Dear Sirs:
Re: Paragraph 85(1)(c.1) of the Income Tax Act (the "Act") and Subsection 26(4) of the Income Tax Application Rules (the "ITAR")
We are writing in response to your letter dated February 5, 1991 wherein you requested whether the Department's interpretation regarding the application of subsection 26(4) of the ITAR to the transfer of capital property by a taxpayer to a corporation under the provisions of subsection 85(1) of the Act in the following hypothetical situation remains as described in a technical interpretation issued by this Department on June 25, 1986.
Facts
1. A taxpayer transfers shares of a Canadian-controlled private corporation (the "subject shares") to another corporation pursuant to subsection 85(1) of the Act.
2. The taxpayer owned the subject shares on December 31, 1971. We shall assume, for discussion purposes, that the paid-up capital and actual cost of the subject shares was $10, the fair market value of the subject shares on December 31, 1971 was $15 and the fair market value of the subject shares on the date of transfer was $30.
3. For purposes of the subsection 85(1) election, the taxpayer elected an amount of $10.
4. The taxpayer has never elected under subsection 26(7) of the ITAR.
Your analysis of the application of the relevant provisions of the Act and the ITAR to the hypothetical situation described above is as follows. Since subsection 26(4) of the ITAR provides that, for the purposes of computing the adjusted cost base to a taxpayer of any capital property (other than depreciable property or an interest in a partnership) at any particular time before he disposed of it, where the property was owned by him on December 31, 1971 and thereafter without interruption until that particular time, the cost to him shall be deemed to be the amount that would be determined under subsection 26(3) of the ITAR as if he had disposed of it at the particular time and his proceeds of disposition had been the fair market value at that time. In the above example, the provisions of subsections 26(4) and 26(3) of the ITAR would result in a median amount of $15 (the V-Day value). Even though the taxpayer has elected at $10, the provisions of paragraph 85(1)(c.1) of the Act would adjust the elected amount to $15 which represents the lesser of the fair market value of the shares at the time of disposition ($30) and the cost amount to the taxpayer of the property at the time of disposition ($15).
You have advised us that many transfers similar to that described in the above hypothetical situation were made in order to avoid any adverse consequences that may have resulted pursuant to section 84.1 of the Act. The transferors assumed that paragraph 85(1)(c.1) of the Act would adjust the adjusted cost base of the property from the elected amount to the V-Day value thereby preserving the amount of any tax-free gain accruing prior to V-Day (the "V-Day gain"). You believe that the purpose of the provisions of subsection 26(5) of the ITAR was to preserve the V-Day gain for the transferee corporation and the provisions of paragraph 85(1)(c.1) of the Act did not require the enactment of similar provisions to preserve the V-Day gain in the hands of the transferor.
Our Comments
Notwithstanding the arguments that you have presented, our position regarding this type of situation continues to be as reflected in the technical interpretation issued by this Department on June 25, 1986. The amount determined in the calculation of the lower limit for the elected amount pursuant to paragraph, 85(1)(c.i) of the Act is the cost amount of the property at the time of the disposition. Since there has been a disposition of property to a taxable Canadian corporation to which the provisions of subsection 85(1) of the Act apply, the agreed amount is deemed to be the taxpayer's proceeds of disposition of the property for the purposes of calculating the cost amount pursuant to the provisions of subsection 26(3) of the ITAR. The provisions of subsection 26(4) of the ITAR only apply to determine the cost of property at any time prior to the disposition of the property and, as such, the provisions would not apply to the determination of the cost amount for purposes of paragraph 85(1)(c.1). In your hypothetical situation, the provisions of subsection 26(3) of the ITAR would result in a cost amount equal to the actual cost of the property and, as such, paragraph 85(1)(c.1) of the Act would not result in an adjustment of the elected amount.
Requests made on behalf of specific taxpayers pursuant to paragraph 85(7.1)(b) of the Act should be directed to the relevant district office for consideration. Each request must be made in the prescribed form and should include a submission stating the taxpayer's reasons for believing that the amended election should be accepted. Paragraph 85(7.1)(d) of the Act requires that an estimate of the applicable penalty as described in subsection 85(8) must be paid at the time the amended election is submitted.
The foregoing comments represent our general views with respect to the subject matter of your letter.
Yours truly
for DirectorReorganizations and Non-Resident DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch