Principal Issues: [TaxInterpretations translation] Does section 256(6) apply?
Position: No
Reasons: Safeguarding rights over shares was not the only reason for the existence of control. Furthermore, the shares are not redeemable by the corporation.
June 8, 2000
XXXXXXXXXX Tax Services Office Headquarters
Corporate Reorganizations and
Audit Division International Operations Division
Attention: XXXXXXXXXX R. Gagnon
(613) 957-8953
1999-001281
XXXXXXXXXX
This is in response to your memo of November 15, 1999 asking whether subsection 256(3) of the Income Tax Act was applicable to the situation described below XXXXXXXXXX, so as to result in XXXXXXXXXX not being associated with XXXXXXXXXX.
Unless otherwise indicated, all legislative references below are to provisions of the Income Tax Act.
DESIGNATIONS OF PARTIES AND ABBREVIATIONS
In this letter, the names and business names of taxpayers, as well as certain terms, are replaced by the following names, business names and abbreviations:
XXXXXXXXXX Holdco1
XXXXXXXXXX Holdco2
XXXXXXXXXX Opco1
XXXXXXXXXX Opco2
XXXXXXXXXX Opco3
XXXXXXXXXX XXXXXXXXXX
XXXXXXXXXX XXXXXXXXXX
XXXXXXXXXX XXXXXXXXXX
Income Tax Act Act
Fair Market Value FMV
FACTS
1. Holdco1, Holdco2, Opco1, Opco2 and Opco3 are “taxable Canadian corporations” as defined in subsection 89(1) and “Canadian-controlled private corporations” as defined in subsection 125(7).
2. XXXXXXXXXX holds all of the issued and outstanding shares of the capital stock of Holdco1, and has effective (de jure) control of Holdco1.
3. Holdco1 holds all of the issued and outstanding shares of the capital stock of Opco2. XXXXXXXXXX has effective control of Opco2. Opco2 carries on a XXXXXXXXXX.
4. Holdco1 holds XXXXXXXXXX of the issued and outstanding Class XXXXXXXXXX shares of the capital stock of Opco3. The Class XXXXXXXXXX shares are voting (multiple voting - XXXXXXXXXX% of the voting rights are held by Holdco1) and participating (XXXXXXXXXX% ownership by Holdco1). XXXXXXXXXX has effective control of Opco3. Opco3 carries on a XXXXXXXXXX.
5. Holdco1 holds XXXXXXXXXX Class XXXXXXXXXX Shares and XXXXXXXXXX Class XXXXXXXXXX Shares issued and outstanding of the capital stock of Opco1. XXXXXXXXXX has effective control of Opco1.
6. XXXXXXXXXX holds all of the issued and outstanding shares of Holdco2, and has effective control of Holdco2. Holdco2 holds XXXXXXXXXX Class XXXXXXXXXX shares and XXXXXXXXXX Class XXXXXXXXXX issued and outstanding shares in the capital stock of Opco1.
XXXXXXXXXX.
7. The authorized share capital of Opco1 consists of an unlimited number of shares without par value of the following classes, the principal rights, privileges, restrictions and conditions of which are as follows:
- Class XXXXXXXXXX: Voting (1 vote per share), entitles the holders, together with the Class XXXXXXXXXX shareholders and in proportion to the number of shares held by each of them, to receive dividends when declared by the Board of Directors, and to share, concurrently with the Class XXXXXXXXXX shareholders and without preference between them, in the remaining property of the corporation upon its winding-up or dissolution. Any holder of Class XXXXXXXXXX shares has the right (upon written request) on the last day of each month to exchange any Class XXXXXXXXXX shares held for Class XXXXXXXXXX shares.
- Class XXXXXXXXXX: Voting (1 vote per share), entitles the holders, together with the Class XXXXXXXXXX shareholders and in proportion to the number of shares held by each of them, to receive dividends when declared by the Board of Directors, and to share, concurrently with the Class XXXXXXXXXX shareholders and without preference between them, in the remaining property of the corporation upon its winding-up or dissolution. Any holder of Class XXXXXXXXXX shares has the right (upon written request) on the last day of each month to exchange any Class XXXXXXXXXX shares held for Class XXXXXXXXXX shares.
- Class XXXXXXXXXX: Non-voting and non-participating. The shares entitle the holder to a fixed cumulative annual dividend, preferential to the dividends on Class XXXXXXXXXX shares, at a rate of XXXXXXXXXX% of the redemption price of the shares. Those shares are redeemable at the option of the Corporation and the holder, at a redemption price equal to the amount paid into the stated capital account for the shares plus any declared and unpaid dividends. In the event of the dissolution or winding-up of the Corporation, the holders of the Class XXXXXXXXXX shares are entitled to receive an amount equal to the redemption price, in priority to the holders of Class XXXXXXXXXX shares.
- Class XXXXXXXXXX: Non-voting and non-participating. The shares entitle the holder to a fixed cumulative annual dividend, preferential to the dividends on Class XXXXXXXXXX shares, at a rate of XXXXXXXXXX% of the redemption price of the shares. Those shares are redeemable at the option of the Corporation and the holder, at a redemption price equal to the amount paid into the stated capital account for the shares plus any declared and unpaid dividends. In the event of the dissolution or winding-up of the Corporation, the holders of the Class XXXXXXXXXX shares are entitled to receive an amount equal to the redemption price, in priority to the holders of Class XXXXXXXXXX shares.
- Class XXXXXXXXXX: Voting (XXXXXXXXXX votes per share) and non-participating. The shares are entitled to a fixed, cumulative annual dividend, preferential to the dividends on the shares of the XXXXXXXXXX Classes, at a rate of XXXXXXXXXX% of the redemption price of the shares. Those shares are redeemable at the option of the holder, at a redemption price equal to the amount paid into the stated capital account for the shares plus any declared and unpaid dividends. Those shares are redeemable by the Corporation with the consent of the holders. In the event of the dissolution or winding-up of the Corporation, the holders of Class XXXXXXXXXX shares are entitled to receive an amount equal to the redemption price, in priority to the holders of Class XXXXXXXXXX shares.
- Class XXXXXXXXXX: Non-voting and non-participating. The shares entitle holders to a fixed, non-cumulative annual dividend, preferential to dividends on Class XXXXXXXXXX shares, at a rate of XXXXXXXXXX% of the redemption price of the shares. Those shares are redeemable at the option of the corporation and the holder, at an amount equal to the redemption price. In the event of the winding-up or dissolution of the Corporation, the holders of shares of the Class XXXXXXXXXX shares are entitled to receive an amount equal to the redemption price, in priority to the holders of Class XXXXXXXXXX shares. The redemption price of a Class XXXXXXXXXX share consists of an amount equal to: (1) the amount credited to the stated capital account of a Class XXXXXXXXXX share upon its issuance, (2) dividends declared and unpaid on such share, and (3) a premium equal to the difference between the book value of a Class XXXXXXXXXX share at the time of its exchange (determined in accordance with the Corporation's audited financial statements as at the last day of the month in which the exchange takes place) into a Class XXXXXXXXXX share and the amount referred to in (1) above.
8. Opco1 was incorporated on XXXXXXXXXX under the Canada Business Corporations Act. Shortly after its incorporation, Opco1 issued the following shares:
Shareholders Number Class
Holdco1 XXXXXXXXXX XXXXXXXXXX
XXXXXXXXXX
Holdco2 XXXXXXXXXX XXXXXXXXXX
The redemption price of the XXXXXXXXXX Class XXXXXXXXXX shares was $XXXXXXXXXX.
9. A shareholder agreement (“Agreement”) was entered into on XXXXXXXXXX, between Opco1, Holdco1, Holdco2 and XXXXXXXXXX.
10. Pursuant to the XXXXXXXXXX Agreement, the shareholders incorporated Opco1 for the purpose of carrying on XXXXXXXXXX.
11. The XXXXXXXXXX Agreement contains provisions for the purchase by Opco1 of shares of its capital stock held by Holdco1.
The XXXXXXXXXX Agreement provides that:
XXXXXXXXXX.
Sections XXXXXXXXXX of the Agreement provide that Opco1 must purchase within XXXXXXXXXX days of the end of each financial year as many Class XXXXXXXXXX shares as may be purchased, but without its working capital (after a purchase) falling below certain amounts provided for in the Agreement (varying from $XXXXXXXXXX to $XXXXXXXXXX depending on the financial year) or by the terms of the Dealer Agreement.
Sections XXXXXXXXXX of the Agreement provide for an annual limit on the number of Class XXXXXXXXXX shares that may be purchased by Opco1. More specifically, the Agreement provides that Opco1 may not, during a financial year, purchase any Class XXXXXXXXXX shares that would have the effect of increasing by more than 10% the proportion of Class XXXXXXXXXX shares then issued and outstanding of the capital stock of the Corporation over the total number of Class XXXXXXXXXX shares issued and outstanding of the capital stock of the Corporation. If, during a financial year, the corporation has not purchased the maximum proportion of the Class XXXXXXXXXX shares, the unpurchased shares may be purchased during the subsequent financial year(s).
Sections XXXXXXXXXX of the Agreement provide that the Class XXXXXXXXXX shares will be purchased according to their redemption value determined in Opco1's articles of incorporation.
Section XXXXXXXXXX of the Agreement provides that the Class XXXXXXXXXX shares will be purchased at their book value as established in the Corporation's audited financial statements.
12. Section XXXXXXXXXX of the Agreement provides for the exchange of Class XXXXXXXXXX shares and the redemption of Class XXXXXXXXXX shares.
Section XXXXXXXXXX of the Agreement provides that Holdco1 waives its rights to redeem the Class XXXXXXXXXX shares provided for in Opco1's articles of incorporation. Paragraph XXXXXXXXXX of the Agreement provides that Holdco2 waives its right to redeem the Class XXXXXXXXXX shares provided for in Opco1's articles of incorporation as long as the Class XXXXXXXXXX shares are not exchanged. Paragraph XXXXXXXXXX provides that the Agreement only restricts the right to exchange Class XXXXXXXXXX shares if it is initiated by Opco1. Holdco2 may initiate an exchange of its Class XXXXXXXXXX shares for Class XXXXXXXXXX shares at any time.
Section XXXXXXXXXX provides that Holdco1 agrees and undertakes not to exercise its rights to exchange Class XXXXXXXXXX shares as provided in Opco1's articles of incorporation in the following circumstances: (1) during the XXXXXXXXXX months of the XXXXXXXXXX's operations; (2) if the Corporation has not had two complete and consecutive financial years with profits of below XXXXXXXXXX profits; and (3) if any half year of the Corporation shows a profit after a cumulative period of XXXXXXXXXX months having shown a deficit.
Section XXXXXXXXXX provides that in the event of a default by Holdco2 or XXXXXXXXXX under the Agreement, Holdco2 may, in its sole discretion, exercise all the rights to exchange the Class XXXXXXXXXX shares provided for in the Articles of Incorporation, as well as in the event that Opco1 XXXXXXXXXX or XXXXXXXXXX has committed fraud against the Corporation.
13. Article XXXXXXXXXX of the Agreement provides for restrictions on the sale and pledge of shares. Those restrictions apply only in respect of Holdco2 and XXXXXXXXXX.
14. XXXXXXXXXX.
15. For the purposes of filing its tax returns for its XXXXXXXXXX taxation years, Opco1 considered that it was not associated with Holdco1, Opco2 and Opco3, because of the exception provided for in subsection 256(3), and used a business limit of $200,000 under paragraph 125(1)(c).
16. XXXXXXXXXX.
17. No dividends were paid on the issued and outstanding shares of the XXXXXXXXXX Classes.
18. The following share purchases and redemptions were made by Opco1:
Year Description Amount($)
XXXXXXXXXX
It is expected that the balance of the Class XXXXXXXXXX shares and the Class XXXXXXXXXX shares will be repurchased by Opco1 during the year XXXXXXXXXX.
19. In XXXXXXXXXX, Opco1 entered into a building lease agreement with Holdco1 (XXXXXXXXXX) expiring in XXXXXXXXXX. The minimum annual payments due were $XXXXXXXXXXX, excluding any increase due to indexation to the consumer price index. According to XXXXXXXXXX, this contract was recently replaced by a new lease with a term of XXXXXXXXXX, but with an option for the lessee to purchase. Holdco1 is the owner of the building and land used by Opco1 to operate its business.
20. XXXXXXXXXX.
21. Opco1's net income (loss) was as follows during the years XXXXXXXXXX:
Year Amount($)
XXXXXXXXXX
OUR COMMENTS
Interaction between subsections 256(3) and 256(6)
It seems to us that the provisions that should be examined in relation to the situation described above are those of subsection 256(6) rather than those of subsection 256(3).
Subsections 256(3) and 256(6) are similar. However, subsection 256(3) never appears to apply where subsection 256(6) applies. Subsection 256(6) provides a deeming rule that there is no de jure or de facto control at a particular time where the required conditions are satisfied. If there is no de jure or de facto control at a particular time, a corporation cannot be associated at the particular time by virtue of being “controlled, directly or indirectly...” for the purposes of subsection 256(3), and subsection 256(3) then does not apply. On the other hand, the deeming rule created by subsection 256(3) (i.e., that the corporations are deemed not to be associated) does not affect the application of subsection 256(6). Subsection 256(6) is relevant where a corporation would, but for subsection 256(6), be controlled, directly or indirectly in any manner whatever by a person (see preamble). In addition, given that the conditions set out in paragraphs 256(6)(a) and (b) are almost identical to the conditions set out in paragraphs 256(3)(a) and (b), subsection 256(3) does not apply where subsection 256(6) does not apply.
Conditions for the application of subsection 256(6)
For subsection 256(6) to apply to ensure that Opco1 is not associated with other corporations controlled by XXXXXXXXXX for a given taxation year, the conditions set out in paragraphs 256(6)(a) and (b) must be satisfied throughout the taxation year.
It appears to us, based on the information available, that the Agency should take the position that the condition set out in paragraph 256(6)(a) was satisfied during the XXXXXXXXXX taxation years. First, the Agreement provides that all of the shares held by Holdco1 must be purchased by Opco1 using a method that appears reasonable to us. In addition, some of the shares were acquired during the XXXXXXXXXX taxation years (it should be noted that redemptions made during a given taxation year are based on the results of the previous taxation year). Opco1's profitability improved significantly from year XXXXXXXXXX onwards. Finally, given that all of the shares held by Holdco1 will have been purchased during XXXXXXXXXX, we find it difficult to take a different position.
It seems reasonable to conclude on the basis of the available facts that the condition set out in paragraph 256(6)(b) was not satisfied during the XXXXXXXXXX taxation years.
First, the Agency's position is that the condition set out in paragraph 256(6)(b) is satisfied only if the only reason the corporation was controlled or directed, directly or indirectly, in any manner whatsoever, as the case may be, was to safeguard the rights attached to a debt obligation or shares of the capital stock of the controlled corporation. The wording of paragraph 256(6)(b), which before 1985 referred to “the chief purpose”, was amended in 1986 with respect to the 1985 and subsequent taxation years, so that the chief purpose was replaced by an exclusive condition.
We have no doubt that one of the reasons Holdco1 controlled Opco1 was to safeguard its rights with respect to the shares it owned in Opco1 that were to be purchased by Opco1. However, we believe that this was not the only reason for Holdco1's control of Opco1.
We believe that Holdco1's control was probably also intended to indirectly protect its investment in the building that was leased to Opco1. Holdco1 holds the building and land that is leased to Opco1 for the operation of its business. The building was constructed specifically for Opco1. The amount invested by Holdco1 to acquire the land and building was much greater than the amount ($XXXXXXXXXXX) invested in the capital stock of Opco1. The annual rental income was a minimum of $XXXXXXXXXXX. Holdco1 had an interest in the success of Opco1's business in order to protect its real estate investment.
Finally, we believe that the condition in paragraph 256(6)(b) cannot be satisfied because the Class XXXXXXXXXX shares were not shares redeemable by Opco1. The purchase of the shares by the Corporation as provided for in the Agreement is a purchase by agreement and not a share redemption.
In conclusion, we are of the view that neither subsection 256(3) nor subsection 256(6) can apply in this case with respect to Opco1's XXXXXXXXXX taxation years.
For your information, a copy of this memorandum will be severed using the Access to Information Act and will be available in the Legislative Access Database (LAD) located on the mainframe of the Canada Customs and Revenue Agency. 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 Legislative Access Bank 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 that has been severed in accordance with the Privacy Act will be sent to you for delivery to the client.
Best regards,
Maurice Bisson, CGA
Corporate Reorganizations and
International Operations Section
Income Tax Rulings Directorate
Policy and Legislation Branch
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