2018-0745501C6 Meaning of “merged or combined” in 40(3.5)(c)(i)

Principal Issues: Whether the deemed continuity rules in subparagraph 40(3.5)(c)(i) of the Act apply on the wind-up of FA under the hypothetical fact scenario.

Position: Yes.

Reasons: Interpretation of the words "merged or combined" in subparagraph 40(3.5)(c)(i).

Author: Patel, Komal
Section: 40(3.3), 40(3.4), 40(3.5), 87(1), 87(8.1), 87(8.2), 88(3), 89(1) and 128.2(3)

IFA 2018 International Tax Conference
Canada Revenue Agency Roundtable

Question 5 - Meaning of “merged or combined” in subparagraph 40(3.5)(c)(i)

Assume the following hypothetical facts:

*     Canco holds all of the shares of Subco, and both corporations are resident in Canada. 

*     In a prior year, Canco sold all of the shares of a wholly-owned foreign affiliate (“FA”) to Subco and realized a capital loss.

*     Pursuant to subsection 40(3.3) and paragraph 40(3.4)(a) of the Income Tax Act (the “Act”) the capital loss was suspended in the hands of Canco (“the Suspended Loss”).

*     In the current year, Subco will wind-up FA and will make the requisite election to treat the wind-up as a qualifying liquidation and dissolution (“QLAD”) under subsection 88(3) of the Act to defer the accrued gain on the FA shares.

As it relates to the Suspended Loss, do the deemed continuity rules in subparagraph 40(3.5)(c)(i) of the Act apply on the wind-up of FA?

CRA Response

Subparagraph 40(3.5)(c)(i) provides that where subsections (3.3) and (3.4) apply to the disposition by a transferor of a share of the capital stock of a particular corporation and after the disposition the particular corporation is “merged or combined” with one or more other corporations, otherwise than in a transaction in respect of which paragraph 40(3.5)(b) applies to the share, then the corporation formed on the merger or combination is deemed to own the share while the corporation so formed is affiliated with the transferor, so that the loss remains suspended under subsection 40(3.4). In this hypothetical case, the transferor would be Canco, the particular corporation would be FA, and an issue to be resolved is whether FA was “merged or combined” with Subco on the tax deferred wind-up of FA.

It is the CRA’s position that the phrase “merged or combined” as used in subparagraph 40(3.5)(c)(i) is broad and encompassing and may include a wind-up or liquidation. This view is supported by the wording used in a number of provisions in the Act as it relates to a “merger”. For example, the following subsections incorporate exclusionary wording that carves out a “wind-up” when making reference to a “merger”: 87(1), 87(8.1), 87(8.2), 89(1) (the definition of Canadian corporation) and 128.2(3).  Given that these provisions, when making reference to a “merger”, specifically carve out a wind-up, it follows that the term “merger” generally includes a wind-up. Furthermore, we note that subparagraph 40(3.5)(c)(i) carves-out from a “merger or combination” a number of reorganization provisions referred to in paragraph 40(3.5)(b), lending additional support for the broadness of those terms as used in the context of paragraph 40(3.5)(c).

The CRA also interprets the use of the word “formed” in subparagraph 40(3.5)(c)(i) in a broad manner and as the context requires, such that the reference to the corporation “formed” on a wind-up is a reference to Subco in this hypothetical case. It was noted above that other provisions suggest that a “merger” includes a wind-up and that transactions that fall within the provisions listed in paragraph 40(3.5)(b) (i.e., sections 51, 86, 87 or 85.1) are carved out of a merger or combination in subparagraph 40(3.5)(c)(i). This implies that the term “formed” as used in subparagraph 40(3.5)(c)(i) is broad enough to capture the entity in place after different reorganizations (e.g., a subsection 86(1) reorganization of capital), even though there may be no new corporation “formed” in the traditional sense. Accordingly, the use of the word “formed” in subparagraph 40(3.5)(c)(i) does not, in our view, preclude a merger from including a wind-up.

In our view, the above textual analysis, when combined with a contextual and purposive analysis of subsection 40(3.5), supports the conclusion that the deemed continuity rules in subparagraph 40(3.5)(c)(i) apply on the wind-up of FA in this hypothetical case.

Specifically, the rules in subsection 40(3.5) extend the application of subsections 40(3.3) and (3.4) to certain reorganizations. In regards to the above hypothetical facts, the proposed wind-up of FA will not fall within the ambit of subparagraph 40(3.5)(c)(ii) or (iii), however, in the CRA’s view, the phrase “merged or combined” in subparagraph 40(3.5)(c)(i) applies to the proposed wind-up transaction.

Based on the text, context, purpose and overall policy objectives of the stop-loss rules, we note that there are a number of variations of the hypothetical transaction that would result in the same interpretation.

Komal Patel / Yves Moreno
2018-074550
May 16, 2018

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