14 November 2003 External T.I. 2003-0035435 - Surplus Strip - Capital Gains v. Dividend

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: Whether certain transactions which are designed to convert dividends to capital gains on the disposition of shares by an individual are subject to section 84.1 or GAAR?

Position: Yes.

Reasons: Depending on the circumstances the individual could be considered to transfer the beneficial interest in the shares directly to the sons' holding companies.

Alternatively, GAAR may apply to recharacterize the capital gain as a dividend.

XXXXXXXXXX 2003-003543
Fiona Harrison
November 14, 2003

Dear XXXXXXXXXX:

This is in reply to your letter of August 21, 2003, wherein you requested our comments with respect to the following situation:

- Mr. A owns 1,000,000 preferred shares of Opco, a Canadian-controlled private corporation. The preferred shares are redeemable and retractable at $1 per share with an aggregate stated capital and adjusted cost base of $100;

- Bco and Cco each own 50 common shares of Opco with a stated capital and adjusted cost base of $1 per share. All the shares of Bco are owned by Mr. B and all the shares of Cco are owned by Mr. C. Mr. B and Mr. C are the sons of Mr. A;

- Opco was incorporated after 1971 and has no refundable dividend tax on hand;

- Mr. A has already used his capital gain exemption under section 110.6 of the Income Tax Act (the "Act") on the sale of shares of another corporation.

Mr. A would like to liquidate his shares over time. However, he would prefer to sell his shares to his sons instead of having them redeemed by Opco. In a telephone conversation of October 17, 2003, you have advised that the purpose is to realize a capital gain on the sale of shares instead of a deemed dividend on redemption of the shares since the effective tax rate on capital gains in the Province of Quebec is approximately 8% lower than the effective tax rate on dividends. The following transactions are contemplated:

- Every year for a period of five years, Mr. A will sell 100,000 preferred shares of Opco to each of Mr. B and Mr. C. Mr. A will realize a capital gain and will pay the appropriate income tax;

- Mr. B and Mr. C will each issue a promissory note to Mr. A for $100,000 payable one month after the sale;

- Mr. B will sell 100,000 preferred shares of Opco to Bco and will receive as consideration a promissory note of $99,900 and 100 redeemable and retractable preferred shares of Bco. Mr. B and Bco will make the appropriate election under subsection 85(1). It should be noted that Mr. B's adjusted cost base of the preferred shares of Opco will be equal to their fair market value;

- Mr. C will sell 100,000 preferred shares of Opco to Cco and will receive as consideration a promissory note of $99,900 and 100 redeemable and retractable preferred shares of Cco. Mr. C and Cco will make the appropriate election under subsection 85(1). Again, Mr. C's adjusted cost base of the preferred shares of Opco will be equal to their fair market value;

- Opco will redeem the 200,000 preferred shares owned by Bco and Cco. Pursuant to subsection 84(3), Bco and Cco will each be deemed to have received a taxable dividend of $99,999. The dividend will be deductible under subsection 112(1). Since Aco and Bco are connected to Opco within the meaning of subsection 186(4), tax under Part IV will only be exigible to the extent determined under paragraph 186(1)(b);

- Bco and Cco will use the proceeds of redemption to repay the promissory notes of $99,900 and to redeem the 100 preferred shares issued to Mr. B and Mr. C, respectively;

- Mr. B and Mr. C will each pay $100,000 to Mr. A in satisfaction of the promissory notes payable to Mr. A.

It is your opinion that the only tax consequences resulting from the above-described series of transactions is the tax on the capital gain resulting from the sale, by Mr. A, of the preferred shares of Opco to Mr. B and Mr. C. You suggest that section 84.1 will not result in a deemed dividend since the adjusted cost base to Mr. B and Mr. C, respectively, of the preferred shares of Opco will not be subject to any adjustment under subsection 84.1(2). You further suggest that, even if subsection 55(2) were to apply to deem the intercorporate dividends to be proceeds of disposition pursuant to paragraph 55(2)(b), a capital gain would not arise since the adjusted cost base of the shares would be equal to the proceeds of disposition.

OUR COMMENTS

Depending on the circumstances, Mr. A may be considered to have transferred his beneficial interest in the preferred shares of Opco directly to Bco and Co.¹ Consequently, subsection 84.1(1) would apply and each of Bco and Co would be deemed to have paid a dividend to Mr. A under the provisions of paragraph 84.1(1)(b).

Alternatively, GAAR may apply to the above-described series of transactions. In our view, Mr. B, Mr. C, Bco and Cco would be viewed as merely accommodating Mr. A by structuring the series of transactions in this manner since they do not appear to have any independent interest in acquiring the preferred shares of Opco. You have specifically stated that the purpose of the above-described series of transactions is to obtain a lower tax rate applicable to a capital gain resulting from the disposition of shares. Therefore, these transactions are "avoidance transactions" within the meaning of subsection 245(3). We direct your attention to the 1997 Tax Court decision in RMM Canadian Enterprises Inc.² On page 313 thereof, Bowman, J., states as follows: "--- I would add only this : the Income Tax Act, read as a whole, envisages that a distribution of corporate surplus to shareholders is to be taxed as a payment of dividends. A form of transaction that is otherwise devoid of any commercial objective, and that has as its real purpose the extraction of corporate surplus and the avoidance of the ordinary consequences of such a distribution, is an abuse of the Act, as a whole." Consequently, it is our position that subsection 245(2) may apply to redetermine the tax consequences and to recharacterize the proceeds as a taxable dividend received by Mr. A.

The above comments are an expression of opinion and, as noted in Information Circular 70-6R5 issued on May 12, 2002, are not binding on the Canada Customs and Revenue Agency.

Yours truly,

Mark Symes
Manager
Corporate Reorganizations Section
Reorganizations and Resources Division
Income Tax Rulings Directorate

ENDNOTES

¹ See Paxton, 97 DTC 5012 (FCA)
² 97 DTC 302 (TCC)