7 November 2003 External T.I. 2003-0006675 - Deemed ACB under 84.1(2)(a.1)

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: Determination of adjusted cost base of shares of a Canadian corporation for s. 84.1 purposes.

Position: Where shares of the corporation were held on December 31, 1971 by a party that does not deal at arm's length with a person and, through an unbroken chain of non-arm's length transactions, the shares were vested in the person, the adjusted cost base of those shares for s. 84.1 purposes will be reduced by the amount determined under s. 84.1(2)(a.1).

Reasons: The wording of the provisions of the Act as well as the Income Tax Application Rules. Also accords with our previous positions in IT-199 "Identical Properties Acquired in Non-Arm's Length Transactions" and paragraph 7 of IT-132R2 "Capital Property Owned on December 31, 1971 - Non-Arm's Length Transactions".

XXXXXXXXXX 2003-000667
J. MacGillivray
November 7, 2003

Dear Sir:

Re: Determining Adjusted Cost Base under s. 84.1(2)(a.1)

This is in response to your letter dated February 27, 2003 in which you requested comments with respect to the application of s. 84.1(2)(a.1) of the Income Tax Act (Canada) (the "Act") in determining the adjusted cost base of shares of a Canadian corporation to an individual. In this regard, you have asked us to consider the following scenario:

1. Canco, a Canadian corporation, was incorporated in 1960.

2. Canco issued 100 common shares on its incorporation to Mr. A and Mr. B for $100. Mr. A and Mr. B each acquired 50 common shares and have held such shares to the present. Mr. A and Mr. B are brothers.

3. The fair market value of the 100 Canco common shares was $500,000 on December 31, 1971.

4. The current fair market value of the 100 Canco common shares is $800,000.

5. Mr. W is the son of Mr. A.

It is assumed that Mr. B did not elect under s. 26(7) of the ITAR in respect of the 50 Canco shares and that he held the 50 Canco shares as capital property at all relevant times.

You have asked us to comment on the determination of the adjusted cost base of 50 Canco common shares to Mr. W under s. 84.1(2)(a.1) of the Act if he were to acquire such shares from Mr. B, his uncle, for consideration of $400,000. In addition, you have asked us to comment on the determination of the adjusted cost base of 50 Canco common shares to Mr. W under s. 84.1(2)(a.1) of the Act if Mr. A were to acquire Mr. B's 50 Canco common shares for $400,000 and then dispose of those same shares to Mr. W for the same amount of consideration.

Our Comments

Written comments regarding the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject matter of an Advance Income Tax Ruling request. Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office. However, we are prepared to provide the following general comments.

Where s. 84.1(2)(a.1) of the Act is applicable, the adjusted cost base of "subject shares" that can be utilized to reduce deemed dividends or deductions from paid-up capital under s. 84.1(1) (hereinafter referred to as "84.1 ACB") may be reduced for certain pre-1972 appreciation attributable to such shares and by the amount of any capital gains exemption claim attributable to a previous disposition of the subject shares by the taxpayer or a party not dealing at arm's length with the taxpayer. These reductions do not affect the determination of the adjusted cost base of subject shares under the other provisions of the Act (hereinafter referred to as "Ordinary ACB").

In the situation where Mr. W acquires the 50 Canco shares directly from Mr. B, the Ordinary ACB of the 50 Canco shares acquired by Mr. W from Mr. B would be $400,000, assuming that Mr. W deals at arm's length with Mr. B at the time of the transaction. In addition, s. 84.1(2)(a.1) would not apply to reduce the 84.1 ACB of the 50 Canco shares to Mr. W on the assumption that there is an arm's length relationship between Mr. B and Mr. W. While Mr. W and Mr. B would not be considered related parties for the purposes of the Act, it is always a question of fact as to whether unrelated persons are dealing at arm's length. A non-arm's-length relationship may exist between unrelated parties where there is a common mind that directs the bargaining for both parties to a transaction, where the parties act in concert without separate interests or where one party holds an excessive or constant advantage, authority or influence that constitutes de facto control over the other party. For a discussion of the Agency's general guidelines regarding non-arm's-length relationships, we refer you to Interpretation Bulletin IT-419R "Meaning of Arm's Length". Furthermore, it is our view that the family ties existing between an uncle and his nephew would be relevant in determining whether they deal with one another at arm's length.

If Mr. W and Mr. B do not deal at arm's length, the Ordinary ACB of the 50 Canco shares to Mr. W would be $400,000. While the Ordinary ACB of Mr. W's 50 Canco shares is equal to the $400,000 amount that Mr. W actually paid for the share, the Ordinary ACB must be determined with reference to s. 26(5) of the Income Tax Application Rules ("ITAR"). Consequently, Mr. W will be deemed to own the 50 Canco shares on June 18, 1971 and thereafter without interruption pursuant to s. 26(5)(a) of the ITAR and will inherit Mr. B's actual cost of the 50 Canco shares of $50 pursuant to s. 26(5)(b) of the ITAR. Since Mr. W will be deemed to hold the 50 Canco shares on December 31, 1971 pursuant to s. 26(5)(a) of the ITAR, the cost of Mr. W's 50 Canco shares, determined immediately after the acquisition from Mr. B and before taking into account any adjustments under s. 26(5)(c), would be $250,000, being the amount determined under s. 26(3) of the ITAR that is neither the greatest nor the least of:

(a) the actual cost of $50 inherited from Mr. B;

(b) the fair market value of the 50 Canco shares on December 31, 1971, which is $250,000; and

(c) the current fair market value of the 50 Canco shares, which would be $400,000.

Under s. 26(5)(c) of the ITAR, another $150,000 would be added to the cost of Mr. W's 50 Canco shares to arrive at a total cost of $400,000 because s. 26(5)(c)(i) of the ITAR requires that Mr. B's capital gain from the disposition of the 50 Canco shares must be added to Mr. W's cost. Ignoring disposition costs, Mr. B's capital gain would be equal to $150,000, the amount by which the proceeds of disposition of $400,000 exceeds the $250,000 adjusted cost base of Mr. B's 50 Canco shares.¹

Because s. 84.1(2)(a.1) would apply to Mr. W in the event that Mr. W and Mr. B did not deal at arm's length, the 84.1 ACB of Mr. W's 50 Canco shares would be reduced by $249,950 pursuant to s. 84.1(2)(a.1)(i) of the Act, resulting in an 84.1 ACB of $150,050. In arriving at this conclusion, we have assumed that Mr. B would not claim any deduction under s. 110.6 of the Act in respect of the disposition of the 50 Canco shares to Mr. W. In the event that Mr. B claimed such a deduction, the 84.1 ACB of the 50 Canco shares held by Mr. W would also be reduced pursuant to s. 84.1(2)(a.1)(ii).

Where Mr. A first acquires the 50 Canco shares from Mr. B for consideration of $400,000 and then disposes of those shares to Mr. W for the same amount of consideration, we are of the view that Mr. W's 84.1 ACB will be $150,050, provided that neither Mr. A nor Mr. B claim a deduction under s. 110.6 of the Act relating to their respective dispositions.

Mr. A and Mr. B will be considered to be related persons pursuant to s. 251 of the Act and will therefore be deemed not to deal at arm's length with each other. Similarly, Mr. A and Mr. W will be considered to be related persons and will therefore be deemed not to deal at arm's length with each other. Consequently, the 50 Canco shares that are the subject of the transfers will have become vested in Mr. W as a result of two transactions between persons not dealing at arm's length. The determination of the Ordinary ACB of the 50 Canco shares to Mr. W will therefore be made with reference to s. 26(5) of the ITAR. Upon applying the relevant provisions, the cost of the 50 Canco shares to Mr. W, prior to taking s. 26(5)(c) of the ITAR into account, will be $250,000.

As discussed above in the first scenario, where the cost of capital property is required to be determined with reference to s. 26(5) of the ITAR, the amount of all capital gains (other than amounts deemed by s. 40(3) of the Act to be capital gains) from a disposition of the property after 1971 by a previous owner is to be added to the subsequent owner's cost. Mr. W must therefore add the amount of Mr. B's capital gain on the disposition of the 50 Canco shares to Mr. A in computing the Ordinary ACB of those shares. You have advised that Mr. A would designate that he will be disposing of the 50 Canco shares acquired from Mr. B and that such shares will be treated as a separate group of properties in accordance with paragraph 6 of IT-199 "Identical Properties Acquired in Non-Arm's Length Transactions" dated February 17, 1975. Consequently, Mr. A will not realize a capital gain on the disposition of Canco shares to Mr. W. Therefore, taking s. 26(5)(c) of the ITAR into account, the Ordinary ACB of the 50 Canco shares to Mr. W will be $400,000.

Pursuant to s. 84.1(2.01)(c) of the Act, Mr. B and Mr. W will be deemed at all times not to deal at arm's length for s. 84.1(2)(a.1) purposes since the 50 Canco shares will have been vested in Mr. W as a result of two non-arm's-length transactions. Consequently, s. 84.1(2)(a.1) would apply to Mr. W in determining the 84.1 ACB of the 50 Canco shares. The 84.1 ACB of Mr. W's 50 Canco shares would be reduced by $249,950 pursuant to s. 84.1(2)(a.1)(i) of the Act, leaving Mr. W with an 84.1 ACB of $150,050. Again, we have assumed that Mr. B would not claim any deduction under s. 110.6 of the Act in respect of the capital gain realized on the disposition of the 50 Canco shares to Mr. A. In the event that Mr. B claimed such a deduction, the 84.1 ACB of the 50 Canco shares held by Mr. W would be reduced further pursuant to s. 84.1(2)(a.1)(ii).

The foregoing comments are provided in accordance with Information Circular IC 70-6R5 dated May 17, 2002.

Yours truly,

Mark Symes
Section Manager
For Division Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Legislation Branch

ENDNOTES

¹ Mr. B's Ordinary ACB is determined using the same methodology under s. 26(3) and s. 26(4) of the ITAR that was used above to determine the cost of those shares to Mr. W.