| 913247 | ||
| S. Leung | ||
| (613)957-2115 |
24(1)
Attention: 19(1)
January 23, 1992
Dear Sirs:
Re: Subsection 55(2)
We are writing in response to your letter of November 13, 1991 wherein you requested our interpretation of subsection 55(2) of the Income Tax Act (the "Act") in relation to the following hypothetical situation:
The Hypothetical Situation
7. Opco is a small business corporation, within the meaning assigned under subsection 248(1) of the Act, which carries on its business in Canada.
8. All of the issued and outstanding shares of Opco are owned by Mr. A who acquired these shares on the incorporation of Opco. Both the paid-up capital and the adjusted cost base to Mr. A of the shares of Opco are $1. The fair market value thereof is $900,000. The shares of Opco are qualified small business corporation shares within the meaning assigned under subsection 110.6(1) of the Act. The terms "paid-up capital" and "adjusted cost base" have the meanings assigned by paragraphs 89(1)(c) and 54(a) of the Act, respectively.
9. The amount of the income earned or realized by Opco after 1971 which has not been distributed ("safe income") is $500,000.
10. Mr. A intends to transfer all of his shares of Opco to a newly incorporated corporation, Newco, and as sole consideration will receive shares of Newco. An election will be made pursuant to subsection 85(1) of the Act. The agreed amount in respect of the subsection 85(1) election will be $500,000. As a result, Mr. A will realize a capital gain of $499,999 in respect of which he will claim a capital gains deduction pursuant to subsection 110.6(2.1) of the Act.
11. Opco will then pay a taxable dividend, within the meaning assigned by paragraph 89(1)(j) of the Act, of $400,000 to Newco.
12. Newco will then sell the shares of Opco at fair market value to an arm's length person for $500,000.
It is your view that the $400,000 taxable dividend that will be paid by Opco to Newco as described in 5 above is fully out of safe income such that subsection 55(2) would not apply to such taxable dividend. Your view is based on the comments made by John R. Robertson in his paper presented at the 1981 annual conference of the Canadian Tax Foundation ("the 1981 paper") which stated in paragraph (c) on page 85 :
"Where a share (the exchanged share) is exchanged for shares (the new shares) on a rollover basis the portion of safe income of the corporation to which the exchanged share would have been entitled immediately before the exchange will flow through to the new share...
All shares of the corporation in which the new shares have been issued will share pro rata in the safe income of that corporation from the time of the exchange. This is a reasonable approach to take and would cover rollovers such as those provided by sections 51, 85, 85.1, 86, and 87."
You requested our confirmation of your view and, if we disagree with your interpretation, our indication of what portion, if any, of the $400,000 taxable dividend that will be paid to Newco would be considered to have come out of safe income if it were a separate dividend subject to a designation pursuant to paragraph 55(5)(f) of the Act.
Our Comments
You may note that paragraph (d) on page 85 of the 1981 paper stated:
"When a corporation acquires a share as the result of a section 85 rollover such a transferred share will retain its share of safe income that could have been paid as a safe dividend immediately before the transfer. In effect the transferee's holding period in respect of such a transferred share includes the transferor's holding period. This is reasonable because the transferor's potential gain on those shares becomes the transferee's potential gain." (Underlining added)
In the situation outlined in your letter, since $499,999 of the capital gain will be crystallized on the transfer of the shares of Opco by Mr. A to Newco, not all of Mr. A's potential gain on the transferred shares of Opco will become a potential gain of Newco. In addition, as there is no tracing provided for in subsection 55(2) of the Act, it is not reasonable to conclude that the gain that will be realized by Mr. A on the rollover of his Opco shares to Newco is entirely attributable to something other than safe income and that the remaining gain inherent in Newco's shares of Opco is attributable only to safe income.
When a portion of the capital gain inherent in the shares of Opco is crystallized, the only reasonable approach, consistent with the principles outlined in the 1981 paper, is to apportion the safe income, to which the entire gain is in part attributable, proportionally to each part of the gain. Therefore, the amount of safe income that will flow through to Newco as a result of the transfer of the Opco shares by Mr. A to Newco will be
Newco's potential gain x safe income of Opco Mr. A's potential gain immediately before the series of transaction
= $400,000 x $500,000 $899,999
= $222,222
Our above comments are not rulings and are provided in accordance with the practice referred to in paragraph 21 of Information Circular 70-6R2.
Yours truly,
for DirectorReorganizations and Foreign DivisionRulings DirectorateLegislative and IntergovernmentalAffairs Branch