Principal Issues: Each of two brothers owns all of the issued and outstanding shares of the capital stock of a holding corporation ("Holdco 1 and "Holdco 2"). More specifically, each brother owns Holdco common shares and Holdco preferred shares. The preferred shares have a fair market value ("FMV") and an adjusted cost base ("ACB") of approximately $XXXXXXXXXX. The paid-up capital ("PUC") of these preferred shares is nominal. The high ACB is the result of a previous crystallisation of the capital gains deduction by the brothers. Each of Holdco 1 and Holdco 2 owns 50% of the issued and outstanding shares of an operating corporation ("Opco"). First, each of Holdco 1 and Holdco 2 would redeem its preferred shares owned by the brothers. As a result and pursuant to subsection 84(3), each of the brothers would be deemed to receive a dividend. This dividend would be a taxable dividend. As a result of the redemption of shares, each brother would also realize a loss that would be denied under paragraph 40(3.6)(a). The amount of such loss would be added to the ACB of the common shares of the capital stock of Holdco 1 and Holdco 2 held by the brothers under paragraph 40(3.6)(b). Each of the brothers would then dispose of the common shares of the capital stock of Holdco 1 or Holdco 2, as the case may be, in favour of another corporation ("NewHoldco 1" and "NewHoldco 2") in consideration for preferred shares having a FMV, ACB and PUC of $XXXXXXXXXX, and common shares of the capital stock of the NewHoldcos. Finally, each of NewHoldco 1 and NewHoldco 2 would redeem its preferred shares owned by the brothers for cash.
Position: Section 84.1 would technically not apply in this file. However, if a similar file was presented in the context of an income tax ruling request, such a file would be presented to the GAAR Committee, XXXXXXXXXX
Reasons: Wording of the Act.
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August 31, 2005 |
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XXXXXXXXXX Tax Services Office |
Rulings Directorate |
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Tax Audit Division |
S. Prud'Homme |
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XXXXXXXXXX |
(613) 957-8975 |
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Attention: XXXXXXXXXX |
2005-013483 |
Request for opinion - Application of subsections 40(3.6), 84.1(1) and 245(2) of the Income Tax Act
This is in response to your emails of June 6 and July 12, 2005, in which you requested our opinion as to the application of subsections 40(3.6), 84.1(1) and 245(2) of the Income Tax Act (the "Act") in a particular situation.
Unless otherwise indicated, all statutory references herein are to provisions of the Act.
(1) Particular Situation
You have presented us with the situation described below (the "Particular Situation") as part of your request for an opinion.
a) Two individuals resident in Canada are brothers ("Brother 1" and "Brother 2"). Initially, each of Brother 1 and Brother 2 held 50% of all the issued and outstanding shares of the capital stock of an operating company ("Opco"). Specifically, each of Brother 1 and Brother 2 held XXXXXXXXXX Class A shares of the capital stock of Opco.
Immediately prior to the transaction described in (b) below, the fair market value ("FMV") of the Class A shares held by each of Brother 1 and Brother 2 was approximately $XXXXXXX, while their adjusted cost base ("ACB") and paid-up capital ("PUC") were nominal.
At all relevant times, the Class A shares of the capital stock of Opco were “qualified small business corporation shares" as defined in subsection 110.6(1). In addition, Opco, like the corporations referred to below, was a "taxable Canadian corporation" as defined in subsection 89(1).
(b) In XXXXXXXXXX, each of Brother 1 and Brother 2 disposed of XXXXXXXXXX Class A shares of the capital stock of Opco to another corporation of which he was then the sole shareholder ("Holdco 1" and "Holdco 2," respectively) in consideration for the issuance by Holdco 1 or Holdco 2, as the case may be, of Class A shares with a FMV of approximately $XXXXXXX and a nominal PUC.
Brother 1 and Holdco 1, as well as Brother 2 and Holdco 2, made an election pursuant to subsection 85(1) in the prescribed form and within the time limit set out in subsection 85(6). The amount agreed in that regard was nominal. Consequently, the cost and ACB of the Class A shares of the capital stock of Holdco 1 and Holdco 2 received by Brother 1 and Brother 2, respectively, were nominal.
(c) In XXXXXXXXXX, each of Brother 1 and Brother 2 disposed of XXXXXXXXXX Class A shares of the capital stock of Opco to Holdco 1 or Holdco 2, as the case may be, in consideration for the issuance by Holdco 1 or Holdco 2, respectively, of Class E preferred shares having a FMV of approximately $XXXXXXX and a nominal PUC.
Brother 1 and Holdco 1, as well as Brother 2 and Holdco 2, made an election pursuant to subsection 85(1) in the prescribed form and within the time limit set out in subsection 85(6). The agreed amount was approximately $XXXXXXX. Under that share transfer, each of Brother 1 and Brother 2 realized a capital gain of approximately $XXXXXXX, in respect of which he claimed a capital gains deduction pursuant to subsection 110.6(2.1).
Based on the foregoing, the cost and ACB of the Class E preferred shares of the capital stock of Holdco 1 and Holdco 2 received by Brother 1 and Brother 2, as the case may be, was approximately $XXXXXXX.
d) In XXXXXXXXXX, each of Brother 1 and Brother 2 disposed of XXXXXXXXXX Class A shares of the capital stock of Opco to another corporation ("Opco2") for a price equal to the FMV of such shares. In exchange, Opco 2 issued Class A shares of its capital stock. We understand that the PUC of the Class A shares issued by Opco 2 was nominal.
Each of Brother 1 and Brother 2, on the one hand, and Opco 2, on the other, made an election pursuant to subsection 85(1) in the prescribed form and within the prescribed time set out in subsection 85(6). The agreed amount was nominal. Consequently, the cost and ACB of the shares of Class A shares of the capital stock of Opco 2 received by each of Brother 1 and Brother 2, respectively, was nominal.
e) In XXXXXXXXXX, each of Brother 1 and Brother 2 disposed of all of the shares of the capital stock of Holdco 1 or Holdco 2, respectively, to another corporation of which he was the sole shareholder ("Holdco 3" and "Holdco 4," respectively) for a price corresponding to the FMV of such shares. In return, each of Holdco 3 and Holdco 4 issued Class A shares and Class E preferred shares of its capital stock. We understand that the PUC of the Class A shares and Class E preferred shares issued by Holdco 3 and Holdco 4 was nominal.
Brother 1 and Holdco 3, as well as Brother 2 and Holdco 4, made an election under s. 85(1) in the prescribed form and within the time limit set out in s. 85(6). The agreed-upon amount was set at the ACB, for the transferors, of the transferred shares, being approximately $XXXXXXX for the Class E preferred shares of the capital stock of Holdco 1 or Holdco 2, as the case may be, and a nominal amount for the Class A shares of Holdco 1 or Holdco 2, as the case may be.
Based on the foregoing, the Class E preferred shares in the capital stock of each of Holdco 3 and Holdco 4 had an ACB to Brother 1 or Brother 2, respectively, of approximately $XXXXXXX. The Class A shares in the capital stock of each of Holdco 3 and Holdco 4 had a nominal PUC.
f) In XXXXXXXXXX, Holdco 1 and Holdco 3 amalgamated to form Amalco 1, Holdco 2 and Holdco 4 amalgamated to form Amalco 2, and Opco and Opco 2 amalgamated to form Amalco-Opco. Subsection 87(1) applied to each of these amalgamations.
As a result of the application of subsection 87(4), each of Brother 1 and Brother 2 held, inter alia, Class A shares of the capital stock of Amalco 1 or Amalco 2, as the case may be, with a nominal ACB and PUC. In addition, each of Brother 1 and Brother 2 held Class E preferred shares in the capital stock of Amalco 1 or Amalco 2, as the case may be, having an FMV of approximately $XXXXXXX, an ACB of approximately $XXXXXXX, and a nominal PUC.
(g) In XXXXXXXXXX, each of Amalco 1 and Amalco 2 redeemed all of the Class E preferred shares of its capital stock held by Brother 1 or Brother 2, respectively, for non-share consideration having a FMV equal to the redemption value of the preferred shares, i.e. $XXXXXXX.
Upon redemption of those preferred shares, each of Amalco 1 and Amalco 2 was deemed to have paid, and each of Brother 1 and Brother 2 was deemed to have received, a dividend of approximately $XXXXXXX pursuant to subsection 84(3). As a result of the same share redemption, each of Brother 1 and Brother 2 sustained a capital loss of approximately $XXXXXXX. However, pursuant to paragraph 40(3.6)(a), such loss on the redemption of the preferred shares was deemed to be nil. In addition, pursuant to paragraph 40(3.6)(b), such loss would have been added back in computing the ACB, to Brother 1 or Brother 2, as the case may be, after the disposition, of the Class A shares of the capital stock of Amalco 1 or Amalco 2, respectively. As a result, the Class A shares in the capital stock of Amalco 1 or Amalco 2, as the case may be, had an ACB to Brother 1 or Brother 2, respectively, of approximately $XXXXXXX, and a nominal PUC.
No subsection 83(2) election was made in respect of the deemed dividend received by each of Brother 1 and Brother 2 and described above.
h) Immediately after the transaction described in g) above, each of Brother 1 and Brother 2 disposed of all of the Class A shares of the capital stock of Amalco 1 or Amalco 2, as the case may be, to another corporation of which it was the sole shareholder ("Holdco 5" and "Holdco 6", respectively) for a price corresponding to the FMV of said shares. In return, each of Holdco 5 and Holdco 6 issued Class A shares and Class B preferred shares of its capital stock. Those preferred shares had a FMV of approximately $XXXXXXX.
Brother 1 and Holdco 1, as well as Brother 2 and Holdco 2, made an election pursuant to subsection 85(1) in the prescribed form and within the time limit set out in subsection 85(6). The agreed amount was set at the transferors' ACB of the transferred shares, or approximately $XXXXXXX.
Pursuant to paragraph 85(1)(g), the Class B preferred shares in the capital stock of each of Holdco 5 and Holdco 6 had a cost and ACB to Brother 1 or Brother 2, respectively, of approximately $XXXXXXX. In addition, those Class B preferred shares had a PUC of approximately $XXXXXXX. Pursuant to paragraph 85(1)(h), the common shares in the capital stock of each of Holdco 5 and Holdco 6 had a cost and ACB of a nominal amount. The PUC of those shares was also nominal.
i) Also in XXXXXXXXXX and after the transactions described in h) above, each of Holdco 5 and Holdco 6 redeemed for an amount of approximately $XXXXXXX a portion of the Class B preferred shares of its capital stock held by Brother 1 or Brother 2, respectively. In exchange, each of Holdco 5 and Holdco 6 issued to Brother 1 or Brother 2, respectively, non-share consideration having a FMV equal to the redemption value of the preferred shares, i.e. $XXXXXXX.
In XXXXXXXXXX, each of Holdco 5 and Holdco 6 redeemed for approximately $XXXXXXX the balance of the Class B preferred shares of its capital stock held by Brother 1 or Brother 2, respectively. In return, each of Holdco 5 and Holdco 6 issued to Brother 1 or Brother 2, respectively, non-share consideration having a FMV equal to the redemption value of the preferred shares, i.e. $XXXXXXX.
No adverse tax consequences to Brother 1 and Brother 2 resulted from such redemptions of preferred shares, on the basis that their FMV would have been the ACB and PUC of those shares.
j) In summary, as a result of the transactions described above, each of Brother 1 and Brother 2 received from their corporations an amount of approximately $XXXXXXX and paid tax in respect of a dividend of approximately $XXXXXXX.
2) Your Question Regarding the Particular Situation
You wish to know whether section 84.1 applied regarding the transfer by each of Brother 1 and Brother 2 of Class A shares of the capital stock of Amalco 1 and Amalco 2 to Holdco 5 or Holdco 6, respectively, as described in (1)(h) above. You also wish to know whether subsection 245(2) applies in the context of the Particular Situation.
3) Our Comments on the Particular Situation
Comments respecting section 84.1
We are of the view that, technically, paragraph 84.1(1)(a) would not apply to the disposition by each of Brother 1 and Brother 2 of the Class A shares in the capital stock of Amalco 1 or Amalco 2, as the case may be, in order to reduce the ACB in respect of the Class B preferred shares in the capital stock of Holdco 5 and Holdco 6 received as consideration. In that regard, we are of the view that for the purposes of paragraph 84.1(1)(a), the ACB to Brother 1 or Brother 2, as the case may be, of the Class A shares of Amalco 1 or Amalco 2, as the case may be, would technically be deemed to be approximately $XXXXXXX. This is because there would technically be no amount each of which is an amount determined after 1984 under subparagraph 40(1)(a)(i) in respect of a previous disposition of a Class A share of the capital stock of Amalco 1 or Amalco 2, as the case may be, or to an earlier disposition of a share for which that Class A share of the capital stock of Amalco 1 or Amalco 2 would have been substituted (i.e., a Class A share of the capital stock of Holdco 3 or Holdco 4, as the case may be, or, having regard to subsection 248(5), a Class A share of the capital stock of Holdco 1 or Holdco 2, or any of the 149 Class A shares of the capital stock of Opco referred to in (1)(c) above).
Comments on section 245(2)
We would like to inform you that in the event that taxpayers apply for advance rulings in respect of a series of proposed transactions similar to the one described above in 1), our position would be to refer such a case to the General Anti-Avoidance Rule ("GAAR") Committee.
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Other Comments
Of course, any assessment or reassessment in this case should be made taking into account the terms of subsections 152(3.1) and 152(4).
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.
Should you require further information on this subject, please do not hesitate to contact us.
Stéphane Prud'Homme, Notary, M. Fisc.
For the Director
Corporate Reorganizations and Resource Industries Division
Income Tax Rulings Directorate
Directorate General for Policy and Planning
c.c. Peter Dunn
Sharon Gulliver
Tax Avoidance and Special Audits Directorate
Directorate General for Observation Programs