15 October 2002 External T.I. 2002-0155205 - ASSETS USED PRINCIPALLY IN ACTIVE BUS.

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 CCRA.

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

Principal Issues: Whether certain assets held by a corporation would be considered to have been used principally in an active business.

Position: Question of Fact

Reasons: Where the assets are required under contractual obligations and the disposition of such assets would be destabilizing on the business of the corporation, the assets would likely be considered to have been used in an active business.

2002-015520
XXXXXXXXXX Karen Power, CA
(613) 957-8953
October 15, 2002

Dear XXXXXXXXXX:

Re: Qualified Small Business Corporation Shares

This is in reply to your letter of July 31, 2002, requesting our comments on whether certain assets would be considered assets used principally in an active business for the purposes of the definitions of "qualified small business corporation share" and "small business corporation" as defined in subsections 110.6(1) and 248(1) of the Income Tax Act (the "Act"), respectively.

You summarize the facts of your situation as follows:

1. Opco is a Canadian-controlled private corporation that carries on a retail merchandising business exclusively in Canada as a "dealer" of merchandise acquired from Supplyco. All merchandise sold by Opco is purchased from Supplyco.

2. In its financial statements Supplyco is described as being incorporated under the Ontario Business Corporations Act and is 100% Dealer-Owned.

3. Opco's business is operated pursuant to a "dealer agreement" entered into between Opco and Supplyco. Operating as a dealer under the dealer agreement, Opco owns the same number of common shares in Supplyco with the same capital contribution as every other dealer. Each dealer has one vote for the common share investment.

4. Opco is not a Cooperative corporation within the meaning of section 136 of the Act. Supplyco is not connected with Opco within the meaning of Part IV of the Act, and is not related to Opco.

5. Approximately 27% of the fair market value (FMV) of Opco's assets consist of special shares in Supplyco. The special shares in Supplyco rank in priority to its common shares regarding the repayment of capital but otherwise carry no further right to participate in profits or assets of Supplyco. Each special share is issued to Opco for $1.00 and is redeemable for the same amount, subject to the approval of the Supplyco Board of Directors. The special shares are issued by Supplyco to each dealer under a program to provide the necessary equity for Supplyco to properly finance its inventory, accounts receivable, etc.

6. On a calendar year basis, the dealer must subscribe for special shares according to a percentage of his purchases from Supplyco. If the dealer's special share ownership exceeds a stipulated percentage, the difference becomes eligible for redemption upon approval by the Board of Directors, at the $1.00 per share paid-in amount. The special shares carry no dividend entitlement.

7. Supplyco also issues five-year term notes to Opco to assist Supplyco with its continuing expansion and upgrading of its buildings. The term notes are issued to Opco based on an assessment of the volume purchases from Supplyco. The notes are repaid in full at the end of the fifth year from the date of issue. Interest is paid on the notes on an annual basis equal to Supplyco's bank prime lending rate plus 2%. The five-year term notes represent about 3% of the FMV of Opco's assets.

8. The dealer agreement between Opco and Supplyco specifically requires that Opco's common shares, five-year term notes, and redeemable special shares in Supplyco are mortgaged and pledged to Supplyco as security for any indebtedness of Opco to Supplyco. The indebtedness consists of Opco's trade account payable to Supplyco.

9. Upon cessation of membership by Opco in Supplyco, the common shares, special shares and five-year term notes would be redeemed for their original paid-in amounts. There is no premium or other participation in the assets of Supplyco. Generally a dealer such as Opco would cease membership when the shareholder of Opco wishes to retire and/or sell his corporation.

Specifically, you enquire whether the common shares, the special shares and the five-year term notes described above would be considered assets used principally in an active business by Opco.

Our comments

The particular circumstances in your letter on which you have asked for our views involve a factual situation. As explained in Information Circular 70-6R5 issued by CCRA on May 17, 2002, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling. If you wish to obtain a binding commitment with respect to an actual case similar to that outlined in your letter, an advance income tax ruling application should be submitted.

Whether the common shares, the special shares and the five-year term notes can be considered to be an asset used in an active business is a question of fact and in order to make such a determination, it would require a review all the facts surrounding a particular situation. Although we are unable to provide any binding assurance with respect to the interpretation requested, we do provide the following general comments for your information.

For purposes of our comments, we have assumed that Opco's business is an active business. The issue is whether some of Opco's assets can be said to have been used in that active business. The issue of whether property was used or held by a corporation in the course of carrying on a business was considered by the Supreme Court in Ensite Limited v. The Queen (86 DTC 6521). In that case the court held that the holding or using of property must be linked to some definite obligation or liability of the business. A business purpose for the use of the property is not enough. The test was whether the property was used to fulfill a requirement which had to be met in order to do business. The threshold of the test was met when the withdrawal of the property would "have a decidedly destabilizing effect on the corporate operations themselves".

In the situation outlined above, if the corporation has contractual obligations to hold certain shares or notes in order to do business with its only supplier and the disposition of such assets would have a destabilization effect on the operations of the company, we are inclined to agree that the common shares, the special shares and the five-year term notes are required to enable Opco to conduct its business and, therefore, would be considered assets used principally in an active business. We caution, that these views are based on the limited facts provided and that a determination on this issue requires a review of all relevant facts and agreements. In addition, our comments should not be taken as confirmation that Opco is a "small business corporation" nor that the shares of Opco would be "qualified small business corporation shares", as we have not examined all of the requirements which must be met pursuant to the subsections 110.6(1) and 248(1) of the Act.

We trust that our comments are of assistance to you.

Yours truly,

Milled Azzi, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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