24(1)
5-8167
M.F. Symes
(613) 957-2091
Attention: 19(1)July 10, 1990
Dear Sirs,:
Re: Section 84.1 of the Income Tax Act (Canada) ("the Act")
This is in response to your letter of June 1, 1989 wherein you requested our views concerning the application of section 84.1 of the Act in the following hypothetical situation:
1. An individual resident in Canada dies after May 22, 1985.
2. The individual owned shares of a corporation resident in Canada as capital property continuously since before 1972.
3. Immediately before death, the shares have a fair market value of $1,000, an adjusted cost base ("ACB") (as determined pursuant to paragraph 54(a) of the Act, subject to subsection 26(3) of the Income Tax Application Rules, 1971 ("the ITAR")) of $200, equal to their value on valuation date (within the meaning of section 24 of the ITAR( and paid-up capital of $100, equal to the individual's actual original cost.
4. Pursuant to the will of the deceased, the shares are held in trust for the benefit of his child.
5. The ACB of the shares to the trust is deemed by paragraph 70(5)(c) of the Act to be $1,000.
Your Questions
1. Does Revenue Canada consider the ACB of the shares to the trust, for purposes of section 84.1, to be reduced by virtue of subparagraph 84.l(2)(a.1)(i)?
2. If a capital gains exemption pursuant to section 110.6 were claimed in respect of the capital gain on the shares arising pursuant to paragraph 70(5)(a) would Revenue Canada consider the trust's ACB of the shares, for purposes of section 84.1, to be reduced by virtue of subparagraph 84.l(2)(a.l)(ii)?
3. Would the responses to questions 1 and 2 be different if:
(a) the shares were left to a spousal trust under the will
of the deceased, rather than to a trust for the benefit
of a child, (b) the executor made an election under subsection 70(6.2)
of the Act, and (c) a capital gains exemption pursuant to section 110.6 were
claimed in respect of the capital gain arising pursuant
to paragraph 70(5)(a)?4. Would the responses to questions 1 and 2 be different if:
(a) the shares were left to a spousal trust under the will
of the deceased,(b) the executor made an election under subsection 70(6.2),
(c) a capital gains exemption pursuant to section 110.6 were
claimed in respect of the capital gain arising pursuant
to paragraph 70(5) (a), (d) the spouse subsequently died, as a result of which the
trust would be deemed by paragraph 104(4) (a) of the Act
to have disposed of the shares for proceeds equal to
their fair market value on the day that the spouse died,
and to have reacquired the shares immediately thereafter
for that same amount, and (e) the trust claimed a deduction pursuant to subsection
110.6(12) of the Act in respect of the resulting capital
gain?4. Would the responses to question 1 and 2 be different if:
(a) the shares were left to a trust for the benefit of a
child of the deceased under the will of the deceased, (b) a capital gains exemption pursuant to section 110.6
were claimed in respect of the gain on the shares
arising pursuant to paragraph 70(5)(a) 1 and (c) the shares were subsequently distributed to the child by
the trust in satisfaction of his capital interest in the
trust such that subsection 107(2) would apply?6. If, in any of the circumstances above, Revenue Canada does not consider the ACB of the shares to be reduced for the purposes of section 84.1 and, immediately following a transfer of such shares in a manner in which all of the conditions in the preamble of subsection 84.1(1( are met there is a realization of corporate surplus by the trust or beneficiary, as the case may be, (the "taxpayer" within the meaning of section 84.1) without income tax, would Revenue Canada consider that subsection 245(2) would apply to deny any part of the tax benefit achieved?
Our Comments
Paragraph 84.1(2)(a.1) deems the ACB of shares, for purposes of section 84.1 to be reduced in certain circumstances. The paragraph sets out three arm's length tests which are relevant to the questions which you have raised:
1) the preamble to the paragraph provides that its provisions apply "where a share disposed of by a taxpayer was acquired by him after 1971 from a person with.whom he was not dealing at arm's length..." (the "Preamble Arm's Length Test");
2) subparagraph 84.1(2((a.1((i) may deem the ACB of the shares to be reduced where "the share...was owned at the end of 1971 by the taxpayer or a person with whom the taxpayer did not deal at arm's length..." (the'"subparagraph (i) Arm's Length Test"); and
3) subparagraph 84.1(,)(a.1)(ii) may deem the ACE of the shares to be reduced by capital gains realized "...in respect of a previous disposition of the shares...by the taxpayer or an individual with whom the taxpayer did not deal at arm's length" (the "subparagraph (ii) Arm's Length Test").
The Preamble Arm's Length Test must be applied in respect of the transaction or event in which the taxpayer acquires the subject shares. In our view, when an estate acquires property from a deceased upon his death, it acquires the property from a person with whom it was not dealing at arm's length, so that the Preamble Arm's Length Test would be satisfied. We believe this view is supported by the decision of the Tax Court of Canada in the case of Estate of Karna May v. M.N.R. 88 DTC 1189, to which you referred in your letter. Furthermore, we do not agree with your assertion that a deceased and his estate cannot be considered not to deal at arm's length because they do not coexist. In the case of Special Risks Holding Inc. v. The Queen
86 DTC 6035, the Federal Court of Appeal rejected the taxpayer's argument that in order to prove that two unrelated persons are not dealing at arm's length, it is necessary to first establish that those, two persons are dealing with each other. After noting that this argument, which is based on the English version of the Act, cannot be reconciled with the French version, Pratte, J. said:
The French version makes clear, in my view, that what Parliament had in mind in referring to persons dealing or not dealing at arm's length was not persons who were actually dealing with each other, but, rather, persons between whom existed a relationship of subordination.
We are of the view that when an estate acquires property from the deceased pursuant to his will, it is the mind of the deceased which directs both the disposition and the acquisition of the property.
The executors of the estate are bound to carry out the instructions of the deceased contained in his will, and accordingly the estate and the deceased are, in the words of the court `in the Special Risks case, "persons between whom existed a relationship of subordination".
With respect to the subparagraph (i) Arm's Length Test, it is our view that such, test must be applied as at the end of 1971, i.e. it must be determined whether the taxpayer and, the person who owned the shares at the end of 1971 dealt at arm's length' at the end of 1971.
With respect to the subparagraph (ii) Arm's Length Test, it is our view that such test must be applied at the time of the previous disposition of the share which gave rise to the capital gain, i.e. it must be determined whether the taxpayer and the individual who realized the capital gain on such previous disposition dealt at arm's length at the time of such disposition.
Applying the above comments to your specific questions, our answers thereto are, in order:
1. For the reasons set out above, the Preamble Arm's Length Test would be satisfied. However, in our view the subparagraph (i) Arm's Length Test would not be satisfied. It could not be said that, at the end of 1971, the deceased and his estate did not deal at arm's length, because there was no relationship of subordination between them at that time.
Accordingly, the ACE to the trust of the shares for purposes of section 84.1 would not be reduced by virtue of subparagraph 84.l(2)(a.1)(i).
2. For the reasons set out above, the Preamble Arm's Length Test would be satisfied.
Furthermore, in our view the subparagraph (ii) Arm's Length Test would also be satisfied. The deceased and his estate would not have dealt at arm's length with respect to the previous disposition of the shares (i.e. the disposition of the shares to the estate upon death).
Accordingly, the ACE to the trust of the shares for purposes of section 84.1 would be reduced by subparagraph 84.1(2)(a.1)(ii).
3. No, our responses to questions 1 and 2 would not be different.
4. In our view, the Preamble Arm's Length Test would be met, because notwithstanding the deemed disposition and reacquisition of the shares by the trust pursuant to paragraph 104(4)(a), the trust actually acquired the shares from the deceased upon his death. Thus, the trust would have acquired the shares from a person with our response to question 1.
In our view, the subparagraph (i) Arm's Length Test would not be met, for the reasons set out in our response to question 1.
Accordingly, the ACE to the trust of the shares for purposes of section 84.1 would not be reduced by virtue of subparagraph 84.1(2)(a.1)(i).
However, the ACE to the trust of the shares for purposes of section 84.1 would be reduced by virtue of subparagraph 84.1(2)(a.1)(ii) both by the amount of the capital gain realized by the trust on the paragraph 104(4) (a) deemed disposition (because it was a capital gain realized on "a previous disposition of the share... by the taxpayer...") and by the amount of the capital gain realized by the deceased on the paragraph 70(S)(a) deemed disposition (because it was a capital gain realized on "a previous disposition of the share... by an individual with whom the taxpayer did not deal at arm's length..." for the' reasons set out in our response to question 2).
5. Whether or not the Preamble Arm's Length Test would be met in this situation would depend on whether or not the child and the trust dealt at arm's length with respect to the acquisition of the shares by the child from the trust. As you acknowledged in your letter, paragraph 17 of interpretation Bulletin IT-419 indicates that the Department considers a beneficiary and trust not to deal at arm's length, unless the facts indicate the contrary. The relationship between the beneficiary and the trustee may be relevant to this determination, but it would not be conclusive. The comments in IT-419 are applicable with respect to paragraph 84.1(2)(a.1).
Whether or not the subparagraph (i) Arm,'s Length Test would be met in this situation would depend on whether or not the child and his father, who owned the shares at the end of 1971, dealt at arm's length at the end of 1971. If the son were alive at the end of 1971 he would have been related to his father at that time, and would therefore have been deemed, by "paragraph 251(1)(a) not to have dealt at arm's length with his father at that time. If the son were not alive at the end of 1971, we would not consider that the shares were owned at the end of 1971 by a person with whom the son did not deal at arm's length at that time.
With respect to the subparagraph 84.1(2)(a.1)(ii) reduction, there would have been two previous dispositions of the shares after 1984. On the distribution of the shares by the trust to the child, no capital gain would have been realized as a result of the application of subsection 107(2), and hence there would be no reduction under subparagraph (ii). With respect to the paragraph 70(5)(a) deemed disposition by the father upon his death, whether or not the subparagraph (ii) Arm's Length Test were met would depend upon whether the child dealt at arm's length with his father at the time of such deemed disposition. Because paragraph 70(5)(a) deems, such disposition to occur immediately before father's death, the child and his father would both be alive, and therefore related, and therefore deemed not to deal at arm's length at that time. Accordingly, it is our view that subparagraph 84.1(2)(a.1)(ii) would apply to reduce the ACE to the child by the amount of the capital gain deemed by virtue of paragraph 70(5)(a( to have been realized upon his father's death.
6. It is our view that, although some of the transactions described above might constitute avoidance transactions within the meaning of subsection 245(3) of the Act, they would ordinarily not, in and by themselves, be considered to result in a misuse of any provision of the Act or an abuse having regard to the provisions Act read as a whole, and would thus be exempt from the application of subsection 245(2) of the Act by virtue of subsection 245(4) thereof. However, whether or not a particular transaction constitutes an avoidance transaction or results in a misuse of any provision of the Act or an abuse having regard to the provisions of the Act read as a whole cannot be determined without a review of all of the relevant facts and circumstances.
The above comments reflect our position only with respect to the potential application of subsections 84.1(2) and 245(2) of the Act to the hypothetical situations outlined above and should not be interpreted as implying that any other provision of the Act would or would not apply to any actual transactions similar to those described herein.
The foregoing expressions of opinion are given in accordance with the, practice referred to in paragraph 24 of Information Circular 70-6R dated December 18, 1978 and are not binding on Revenue Canada, Taxation.
We are not certain that all of the results described above are consistent with the intended policy of section 84.1, and it is therefore our intention to bring the matter to the attention of the Department of Finance so that it may consider whether any amendments are required.
Yours truly,
for Director Reorganizations and Non-Resident Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch