Principal Issues: [TaxInterpretations translation] (1) Subject to section 65.1 of the Bankruptcy and Insolvency Act, does paragraph 251(5)(b) of the Income Tax Act apply in the case of a shareholder's withdrawal clause if the shareholder takes advantage of a law for the protection of insolvent persons?
(2) Does paragraph 251(5)(b) of the Income Tax Act apply in the case of a shareholder's withdrawal clause if the shareholder makes a voluntary assignment of property for the benefit of creditors?
(3) What were the reasons for the Canada Revenue Agency's conclusion in Technical Interpretation 2002-0172315 dated December 5, 2002, that paragraph 251(5)(b) does not apply to a shareholder convicted of fraud?
(4) Does paragraph 251(5)(b) of the Income Tax Act apply in the case of a letter of intent entered into between two parties where the letter contains clauses allowing the purchaser and vendor to unilaterally terminate the sale of the shares?
Position: (1) Yes.
(2) No.
(3) The person must have the right to compel the corporation to redeem, acquire or cancel shares of its capital stock held by other shareholders of the corporation.
(4) No, in cases where the letter of intent does not create a right or obligation between the parties to buy or sell as the case may be.
Reasons: Interpretation of the Income Tax Act and administrative positions previously taken by the CRA.
CRA PUBLICATIONS: IT-419R2; 2002-0172315; 2002-0145225; 2002-0176825
XXXXXXXXXX 2006-016736 François Bordeleau March 16, 2006
Dear Sir,
Subject: Request for Technical Interpretation:
Options and Rights under Paragraph 251(5)(b) of the Income Tax Act
This is further to your letter dated January 9, 2006, in which you requested clarification from the Montreal Tax Services Office ("TSO") regarding your interpretation of the tax rules contained in paragraph 251(5)(b) of the Income Tax Act (the "Act"). The TSO has asked us to respond to your request.
Facts
Your letter sets out the following two hypothetical situations:
(a) First situation
A shareholders' agreement contains a clause according to which there is withdrawal from the enterprise by a shareholder in the following situations:
- The shareholder takes advantage of insolvency protection legislation in respect of itself; and
- The shareholder makes a voluntary assignment of the shareholder’s property for the benefit of the shareholder’s creditors.
(b) Second situation
A letter of intent was signed between the parties (purchaser and vendor) prior to the sale of all the shares forming the capital stock of the vendor. That letter of intent contains clauses allowing the purchaser and vendor to unilaterally terminate the sale of such shares without any penalty. That letter was issued to all shareholders of the purchaser (public company) by means of a press release.
Questions
In relation to the first situation described above, you asked the following two questions:
(1) Does paragraph 251(5)(b) apply where there is a clause that provides for the withdrawal from the enterprise by a shareholder if the shareholder or its ultimate holder, subject to section 65.1 of the Bankruptcy and Insolvency Act, to take advantage of a statute providing insolvency protection?
(2) Does paragraph 251(5)(b) apply where there is a clause that provides for the withdrawal from the enterprise by a shareholder if the shareholder or the ultimate holder makes a voluntary assignment for the benefit of creditors?
In relation to the second situation described above, you asked the following two questions:
(1) What were the reasons for the Canada Revenue Agency's ("CRA") conclusion in Technical Interpretation 2002-0172315 issued on December 5, 2002, that paragraph 251(5)(b) does not apply in the case of a shareholder convicted of fraud?
(2) Does paragraph 251(5)(b) apply to a letter of intent between two parties where the letter contains clauses allowing the purchaser and vendor to unilaterally terminate the sale of the shares?
Analysis
The particular circumstances described in your letter appear to be an actual situation affecting specific taxpayers. As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, it is the CRA's practice not to issue written opinions on 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 that we hope may be helpful to you. These comments may, however, under certain circumstances, not apply to your particular situation.
First situation
You have confirmed to us by email dated January 25, 2006, that this issue concerns the purchase of the shares of the insolvent/bankrupt shareholder by the other shareholders or, alternatively, the repurchase of the shares of the insolvent/bankrupt shareholder by the corporation.
Question (1)
With respect to the application of paragraph 251(5)(b), the CRA's position is that the wording of that provision is broad enough to apply to almost any buy-sell agreement. However, as a matter of policy, the CRA does not apply paragraph 251(5)(b) to buy-sell clauses in a shareholders' agreement where the parties do not have a clear right or obligation to buy and/or sell, as the case may be.
(i) Purchase of the shares of the insolvent shareholder by the other shareholders
With respect to this part of your question, it is necessary that the use of insolvency protection legislation by that shareholder result in an obligation on the part of that shareholder to sell that holder’s shares to the other shareholders of the corporation and a right on the part of those shareholders to purchase those shares. You will understand that the CRA will not apply paragraph 251(5)(b) if such rights and obligations are not created.
If such rights and obligations are created, it then becomes necessary to determine whether the buy-sell rights provided for in that paragraph fall within one of the stated exceptions, i.e., that they can only be exercised on the death, bankruptcy or permanent disability of an individual.
In a telephone conversation dated January 24, 2006 (Bordeleau/XXXXXXXX), you confirmed that the term "insolvent" used in your January 9, 2006, letter refers to the state of an insolvent individual covered by the BIA, the Companies' Creditors Arrangement Act ("CCAA") or the Winding-Up and Restructuring Act, but does not include the state of an individual who is bankrupt as defined by the BIA.
In order to determine the particular meaning of the words "on the … bankruptcy … of an individual" in relation to one of the exceptions to the application of paragraph 251(5)(b), it is necessary to have recourse to the modern rule of interpretation which provides that the words of a statutory provision are to be interpreted according to their ordinary and grammatical meaning having regard to its purpose, context and the objective pursued by the legislature.
Therefore, the question to be answered is whether the word "bankruptcy" can include the state of insolvency in which an individual may find himself under the various relevant laws.
Bankruptcy is a state that is specific to the Bankruptcy and Insolvency Act. This Act defines the term as "the state of being bankrupt or the fact of becoming bankrupt". Clarification can also be obtained by examining the definition of "bankrupt", defined as follows:
[A] person who has made an assignment or against whom a bankruptcy order has been made or the legal status of that person.
As for the term "insolvent", it can have different meanings depending on the legislative context in which it is used. For example, the BIA defines an insolvent person as follows:
[A] person who is not bankrupt and who resides, carries on business or has property in Canada, whose liabilities to creditors provable as claims under this Act amount to one thousand dollars, and
(a) who is for any reason unable to meet his obligations as they generally become due,
(b) who has ceased paying his current obligations in the ordinary course of business as they generally become due, or
(c) the aggregate of whose property is not, at a fair valuation, sufficient, or, if disposed of at a fairly conducted sale under legal process, would not be sufficient to enable payment of all his obligations, due and accruing due;
On the other hand, the Winding-up and Restructuring Act deems a company to be insolvent in nine different situations, one of which is to make a general conveyance or assignment of its property for the benefit of its creditors.
Since the notions of bankruptcy and insolvency do not refer to the same concepts and the legal status of a taxpayer differs depending on whether the taxpayer is bankrupt or simply insolvent, we are of the view that if Parliament had wanted to include the notion of insolvency in addition to that of bankruptcy in paragraph 251(5)(b), it would have used clear words to that effect. Consequently, we believe that the exception found in paragraph 251(5)(b) can only apply where an individual is bankrupt and not when the individual is insolvent and has not made an assignment of property or against whom a receiving order has not been made.
Indeed, the very nature of the terms "bankrupt" and "insolvent" means that an individual who is bankrupt is necessarily insolvent. However, an individual who is insolvent is not necessarily a bankrupt since that state requires that the individual make an assignment of the individual’s property or that a receiving order be made against the individual.
Thus, we confirm that the exceptions in paragraph 251(5)(b) do not apply where an individual is merely "insolvent" without being bankrupt.
(ii) Redemption of shares of the insolvent shareholder by the corporation
With respect to this second part of your question, our comments are limited to confirming the application of subparagraph 251(5)(b)(ii) to a redemption of the shares of an insolvent shareholder only if the person to whom the provision applies has a right, conditional or not, future or immediate, to compel the corporation to redeem the shares of the shareholder.
Question (2)
(i) Purchase of the bankrupt shareholder's shares by the corporation's other shareholders
For reasons similar to those underlying our answer to your first question, we confirm that the exception to paragraph 251(5)(b) will apply in the case of the purchase of a bankrupt shareholder's shares by the corporation's other shareholders.
(ii) Redemption of bankrupt shareholder's shares by the corporation
Subparagraph 251(5)(b)(ii) applies to a redemption of a shareholder's shares only if the person to whom it applies has a right, conditional or unconditional, future or immediate, to require the corporation to redeem the shareholder's shares. If such a right exists, the CRA may find that one of the exceptions in subparagraph 251(5)(b)(ii) applies because of the individual's bankruptcy status.
Second Situation
Question (1)
Although your question refers to Technical Interpretation 2003-0004255, you have confirmed that the technical interpretation in question is 2002-0172315. In that technical interpretation, the CRA concluded that paragraph 251(5)(b) did not apply to a shareholders' agreement providing for an obligation by a corporation to redeem the shares of any shareholder found to have committed fraud.
The facts of that technical interpretation were straightforward. Mr. A, Mr. B and Mr. C all owned 33.3% of the shares of Opco, a Canadian-controlled private corporation. In addition to the shares of Opco, M.C. owned all of the issued and outstanding shares of the capital stock of Portco. The unanimous shareholder agreement included an obligation on Opco to redeem the shares of any shareholder found to have committed fraud.
The purpose of subsection 251(5) is to assess the position of a shareholder with respect to the control it may exercise over a corporation by taking into account any future transactions that may affect the percentage of shares held by the shareholder.
In the case of a redemption of shares by a corporation, subparagraph 251(5)(b)(ii) applies only if a person has a right, whether immediate or future, conditional or not, to require the corporation to redeem from one or more shareholders of the corporation. On the facts of Interpretation 2002-0172315, where no shareholder had the right to compel Opco to redeem the shares of the other shareholders in the event of fraud, the CRA had no choice but to conclude that paragraph 251(5)(b) did not apply.
Question (2)
It is not possible for us to comment specifically on the application of paragraph 251(5)(b) without having seen the text and legal effect of the letter of intent to which you refer.
However, if that letter does not create any obligation, conditional or otherwise, immediate or future, on the part of the purchaser to make a formal offer to purchase the shares, the CRA's administrative position is not to apply paragraph 251(5)(b). However, if such rights or obligations are created, the CRA may conclude that paragraph 251(5)(b) applies.
If you have concerns about the scope of the application of paragraph 251(5)(b) in circumstances similar to those you have advised us of, you may make representations to the Department of Finance in that regard.
Best regards,
Phil Jolie
Director
Business and Partnerships Division
Income Tax Rulings Directorate