Dear Sirs:
Re: Subsections 85(4) and 164(6) of the Income Tax Act (the "Act"
We are writing in response to your letter of March 19, 1991 wherein you requested our views on the interpretation of the above referenced provisions of the Act with respect to the following hypothetical situation.
The Hypothetical Situation
1. Xco is a Canadian-controlled private corporation the shares of which are not qualified small business corporation shares within the meaning assigned under subsection 110.6(1) of the Act. The term "Canadian-controlled private corporation" has the meaning assigned by paragraph 125(7)(b) of the Act.
2. The issued and outstanding share capital of Xco consists of 100 common shares, 60 of which are owned by Father and 40 by Son.
3. Father and Son are both residents of Canada.
4. The paid-up capital and the adjusted cost base, to each of Father and Son, of the shares of Xco are nominal. 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.
5. The fair market value of each of the common shares of Xco is $ 1, 000.
6. Xco has a refundable dividend tax on hand, within the meaning assigned by subsection 129(3) of the Act, of $25,000.
7. Father has previously claimed the maximum capital gains deduction referred to in subsection 110.6(3) of the Act.
8. Father's will provides that on his death all Father's shares of Xco will be given to Son.
9. Father dies.
Your Interpretation
It is your view that upon Father's death, Father is deemed to have disposed of his 60 common shares of Xco at fair market value, resulting in a capital gain of $60,000. If those shares are then purchased by Xco for cancellation, a deemed dividend and a capital loss of $60,000 will arise. Such deemed dividend, to the extent that it is taxable, will give rise to a dividend refund of $15,000 in Xco. It is also your view that the capital loss arising on the purchase for cancellation of the 60 common shares of Xco will be deemed to be nil pursuant to paragraph 85(4)(a) of the Act because Son will control Xco at the time the shares are purchased for cancellation. As a result, even if Xco purchases the 60 common shares within the time frame referred to in the preamble of subsection 164(6) of the Act, paragraphs (c), (e) and (f) of that subsection will not apply since there will not be any capital loss realized by the estate. It is your opinion that such a result is not reasonable. You noted that if the shares were purchased for cancellation immediately before Father's death, there would not have been any capital gain or loss in the year of death and the deemed dividend would have been included in Father's income in the year of the purchase for cancellation of those shares by Xco.
Our Comments
We concur with your view that upon the death of Father, Father is deemed, pursuant to subsection 70(5) of the Act, to have disposed immediately before his death, of the 60 common shares of Xco and to have received proceeds of disposition therefor equal to the fair market value of the shares immediately before his death, provided that the shares constitute capital property to Father immediately before his death. The estate is deemed to have acquired the shares at a cost equal to their fair market value immediately before Father's death. In the event that Xco subsequently purchases for cancellation the shares held by the estate, Xco is deemed to have paid and the estate is deemed to have received, pursuant to subsection 84(3) of the Act, a dividend in an amount equal to the amount by which the amount paid on the purchase for cancellation of the shares exceeds their paid-up capital. Upon the purchase for cancellation by Xco of its 60 common shares held by the estate, the estate will realize a capital loss through the operation of subparagraph 54(h)(x) of the Act. Whether this capital loss will be deemed to be nil by virtue of paragraph 85(4)(a) of the Act will depend on whether the conditions described in the preamble of subsection 85(4) of the Act are met. In the hypothetical situation outlined herein, in order for paragraph 85(4)(a) to apply, Xco must, immediately after the purchase for cancellation of its 60 common shares held by the estate, be controlled, directly or indirectly in any manner whatever, by the estate. The expression "controlled directly or indirectly in any manner whatever" in respect to a corporation has the meaning assigned by subsection 256(5.1) of the Act. Even though the estate will not own any shares of Xco after the purchase for cancellation by Xco of its 60 common shares held by the estate, Xco will be considered to be controlled, directly or indirectly in any manner whatever, by the estate if the estate has any direct or indirect influence that, if exercised, would result in control in fact of Xco.
Provided that Xco will be so controlled by the estate immediately after the purchase for cancellation by Xco of its 60 common shares held by the estate, we agree with your view that paragraph (a) of subsection 85(4) of the Act will operate to deem the capital loss that will be realized by the estate on the disposition of the shares of Xco to be nil such that paragraphs (c), (e) and (f) of subsection 164(6) of the Act will not apply.
Yours truly,
for DirectorReorganizations and Non-Resident DivisionRulings Directorate Legislative and Intergovernmental Affairs Branch