2020-0842241C6 CALU 2020–Q6-Post-mortem pipeline: Gradual repayment of note

Principal Issues: 1. What is the maximum repayment amount per quarter or per annum that a corporation (debtor) can make to the holder (creditor) of the "pipeline note" that will not cause the application of subsection 84(2)? 2. Can the holder of the "pipeline note" borrow funds from the corporation in order to pay its liabilities during the period in which the "pipeline note" is being repaid and not have subsection 84(2) apply?

Position: 1. General comments provided. We can confirm whether or not the pipeline loan repayment schedule causes the deemed dividend rules in subsection 84(2) to apply in the context of an advance income tax ruling. 2. General comments provided. We can confirm whether or not a debt between the corporation and the holder of the "pipeline note" that is separate from the "pipeline note" causes the deemed dividend rules in subsection 84(2) to apply in the context of an advance income tax ruling.

Reasons: A complete analysis of all the relevant facts and circumstances is required in order to conclude on the application of subsection 84(2) to particular taxpayers.

Author: Verlinden, Nicole
Section: 84(2)

2020 CALU CRA Roundtable – July 2020

Question 6 – Post-mortem Pipeline: Gradual Repayment of Note

Background

Previously, the CRA provided a number of favourable advance income tax rulings (“rulings”) in connection with post-mortem pipeline transactions. The following are some recent examples of favourable post-mortem pipeline rulings: 2013-0503611R3, 2014-0563081R3, 2015-0569891R3, 2018-0767431R3, and 2018-0780201R3. In each of the situations described in these rulings, a promissory note was issued as part of the pipeline transactions (herein referred to as the “Pipeline Note”).

Typically, a post-mortem pipeline transaction includes the following general steps: (i) the estate incorporates a “pipeline corporation”; (ii) the estate transfers shares of the corporation to the pipeline corporation in exchange for the Pipeline Note that has a principal amount equal to the “hard basis” of the corporation’s shares at the time of death; (iii) the two corporations amalgamate at a later date; and (iv) the Pipeline Note is paid by the amalgamated corporation over a period of time.

In the rulings noted above, the repayment terms of the Pipeline Note include a description of the percentage of the principal amount of the Pipeline Note that will be repaid per quarter or per annum in the first year that it is outstanding after the amalgamation.  For example, in 2018-0767431R3, the proposed transactions state that the amount paid in any single quarter of the first year that the Pipeline Note is outstanding after the amalgamation will not exceed 15 per cent of the principal amount of said note when it was first issued.  In 2018-0780201R3, the proposed transactions state that the amount paid on the Pipeline Note during the first year immediately following the amalgamation, will not exceed 10 per cent of the principal amount of said note when it was first issued. 

Questions

(a)   Can the CRA confirm that a limitation on the repayment terms for the Pipeline Note is a required feature to meet the administrative conditions for CRA not to apply subsection 84(2) on the repayments?  In addition, can the CRA provide guidance on the maximum percentage of the principal amount of the Pipeline Note that can be repaid per quarter or per annum without causing subsection 84(2) to apply?

(b)   In many post-mortem situations, the funds held in the corporation subject to the pipeline transactions are needed to pay debts of the estate, including income taxes owing.  Can the CRA comment on whether it is permissible for the creditor of the Pipeline Note (e.g., the estate) to borrow funds from the debtor (the corporation) in order to pay its liabilities during the period in which the Pipeline Note is being repaid while still avoiding the application of subsection 84(2)? 

CRA Response

(a)   Subsection 84(2) applies where funds or property of a corporation resident in Canada have at any time after March 31, 1977 been distributed or otherwise appropriated in any manner whatever to or for the benefit of the shareholders of any class of shares in its capital stock, on the winding-up, discontinuance or reorganization of its business. Where it applies, the corporation is deemed to have paid at that time a dividend on the shares of that class.

The Federal Court of Appeal (“FCA”) decision MacDonald v. The Queen, 2013 FCA 110 is one of the leading cases dealing with the application of subsection 84(2). In this case, subsection 84(2) was held to apply, and at Paragraph 17, Justice Near emphasized that there are four required elements for its application:

(1) a Canadian resident corporation that is
(2) winding-up, discontinuing or reorganizing
(3) a distribution or appropriation of the corporation’s funds or property in any manner whatever
(4) to or for the benefit of its shareholders.

The FCA’s decision highlights the notion that “in any manner whatever” is intended to capture the breadth of methods in which a corporation’s property can be repatriated to its shareholder(s).

At Paragraph 27, Justice Near referred to comments made by the court in RMM Canadian Enterprises Inc. et al v The Queen (T.C.C.), 97 DTC 302:

The words "distributed or otherwise appropriated in any manner whatever on the winding-up, discontinuance or reorganization of its business" are words of the widest import and cover a large variety of ways in which corporate funds can end up in a shareholder's hands. See Merritt (supra); Smythe et al. v. M.N.R., 69 DTC 5361 (S.C.C.).

The CRA has issued several favourable rulings on the non-application of subsection 84(2) in the post-mortem pipeline context where taxpayers structured their proposed transactions such that at least one of the required elements noted above were not present. As stated in Question 23 of the 2011 STEP Conference (2011-0426371C6), and reiterated in Question 10 of the 2018 STEP Conference (2018-0748381C6), we continue to receive ruling requests whereby the taxpayers’ proposed transactions, include, among other things, the continuation of the original corporation’s business for a period of at least one year following the implementation of the pipeline structure, followed by a progressive distribution of the original corporation’s assets over an additional period of time.

As noted in your question, we have issued favourable subsection 84(2) rulings in the post-mortem pipeline context when the proposed repayment terms of the Pipeline Note have varied.

These repayment terms have been and continue to be part of the proposed transactions submitted by taxpayers, and as such, cannot be considered to be requirements stipulated by our Directorate. 

Our Directorate continues to rule on the potential application of subsection 84(2) on a case-by-case basis, after a thorough review of all the facts and circumstances surrounding each specific situation, including, inter alia, the repayment terms of the Pipeline Note.

(b)   The application of subsection 84(2) to a situation whereby a loan between the estate and the corporation (separate from the Pipeline Note) is issued prior to the repayment of the Pipeline Note can only be determined after an analysis of all the facts and circumstances surrounding the specific situation, including, inter alia, the terms of this separate loan. If the required elements for the application of subsection 84(2) noted in question (a) above are present in a particular situation involving a separate loan, then it cannot be said that subsection 84(2) does not apply. One example of when this might occur would be if the corporation has to liquidate business assets in order to make the loan to the estate and in doing so causes a wind-up, discontinuance or reorganization of the corporation’s business.

We have issued favourable subsection 84(2) rulings in the post-mortem pipeline context when a separate note is issued either before or as part of the proposed transactions. An example of this is in a “hybrid pipeline” transaction, in which a partial subsection 164(6) plan is undertaken prior to the pipeline transaction in order for the estate to access certain tax attributes of the corporation, such as the capital dividend account or refundable dividend tax on hand, in addition to the corporate property. In some instances, a note was issued by the corporation to the estate as consideration for the redemption of a portion of its shares held by the estate; and some of the proposed transactions contemplated the corporation liquidating some of its assets in order to repay this note before the Pipeline Note is repaid. See for example: 2010-0377601R3 and 2015-0606721R3. In those rulings, corporate property was not distributed to the estate on the wind-up, discontinuance or reorganization of the business of the corporation. Furthermore, one of the factors that the CRA considered when accepting these “hybrid pipeline” transactions is the fact that the deemed dividend provisions in subsection 84(3) applied on the redemption of the shares in the corporation held by the estate.

Nicki Verlinden
July 8, 2020
2020-084224

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