Dear Sirs:
Re: Subsection 87(9) of the Income Tax Act (the "Act")
We refer to your letter of March 21, 1991 in which you requested a technical interpretation of the provisions of subsection 87(9) of the Act to the merger of two corporations in the hypothetical fact situation described below.
Parent, a public corporation, owns 75% of the issued and outstanding common shares of Holdco, a taxable Canadian corporation. Public corporation and taxable Canadian corporation have the meanings assigned by paragraphs 89(1)(g) and 89(1)(i) of the Act, respectively. The remaining 25% of the issued and outstanding common shares of Holdco are held by Privateco, a private corporation, within the meaning of paragraph 89(1)(f) of the Act. Holdco owns a significant minority interest in the shares of Targetco, a public corporation and taxable Canadian corporation.
The remaining shares of Targetco are widely held by members of the public (the "public").
It is proposed that Holdco and Targetco be amalgamated to form Amalco. On the amalgamation, Parent and Privateco will receive common shares of Amalco, the shareholding of Holdco in Targetco will be cancelled, and the shares of Targetco held by the public will be converted into a combination of preferred shares of Amalco that will be redeemable by Amalco immediately after the amalgamation, and common shares of Parent. In consideration of Parent issuing its common shares to the public, Amalco issues additional common shares to Parent such that Parent will hold 90% of the issued and outstanding common shares of Amalco and Privateco will hold the remaining 10% of such shares. If these additional common shares were not issued to Parent, then Parent would be inappropriately diluted in its shareholding in Amalco vis-à-vis Privateco.
You have concluded that the provisions of subsection 87(9) of the Act would apply to the amalgamation (the "merger") described above, with the result that, pursuant to subparagraph 87(9)(c)(i), the cost to Parent of the common shares of Amalco would be the amount otherwise determined under paragraph 87(4)(b) of the Act to be the cost of those shares. Since this cost would be equal to the aggregate adjusted cost base of the common shares of Holdco held by Parent prior to the merger, and since Parent would not own all of the issued shares of the capital stock of Amalco immediately after the merger, you have also concluded that the cost of the common shares of Amalco to Parent as so determined would not be increased by the amount described under subparagraph 87(9)(c)(ii) of the Act.
Adjusted cost base ("ACB") has the meaning assigned by paragraph 54(a) of the Act.
You consider this result to be inappropriate, and request our opinion on whether Parent may increase the cost of its common shares of Amalco to reflect the issue by Parent of its common shares to the public, and if so, how the increased cost should be determined.
Your letter implies that, since the additional common shares issued by Amalco to Parent relate to the common shares issued by Parent to the public, then the cost of these additional common shares should be equal to the fair market value of the common shares issued by Parent to the public.
Opinions
The merger of Holdco and Targetco described above falls squarely within the preamble of subsection 87(9) of the Act, and consequently, the provisions of the subsection must govern the results of the merger as it would affect the cost of Parent's common shares of Amalco. In this regard, we agree that, because Parent does not own all of the shares of Amalco immediately after the merger, subparagraph 87(9)(c)(ii) of the Act will not apply to increase the cost to Parent of its Amalco common shares otherwise determined under subparagraph 87(9)(c)(i). However, we do not agree that Parent can increase the cost of its common shares of Amalco as so determined by any amount, fair market value or otherwise, that would be calculated by reference to the issue of its common shares to the public.
In this regard, since the provisions of subsection 87(9) of the Act govern the merger, the cost of Parent's common shares of Amalco must be determined solely by reference to that subsection, and in our view, it would require a special rule to take cognizance of a situation, such as the one described in your letter, where Parent does not own all of the issued shares of Amalco immediately after the merger.
Although we agree that the result flowing from the application of subsection 87(9) of the Act in the above described situation may not be an equitable one, It is our view that your proposal to increase the cost of additional shares issued to a parent corporation on a merger by the fair market value of shares issued by the parent to the public may be inappropriate given the provisions of paragraph 85.1(1)(b) of the Act, which restrict the cost of the exchanged shares referred to therein to the lesser of the fair market value and the paid-up capital thereof.
We intend to draw the anomaly pointed out in your letter to the attention of the Department of Finance, so that they may consider an appropriate amendment to the Act.
We regret that our reply could not have been more favourable.
Yours truly,
for DirectorReorganizations and Non-Resident DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch