CRA provided various examples to illustrate the impact of reorganizations on safe income. CRA indicated that this determination essentially turned on the application of the words “reasonably” and “contribute” in s. 55(2.1)(c).
Fxample 1 (allocation of direct safe income)
Opco is wholly owned by Holdco and has realized after-tax income of $1,000. This income is reflected in the ACB of Asset 2 held by it, which it acquired with the income realized. Now Opco proceeds with a s. 55(3)(a) spin-out of Asset 2 to Newco. Consequently, Asset 2, having an ACB of $1,000, is transferred to Newco on a rollover basis.
CRA indicated that, as the direct safe income of Opco was used to acquire Asset 2, it would be inappropriate to split that safe income so that a portion remains with the Opco shares. Instead, it should all go to the Newco shares.
This result accords with the observation that the direct safe income of $1,000 transferred to the Newco shares contributes to the gain on the Newco shares, and it should not be considered as contributing to the gain on the Opco shares that are left behind (the only asset of Opco is one with no ACB, so that all the unrealized gain remains in the assets retained by Opco.)
Example 2 (allocation of indirect safe income following an internal reorganization)
The structure is similar to Example 1, but now Opco has two subsidiaries, Subco 1 and Subco 2. Here Opco did not realize any income, so that there is no direct safe income in Opco - but there is indirect safe income in Opco, because Subco 2 realized income that constitutes direct safe income, and indirect income, of $1,000 on the shares of Subco 2, and Opco, respectively.
Opco transfers Subco 2 in a s. 55(3)(a) reorganization, and again the question is how to allocate the indirect safe income afterwards. Once again, because the shares of Subco 2 are transferred to Newco on a rollover basis, the direct safe income in the shares of Subco 2 is transferred over to Newco. On a consolidated basis, the shares of Newco held by Opco have indirect safe income of $1,000. Again, the indirect safe income is pushed over to Newco.
This accords with the observation that there no longer should be any indirect safe income in the Opco shares, as there is only unrealized gain on the assets owned by Opco (the shares of Subco 1), and there is no underlying safe income in Subco 1. By contrast, there is unrealized gain on the Newco shares, which is fully supported by the direct safe income in the Subco 2 shares.
Example 3 (misalignment of outside and inside basis)
Holdco owns Opco, and Opco has two subsidiaries (Subco 1 and 2). Holdco had acquired Opco for $300 a few years previously, and at that time, Subco 2 had direct safe income of $200, and since then Subco 2 generated an additional $150 of safe income. Thus, even though Subco 2 has $350 of direct safe income, Opco only has an indirect safe income of $150, as the $200 of preacquisition safe income generated by Subco 2 is reflected in the ACB to Holdco of the Opco shares.
The safe income is then capitalized before the reorganization, so that Holdco would have an ACB for its Opco shares of $450, being $300 plus the indirect safe income of $150. If Opco were wound up, Holdco would have shares of Subco 1 and Subco 2 with an aggregate ACB of $350. The maximum ACB that Holdco could have in the subs should be $450.
Suppose that there is a s. 55(3)(a) spin-off of Subco 2 to Newco, and that to effect that spin-off, Holdco transfers shares of Opco having an ACB of $150, and an FMV of $500. The transaction occurred on a rollover basis, so the direct safe income of $350 in the Subco 2 shares is transferred over to Newco on a consolidated (and rollover basis), and the indirect safe income of $150 on the Opco shares is transferred over to the Newco shares, as in the previous two examples.
However, this results in a duplication of ACB - because if the safe income is capitalized after the reorganization and Newco is wound-up, there is a resulting aggregate ACB of $500 in the shares of Opco and Subco 2, which exceeds the $450 maximum stated above. In CRA’s view, this $50 ACB increase is unacceptable, and the solution would be to proceed with a reorganization that results in an alignment of the basis.
Instead of transferring Opco shares to Newco with an ACB of $150, Opco shares having an ACB of at least $200 could be transferred. This would achieve alignment of the basis.
The above structure is similar to the one in Example 3. The only change made here is that Subco 1 has realized its safe income of $500 after the acquisition of control. If the safe income is capitalized before the transaction, there will be an ACB of $950 of the Opco shares. If Opco is wound up, Holdco will have an aggregate ACB of $950. In Example 3, our magic number was $450, and now it is $950, the maximum ACB that these entities can hold.
CRA went on to provide examples illustrating a misalignment going the other way (resulting in the loss of basis), and stated that it was “ready to find solutions to avoid what would be perceived as a loss of safe income or tax basis.”