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Wyman W. Webb (613) 957-2109
JUN 21 1988
Dear Sirs:
Re: Paragraph 55(3)(b) of the Income Tax Act (the "Act")
This is in reply to your letter of March 7, 1988 in which you asked for our opinion concerning the allocation of liabilities when using the net equity method of valuation of types of property for the purposes of paragraph 55(3)(b) in various hypothetical situations.
In determining whether or not the conditions set out in paragraph 55(3)(b) of the Act have been satisfied in a particular case, it is a question of fact whether or not each shareholder has received, in the course of a reorganization in which property of a particular corporation is transferred directly or indirectly to one or more corporations, his proportionate share of the type of property so transferred. This question of fact can only be answered with a knowledge of all of the facts of a particular reorganization. We are therefore unable to provide any opinion concerning the appropriate allocation of liabilities in the hypothetical situations which you described. We are, however, able to provide the following general comments.
Paragraph 55(3)(b) of the Act requires that each transferee in a butterfly receive its proportion of the fair market value of each type of property transferred. The required proportion for a specific shareholder transferee is based on the relative proportion of the fair market value of all of the issued shares of the particular corporation held by the transferee immediately before the transfer. The proportion is applied to the fair market value of each type of property owned by the particular corporation at that time to determine the value of property of each type which must be received by the specific shareholder.
In determining the fair market value of a type of property for the purposes of paragraph 55(3)(b) of the Act, it is acceptable to deduct liabilities from the value of gross assets related to those liabilities provided that:
(a) there have been no debts incurred by the company in contemplation of the butterfly;
(b) there have been no asset acquisitions or dispositions by the company in contemplation of the butterfly; and
(c) there is a good business reason for the assumption of liabilities by the shareholders in a different proportion than the acquisition of assets.
In determining the fair market value of each type of property of the corporation on a net equity basis, current liabilities will generally first be offset against cash or near cash, and any excess current liabilities may be offset against business assets or investments. Other liabilities will generally be offset against the assets to which they relate. Any refinancing or repayment of debt in contemplation of a butterfly may be considered to be an acquisition of property which alters the mix of properties and offends the prohibition in paragraph 55(3)(b) of the Act.
Which liabilities may be deducted from the value of which assets is a question that can only be determined based on an examination of all of the relevant facts and in particular the overall effect of the transactions related to the reorganization. In our opinion, the provisions of paragraph 55(3)(b) of the Act can not be interpreted so as to permit a disguised sale or barter transaction or to allow one or more shareholders to be bought out for cash or near cash assets.
You have also asked for our general comments with respect to the types of property for the purposes of paragraph 55(3)(b) of the Act.
The Department's position with respect to types of property is discussed in papers presented at the 1981 and 1983 Annual Conference of the Canadian Tax Foundation. (John R. Robertson, "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55", in Report of Proceedings of the Thirty-third Tax Conference, November 23 - 25, 1981 (Toronto: Canadian Tax Foundation, 1982), 81-109, at 95-100, and Robert J.L. Read, "Technical Matters", in Report of Proceedings of the Thirty-fifth Tax Conference, November 28 - 30, 1983 (Toronto: Canadian Tax Foundation, 1984), 783-795 at 785-6)). In general, property of a corporation is classified as one of three types: cash or near cash assets, business assets or investments.
The cash or near cash category generally consists of the corporation's current assets including cash, short term deposits and some marketable securities and. subject to the following comments relating to business assets, may also include accounts receivable, inventory and prepaid expenses. Advances to other corporations within a corporate group are generally considered to be cash or near cash assets. This category may also include other assets which would otherwise be classified as business assets or investments and which will imminently be converted to cash or near cash following the butterfly.
The business asset category generally consists of the corporation's assets, other than cash or near cash, which are used to earn business income reported by the corporation. Rental properties may be classified as business assets if the rental income is reported as active business income. Accounts receivable, inventory and prepaid expenses acquired by a transferee (or, in the case of a single-wing butterfly, retained by the particular corporation) may also be classified as business assets where the transferee (or the particular corporation) will acquire (or retain) and operate the business to which they related, and they will be collected, sold or consumed, as the case may be, in the ordinary course of that business.
The investment category generally consists of the corporation's assets, other than cash or near cash, which are not used to earn business income reported by the corporation. Shares in a subsidiary may be classified as investments, cash or near cash, or business assets depending on the nature of the underlying assets of the subsidiary and other surrounding circumstances.
You had also asked for our opinion on whether the net equity method of valuation may be used in respect of one type of property and the gross value method of valuation used in respect of other types of properties in the same reorganization. Although we are unable to provide a complete response to this question without knowing the context in which the question arises and all of the facts and transactions related thereto, it is our view that a taxpayer should use one method consistently in a particular reorganization in order to qualify for the exemption contained in paragraph 55(3)(b) of the Act.
As our comments herein are only expressions of our opinion they are not rulings and are not binding on the Department, as explained in paragraph 24 of Information Circular 70-6R.
Yours truly,
for Director Reorganizations and Non-Resident Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch