Class B preferred shares, and the FMV of those shares, was then $1 million each.
Our Comments
It appears to us that the situation described in your letter may be an actual situation involving taxpayers. The CRA does not generally provide written opinions on proposed transactions otherwise than by way of advance ruling. Furthermore, it is the responsibility of the relevant Tax Services Office to determine whether completed transactions have received the appropriate tax treatment. We can, however, offer the following general comments which may not apply in full to the situation submitted.
In a situation such as the one described above, it is not subsection 15(1) that the CRA would consider applying if the FMV of the freeze preferred shares was less than the FMV of the exchanged common shares, but rather subsection 51(2).
In the situation described above, the adjustment clause that would apply would not be an adjustment clause for the price of the transferred property (i.e., the common shares) as contemplated in IT-169, but rather an adjustment clause for the value of the consideration received for the transferred property. In other words, in such a situation, there would be no change in the price assigned to the transferred property. Interpretation Bulletin IT-169 is long-standing (dated August 6, 1974) and does not take into account all types of price adjustment clauses, nor all situations where price adjustment clauses are commonly used.
It appears to us that an adjustment clause to the value of the consideration as provided for in the contract in the situation described above would not be acceptable because of the legal and technical problems it would entail, in particular it did not provide for the necessary measures to settle any difference between the FMV of the consideration in relation to the transferred assets, should the preferred shares be redeemed before the CRA contests the FMV of the preferred shares.
The CRA would generally agree to recognize a clause for adjustment to the consideration and not apply subsection 51(2), where the facts (including the contract) evinced that the parties actually intended to deal in the shares at their FMV and established the FMV of the preferred shares for the purposes of the arrangement, by a fair and reasonable method, and the relevant adjustments provided for in the adjustment clause were effected by the parties where the FMV of the preferred shares was less than the FMV of the common shares.
Whether the parties used a fair and reasonable method to determine the FMV consideration is a question that must be resolved in light of a full examination of all the relevant facts. It is difficult for us to conclude on this issue in the situation described above, as we do not have all the relevant facts.
Where there is a significant discrepancy between the FMV determined by the taxpayer for freeze preferred shares and the actual FMV, it usually demonstrates that the taxpayer had not made a genuine effort to determine the FMV of the shares. The jurisprudence has shown that an adjustment clause can be disregarded in cases where there is no good faith effort to determine the FMV of a property (Guilder News Co. (1963) Limited et al, 73 DTC 5048(FCA), Daniel Wagner et al, 2001 DTC 5674 (FCA)).
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 Resource Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch