10 October 1997 APFF Roundtable Q. 1, 9M19020 - APFF 1997 TABLE RONDE

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.

FEDERAL ROUND TABLE ON TAXATION

1997 APFF CONFERENCE

INDEX

1.1 ..................................................4
1.2 ..................................................6
1.3 ..................................................8
1.4 ..................................................9
2.1 ..................................................10
2.2 ..................................................12
2.3 ..................................................14
2.4 ..................................................15
2.5 ..................................................18
2.6 ..................................................19
2.7 ..................................................20
2.8 ..................................................22
2.9 ..................................................23
2.10 ..................................................24
3.1 ..................................................25
3.2 ..................................................26
3.3 ..................................................28
3.4 ..................................................30
3.5 ..................................................32
3.6 ..................................................34
3.7 ..................................................35
4.1 ..................................................36
5.1 ..................................................39
5.2 ..................................................Withdrawn
5.3 ..................................................40
5.4 ..................................................41
5.5 ..................................................42

1. USE OF TAX ATTRIBUTES WITHIN A GROUP OF COMPANIES

In 1985, the Department of Finance tabled a White Paper on establishing a system to allow group filing. Many industrialized countries have adopted a tax consolidation system allowing the use of tax attributes within groups of companies. More than 10 years later, Canada still has not adopted this group filing system, and this has prompted taxpayers to use strategies for the internal consolidation of tax attributes. Most of these strategies have no business justification, other than a tax-related one, and the costs associated with implementing them are often very high. Further, numerous legislative changes, developments in case law and the adoption of new administrative positions have resulted in technical difficulties that are specific to certain strategies. The questions that follow have been designed to clarify the position of the Department of Finance and the Department of Revenue with respect to operations that allow transfers from one Canadian corporation to another profitable Canadian corporation in the same group of unused tax losses or deductions.

Question 1.1

Transfers Between Related or Affiliated Companies

At the 1996 conference of the Canadian Tax Foundation, the Department of Revenue announced that henceforth it would allow transfers of tax deductions between Canadian corporations that are affiliated with one another, as opposed to related, following the introduction of the concept of affiliated persons in a number of avoidance measures, including primarily subsection 69(11). However, provisions favoring the transfer of tax deductions between Canadian corporations continue to use the concept of related persons, and this is the case in new paragraph 55(3)(a) and paragraphs 55(3.1)(c) and (d), among others.

(i) Does the Department of Revenue hold to its position announced last year, namely that the transfer of deductions can only occur between affiliated corporations?

(ii) Does the Department of Finance intend to introduce the concept of affiliated persons in the other tax provisions favoring the transfer of tax deductions, such as new paragraph 55(3)(a) and paragraphs 55(3.1)(c) and (d)?

Response from the Department of Revenue

The Department's comments made at the 1996 conference of the Canadian Tax Foundation which were repeated more recently in Technical News No. 9, dated February 10, 1997, still reflect the Department's position.

The Department will continue to use the concept of "related person" in the provisions that use this term.

Response from the Department of Finance

The Department does not plan for the time being to make any such changes to paragraphs 55(3)(a) or 55(3.1)(c) and (d) of the Income Tax Act. However, it should be noted that the concept of "affiliated person" in section 251.1 is new (it will apply retroactively to April 26, 1995 once it has been passed) and it will be used as a test or standard regarding the realization of losses on certain transfers of property. From the taxpayer's viewpoint, this new test will sometimes be beneficial (primarily in cases involving the realization of apparent losses between brothers) and sometimes not (limit to the size of the group of related persons that can take advantage of a deferral under subsection 69(11)).

Much more than uniformity in standards and control measures provided in the Act, the Department of Finance is seeking instead to set standards or controls that can be adapted to the many and varied situations in which taxpayer business operations can take place. The concept of affiliated person attempts to more narrowly target the economic unit - the taxpayer, his spouse, companies (and partnerships) they control - in order to place more appropriate restrictions on transfers of losses or facilitate the realization of these losses by the appropriate economic unit. If experience with the affiliated person test makes it easier to better target operations and more closely achieve our objectives and if it proves simpler to monitor or apply, this test could make its appearance in other provisions which would otherwise be deemed deficient. Finally, it should be noted that at any rate the concept of unrelated person for purposes of section 55 is strangely reminiscent of the new concept of affiliated person if one considers that it includes brothers and sisters and excludes partnerships where not all members are unrelated.

1.2 Impact of Hickman on Transfers of Depreciable Property

Some strategies involve the realization of gains through the transfer of a depreciable asset from one corporation to another corporation within the same group, followed by another transfer of the depreciable asset or an amalgamation of the transferor and the transferee. In order for these operations to achieve the desired result, the depreciable asset must have been disposed of, and this implies a change in the effective ownership of the property. Normally, these strategies do not achieve the desired result, except when the asset constitutes depreciable property for the transferee (which allows it to claim the Capital Cost Allowance (CCA) or allows the application of certain CCA transfer rules, which are set out in sections 1100 to 1102 of the Income Tax Regulations ("the Regulations")). In order for the asset to constitute depreciable property for the transferee, the transferee must, pursuant to paragraph 1102(l)(c) of the Regulations, acquire it for the purpose of gaining or producing income. In the Supreme Court of Canada decision in Hickman Motors Limited v. Her Majesty the Queen, 97 DTC 5363, Madam Justice Claire L'Heureux-Dubé provided an analysis of the concept of "for the purposes of producing income".

In her analysis, Madam Justice L'Heureux-Dubé stated that the word "income" is susceptible of two meanings: "gross income" (revenue) or "net income" (profit). She states that while an item of property may produce revenue, it does not necessarily produce profit by itself, and it would be absurd to demand that each individual item of property actually yield a profit. Madam Justice L'Heureux-Dubé noted that the depreciable property of the subsidiary acquired by the parent, in this case Hickman Motors, had produced revenue during the few days in which Hickman Motors owned it and that this fact was sufficient to conclude that it had been acquired for the purpose of earning or producing income. According to Madam Justice L'Heureux-Dubé, it is only if an item of property does not produce income that there are grounds for asking whether it had been acquired for the purpose of producing income.

(i) What weight does the Department of Revenue plan to give to the words of Madam Justice L'Heureux-Dubé when it comes to determining the purpose test and what meaning does it intend to give to the words "for the purpose of earning income" and what criteria will the Department apply to a loss consolidation strategy that involves the transfer of depreciable property with respect to the period in which the transferee must own the property, in light of the decision handed down in Hickman?

(ii) Does the Department of Finance intend to clarify any tax provisions as a result of the divergent comments made by the judges in Hickman?

Response from the Department of Revenue

In Hickman Motors, Madam Justice McLachlin, on behalf of three of the four judges comprising the majority of the Supreme Court, preferred to decide the appeal differently from Madam Justice L'Heureux-Dubé, though she concurred in her colleague's conclusion.

By the operation of subsection 1102(14) of the Income Tax Regulations (hereinafter "the Regulations"), the assets in question were deemed, on the winding-up, to have been acquired for the purpose of producing income. Since Hickman Motors was carrying on a business and the majority of the judges were of the view that the new assets acquired by Hickman Motors as a result of the winding-up of its subsidiary were related to the same business, these assets had therefore continued to be held for the purpose of producing income, thereby avoiding the operation of paragraphs 1102(1)(c) of the Regulations and 13(7)(a) of the Act. This conclusion was further supported by Madam Justice L'Heureux-Dubé's comments, in which she demonstrated that the new assets had generated revenue, however small.

The ruling that the new assets acquired by Hickman Motors were part of the assets of its ordinary business is primordial, and opinion on the facts on which this ruling rests may be divided. This is supported by the fact that the three dissenting judges concluded that the facts showed that the new assets acquired by Hickman Motors were not related to its ordinary business.

The Act does not specify a minimum period of time that assets must be held in order for the conditions set out in paragraph 20(1)(a) to be met when there is a business. Thus, a business can acquire an asset on the last day of a fiscal year and still qualify for a capital cost allowance deduction. The only limit applicable in these circumstances is the half-year rule.

A loss utilization scheme that requires that a depreciable asset be transferred from one corporation to another within the same group, followed by a transfer of the asset back to the original transferor or to another corporation within the same group, will not necessarily be non-applicable if the asset is held for only a short period of time. In these circumstances, whether the transferee is carrying on a business must first be determined. In order for there to be a business, there must at least be a reasonable expectation of profit if there is no profit. When this condition is met and the asset is used in the business, which is a question of fact, then the asset is held for the purpose of earning income. Consequently, when such a scheme involves the use of a corporation whose sole activity is to temporarily hold property and transfer it soon after to another corporation within the same group or back to the transferor, we are of the view that the transferee is not carrying on a business and that it cannot claim a deduction under paragraph 20(1)(a) in respect of the said property.

Response from the Department of Finance

The Department of Finance still considers that section 20 of the Act provides that, in order to obtain a Capital Cost Allowance, depreciable property must be used in the business. In this case, the majority of the Supreme Court found that the appellant's business included a rental component and that the rental of heavy equipment was closely enough related to the rental of automobiles and trucks for it to be an integral part of the appellant's business. The Court seems to have accepted that rental and sales activities, including the rental of heavy equipment, constituted a whole. Therefore, the conditions in paragraph 20(1)(a), notably those that require that assets acquired be used in the business, have been met to the Court's satisfaction. The Court also pointed out that the use of the depreciable property did not change and that the fact that the assets continue to produce income would serve to confirm that the use had not changed.

The Department is therefore of the view that the existing rules concerning paragraph 20(1)(a) are preserved, but it still intends to monitor developments in this area very closely.

1.3 The Impact of Mark Resources, Canwest and Hickman on the Transfer of an Interest Outlay

Strategies for the use of losses frequently involve one corporation borrowing money from another corporation or group. (See Advance Tax Ruling ATR-44 or example 5 in the Supplement to Information Circular 88-2). As seen by the ruling handed down in Mark Resources and Canwest, it is obvious in situations similar to this that the money borrowed did not meet the criteria set out in paragraph 20(1)(c) that it be used to earn income, when the principal financial goal of the loan was to allow the use of losses by the companies in the group. Since the ruling in Mark Resources will not be heard before the Federal Court of Appeal, does the Department of Revenue intend to hold to the position set out in ruling ATR-44 and Information Circular 88-2? What weight does the Department of Revenue intend to place on the words of Madam Justice L'Heureux-Dubé when it comes to determining the "purpose test" (for purposes of earning income) or, for example, for purposes of applying paragraph 20(1)(c), for purposes of determining whether money has been borrowed and used for the purpose of earning income? Will the ruling in Hickman affect the interpretation that is given to the concept of action taken with a view to earning income and, primarily, the interpretation given to it by Justice Bowman in Mark Resources Inc. which gives the "purpose test" a much broader meaning which requires that the taxpayer's ultimate economic goal be considered.

Response from the Department of Revenue

As you note, the principles set out in Mark Resources Inc. were affirmed in Canwest Broadcasting Ltd. The latter is now final, since the taxpayer has withdrawn its appeal to the Federal Court of Appeal.

In similar situations of fact, the Department is maintaining its position as set out in Advance Tax Ruling ATR-44 and Information Circular 88-2 with respect to the use of loss utilization schemes involving related Canadian companies. However, this position will be reviewed in light of any subsequent decision, based on the comments in Mark Resources Inc. and Canwest Broadcasting Ltd., handed down by a higher court. Any change in the Department's position will be announced in the Income Tax Technical News.

The decision in Hickman Motors Limited pertains to capital cost allowance and carrying on a business. As we pointed out in response to Question 1.2, whether there is a business must first be determined. In order for there to be a business, there must at least be a reasonable expectation of profit if there is no profit. When this condition is met, and an asset is used or an expense is incurred in the business, including an interest expense, which is a question of fact, then the asset is used or the expense incurred for the purpose of earning income.

1.4 Introduction of a Group Filing System

It appears that the subject of transferring deductions within a group is being considered by the Mintz Committee.

(i) Does the Department of Finance intend to introduce a group filing system to facilitate the transfer of deductions between companies within the same group?

(ii) If so, will the system be adopted even though the provinces decline to participate?

(iii) If a group filing system is adopted, does the Department of Finance intend to allow this tax consolidation for Canadian corporations that are affiliated with one another, corporations that are related, or does it intend to introduce a new concept for this purpose?

Response from the Department of Finance

(i), (ii) and (iii): It is much too soon to speculate on whether or not the Department of Finance intends to further facilitate the transfer of deductions between corporations within the same group by bringing in a group filing system. We will first have to wait and see what the Technical Committee on Business Taxation (Mintz Committee) has to say on the subject. The committee's report is expected by the end of the year. It is impossible to predict at this stage whether the committee will make specific recommendations along the lines that you are suggesting, and even less so whether the federal government and the provinces will act together or in different directions in light of these recommendations. As for the concept that will form the basis of a standard (i.e. related or affiliated or something else) in the development of such rules, if there are any, our response to your question 1.1 above shows that the Department feels that the use of the concept of affiliated person sometimes makes it possible to more closely target the appropriate economic unit, when it comes to dealing with loss transfers.

2. CORPORATE REORGANIZATIONS

2.1 New Subsection 69(11)

It has been proposed that subsection 69(11) of the Act will be amended to, among other things, prevent a disposition as part of a series of transactions or events from being carried out for proceeds of disposition that are less than fair market value in cases where one of the main purposes of the series is to obtain the exemption that is available to any person (from tax payable) under the Act on a subsequent disposition of the property. What is the position of the Department of Revenue for each of the following situations with respect to the application of subsection 69(11) as proposed in Bill C-69?

(1) Profitco owns a target asset and all the shares in a corporation ("Lossco") which has a non-capital loss. Profitco transfers the target assets to Lossco by means of a roll-over for the sole purpose of taking advantage of its loss to eliminate the income from a subsequent disposition of the target asset.

(2) Mr. Individual owns an active business. Individual transfers all of the assets he uses in his business to a new corporation ("Newco"), in exchange for shares in Newco. Immediately after this transfer, Individual disposes of his Newco shares and uses his capital gains deduction to eliminate any tax payable. The sole purpose of incorporating the business was to take advantage of the capital gains deduction on a subsequent disposition.

Response from the Department of Revenue

For purposes of our response, we have assumed that the proposed amendments to subsection 69(11) of the Act and new section 251.1 contained in Bill C-69 will be taken up in a future bill and passed.

The Department is of the view that subsection 69(11), as it was proposed, would not be applicable to the two situations described in the question.

Proposed paragraph 69(11)(a) provided an exception when a taxpayer carries out a series of transactions to take advantage of the tax benefits of an affiliated person. In the case of situation No.(1), Profitco and Lossco are affiliated by virtue of proposed subparagraph 251.1(1)(b)(i). With respect to situation No. (2), Individual is affiliated with himself by virtue of subsection 251.1(4).

The Department is of the view that paragraph 69(11)(b) that was proposed would not be applicable to the deduction of a non-capital loss or a capital gains deduction in computing income or taxable income. This provision would only apply if one of the primary purposes of the series of transactions was to take advantage of a person's exempt status; the use of a loss or the capital gains deduction of a person has nothing to do with the person's exempt status, as provided in section 149 of the Act, for example.

2.2 Dividend Recipient, Where Are You?

Mco owns all the shares in another company, Subco. Subco operates two divisions, A and B. Mco wants to restructure Subco so that the new A division will be operated by a new corporation ("Newco"), all the shares of which will be held by Mco. The following are the steps in restructuring:

(i) Mco incorporates Newco under the Canada Business Corporations Act ("CBCA"). Mco subscribes to shares in Newco for a nominal amount.

(ii) Mco transfers to Newco an appropriate number of the shares in Subco representing the fair market value of A division in exchange for common shares of Newco.

(iii) Subco transfers its A division to Newco in consideration for preferred shares in Newco.

(iv) The crossed shareholdings of Subco and Newco are redeemed, and this results in deemed dividends.

The dividend resulting from the redemption of the Subco shares held by Newco would be subject to subsection 55(2) because the criterion set out in subparagraph 55(3)(a)(ii) as it has been proposed would not be met. In stage (i) above, Mco substantially increased its interest in Newco (the recipient of a dividend) and Mco was an unrelated person immediately prior to this point. Does the Department of Revenue agree with this position? Does the Department of Finance plan to bring in any amendments to correct this situation?

In an attempt to mitigate this problem, Mco will place itself in the position of founder of Newco for purposes of the CBCA and Newco will not issue any shares upon incorporation. The first issue of Newco shares will take place in stage (ii), that is these shares will be issued to Mco in consideration of the acquisition of shares in Subco. Therefore, upon the increase in the total direct interest of Mco in Newco, Mco is a person who is related to the recipient of the Newco dividends immediately prior to this point, and the condition set out in subparagraph 55(3)(a)(ii) is met. The reasoning behind this position is section 106 of the CBCA, which requires that the incorporator (Mco) send to the Director a notice of directors at the time of sending the articles of incorporation and that these directors shall act as nominees until the first meeting of shareholders. In this context, it can be maintained that Mco (the incorporator of Newco) controls Newco before the first issue of Newco shares and, where applicable, the condition set out in subparagraph 55(3)(a)(ii) is met. Does the Department of Revenue agree with this position?

Response from the Department of Revenue

For purposes of our response, we have assumed that the proposed amendments to paragraph 55(3)(a) contained in Bill C-69 will be taken up in a future bill and passed.

With respect to the first situation, the Department would generally not consider that the issue of shares at stage (i) above in a situation of this type would be an event to which subparagraph 55(3)(a)(ii) of the Act applies.

In the second situation presented, the Department agrees that Mco is related to Newco immediately prior to the issue of the shares. Consequently, the event mentioned in subparagraph 55(3)(a)(ii) is not present, and subsection 55(2) would not be applicable.

Response from the Department of Finance

The Department of Finance does not intend to recommend any changes with respect to this aspect of subparagraph 55(3)(a)(ii). From a tax policy standpoint, when Newco was incorporated the parent, Mco, was already acting as a "guiding spirit" behind Newco. The Newco shares, when issued to Mco, are issued to a person who could be considered related to Newco. Therefore, for purposes of subsection 55 (3)(a)(ii), since the parent is not an unrelated person immediately prior to the issuance of the Newco shares, the substantial increase in its interest is not covered by the subparagraph, and therefore is not of a nature that is likely to trigger the application of section 55(2). Assuming that subparagraph 55 (3)(a)(ii) is passed, we trust that Revenue Canada will apply it thusly.

Question 2.3

Grouping of Losses

Parentco owns 100% of the shares in Lossco and 65% of the shares in Profitco. The remaining 35% of the shares in Profitco is widely held ("other shareholders") and the other shareholders are not related to Parentco. All the outstanding shares in Lossco and Profitco are common shares. Parentco transfers all its shares in Lossco to Profitco by means of a roll-over in exchange for preferred shares in Profitco. Lossco is wound up into Profitco. Finally, Profitco redeems its preferred shares held by Parentco. Is the Department of Revenue of the view that the deemed dividend upon the redemption of the preferred shares of Profitco held by Parentco is subject to subsection 55(2) of the Act?

Response from the Department of Revenue

For purposes of our response, we have assumed that the proposed amendments to section 55 contained in Bill C-69 will be taken up in a future bill and passed.

Subsection 55(2) is applicable if, as provided under proposed subparagraph 55(3)(a)(ii), there is a significant increase (apart from any increase resulting from a disposition of shares in the capital stock of a corporation for proceeds of disposition equal to or greater than their fair market value) in the total direct interest in a corporation of one or more persons who were unrelated persons immediately prior to the significant increase. Proposed paragraph 55(3.01)(a) provides that an unrelated person includes a person (other than the dividend recipient) to whom the dividend recipient is not related.

Since the others are not related to Parentco, the Department is of the view that there is an increase in the total direct interest of unrelated persons in Profitco upon the redemption of the preferred shares. The issue of whether or not there is a significant increase depends on the fair market value of the common and preferred shares outstanding immediately prior to the redemption of the preferred shares.

Question 2.4

Bump-Up of the ACB under paragraph 88(1)(c) - Myth or Reality?

Subparagraph 88(1)(c)(vi) (as amended by the June 20, 1996 proposed amendments) eliminates the bump-up of a property distributed to a parent on the winding up of the subsidiary if, as part of the series of transactions or events that includes the winding-up, the parent acquired control of the subsidiary and one or more persons described in sub-provisions 88(1)(c)(vi)(B)(I), (II) or (III) (subsequently referred to as "restricted person") acquired a property (subsequently referred to as "restricted property") that is a property distributed to the parent upon the winding-up or a property that replaces such property. Paragraph 88(1)(c.3) describes the property that is considered the replacement property for purposes of subparagraph 88(1)(c)(vi). The restricted persons described in 88(1)(c)(vi)(B)(I),(II) or (III) include persons who were specified shareholders of the subsidiary before control of the subsidiary was acquired by the parent.

Normally, a bump-up of a property should be disallowed only when the restricted person acquires a restricted property on or after the date the parent acquired control of the subsidiary. However the bump-up may be disallowed under certain circumstances even if the acquisition was made before the parent acquired control of the subsidiary. Below are three situations that illustrate this statement.

Example 1

SMco owns shares in Targetco and Lossco. Targetco owns a property which Buyco, an unrelated person, intends to purchase. Before proceeding with the sale of shares in Targetco, SMco transferred its shares in Targetco to Lossco using a roll-over and then Lossco will dispose of the shares in Targetco to Buyco. Finally, Targetco will be wound up into Buyco because Buyco wants to obtain a bump-up in the cost of the property owned by Targetco.

Under subparagraph 88(1)(c)(vi) and paragraph 88(1)(c.3), the bump-up in the cost of the property sought by Buyco does not work for the following reasons:

(i) Lossco was a specified shareholder in Targetco before Buyco acquired control of Targetco; and

(ii) Lossco acquired the shares of Targetco, which constitute a property described in subparagraph 88(1)(c.3)(i) (a property, the fair market value of which is wholly or partially attributable to the particular property distributed to Parentco on the winding-up).

Example 2

Holdco owns 20% of the shares in Pubco, a publicly held corporation. Holdco proposes to sell all its shares in Pubco to Buyco, a non-arm's length corporation. Before proceeding with the sale, Holdco transfers its Pubco shares to Newco, a new corporation, increases the paid-in capital and the adjusted cost base of the Newco shares by an amount equal to the protected income that Holdco has in Pubco and, finally, disposes of its Newco shares to Buyco. Newco is wound up into Buyco. Buyco wishes to obtain a bump-up in the cost of the Pubco shares held by Newco. However, this will not work for the following reasons:

(i) Holdco was a specified shareholder in Newco before Buyco acquired control of Newco; and

(ii) Holdco acquired the shares of Newco, which constitute property that has been substituted for the property distributed to Buyco on the winding-up, as described in division 88(1)(c)(vi)(B) (the presumption contained in paragraph 88(1)(c.3) is not necessary in this case).

Example 3

Holdco owns 100% of the shares in Targetco. Targetco operates businesses A and B. Buyco wishes to acquire all the shares in Targetco. Buyco is to remain owner of business A and will dispose of business B to a third party. In order to accommodate Buyco, Targetco incorporates businesses A and B following a roll-over to two new corporations named Aco and Bco, respectively. Buyco will acquire the shares of Targetco, wind-up Targetco to obtain a bump-up in the cost of the shares of Aco and Bco, and dispose of the shares of Bco to a third party. However, the bump-up does not work for the following reasons:

(i) Targetco was a specified shareholder in Targetco before Buyco acquired control of Targetco and will not be a specified person within the meaning of subparagraph 88(1)(c.2)(i). Technically, Targetco is a specified shareholder in Targetco because, for purposes of the definition of specified shareholder found in subsection 248(1), Targetco is deemed to own the shares in the
capital stock of a corporation belonging at that time to a person having a non-arm's length relationship with it. Since Targetco was related to Holdco, Targetco was therefore deemed to own the shares in Targetco that were owned by Holdco; and

(ii) Targetco acquired the shares of Aco and Bco, which constitute a property distributed to Buyco on the winding-up as described in division 88(1)(c)(vi)(B) (the presumption in paragraph 88(1)(c.3) is not necessary in this case).

Does the Department of Revenue agree that the bump-up in the cost of a property under paragraph 88(1)(c) does not apply in each of the three situations described above? Does the Department of Finance intend to bring in any amendments to correct these situations ?

Response from the Department of Revenue

We agree with the interpretation that you have given.

Response from the Department of Finance

The Department of Finance does indeed intend to recommend changes to paragraph 88(1)(c.3) that would correct the problems noted in the three examples given, such that the contraventions described do not in themselves constitute barriers to the bump-up of property distributed to a parent on the winding-up of the subsidiary. These amendments, provided they are accepted, could be made in the draft legislation that should be tabled later this year and would be tied to the same coming-into-force terms and conditions as are contemplated for paragraph 88(1)(c.3).

Question 2.5

Freezes Following a Drop in Value

We understand that the Department of Revenue has had the position for several years that it would not agree to a refreeze following a drop in value that occurred after an initial freeze, and the reason given has been that a benefit was conferred on the common shareholders by the shareholder who held the shares that had been frozen. According to recent technical interpretations (5-922990 and 5-960763), it appears that this position has been modified.

Can the Department of Revenue tell us what this new position is and more particularly the terms and conditions that must be met for a refreeze following a drop in value such that a benefit is not considered as having been conferred on the common shareholders?

Response from the Department of Revenue

The Department had stated in response to Question No. 53 from the 1985 Round Table of the Canadian Tax Foundation that it would normally consider that a benefit had been conferred on the holders of common shares on a refreeze. This position has been modified recently.

The Department will not normally consider that a benefit has been conferred upon common shareholders under this type of transaction where preferred shares were initially issued as part of an estate freeze or a freeze to benefit key employees, provided that the reduction in the fair market value of the preferred shares has not been caused by a stripping of the assets of the corporation and the fair market value of new preferred shares corresponds to the fair market value of the preferred shares that would be covered by the refreeze.

Question 2.6

Unfreezing Following an Increase in Value

A number of years after carrying out an estate freeze, an individual will frequently discover that his children who are the beneficiaries of the freeze are worth much more than he intended, or that his own personal worth is too greatly reduced, or that some of his children are worth more than others. In these cases, it is normal to consider either unfreezing the value of the individual or freezing the value of the children who benefited from the initial freeze. These transactions take the form of an exchange of the participating shares held by the children who were beneficiaries of the initial freeze, for preferred shares, followed by the issuance of new common shares to the persons involved, that is, the individual, certain of his children or a new family trust.

Is this type of transaction acceptable to the Department of Revenue, primarily with respect to the various special anti-avoidance provisions (sections 15, 56, etc.) or general provisions of the Income Tax Act, and under what conditions?

Response from the Department of Revenue

The question is a general one and we cannot make a definitive pronouncement on the application of the anti-avoidance provisions referred to. However, we do not see any reason why we would be inclined to invoke subsections 15(1) and 56(2) of section 245 because of the transactions required to carry out a reverse freeze if the taxpayers' shares that are exchanged have a fair market value equal to the frozen shares received in consideration. First, there is no benefit to a shareholder who is taxable under subsection 15(1) of the Act. Further, there are no payments or transfers of assets that could cause the application of subsection 56(2) of the Act. We note that subsection 86(1) of the Act may be applied to any shareholder of a corporation, whether it be the father, mother, son or daughter; such a freeze may be carried out in any direction.

It is obviously impossible to anticipate all possible freeze variations, and we cannot exclude the possibility that some arrangements would be affected by a given anti-avoidance provision without examining all the facts surrounding this type of transaction.

Question 2.7

Paid-up Capital and Amalgamations

Subsection 87(3) has the effect of bringing the paid-up capital of the shares in a corporation that was formed as the result of an amalgamation down to the value of the paid-up capital of the replaced corporations.

Under the provisions of subsection 87(3.1), the new corporation, when the conditions in the subsection are met, can elect to have subsection 87(3) not apply and deem each replacement class in the new corporation to be the same as the class in the replaced corporation that was exchanged and the continuation of that same class.

Subsection 87(3.1) requires that the shares issued immediately prior to the amalgamation of each class of shares in the capital stock of each corporation that has been replaced be converted into shares issued immediately after the amalgamation of another class of shares in the capital stock of the new corporation.

When a parent merges with a wholly owned subsidiary under the short-form procedure (that is, a vertical short-form amalgamation under the terms of section 123.129 of the Companies Act (Quebec) or subsection 184(1) of the Canada Business Corporations Act), the shares of the subsidiary are canceled, the shares of the parent become shares in the replaced corporation, and the shares in the replaced parent do not need to be converted into shares of the new corporation, as in the case of a normal amalgamation.

On the corporate level, this type of amalgamation does not appear to involve a conversion, cancellation or exchange of shares of the capital stock in the replaced parent for shares in the new corporation. It is indeed to take into account such situations and to qualify this type of amalgamation for purposes of section 87 that the provisions of subsection 87(1.1) deem, in the case of a vertical short-form amalgamation, the shares of the parent to be shares of the capital stock of the new corporation received as the result of a merger as consideration for the dispositions of shares in the capital stock of a replaced corporation. However, this presumption applies only for purposes of paragraph 87(1)(c) and the Income Tax Application Rules, and not for purposes of subsection 87(3.1).

Is the Department of Revenue of the view that subsection 87(3.1) can be applied to an amalgamated corporation that results from a vertical short-form amalgamation to which subsection 87(1) applies?

Response from the Department of Revenue

Yes, the Department will consider that the shares in the parent have been converted into shares of the amalgamated corporation.

Question 2.8

Acquisition of Property under subsection 87(11)

Subsection 87(11) of Bill C-69 allowed, under certain circumstances, in cases involving amalgamations of a parent with a wholly owned subsidiary, an increase in the cost of certain properties acquired by the new corporation as a result of the amalgamation. This increase was the same as the one that the parent would have been able to obtain if the subsidiary had been wound-up under subsection 88(1).

Under the corporate legislation that normally governs amalgamations of two corporations, the property owned by each of the replaced corporations prior to the amalgamation becomes property of the amalgamated corporation and is not acquired as a result of the amalgamation. This principle has been confirmed in Palmer-McLellan (United) Limited v. MNR 68 DTC 5304 (decision by the Exchequer Court of Canada).

For purposes of subsection 87(11), should a merger of a parent with its wholly owned subsidiary be considered to automatically give rise to an acquisition of the property of the wholly owned subsidiary by the parent, even when the corporate legislation governing such amalgamations does not result in the acquisition of the property owned by the replaced corporations by the amalgamated corporation?

Response of the Department of Revenue

Yes, the Department considers that the parent acquires the property of its subsidiary for purposes of subsection 87(11).

Question 2.9

Elections Regarding the Application of Subsection 87(11)

A parent amalgamates with its wholly owned subsidiary under subsection 87(11) under circumstances in which this amalgamation allows the cost of the property to be bumped up by the parent, provided the property had been distributed to it on a winding-up to which subsection 88(1) applied. Should the election required under subsection 88(1) for purposes of applying subsection 87(11) be filed with the return of income for the parent for its taxation year just ended on account of the amalgamation or in the taxation year following the amalgamation?

Response from the Department of Revenue

Proposed paragraph 87(11)(b) does not specify when the designation must be made, but we note that Bill C-69 provided, for purposes of this provision, that any designation of an amount before the end of the third month after the month in which the amending legislation is assented to would be deemed to have been made in the return of income filed under Part I for its first taxation year. Also, it seems to us that it was intended that the designation be made in the first taxation year of the amalgamated corporation. We have already pointed this out to the Department of Finance.

Question 2.10

Transfers of Protected Income

The question is based on the following example.

Two shareholders exchanged their common shares for preferred shares several years ago. At the same time, they took back a number of common shares. Later on, one sells his shares to the other at a price equal to the redemption value of the preferred shares, that is, the fair market value of the shares. No value was attached to the common shares. Since the freeze, an amount of protected income has built up on the common shares.

To avoid losing the protected income that is built up on the common shares, the preferred shares are exchanged for other common shares.

In the view of the Department of Revenue, can the taxpayer take advantage of the protected income that should follow as a result of the exchange?

Response of the Department of Revenue

WITHDRAWN

3 INTERNATIONAL TAXATION

Question 3.1

Anti-Avoidance Provision Contained in Subsection 95(6)

Canco, a Canadian corporation, owns all the shares in USco, an American corporation. Pubco, a public U.S. corporation, made an offer to Canco to acquire all its shares in USco in exchange for 10% of the shares issued in a given class of its capital stock in order to allow Canco to take advantage of the roll-over provision contained in subsection 85.1(3). Since this exchange would allow Canco to defer tax that would otherwise be payable, can paragraph 95(6)(b) be applied to eliminate the roll-over on the exchange of shares even if the anti-avoidance measure provided in subsection 85.1(4) does not apply?

Response from the Department of Revenue

Paragraph 95(6)(b) is applicable whenever it is reasonable to consider that the primary reason for acquiring the shares in the capital stock of a corporation is to allow a person to avoid, reduce or defer the payment of income taxes or any other amount that would otherwise be payable under this Act.

It is not possible to offer an opinion in a hypothetical situation in which all the facts are not known. However, we cannot exclude the possibility of applying this anti-avoidance provision in this type of situation.

Question 3.2

Tax on Emigration

An individual may be considered a resident of Canada for purposes of the Act based on the criteria listed in Interpretation Bulletin IT-221R2. However, under the provisions of the tax treaty that applies in a given situation, the individual in question may not be considered a resident of Canada. In this respect, we would point out the situation of an individual who does not have a permanent home in Canada (see paragraph 2(a) of Article IV of the Canada-U.S. Income Tax Convention).

In such cases, would the individual be considered as having ceased to reside in Canada for purposes of subsection 128.1(4) of the Income Tax Act ("the Act")?

Response from the Department of Revenue

In some situations, an individual may be a resident of Canada and of another country at the same time under the domestic legislation of each country. In such cases, if there is a tax treaty between Canada and a foreign country, the article of the treaty dealing with residency is used to determine a single country of residence for purposes of applying the treaty and thereby avoid double taxation.

However, when the provisions of a tax treaty result in a situation where an individual resident in Canada for purposes of the Act is a resident of the foreign country for purposes of the treaty, the treaty does not appear to make the individual a non-resident of Canada for purposes of the Act. Therefore, such a resident who continues to be a resident of Canada under domestic legislation may not be considered as having ceased to reside in Canada for purposes of subsection 128.1(4) of the Act.

However, this issue raises tax policy problems and has been referred to the Department of Finance for study.

Response from the Department of Finance

From a tax policy standpoint, a taxpayer who ceases to reside in Canada becomes a non-resident and should be subject to the rules which apply to changes of residence, regardless of the nature of the change. As to whether or not an individual may be both a resident of Canada under Canadian law and a non-resident of Canada under a tax treaty, let us say that this proposal deserves to be analyzed closely. Now, one may wonder if it is logical that a taxpayer would take advantage of the benefits conferred by a tax treaty on the residents of another country, such as reductions in the rate of Canadian withholding taxes, while at the same time taking advantage, as a resident of Canada, of other benefits for tax purposes. We would like to give this matter further consideration.

Question 3.3

Tax on Emigration

According to different sources, the Department of Revenue would allow an individual who ceases to reside in Canada under the terms of subsection 128.1(4) and who, as a result, is deemed to have disposed of his shares in a corporation that is a private corporation and a Canadian corporation within the meaning of subsection 89(1) of the Act ("private Canadian corporation"), to put up the said shares as security to satisfy the requirements of sub-paragraph 128.1(4)(b)(iv) of the Act.

Could the Department of Revenue describe for us the administrative policies that it has adopted in this regard?

Response from the Department of Revenue

A taxpayer is not deemed to have disposed of property that is taxable Canadian property when he ceases to be a resident of Canada under subsection 128.1(4) as it currently exists. We assume therefore that your question relates to other proposed changes contained in a Notice of Ways and Means Motion intended to amend the Act, tabled by the Minister of Finance on October 2, 1996.

The Department will normally agree to allow an individual to furnish the shares in a private corporation that is a Canadian corporation as security for the payment of tax that he owes as the result of a deemed disposition of shares when he ceases to be resident in Canada. However, acceptance of this type of security will be subject to reasonable precautions designed to ensure that the fair market value of the shares will not be reduced by asset stripping or by dilution. Therefore, each request will be examined on a case-by-case basis. There may be situations in which the Department will require other forms of security in place of the shares or in addition to the shares.

Please note that this is a preliminary position based on the fact that the proposed measures have not yet been included in draft legislation. The Department's position could change once proposed legislation is tabled.

Response from the Department of Finance

We can confirm that the draft bill on migrations will include the required authorizations to enable Revenue Canada to exercise appropriate discretion with regard to security.

3.4 Partnerships and foreign affiliates

The use of partnerships has become increasingly common in international structures involving a number of partners. If the shares in a foreign affiliate are held through a partnership, it appears that the Department of Revenue's position is that since the shares are held by a partnership, a "corporate" partner in a partnership cannot consider that it holds shares in a foreign affiliate. Therefore, the surplus accounts of the foreign affiliate are not available to the "corporate" partner. According to a number of recent articles, the Department of Finance is planning legislative measures to change this situation. Does the Department of Finance intend to bring forward amendments to the Act in order to achieve this?

Response from the Department of Finance

The Department of Finance intends to recommend to the Minister of Finance that he bring in a number of technical amendments to the Income Tax Act and Regulations with respect to the shares in foreign corporations held by partnerships. These amendments would mean that, under the appropriate circumstances, dividends paid by the foreign corporation to the partnership then distributed by the partnership to a Canadian corporation are deductible under the terms of section 113.

In computing the surplus accounts of a foreign corporation held by a partnership, each partner in the partnership would be deemed, under the proposed amendments, to have owned a proportion of the shares in the non-resident corporation equal to his share of the income of the partnership. These accounts would be determined from the date the corporation last became the foreign affiliate of a taxpayer.

For purposes of section 113 of the Act, in cases where a partnership receives a dividend from a foreign corporation, each of the partners would be deemed, under the proposed changes, to have received a proportion of the dividend equal to that proportion of the partnership's income to which he is entitled. Therefore, after the date the amendments are published, dividends received on the shares of the foreign affiliate of a taxpayer held by a partnership would qualify for the deduction under section 113 of the Act.

If a taxpayer or one of its foreign affiliates disposes of its interest in the partnership, or the partnership disposes of shares in the taxpayer's foreign affiliate, the proposed amendments would allow the taxpayer to designate a portion of the proceeds as a dividend received from the affiliate. The amount that can be designated will be subject to provisions similar to those set out in subsection 93(1) of the Act.

Question 3.5

Corporation Resident in a Country for Purposes of a Tax Treaty

We understand that the Department of Revenue is currently reviewing the situation regarding certain foreign corporations in light of Crown Forest Industries Limited [1995] 2 CTC 64 (SCC). Among other things, it would appear that companies that are taking advantage of the Labuan Island tax system -- "exempt insurance companies" ("EIC") that have received a license under the Barbados Exempt Insurance Act and "societies with restricted liability" ("SRL") incorporated under the Barbados Societies with Restricted Liability Act -- would not be considered corporations residing in the foreign country for purposes of the tax treaty between Canada and the foreign country. Could the Department indicate to us whether or not it has taken a definitive position regarding these types of entities and whether other types of entities are currently being looked at?

Response from the Department of Revenue

The Department has long been of the view that for a corporation to be considered residing in a foreign country under the criteria set out in paragraph 1 of Article IV of a tax treaty, the corporation must be subject to the most exhaustive form of taxation (in terms of liability of world income) that the foreign country is able to impose on a corporation under the laws of that country. The Department considers that the Supreme Court decision in Crown Forest supports the Department's existing position rather than a change in position. Therefore, a review of the status of certain foreign corporations for tax treaty purposes will not result from the Crown Forest decision.

For purposes of proposed Income Tax Regulation 5907(11.2)(c), the Department has examined whether:

(1) an EIC

(2) a corporation considered an "Enclave Enterprise" ("EE") under the Barbados Fiscal Incentives Act, 1978, and

(3) a corporation that is not incorporated under the law of Barbados which has a branch in Barbados that qualifies as an International Business Company ("IBC") under the International Business Companies Act ("IBC Act"),

would be corporations resident in Barbados under the Canada-Barbados Tax Convention without regard for paragraph 3 of Article XXX of that convention.

The Department took the position in 1996 that an EIC would not be a resident of Barbados because the taxes payable by an EIC are negligible and do not represent the most exhaustive form of taxation that Barbados can impose on a corporation.

An EE is a corporation that benefits under certain conditions from a 10-year tax holiday. The Department found in 1997 that the fact that an EE is receiving a tax holiday does not prevent it from qualifying as a resident of Barbados if it is otherwise fully taxable on its world income. However, the Department is of the view that an EE would not be a resident of Barbados for purposes of the Canada-Barbados Tax Convention if, under the provisions of another Barbados tax system (such as the IBC Act), the corporation would not be liable for tax on its world income, were it not for a tax holiday, or after the tax holiday.

Under the IBC Act, a corporation that is not incorporated under the laws of Barbados and which has a branch that qualifies as an IBC, is liable for Barbados tax only with respect to the income attributable to its Barbados branch. The Department is of the view that such a corporation would not be a resident of Barbados for purposes of the tax convention because it is not liable for tax on its world income.

The Department has not made a specific ruling on the status of Labuan Island. The status of SRLs is currently under review. The Department is not currently reviewing the status of any other entity.

Finally, we wish to state that the issue of whether a corporation is resident of a foreign country for purposes of a tax treaty is a question of law and of fact which depends primarily on the tax laws of the foreign country, and the status of a corporation can change when those laws are amended.

Question 3.6

Exchange of Shares in a Foreign Affiliate

Within the domestic context, subsection 85(1) of the Act can apply to internal roll-overs, that is when a Canadian corporation issues shares in consideration for the acquisition of its own shares. It seems to us that similar reasoning should apply to an analogous transaction involving shares held by a Canadian taxpayer in a foreign affiliate as a result of the application of the provisions contained in subsection 85.1(3) of the Act.

Could the Department of Revenue inform us as to its opinion on this position?

Response from the Department of Revenue

Assuming that a corporation is able to legally acquire its own shares, the transaction otherwise complies with all the conditions set out in subsection 85.1(3) of the Act and the transaction is not excluded under subsection 85.1(4), we are of the view that subsection 85.1(3) could apply to internal roll-overs.

3.7 Hong Kong: Tax Convention with China

Could the Department of Finance indicate to us whether the Tax Convention between Canada and China applies to Hong Kong following unification?

Response from the Department of Finance

The tax treaty between Canada and China will not apply to Hong Kong despite unification, because under the terms of the unification agreement, it was agreed that Hong Kong would maintain its tax system, and therefore Chinese tax law would not apply to Hong Kong. As you may perhaps know, Canada did not have a tax convention with Hong Kong.

4. TAX COMPLIANCE

4.1 Restructuring of the Processing of Corporation Tax Returns

In a press release issued this past summer, the Department of Revenue announced a major change in the way corporation returns would be processed. This change involves such things as:

( a new return of income and new schedules;

( the presentation of financial data based on a predetermined accounting system, the new General Index of Financial Information (GIFI);

( planned implementation by April 1998;

( the possibility of filing electronically.

Therefore, most corporations that have a year-end of December 31 will be affected by this restructuring for the current year.

Many tax experts and practitioners working in business feel that the compliance and implementation costs relating to this restructuring will be high. Also, it seems to us that the time allowed businesses and their consultants to change their accounting systems is very short. Finally, the Department claims that the data required for the GIFI are available from existing financial statements. We know from experience that the data required for the GIFI are much more detailed than the information required under financial statement presentation standards based on generally accepted accounting principles.

Could the Department of Revenue provide us with the following information:

1. According to the GIFI model currently being circulated, a corporation is required to supply only those items that appear in their financial statements. Therefore, if information is not disclosed in financial statements drawn up in accordance with the standards of presentation of the Canadian Institute of Chartered Accountants, does this mean that they will not have to be included in the GIFI? In cases where the financial statements are not presented according to these standards, will the information required for the GIFI be limited to the information presented in the financial statements?

2. Is it still expected that the GIFI will come into effect in April 1998?

3. What measures have been planned to safeguard the financial information that is transmitted through Electronic Data Interchange?

4. Have returns processing software suppliers been given the information they need to modify their software and validate the new software by the planned effective date?

Response from the Department of Revenue

1. The GIFI is a tool that has been designed to gather financial statement information based on a predetermined accounting system. The information that is currently presented on financial statements will be reported in the same fashion, except that the heading names will be replaced by codes. The use of the GIFI will not require corporations to report more financial information than they are now reporting. In any case, only those items that appear in the financial statements will have to be reported.

2. No. After reviewing the system's requirements, we can state that implementation of the GIFI cannot take place before the end of October 1998. At that point, corporations that elect to use our new corporate E-file option will have to use the GIFI. Also, software developers will incorporate the GIFI into their packages to encourage the use of the GIFI for computer-produced returns. This formula will not be mandatory for all filers until at least one year after that date.

3. All tax data that are transmitted will have to be encrypted. An encryption module will be included in the corporate E-file software. Revenue Canada will not accept unencrypted tax data.

4. The software developers are important players in the T2 processing redesign process. They have all the required information and specifications and we will continue to keep them up to date on the latest developments.

Question 5.1

Corporations That are Connected for Purposes of Part IV Tax

According to subsection 186(4), corporations are connected if a value and voting rights test is met. The question deals with the wording regarding the voting test in sub-paragraph 186(4)(b)(i).

The sub-paragraph refers to more than 10% of the issued share capital having full voting rights. It appears to refer to 10% of the number of shares rather than 10% of the votes.

We are of the view that this test is aimed at votes rather than the simple calculation of the number of shares. Does the Department of Revenue agree with this position?

Response from the Department of Revenue

We are of the view that this subsection refers to a calculation of the number of shares having full voting rights under all circumstances. Take the example where Corporation A holds one share in a class of the payer corporation which entitles the holder to ten votes and Corporation B holds ten shares in a class of the payer corporation, where each share has one vote. Corporation A would not meet the sub-paragraph 186(4)(b)(i) test because it holds only one out of the 11 voting shares. The subsection 186(2) test would be interpreted in a similar fashion.

Question 5.3

The Concept of Control in Light of Duha Printers

The concept of control is based on control in right and not control in fact. The courts have stated that it is the right to elect a majority of the members of the board of directors that provides control.

The decision in Duha Printers 96 DTC 6323 seems to broaden that concept to an analysis of all the legal documents governing the relationship between shareholders in order to determine the identity of the controlling shareholder.

Is the Department of Revenue of the view that all legal documents, not just the articles of incorporation, need to be analyzed? Does this decision change the position of the Department of Revenue?

Response from the Department of Revenue

Justice Stone found that to the extent that the shareholder agreement was a unanimous agreement among shareholders within the meaning of the relevant corporate legislation, it should be examined along with the statutes of incorporation in order to determine legal control of the corporation. Case law has established that the statutes of incorporation must be examined in determining legal control of a corporation (MNR v. Dworkin Furs Ltd. et al. [1967] CTC 50 and Donald Applicators Ltd. et al. v. MNR [1971] CTC 402). Since an agreement of this type could affect the ability of the directors to manage both the business affairs and internal affairs of a corporation, the power of the directors to amend the statutes of incorporation may be limited or canceled. Justice Stone's approach seems to be in compliance with the case law confirming the importance of reviewing the statutes of incorporation in making this determination, but Justice Linden was of the opinion that the shareholder's agreement could be examined as part of this determination even if it was not a unanimous agreement among the shareholders within the meaning of the relevant corporate legislation. The issue of whether Justice Linden's approach would be applicable in situations other than situations involving tax avoidance remains unresolved.

No doubt, these divergent opinions will be examined by the Supreme Court, which has agreed to hear the case. The Department will await the findings of the Supreme Court before taking a definitive position on this matter.

Question 5.4

Participating Loan (JPC)

In Sherway Centre Limited v. The Queen, 96 DTC 1640, the issue was whether participating interest payable by a borrower equal to a percentage of its operating surpluses could be deducted under paragraph 20(1)(c) or 20(1)(e). In this case, the Court found that the nature of the participating interest did not constitute interest within the meaning of paragraph 20(1)(c); however, it did consider the amount to be deductible under paragraph 20(1)(e) as expenses incurred in the course of borrowing money which the taxpayer used for the purpose of earning income from a business or property. What weight does the Department of Revenue intend to give to this ruling in order to allow the deductibility of amounts which constitute participating interest under paragraph 20(1)(e)?

Response from the Department of Revenue

The Department's position with respect to the application of paragraph 20(1)(e) of the Act and participating payments is that paragraph 20(1)(e) of the Act does not allow a deduction for payments which constitute consideration for the use of the money. In our view, this position is in line with the tax policy that underlies paragraph 20(1)(e), that is, that a deduction is allowed for soft costs incurred in the course of borrowing money.

The Sherway decision was appealed by the Department before the Federal Court of Appeal. The Department feels that in this case the participating expenses essentially constitute compensation for the use of the amount borrowed and are therefore not a cost for the loan or obtaining the funds, such that 20(1)(e) of the Act would not apply to allow such expenses to be deducted. Further, the Department is of the view that these expenses constitute a distribution of profits and, accordingly, are not an expense.

The Sherway ruling is based on the decision by the Federal Court of Appeal in Yonge-Eglington Ltd., 74 DTC 6180. However that case dealt with standby fees, which do not represent a consideration for the use of borrowed money. Standby fees were payable regardless of whether or not the taxpayer actually borrowed the money and whether or not he repaid the principal.

Question 5.5

Consequences of Crystallizing a Capital Gain on Depreciable Property

An individual owns depreciable property which had a capital cost of $50,000 and a fair market value ("FMV") of $120,000. This was the only property in its class and the undepreciated capital cost ("UCC") for the class was $20,000. An election was made to report a deemed capital gain on this property under subsection 110.6(19) of the Act with respect to accumulated capital gains as at February 22, 1994, and this produced an exempt capital gain of $50,000. As a result of this election, the adjusted cost base ("ACB") of the depreciable property was increased to $100,000, that is, the FMV of the property as at February 22, 1994.

Under paragraph 13(7)(e.1), when this type of election is made on depreciable property, the elector is deemed to have a non-arm's length relationship with himself. Since the cost of the property to the individual following this election ($100,000) is greater than the capital cost of the property ($50,000) for the individual immediately before he disposed of it, subparagraph 13(7)(e)(i) applies, and this means that the capital cost of the property for purposes of the capital cost allowance is equal to the capital cost of the property ($50,000) immediately prior to the election. Further, since the amount that is added to the UCC for the class of property is equal to the amount to be deducted from the UCC for the individual (that is, the capital cost of the property), the UCC for the class is the same immediately after the deemed disposition of the property that results from the election. No recapture of depreciation is realized by the individual as a result of this election.

Following this election, the individual transfers the depreciable property to a corporation of which he is the sole shareholder ("Manco") in consideration for shares in Manco. The individual and Manco wish to effect this transfer on a tax-free basis and make the election provided under subsection 85(1). In order for the individual to avoid having to take a recapture of depreciation, the agreed-upon sum for purposes of subsection 85(1) is set at the UCC of the property, that is, $20,000. This amount becomes the proceeds of disposition for the individual and the cost of acquisition for Manco under paragraph 85(1)(a). Under such circumstances, what happens to the ACB of the depreciable property (increased to $100,000 following the subsection 110.6(19) election) for purposes of calculating the capital gain when the property is transferred to Manco?

Response from the Department of Revenue

When subsection 85(1) is applied to the transfer of depreciable property to a corporation, paragraph 85(1)(a) provides that the cost of the property is equal to the agreed-upon amount ($20,000). The ACB for purposes of calculating the capital gain is the agreed-upon amount because the adjustments provided for in subsections 13(7) and 85(5) do not apply for purposes of subdivision C of the Act.

Subsection 85(5) of the Act applies whenever subsection 85(1) is applied to the disposition of depreciable property and the capital cost of the elector's property exceeds his proceeds of disposition. Subsection 85(5) provides then, for purposes of sections 13 and 20 and the Regulations, that: (a) the capital cost of the property to the corporation is deemed to be the capital cost for the elector; (b) the amount by which the capital cost exceeds the agreed-upon amount is deemed to have been allowed to the corporation as a capital cost allowance.

Subsection 13(7) does not apply for purposes of subsection 85(5). In the present situation, the capital cost to the individual, not including the adjustments under subsection 13(7), is $100,000. This is more than the individual's proceeds of disposition of $20,000. Consequently, the deemed capital cost to the corporation under subsection 85(5) is $100,000. The deemed capital cost allowance claimed is $80,000.

Paragraph 13(7)(e) provides rules for determining the capital cost of depreciable property for purposes of section 13 and 20 and the regulations made under paragraph 20(1)(a) of the Act. Paragraph 13(7)(e) applies despite the other provisions of the Act. Sub-paragraph 13(7)(e)(i) applies when the cost of the property to the corporation, without taking paragraph 13(7)(e) into account, exceeds the capital cost of the elector's depreciable property. In this situation, the cost of the depreciable property to Manco is $20,000 under paragraph 85(1)(a) of the Act. This amount is less than the individual's capital cost ($50,000) even taking into account the adjustments in subsection 13(7). Therefore, paragraph 13(7)(e) is not applicable and does not affect the deemed capital cost under subsection 85(5).

Disposition of the property by the corporation for proceeds of disposition of $120,000 would have the following tax consequences:

By reason of the presumptions in subsection 85(5), there would be a recapture of the capital cost allowance of $80,000 under subsection 13(1) of the Act. Manco's capital gain under paragraph 40(1)(a) of the Act would be $100,000 ($120,000 minus the cost of $20,000 determined under paragraph 85(1)(a)). On the other hand, the capital gain would be reduced to $20,000 under paragraph 39(1)(a) of the Act because the $80,000 recapture would be included in Manco's income.

The amount of Manco's recapture is higher than the capital cost allowance claimed by the individual. This outcome is obviously not appropriate. The Department has already informed the Department of Finance of this problem. Further, there is no transfer to the corporation of the cost or the deemed capital cost for the individual determined under subsections 110.6(19) of the Act for purposes of calculating the capital gain on the disposition of depreciable property by a corporation.