27 November 1996 CTF Roundtable Q. 1, 9637410 - BACKDOOR BUTTERFLY - DETERMINABLE PRIMARILY BY REFERENCE

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 Department.

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

Canadian Tax Foundation
1996 Annual Conference
Revenue Canada Forum
November 27, 1996

The Backdoor Butterfly Rule - Paragraph 88(1)(c.3)

Subparagraph 88(1)(c)(vi) of the Income Tax Act was introduced in 1994 in order to prevent the circumvention of the restrictions governing "purchase butterfly" transactions in subsection 55(3.1) of the Act. Property described in subparagraph 88(1)(c)(vi) is ineligible for a "bump" in adjusted cost base under paragraphs 88(1)(c) and (d) on the winding-up of a subsidiary into its parent. In general terms, the rule denies the bump where property of the subsidiary or property substituted therefor is acquired by persons who had a significant interest in the subsidiary before its control was acquired by the parent.

The Notice of Ways and Means Motion tabled on June 20, 1996 (and retabled on November 20, 1996) proposes to introduce paragraph 88(1)(c.3) which would deem certain property to be substituted property for purposes of the rule in subparagraph 88(1)(c)(vi). Questions have arisen as to how the Department intends to interpret the potentially broad wording of paragraph 88(1)(c.3). In particular we have been asked how we will interpret the expressions "property the fair market value of which is wholly or partly attributable to" in subparagraph 88(1)(c.3)(i) and "property the fair market value of which is determinable primarily by reference to" in subparagraph 88(1)(c.3)(ii).

It is clear from the context of the provision, as well as from the Department of Finance Explanatory Notes which accompanied the June 20 Notice, that the two expressions are intended to have different meanings.

The words "wholly or partly attributable to" in subparagraph 88(1)(c.3)(i) are very broad and would apply, for example, to a share or interest in a corporation, partnership or trust which owns or has an interest in the subsidiary's property. However, shares of the parent issued as consideration for the shares of the subsidiary are expressly excluded from the rule.

The words "determinable primarily by reference to" in subparagraph 88(1)(c.3)(ii) are, we understand, intended to have a narrower meaning. As the Explanatory Notes confirm, subparagraph 88(1)(c.3)(ii) would apply to property such as "tracking" shares or debt, the value of which is somehow tied to the value of or proceeds from certain underlying property of the corporation. On the other hand, the provision would not ordinarily apply to conventional common or preferred shares or debt issued by the parent as consideration for the acquisition of the shares of the subsidiary. The following examples will illustrate the circumstances in which conventional shares of the parent that are expressly excluded from subparagraph 88(1)(c.3)(i) may or may not be considered to be covered by subparagraph (ii).

Example 1

X owns all the shares of Targetco and Y owns all the shares of Buyco. Buyco acquires all the shares of Targetco in a share-for-share transaction. The shares of Buyco issued to X on the acquisition are ordinary common shares representing 20% of all of the common shares of Buyco. Buyco winds up Targetco and seeks to bump the cost of a non-depreciable capital property of Targetco which Buyco wishes to sell to an arm's-length third party.

In this situation, the Department would not consider the value of the shares of Buyco acquired by X to be "determinable primarily by reference to" the value of property distributed to Buyco on the winding-up of Targetco for purposes of subparagraph 88(1)(c.3). There has been a true take-over of Targetco by Buyco and although X's shares of Buyco represent a continuing indirect interest in the former property of Targetco, they represent an interest in all of the underlying assets of Buyco.

Example 2

X owns all of the shares of Targetco. Targetco owns all the shares of Keepco, which have a value of $10 million, and all the shares of Sellco, which have a value of $5 million. Y wishes to buy Sellco. The following transactions are carried out:

1.Y incorporates Buyco and subscribes for $5 million of voting redeemable preferred shares of Buyco.

2.Buyco acquires all of X's shares of Targetco in consideration for $5 million in cash and common shares of Buyco.

3.Buyco winds up Targetco and, but for subparagraph 88(1)(c)(vi), would bump the cost of the shares of Sellco and Keepco to their fair market value.

4.Buyco redeems the preferred shares held by Y and, in satisfaction of the redemption price, transfers to Y its shares of Sellco.

The result of these transactions is that part of Targetco's assets, its shares of Sellco, has been sold to an arm's-length buyer. X retains its interest in Keepco, not by buying back Keepco from Buyco directly, but rather by acquiring the common shares of Buyco from which Y then extracts the assets which Y wishes to acquire. But for subparagraph 88(1)(c)(vi), the transactions could be carried out without incurring corporate-level tax. The transactions seek to achieve the result that subparagraph 88(1)(c)(vi) was designed to prevent. In such circumstances, the Department would consider the value of the common shares of Buyco acquired by X to be "determinable primarily by reference to" property distributed to Buyco on the winding-up of Targetco, such that subparagraph 88(1)(c.3)(ii) would apply. This view is supported by the June 20, 1996 Department of Finance Explanatory Notes.

File 963741
Mark Symes
November 27, 1996