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This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.
Principal Issues: [TaxInterpretations translation]
Does subsection 55(2) apply to the redemption of preferred shares issued in connection with a freeze?
Position: Yes
Reasons: There was a significant increase in interest
XXXXXXXXXX 2001-007950
R. Gagnon
June 7, 2001
Dear Sir,
Subject: Subsection 55(2) of the Act
This is in response to your letter of April 10, 2001 in which you asked questions regarding the situation described below.
Unless otherwise indicated, all legislative references below are to provisions of the Income Tax Act (the "Act").
Facts
1. Holdco and Opco are "taxable Canadian corporations" as defined in subsection 89(1) and "Canadian-controlled private corporations" as defined in subsection 125(7).
2. All of the issued and outstanding shares of the capital stock of Holdco are held by Mr. X and Ms. Y.
3. The issued and outstanding share capital of Opco currently consists of 1,000 Class A shares and 10,000 Class B shares. The Class A shares are voting, entitle their holders to receive dividends when declared by the Board of Directors, and entitle their holders to receive the remaining property of the corporation upon winding-up. The paid-up capital (as defined in subsection 89(1)) of the 1,000 Class A shares of the capital stock of Opco is $1,000. The Class B shares are redeemable at the holder's option at their redemption value of $10,000,000. The paid-up capital of the 10,000 preferred shares is $1,000 and their fair market value ("FMV") is $10,000,000.
4. Holdco holds 10,000 Class B shares and 900 Class A shares of the capital stock of Opco. Mr. A and Mr. B each hold 50 Class A shares of the capital stock of Opco. The 10,000 Class B shares and 1,000 Class A shares of the capital stock of Opco constitute capital property (as defined in section 54) to the shareholders of Opco.
5. The adjusted cost base ("ACB"), within the meaning of section 54, of the 10,000 Class B shares and 900 Class A shares of the capital stock of Opco held by Holdco are $1,000 and $900 respectively. The ACB of the 50 Class A shares held by Mr. A and Mr. B is $50 each.
6. Mr. X, Ms. Y, Mr. A and Mr. B are individuals. Ms. Y is the wife of Mr. X. Mr. A and Mr. B are employees of Opco. Mr. A and Mr. B are not related to Mr. X and Ms. Y pursuant to subsection 251(2).
7. The safe income on hand attributable to the 1,000 Class A shares of the capital stock of Opco is $2,000,000, and is allocated equally between the Class A shares held by Holdco, Mr. A and Mr. B. The FMV of the 1,000 issued and outstanding Class A shares of the capital stock of Opco exceeds $2,000,000 (we have assumed that the FMV of the 1,000 Class A shares exceeds $2,000,000 because you did not state in your letter what was the FMV of the 1,000 Class A shares).
8. During 1998, a freeze was effected for the benefit of two employees (Mr. A and Mr. B) of Opco. More specifically, Opco purchased for cancellation the 1,000 Class A shares of its capital stock that were held by Holdco, and issued to Holdco as consideration the 10,000 Class B shares of its capital stock, the redemption value of which corresponded to the FMV of the exchanged 1,000 Class A shares. Immediately after the share exchange, Opco issued 1,000 new Class A shares of its capital stock to Holdco (900 shares), Mr. A (50 shares) and Mr. B (50 shares), for $1,000. The share exchange was subject to the provisions of subsection 51(1).
9. Immediately prior to the share exchange, the safe income on hand attributable to the 1,000 Class A shares of Opco held by Holdco was $8,000,000. In addition, the paid-up capital (as defined in subsection 89(1)) and ACB (as defined in section 54) of the 1,000 Class A shares exchanged was $1,000.
Your Questions
1. Would subsection 55(2) apply in respect of the dividend that would be deemed to be received by Holdco under subsection 84(3), if the 10,000 issued and outstanding Class B shares of the capital stock of Opco were redeemed by Opco during 2001 for $10 million?
2. What would be the effect on the safe income on hand attributable to the issued and outstanding 1,000 Class A shares and 10,000 Class B preferred shares of the capital stock of Opco, of a redemption by Opco of the 10,000 Class B shares of its capital stock?
3. Would the payment of a dividend on the Class B Preferred Shares, which would be made in accordance with the dividend rate set out in Opco's articles and shortly before a redemption by Opco of the 10,000 Class B Shares of its capital stock, be subject to subsection 55(2)?
4. What would be the impact on safe income on hand attributable to the issued and outstanding 1,000 Class A shares and 10,000 Class B preferred shares of the capital stock of Opco of a dividend as described in Question 3 above?
Our Comments
It appears to us that the situation described in your letter is an actual situation involving taxpayers. The Canada Customs and Revenue Agency (the "CCRA") does not generally provide written opinions on proposed transactions otherwise than by way of advance rulings. Furthermore, it is the responsibility of the relevant Tax Services Office to determine whether completed transactions have received the appropriate tax treatment. We can, however, offer the following general comments which may not fully apply to the situation submitted.
Question 1
The question of when a series of transactions begins and ends for the purposes of the Act is one of fact. Subsection 248(10) deems a series of transactions to include any related transactions or events completed in contemplation of the series. In a situation such as the one described above, the CCRA generally considers that the redemption of the preferred shares is part of a series of transactions that includes the exchange of shares and the acquisition of new participating shares as part of the freeze.
In addition, in a situation such as the one described above, the CCRA generally considers that there are two significant increases in holdings covered by subparagraph 55(3)(a)(ii), one at the time of the acquisition of the participating shares under the freeze, and the other at the time of the redemption of the preferred shares. As a result, subsection 55(2) is generally applicable in such a situation with respect to the redemption of the preferred shares.
Question 2
Where participating shares are exchanged for preferred shares having a FMV and a redemption value equal to the FMV of the participating shares, and because of the application of subsection 51(1) to the exchange, the ACB of the preferred shares is equal to the ACB of the exchanged participating shares, then the portion of the income earned on hand attributable to the participating shares immediately before the exchange is transferred to the preferred shares.
In the situation described above, the safe income on hand attributable to the 10,000 Class B shares for purposes of the redemption would therefore be $8 million. In addition, the redemption of the preferred shares in such a situation would not normally have an impact on the safe income on hand attributable to the participating shares.
Questions 3 and 4
In general, a share held by a shareholder of a corporation can only participate in safe income on hand during the holding period, i.e., from the date the share was acquired. An exception to this rule is safe income on participating shares that can be transferred to preferred shares in a share exchange. However, after such a share exchange, the preferred share can only participate in the safe income realized by the corporation after the share was issued.
In addition, the amount of safe income on hand in which a preferred share may participate after its issue depends, among other things, on the rights, privileges, conditions and restrictions for the preferred shares.
For example, an issued and outstanding preferred share of the capital stock of a corporation is generally entitled to participate in the safe income realized by the corporation after the share is issued to the extent of dividends declared and paid on the share, where the articles of the corporation provide that such share is entitled to a reasonable annual non-cumulative dividend, payable at the discretion of the directors. In the case of such a preferred share, it cannot be claimed that the preferred share participates in safe income on hand until a dividend is declared.
If, in a situation such as that described above, dividends on the preferred shares are not cumulative, a dividend declared and paid on the Class B preferred shares would reduce the capital gain that could be realized on the participating Class A shares, and would generally reduce the income earned on hand attributable to the Class A shares.
Subsection 55(2) could not apply to a dividend paid on the Class B preferred shares if it did not exceed the income earned on hand realized by the corporation after the Class B preferred shares were issued and that can be allocated to those shares.
Best regards,
Maurice Bisson, CGA
for the Director
Corporate Reorganizations and
Resource Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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