| 19(1) | File No. 5-8487 |
| S.J. Tevlin | |
| (613) 957-2118 |
October 4, 1989
Dear Sirs:
Re: Section 55 of the Income Tax Act (the "Act")
This is in response to your letter of August 3, 1989 wherein you requested our comments regarding the application of subsection 55(2) of the Act to the following situation:
Pursuant to Section 86 of the Act, Mr. A freezes Opco taking back fixed value shares and having Opco issue new common shares to a corporation ("Holdco") owned solely by Mr. A's son. Immediately following the freeze, all of the preferred shares are redeemed creating an accounting deficit. If and when Opco is sold to an arm's length third party, it is proposed that a safe dividend would be paid at that time from Opco to Holdco in order to reduce the capital gain on the sale of Opco shares.
Your concern is whether the accounting deficit created when the preferred shares were redeemed would have any impact upon the determination of the amount of "safe income on hand" in respect of the new common shares held by Holdco. In addition you asked that we provide an explanation as to what the Department's position is in the determination of whether an accrued, capital gain on assets of the corporation is attributable to the accrued gain on the shares of the corporation.
Mr. Robertson stated in his 1981 paper that, the term "income earned or realized" as used in subsections 55(2) and (5) is income as otherwise determined pursuant to the Act. However, it is logical that only that portion of the income earned or realized that remains on hand immediately before the dividend can attribute to the gain. In addition, we have taken the position that such undistributed retained taxed earnings only attribute to the value of the share of a corporation on a dollar for dollar basis and any balance of the gain, including any balance that may reasonably be attributable to earnings (if, for example, the company was valued using the earnings method) is attributable to something other than income earned or realized. This position is supported by paragraph 55(5)(a) and the intent of the law, which was (where capital gains strips are involved) to allow income to pass tax free subject to Part IV within the corporate sector only to the extent that it had been taxed at the corporate level."
As stated in Mr. Read's 1988 paper, "accounting deficits at the beginning of the holding period or at a particular time should not prevent the payment of a safe dividend in and by themselves".
However at the time the dividend is paid to Holdco, as described above it will be necessary to determine the capital gain, if any, applicable to those common shares, and determine the portion of that gain which is attributable to income earned or realized during the holding period of those shares and the portion of the gain which is attributable to something else.
In our view the, income earned during the holding period may not constitute "safe income on hand" to the extent that it was paid out. The gain on the preferred shares held by Mr. A was attributable to safe income on hand and something else. When the preferred shares were redeemed the gain attributable to something else remains in Opco and is offset by a deficit. To the extent that subsequent earnings restore that deficit while the gain on something else remains, it appears that the gain on the common shares will not be attributable to that amount of subsequent earnings. In your example we would expect that the "safe income on hand" with respect to the common shares would be $100, assuming that taxable income and accounting incomes were equal.
Whether accrued gains on assets of the corporation contribute to the accrued gain on the shares of the corporation, and to what extent, is a question of fact.
As explained in paragraph 24 of Information Circular 70-6R, any written or verbal opinions are not rulings and are not binding upon Revenue Canada in respect of any taxpayers.
Yours truly,
for Director Reorganizations and Non-Resident Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch