Principal Issues: In a given situation, where Holdco's shareholder and Employeeco's common shareholders are not related to each other, Holdco and Employeeco each own 50% of Opco's common shares, Holdco controls Employeeco and owns all Employeeco high-low redeemable preferred shares which Holdco acquired over a 5 year period as consideration for the rollover transfer each year of 10% of its Opco common shares, and Employeeco redeems part of its preferred shares owned by Holdco, whether 55(2) applies?
Position: Yes.
Reasons: 55(3)(a)(ii) and (v) could apply.
XXXXXXXXXX 2005-012653
Marc LeBlond
May 13, 2005
Dear Sir,
Subject: Application of subsection 55(2) of the Income Tax Act and the concept of a substantial increase in ownership in a corporation
This is in response to your letter of April 14, 2005, requesting our comments on the application of subsection 55(2) of the Income Tax Act (the "Act") and the concept of a significant increase in a corporation's shareholding, for the purposes of paragraph 55(3)(a), in the situation described below.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act.
The Situation
1. Holdco and Employeeco each hold XXXXXXXXXX common shares in the capital stock of Opco (voting and participating). Holdco, Employeeco and Opco are "Canadian-controlled private corporations" as defined in subsection 125(7).
2. All of the common shares of the capital stock of Employeeco are held by employees of Opco (the "Employeeco Common Shareholders").
The "Employeeco Common Shareholders" and the sole shareholder of Holdco are not "related persons" as defined in section 251(2).
3. Holdco has de jure control of Employeeco through the holding of non-participating voting shares of the capital stock of Employeeco. Consequently, Employeeco is "connected" to Holdco, as defined in paragraph 186(4)(a).
4. Holdco also holds all the preferred shares (voting and non-participating) of the capital stock of Employeeco ("Employeeco Preferred Shares").
5. Holdco acquired the "Employeco Preferred Shares" held by it, over the past five years, as consideration for the transfer in each year of XXXXXXXXXX common shares of Opco to Employeco (a total of XXXXXXXXXX common shares), pursuant to subsection 85(1), for an agreed amount equal to the adjusted cost base ("ACB") of such shares. The aggregate ACB of the "Employeeco Preferred Shares" to Holdco is nominal. The aggregate paid-up capital of the "Employeeco Preferred Shares" is nominal.
6. The "Employeeco Preferred Shares" have a fixed redemption value of $XXXXXXXXXX while the total market value of the Employeeco common shares is $XXXXXXXXXX.
7. It is intended that the "Employeeco Preference Shares" held by Holdco will be redeemed by Employeeco.
8. Employeco redeems $XXXXXXXXXX of "Employeco Preferred Shares" held by Holdco, resulting in a deemed dividend pursuant to subsection 84(3) of approximately $XXXXXXXXXX.
9. The safe income attributable to the XXXXXXXXXX Opco common shares transferred to Employeeco is non-material and therefore significantly less than the deemed dividend on the redemption of the "Employeeco Preferred Shares".
Your Questions and Comments
In the situation you have submitted to us, as a result of the redemption of $XXXXXXXXXX of "Employeco Preferred Shares", you pointed out that there is an increase of approximately 3% in the interest of the "Employeco Common Shareholders" in Employeco, for the purposes of paragraph 55(3)(a).
You asked whether such an increase is a significant increase for the purposes of paragraph 55(3)(a).
Furthermore, you asked whether our answer would be the same if the redemption referred to above is only the first redemption in a series of transactions leading to the redemption of all the "Employeeco Preferred Shares".
Finally, you asked whether subsection 55(2) could apply in the particular situation.
Our Comments
As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, it is the practice of our Directorate not to issue a written opinion regarding proposed transactions otherwise than through advance rulings. Furthermore, when it comes to determining whether a completed transaction has received appropriate tax treatment, that determination is made first by our Tax Services Offices as a result of their review of all facts and documents, which is usually performed as part of an audit engagement. However, we can offer the following general comments which may not apply in full to the situation you have submitted to us.
In our view, in the particular situation, the question of whether, as a result of the redemption of $XXXXXXXXXX of "Employeeco Preferred Shares", the increase of approximately 3% in the interest of the "Employeeco Common Shareholders" in Employeeco is significant for the purposes of paragraph 55(3)(a) is not relevant. Nevertheless, we are of the view that subsection 55(2) could apply in the particular situation. Our conclusions are based on the following observations.
The pertinent parts of subsection 55(3) for the purposes of the present situation are as follows:
Application
(3) Subsection 55(2) does not apply to any dividend received by a corporation (in this subsection and subsection 55(3.01) referred to as the “dividend recipient”)
(a) if, as part of a transaction or event or a series of transactions or events as a part of which the dividend was received, there was not at any particular time
[…]
(ii) a significant increase (other than as a consequence of a disposition of shares of the capital stock of a corporation for proceeds of disposition that are not less than their fair market value) in the total direct interest in any corporation of one or more persons or partnerships that were unrelated persons immediately before the particular time,
[...]
(v) a significant increase in the total of all direct interests in the dividend payer of one or more persons or partnerships who were unrelated persons immediately before the particular time;
[Emphasis added]
In our view, in the situation you have referred to us, the following transactions form part of a "series of transactions or events" ("series of transactions") for the purposes of section 55(2):
(1) the subscription for common shares of the capital stock of Employeeco by the "Employeeco Common Shareholders"; (2) each transfer by Holdco to Employeeco of XXXXXXXXXX common shares of Opco within the last five years; (3) the acquisition by Holdco of the "Employeeco Preferred Shares", as consideration for the transfer of such Opco shares, pursuant to Section 85(1), for an agreed amount equal to the ACB of such transferred shares; and, (4) the redemption(s) by Employeeco of the "Employeeco Preferred Shares" held by Holdco.
Consequently, the facts set out in subparagraph 55(3)(a)(ii) and (v) could be present in the particular situation.
Indeed, in the particular situation, at some point in the "series of transactions" in which the dividend was received, subparagraph 55(3)(a)(ii) could be engaged because, by subscribing for common shares of the capital stock of Employeeco, the "Employeeco Common Shareholders" would have significantly increased their total direct interest in a corporation (Employeeco) and each "Employeeco Common Shareholder" was an "unrelated person" as defined in subparagraph 55(3. 01)(a)(i), immediately prior to subscribing for common shares in the capital stock of Employeeco. Each "Employeeco common shareholder" was an "unrelated person" because the dividend recipient (Holdco) was not "related", within the meaning of subsection 251(2), to each "Employeeco common shareholder" immediately before subscribing for such shares.
Furthermore, in the particular situation, at some point in the "series of transactions" in which the dividend was received, subparagraph 55(3)(a)(v) could also be engaged since by subscribing for common shares of the capital stock of Employeeco, the "Employeeco Common Shareholders" would have significantly increased their total direct interest in the dividend payer (Employeeco) and each "Employeeco Common Shareholder" was an "unrelated person" as defined in subparagraph 55(3.01)(a)(i), immediately prior to subscribing for common shares of the capital stock of Employeeco. Each "Employeeco Common Shareholder" was an "unrelated person" because the dividend recipient (Holdco) was not "related" to each "Employeeco Common Shareholder" immediately prior to their subscription to such shares.
Consequently, in the situation you have presented, subsection 55(2) could apply since paragraph 55(3)(a) would not apply to exempt the deemed dividends received by Holdco on any redemption of the "Employeeco Preferred Shares" by Employeeco.
In conclusion, due to the fact that your letter does not contain several essential pieces of information, we are unable to comment on the other tax implications that may result from the situation you have submitted to us.
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
Manager
Corporate Reorganizations and Resource Industries Section
Corporate Reorganizations and Resource Industries Division
Income Tax Rulings Directorate
Directorate General for Policy and Planning