2016-0626781E5 Neuman Type Situation

Principal Issues: What are the tax consequences for the shareholders of a corporation and the corporation that may arise on the issuance of shares which carry an entitlement to discretionary dividends for nominal consideration and the payment of any discretionary dividends from such shares.

Position: See analysis below.

Reasons: See analysis below.

Author: Ng, Tania
Section: 56(2), 15(1), 73(1), 69(1), 74.1(1), 74.4(2), 245(2)

XXXXXXXXXX                                                                    2016-062678
                                                                                            T. Ng
                                                                                            (416) 512-4013
March 14, 2016

Dear XXXXXXXXXX,

Re: Request for Technical Interpretation – “Neuman” Type Situation

We are writing in reply to your e-mail, in which you requested our comments with respect to the tax consequences that may result from implementing a “Neuman” type situation which involves the issuance of shares that entitle the holder to discretionary dividends for nominal consideration. 

Facts

The Articles of Incorporation of a small business corporation (“Opco”) provides for two categories of shares: (1) Class A common shares; and (2) Class B preferred shares.  The holders of Class A common shares are entitled to the following rights:

(a)    votes;

(b)    discretionary dividends as and when declared by the board of directors, which can be declared to the exclusion of dividends on any Class B preferred shares; and

(c)    all of the assets upon liquidation of the corporation that is in excess of the redemption/retraction value of any issued Class B preferred shares.

The Class B preferred shares, which are non-voting, have the following rights attached to them:

(a)    redeemable/retractable for the fair market value for which it is issued; and

(b)    entitled to discretionary dividends as and when declared by the board of directors, which can be declared to the exclusion of dividends on any issued Class A common shares.

The taxpayer (“Mr. A”) owns 1 Class A common share in the capital stock of Opco, which is 100% of the issued and outstanding shares of Opco.  The Class A common share has a fair market value of $1 million.  Opco has $500,000 of retained earnings. Opco intends on issuing 1 Class B preferred share to Mr. A’s spouse (“Mrs. A”) for nominal consideration.  Subsequent to the issuance of the Class B preferred share to Mrs. A, there are two possible scenarios:

Scenario 1: Opco immediately declares and pays out a $100,000 dividend on the Class B preferred share, which would have the effect of reducing the FMV of Opco and the 1 Class A common share by the same amount.

Scenario 2: Opco continues to carry on its business.  Opco declares and pays out a $100,000 dividend on the Class B preferred share only after it earns an additional $100,000 of income subsequent to the issuance of the Class B preferred share to Mrs. A and only to the extent that the FMV of Opco after such dividend is not less than $1,000,000.

Your Question

You inquired on the tax consequences for Opco and the shareholders of Opco that may arise on the issuance of the 1 Class B preferred share to Mrs. A for nominal consideration and the payment of any discretionary dividends on the Class B preferred shares.

Our Comments

This technical interpretation provides general comments about the provisions of the Income Tax Act (the “Act”) and related legislation (where referenced).  It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination.  The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information  Circular IC 70-6R6, Advance Income Tax Rulings and Technical Interpretations.

Application of Subsection 56(2)

Consistent with the Supreme Court of Canada’s decision in Neuman v. R., [1998] 3 CTC 177 (“Neuman”), it is our view that, generally, subsection 56(2) will not apply to arrangements involving the payment of dividends by a corporation, provided that the applicable taxpayer does not have a pre-existing entitlement to the dividends and provided that proper consideration was given for the shares when issued.  

Issuance of Discretionary Dividend Shares

Whether an amount paid for a share which carries an entitlement to discretionary dividends would be considered fair market value is a question of fact.  The Income Tax Rulings Directorate does not deal with the determination of value and therefore, we cannot confirm or provide any comments regarding whether the nominal consideration paid by Mrs. A for the 1 Class B preferred share would be considered fair market value paid for such share at the time of issuance.  

The tax consequences of the subscription of the Class B preferred share by Mrs. A would depend, among other things, on the fair market value of such shares upon subscription.

It is possible that, after a comprehensive review and analysis of the relevant facts such as agreements between the parties, the objective of the tax planning/reorganization and the intent of the parties (express or implied) to use the discretionary dividend feature to pay out dividends, one could take the position that an economic advantage is being conferred by Opco to Mrs. A as the holder of the Class B preferred share.  In such circumstances, we could conclude that subsection 15(1) applies upon the issuance of the Class B preferred share, particularly if the amount that is being paid by Mrs. A as consideration for the share does not represent the fair market value of such share at the time of subscription.

Alternatively, it may be possible that the circumstances of a particular situation would suggest that Mr. A rather than Opco is conferring the benefit to Mrs. A.  If it could be demonstrated that there was a transfer of economic interest in Opco from Mr. A to Mrs. A similar to the situation in Queen v. Kieboom, 92 DTC 6382, Mr. A would be considered to have disposed of a right, interest or right to dividends in Opco to Mrs. A.  Under these circumstances, because Mr. A and Mrs. A are spouses, the automatic rollover provision in subsection 73(1) would apply such that the disposition of Mr. A’s economic interest would be at cost.  In the event that the taxpayer elects not to have subsection 73(1) apply, subsection 69(1) would apply, in which case the disposition is deemed to have occurred at fair market value. 

If Mr. A is considered to have disposed of a right, interest or right to dividends in Opco to Mrs. A, the attribution rules should be considered and it is possible that subsection 74.1(1) would apply to reassign to Mr. A any dividends paid on the Class B preferred share held by Mrs. A.

All of the relevant facts and circumstances of any given situation should be considered to determine whether the use of discretionary dividends on shares would cause the application of subsection 245(2).  While we have considered the application of subsection 245(2) in respect of the Neuman type income splitting arrangements in the past and have taken the position that GAAR does not apply, we have also specifically stated that this comment regarding the non-application of GAAR relates only to the Neuman case.  To determine whether subsection 245(2) would apply to a particular set of proposed transactions, we would have to consider all the pertinent facts and relevant documentation and as such, the determination of whether GAAR is applicable is best dealt within the context of an advance income tax ruling request.  

Subject to the application of the attribution rules or GAAR in any given situation, the normal rules of taxation of dividends would apply to Mrs. A in respect of any discretionary dividends that she receives on the Class B preferred share.

We trust that these comments will be of assistance.

Yours truly,

Stéphane Prud’homme
Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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