TX2 Advanced Personal & Corporate Taxation

Transcription

1 TX2 Advanced Personal & Corporate Taxation 2011 Printing Authored by Johanne Leduc and Francine St-Onge 2 nd Edition Readings Book PACE Level

2 Certified General Accountants Association of Canada North Fraser Way Burnaby, British Columbia Canada V5J 5K7 CGA-Canada, 2011 All rights reserved. These materials or parts thereof may not be reproduced or used in any manner without the prior written permission of the Certified General Accountants Association of Canada. Printed in Canada

3 About CGA-CANADA CGA-Canada today CGA is the fastest-growing accounting designation in Canada. The CGA designation focuses on integrity, ethics and the highest education requirements. Recognized as the country s accounting business leaders, CGAs provide strategic counsel, financial leadership, and overall direction to all sectors of the Canadian economy. The Certified General Accountants Association of Canada Association sets standards, develops education programs, publishes professional materials, advocates on public policy issues, and represents CGAs nationally and internationally. The Association represents 75,000 CGAs and students in Canada, Bermuda, the Caribbean, Hong Kong and China. Mission CGA-Canada advances the interests of its members and the public through national and international representation and the establishment of professional standards, practices, and services. A proud history The Certified General Accountants Association of Canada CGA-Canada was founded in Montréal in 1908 under the leadership of John Leslie, vice-president of the Canadian Pacific Railway. From the beginning, its objective was to encourage improvement in skills and job performance a goal the Association holds to this day. On April 14, 1913, Canada s Parliament passed the Act that incorporated CGA-Canada as a self-regulating professional Association. Over the decades that followed, branches became associations in their own right, affiliated with the national body. A revised Act of Incorporation, passed in 1999, updated CGA-Canada s powers and reflected the Association s objectives and initiatives for the next millennium. The Act also established a French name for CGA-Canada Association des comptables généraux accrédités du Canada. Structure and roles CGA-Canada is governed by a Board of Directors that represents members from all provinces and territories of Canada as well as international members. Individual CGAs are represented nationally through CGA-Canada, and regionally through their provincial/territorial/regional associations and local chapters. The Association: ensures national recognition for the profession and advocates on policy issues of concern to the profession raises the profile of the CGA designation and represents members internationally sets national educational standards, and develops and maintains an internationally competitive program of professional studies and examinations to certify CGAs in Canada and overseas provides a range of services to Affiliates and members iii

4 contributes to the profession s body of knowledge through research and participation in international accounting organizations, particularly the International Federation of Accountants (IFAC) Nationally and internationally, CGA-Canada contributes to accounting standard-setting by sharing its research findings and views. The Association also represents its members in debates of public policy. As a self-regulating organization, CGA-Canada also sets high standards of professionalism through its own Code of Ethical Principles and Rules of Conduct for members. This comprehensive set of rules and guidelines protects the public interest and ensures that CGAs maintain the highest ethical standards. Education and professional development CGA-Canada's competency-based education program has long been acknowledged as a leader among distance learning education programs. Innovative technology is used not only in the delivery of the program, but is incorporated into the curriculum content as well. Similarly, ethical principles are also integrated throughout the curriculum. Education partnerships with Laurentian University and the Southern Alberta Institute of Technology offer students a range of options for meeting the mandatory degree requirement. Mandatory continuing professional education ensures that CGAs maintain their professional competence. CGA-Canada provides professional development opportunities in public practice, ethics, accounting and auditing standards, business valuation, taxation, and other topics. The Professional Development Network PD Network developed collaboratively with CGA Affiliates, is an extensive and powerful online information resource for members. For more information More information about CGA-Canada is available on its Web site at iv

5 Contents: TX2 Readings Book Module 1 Benefits to shareholders Module 2 Reading 1-1: Benefits conferred on a shareholder Reading 1-2: Loans to shareholders Reading 1-4: Paid-up capital Reading 1-5: Deemed dividends Reading 1-6: Ethics and tax planning Reading 1-7: Writing a tax opinion Transfer of property to a taxable Canadian corporation Module 3 Corporate reorganizations (Part 1) Module 4 Corporate reorganizations (Part 2) Module 5 Various tax considerations Reading 2-1: Objectives of using section 85 Reading 2-2: Conditions Reading 2-3: Rule for the benefit conferred on related shareholders Reading 2-4: Transfer of property to an affiliated corporation Reading 2-5: Adjustments to paid-up capital Reading 2-6: Election forms Reading 2-7: Example of a transfer of property Reading 3-1: Non-arm s length sale of shares Reading 3-2: Reorganization of capital Reading 3-3: Property convertible to shares of a corporation Reading 3-4: Exchange of shares of one corporation for shares of another corporation Reading 4-1: Amalgamation Reading 4-2: Winding up a subsidiary owned 90% or more Reading 4-3: Winding up a Canadian corporation Reading 4-4: Deemed proceeds or capital gain under subsection 55(2) Reading 5-1: Incorporated or unincorporated business Reading 5-2: Capital gains deduction Reading 5-3: Debt forgiveness and seizure of property Reading 5-4: Anti-avoidance rules v

6 Module 6 Purchase or sale of a business Module 7 Reading 6-1: Purchase or sale of shares Reading 6-2: Purchase or sale of property Reading 6-3: Assets or shares Reading 6-4: Acquisition of control Partnerships Reading 7-1: Definition Reading 7-1A: Partnership nature Reading 7-2: Computation of income Reading 7-3: Computation of the ACB of a partnership interest Reading 7-4: Transfer of property to the partnership and admission of a new partner Reading 7-5: Withdrawal of a partner Reading 7-6: Dissolution of a partnership Reading 7-7: Limited partnership Reading 7-8: Transfer of property by a partnership to a corporation Reading 7-9: Information return Module 8 Death of a taxpayer Reading 8-1: Income in the year of death Reading 8-2: Deemed disposition of property on death Reading 8-3: Deferred income plans Reading 8-5: Deductions, tax credits, and alternative minimum tax Reading 8-6: Filing of income tax and benefit returns and payment of income tax Reading 8-7: Capital losses realized by the estate Reading 8-8: Death of the shareholder of a private corporation Reading 8-9: Planning Module 9 Trusts Reading 9-1: Trusts General Reading 9-2: Creation of a trust Reading 9-3: Taxation of a trust resident in Canada Reading 9-4: Taxation of beneficiaries Reading 9-5: Deemed disposition of trust property after 21 years Reading 9-6: Income interest of a trust Reading 9-7: Capital interest and liquidation of a trust Reading 9-8: Use of a trust Module 10 Transfers of property among family members Reading 10-1: Gifts and non-arm s length transactions Reading 10-2: Attribution rules Reading 10-3: Estate freeze Reading 10-4: Case studies vi

7 READING 1-1 Benefits conferred on a shareholder LEVEL 1 The Canadian tax system provides for a two-level system for taxing corporate income: first in the corporation, and then in the hands of the shareholder when dividends are received from the corporation. Dividends received from a corporation resident in Canada by an individual are subject to a specific tax treatment based on the principle of integrating the income of the corporation and that of the shareholder. These concepts have been covered in your previous study of taxation and will not be repeated here. General rule under subsection 15(1) A shareholder may also be an employee or executive of the corporation and, in this capacity, receive remuneration in the form of salary. A shareholder-manager of a private corporation may therefore remove funds from the corporation in the form of salary or dividends. The method of distribution chosen will generally be that which maximizes net after-tax cash in the hands of the shareholder, after taking into consideration the income tax payable by both the shareholder and the corporation. However, this does not mean that the shareholder may avoid personal income taxes on the income received from the corporation. This approach merely serves to minimize income taxes. To prevent shareholders from withdrawing or benefiting from the corporation s property or capital other than in the form of salary or dividends, thereby avoiding tax at the personal level, the Income Tax Act (ITA) contains a number of special rules. Subsection 15(1) was introduced to prevent shareholders of a corporation from directly or indirectly appropriating corporate funds or property free of tax. Subsection 15(1) applies each time a corporation confers a benefit of any kind on a shareholder. As defined by subsection 248(1), a shareholder includes a person entitled to receive payment of a dividend. Subsection 15(1) also applies to a benefit that is conferred on a person in contemplation of that person becoming a shareholder. It is recognized in case law that there is a benefit conferred if there is economic enrichment on the part of the shareholder. The rules contained in subsection 15(1) are very broad and cover a multitude of situations. They apply where a payment has been made to a shareholder otherwise than pursuant to a bona fide business transaction. For example, a shareholder sells property to the corporation for a consideration greater than the fair market value (FMV) of the property transferred. funds or property of the corporation have been appropriated in any manner whatever to, or for the benefit of, a shareholder. For example, the corporation pays personal expenses of the shareholder, or the shareholder personally receives the income of the corporation without recording the transaction in the books of the corporation as income and as an advance to the shareholder. a benefit or advantage has been conferred on a shareholder by a corporation. For example, a cottage owned by the corporation is used by a shareholder for personal use, free of charge. Under the rules in subsection 15(1), the value of any benefit conferred on a shareholder is included in the shareholder s income as ordinary income and not as a dividend, thus denying the dividend tax credit to individual shareholders. Also, corporate shareholders are Advanced Personal & Corporate Taxation Reading 1-1 1

8 denied the section 112 deduction, which would otherwise be available on the receipt of a dividend from a taxable Canadian corporation. Very often, the application of the rules relating to benefits conferred on a shareholder results in double taxation. For example, if a corporation pays for a shareholder s trip to Hawaii, which is solely for pleasure, under paragraph 18(1)(a), the corporation may not deduct the amount expended, since this is not an expense incurred in order to obtain business or property income. In turn, under subsection 15(1), the shareholder is taxed on the amount of the benefit conferred. Where the shareholder is also an employee of the corporation, it is important to determine whether the property is appropriated or whether the benefit is conferred on the shareholder in the capacity of an employee or a shareholder. Where the benefit is conferred on the shareholder in the capacity of an employee, the corporation may generally deduct the cost of the benefit from income. The facts determine whether the benefit is conferred on the shareholder in the capacity of an employee or a shareholder. As a general rule, if employees of the enterprise or similar enterprises who are not shareholders receive benefits similar to those conferred on employee-shareholders, the taxable benefit conferred on employee-shareholders will be considered a benefit conferred by virtue of employment under paragraph 6(1)(a) rather than a taxable benefit under subsection 15(1). Under subsection 15(7), the rules in subsection 15(1) apply whether the corporation conferring the benefit is resident in Canada or not. For example, where an American corporation confers a benefit on a Canadian shareholder, the shareholder must include the value of the benefit in income taxable in Canada. Note that if, under section 84, a portion of the benefit conferred on a shareholder is considered to be a deemed dividend, this portion of the benefit will not be included in computing the shareholder s income under subsection 15(1). A benefit conferred on a person related to the shareholder may constitute a taxable benefit for the shareholder, either because he indirectly derives a benefit from it or because, under subsection 56(2), any payment or transfer of property made to a person with the concurrence of the taxpayer as a benefit that the taxpayer desires to have conferred on the other person, must be included in computing the taxpayer s income to the extent that it would be if the payment had been made to the taxpayer. For example, a taxable benefit will be added to the shareholder s income if the corporation pays the travel expenses of the shareholder s spouse accompanying the shareholder when the shareholder attends a convention, or if the corporation gives property to a child of the shareholder or sells it to him at a preferential price. Under subsection 246(1), where the benefit is conferred by a subsidiary of the corporation of which the taxpayer is a shareholder, the taxpayer is liable for tax on the value of the benefit as if he were a shareholder of the subsidiary. Value of benefit The taxable value of a benefit is generally based on the FMV of the property appropriated by, or the benefit conferred on, a shareholder. Determining this value is often difficult and complex. Court cases dealing with the method of valuing a taxable benefit arising from the personal use of corporate property (cottage, airplane, Florida condominium) demonstrate that the valuation method may vary depending on the applicable facts in each case. As a general rule, if the property is used principally for business purposes, the rental value or the costs of maintaining the property for the period of personal use will be used to determine the value of the taxable benefit for the shareholder. Where the property is used mainly by the shareholder, Canada Revenue Agency (CRA), supported by the decisions of the Federal Court of Appeal in Youngman v. The Queen, 90 DTC 6322 and The Queen v. Fingold, DTC 5449, values the 2 Reading 1-1 Advanced Personal & Corporate Taxation

9 benefit on the basis of costs assumed by the corporation with respect to the property, plus the foregone yield on the capital invested for the acquisition of the property where the amount thus calculated exceeds the rental value or where no rental value can be established. On this subject read paragraph 11 of IT-432R2. Under subsection 15(1.2), where a shareholder s debt is settled or extinguished for an amount that is less than the amount of the obligation outstanding at that time, there is a taxable benefit for the shareholder equal to the amount of the forgiven amount, as defined in subsection 15(1.21). In brief, the forgiven amount is the principal of the debt less repayments made and amounts already included in the shareholder s income. Thus, when a loan is made by a corporation to a shareholder and the amount of this loan is included in the shareholder s income under the provisions of subsection 15(2), there will be no forgiven amount to be included in the shareholder s income if the corporation subsequently foregoes collection of the amount owing to it. On the other hand, if the loan is exempted from the application of subsection 15(2) because of one of the exceptions contained in that subsection, then subsections 15(1), 15(1.2), and 15(1.21) will apply, requiring inclusion in the shareholder s income a taxable benefit corresponding to the amount that remained unpaid on the loan when the debt was forgiven. Where a corporation makes an automobile available to a shareholder or related person, the shareholder must include in income the value of the benefit obtained. Under subsection 15(5), the computation of the taxable benefit for the use of an automobile by a shareholder is identical to the computation of the benefit where the automobile is made available to an employee. Example 1-1 illustrates the rules that apply when benefits are conferred on shareholders. EXAMPLE 1-1 Frances Baron is the president and sole shareholder of Active Ltd. She devotes more than 55 hours per week to the management of the business operated by Active Ltd. In 2011, Frances had a swimming pool installed at her residence, at a cost of $15,000. Active Ltd. paid the bill and claimed the $15,000 in its expenses. In 2010, Active Ltd. purchased a $225,000 condominium in an American city where Frances son is studying. The condo was inhabited by Frances son for the entire year of The rental value of the condo is estimated by Frances at $950 per month. However, since such condos are not usually rented out, this value cannot be determined with certainty. The expenses relating to the condo were paid entirely by Active Ltd. in 2011, and they are as follows: Property taxes $ 1,800 Insurance $ 700 Electricity/heating $ 1,500 Condo fees $ 3,000 Active Ltd. currently obtains a return of 4% on its investments. In 2011, Active Ltd. realized exceptional profits. As a token of appreciation for the efforts of five key employees, including Frances, Active Ltd. bought them a trip to Las Vegas. The cost of the trip was $1,500 per employee. All figures are in Canadian dollars. Advanced Personal & Corporate Taxation Reading 1-1 3

10 Tax consequences Active Ltd. confers several benefits on Frances: payment of a personal expense: construction of a pool at her residence use of the corporation s property for personal purposes without consideration: the condo purchase of a pleasure trip Frances is a shareholder and employee of Active Ltd. Therefore, before it is concluded that these benefits are taxable under subsection 15(1), it is necessary to look at the facts and determine whether one or more of these benefits may be considered to be a benefit to an employee. The trip to Las Vegas was not limited to Frances, and its purpose was to reward certain key employees. Accordingly, this benefit is an employment benefit taxable under paragraph 6(1)(a). Therefore, the tax consequences for Frances and Active Ltd. are as follows: 1. For Frances: She must include the following in her income: Benefit by virtue of her employment [6(1)(a)] Value of the trip to Las Vegas $ 1,500 Benefit to shareholder [15(1)] Cost of the swimming pool $ 15,000 Benefit from personal use of the condo by her son The greater of: i) rental value of the condo (12 $950) $ 11,400 ii) cost of operation plus foregone return on the capital invested Property taxes $ 1,800 Insurance 700 Electricity/heating 1,500 Condo fees 3,000 Foregone return (4% $225,000) 9,000 $ 16,000 $ 16,000 Total benefits to shareholder $ 31, For Active Ltd.: Under paragraph 18(1)(a), Active Ltd. cannot deduct the cost of the swimming pool or the costs related to the condo since these are not expenses incurred in order to gain income. Subsection 15(1.3) spells out the effect of sales taxes (GST, HST, PST) on the taxable value of the benefit. Under subsection 15(1.3), the value of the benefit is to be calculated taking into account the sales taxes that were payable by the corporation with respect to the property or that would have been payable had the corporation not been exempted from payment of the GST because of its nature or the use to which the property or service was to be put. Since the GST and other sales taxes are not studied in this course and were not covered in a previous course, their effects should be ignored for purposes of this course and, unless otherwise indicated, they are not examinable. 4 Reading 1-1 Advanced Personal & Corporate Taxation

11 Exceptions The following transactions are specifically excluded from the application of the rules in subsection 15(1): reducing the corporation s paid-up capital redeeming, cancelling, or acquiring shares by the corporation winding-up, discontinuing, or reorganizing the corporation s business winding-up a Canadian corporation paying a dividend or a stock dividend conferring on all holders of common shares a right, identical for each common share, to buy additional shares of the corporation converting contributed surplus into paid-up capital by an insurance corporation or a bank converting any contributed surplus created on the issue of shares of a class after March 31, 1977, to paid-up capital of such class of shares, pursuant to paragraph 84(1)(c.3) Transfer of property between corporations and their shareholders The purchase and sale of property between corporations and their shareholders are situations that most often invoke the rules relating to benefits to shareholders contained in subsection 15(1). The provisions of subsections 69(1) and 69(4) may also affect such transactions. Thus, when a shareholder sells property to the corporation of which he or she is a shareholder at a price that exceeds its FMV, the shareholder must include in his or her income, as a benefit conferred on a shareholder under subsection 15(1), the difference between the price paid by the corporation and the FMV of the property. This could result in double taxation, when the capital gain on the disposition of the property based on the excess of proceeds of disposition (POD) over adjusted cost base (ACB) is calculated. However, paragraph 39(1)(a) provides that the portion of the capital gain otherwise included in income is excluded from the amount considered to be capital gain. From the corporation s perspective, the cost of the property will be limited to its FMV under paragraph 69(1)(a) if the shareholder and the corporation do not deal at arm s length. On the other hand, subsection 69(4) applies whenever a corporation confers property on a shareholder for an amount below its FMV; it provides that the corporation is deemed to have disposed of the property at its FMV. The shareholder, in turn, must pay tax under subsection 15(1) on the value of the benefit conferred by the corporation, namely, the difference between the FMV of the property and the price paid. If the property acquired by the shareholder is a capital property, the amount of the benefit taxed under subsection 15(1) is added to the adjusted cost base of the property under subsection 52(1). Examples 1-2 and 1-3 illustrate these situations. EXAMPLE 1-2 Disposition of a non-depreciable capital property by a shareholder to a corporation at a value in excess of FMV, where the shareholder does not deal with the corporation at arm s length. POD (in cash) $ 150,000 FMV of the property $ 100,000 ACB of property for shareholder $ 40,000 Advanced Personal & Corporate Taxation Reading 1-1 5

12 Tax consequences 1. For the shareholder: Taxable benefit [15(1)] Cash received from the corporation $ 150,000 FMV of the property transferred (100,000) Taxable benefit [15(1)] $ 50,000 Capital gain Cash received from the corporation (POD) $ 150,000 ACB (40,000) Gain 110,000 Less: Portion of gain already included in income under 15(1) [39(1)(a)]* (50,000) Capital gain $ 60,000 Taxable capital gain (1/2) $ 30,000 * Under paragraph 39(1)(a), the portion of a capital gain that is otherwise included in income under paragraph 3(a) is excluded from the capital gain. 2. For the corporation: The cost of the property will be deemed to be equal to the FMV [ 69(1)(a)] $ 100,000 EXAMPLE 1-3 Acquisition of non-depreciable property by a shareholder from the corporation for an amount less than FMV. The property would not have been subject to any sales tax if acquired on the open market. Purchase price to the shareholder $ 50,000 FMV of the property $ 75,000 ACB of the property for the corporation $ 10,000 Tax consequences 1. For the shareholder: Taxable benefit [15(1)] FMV of the property $ 75,000 Purchase price (50,000) Taxable benefit [15(1)] $ 25,000 ACB of the property acquired Purchase price $ 50,000 Taxable benefit [52(1)] 25,000 ACB of the property for the shareholder $ 75,000 6 Reading 1-1 Advanced Personal & Corporate Taxation

13 2. For the corporation: Capital gain Deemed POD under 69(4) FMV of the property $ 75,000 ACB of the property (10,000) Capital gain $ 65,000 Taxable capital gain (1/2) $ 32,500 Penalty under subsection 163(2) The penalty provided for in subsection 163(2) is often imposed when CRA makes an assessment under subsection 15(1). This penalty, which can amount to 50% of the income tax payable on the amount of the taxable benefit, may be imposed when a person, knowingly or in circumstances amounting to gross negligence, has made or participated in, assented to, or acquiesced in a false statement or omission in a return. Where a majority shareholder appropriates the income of the corporation that he controls, he will, under subsection 15(1), be liable for tax on the income that he has appropriated, and the income appropriated by the shareholder will also be added to the income of the corporation. Also, a penalty under subsection 163(2) will generally be imposed on both the shareholder and the corporation. Where the corporation claims personal expenses of a shareholder in its expenses and CRA makes an assessment under subsection 15(1) for the shareholder and an assessment denying the deduction of expenses for the corporation, the penalty under subsection 163(2) will automatically be applied if an assessment for the same reason was made in the past. If this is the first assessment for this reason, the facts will be examined to determine whether the taxpayer acted knowingly or was grossly negligent. Where there is a transfer of property to or from a corporation for an amount that triggers the application of subsection 15(1), the penalty under subsection 163(2) may also be imposed if the facts of the case indicate that the taxpayer acted knowingly or in circumstances amounting to gross negligence. The CGA must inform the client that this penalty may apply in the case of false statements or deliberate omissions of information, and must in no way associate himself with such manoeuvres. Planning Since there is the possibility of double taxation and heavy penalties in the application of subsection 15(1), transactions between a corporation and its shareholders should be adequately structured in order to avoid the application of this subsection. Price adjustment clause Where the shareholder and the corporation transact at FMV, subsection 15(1) may not be invoked because a benefit is not conferred on the shareholder. However, given that it may be difficult to arrive at FMV and that it may be challenged by CRA, a price adjustment clause should be included in contracts for transfers of property between a corporation and its shareholders. Read Interpretation Bulletin IT-169 dealing with this topic. Advanced Personal & Corporate Taxation Reading 1-1 7

14 Control and records A procedure for controlling shareholders expenses should be put in place to ensure that their personal expenses are not claimed by the corporation. When the corporation pays a shareholder s personal expenses, the amount paid should be recorded as a shareholder advance or loan that may be subject to inclusion in income under subsection 15(2) if it is not repaid within the time period provided for in that subsection. In the interest of the client, the CGA should assist the client with setting up a system of procedures for determining whether an expense is a legitimate business expense or a personal expense, and for recording expenses correctly. 8 Reading 1-1 Advanced Personal & Corporate Taxation

15 READING 1-2 Loans to shareholders LEVEL 1 Interest-free or low-interest loans are another way for shareholders to benefit from the corporation s funds. There are rules governing shareholder loans which deal with this issue. These rules apply when a corporation advances funds to a shareholder or members of his family, in the form of a loan or otherwise, or carries out any other transaction that makes the shareholder a debtor of the corporation, such as the sale of property on credit by the corporation to a shareholder. As used below, the term loan applies to any form of debt of the shareholder toward the corporation. Inclusion of loan in income under subsection 15(2) Under subsection 15(2), where a corporation has made a loan (or advanced funds in any other manner) to a person or partnership that was a shareholder of the particular corporation, the amount of the loan must be included in the income of the person or partnership to whom the loan was made for the taxation year during which it was made. This rule does not apply when the loan is made to a corporation resident in Canada or a partnership all of whose members are corporations resident in Canada. Under subsection 15(7), subsection 15(2) applies even if the lending corporation is not resident in Canada and does not carry on business there. However, the shareholder must reside in Canada in such a case, because under subsection 15(2.2), if a corporation not resident in Canada makes a loan to a non-resident, the ITA does not allow for the nonresident to be taxed on this loan. Subsection 15(2) applies where the corporation that makes the loan to the shareholder is the one whose shares he holds, a corporation related to that corporation, or a partnership of which the corporation or the related corporation is a member. Example 1-4 illustrates this principle. EXAMPLE 1-4 Jean Merso is a shareholder of Merso Holdco Ltd., which holds 51% of the shares of Bosol Inc. If Bosol Inc. makes a loan to Jean Merso, the provisions of subsection 15(2) may apply with respect to the loan. If subsection 15(2) applies, Jean Merso must include the total amount of the loan in his income for the year in which the loan was made. The provisions of subsection 15(2) also apply when the loan is made, not to the shareholder himself but to a person who is connected with him or to a person who is indirectly a shareholder through a partnership or trust of which he is a member or beneficiary. In such a case, the person to whom the loan was made must include it in his income. Persons connected with a shareholder are described in subsection 15(2.1) as any person not dealing at arm s length with the shareholder, with the exception of certain foreign affiliates. EXAMPLE 1-5 Return to Example 1-4. Subsection 15(2) could apply to a loan made by Bosol Inc. or Merso Holdco Ltd. to the daughter of Jean Merso. If subsection 15(2) applies, it is the daughter of Jean Merso who must include the total amount of the loan in her income for the year in which the loan was made to her. Advanced Personal & Corporate Taxation Reading 1-2 1

16 Exceptions Subsection 15(2) does not apply unless the person to whom the loan is made is a shareholder or is connected with the shareholder. Consequently, a loan made by a corporation to an employee who is neither a shareholder nor connected with a shareholder does not fall under this rule. Exceptions for shareholders include: 1. Repayment in the year following the taxation year in which the loan is made or the indebtedness incurred [subsection 15(2.6)]: The loan is not required to be included in the shareholder s income if it is repaid within the year following the end of the taxation year of the lending corporation in which the loan was made. Example 1-6 illustrates this exception. EXAMPLE 1-6 The lender corporation s taxation year ends on June 30. On July 2, 2010, the corporation made a loan to one of its shareholders. The shareholder will be able to take a maximum of just under two years to repay the loan. The corporation made a loan in its taxation year from July 1, 2010, to June 30, To avoid including this amount as income for 2010, the shareholder must repay the loan in the year following the end of the corporation s taxation year in which the loan was made, that is, it must be repaid no later than June 30, If only a portion of the loan is repaid before July 1, 2012, only the portion unpaid on June 30, 2012 must be added to the income for the year in which the loan was made, which in this example is In order for this exception to apply, the repayment must not be part of a series of loans and repayments. In Example 1-6, if the shareholder repaid the loan on June 28, 2012, and the corporation reloaned him the amount on July 3, 2012, the loan would not be considered as repaid, and the amount of the loan would be included in the shareholder s income for 2010 under subsection 15(2). When a shareholder has a current loan account in which payments made by the corporation to third parties on behalf of the shareholder, advances, or other transactions are recorded, the specific facts of each case must be examined to determine if the transactions in this account are part of a series of loans and repayments. When the year-end balance of a current loan account is repaid in the form of declared dividends and wages credited to the loan account, CRA agrees that these payments should not be considered as being part of a series of loans or repayments. Example 1-7 illustrates the treatment of a series of current loan accounts according to the current policy of CRA when the annual balance of the loan account is repaid by means of an annual dividend declaration. 2 Reading 1-2 Advanced Personal & Corporate Taxation

17 EXAMPLE 1-7 Sergei Romanov is the sole shareholder of Juxtapose Inc. The corporation s taxation year ends August 31. Throughout the year, Juxtapose Inc. advances amounts to Sergei in the form of cheques made out to him or payments to third parties on his behalf. Two months after the end of the taxation year, a dividend equal to the year-end balance of Sergei s running account is declared and paid, reducing the running account. Following is a breakdown of Sergei s running account as shown in the books of Juxtapose Inc. for 2008 to Balance as at August 31, 2008 $ September to December: various payments 15,000 Balance as at December 31, ,000 January to August: various payments 18,000 Balance as at August 31, ,000 September to December: various payments 22,000 October: repayment in the form of a declared dividend (33,000) Balance as at December 31, ,000 January to August: various payments 17,000 Balance as at August 31, ,000 September to December: various payments 12,000 October: repayment in the form of a declared dividend (39,000) Balance as at December 31, ,000 January to August: various payments 9,000 Balance as at August 31, 2011 $ 21,000 Tax consequences According to the administrative position adopted by CRA, the repayments of the balance at the end of the taxation year of Juxtapose Inc. (August 31) two months after the year end by means of a declared dividend to Sergei are not part of a series of loans and repayments. Since the money advanced or loaned by Juxtapose Inc. in a given taxation year was repaid within twelve months after the year end no amount is taxable under subsection 15(2). Consult paragraph 36 of interpretation bulletin IT-119R4 for an illustration of how subsection 15(2) applies when there are a series of loans and repayments. 2. Loans made or indebtedness arising in the ordinary course of the lender s business [subsection 15(2.3)]: A corporation whose ordinary activity is the lending of money may make a loan to a shareholder or connected person in the ordinary course of business without the loan being included in their income. This also applies to indebtedness arising in the normal course of the lender s business. However, for this exception to apply, bona fide arrangements must be made, and adhered to, for the loan to be repaid within a reasonable time. 3. Loans received as employees [subsection 15(2.4)]: There are exceptions to the application of subsection 15(2) that depend on the use for which the money is borrowed; however, these apply only to shareholders or connected persons who are also executives or employees of the lender corporation. The executive or employee must use the loan to: Advanced Personal & Corporate Taxation Reading 1-2 3

18 Deduction on repayment purchase or construct a dwelling for personal use [paragraph 15(2.4)(b)]; purchase treasury shares (previously unissued shares) of the corporation or a related corporation [paragraph 15(2.4)(c)]; or purchase an automobile to be used in the performance of the duties of his office or employment [paragraph 15(2.4)(d)]. In addition, in all cases: the loan must be obtained because of the employment and not because of the number of shares held [paragraph 15(2.4)(e)], and bona fide arrangements must be made and adhered to for repayment of the loan within a reasonable time [paragraph 15(2.4)(f)]. The exemption applicable to an employee purchasing a dwelling for personal use also applies to a loan made to the employee s spouse. Note also that it extends to the purchase of shares of the capital stock of a cooperative housing corporation where the sole purpose of the purchase is to acquire the right to personally inhabit a dwelling owned by the cooperative corporation. The exception relating to loans for the purchase of shares also applies where the loan is made by a corporation related to the corporation that employs the shareholder or the person connected with the shareholder. Where the employee-shareholder to whom the loan was made has, alone or together with persons with whom the employee-shareholder does not deal at arm s length, less than 10% of the issued shares of a given class of the capital stock of the corporation or a related corporation, the use made of the money is irrelevant [paragraph 15(2.4)(a)]. It is sufficient that the loan is made to him in his capacity as an employee and arrangements have been made in good faith to repay the loan within a reasonable time. It is not always easy to determine whether a person obtained a loan as an employee or as a shareholder. The following criteria may be considered in making this determination: Are similar benefits granted to other employees of the corporation? Is the loan in proportion to the importance of the services rendered to the corporation, considering the salary and other remuneration paid? Would an employee of a similar-sized business who was not a shareholder have received a similar loan? What is the extent of the employee-shareholder s control over the corporation? If the loan is made to the employee-shareholder in his capacity as a shareholder, the above-mentioned exceptions do not apply, and the amount loaned must be included in the shareholder s income for the year in which the loan was made, even if the loan is interest-bearing and reasonable arrangements have been made for repayment. When a person repays, in whole or in part, a loan included in his income for a previous year under subsection 15(2), he may, under paragraph 20(1)(j), deduct the amount of the repayment from his income for the year in which the repayment is made. 4 Reading 1-2 Advanced Personal & Corporate Taxation

19 Example 1-8 illustrates how subsection 15(2) and paragraph 20(1)(j) apply. EXAMPLE 1-8 Jambore Inc., whose fiscal period ends March 31, made an interest-free loan of $20,000 to Myriam Dusseault on February 5, Myriam, who owns 25% of the shares of Jambore Inc., uses the borrowed money to purchase a painting by a recognized artist. She repays the loan on October 31, Jambore Inc. is in the business of importing and distributing oriental carpets. Tax consequences Myriam will have to include an amount of $20,000 in her income for 2010, since the loan was not repaid within the one-year period following the end of the taxation year of Jambore Inc. during which the loan was made, that is, before April 1, 2011, and it is not a loan that is otherwise exempt. Under paragraph 20(1)(j), Myriam will be able to deduct $20,000 from her income for 2012, that being the amount repaid during the year. Deemed interest Under subsections 80.4(2) and 15(9), where a shareholder or person with whom the shareholder does not deal at arm s length has received an interest-free or low-interest loan, the shareholder or that person may be required to include an amount in income equal to the benefit of paying little or no interest. However, a taxable benefit for insufficient interest is not required to be included in the shareholder s income where the amount of the loan must otherwise be included in computing his income under subsection 15(2) [paragraph 80.4(3)(b)]. More particularly, this rule applies where: a particular corporation, a corporation related to the particular corporation, or a partnership of which either or both corporations is a member; has made a loan to a person or partnership that was: a shareholder of the particular corporation, a person connected with the shareholder of the particular corporation, or a person who is a shareholder indirectly through a partnership or trust; and the loan has not been included in income under subsection 15(2). Subsection 80.4(2) does not apply where the loan is granted to a corporation resident in Canada or to a partnership whose members are all corporations resident in Canada. Where subsection 80.4(2) applies, the value of the benefit calculated for a taxation year, and hence the calendar year for an individual, is determined as follows: 1. Determine the amount of deemed interest computed at the prescribed rate for the period in the year during which the loan was outstanding. 2. From the amount obtained in step 1, deduct the interest for the year paid to the corporation on the loan during the year and within 30 days after the end of the year. Advanced Personal & Corporate Taxation Reading 1-2 5

20 The prescribed interest rate is contained in REG 4301 and is set every quarter. In practice, you can obtain the rates prescribed for the different quarters since 1996 on the CRA website under the tab All rates. Where a taxable benefit in the form of deemed interest has been included in a shareholder s income for an interest-free loan or low-interest loan, and subsequently this loan is taxed under subsection 15(2), the taxable benefit must be cancelled and the return will be amended, as illustrated in Example 1-9. EXAMPLE 1-9 Interest-free loan made on July 1, 2009 $ 50,000 Corporation s year end: December 31 Amount of the interest included in the shareholder s income in 2009 as a taxable benefit (assume the prescribed rate is 3% for the entire year) $ 750 Loan repaid in December 2011 Because the shareholder did not repay the loan within one year after the end of the corporation s taxation year in which the loan was made, the amount of the loan must be included in the shareholder s income for Furthermore, since the loan is included in the shareholder s income, no taxable benefit for unpaid interest need be imputed to him for 2009, 2010, or Amendment to the shareholder s income 2009 Inclusion of the loan [15(2)] $ 50,000 Cancellation of the deemed interest [80.4(3)(b)] (750) Increase in 2009 income $ 49,250 As the loan was repaid in 2011, the shareholder may deduct $50,000 from his 2011 income under paragraph 20(1)(j). Employee-shareholder Where an employee-shareholder received a loan in his capacity as an employee (such as a loan for the purchase of an automobile to be used in his employment), the interest benefit is computed under subsections 80.4(1) and 6(9) rather than subsections 80.4(2) and 15(9). The computation is essentially the same, but the amount of the benefit is included in computing employment income. Where subsection 80.4(1) applies, the employee is still taxed on the amount of the benefit, even if the loan is made to a person related to that employee. Where the loan is made to the employee-shareholder, by virtue of employment, for the purchase of a dwelling, the benefit may be calculated by using the lesser of a. the prescribed rate in effect when the loan was made, or b. the prescribed rate in effect each quarter during which the loan remains unpaid. Where the loan has a term exceeding five years, it will be deemed to be a new loan on each fifth anniversary. The prescribed rate in effect on that date will replace the original prescribed rate. These rules are contained in subsections 80.4(4) and 80.4(6), and apply to both home purchase loans and home relocation loans. Read paragraphs 17 to 22 of IT-421R2, which cover these rules. 6 Reading 1-2 Advanced Personal & Corporate Taxation

21 Deduction under section 80.5 Under section 80.5, if the loan is used to earn income or acquire income-producing property, the amount of the benefit may be deducted as interest paid on a loan in computing the shareholder s income. This matter is explained in paragraph 24 of IT-421R2. For example, where a corporation makes an interest-free loan to an employee-shareholder to enable the person to purchase an automobile to be used in the performance of the duties of his office or employment, the amount of the taxable benefit corresponding to the unpaid interest on the loan will be considered to be interest paid on a loan for the purchase of an automobile. Consequently, it will be included in computing the automobile expenses deductible by the employee-shareholder under paragraph 8(1)(j). Examples 1-10 and 1-11 illustrate the joint application of subsections 15(2) and 80.4(2), and paragraph 20(1)(j). EXAMPLE 1-10 Mary Yasita is the sole shareholder of Mataploc Inc., whose fiscal period ends November 30 of each year. On January 15, 2010, Mataploc Inc. made a $300,000 loan to Mary for the purchase of a residence. Mataploc Inc. does not make loans to its employees. The loan bears interest at 5%, and the principal is repayable at the rate of $30,000 per year for a period of 10 years. Mary makes her payments of principal and interest annually on the date stipulated, that is, on January 15 of each year. Assume that the prescribed rate is constant at 3% and the commercial rate prevailing at the time the loan was made was 6%. Tax consequences The loan made to Mary is not an exempt loan, for although it was used to purchase a residence and arrangements were made in good faith to repay it within a reasonable period, it was not made to Mary by reason of her employment. In her income for 2010, Mary will have to include an amount of $270,000 ($300,000 less the January 2011 repayment). Under paragraph 20(1)(j), for 2012 and following years, she will be able to deduct from her income $30,000 per year, the amount repaid during the year. The amount of $30,000 repaid in January 2011 does not have to be included in income under subsection 15(2) because it was repaid within the one-year period following the end of the taxation year of the corporation during which the loan was made. This amount is subject to the provisions of subsection 80.4(2). However, since the loan bears interest at a rate higher than the prescribed rate and the interest was actually paid within thirty days following the end of the year, there will be no amount to be included in income for 2010 or 2011 under 80.4(2). EXAMPLE 1-11 Return to the facts of Example 1-10, but assume that Mary makes the first payment of capital and interest on March 15, 2011 instead of January 15, 2011 and that the subsequent annual payments are made on time. What are the tax consequences of the late payment? The amount of $30,000 repaid in March 2011 does not have to be included in income under subsection 15(2) because it was repaid within the one-year period following the end of the taxation year of the corporation during which the loan was made. However, a taxable benefit with respect to the interest will have to be included in Mary s income for 2010 because the interest, while higher than the prescribed rate, was not paid within the 30 days after the end of the year as required by subsection 80.4(2). Advanced Personal & Corporate Taxation Reading 1-2 7

22 (2) applicable on $30,000 from January 15 to December 31, % $30, $ 863 Less: Interest paid in 2010 or at the latest on January 30, 2011 ( 0) Benefit $ There is no taxable benefit for 2011 since the interest on the $30,000 for the period unpaid in 2011 (January 1, 2011 to March 15, 2011) will have been paid before January 30, Specifically, the payment on March 15, 2011 covers the interest from January 1, 2011 to January 15, 2011 and the payment on January 15, 2012 includes the interest from January 16, 2011 to March 15, (2) applicable on $30,000 from January 1 to March 15, % $30, $ 182 Less: Interest paid on March 15, 2011 and January 15, 2012 with respect to this period 5% $30, ( 304) Benefit (cannot be negative) $ This example illustrates an important point. When a loan to a shareholder is not included in income under subsection 15(2) and it bears interest, the terms with respect to the payment of interest must be such as to ensure that the payment of the interest for a calendar year will be made at the latest by January 30 of the following year. Sometimes this means that the date for the annual repayment of principal may be different from the date for the payment of interest. For example, assume a loan exempted from subsection 15(2) is granted to a shareholder on April 1 and that the terms of the loan specify that the annual payments of principal and interest are to be made on April 1 of each year. In such a case, even though the interest is paid on the due date under the terms of the loan and is at a rate higher than the prescribed rate, the interest paid on April 1 of a year with respect to interest accrued from April 2 to December 31 of the previous year will not be taken into account when computing a taxable benefit under subsection 80.4(2) for that previous year because it was not paid within the required time period. The terms of the loan must insure that the payment of interest for a given calendar year are paid at the latest by January 30 of the following year while the repayment of principal may be at the anniversary date of the loan or any other date. Under paragraph 80.4(3), the interest benefit rules under 80.4 (1) and (2) do not apply on a loan on which the interest rate is equal or higher than the commercial rate available from a financial institution on the open market at the time the loan was received for loans having similar terms and conditions. In Example 1-11, if the interest rate on the loan had been 6%, that is, the commercial rate, no interest benefit would have to be included in the 2010 income, since subsection 80.4(2) would not have applied by virtue of the exception in paragraph 80.4(3). 8 Reading 1-2 Advanced Personal & Corporate Taxation

23 Control and records Loans and advances to shareholders and members of their families must be recognized separately from other debts. The terms and conditions of each loan must be known and must be checked annually for compliance. This serves to determine whether a shareholder or a member of his family must include an amount in his income under subsection 15(2) or 80.4(2). Here again, it is the CGA s duty to help the client set up a procedure for proper follow-up of loans and advances to shareholders and persons related to them, and thereby avoid harmful tax consequences. Advanced Personal & Corporate Taxation Reading 1-2 9

24

25 READING 1-4 Paid-up capital LEVEL 1 Before being able to compute the amount of a deemed dividend under section 84, you must understand the concept of paid-up capital (PUC). According to the definition of PUC in subsection 89(1), paid-up capital is generally equal to the amount recorded as issued and outstanding share capital as determined under the legislation under which the corporation was formed (legal PUC). It therefore represents the contribution of capital to the corporation on the issue of shares, as recorded in the corporation s legal records. An amount recorded in contributed surplus is not included in PUC. For example, if a share is issued for $100 but only $25 is entered as the amount paid for the share while $75 is entered as part of a contributed or other surplus, then $25 will be taken into account when calculating the PUC. It should not be assumed that the capital entered on the financial statements in accordance with GAAP is always equal to the legal capital. Under some accounting rules, such as those on transactions between related persons provided for in section 3840 of the CICA Handbook, accounting capital is sometimes shown as different from legal capital. When shares are issued as consideration for a non-cash contribution and in some exceptional cases, adjustments to PUC are required under specific provisions of the ITA. Sections 84.1, 84.2, and as well as subsections 51(3), 66.3(2), 66.3(4), 85(2.1), 85.1(2.1), 86(2.1), 87(3), 87(9), 128.1(2), 128.1(3), 138(11.7), 139.1(6) and (7), 192(4.1), and 194(4.1) contain such provisions. Note that most of these adjustments are intended to prevent the conversion of other income into a capital gain in transactions involving the issue of shares, so as to prevent undue use of the capital gains deduction (CGD also called the capital gains exemption or CGE) or avoidance of non-resident tax on dividends, or merely to take advantage of the more favourable tax rate for capital gains. PUC is determined by class of shares and the PUC of a share of a particular class is equal to the PUC of the class divided by the number of shares issued in the class. Example 1-12 illustrates the computation of PUC in a case where no adjustment applies. EXAMPLE 1-12 Joe Perkins acquires 100 Class A treasury shares from Opco Ltd. for $10,000. This amount is entered as legal PUC in the corporation s books. Class A shares previously issued: 500 shares with a PUC of $2,000. Tax consequences 1. PUC of each Class A share after the issue of 100 shares: Total PUC ($10,000 + $2,000) $ 12,000 Divided by the number of issued shares 600 PUC per share $ 20 Advanced Personal & Corporate Taxation Reading 1-4 1

26 2. For Joe Perkins: Total PUC of the 100 Class A shares held by Joe (100 $20) $ 2,000 ACB of the 100 Class A shares held by Joe $ 10,000 In this example, note that Joe Perkins paid $10,000 for 100 Class A shares but their PUC is $2,000. This is due to the fact that PUC is not a concept connected with the shareholder, as is ACB. The PUC is connected with the class of shares. It is computed at a given point in time, taking into account all the capital paid to the corporation for the shares issued in a given class on the date in question, regardless of who actually paid these amounts. The PUC represents the return of capital that may be received by a shareholder without the amount being subject to tax as a dividend, as you will see below. The PUC of a share is not affected by the subsequent purchase or sale of this share. In Example 1-12, if Joe Perkins were to sell his 100 shares to Sally Chong for $15,000, the PUC of the shares in Sally s hands would remain at $2,000, even though for Sally the ACB of the shares would be $15,000. This distinction between the PUC of shares and their ACB is very important. The PUC serves to determine whether there is a deemed dividend in the case of certain transactions provided for in section 84 that involve the issuing corporation, whereas the ACB is one of the elements entering into the calculation of the capital gain or loss where there is a disposition of shares. Exhibit 1-1 compares and contrasts PUC and ACB. EXHIBIT 1-1 PUC of a share Comparative table ACB of a share Same for all shareholders holding shares of the same class Equal to the average of the PUC of all shares issued in the class Serves to determine the deemed dividend in some transactions carried out by the issuing corporation May be different for each shareholder holding shares in the class Equal to the price paid by the shareholder to acquire the share Serves to determine the capital gain or loss on disposition of the share Legal considerations The corporation s Act of incorporation determines the amount that can be recorded as the amount paid for the shares in the legal books of the corporation. In general, 1. If the shares have a nominal value, the amount paid is the nominal value. Any excess amount paid is included in a contributed surplus. 2. If the shares have no nominal value, what is generally recorded is the FMV of the consideration received when they are issued, unless the Act of incorporation provides for exceptions. Normally, when the shares are issued as consideration for a cash payment, the amount paid is equal to the amount received. Exceptions may apply only when the 2 Reading 1-4 Advanced Personal & Corporate Taxation

27 consideration consists of property other than cash or services, or when the shares are issued as part of a reorganization. For the purposes of this course, unless otherwise indicated, the shares mentioned in examples or exercises have no nominal value and are issued for cash. Practical aspect Determining the ACB of a share is usually easy. Ask the client how he acquired the shares and check the documents relating to this acquisition, such as the agreement of sale, the term sheet or, if the shares were acquired on the death of a person, the final return of the person from whom the shares were inherited. In exceptional cases, there will be an adjustment under paragraph 53(1)(b) or 53(2)(b). However, it is sometimes difficult to determine the PUC of a share. The legal books of the corporation should be consulted to find information on the original issue of the shares of the class. Sometimes, these books are not up-to-date or are unavailable. In this case, the corporation s legal advisor should be consulted. Also, other documents must be examined if the shares were issued for a non-cash consideration, in order to determine whether adjustments must be made under various provisions of the ITA, including sections 84.1, 84.2, and 212.1, as well as subsections 51(3), 66.3(2), 66.3(4), 85(2.1), 85.1(2.1), 86(2.1), 87(3), 87(9), 128.1(2), 128.1(3), 138(11.7), 139.1(6) and (7), 192(4.1), and 194(4.1). The financial statements should not serve as a basis for determining the PUC. Nor should you rely on the amount supplied by the client or the accountant of the corporation without checking the method that was used to determine it. Once checked, the information on the PUC of the different classes of shares should be kept in the permanent file on the client. Advanced Personal & Corporate Taxation Reading 1-4 3

28

29 READING 1-5 Deemed dividends LEVEL 1 The purpose of section 84 is to prevent the withdrawal of funds of a corporation resident in Canada as a return of capital. Certain transactions, which are not dividend payments from a legal point of view, will be treated as such for purposes of the ITA. Such dividends are deemed dividends. These deemed dividends, like all dividends from corporations resident in Canada, must be grossed up under subsection 82(1)(b) and will entitle the shareholder to a dividend tax credit if the shareholder is an individual. If the shareholder is a corporation, a dividend from a taxable Canadian corporation will be deductible from income under subsection 112(1) and may be subject to Part IV tax. Before dealing with deemed dividends under section 84, it is useful to review the rules on the taxation of dividends received from corporations resident in Canada by individuals resident in Canada. After 2005, the taxation of dividends depends on whether or not the dividend is designated as an eligible dividend. Designation is done by notifying the beneficiary in writing that the dividend paid to him is an eligible dividend. The table below shows the grossup and dividend tax credit rates on an eligible dividend and a non-eligible taxable dividend for Type of dividend Gross-up Federal credit % of grossed-up dividend Non-eligible dividend 25% 13.33% (2/3 of gross-up) Eligible dividend 41% 16.44% (13/23 of gross-up) The gross-up rate and the tax credit rate on eligible dividends are different from 2009 to 2012 to take account of the reduction in the corporate tax rate. Starting in 2012, the gross-up rate will be 38% and the federal dividend credit will be 15%. Whether or not an eligible dividend can be paid depends on the type of corporation. For a Canadian-controlled private corporation (CCPC), a dividend can be designated as eligible up to the balance in the corporation s general rate income pool (GRIP) at the end of the taxation year. Essentially, the GRIP of a CCPC will be its income that was not subject to the small business deduction (SBD) or any other special tax rate. The GRIP rules and calculations have been studied in a previous course. For corporations other than a CCPC, it is possible to designate all dividends as eligible dividends, provided that the low rate income pool (LRIP) of the corporation is nil at the time the dividend is paid. If the corporation has an LRIP, it must first pay enough taxable dividends to bring the LRIP down to zero before it can pay eligible dividends. Essentially, the LRIP of a corporation (other than a CCPC) will be its income which is not taxed at the general tax rate (that is, non-eligible taxable dividends received from other corporations that are deducted in computing its taxable income). The LRIP rules and calculations have been studied in a previous course. When a transaction involving a corporation resident in Canada results in a deemed dividend under section 84, this dividend can be designated as an eligible dividend, taking the abovementioned limitations into account. The rules set out below regarding deemed dividends apply to private corporations. They may also apply to public corporations in some cases. The study of rules for public corporations is highly specialized and will not be covered here. Advanced Personal & Corporate Taxation Reading 1-5 1

30 Artificial increase in paid-up capital Since the PUC may be returned to shareholders without being treated as a taxable dividend, it may be advantageous to artificially increase the PUC of a class of shares of the corporation. Under subsection 84(1), where there is an artificial increase in the PUC of a class of shares, the amount of the increase is deemed to be a dividend paid immediately after the transaction by the corporation to the shareholders of the class. The deemed dividend is distributed among the shareholders of the class of shares proportionately to the number of shares held after the increase that gave rise to the deemed dividend. An artificial increase in PUC arises where the PUC of the issued shares of a class of shares is increased without: a corresponding increase in the value of the corporation s assets a corresponding reduction in the value of its net liabilities a corresponding reduction in the PUC of another class of shares The conversion of contributed surplus to PUC of a class of shares may also give rise to a deemed dividend under subsection 84(1). Such conversion does not give rise to a deemed dividend provided that the two following conditions are met: the contributed surplus arises from the issue of shares of such class after March 31, 1977, and neither the rollover provisions nor sections 84.1 or are applied on the issuance. Under this provision, the PUC of a class of shares may be increased without tax consequences to reflect the amount received from shareholders on the issue. For example, shares having a nominal value of $20 were issued for $25. At the time of the issue, $20 was added to the legal PUC and $5 to contributed surplus. If the corporation wishes to amend its share capital structure to convert the contributed surplus created on the issue to PUC of shares, this conversion may be undertaken without any deemed dividend consequences provided the conditions mentioned above are met. Also excluded from the purview of subsection 84(1) is the conversion of a contributed surplus created after March 31, 1977, through the transfer of property to the corporation by a shareholder of that class, even if no shares were issued at the time, as, for example, in the case of a gift of property to the corporation. Under paragraph 53(1)(b), a deemed dividend received under subsection 84(1) is added to the adjusted cost base (ACB) of the shares held. This adjustment is allowed so that the amount will not be subject to double taxation. Under proposed technical amendments to the ITA, in the case of a corporation taxed on a deemed dividend under subsection 84(1), the amount of the dividend is not added to the ACB of the shares if the corporation deducted the amount of the dividend from its income under section 112, except for the portion of the dividend that is attributable to safe income. Example 1-13 provides an example of how subsection 84(1) applies when the PUC of a corporation increases without there being a corresponding increase in the value of the net assets of the corporation. EXAMPLE 1-13 Liz Kelly and her spouse, Rafael Gomez, each own 50 Class A shares of the corporation Phoenix Ltd., for which each paid $5,000. Phoenix Ltd. is a CCPC that has a nil GRIP. Liz transfers land valued at $20,000 to Phoenix Ltd. in exchange for 50 Class A shares having a PUC and FMV of $30,000. The ACB of the land for Liz is $15, Reading 1-5 Advanced Personal & Corporate Taxation

31 Tax consequences The provisions of subsection 84(1) apply because Phoenix Ltd. issues shares having a PUC of $30,000 in exchange for property that is worth only $20,000. The PUC of the Class A shares has increased by $30,000, whereas the value of the net assets has increased by only $20,000. Therefore, there is an artificial increase of $10,000 in the PUC. Furthermore, since Liz receives $30,000 from the corporation for property that is worth only $20,000, she receives a benefit that must also be taken into account when the land is disposed of. The tax consequences of the transaction for Liz, Rafael, and Phoenix Ltd. are as follows: For Liz: Deemed dividend [84(1)] Increase in the PUC of the Class A shares $ 30,000 Increase in net assets: FMV of the land (20,000) Deemed dividend $ 10,000 Liz s share ( ) $ 6,667 Under paragraph 82(1)(b), this amount must be grossed up by 25% when it is included in Liz s income as this is not an eligible dividend. Since the corporation has no GRIP, it cannot make a designation to this effect. The dividend tax credit granted is 13.33% of the grossed-up dividend at the federal level, and the provincial tax credit varies depending on Liz s province of residence. Taxable benefit [15(1)] FMV of the Class A shares received $ 30,000 FMV of the land (20,000) 10,000 Deemed dividend [84(1)] (10,000) Benefit conferred [15(1)] $ Under subsection 15(1), a benefit conferred on a shareholder is not taxed under that subsection to the extent of the amount deemed to be a dividend by section 84. ACB of the Class A shares Acquisition cost of the 50 new shares $ 20,000 Deemed dividend [84(1), 53(1)(b)] 6,667 26,667 ACB of the 50 shares held before the transfer of the land 5,000 ACB of the 100 shares held by Liz $ 31,667 Capital gain on land POD FMV of shares received $ 30,000 ACB (15,000) Gain 15,000 Less: Amount already included in income [84(1), 39(1)(a)]* (6,667) Capital gain $ 8,333 Taxable capital gain (1/2) $ 4,167 Advanced Personal & Corporate Taxation Reading 1-5 3

32 * An adjustment under paragraph 39(1)(a) is made because the portion of the POD of the land that exceeds its FMV constitutes a taxable benefit to the shareholder that is taxed as a deemed dividend. For Rafael: Deemed dividend [84(1)] Increase in the PUC of the Class A shares $ 30,000 Increase in net assets: FMV of the land (20,000) Deemed dividend $ 10,000 Rafael s share (50 150) $ 3,333 Under paragraph 82(1)(b), this amount must be grossed up by 25% when it is included in Rafael s income as this is not an eligible dividend. Since the corporation has no GRIP, it cannot make a designation to this effect. The dividend tax credit granted is 13.33% of the grossed-up dividend at the federal level, and the provincial tax credit rate varies depending on Rafael s province of residence. ACB of the Class A shares ACB of the 50 shares held before the deemed dividend $ 5,000 Deemed dividend [84(1), 53(1)(b)] 3,333 ACB of the 50 shares held by Rafael $ 8,333 For Phoenix Ltd.: Cost of land [69(1)(a)] $ 20,000 You should recall that when a shareholder transfers property to a corporation and receives consideration greater than the FMV of the property transferred, the shareholder obtains a taxable benefit that must normally be included in the shareholder s income under subsection 15(1). However, it is mentioned at the beginning of subsection 15(1) that only that portion of the benefit that is not considered a dividend under section 84 is included in income under subsection 15(1). In Example 1-13, since the amount of the taxable benefit ($10,000) is equal to the amount of the deemed dividend under subsection 84(1), there is no taxable benefit under subsection 15(1). See paragraph 7 of IT-432R2 for an illustration of where subsections 15(1) and 84(1) apply. Distribution on the reorganization or winding-up of a business Where property or funds of a corporation have been distributed or appropriated to its shareholders on a winding-up, discontinuance, or reorganization of its business, the corporation is deemed to have paid a dividend to the shareholders to the extent that the value of the assets distributed exceeds the reduction in PUC at that time. The dividend is computed by class of shares, and each shareholder of a class of shares is deemed to have received a dividend proportionate to the number of shares held before the transaction. Under subsections 69(4) and 69(5), if the corporation distributes property other than cash, there is a deemed disposition of such property at its FMV. This may result in tax consequences. 4 Reading 1-5 Advanced Personal & Corporate Taxation

33 The deemed dividend under subsection 84(2) is not considered to be POD if there is a disposition of shares in the process [section 54: proceeds of disposition, paragraph (j)]. Purchase or redemption of shares by the issuing corporation In corporate law, a corporation may issue redeemable or retractable shares. Other shares may be issued without a right of redemption being attached to them, as is usually the case with common shares. In the latter case, there is nothing to prevent the issuing corporation from purchasing by mutual consent the shares held by a shareholder and cancelling them. Regardless of whether the shares are redeemed under a right of redemption or purchased by the issuing corporation by mutual consent, under subsection 84(3) there is a deemed dividend for the shareholder equal to the difference between the amount paid by the corporation and the PUC of the shares. According to the definition of a disposition in subsection 248(1), when a share is redeemed, acquired, or cancelled, there is a disposition of that share, and the capital gain or loss realized on the disposition must therefore be determined. In order to avoid double taxation, the amount of the deemed dividend under subsection 84(3) is excluded from the POD of the share under paragraph (j) of the definition of proceeds of disposition in section 54. In summary, each time a corporation carries out a redemption or retraction of one of its shares, there are two possible tax consequences for the shareholder from whom the share is redeemed or retracted. These tax consequences are not mutually exclusive but are instead cumulative. Thus, it is necessary to proceed in two steps: 1. Determine whether there is a deemed dividend under subsection 84(3): this will be the case when the amount paid to the shareholder is greater than the PUC of the share; and then 2. Determine whether the disposition of the share results in a capital gain or loss: this will be the case when the POD adjusted to take the deemed dividend into account is greater or lesser than the ACB of the share. Example 1-14 illustrates the tax consequences of a redemption of shares. EXAMPLE 1-14 Jean Noël owns 1,000 Class B shares of Delta Ltd. These shares have a PUC of $10,000 and a redemption value of $15,000. The ACB of the shares for Jean is $9,000. On December 31, 2011, Delta Ltd. redeems the 1,000 Class B shares held by Jean. Delta Ltd. is a CCPC with a large GRIP. Tax consequences Deemed dividend [84(3)] Amount paid on redemption $ 15,000 PUC (10,000) Deemed dividend $ 5,000 Under paragraph 82(1)(b), this amount must be grossed up by 25% or 41% when it is included in Jean s income, depending on whether the dividend is non-eligible or eligible. The dividend tax credit granted is equal to 13.33% or 16.44% of the grossed-up dividend at the federal level, and the provincial tax credit rate varies depending on Jean s Advanced Personal & Corporate Taxation Reading 1-5 5

34 province of residence. In order for the dividend to be an eligible dividend, Delta Ltd. must inform Jean of this in writing. Capital gain POD [54] Amount received $ 15,000 Deemed dividend [84(3)] (5,000) $ 10,000 ACB (9,000) Capital gain $ 1,000 Taxable capital gain (1/2) $ 500 Example 1-14 shows the distinction to be made between PUC, which is used for calculating the deemed dividend, and the ACB, which enters into the calculation of capital gain. Also note that a single transaction, in this case a share redemption, gives rise to both a deemed dividend and a capital gain. This is because a share redemption, subject to the provisions of subsection 84(3), constitutes a disposition of shares according to the definition of a disposition in subsection 248(1). When a shareholder suffers a loss on the redemption, acquisition, or cancellation of a share and immediately after the redemption, acquisition or cancellation of the share, the shareholder or his spouse controls the corporation, the loss is deemed to be nil under subsection 40(3.6). Subsection 40(3.6) applies because subsection 84(9) presumes that the redeemed, acquired, or cancelled shares have been disposed of to the corporation. Under paragraph 40(3.6)(b), the capital loss denied under subsection 40(3.6) is added to the ACB of the shares that the shareholder still holds in the corporation. If he does not hold any, the loss can no longer be used. Example 1-15 illustrates a situation in which subsection 40(3.6) applies. EXAMPLE 1-15 Josie owns 75% of the common shares of Coats Ltd. as well as 500,000 non-voting, nonparticipating preferred shares redeemable or retractable for $1 each. The details of her shareholdings are as follows: PUC ACB FMV 750 common shares $ 750 $ 750 $ 100, ,000 preferred shares $ 10,000 $ 500,000 $ 500,000 In 2011, Josie needs cash, and 200,000 preferred shares are redeemed by Coats Ltd. for $200,000. Coats Ltd. is a CCPC with a large GRIP. Tax consequences For Josie: Deemed dividend [84(3)] Amount paid on redemption $ 200,000 PUC [(200, ,000) $10,000] (4,000) Deemed dividend $ 196,000 6 Reading 1-5 Advanced Personal & Corporate Taxation

35 Under paragraph 82(1)(b), this amount must be grossed up by 25% or 41% when it is included in Josie s income, depending on whether the dividend is non-eligible or eligible. The dividend tax credit granted is equal to 13.33% or 16.44% of the grossed-up dividend at the federal level, and the provincial tax credit rate varies depending on Josie s province of residence. In order for the dividend to be an eligible dividend, Coats Ltd. must inform Josie of this in writing. Capital loss POD [54] Amount received $ 200,000 Deemed dividend [84(3)] (196,000) $ 4,000 ACB [(200, ,000) $500,000] (200,000) Capital loss $ (196,000) Since Josie controls Coats Ltd. after the redemption, she is affiliated with it and the loss of $196,000 is deemed nil under paragraph 40(3.6)(a). Under paragraph 40(3.6)(b), the amount of the loss is added to the ACB of the shares that Josie still owns in proportion to their FMV. Increase in the ACB of the common shares $196,000 ($100,000 $400,000) $ 49,000 Increase in the ACB of the preferred shares $196,000 ($300,000 $400,000) $ 147,000 Therefore, following the redemption, the shares held by Josie have the following characteristics: PUC ACB FMV 750 common shares $ 750 $ 49,750 $ 100, ,000 preferred shares $ 6,000 $ 447,000 $ 300,000 As a final point on the redemption or purchase of shares by the issuing corporation, it should be kept in mind that the PUC of the class will be reduced by the amount of the PUC of the shares redeemed or purchased, with the result that the PUC of the share will not be changed. In Example 1-15, assuming that Josie held all the preferred shares issued, the PUC of the class, which was $10,000 before the redemption, will be reduced by the PUC of the redeemed shares ($4,000) and therefore the PUC of the class after the redemption will be $6,000 for 300,000 shares, or $0.02 per share. Reduction in paid-up capital Subsection 84(4) covers situations where there is a reduction in the PUC of a class of shares without a reduction in the number of shares through the redemption, acquisition, or cancellation of shares. Where there is such a reduction in PUC, a deemed dividend may result if the amount paid to the shareholder exceeds the amount of the reduction in the PUC of the class. A PUC reduction does not give rise to a disposition by the shareholder of shares whose PUC has been reduced. However, the amount paid in the capital reduction, except insofar as it has Advanced Personal & Corporate Taxation Reading 1-5 7

36 been included in income as a deemed dividend under subsection 84(4), reduces the ACB of the shares [subparagraph 53(2)(a)(ii)]. Example 1-16 shows the tax consequences of a reduction in the PUC of a class of shares. EXAMPLE 1-16 Maria Garcia holds 500 Class Z common shares of Dennon Ltd., a CCPC with a nil GRIP. The PUC of the shares is $100,000 and their FMV is $500,000. Dennon Ltd. no longer requires as much capital as it did on incorporation. It decides to reduce the PUC of the 500 Class Z shares to $10,000 and pays Maria $90,000. The ACB of the 500 Class Z shares for Maria is equal to their PUC of $100,000. Tax consequences For Maria: Deemed dividend [84(4)] Amount paid $ 90,000 Reduction in PUC ($100,000 $10,000) (90,000) Deemed dividend $ ACB of the 500 Class Z shares ACB before the reduction in PUC $ 100,000 Amount paid less dividend under 84(4) [53(2)(a)(ii)] (90,000) ACB after the reduction in PUC $ 10,000 Subsection 84(4) may be very useful where a shareholder has invested significant amounts in a corporation in the form of participating shares and wishes to withdraw the capital without any immediate tax consequences. For example, if Dennon Ltd. had purchased or redeemed the Class Z shares for $90,000 rather than reducing the PUC, it would have had to redeem 90 shares at a FMV of $1,000 each. This would have resulted in a deemed dividend under subsection 84(3). Deemed dividend [84(3)] Amount paid $ 90,000 PUC of the shares ( $100,000) (18,000) Deemed dividend [84(3)] $ 72,000 8 Reading 1-5 Advanced Personal & Corporate Taxation

37 Under paragraph 82(1)(b), this amount must be grossed up by 25% when it is included in Maria s income, as this is not an eligible dividend. Since Dennon Ltd. has no GRIP, it cannot make a designation to this effect. The dividend tax credit granted is 13.33% of the grossed-up dividend at the federal level, and the provincial tax credit rate varies depending on Maria s province of residence. Capital gain POD [54] Amount received $ 90,000 Deemed dividend [84(3)] (72,000) $ 18,000 ACB (18,000) Capital gain $ In comparison, by reducing the PUC, there were no immediate tax consequences. Note that when a corporation reduces its PUC without making a payment to the shareholders, subsection 84(4) does not apply and there is no tax consequence for the shareholders. Deemed dividend payable from the capital dividend account A deemed dividend under section 84 constitutes a taxable dividend under the usual rules. As you know from previous tax courses, these rules vary depending on whether the dividend is received by a corporation or an individual. If the corporation has a capital dividend account (CDA), a deemed dividend under one of subsections 84(1) to (4) may be deemed to be paid from the CDA if the election provided in subsection 83(2) is made. Subsection 84(7) allows a CDA election to be made for a deemed dividend under section 84 by deeming the dividend to have become payable, which is one of the conditions set out in subsection 83(2). You will recall that a dividend paid from the CDA is not taxable and it does not affect the ACB of the shares. Under subsections 112(3) to (3.2), if the shares on which the dividend is deemed to be paid are disposed of and the result is a loss, this loss may be reduced by the dividend paid out of the CDA. Shares distributed in transactions covered by subsections 84(2) to 84(4) For purposes of subsections 84(2) to 84(4), where property distributed to shareholders includes shares of the capital stock of the corporation, the shares should be valued at their PUC rather than at FMV. This rule is contained in subsection 84(5). It is illustrated in Example EXAMPLE 1-17 Annie Duncan owns 200 Class D shares of Zeolite Mines Ltd., having a PUC and ACB of $2,000 and a FMV of $10,000. In 2011, Zeolite Mines Ltd. redeems 100 Class D shares owned by Annie in exchange for 10 Class E shares and $3,000 cash. The Class E shares have a PUC of $800 and a FMV of $2,000. Zeolite Mines is a CCPC with a large GRIP. Advanced Personal & Corporate Taxation Reading 1-5 9

38 Tax consequences Deemed dividend [84(3)] Cash $ 3,000 PUC of Class E shares [84(5)] 800 $ 3,800 PUC of the 100 Class D shares (1,000) Deemed dividend $ 2,800 Under paragraph 82(1)(b), this amount must be grossed up by 25% or 41% when it is included in Annie s income, depending on whether the dividend is non-eligible or eligible. The dividend tax credit granted is equal to 13.33% or 16.44% of the grossed-up dividend at the federal level, and the provincial tax credit varies depending on Annie s province of residence. In order for the dividend to be an eligible dividend, Zeolite Mines must inform Annie of this in writing. Capital gain POD [54] FMV of the Class E shares + cash $ 5,000 Dividend [84(3)] (2,800) $ 2,200 ACB (1,000) Capital gain $ 1,200 Taxable capital gain (1/2) $ 600 ACB of the 10 Class E shares $ 2,000 Planning As you can see, the concept of PUC is very important in transactions affecting the capital stock of a corporation. On a new issue of shares of a given class, it is always necessary to assess the impact on the PUC of the class as well as the future impact for shareholders in the case of, say, the purchase or redemption of shares by the corporation. This assessment will show whether the new issue should instead be done in a different class of shares. Example 1-18 illustrates a situation in which a new shareholder of the corporation subscribes for common shares of the corporation at a different price than the founding shareholder. EXAMPLE 1-18 In 2003, Amira Bissada incorporated Communication Inc. On the incorporation, Amira acquired 100 common shares of the capital stock of Communication Inc. for $10,000. Communication Inc. has grown, and Amira s shares are currently worth $200,000. In order to continue growing, Communication Inc. needs new capital. John Cheng, a Canadian resident, is willing to invest $200,000 in the corporation for a 50% interest. It is therefore agreed to issue him 100 common shares of the capital stock of Communication Inc. in consideration of his investment of $200,000. Communication Inc. is a CCPC with a large GRIP. The transaction takes place in Reading 1-5 Advanced Personal & Corporate Taxation

39 Tax consequences 1. PUC of each of the 200 common shares issued: PUC of the 200 common shares $10,000 + $200,000 $ 210,000 PUC per share $210, $ 1, For John, if his 100 shares were purchased by Communication Inc. for $200,000: Deemed dividend [84(3)] Amount paid $ 200,000 PUC of the 100 common shares (100 $1,050) (105,000) Deemed dividend $ 95,000 Under paragraph 82(1)(b), this amount must be grossed up by 25% or 41% when it is included in John s income, depending on whether the dividend is non-eligible or eligible. The dividend tax credit granted is 13.33% or 16.44% of the grossed-up dividend at the federal level, and the provincial tax credit varies depending on John s province of residence. In order for the dividend to be an eligible dividend, Communication Inc. must inform John of this in writing. Capital gain POD [54] Amount paid $ 200,000 Deemed dividend [84(3)] (95,000) $ 105,000 ACB of the 100 common shares (200,000) Capital loss $ (95,000) Allowable capital loss (1/2) $ (47,500) 3. For Amira, if her 100 common shares were purchased by Communication Inc. for $200,000: Deemed dividend [84(3)] Amount paid $ 200,000 PUC of the 100 common shares (100 $1,050) (105,000) Deemed dividend $ 95,000 Under paragraph 82(1)(b), this amount must be grossed up by 25% or 41% when it is included in Amira s income, depending on whether the dividend is non-eligible or eligible. The dividend tax credit granted is equal to 13.33% or 16.44% of the grossedup dividend at the federal level, and the provincial tax credit rate varies depending on Amira s province of residence. In order for the dividend to be an eligible dividend, Communication Inc. must inform Amira of this in writing. Advanced Personal & Corporate Taxation Reading

40 Capital gain POD [54] Amount paid $ 200,000 Deemed dividend [84(3)] (95,000) $ 105,000 ACB of the 100 common shares (10,000) Capital gain $ 95,000 Taxable capital gain (1/2) $ 47,500 In Example 1-18, you can see that John may incur immediate tax consequences, even though he merely recovers his investment. He would be taxed on a dividend, and he would be recognized as having a capital loss of an amount equal to that dividend. Since a capital loss can only be used against capital gains, it will probably be some years before John can use this loss. The deemed dividend results from the fact that the PUC of John s shares is not equal to the amount that he contributed because of the calculation of the PUC that is done for all the shares in the class. This also explains the result obtained in the case of Amira, who, instead of realizing a deemed dividend of $190,000 [$200,000 $10,000], realizes a deemed dividend of $95,000 and a capital gain of $95,000 (of which $47,500 is taxable). On a new share issue, in order to ensure that the PUC of the shares corresponds to the amount paid to the corporation for their issuance, it is necessary to issue shares of a class separate from that of the shares currently issued. Note that if common shares A and common shares B have identical rights, they cannot constitute separate classes. It is therefore necessary to provide for a difference, however minimal it may be, such as the preference granted to common shares B to receive $100 in the event of liquidation before equally dividing the residual among common shares A and common shares B. Practical aspect Each time a corporation issues, redeems, or purchases shares of its capital stock by mutual consent, or carries out transactions affecting the PUC of a class of shares, the CGA must determine whether the transaction has tax consequences for the shareholders. Exhibit 1-2 summarizes the tax consequences of these transactions in the case of a private corporation. To be able to determine what these consequences are without too much difficulty, the CGA must keep relevant data on the PUC of each class of shares and must update those data after each transaction affecting the class. In the same file, he must also keep information on the ACB of the shares for each shareholder in the case of a private corporation. 12 Reading 1-5 Advanced Personal & Corporate Taxation

41 EXHIBIT 1-2 Section 84 and private corporations Situation considered Subsection 84(1) Artificial increase in PUC Computation of deemed dividend Effect on ACB Effect on POD Amount of increase in the PUC of the shares of a class less: amount of increase in net assets amount of decrease in net liabilities amount of decrease in the PUC of the shares of any other class Under paragraph 53(1)(b), the amount of the deemed dividend is added to the ACB of the shares. None. There is no disposition of the shares. The deemed dividend is distributed among the shareholders of the class after the increase in the PUC according to the number of shares that they obtain. Subsection 84(2) Windups, reorganizations, or discontinuance of a business Subsection 84(3) Purchase or redemption of shares of a class by the issuing corporation Subsection 84(4) Reduction of PUC Amount or value of the property distributed to the shareholders of a class less: reduction of the PUC of the shares of the class The deemed dividend is distributed among the shareholders of the class according to the number of shares that they held immediately before the distribution. Amount paid less: PUC of the purchased or redeemed shares The deemed dividend is distributed among the shareholders whose shares have been purchased or redeemed according to the number of purchased or redeemed shares that they held as a proportion of the total number of purchased or redeemed shares. Amount paid to shareholders for the reduction of PUC of the class of shares less: amount subtracted from the PUC of the class of shares The deemed dividend is distributed among the shareholders of the class on the basis of the number of shares that they held immediately before the reduction. None None Reduction of the ACB of the shares according to subparagraph 53(2)(a)(ii) for that amount received in the reduction of the PUC which is not considered a deemed dividend. Deemed dividend excluded from the POD under paragraph (j) of the definition of POD in section 54. Deemed dividend excluded from the POD under paragraph (j) of the definition of POD in section 54. None. There is no disposition of the shares. Advanced Personal & Corporate Taxation Reading

42

43 READING 1-6 Ethics and tax planning LEVEL 1 Advanced Personal & Corporate Taxation examines different issues arising in tax planning, particularly for corporations but also for individuals, trusts, and partnerships. Ethical issues arise when there is a choice between right and wrong. Unit A6 of the Ethics Readings Handbook deals with moral principles. It states that wrongful actions include: harming others, interfering with their freedom of choice, denying them benefits to which they are entitled, and treating them unfairly. Hence, wrongful actions are often those that have serious adverse effects on third parties. Tax policy and tax payers In tax planning, there are three principal parties: the government representing the public the client as the taxpayer the CGA acting as a tax advisor Earlier, you learned that the Canadian tax system provides for the taxation of corporate income at two levels, first within the corporation itself and second as dividends in the hands of shareholders. This two-level system of taxation is based on the principle of income integration that underlies the Canadian tax system. Our tax system also distinguishes between different sources of income, namely employment income, business income, income from property, and other sources of income, and it grants them different tax treatments for reasons based on fiscal policies. Fiscal policies also underlie the deductions and tax credits that are granted to corporations and individuals in computing their taxable income and their income tax payable. The choice of fiscal policies is in the hands of the government of the day, and it is open to criticism. However, when these policies are incorporated into the ITA, they must be respected by taxpayers and tax advisors. Taxpayers are entitled to plan their financial affairs in such a way as to minimize their income tax payable, provided that they act within the framework of the ITA and hence the social choices made by the government. Some taxpayers who do not approve of these social choices will be tempted to circumvent the rules or avoid them. For example, some taxpayers may want to use, for personal purposes, assets of a corporation that they control without being taxed on the benefit that they are receiving. Others will be tempted to act as free riders getting the benefits of taxation in the form of public services without paying their fair share of the costs. This was illustrated in Example 1-1, where Frances Baron had a swimming pool built at her personal residence at the expense of her corporation, Active Ltd., which claimed the construction costs as an expense. The ethical problems facing CGAs in taxation matters are not limited to illegal actions that their clients may take. Indeed, owing to the complexity of the ITA, many Canadian taxpayers may violate the ITA without intending to. The CGA, as a tax advisor, then faces two challenges: 1. to inform the client about the ITA provisions that the client is violating; 2. to deal with situations in which the client wants to structure financial affairs in ways that are contrary to the ITA. Advanced Personal & Corporate Taxation Reading 1-6 1

44 The CGA as a tax advisor The CGA acting as a tax advisor therefore has the following obligations: 1. to possess the knowledge required in taxation matters in order to convey appropriate information to clients; and 2. to act professionally when advising clients. The first obligation is in accord with the Code of Ethical Principles and Rules of Conduct (Code), found in ERH, Unit C3, in particular the principle of due care and professional judgment: Members shall strive to continually upgrade and develop their technical knowledge and skills in the areas in which they practice as professionals. This technical expertise shall be employed with due professional care and judgment. As noted above, the ITA is complex, and it is continually changing. As a tax advisor, the CGA has a duty to stay up to date on tax matters. CGAs should not offer tax advice if they lack the requisite knowledge. This means being honest with clients about the limits of one s expertise. If the CGA cannot provide an off-the-cuff answer to a given question, the CGA must take the time to study the question and if necessary obtain the required assistance from a person specializing in the subject in order to give the client an informed answer. You should also make the client aware of any risk or uncertainties surrounding the opinion being given. This is especially important in tax matters, since the ITA and its interpretation are constantly changing as a result of both legislative amendments and case law. Efforts on the part of governments to close loopholes often result in new loopholes being created. Furthermore, in tax planning, there are sometimes alternative ways of achieving a client s objectives, where each alternative has its own pluses and minuses. In these situations the CGA should discuss the different alternatives with the client so that the client can make an informed decision. The Code also offers important guidance on the CGA s second duty, that is to act professionally. The Preamble to the Code specifies that: Certified General Accountants are committed to the public interest. Normally, acting in the public interest is achieved by acting in the interest of one s client or employer. However, whenever there is a conflict between these interests, the professional s first obligation is to the public at large. Acting appropriately in such situations may require the courage of one s convictions. Two types of situations may arise: those in which CGAs are expected to act in the interests of clients or employers, and those where there is a conflict between the interests of the client or the employer and the public. Knowing the difference between these two situations requires moral judgment or discernment; acting appropriately in the two cases requires moral integrity and, as stated in the Preamble, the courage of one s convictions. The usual situation: The interest of the client or employer prevails Normally the CGA, acting in the interests of the client, also serves the public interest. In this situation, the primary responsibility of the CGA acting as a tax advisor is to serve the interests of clients or employers. The CGA can leave it to the government to be concerned with the fairness and adequacy of tax policies. From a legal perspective, the CGA is not an agent of CRA. For example, when CRA makes an error in assessing a tax return, the CGA has no legal obligation to report the error to CRA. From an ethical perspective, it would be right for the CGA to inform the client of the error and obtain the client s approval for disclosing it to CRA. 2 Reading 1-6 Advanced Personal & Corporate Taxation

45 However, this claim that tax advisors are not expected to act as agents of CRA is subject to the following important qualification. The CGA as a tax advisor must always act within the law. A CGA must never advise a client to break the law. For example, counselling a client to transfer assets to a tax haven in order to avoid Canadian taxes would be a violation of ethical principles and illegal as well. Indeed, subsection 239(1) of the ITA provides for criminal penalties of up to 200% of the tax amount the guilty party sought to evade, as well as a maximum of two years of imprisonment when a person who either participates in, consents to, acquiesces in, or conspires in evasion of the payment of tax. Furthermore, under section 163.2, civil penalties are provided for in the case of advising or participating in a false statement or omission or, in the case of a person who knowingly plans, promotes, or sells an arrangement that includes a false statement or omission that may be used for tax purposes. The administrative penalty is generally the greater of $1,000 or the tax that the taxpayer attempted to evade or the refund that he attempted to obtain. Acting in the interest of the client or employer does not mean following all the orders of the client or employer. CGAs must play an active role in helping clients or employers understand their best interest. For example, in the case of complex tax planning, they should suggest alternatives that the client or employer has not considered or point out difficulties that the client or employer may have ignored. Furthermore, showing respect for the interests of the client or employer requires the avoidance of conflict of interest. As the Code notes in the principle of trust and duties: Members shall honour the trust bestowed on them by others, and shall not use their privileged position without their principal s knowledge and consent. Members shall strive to be independent of mind and in appearance. This has particular relevance for tax planning, since the CGA has access to important financial information and also has the client s confidence. Thus, if a tax advisor who advises a client to invest in an advantageous tax shelter in which the tax advisor or a member of his or her family is directly or indirectly involved, it is necessary to disclose to the client one s interest in the project and also inform the client of the risk inherent in this type of investment. Not to do so is to break the rules on conflict of interest. Similarly, if a tax advisor of a public corporation learns in the course of the engagement that the corporation is planning to make a major acquisition, he or she may see an opportunity to realize a sizable gain and purchase shares of the corporation on the strength of this information. Not only does this go against R203 of the CGA-Canada Code, but it may also violate the rules on insider trading that are provided for in securities legislation. Tax advisors not only have a duty to avoid conflicts of interest, but they must also respect the confidentiality of information relating to a given client, even if that information could be useful to another client. Normally, confidential information cannot be disclosed to others without the consent of the client or unless required by law. This subject is dealt with in rule R201 of the Code. Acting as a tax advisor for their clients or employer, CGAs not only have negative obligations (things they must not do), but also positive obligations (things they must do). For example, a CGA who regularly gives a client tax advice must inform the client about relevant changes to the ITA. For instance, say a CGA has advised a client regarding the method of valuing the taxable benefit relating to the use of a condo belonging to the corporation of which the client is a shareholder. The CGA must inform the client of any possible change in the valuation method Advanced Personal & Corporate Taxation Reading 1-6 3

46 as a result of amendments to the ITA or court decisions if the CGA is still working for that client or had given the original opinion not long before the change. Another duty of CGAs in tax matters is to file returns or forms in a timely manner. Not to do so is to expose the client to the risk of penalties. The CGA is then liable to be sued by the client for negligence and may be required to pay damages. The client may also submit the case to the provincial association, which may result in disciplinary action. The exceptional situation: Acting to protect the public Competence and competition In exceptional cases, the CGA acting as a tax advisor will be faced with a choice between serving the interests of the client or the employer and the public interest. This generally occurs when the client or employer chooses to plan their financial affairs in a way that is contrary to the ITA. In such a case, the CGA must inform the client or employer that what they propose to do goes against the ITA. The CGA must not participate or help the client carry out his or her plan and must even, in some circumstances, sever relations with the client or employer (see R102 of the Code). Carrying on a relationship with a client who is acting unlawfully is not only a breach of ethics but may also cause the CGA to have to answer difficult questions in court or before the discipline committee of the provincial association. If a CGA decides to resign from the engagement, he will probably have to inform his replacement of the reasons for resigning (see R504 and R505 of the Code). Like other areas in financial planning, tax planning is a highly competitive area including competition from those with no professional, let alone accounting, training. There is no legal restriction on who may claim to offer tax-planning services. Even though this is a competitive area, it is important for accounting professionals not to make exaggerated or unrealistic claims to clients (see R509 on advertising and other forms of solicitation). Ultimately, such claims damage both the individual s and the profession s credibility. CGAs may encounter a situation in which they believe another tax planner has given a client inadequate or even poor advice. In such a situation, it is essential to provide the client with correct tax advice. However, before moving to the conclusion that the previous tax planner was possibly negligent, the CGA should make reasonable efforts to find out the facts from the client (for example, did the client provide sufficient information to the previous tax planner, have relevant provisions of the ITA changed since the advice was provided). It should be noted that any criticism of a professional colleague (another CGA) is subject to R105. But it is important to understand that this provision must be interpreted in light of R104, Breach of Rules. R104 requires reporting the competence, lack of integrity, and other matters to the Association where the member has sufficient knowledge. Clearly it is the responsibility of each CGA engaged in tax planning to provide accurate and timely advice to clients. In cases where mistaken advice has been given or an error has occurred, it is important to inform the client as soon as possible and provide the correct information. The failure to be candid with clients and accept responsibility for mistakes not only damages the trust relationship, but it may also place the client at financial risk and perhaps even result in a penalty from tax authorities. 4 Reading 1-6 Advanced Personal & Corporate Taxation

47 Who is the client? A final ethical complication for CGAs concerns corporate clients. CGAs face a question when dealing with clients who are corporations, namely, who is the client the corporation, or one or more shareholders? This question becomes especially thorny when a shareholder seems to have been aggrieved by other shareholders. CGAs should not overlook the rights of shareholders, especially when there is pressure to favour majority shareholders. The same problem arises if the client is a trust or partnership. Who is the client the trust or the beneficiaries, the partnership or particular partners? To sort out such questions, the CGA must know the rights of the different stakeholders. The case Ethics in Focus, written by Michael McDonald, illustrates one possible ethics problem that a CGA may encounter, and the solution to such a problem. Ethics in Focus By Michael McDonald, PhD, CGA (Hon.) I suggest that after checking with the Members Advisor at CGA-BC, Jody might find it prudent and ethical to consider resigning from the engagement and she may wish to consult legal counsel with respect to her obligations. The Dilemma Jody Walniuk had a busy tax season. She was very pleased to attract several new corporate clients, who are now asking for management accounting services in addition to tax preparation. However, one of these new clients, Walnut Enterprises, is proving difficult. While designing a new inventory control system for Walnut, Jody noticed significant discrepancies between the inventory as indicated by the new system and the inventory as provided by Walnut s treasurer when she prepared the company s 2009 tax return. Jody has double-checked the new inventory system, including making relevant, on-site checks of materials and supplies. When she asked Walnut s treasurer about the numbers he provided for the tax return, he affirmed their accuracy but would not explain the discrepancies with the new figures. Jody is concerned. She signed off on Walnut s 2009 tax return on the basis of the information provided at the time. Yet she feels confident that the inventory control system is accurate. What Should Jody Do? While Jody is in a difficult situation, she is starting out on the right ethical foot. She carefully prepared the 2009 tax return using information from the treasurer that appeared to be reasonable at the time. (Note that we are not provided with details regarding the type of engagement she had with respect to 2009 services. This would determine her obligation to verify information prior to completing the tax return and whether or not she could have been in breach of professional standards.) Professor McDonald s Response As noted, Jody did her best to ensure that the return was accurate. So I don t think that we should blame her for signing it. However, I agree with the suggestion of going back to the treasurer to seek further explanation and documentation. If that is not forthcoming, my suggestion is that Jody explain to the treasurer that he has put her in a difficult position and that she is not free to let the matter drop. She should indicate that her next step will be to go to the CEO and, if necessary, to the Chair of the Board to say Advanced Personal & Corporate Taxation Reading 1-6 5

48 that she will have to withdraw from the engagement because of a lack of cooperation on the part of the treasurer and that the company may face serious penalties. It is possible that the treasurer will hang tough and that the CEO and Chair will back him. Jody will then have to withdraw. But is that all Jody should do? I suggest that after checking with the Members Advisor at CGA-BC, Jody might find it prudent and ethical to consider resigning from the engagement and she may wish to consult legal counsel with respect to her obligations. Michael McDonald is Maurice Young Chair of Applied Ethics at the W. Maurice Young Centre for Applied Ethics at UBC. In 2006, McDonald received an honorary CGA for his extensive work in accounting ethics education. Source: Michael McDonald, Ethics in Focus, Outlook, CGA-BC, Vol3 35, No. 4, December Reproduced with permission. 6 Reading 1-6 Advanced Personal & Corporate Taxation

49 READING 1-7 Writing a tax opinion LEVEL 1 You have seen that tax planning raises a number of ethical issues. In tax matters, another concern of the CGA is how to communicate clearly and effectively with the client and, at the same time, to limit the potential for a professional liability lawsuit. The point here is not to get around the rules of ethics but rather to state your opinions or conclusions on a tax matter in such a way that their limitations and scope will be clearly understood by the client so as to avoid legal disputes. Taxation is a complex matter in which the rules are continually changing. An opinion given today might not be valid when the client decides to implement the planning proposed, either because of a change in the law or because the client s own situation has changed since the opinion was given. And what if the client were to show the opinion to a third party who then used it himself in a similar case? These are examples of situations that may give rise to possible lawsuits. To avoid these situations, it is therefore important to follow certain rules when a client consults you on tax matters. Tax opinions should be set out in writing and should contain the following elements: terms of reference facts and assumptions laws and documents consulted analysis and conclusion limitations restrictions on use The tax opinion provided to the client, whether in the form of a memorandum or a letter, should always contain all these elements. The order may sometimes vary; however, the terms of reference and the facts should be presented at the beginning. If all the above elements are included in the opinion, the client will be able to determine whether the opinion corresponds to what he requested and whether it is based on all the facts or on reliable facts, and he will be able to understand the limitations of the opinion. If he does not agree with one of the elements or wants more details, he can react immediately and ask the CGA to revise his opinion accordingly. For his part, the CGA is protected in the event of a possible professional liability lawsuit, since he is able to demonstrate that he acted with the skill and care required at the time the opinion was requested, using the information provided to him. Very often in practice, the opinion is not given to the client but rather to a partner. The opinion, which in that case will generally be in the form of a memorandum, should still contain the same elements as those listed above for the opinion given to the client. This is especially true when it there is a possibility that a copy of the memorandum will be given to the client. The memorandum to a partner will normally be written in more technical terms and will include more detailed calculations, since it will be given to someone who is more informed on the subject. Example 1-19 presents a sample tax opinion to a client concerning the transfer of property from a corporation to its shareholder. Advanced Personal & Corporate Taxation Reading 1-7 1

50 EXAMPLE 1-19 Sydney is the sole shareholder of Water Lily Inc., a private Canadian corporation. Recently, he has noticed that the taxable benefit for an automobile supplied by the corporation is very high. He wants to transfer the automobile to his name. He therefore calls a CGA recommended by a friend to ask whether it is possible for the company to sell him the automobile for $1. According to Sydney, the automobile, purchased for $65,000, is currently worth $22,000, and the undepreciated capital cost (UCC) is $13,000. After some discussion, it is agreed that the CGA will give him a written opinion on the income tax consequences if the automobile is sold for $1. If appropriate, the CGA will also make recommendations on how to reduce the tax consequences. In no event does Sydney want to pay more than $1 to the company for the transfer of the automobile. The CGA sends Sydney the following opinion: Sample opinion (date) Mr. Sydney (Address) Re: Acquisition of the automobile owned by Water Lily Inc. Dear Sir: [Terms of reference] You requested our opinion regarding acquisition for $1 of the automobile that is currently supplied to you by Water Lily Inc. More specifically, you want to know the income tax consequences of such a sale, both for you and for the corporation. You also want to know whether there is a way to reduce these tax consequences without your having to pay more than $1 to Water Lily Inc. [Facts and assumptions] Our opinion is based on the following facts that you gave us by telephone: 1. You are the sole shareholder of Water Lily Inc. 2. Water Lily Inc. provides you with an automobile that originally cost $65, The current market value of the automobile is $22, You want to acquire the automobile currently owned by Water Lily Inc. for $1. 5. The automobile is a Class 10.1 depreciable property of Water Lily Inc. with a UCC of $13,000. We wish to make it clear that we have not verified any of these factual data and we take it for granted that they are accurate. Furthermore, for the purposes of this opinion, we assume that you are currently taxed at the maximum rate applicable in the province, that is, at a combined federal-provincial rate of 32% on dividends and 45% on other types of income. [Analysis and conclusions] The sale of the automobile for $1 will have no major tax consequence for Water Lily Inc. Under subsection 69(4) of the Income Tax Act (hereinafter ITA), the company will be deemed to have disposed of the automobile at its fair market value. However, since the automobile is a Class 10.1 property on which the corporation cannot recapture depreciation under subsection 13(2) of the ITA, the only impact is that in the year of the sale, Water Lily Inc. can 2 Reading 1-7 Advanced Personal & Corporate Taxation

51 claim only half the CCA that it could have claimed if it had not sold the automobile, pursuant to REG 1100(2.5). On the other hand, if Water Lily Inc. sells you the automobile for $1, you will be taxable on a shareholder benefit of $21,999 under subsection 15(1) of the ITA, which will represent taxes in the order of $9,900. The cost of the automobile for you will be $22,000. A way to reduce the tax payable on the transfer of the automobile would be for Water Lily Inc. to declare a dividend of $22,000, which it would pay you in kind, that is, by the transfer of the automobile. The tax consequences for Water Lily Inc. would be identical to the consequences of selling the automobile for $1. On the other hand, for you, the amount of $22,000 will be taxed as a dividend rather than as ordinary income, which means that the tax payable would be $7,040 instead of $9,900. [Limitations of the opinion] In this opinion, we have assumed that the market value of the auto, which you set at $22,000, was accurate. However, if the value were different, it would be necessary to change the value of the taxable benefit or dividend accordingly, which would change the amount of tax payable. An appraisal by an independent expert is desirable in order to avoid problems with the tax authorities. Also, we have not considered the impacts of the goods and services tax (GST), motor vehicle transfer fees, or other fees or taxes that might be applicable on the transfer of the automobile. [Laws and documents consulted] This opinion is based on the Income Tax Act and its regulations in force on the date of this opinion. It also takes into account any proposed amendment to the ITA and administrative practices published as of that date. We have consulted no other provincial or federal law. Note that the law and administrative practices are subject to amendment. Therefore, if the transaction being considered is not carried out for some time, it will be necessary to verify whether the conclusions in this opinion are still valid. [Restrictions on use of opinion] Also, this opinion is intended exclusively for your use and is limited to the facts described above. If you have any comments or questions, we are at your disposal to discuss any aspect of the opinion at your convenience. Yours truly, CGA Note You will notice that in the sample the opinion given to Sydney, specific references were made to the ITA. Such references are often omitted when writing an opinion to a client who is not familiar with the ITA, since such a client is interested in the conclusions and not in all the technical analysis underlying the opinion. However, the CGA s file should contain the references that support the conclusions Advanced Personal & Corporate Taxation Reading 1-7 3

52

53 READING 2-1 Objectives of using section 85 LEVEL 1 The provisions of section 85 are used principally to transfer property from the business carried on by an individual or a partnership to a corporation, or from a corporation to another corporation. In most cases, the goal is to transfer property without realizing an accrued gain or recapture of capital cost allowance (CCA) at the time of transfer. This entails deferral but not avoidance of tax on the gain and/or recapture of CCA. A rollover always refers to a transfer with no immediate tax consequences or with reduced tax consequences. Generally, property is transferred at fair market value (FMV) between persons not dealing at arm s length, since this is a business transaction from which both parties want to gain. Section 69 requires property to be transferred between persons not dealing at arm s length at FMV for tax calculation purposes. Section 85 does not allow any departure from the FMV rule. For example, it does not allow a sale of assets by a person to the corporation of which he is a shareholder at a value other than FMV. For tax purposes, however, it deems POD different from FMV for purposes of computing the capital gain or loss or the recapture of CCA. There are limits regarding this type of transfer. The deemed POD or agreed amount are not arbitrary values, and the non-share consideration (NSC) cannot exceed the deemed POD or agreed amount without there being immediate tax consequences. Among the numerous reasons or occasions for using section 85 are the following: the deferral of tax on the disposition of property to a corporation the incorporation of a sole proprietorship or a business carried on by a partnership in order to take advantage of tax benefits associated with the use of a corporation an estate freeze the transfer of assets between affiliated corporations planning to enable a sole proprietor of a business to take advantage of the capital gains deduction (CGD) of $375,000 on the sale of a business crystallizing a capital gain on shares qualifying as small business corporation shares the transfer of property to a corporation in order to produce income against which the purchaser s non-capital losses may be used There are disadvantages in using section 85, which include the possibility of double taxation on the sale of the shares received in consideration for the transfer and on the sale of the assets acquired by the corporation. Advanced Personal & Corporate Taxation Reading 2-1 1

54

55 READING 2-2 Conditions LEVEL 1 Eligible persons Under subsection 85(1), the transferor must be a taxpayer, as defined in subsection 248(1). The taxpayer may be an individual, a trust, or a corporation, even if this person is not required to pay tax. An exempt corporation, for example, is a transferor taxpayer which may use the provisions of section 85. Under subsection 85(2), the transferor may also be a partnership. Whether or not the transferor is resident in Canada is not a condition of this subsection. Assets eligible for transfer However, the transferee (or purchaser) must be a corporation that is both Canadian and taxable. These two definitions are contained in subsection 89(1). An exempt corporation, such as a Crown corporation, which is exempt under paragraph 149(1)(d), is therefore not eligible as a purchaser under the provisions of section 85. This exception for exempt corporations is intended to prevent assets on which there is an unrealized gain from being transferred to an exempt corporation and then disposed of without any tax being payable. Under subsection 85(1), the taxpayer must have disposed of an eligible property to a taxable Canadian corporation in a taxation year in order for the rollover provisions to apply. Subsection 85(1.1) contains a list of eligible property. Any property not included in this list may not be rolled over under section 85. This list includes: a capital property, as defined in subsection 248(1) and section 54, other than real property (land or buildings), or an interest in real property or an option in respect thereof, owned by a non-resident person. Capital property includes the shares of a taxable Canadian corporation, and the shares of such a corporation may be transferred to the corporation itself. This type of transaction is generally referred to as an internal rollover and is often used in the crystallization of a capital gain or in an estate freeze. a capital property that is a real property, or an interest therein or an option in respect thereof, owned by a non-resident insurer where such property and the property received as consideration for such property are designated insurance property a Canadian resource property, unless it is excluded a foreign resource property an eligible capital property (ECP) such as goodwill an inventory, other than real property. Inventory which is an interest in real property or an option with respect thereto is also excluded. a property, other than capital property or an inventory, that is a security or debt obligation used or held in the year in the course of carrying on the business of insurance or lending money a capital property that is a real property, or an interest therein or an option in respect thereof, owned by a non-resident other than a non-resident insurer and used in a business actively carried on in Canada, if certain conditions are met Advanced Personal & Corporate Taxation Reading 2-2 1

56 Consideration received Some types of property, generally included among the assets of a business, are ineligible for a rollover. These include cash, accounts receivable (if an election was made under section 22), prepaid expenses, real property owned by a non-resident (except as described above), and real property held as inventory. The latter exception is especially intended for real estate speculators who would be tempted to convert business income into a capital gain on the dispositions of shares that they received as consideration in a rollover. With respect to accounts receivable, a taxpayer who is selling all or substantially all the property used in a business to a person who intends to continue carrying on the business must decide whether to use the election under section 22 or section 85. Tax consequences of a section 22 election: The transferor must add to his income in the year of transfer, the amount of the reserve for doubtful accounts claimed in the preceding year. Any loss resulting from the disposition of the accounts receivable is deductible in computing income in the year of transfer. The purchaser must add to his income in the year of transfer an amount equal to the deduction claimed by the transferor. The accounts receivable are deemed to have been included in the purchaser s income and the purchaser may claim a reserve for doubtful accounts or a deduction for bad debts with respect to them. Tax consequences of a section 85 election: In the year of transfer, the transferor must add to his income the amount of the provision for doubtful accounts that he claimed in the preceding year. With certain exceptions, any loss resulting from the disposition is a capital loss for the year of transfer. This loss can be denied if subsection 40(3.3) or subparagraph 40(2)(g)(ii) applies. For the purchaser, any gain or loss realized on the accounts receivable is a capital gain or loss. Because in this case the accounts receivable are not deemed to have been included in income, the purchaser may not, as is the case with section 22, claim a reserve for doubtful accounts or deduction for bad debts with respect to the accounts receivable. In light of these consequences, it is usually more advantageous to make the election under section 22. The consideration received by the transferor will usually equal the FMV of the property transferred. As you will see below, paragraph 85(1)(e.2) sets out rules to prevent transactions where the consideration is less than the FMV of the property transferred in order to confer a benefit on another related shareholder. A necessary condition that cannot be avoided, however, is that subsection 85(1) requires that the consideration include treasury shares of the corporation to whom the property is transferred. Shares issued as consideration may be from any class, that is, they may be common or preferred shares. At least one share must be issued for each asset transferred because, as you will see below, the rollover rules apply asset by asset. It is sufficient that one share of the capital stock of the corporation be received by the transferor for the provisions of section 85 to apply, even if more than one property is transferred under the same rollover. From a practical standpoint, at least one share per group of assets transferred is often issued. In addition, subsection 248(1) defines share as a share or fraction thereof of the capital stock of a corporation. If a single share is issued for several assets transferred, it would be prudent to indicate in the sale agreement that the consideration (one share) is the total for all property transferred. 2 Reading 2-2 Advanced Personal & Corporate Taxation

57 Agreed amount EXAMPLE 2-1 Under paragraph 85(1)(a), the amount that the transferor and the corporation have agreed upon in their election is deemed to be the transferor s POD of the property disposed of and the corporation s cost of the property acquired, as shown in Example 2-1. Pascal Roy, sole shareholder of Citrus Computers Ltd., transfers a non-depreciable capital property to Citrus Computers Ltd. under section 85 and receives only shares in return. ACB of the property transferred $ 100 FMV of the property transferred $ 150 FMV of the shares received $ 150 Agreed amount $ 100 Under paragraph 85(1)(a): POD of the transferred property for Pascal (agreed amount) $ 100 Cost of the transferred property for tax purposes (ACB) for Citrus Computers Ltd. (agreed amount) $ 100 Capital gain deferred ($150 $100) $ 50 The capital gain is deferred until disposition of the non-depreciable capital property acquired by Citrus Computers Ltd. When determining the agreed amount, the tax status of the transferor must also be taken into account. A transferor who has, say, a capital loss carryforward balance might find it advantageous to realize a capital gain on a rollover. He would then choose an agreed amount enabling him to realize a capital gain that would be eliminated by the full or partial use of the capital loss carryforward balance. It might even be unnecessary to use the provisions of section 85 if the capital loss balance is sufficient to eliminate all of the capital gain. An agreed amount, within certain limits, must now be determined. There is a lower [paragraph 85(1)(b)] and an upper limit [paragraph 85(1)(c)] that must be respected and within which the amount agreed upon by the parties must fall. Furthermore, the rules for determining the agreed amount fall into two categories: rules applicable to all property regardless of its nature, and rules applicable to specific types of property. Lower limit Paragraph 85(1)(b) states that the agreed amount may not be less than the FMV of the non-share consideration (NSC) received by the transferor as consideration for the assets transferred. However, it may be equal to the non-share consideration. EXAMPLE 2-2 Use the information in Example 2-1 with the following changes: Consideration received: Cash $ 110 Shares having a FMV of $ 40 Agreed amount elected in order to avoid a capital gain $ 100 In this case, the agreed amount of $100 is not acceptable; it cannot be less than $110 (FMV of the non-share consideration or cash). Advanced Personal & Corporate Taxation Reading 2-2 3

58 POD for Pascal [85(1)(b)] $ 110 ACB (100) Capital gain $ 10 Cost for tax purposes (ACB) for Citrus Computers Ltd. [85(1)(a)] $ 110 Deferred capital gain ($150 $110) $ 40 Pascal could have received cash and deferred the entire capital gain ($50) without immediate tax consequences if he had better planned the consideration he received. Because the agreed amount cannot be less than the non-share consideration, Pascal could have received up to $100 in cash (the ACB of the transferred property) without incurring any immediate tax consequences. EXAMPLE 2-3 Consideration received: Cash $ 100 Shares having a FMV of $ 50 Agreed amount $ 100 The agreed amount is acceptable since it is equal to the NSC and is therefore not less than the FMV of the non-share consideration of $100. Therefore, Pascal does not have a capital gain. The cost of the acquired property for tax purposes (ACB) for Citrus Computers Ltd. is $100. In effect, the gain may be deferred, provided it is received in the form of shares issued by the purchaser. Upper limit Paragraph 85(1)(c) specifies the upper limit of the agreed amount. It states that the agreed amount may not be greater than the FMV of the property transferred. This rule applies even if the cost amount of the property transferred is greater than its FMV. A taxpayer cannot artificially create a capital gain by transferring property to a corporation. In addition, paragraph 85(1)(c) takes precedence over paragraph 85(1)(b) so that the agreed amount will never be greater than the FMV of the transferred property. The following two examples show how paragraph 85(1)(c) applies. EXAMPLE 2-4 Using the data from Example 2-1, assume that Pascal receives $160 plus one common share without par value as consideration for the property transferred. Under paragraph 85(1)(c), the agreed amount may not be greater than the FMV of the property transferred of $150. The excess of the amount received over the FMV of the property transferred will be taxed under subsection 15(1) as a taxable benefit conferred on a shareholder (IC 76-19R3, paragraph 25). Agreed amount 85(1)(c) $ 150 For Pascal: Agreed amount or POD 85(1)(a) $ 150 ACB (100) Capital gain $ 50 Taxable capital gain (50%) $ 25 Benefit conferred on a shareholder 15(1) $ 10 4 Reading 2-2 Advanced Personal & Corporate Taxation

59 For Citrus Computers Ltd.: Cost of the acquired property for tax purposes (ACB) 85(1)(a) $ 150 The corporation s cost of the property may not exceed the FMV of the property transferred. This is to prevent the corporation from realizing a loss on the subsequent disposition of property acquired in a rollover. In addition, remember that the purpose of section 85 is to defer a real accrued gain and not to artificially create a gain for the transferor. This may be the goal where the transferor has loss carryforwards and the transferee is earning income. Paragraph 85(1)(c) takes precedence over paragraph 85(1)(b) if the FMV of the non-share consideration is greater than the FMV of the property transferred, as shown in Example 2-5. EXAMPLE 2-5 Cost amount of property transferred $ 100 FMV of property transferred $ 50 Cash received in consideration, in addition to one share $ 100 Agreed amount $ 70 Under paragraph 85(1)(b), the agreed amount, since it cannot be less than the non-share consideration, should be $100. The corporation would then have an acquisition cost of $100, and the transferor would have no gain or loss. However, under paragraph 85(1)(c), the agreed amount cannot be greater than the FMV of the property transferred. The agreed amount must therefore be equal to $50, and the $50 excess of the amount received over the FMV of the property transferred is taxed under subsection 15(1) as a benefit conferred on a shareholder. Agreed amount [85(1)(c)] $ 50 For Pascal: Agreed amount or POD [85(1)(a)] $ 50 ACB (100) Capital loss $ (50) Allowable capital loss (50%) $ (25) Benefit conferred on a shareholder [15(1)] $ 50 For Citrus Computers Ltd.: Cost of the acquired property for tax purposes (ACB) [85(1)(a)] $ 50 Specific limits There are also specific lower limits depending on the type of property transferred. Under paragraph 85(1)(c.1), where the property is inventory, capital property (other than depreciable property of a prescribed class), or property that is a security or debt obligation used or held in the course of carrying on the business of insurance or lending money, Advanced Personal & Corporate Taxation Reading 2-2 5

60 the agreed amount cannot be less than the lesser of (i) the FMV of property transferred, at the time of disposition (ii) the cost amount of the property transferred at the time of disposition EXAMPLE 2-6 Cost amount (ACB) of the capital property $ 5,000 FMV of the capital property $ 10,000 Amount agreed to by the parties $ 3,000 The agreed amount cannot be less than the lesser of the following amounts: (i) FMV of the property transferred $ 10,000 (ii) cost amount of the property transferred $ 5,000 Amount deemed to be the agreed amount 85(1)(c.1) $ 5,000 No gain or loss on disposition of the capital property. If this limit did not exist, the transferor would be able to incur an artificial loss on the transfer of the property. Under paragraph 85(1)(d), where the property transferred is an ECP in respect of the business of the taxpayer, the agreed amount cannot be less than the least of (i) (ii) (iii) 4/3 of the taxpayer s cumulative eligible capital (CEC) in respect of the business immediately before the disposition the cost of the ECP the FMV of the ECP at the time of disposition EXAMPLE 2-7 Cost of the ECP $ 100 CEC $ 25 FMV of the ECP $ 70 Agreed amount $ 30 The agreed amount cannot be less than the least of the following amounts: (i) 4/3 of CEC: 4/3 $25 $ 33 (ii) cost of the ECP $ 100 (iii) FMV of the ECP $ 70 Amount deemed to be agreed 85(1)(d) $ 33 POD (3/4 $33) [14(1)] $ 25 CEC (25) Income $ Under paragraph 85(1)(e), where the property transferred is depreciable property, the agreed amount cannot be less than the least of (i) the undepreciated capital cost (UCC) of all property of that class immediately before the disposition (ii) the capital cost (CC) of the property transferred (iii) the FMV of the property transferred, at the time of disposition 6 Reading 2-2 Advanced Personal & Corporate Taxation

61 Example 2-8 illustrates how paragraph 85(1)(e) applies. EXAMPLE 2-8 CC of the property transferred $ 100 UCC of the class $ 40 FMV of the property transferred $ 70 Agreed amount $ 35 Terminal loss (possible if the agreed amount is $35) $ 5 The agreed amount cannot be less than the least of the following amounts: (i) UCC of the class $ 40 (ii) CC of the property transferred $ 100 (iii) FMV of the property transferred $ 70 Amount deemed to be agreed under 85(1)(e) $ 40 Therefore, a terminal loss is not realized. These limits prevent a terminal loss from being created artificially. However, if there is an actual terminal loss, because the FMV of the property is less than the UCC of the class and there is no other property in the class, it will be deductible provided the provisions of subsection 13(21.2) do not apply. These provisions will be analyzed below. Under subsection 85(5), upon the transfer of a depreciable property, if the agreed amount is less than the CC of the transferor, the transferee is deemed to have the same CC that the transferor had. The difference between that CC and the agreed amount is deemed to have been CCA taken in prior years by the transferee. In this way, the corporation is subject to recapture of any CCA that was deferred by the transferor on the rollover when the depreciable property is subsequently disposed of. The application of subsection 85(5) is illustrated in Example 2-9. EXAMPLE 2-9 Class 1 building (only property in the class) 1. Transferor: CC $ 100,000 FMV $ 200,000 UCC $ 40,000 Agreed amount $ 40,000 The building is transferred at $40,000 to defer income taxes. The recapture of CCA that would be $60,000 is deferred. The capital gain of $100,000 is also deferred. The agreed amount cannot be less than the least of the following amounts: (i) UCC $ 40,000 (ii) CC of the building $ 100,000 (iii) FMV of the building $ 200,000 Deemed agreed amount [85(1)(e)] $ 40,000 Advanced Personal & Corporate Taxation Reading 2-2 7

62 2. Transferee (corporation): Deemed CC $ 100,000 CCA deemed to have been claimed (60,000) UCC $ 40,000 If the corporation subsequently sold the building for $200,000, the tax consequences would be as follows: POD $ 200,000 CC (100,000) Capital gain $ 100,000 Taxable capital gain (1/2) $ 50,000 UCC $ 40,000 Less the lesser of: CC $ 100,000 POD $ 200,000 (100,000) Recapture of CCA $ (60,000) Order of priority of the limits Paragraph 85(1)(e.3) specifies general limits to the agreed amount which override the specific limits previously listed. Thus, for the agreed amount the upper limit is the FMV of the property transferred the lower limit is the greater of: the FMV of the non-share consideration received [limit under paragraph 85(1)(b)] the amount deemed to be agreed under paragraphs 85(1)(c.1), (d), or (e) EXAMPLE 2-10 A building is transferred by one corporation to another corporation. The land continues to be owned by the transferor. CC $ 100,000 UCC of the class $ 50,000 FMV of the building $ 80,000 FMV of the non-share consideration $ 60,000 Agreed amount $ 40,000 Under paragraph 85(1)(e), the agreed amount would be equal to the UCC of $50,000. However, under the limits contained in paragraph 85(1)(b), which take precedence, the agreed amount would be equal to $60,000, being the FMV of the non-share consideration received by the transferor. This would give rise to a recapture of CCA amounting to $10,000 ($60,000 $50,000). Thus if all immediate tax consequences are to be avoided, the FMV of the non-share consideration should not exceed $50,000. Paragraph 85(1)(e.1) states that where two or more properties described in paragraphs (d) or (e) are disposed of at the same time, the taxpayer must designate the order of transfer of the properties. Since the rules apply on an asset-by-asset basis, the designation will avoid recapture of CCA where non-share consideration is received on the transfer. If the taxpayer has not designated the order, it will be designated by the Minister of Revenue. 8 Reading 2-2 Advanced Personal & Corporate Taxation

63 Example 2-11 shows the importance of designating an order of transfer when two properties of the same class are transferred. EXAMPLE 2-11 Property 1 Property 2 (same class) CC $ 5,000 $ 6,000 FMV $ 7,000 $ 5,500 Mortgage payable assumed by the transferor (non-share consideration) $ 4,000 $ 1,000 UCC of the class $ 8,500 Tax consequences To avoid recapture of CCA, the total agreed amount for both properties must not be higher than the UCC of $8, Designation by the taxpayer: Property 1 CC $ 5,000 FMV $ 7,000 UCC of the class $ 8,500 Mortgage $ 4,000 Minimum agreed amount, based on the limits $ 5,000 Recapture of CCA $ Property 2 CC $ 6,000 FMV $ 5,500 UCC ($8,500 $5,000) $ 3,500 Mortgage $ 1,000 Minimum agreed amount, based on the limits $ 3,500 Recapture of CCA $ 2. If the taxpayer does not designate the order, the Minister could designate the following order, an order which would not be advantageous for the transferor: Property 2 CC $ 6,000 FMV $ 5,500 UCC of the class $ 8,500 Mortgage $ 1,000 Agreed amount $ 5,500 Recapture of CCA $ Advanced Personal & Corporate Taxation Reading 2-2 9

64 Property 1 CC $ 5,000 FMV $ 7,000 UCC ($8,500 $5,500) $ 3,000 Mortgage $ 4,000 Minimum agreed amount, based on the limits $ 4,000 Recapture of CCA ($3,000 $4,000) $ 1,000 The order of disposition of property does not have to be indicated when filing the election forms, especially when several depreciable properties are being transferred. However, it should be available if the Minister so requests (see IC 76-19R3, paragraph 3). ACB of the consideration received by the transferor After determining the amounts at which property may be transferred to a corporation, the cost for the transferor of the property received in payment for the transfer must be determined. Under paragraphs 85(1)(f), (g), and (h), the agreed amount for the property transferred is allocated among the properties received in exchange by the transferor. The agreed amount must be allocated in the following order: 1. to the non-share consideration, under paragraph 85(1)(f) 2. to preferred shares, under paragraph 85(1)(g) 3. to common shares, under paragraph 85(1)(h) For non-share consideration, if any, the portion of the agreed amount that is allocated to the transferor is equal to the lesser of the FMV of the property received by the transferor the FMV of the property transferred to the corporation For preferred share consideration, if any, the allocated amount is equal to the lesser of the FMV of the preferred shares after the disposition the excess of the agreed amount over the FMV of the non-share consideration received by the transferor With respect to common share consideration, if any, the allocated amount is equal to the excess of the agreed amount over the FMV of the non-share consideration and the amount allocated to the preferred shares. If more than one class of preferred shares is issued as consideration, the cost must be allocated among the classes of preferred shares according to their FMV. This principle also applies if more than one class of common shares is issued as consideration. EXAMPLE 2-12 A non-depreciable capital property is transferred by an individual to a corporation under section 85. ACB of the property transferred $ 10,000 FMV of the property transferred $ 20,000 Agreed amount $ 10, Reading 2-2 Advanced Personal & Corporate Taxation

65 Consideration received: Note issued by the corporation $ 8,000 Preferred shares FMV $ 10,000 Common shares FMV $ 2,000 ACB of property received by the individual: 1. Note [85(1)(f)] The lesser of: the FMV of the property received (note) $ 8,000 the FMV of the property transferred $ 20,000 ACB of the note $ 8, Preferred shares [85(1)(g)] The lesser of: the FMV of the preferred shares $ 10,000 the excess of the agreed amount over the FMV of the NSC received ($10,000 $8,000) $ 2,000 ACB of the preferred shares $ 2, Common shares [85(1)(h)] The excess of the agreed amount over the FMV of the NSC and the ACB allocated to the preferred shares ($10,000 $8,000 $2,000) $ ACB of the common shares $ Therefore, when computing the capital gain or loss on the disposition of the shares by the individual, it is necessary to take into consideration an ACB of $2,000 for the preferred shares and a nil ACB for the common shares. The non-share consideration, namely the note, could have been for $10,000 without there being immediate tax consequences for the transferor, since the agreed amount is $10,000. In such a case, the ACB of the preferred shares would have been nil. Allocation of non-share consideration Where property is transferred under the provisions of section 85, the NSC received by the transferor must be allocated between the different properties transferred. The following example illustrates such a situation. EXAMPLE 2-13 Taking advantage of the provisions of section 85, Claudio Romano transfers the following assets to Mozzarello Ltd. at the minimum allowed agreed amounts. Claudio wants to avoid all the immediate tax consequences of the transfer of the property. Equipment Building Land CC $ 50,000 $ 100,000 $ 20,000 FMV $ 30,000 $ 120,000 $ 30,000 UCC $ 18,000 $ 60,000 Mortgage $ 70,000 Advanced Personal & Corporate Taxation Reading

66 At the time the assets are transferred, it is agreed that Mozzarello Ltd. will assume the mortgage on the building. Since this is a debt related to the building, it would be logical for the mortgage to be considered as a portion of the consideration for the building. If such were the case, the agreed amount ($60,000) would be less than the non-share consideration (mortgage of $70,000), which is not allowed under paragraph 85(1)(b). The agreed amount would then be equal to the mortgage, resulting in an unwanted recapture of CCA. This is why it is permissible to allocate a debt among a number of assets in a rollover. Asset transferred Agreed Consideration received amount Non-share Preferred Total shares Equipment $ 18,000 Note: $ 18,000 $ 12,000 $ 30,000 Building $ 60,000 Mtge: $ 60,000 $ 60,000 $120,000 Land $ 20,000 Mtge: $ 10,000 $ 10,000 $ 30,000 Note: $ 10,000 Under paragraph 85(1)(g), the ACB of the preferred shares received in consideration of the transfer of the assets is nil, since for each asset, the agreed amount has already been wholly attributed to the non-share consideration under paragraph 85(1)(f). Valuation The concept of FMV is very important on a rollover. On a transfer of assets under section 85, FMV must be determined for each asset transferred in accordance with generally accepted valuation principles. The FMV of the property received as consideration must also be determined. The CGA generally lacks the expertise required to assign a value to the transferred property. If, as part of his engagement, the client has asked him to determine the value of the property, he will probably have to use the services of professionals in the field, especially for valuing real estate or shares of private corporations. If the client provides him with the FMV of the shares, the CGA should ask how and by whom the valuation was done in order to ensure that acceptable methods were used. The CGA should explain to the client that the valuation is important for determining the agreed amount and the consideration to be received, in order to avoid harmful tax consequences. A second important aspect is the FMV of the consideration paid, and more specifically the characteristics of the shares issued in the transfer. Different characteristics may be attached to the shares, which may be voting or non-voting with fixed or discretionary dividends with cumulative or non-cumulative dividends redeemable at the option of either the corporation or the holder, the holder only, or the corporation only redeemable for a fixed amount or at a premium superseding other shares with respect to dividends or upon winding up, and so on. The characteristics given to shares serve to determine their value. CRA has at different times stated its position on the FMV of preferred shares. Thus, the redemption value of preferred shares will be considered to be their FMV when they have the following characteristics: 12 Reading 2-2 Advanced Personal & Corporate Taxation

67 The shares are retractable (at the option of the shareholder). The shares entitle the shareholder to a reasonable dividend. However, this dividend may be non-cumulative. The shares may or may not entitle the shareholder to vote in all circumstances. If they are non-voting shares, they must nevertheless provide for a right to vote with respect to any change affecting the class. The shares must have priority in the event of distribution of the assets of the corporation on a liquidation or dissolution. No dividend may be payable on the shares of the other classes if the amount of the dividend is such that the corporation cannot redeem the preferred shares for the amount stipulated for the redemption. No redemption or purchase of shares of another class may be carried out if this has the effect of making the corporation unable to redeem the preferred shares for the amount stipulated for the redemption. Given the difficulties that may occur on a valuation, a price adjustment clause is generally recommended in the agreement to roll over property to a corporation. A price adjustment clause should also be included in the agreement when property is sold to a person with whom the vendor does not deal at arm s length, so as to avoid the negative consequences of the application of section 69. CRA s policy is clearly outlined in IT-169. CRA will accept a price adjustment clause in computing the income of the parties to the transaction, provided all of the following conditions are met: the agreement reflects a bona fide intention of the parties to transfer the property at FMV and arrive at the value by a fair and reasonable method the excess or shortfall in price is actually refunded or paid, or a legal liability therefore is adjusted Double taxation EXAMPLE 2-14 Using the provisions of section 85 could create a double taxation problem. Transferring a property at its cost amount, and receiving share consideration having an ACB equal to the cost amount of the property transferred, may result in double taxation on the subsequent sale of the property at FMV. Rosaria Blanchette, the sole shareholder of Solar Centres Ltd., wishes to transfer a non-depreciable capital property to Solar Centres Ltd. under the provisions of section 85. Cost amount $ 3,000 FMV $ 24,000 Without section 85 POD $ 24,000 Cost amount (3,000) Capital gain $ 21,000 Taxable capital gain (1/2) $ 10,500 Using section 85 POD (agreed amount) $ 3,000 Cost amount (3,000) Capital gain $ Advanced Personal & Corporate Taxation Reading

68 Consideration received Common shares having an FMV of $24,000 and an ACB and a PUC for tax purposes of $3,000. Immediately after the transfer to Solar Centres Ltd., the corporation sells the capital property and Rosaria sells the common shares she received as consideration. Tax consequences 1. For Rosaria: POD $ 24,000 ACB (3,000) Capital gain $ 21,000 Taxable capital gain (1/2) $ 10, For Solar Centres Ltd.: POD $ 24,000 ACB (3,000) Capital gain $ 21,000 Taxable capital gain (1/2) $ 10,500 Total taxable capital gain: Rosaria $ 10,500 Solar Centres Ltd. 10,500 $ 21,000 This potential double taxation should not prevent the provisions of section 85 from being used. Its goal, which is to defer tax on an accrued gain and/or recapture of CCA, is generally achieved without immediate double taxation. The property transferred and the shares will probably be sold only after several years, thereby reducing the effect of double taxation, which is deferred over a long period. The two events rarely arise simultaneously. Furthermore, the CGD allowed under subsection 110.6(2.1) on the disposition of the qualified small business corporation shares may erase or at least reduce this double taxation. If a transferred property is a corporation s only asset, it is also possible, following the sale of the property, to wind up the corporation. Given the CDA created on the sale of the property, the refundable dividend tax on hand (RDTOH) acquired on the income tax paid by the corporation and the income tax credit for dividends that the shareholder is entitled to claim on the winding-up dividend (eligible or non-eligible), it is possible to reduce or even erase the double taxation that arises as a consequence of the rollover. To review the provisions relating to rollovers, you should read IT-291R3 inclusive of paragraph Reading 2-2 Advanced Personal & Corporate Taxation

69 READING 2-3 Rule for the benefit conferred on related shareholders LEVEL 2 Under section 85, when property is transferred, taxation may be deferred on the accumulated increase in value that is transferred to the shares received as consideration. If the FMV of the shares received were insufficient given the FMV of the property transferred, another related shareholder would benefit. The anti-avoidance rule provided for in paragraph 85(1)(e.2) prevents a taxpayer (shareholder) from carrying out a transaction with a corporation for the purpose of transferring the accrued value of a property to another related shareholder. In this way, the ITA prevents an indirect benefit from being conferred on other shareholders. Where the FMV of the property transferred exceeds the greater of (i) and (ii) the consideration received (including shares) the agreed amount and it is reasonable to regard any portion of such excess as a benefit conferred on a related person, the amount of the benefit conferred on others must be added to the agreed amount. However, if the related person is a corporation wholly owned by the transferor immediately after the disposition, paragraph 85(1)(e.2) does not apply, since he is the sole shareholder. A wholly-owned corporation, as defined in subsection 85(1.3), is a corporation in which all the outstanding shares (except directors qualifying shares) belong to (a) (b) or (c) the taxpayer (transferor) a corporation wholly owned by the taxpayer any combination of persons described in (a) or (b) Where paragraph 85(1)(e.2) applies, the agreed amount is deemed to be adjusted with the effect that the POD for the transferor and the acquisition cost for the corporation are increased by the value of the benefit conferred. However, this deemed increase does not affect the ACB of the consideration received on the transfer. The transferor is thus penalized, since double taxation could result on the disposition of the property received as consideration. Computation of the benefit is not covered by the ITA, but it could be done as illustrated in Example EXAMPLE 2-15 The holders of the common shares of Zilco Ltd. are: Danny Charles: 10% 10 shares Cindy Chouinard (Danny s wife): 50% 50 shares Children of Cindy and Danny: 40% 40 shares Each common share is worth $1,000 immediately prior to the transfer below. Danny transfers a non-depreciable capital property to Zilco Ltd.: ACB $ 10,000 FMV of the property transferred $ 60,000 Agreed amount $ 10,000 Advanced Personal & Corporate Taxation Reading 2-3 1

70 As consideration, Danny receives 10 common shares, thereby increasing the number of outstanding shares to 110. Tax consequences 1. For Danny: Calculation of excess amount FMV of the property transferred $ 60,000 Less: the greater of: FMV of shares received (10 $1,455*) $ 14,550 agreed amount $ 10,000 (14,550) Excess $ 45,450 * FMV of 100 common shares prior to transfer (100 $1,000) $ 100,000 Plus: FMV of property transferred 60,000 FMV of 110 common shares after the transfer $ 160,000 FMV of 1 common share after the transfer ($160, shares) $ 1,455 Benefit conferred on spouse and children who own 90 shares FMV of 90 shares after the transfer (90 $1,455) $ 130,950 Less: FMV of 90 shares before the transfer (90 $1,000) (90,000) Benefit conferred on related persons $ 40,950 Tax consequences for Danny Amount deemed to be agreed or POD ($10,000 + $40,950) $ 50,950 ACB (10,000) Capital gain $ 40,950 Taxable capital gain (1/2) $ 20,475 Cost of the shares received by Danny $ 10,000 This cost must be averaged with 10 shares previously owned because they are identical properties. However, according to paragraph 85(1)(e.2), the amount of the benefit conferred on related persons, namely $40,950, is not added to the ACB of the shares received by Danny in spite of the effect on the agreed amount. 2. For Zilco Ltd.: Cost of the property $ 50,950 Note that the amount of the benefit conferred on related persons does not correspond to the $45,450 excess. This is because Danny partially benefits from the transaction, since the value of the 10 shares that he held before the transaction has also increased to $1,455 each. To avoid paragraph 85(1)(e.2) application when there are other shareholders related to the transferor, ensure that the FMV of the consideration received by the transferor equals the FMV of the property transferred. 2 Reading 2-3 Advanced Personal & Corporate Taxation

71 READING 2-4 Transfer of property to an affiliated corporation LEVEL 1 There are a number of rules intended to restrict the recognition of losses in transactions between affiliated persons. These rules, which may also apply outside a transaction by rollover under section 85, are studied here because they often apply in this context. The tax treatment of the loss incurred in the disposition of property to an affiliated person varies according to the nature of the property (depreciable, non-depreciable, or eligible capital) and the type of taxpayer the transferor is. The definition of affiliated persons is provided in section Under subsection 251.1(4), persons are deemed to be affiliated with themselves, and a person includes a partnership. Among the definitions in subsection 251.1(3) that apply for the purposes of the present section only, the following should be noted: controlled: means controlled, directly or indirectly in any manner whatever; thus, both de facto control and de jure control are covered. affiliated group of persons: means a group of persons each member of which is affiliated with every other member. For the purposes of the ITA, subsection 251.1(1) provides that the following persons are affiliated: (a) an individual and the spouse of the individual; (b) (c) a corporation and (i) a person by whom the corporation is controlled, (ii) each member of an affiliated group of persons by which the corporation is controlled, and (iii) a spouse of a person described in (i) or (ii); two corporations, if (i) each corporation is controlled by a person, and these two persons are affiliated, (ii) one corporation is controlled by a person and the other corporation is controlled by a group of persons, and each member of that group is affiliated with that person, or (iii) each corporation is controlled by a group of persons, and each member of each group is affiliated with at least one member of the other group. Non-depreciable capital property Therefore, brothers and sisters, or parents and children, are not affiliated persons. Paragraphs 251.1(1)(d) to (f) apply to partnerships and paragraphs (g) and (h) apply to trusts. Those provisions are not studied in this course. In the case of non-depreciable property, the rules on losses in transactions involving affiliated persons differ, depending on whether the transferor is a corporation or an individual. Advanced Personal & Corporate Taxation Reading 2-4 1

72 Corporation If a corporation disposes of a non-depreciable capital property and an affiliated person, or an affiliated corporation in the case of a rollover under section 85, acquires or has a right to acquire the transferred capital property or an identical property (substituted property) in the period of 30 days before or after the disposition, the loss resulting from the transaction is deemed nil under paragraph 40(3.4)(a). The property must be owned by the transferor or an affiliated person at the end of this period. However, under paragraph 40(3.4)(b), the denied loss may be claimed by the corporation that suffered the loss (the transferor) when any of the following events occurs: the capital property is disposed to a person other than the transferor or a person affiliated with the transferor. However, neither the transferor nor a person affiliated with the transferor may acquire the property or an identical property within 30 days after the disposition; the transferor s taxable status changes (becomes non-resident or exempt from tax); the control of the transferor is acquired by a person or group of persons; if the substituted property is a debt or a share, a deemed disposition occurs under section 50; the winding-up of the transferor, unless it is a winding-up under subsection 88(1). The denied loss is also referred to as a suspended loss because its realization is in effect kept suspended until the property is no longer within the affiliated group. Individual If the person who disposes of a non-depreciable capital property is an individual other than a trust, the provisions of section 54 and subparagraph 40(2)(g)(i) apply rather than those of subsection 40(3.4). Under subparagraph 40(2)(g)(i), a taxpayer s loss, if any, is deemed nil if it is considered a superficial loss as defined in section 54. A loss resulting from the disposition of a particular property is considered a superficial loss if: (a) within 30 days before or after the disposition, the taxpayer or a person affiliated with the taxpayer acquired or had a right to acquire a property that is the same as, or identical (substituted property) to, the particular property; (b) at the end of that period, the taxpayer or a person affiliated with the taxpayer owned or had a right to acquire the substituted property. However, the loss is not considered a superficial loss if the individual s taxable status changes (that is, the individual becomes exempt from tax or becomes a non-resident) within 30 days after the disposition. Under paragraph 53(1)(f), the amount of the superficial loss that the individual may not deduct is added to the ACB of the property or the identical property (substituted property) of the purchaser. Individual or corporation purchase or redemption of shares by issuing corporation When a corporation purchases or redeems any of its shares and the shareholder (individual or corporation) suffers a capital loss, that loss is not a superficial loss, since the shares are then cancelled. The loss will then be deemed to be nil, under subsection 40(3.6), if the corporation is affiliated with the shareholder immediately after the purchase or redemption. Under paragraphs 40(3.6)(b) and 53(1)(f.2), the denied loss is then added to the ACB of all other shares held in the corporation by the shareholder immediately after the redemption. The ACB of each of these shares is adjusted in proportion to their FMV relative to the FMV of all the shares held. Note that the latter rule applies when the shareholder is either a corporation or an 2 Reading 2-4 Advanced Personal & Corporate Taxation

73 individual. Example 1-15, seen in Reading 1-5, illustrates a situation where subsection 40(3.6) applies. Example 2-16 illustrates how the rules on superficial losses apply when an individual transfers property at a loss to an affiliated person. Example 2-17 illustrates how subsection 40(3.4) applies when the transferor is a corporation. EXAMPLE 2-16 Dolores Savard incorporates Savory Ltd. and is the sole shareholder. She transfers a non-depreciable capital property, namely a parcel of land, to Savory Ltd., using the rollover provisions of section 85. ACB of the land transferred $ 20,000 FMV of the land transferred $ 10,000 Agreed amount $ 10,000 Consideration received: common shares FMV $ 10,000 Tax consequences 1. For Dolores: Deemed POD (agreed amount) $ 10,000 Less: ACB (20,000) Capital loss $ (10,000) Under section 54, the capital loss of $10,000 is a superficial loss, since the land was acquired by a person affiliated with Dolores under subparagraph 251.1(1)(b)(i). Under subparagraph 40(2)(g)(i), the loss is deemed to be nil. ACB of the common shares [85(1)(h)] (agreed amount) $ 10, For Savory Ltd.: ACB of the land acquired [53(1)(f)] (agreed amount + Dolores s capital loss) ($10,000 + $10,000) $ 20,000 EXAMPLE 2-17 Use the information in Example 2-16, but assume that the transferor is the corporation Hardy Ltd. instead of an individual. Tax consequences 1. For Hardy Ltd.: Deemed POD (agreed amount) $ 10,000 Less: ACB (20,000) Capital loss $ (10,000) The capital loss is deemed nil under paragraph 40(3.4)(a) if Hardy Ltd. and Savory Ltd. are affiliated corporations under subparagraph 251.1(1)(b)(i). This loss will be deductible by Hardy Ltd. only when one of the events provided for in paragraph 40(3.4)(b) occurs. Advanced Personal & Corporate Taxation Reading 2-4 3

74 ACB of the common shares [85(1)(h)] (agreed amount) $ 10, For Savory Ltd.: ACB of the acquired property (agreed amount) $ 10,000 Depreciable property Note that in examples 2-16 and 2-17, the transfer could have been carried out at FMV without making an election under section 85, since the property did not increase in value. The tax consequences would have been the same. Subsection 13(21.2) applies on the transfer by a person or partnership (the transferor) of a depreciable property whose tax cost is greater than the amount that would otherwise be the transferor s POD, where the transferor or a person affiliated with the transferor holds or has a right to acquire the property 30 days after the disposition. When all these conditions are met, the terminal loss resulting from the transaction is not recognized at that point but is instead amortized until certain subsequent events occur. In addition, subsections 85(1) and 85(2) and section 97 do not apply; in other words, the provisions allowing a rollover are denied. For the purposes of this rule, the tax cost is equal to the lesser of UCC of the class immediately FMV of the property disposed of before the disposition FMV of all the property of the class or CC of the property disposed of Under subparagraph 13(21.2)(e)(i), the tax cost thus determined becomes the POD for the transferor. If the tax cost of the property is higher than the FMV of the property at the time of its disposition, no loss is recognized. However, the transferor is deemed to have acquired a property whose CC is equal to this excess amount. That property, included in the same class as the transferred property, is deemed to have been acquired by the transferor before the taxation year during which the transfer took place, and the transferor is deemed to hold it until one of the following events listed in subparagraph 13 (21.2)(e)(iii) occurs: a disposition of the depreciable property to a person other than the transferor or a person affiliated with the transferor occurs. However, the transferor or a person affiliated with the transferor must not acquire the capital property or a property identical to it within 30 days after the disposition; there is a change in the property s use from an income-earning to a non-income-earning purpose; there is a change in the transferor s taxable status (becomes non-resident or exempt from tax); the control of the transferor is acquired by a person or group of persons; the winding-up of the transferor, unless it is a winding-up under subsection 88(1). The transferor is entitled to claim CCA, at a rate equal to that applying to the transferred property, with respect to the property deemed to have been acquired so long as the transferor is deemed to hold that property. When any of the events listed above occurs, the undepreciated balance becomes a terminal loss deductible under subsection 20(16) if there is no longer any property in the class. 4 Reading 2-4 Advanced Personal & Corporate Taxation

75 In addition, under paragraph 13(21.2)(g), the purchaser is in the same position as the transferor with respect to the provisions of section 20, as in the case of a rollover; that is, the CC of the property for the purchaser is deemed to be the transferor s CC, and the purchaser is deemed to have deducted as CCA the amount by which the CC of the property for the transferor exceeds the property s FMV at the time of acquisition. Subsection 13(21.2) does not apply if the disposition of the property is covered by paragraphs (c) to (g) of the definition of superficial loss in section 54, such as on the expiry of an option. EXAMPLE 2-18 In 2011, Poulos Inc. transfers two antique desks to Alias Ltd., a wholly-owned corporation. Thus, they are affiliated with each other. The desks are the only property in the class. Desk 1 Desk 2 CC $ 2,000 $ 2,500 FMV at the time of transfer $ 800 $ 3,500 UCC of the class $ 4,000 As consideration, Poulos Inc. receives preferred shares with a FMV of $4,300, equal to the FMV of the desks. Desk 2 is sold first. 1. Disposition Desk 2 The tax cost is equal to the lesser of: $3,500 $4,000 $3,256 $4,300 or $2,500 Subsection 13(21.2) does not apply, since the tax cost ($2,500) is less than the FMV ($3,500). Under paragraph 85(1)(e), an agreed amount is set at $2,500, since this is the lesser of: UCC for all property in the class immediately before the disposition $ 4,000 or CC of Desk 2 $ 2,500 or FMV of Desk 2 $ 3,500 Thus, there is no immediate tax consequence. The ACB of the preferred shares received in consideration is $2,500, which is the agreed amount, although the shares have a FMV of $3,500. Since there is no NSC, the entire agreed amount is attributed to the preferred shares issued on the rollover, as stipulated in paragraph 85(1)(g). 2. Disposition Desk 1 The tax cost is equal to the lesser of: ($4,000 $2,500) or $1,500 or $2,000 $800 $800 = $1,500 Advanced Personal & Corporate Taxation Reading 2-4 5

76 Subsection 13(21.2) applies, since the tax cost ($1,500) is greater than the FMV ($800). The deemed POD for Poulos Inc. become $1,500 under subparagraph 13(21.2)(e)(i). There is no tax consequence for Poulos Inc. since the UCC is also $1,500. Thus, no terminal loss is recognized. However, the amount by which the tax cost ($1,500) exceeds the FMV ($800), namely $700, is deemed to be the CC of a property acquired before 2011 and included in class 8. Instead of being entitled to a terminal loss of $700 in 2011, Poulos Inc. will be entitled to a CCA deduction of $140 ($700 20%). Poulos Inc. may continue to amortize this excess amount until any of the events contemplated in subparagraph 13(21.2)(e)(iii) occurs. Eligible capital property If a corporation, trust, or partnership (the transferor) disposes of an ECP and an affiliated person holds or is entitled to acquire that property, or a property identical to it, 30 days after the disposition and that person would be entitled to a deduction under paragraph 24(1)(a), the rules set out in subsection 14(12) will apply. Paragraph 24(1)(a) generally allows for the deduction of the balance of the CEC where a taxpayer has ceased to carry on a business and no longer has any ECP with respect to that business. Under subsection 14(12), this otherwiseallowed deduction is deferred until one of the following events occurs: the capital property is disposed of to a person other than the transferor or a person affiliated with the transferor. However, neither the transferor nor a person affiliated with the transferor may acquire the property or an identical property within 30 days after the disposition; the transferor s taxable status changes (becomes non-resident or exempt from tax); the control of the transferor is acquired by a person or group of persons; a change whereby the ECP no longer constitutes ECP of a business of the transferor or an affiliated person; the winding-up of the transferor, unless it is a winding-up under subsection 88(1). During the period between the disposition of the ECP and any of the above-mentioned events as set out in paragraphs 14(12)(c) to (g), the transferor is still considered to be the owner of the ECP and not to have ceased to carry on the business. During this period, the transferor is therefore entitled to the deduction provided for in paragraph 20(1)(b). The application of subsection 14(12) is shown in Example EXAMPLE 2-19 During its fiscal period ended in 2011, in the process of ceasing to carry on its business, McKeogh Ltd. disposed of a customer list to Hétu Inc. The customer list is the only ECP that McKeogh Ltd. owned. No deduction was claimed under paragraph 20(1)(b) in a previous fiscal period. POD and FMV $ 40,000 CEC immediately before the disposition $ 47,500 In 2012, Hétu Inc. disposes of the customer list to Mackenzie Gardens Ltd. 6 Reading 2-4 Advanced Personal & Corporate Taxation

77 Tax consequences for McKeogh Ltd. 1. If Hétu Inc. is not affiliated with McKeogh Ltd POD ($40,000 3/4) $ 30,000 Less: CEC (47,500) Allowed deduction [24(1)(a)] $ (17,500) 2. If Hétu Inc. is a corporation affiliated with McKeogh Ltd POD ($40,000 3/4) $ 30,000 Less: CEC (47,500) Deferred loss [14(12)] $ (17,500) Allowed deduction [14(12) and 20(1)(b)] ($17,500 7%) $ 1, a. If Mackenzie Gardens Ltd. is not a corporation affiliated with McKeogh Ltd. Allowed deduction [14(12) and 24(1)(a)] ($17,500 $1,225) $ 16,275 b. If Mackenzie Gardens Ltd. is a corporation affiliated with McKeogh Ltd. Allowed deduction [14(12) and 20(1)(b)] ($17,500 $1,225) 7% $ 1,139 Advanced Personal & Corporate Taxation Reading 2-4 7

78

79 READING 2-5 Adjustments to paid-up capital LEVEL 1 PUC adjustments In certain cases, the legal PUC of the shares received on a rollover may be adjusted by the provisions of subsection 85(2.1). Subsection 85(2.1) does not apply if section 84.1 applies, even if the application of section 84.1 yields a nil result. Subsection 85(2.1) provides for a possible reduction in the legal PUC of the class of shares received on a rollover under subsection 85(1) or 85(2) an increase in the PUC of that class of shares for tax purposes if a deemed dividend computed subsequently is due to a reduction in the legal PUC under subsection 85(2.1) Reduction of PUC If all the following conditions are met, subsection 85(2.1) is applicable: a taxpayer (person or partnership) transfers property to a corporation an election is made under subsection 85(1) or 85(2) section 84.1 (or section 212.1) does not apply to the disposition on the transfer of shares to a corporation with which the transferor does not deal at arm s length Under paragraph 85(2.1)(a), the PUC reduction is equal to ( A B) where C A A = the increase in the legal PUC of all the shares of the capital stock of the corporation issued as a result of the acquisition by the corporation of the property B = the agreed amount in excess of the FMV of the non-share consideration C = the increase in the legal PUC of the particular class of shares received in consideration of the rollover This reduction is provided for in order to prevent the transferor from being able to receive, in a share redemption, an amount that would be taxed as a capital gain eligible for the CGD, rather than as a dividend. The application of paragraph 85(2.1)(a) is illustrated in Example Advanced Personal & Corporate Taxation Reading 2-5 1

80 EXAMPLE 2-20 Sajjad Diaz sells a parcel of land, which is a capital property, to Caviar Ltd. using the provisions of subsection 85(1). Land FMV $ 500,000 ACB $ 100,000 Consideration received Note $ 100,000 Preferred shares FMV and legal PUC $ 400,000 Agreed amount $ 100,000 For the note, the portion of the agreed amount that is attributed to the note is equal to the lesser of the following amounts [85(1)(f)]: FMV of the note received $ 100,000 or FMV of the transferred land $ 500,000 The ACB of the note for Sajjad is therefore $100,000. For the preferred share consideration, the amount attributed is equal to the lesser of the following amounts [85(1)(g)]: FMV of the preferred shares $ 400,000 or Excess of the agreed amount over the FMV of the note ($100,000 $100,000) $ The ACB of the preferred shares for Sajjad is therefore nil. Tax consequences Reduction of the legal PUC [85(2.1)] A B where C A A = increase in the legal PUC of all shares of the capital stock of the corporation as a result of the acquisition of the property by the corporation = $400,000 B = agreed amount less FMV of the non-share consideration = $0 ($100,000 $100,000) C = increase in the legal PUC of the class of shares received as consideration for the rollover = $400,000 $400,000 $ 400,000 $0 = $ 400,000 $400,000 2 Reading 2-5 Advanced Personal & Corporate Taxation

81 Paid-up capital for tax purposes Legal PUC of preferred shares $ 400,000 Less: PUC reduction (400,000) PUC for tax purposes $ If the non-share consideration exceeded $100,000, Sajjad would realize a capital gain on the excess amount. He therefore obtained, exempt from tax, the maximum consideration to which he was entitled, namely the ACB of the land. However, since the PUC of the preferred shares for legal purposes is set at $400,000, had there not been this reduction, Sajjad could have received an amount of $400,000 taxed as a capital gain on the redemption of the shares and perhaps be entitled to the CGD if the shares qualified as small business corporation shares at the time of redemption. Without the PUC reduction, the tax consequences would have been as follows: Amount received $ 400,000 PUC of the redeemed shares (400,000) Deemed dividend [84(3)] $ POD [54] Amount received $ 400,000 Dividend [84(3)] Capital gain $ 400,000 Taxable capital gain (1/2) $ 200,000 This gain might be eligible for the CGD. The tax consequences on the redemption of the preferred shares will instead be as follows: Deemed dividend [84(3)] Amount received $ 400,000 PUC of the redeemed shares Deemed dividend $ 400,000 Under paragraph 82(1)(b), this amount must be grossed up by 25% or 41% when it is included in Sajjad s income, depending on whether the dividend is non-eligible or eligible. The dividend tax credit granted is equal to 13.33% or 16.44% of the grossed-up dividend at the federal level, and the provincial tax credit may vary depending on the individual s province of residence. Capital gain POD [54] Amount received $ 400,000 Deemed dividend [84(3)] (400,000) $ 0 ACB (0) Capital gain $ 0 Advanced Personal & Corporate Taxation Reading 2-5 3

82 Increase of PUC Paragraph 85(2.1)(b) provides for a PUC increase equal to the lesser of (i) the excess of (A) over (B) the total dividends deemed by subsections 84(3), 84(4), or 84(4.1) to have been paid after November 21, 1985, on shares of that class the amount of the deemed dividend that would have been determined if there had not been a PUC reduction under paragraph 85(2.1)(a) in computing the PUC of the shares of that class (ii) the PUC reduction under paragraph 85(2.1)(a) for that class of shares An increase in the PUC of a class of shares is required if, on the redemption of shares of this class, the deemed dividend computed on the redeemed shares is due to a PUC reduction under paragraph 85(2.1)(a). The PUC increase is required because this reduction applies to the entire class as long as there are shares issued from this class still outstanding. On a partial redemption of the shares of the class, the PUC of the remaining shares must be affected only by their share of the PUC reduction as explained in Example EXAMPLE 2-21 Using the information in Example 2-20, assume that Caviar Ltd. redeems 25% of the preferred shares for $100,000. Tax consequences Deemed dividend [84(3)] Amount received by Sajjad $ 100,000 PUC of the redeemed shares Deemed dividend [84(3)] $ 100,000 POD [54] Amount received $ 100,000 Dividend [84(3)] (100,000) Less: ACB Capital gain $ PUC increase [85(2.1)(b)] The lesser of: deemed dividend under 84(3) less deemed dividend without 85(2.1) ($100,000 $0) = $100,000 PUC reduction = $400,000 PUC increase $ 100,000 Following the redemption of the preferred shares, the PUC of the preferred shares still held by Sajjad is: PUC of the remaining shares $ 300,000 Less: reduction [85(2.1)(a)] (400,000) Plus: increase [85(2.1)(b)] 100,000 $ 4 Reading 2-5 Advanced Personal & Corporate Taxation

83 In this example, where 25% of the shares have been redeemed, you can see that the PUC increase under paragraph 85(2.1)(b) has the effect of eliminating a corresponding 25% of the PUC reduction under paragraph 85(2.1)(a) so as to keep the PUC of each share at zero. Advanced Personal & Corporate Taxation Reading 2-5 5

84

85 READING 2-6 Election forms LEVEL 1 Requirements of the election Under subsection 85(1), the election to use the rollover provisions is accepted provided Form T2057 is filed. It must be filed with CRA within the required time limit and must be completed in a professional manner, that is, without any error that would adversely affect the validity of the election. The time limit for filing the joint election by the transferor and the corporation is specified in subsection 85(6). Form T2057 must be filed no later than the earliest of the days on which one of the two taxpayers is required to file an income tax return for the taxation year in which the transfer occurred: If the transferor is an individual: April 30 or June 15 of the following year a corporation: six months after the end of its taxation year a trust or estate: 90 days after the end of its taxation year For the purchaser, which is always a corporation: six months after the end of its taxation year EXAMPLE 2-22 Kumar Ltd. s year end is December 31. Caravelle Ltd. s year end is November 30. On March 1, 2011, Kumar Ltd. transfers assets to Caravelle Ltd. under subsection 85(1). Form T2057 must be filed no later than May 31, 2012, being six months after the end of Caravelle Ltd. s taxation year. Subsection 85(7) allows late elections to be filed with respect to section 85. The election is accepted if within three years following the deadline for filing the election, the taxpayer makes an election using Form T2057 and the taxpayer pays the penalty for late filing provided for in subsection 85(8) This penalty is equal to the lesser of 1/4 of 1% of the excess of the FMV of the property at the time of the disposition over the amount agreed upon in the election for each month or part of a month for which the election is late or $100 per month or part of a month not exceeding $8,000 Advanced Personal & Corporate Taxation Reading 2-6 1

86 EXAMPLE 2-23 Gibson Ltd. and Luong Ltd. have fiscal periods ending on June 30. Taking advantage of the provisions of section 85, Gibson Ltd. transfers to Luong Ltd. a parcel of land that is a capital property. Date of transfer: June 1, 2011 ACB of parcel of land $ 20,000 FMV of parcel of land $ 50,000 Agreed amount $ 20,000 Form T2057 is filed on December 15, 2012, whereas it should have been filed no later than December 31, The penalty to be paid in order for the election to be valid is equal to the lesser of the following amounts: 1/4 of 1% (FMV of the parcel of land agreed amount) number of months or part of a month late, that is, 1/4 of 1% ($50,000 $20,000) 12 $ 900 $ months (not exceeding $8,000) $ 1,200 A penalty of $900 is therefore payable. In Example 2-23 you studied how to calculate the penalty for the late filing of Form T2057. The example raises an issue as to the reasons for the late filing. Sometimes this is due to a delay on the part of the taxpayer in calling the transaction to the attention of his or her CGA. Unfortunately, there are also cases where the delay is the fault of the CGA, for example, too much work, inattention, or inefficiency in the accountant s office. Not only will clients be unhappy with having to pay penalties for the failure of their CGA to file the prescribed form on time, but an ethical question also arises as to the lack of professional diligence. Example 2-24 illustrates these ethical points. EXAMPLE 2-24 Amanda Fife and Marcel Tambour are both CGAs and work together as Fife and Tambour, Partners. Until recently, Marcel has done most of the tax planning and related work, including the filing of prescribed forms where required. But because of a sizable increase in client demand for tax planning, Amanda has taken over some of Marcel s former clients. One of these clients is Gur Singh. In 2009, on Marcel s advice, Gur formed a corporation to which he transferred the business that he was carrying on as sole proprietor. Gur and his spouse are the sole shareholders of the new corporation. The first fiscal period of the corporation ended on December 31, In reviewing the file for her first meeting with Gur, Amanda notices that Form T2057 was filed on December 12, 2010, whereas it should have been filed on June 15, When she mentions this fact to her partner Marcel, he explains to her that he was very busy at that time and that in any case Gur is not aware that a penalty was imposed for late filing. What should Amanda do? 2 Reading 2-6 Advanced Personal & Corporate Taxation

87 Suggested solution 1. Amanda should discuss with Marcel the importance of filing prescribed forms within the time limits stipulated in the ITA. That the client failed to notice the late filing is beside the point. 2. Amanda should suggest that they develop appropriate procedures in the firm to ensure timely filing of forms. 3. Gur should be told the reason for the late filing. The firm of Fife and Tambour should offer to pay any excess penalty caused by Marcel s negligence. It would be fair for Marcel, who made the error, to assume the cost of the penalty. This is a matter to be settled between the partners. 4. Amanda can check to see whether there were other forms that Marcel filed late, so as to determine whether this is an isolated case or a repetitive behaviour indicating a lack of professionalism that may have negative consequences for the firm and for the profession in general. In addition, under subsection 85(7.1), a taxpayer may file an election after the expiry of the three-year limit or amend an election previously filed if, in the opinion of the Minister, the circumstances are such that it would be just and equitable to allow the election. However, the penalty under subsection 85(8) remains applicable. Subsection 85(7.1) raises another ethical issue for CGAs engaged in tax planning. By either failing to file the form within the three years allowed by the ITA or failing to file an amended form, a CGA could cause serious problems for the taxpayer who is his or her client. At a minimum the taxpayer will have the anxiety of waiting for the Minister s decision on the application to have the form accepted after the three-year time limit. Even if the response is favourable, substantial penalties will have to be paid. In a worst-case scenario, the election will not be allowed and the client will potentially forego substantial tax advantages or end up with an unexpected tax burden. Filing the election The form should be filed on or before the deadline at the CRA taxation centre where the transferor s income tax return is filed if there is more than one transferor, such as in the case of co-owners, at the taxation centre where the transferee files his income tax return separately from any income tax return The original must be sent at the earliest date upon which any one of the parties to the election must file an income tax return for the taxation year in which the transfer occurred. If a property transferred was omitted from the rollover, another election for that property will be accepted, provided it is filed within the time limit and the appropriate penalty, if any, is paid. Read IC76-19R3, paragraphs 9 to 22, regarding filing requirements and late or amended elections. Advanced Personal & Corporate Taxation Reading 2-6 3

88 Comments on the form Certain points should be noted when completing the form: Each property transferred should be described in a summary but precise manner. In the case of depreciable property, the documents indicating the designated order should be retained. Goodwill should not be omitted; if the value cannot be determined, a value of $1 should be used. The transfer of depreciable property for which the UCC of the class is nil, such as may be the case for classes 12 and 29, should not be omitted. A value of $1 should be used. The description of the consideration should indicate that shares have been allocated to each property and the non-share consideration should be accurately described. The terms of each class of shares should be described. The agreed amount should be exact because it represents the vendor s POD and the purchaser s cost of acquisition. Ensure that the agreed amount is not less than the non-share consideration. The form contains a list of questions that must be answered meticulously. It will include information on whether the property transfer agreement signed by the transferor and the purchaser contains a price adjustment clause. If the shares are the object of a rollover under section 85, the PUC of these shares must be indicated. 4 Reading 2-6 Advanced Personal & Corporate Taxation

89 READING 2-7 Example of a transfer of property LEVEL 1 EXAMPLE 2-25 Example 2-25 provides a comprehensive illustration of the transfer of property and the corresponding tax consequences. In 1996, Mark Benson acquired 1,000 common shares of Cornet Ltd., a public corporation, for $150,000. The PUC of these shares is $1,000. Mark s share ownership in Cornet Ltd. constitutes less than 1% of Cornet s outstanding shares. Mark s two children are the only shareholders of Quality Ltd. and each of them holds 50 common shares of Quality Ltd. The total PUC of these shares is $15,000, and the FMV is $1,000,000. Mark wants to transfer his 1,000 common shares of Cornet Ltd. to Quality Ltd. They have a FMV of $500,000. On May 1, 2011, an election is made under subsection 85(1). Agreed amount $ 150,000 Consideration received: 50 common shares FMV $ 500,000 PUC $ 500,000 Mark also owns land and a building that are rental properties. He decides to take the opportunity to transfer them to Quality Ltd., so that his children can participate in the future appreciation. The following data relate to this transfer, for purposes of subsection 85(1): Agreed FMV and Cost FMV amount Consideration PUC Land $ 40,000 $ 120,000 $ 90, A pref. $ 120,000 Building $ 100,000 $ 230,000 $ 50,000 $30,000 note (UCC $50,000) 100 A pref. $ 120, B pref. $ 80,000 On December 1, 2011, all the common shares held by Mark and the Class A preferred shares of Quality Ltd. are redeemed for $740,000, namely, $500,000 for the common shares and $240,000 for the Class A preferred shares. Tax consequences A. At the time of the transfers 1. For Mark: Shares of Cornet Ltd. Deemed POD (agreed amount) $ 150,000 Less: ACB (150,000) Capital gain $ ACB of the 50 common shares received as consideration [85(1)(h)] $ 150,000 Advanced Personal & Corporate Taxation Reading 2-7 1

90 Land Deemed POD (agreed amount) $ 90,000 Less: ACB (40,000) Capital gain $ 50,000 Taxable capital gain (1/2) $ 25,000 ACB of the 100 Class A preferred shares received as consideration [85(1)(g)] $ 90,000 Building Deemed POD (agreed amount) $ 50,000 Less: CC (100,000) Capital gain (no capital loss on the disposition of a depreciable property) $ UCC $ 50,000 Less the lesser of: CC $ 100,000 POD $ 50,000 $ 50,000 Recapture of CCA $ ACB of the note [85(1)(f)] The lesser of: FMV of the note received $ 30,000 FMV of the transferred building $ 230,000 ACB of the 100 Class A preferred shares [85(1)(g)] The lesser of: FMV of the A and B preferred shares $ 200,000 Excess of the agreed amount over the FMV of the note ($50,000 $30,000) $ 20,000 Since there are two classes of preferred shares that are issued in consideration of the transfer of the building, a distribution must be made between the two classes. ACB of Class A preferred shares $120,000 $ 20,000 $ 12,000 $200,000 ACB of the Class B preferred shares $80,000 $ 20,000 $ 8,000 $200, For Quality Ltd.: 1,000 common shares of Cornet Ltd. having an ACB of $150,000 and a PUC of $1,000 The ACB of the land is $90, Reading 2-7 Advanced Personal & Corporate Taxation

91 Cost of the building [85(5)] $ 100,000 Deemed CCA deducted (50,000) UCC $ 50, PUC of the shares of Quality Ltd.: Subsection 85(2.1) provides that there is a reduction of the PUC if: a taxpayer transfers property to a corporation an election is made under subsection 85(1) section 84.1 does not apply to the disposition Common shares Reduction of the legal PUC under subsection 85(2.1) as a result of the transfer of the shares of Cornet Ltd. C (A B) A where A = increase in the PUC of all the shares $ 500,000 B = agreed amount $ 150,000 Less: FMV of the non-share consideration $ 150,000 C = increase in the PUC of the common shares $ 500,000 $500,000 $ 500,000 $150,000 $ 350,000 $500,000 PUC before reduction ($15,000 + $500,000) $ 515,000 Less: Reduction [85(2.1)] (350,000) PUC of the 150 common shares for tax purposes $ 165,000 Hence, $1,100 per share. Class A preferred shares Reduction of the legal PUC under subsection 85(2.1) as a result of the transfer of land C (A B) A where A = increase in the PUC of all the shares $ 120,000 B = agreed amount $ 90,000 Less: FMV of the non-share consideration $ 90,000 C = increase in the PUC of the Class A preferred shares $ 120,000 Advanced Personal & Corporate Taxation Reading 2-7 3

92 $120,000 $ 120,000 $90,000 $ 30,000 $120,000 Reduction of the legal PUC under subsection 85(2.1) as a result of the transfer of the building A = $120,000 + $80,000 = $200,000 B = $50,000 $30,000 = $20,000 C = $120,000 $120,000 ($200,000 $20,000) $200,000 $ 108,000 PUC before reduction $ 240,000 Less: Reduction due to transfer of: land (30,000) building (108,000) PUC of the 200 Class A preferred shares for tax purposes $ 102,000 Hence, $510 per share. Class B preferred shares Reduction of the legal PUC under subsection 85(2.1) as a result of the transfer of the building ( A B) C A A = $200,000 B = $20,000 C = $80,000 $80,000 $ 200,000 $20,000 $ 72,000 $200,000 PUC before reduction $ 80,000 Less: Reduction (72,000) PUC of the 100 Class B preferred shares for tax purposes $ 8,000 Hence, $800 per share. B. Redemption of the common shares and Class A preferred shares 1. Redemption of the 50 common shares Amount received $ 500,000 Less: PUC of the 50 common shares 50 $165,000 (55,000) 150 Deemed dividend [84(3)] $ 445,000 4 Reading 2-7 Advanced Personal & Corporate Taxation

93 POD [54] Amount received $ 500,000 Dividend [84(3)] (445,000) $ 55,000 Less: ACB (150,000) Capital loss $ (95,000) Allowable capital loss (1/2) $ (47,500) 2. Redemption of the 200 Class A preferred shares Amount received $ 240,000 Less: PUC (102,000) Deemed dividend [84(3)] $ 138,000 POD [54] Amount received $ 240,000 Dividend [84(3)] (138,000) $ 102,000 Less: ACB ($90,000 + $12,000) (102,000) Capital gain $ C. Increase of PUC of common shares Deemed dividend without 85(2.1) Amount received $500,000 PUC without reduction under 85(2.1) [$515, ] (171,667) $328,333 PUC increase [85(2.1)(b)] The lesser of: $445,000 $328,333 [deemed dividend under 84(3) less deemed dividend without 85(2.1)] $350,000 [ PUC reduction] $116,667 PUC of remaining 100 common shares Stated PUC of remaining shares [$515, ] $343,333 Less: reduction [85(2.1)(a)] (350,000) Plus: increase [85(2.1)(b)] 116,667 PUC after adjustments $110,000 Hence, $1,100 per share. Advanced Personal & Corporate Taxation Reading 2-7 5

94

95 READING 3-1 Non-arm s length sale of shares LEVEL 1 The disposition of shares of a corporation resident in Canada in favour of a corporation with which the person disposing of them does not deal at arm s length is subject to the special rules contained in section 84.1, in the case of a resident of Canada, and in section 212.1, in the case of a non-resident. These rules are designed to prevent surplus stripping. Sale of shares by a resident The rules set out in section 84.1 were introduced at the same time as the capital gains deduction (CGD). These are anti-avoidance rules which prevent a taxpayer (other than a corporation) from receiving, as a capital gain, funds that would otherwise have been received as taxable dividends from a corporation. Without this rule, it would have been possible, for example, for an individual owning qualified small business corporation shares to take advantage of the $375,000 ($250,000 before March 19, 2007) CGD and withdraw up to $750,000 ($500,000 before March 19, 2007) tax-free by transferring the shares to another corporation that the individual controls, as illustrated in Example 3-1. EXAMPLE 3-1 Alex Sinclair holds all the issued and outstanding shares of Illusion Ltd., namely 1,000 common shares. These shares have an FMV of $700,000 and an ACB of $1,000. The PUC of the shares is $1,000. Illusion Ltd. has $100,000 available in cash that it could pay as a dividend to Alex. Alex Sinclair 1,000 common shares PUC and ACB: $1,000 FMV: $700,000 Cash Available: $100,000 Illusion Ltd. Alex has never used his CGD, and the shares of Illusion Ltd. are qualified small business corporation shares. Planning In order to take advantage of the CGD and withdraw from Illusion Ltd. an amount equal to the FMV of the shares free of tax, Alex could establish a new corporation, Holdco Ltd., and sell to it the 1,000 common shares of Illusion Ltd. at their FMV of $700,000. The consideration received from Holdco Ltd. would be a note for $700,000. Advanced Personal & Corporate Taxation Reading 3-1 1

96 Alex Sinclair Note to be received: $ 700, % of shares Holdco Ltd. 1,000 common shares Cash available: $100,000 Illusion Ltd. Were it not for section 84.1, the sale of the shares of Illusion Ltd. to Holdco Ltd. would result in Alex having a taxable capital gain of $349,500 [($700,000 $1,000) 1/2], which would qualify for the CGD, and thus Alex would not pay any tax on this gain. Illusion Ltd. would pay Holdco Ltd. a dividend of $100,000 that would not be subject to Part I tax, since it is deductible under section 112. Nor would this dividend be subject to Part IV tax, except insofar as Illusion Ltd. was entitled to a dividend refund, since Holdco Ltd. and Illusion Ltd. are connected corporations. Lastly, Holdco Ltd. would repay Alex $100,000 on the $700,000 note. This repayment would have no tax consequences. In the future, the balance of $600,000 on the note could be repaid in the same way as funds became available to Illusion Ltd. Thus, Alex could, with no tax consequences, withdraw $700,000 from Illusion Ltd. whereas that amount should have been paid to him as a dividend, since it comes from the retained earnings of Illusion Ltd. This is what is called surplus stripping. In order to prevent this type of transaction, section 84.1 provides for an immediate deemed dividend, if there is non-share consideration, and for a reduction of PUC if shares are received in consideration. The purpose of the PUC reduction is to preclude surplus stripping at the time the shares are redeemed. Section 84.1 applies both when the shares are disposed of at FMV and when the transfer is carried out at a lesser amount, as when making the election provided for in subsection 85(1). Furthermore, for purposes of the PUC reduction, section 84.1 takes precedence over subsection 85(2.1), as stipulated at the beginning of subsection 85(2.1). In the case of a rollover of shares using the provisions of subsection 85(1), special attention must be paid to the NSC. Although the NSC may be acceptable for the purposes of subsection 85(1), the effect of subsection 84.1(1) may be such that there is a deemed dividend. Examples 3-5 and 3-6 illustrate this point and should be studied carefully. Conditions Section 84.1 applies when all the following conditions are met: the shares transferred are capital property of the person disposing of them (the vendor) the vendor is not a corporation the vendor is resident in Canada the purchaser is a corporation the vendor and the purchaser do not deal at arm s length 2 Reading 3-1 Advanced Personal & Corporate Taxation

97 the corporation whose shares are sold is resident in Canada and the corporation whose shares are sold is connected, within the meaning of subsection 186(4), with the purchaser corporation immediately after the transaction, that is, (a) or (b) the corporation whose shares are sold is controlled by the purchaser corporation, within the meaning of subsection 186(2) the purchaser corporation owns more than 10% of the issued voting shares and more than 10% of the FMV of all the shares issued by the corporation whose shares are transferred LEVEL 2 When determining whether the vendor and the purchaser are dealing at arm s length, it is necessary not only to consider the usual concept set out in section 251, but also the provisions of paragraphs 84.1(2)(b) and (d), which serve to extend that concept. Paragraph 84.1(2)(b) extends the concept of not dealing at arm s length with the purchaser corporation to the following situation: (i) and (ii) the vendor was, immediately before the disposition, one of a group of less than six persons that controlled the corporation whose shares are transferred the vendor was, immediately after the disposition, one of a group of less than six persons that controlled the purchaser corporation, each member of which was a member of the group referred to in (i) Under paragraph 84.1(2.2)(a), for purposes of determining whether or not the vendor was a member of a group of less than six persons that controlled a corporation, any shares owned by (i) (ii) or (iii) the vendor s spouse or the vendor s child who is under 18 years of age (the vendor s child, as defined in subsection 70(10), includes a child of his child, a child of his child s child, and a person who prior to reaching 19 years of age was wholly dependent on the vendor for support and of whom the vendor then had custody and control), a trust of which the vendor, his spouse, his child who is under 18 years of age or a corporation described in (iii) is a beneficiary, a corporation controlled by the vendor, his spouse or his child who is under 18 years of age, a trust described in (ii) or any combination thereof are deemed to be owned at that time by the vendor and not by the person who actually owned the shares at that time. In addition, paragraphs 84.1(2.2)(b) to (d) stipulate that a group that controls a corporation consists of two or more persons each of whom owns shares of the corporation; the shares need not necessarily be voting shares; even if a corporation is controlled by only one member of a group, it is considered to be controlled by that group; a corporation may be considered to be controlled by a person or a particular group of persons notwithstanding that it is also controlled by another person or group of persons; a corporation may thus be considered to be controlled by two or more persons or groups of persons at the same time. Example 3-2 illustrates a situation in which subsection 84.1(1) applies because a taxpayer is considered as not dealing at arm s length owing to the application of paragraph 84.1(2)(b). Advanced Personal & Corporate Taxation Reading 3-1 3

98 EXAMPLE 3-2 The shares of Black Inc., a Canadian corporation, are held in the following proportions by three Canadian residents dealing with each other at arm s length: Jean Leblanc 51% Margot Kelly 24% Paul Cherez 25% The shares are held by each as capital property. Margot and Jean decide to transfer the shares that they hold in Black Inc. to another Canadian corporation, LK Management Inc. Immediately after the transfer of the shares, Jean holds 50% of the shares of LK Management Inc. and Margot holds the other 50%. Tax consequences 1. For Jean: Subsection 84.1(1) applies to the transfer by Jean of his shares of Black Inc. to LK Management Inc., since the shares of Black Inc. are capital property for Jean; Jean is not a corporation; Jean resides in Canada; LK Management Inc. is a corporation; Black Inc. resides in Canada; immediately after the transfer of the shares of Black Inc. to LK Management Inc., these two corporations are connected within the meaning of subsection 186(4), since LK Management Inc. holds more than 10% of the shares of Black Inc., in terms of both voting rights and value; Jean does not deal at arm s length with LK Management Inc. under paragraph 84.1(2)(b), since before the transfer of the shares of Black Inc. to LK Management Inc., he was one of a group of fewer than six persons that controlled Black Inc. and immediately after the transfer he is one of a group of fewer than six persons that control LK Management Inc., each of whom was a member of a group that controlled Black Inc., namely him and Margot. While Jean controlled Black Inc. on his own prior to the transfer, under paragraph 84.1(2.2)(c) he is considered to be one of a group that controls it. 2. For Margot: Subsection 84.1(1) applies to the transfer of her shares to LK Management Inc. for the same reasons. Paragraph 84.1(2)(d) extends the concept of arm s length as defined in section 251, stipulating that a trust and its beneficiaries or persons related to the beneficiaries are deemed not to deal with each other at arm s length. 4 Reading 3-1 Advanced Personal & Corporate Taxation

99 LEVEL 1 Paid-up capital reduction As noted above, the tax consequences of section 84.1 depend on the nature of the consideration received on the transfer: shares or non-share consideration. Under paragraph 84.1(1)(a), where the consideration received on the transfer includes shares, the PUC of each class of shares affected by the share issue may be reduced. The reduction of the PUC of a particular class is computed using the following formula: A B where C A A = the increase in the PUC of all classes of shares of the share capital of the purchaser corporation following the issue of new shares in consideration of the transfer B = the greater of: (i) PUC, immediately before the disposition, of the shares sold; (ii) the ACB to the vendor, immediately before the disposition less: the FMV, immediately after the disposition, of the NSC received by the vendor C = the increase in the PUC of the particular class of shares following the issue of share of this class in consideration of the transfer Note that the second part of the operation, expressed by the fraction C/A, has effect only when shares of more than one class are issued in the transfer. If shares of only one class are issued, the result of the fraction C/A is 1. If the vendor receives shares of more than one class as consideration, the reduction is applied to the different classes of shares received in proportion to the increase in the PUC before the reduction. Examples 3-3 and 3-4 illustrate how the PUC reduction is calculated under paragraph 84.1(1)(a). EXAMPLE 3-3 Rita Gagné resides in Canada. She is the sole shareholder of Xiang Ltd. and Pelican Ltd. She transfers to Pelican Ltd., at their FMV, shares of Xiang Ltd. acquired when issued after 1971 and receives in consideration only Class C shares issued by Pelican Ltd. No Class C shares were issued before this transaction. Xiang Ltd. is resident in Canada. Shares of Xiang Ltd. FMV $ 50,000 ACB $ 100 PUC $ 100 Class C shares of Pelican Ltd. issued as consideration FMV $ 50,000 Legal PUC $ 50,000 Advanced Personal & Corporate Taxation Reading 3-1 5

100 Tax consequences Subsection 84.1(1) applies to the transfer of shares since all the conditions set out in it are met: The shares of Xiang Ltd. are a capital property for Rita. The vendor, Rita, is not a corporation. Rita and Xiang Ltd. are resident in Canada. The purchaser, Pelican Ltd., is a corporation. Rita and Pelican Ltd. do not deal at arm s length, since Rita is the sole shareholder of Pelican Ltd. After the purchase, Pelican Ltd. holds all the shares of Xiang Ltd., and the corporations are therefore connected within the meaning of subsection 186(4). Since Rita has received only Class C shares in exchange for the shares of Xiang Ltd., paragraph 84.1(1)(a) applies, reducing the PUC of the Class C shares. The following is a breakdown of the tax consequences of the transaction for the parties involved. 1. Reduction of the PUC of the Class C shares of Pelican Ltd. [84.1(1)(a)]: Computation of the reduction A = Increase in the PUC of all classes of shares of the capital stock of Pelican Ltd. as a result of the issue of new shares as consideration for the transfer $ 50,000 B = The greater of the following amounts relating to the transferred shares: (i) PUC: $100 (ii) ACB: $100 $ 100 Less: FMV of the NSC $ 100 C = Increase in the PUC of the Class C shares $50,000 C (A B) = A $ 50,000 $100 $50,000 $ 49,900 $50,000 Computation of the paid-up capital of the Class C shares PUC before the reduction $ 50,000 Less: Reduction under 84.1(1)(a) (49,900) PUC for tax purposes $ 100 Legal PUC $ 50, For Rita: Capital gain on disposition of the shares of Xiang Ltd. POD $ 50,000 ACB (100) Capital gain $ 49,900 Taxable capital gain (1/2) $ 24,950 6 Reading 3-1 Advanced Personal & Corporate Taxation

101 Note that Rita will be able to claim the CGD with respect to this gain if the shares of Xiang Ltd. are qualified small business corporation shares. ACB of Class C shares of Pelican Ltd. $ 50,000 PUC of the Class C shares of Pelican Ltd. Since Rita holds all the Class C shares: 100% $100 $ For Pelican Ltd.: ACB of the shares of Xiang Ltd. $ 50,000 EXAMPLE 3-4 Using the same information as in Example 3-3, now assume that the ACB of the shares transferred is not $100 but $20,000. This could be the case, for example, if Rita Gagné purchased the shares from a previous shareholder. Tax consequences The tax consequences are the same except with respect to the reduction of the PUC of the Class C shares of Pelican Ltd. Reduction of the PUC of the Class C shares of Pelican Ltd. [84.1(1)(a)]: Computation of the reduction A = Increase in the PUC of all classes of shares of the capital stock of Pelican Ltd. as a result of the issue of new shares in consideration of the transfer $ 50,000 B = The greater of the following amounts relating to transferred shares: (i) PUC: $100 (ii) ACB: $20,000 $ 20,000 Less: FMV of the NSC $ 20,000 C = Increase in the PUC of the Class C shares $50,000 C (A B) = A $ 50,000 $20,000 $50,000 $ 30,000 $50,000 Computation of the paid-up capital of the Class C shares PUC before the reduction $ 50,000 Less: Reduction under 84.1(1)(a) (30,000) PUC for tax purposes $ 20,000 Legal PUC $ 50,000 The PUC of the shares received in consideration therefore cannot be reduced for tax purposes to an amount less than the ACB of the transferred shares, since there is no non-share consideration. If there was NSC of $20,000, the PUC of the shares received as consideration Advanced Personal & Corporate Taxation Reading 3-1 7

102 would be reduced to nil for tax purposes, since element B of the formula would then have been equal to zero. Immediate dividend Under paragraph 84.1(1)(b), a dividend may result from a non-arm s length sale of shares, if the consideration includes non-share property. Thus, the vendor may receive tax-free, NSC for an amount equal to the greater of the following amounts: PUC of the shares transferred ACB of the shares transferred When the non-share consideration exceeds this amount, the excess is taxed as a dividend. The deemed dividend is computed using the following formula: (A + D) (E + F) where A = the increase in the PUC of all classes of shares of the purchaser corporation following the issue of new shares in consideration of the transfer D = the FMV, immediately after the disposition, of the NSC received by the transferor E = the greater of: (i) PUC, immediately before the disposition, of the shares transferred (ii) the ACB to the vendor, immediately before the disposition, of the shares transferred F = the PUC reduction computed in paragraph 84.1(1)(a) for all classes of shares concerned However, to prevent double taxation, paragraph (k) of the definition of POD in section 54 provides that, if a deemed dividend is taxed under paragraph 84.1(1)(b), the POD of the shares disposed of are reduced, as illustrated in Example 3-5. EXAMPLE 3-5 Pat Moore holds 25% of the issued and outstanding shares of Glory Ltd. In 2011, he transfers to Beau Ltd., a corporation related to him, the shares of Glory Ltd. that he acquired after The transfer is carried out under subsection 85(1), and the agreed amount is $40,000. Shares of Glory Ltd. FMV $ 50,000 ACB $ 100 PUC $ 100 Consideration paid by Beau Ltd. Note $ 40,000 Class A shares FMV $ 10,000 Legal PUC $ 100 No other Class A shares of Beau Ltd. were issued before the transaction. 8 Reading 3-1 Advanced Personal & Corporate Taxation

103 Tax consequences Subsection 84.1(1) applies to the transfer of the shares since all the conditions set out in it are met: The shares of Glory Ltd. are a capital property for Pat. The vendor, Pat, is not a corporation. Pat and Glory Ltd. are resident in Canada. The purchaser, Beau Ltd., is a corporation. Pat and Beau Ltd. do not deal with each other at arm s length. After the purchase, Beau Ltd. holds 25% of the voting shares and the FMV of the shares of Glory Ltd., and the corporations are therefore connected within the meaning of subsection 186(4). The fact that the transfer is carried under the provisions of section 85 does not prevent subsection 84.1(1) from applying. Since Pat receives both a share consideration and a non-share consideration, paragraphs 84.1(1)(a) and (b) apply. The following is a breakdown of the tax consequences of the transaction for the parties involved. 1. Reduction of the PUC of the Class A shares of Beau Ltd. [84.1(1)(a)]: Computation of the reduction A = Increase in the PUC of all classes of shares of the capital stock of Beau Ltd. as a result of the issue of new shares in consideration of the transfer $ 100 B = The greater of the following amounts relating to the transferred shares: (i) PUC: $ 100 (ii) ACB: $ 100 $ 100 Less: FMV of the NSC (40,000) (Cannot be negative) $ C = Increase in the PUC of the Class A shares $ 100 C (A B) = $ 100 $0 $100 $ 100 A $100 Computation of the paid-up capital of the Class A shares PUC before reduction $ 100 Less: Reduction under 84.1(1)(a) (100) PUC for tax purposes $ Advanced Personal & Corporate Taxation Reading 3-1 9

104 2. For Pat: Deemed dividend [84.1(1)(b)] A = Increase in the PUC of all classes of shares of the capital stock of Beau Ltd. as a result of the issue of new shares in consideration of the transfer $ 100 D = FMV of the NSC $ 40,000 E = The greater of the following amounts relating to the transferred shares: (i) PUC: $ 100 (ii) ACB: $ 100 $ 100 F = Reduction of the PUC under paragraph 84.1(1)(a) $ 100 Deemed dividend: (A + D) (E + F) ($100 + $40,000) ($100 + $100) $ 39,900 Under paragraph 82(1)(b), this deemed dividend must be grossed up by 25% or 41% when included in Pat s income, depending on whether the dividend is non-eligible or eligible. The dividend tax credit granted is equal to 13.33% or 16.44% of the grossed-up dividend at the federal level, and the provincial tax credit varies depending on Pat s province of residence. Capital gain on disposition of the shares of Glory Ltd. [39(1)(a)] POD [54] Deemed POD [85(1)(a)] $ 40,000 Less: Deemed dividend [84.1(1)(b)] (39,900) $ 100 ACB of the shares transferred (100) Capital gain $ ACB of the Class A shares of Beau Ltd. [85(1)(g)] $ PUC of the Class A shares of Beau Ltd. Since Pat holds all the Class A shares: 100% $0 $ 3. For Beau Ltd. ACB of the shares of Glory Ltd. [85(1)(a)] $ 40,000 Example 3-5 clearly illustrates the need to have a good grasp of how subsections 85(1) and 84.1(1) interrelate when there is a transfer of shares to a corporation which is being dealt with at arm s length. In this example, assuming that the agreed amount was set at $40,000 in order to create a capital gain eligible for the CGD or to use net capital losses, the objective is not achieved. The NSC, set at $40,000, is greater than the PUC and the ACB of the transferred shares, and this results in a deemed dividend under paragraph 84.1(1)(b). Also note that under paragraph 84.1(1)(a), there is a reduction of the PUC of the shares received, and this takes precedence over subsection 85(2.1). 10 Reading 3-1 Advanced Personal & Corporate Taxation

105 ACB adjusted for purposes of section 84.1 For purposes of the computation of the PUC reduction [84.1(1)(a)] and the deemed dividend [84.1(1)(b)], the ACB of the shares sold may be modified if the shares sold were acquired before January 1, 1972, or if they were acquired after 1971 from a person with whom the taxpayer was not dealing at arm s length. Under paragraph 84.1(2)(a), the ACB of a share acquired before 1972 is determined without considering the increase in value accrued to December 31, Under paragraph 84.1(2)(a.1), the ACB of a share acquired after 1971 from a person who does not deal at arm s length with the vendor is deemed to be equal to: ACB for the vendor Less: (i) Where the share was owned before 1972 by a person not dealing at arm s length with the vendor: FMV on V-day Less: actual cost on January 1, 1972, for the person not dealing at arm s length with the vendor and any dividend received after 1971 in respect of which an election was made under subsection 83(1) The result cannot be a negative amount. (ii) In any other case, including shares owned in 1971: Capital gains which were reported on the share by the taxpayer or an individual with whom the taxpayer did not deal at arm s length after 1984, to the extent the CGD under section was claimed against them. In both cases, such information is not always easy to obtain, since the income tax and benefit return of the person with whom the taxpayer does not deal at arm s length is not necessarily accessible. Subparagraph (ii) above prevents two related persons from planning a transaction to take advantage of the CGD and withdraw funds from a corporation owned by them. For example, an individual could sell his shares to his spouse and take advantage of the CGD. His spouse would then sell the shares to a related corporation and would thus receive tax-free POD, since her ACB for the shares would be equal to the FMV. Paragraph 84.1(2)(a.1) prevents such planning, since for the purposes of section 84.1 only the CGD claimed by the individual reduces the ACB of the spouse s shares by an equivalent amount. Subsection 84.1(2.1) also takes into account the fact that a capital gains reserve may have been claimed and the portion of the CGD accordingly claimed in a subsequent year for purposes of subparagraph 84.1(2)(a.1)(ii). Example 3-6 illustrates how paragraph 84.1(2)(a.1) applies and shows a transaction that gives rise to both a PUC reduction and a deemed dividend. EXAMPLE 3-6 In 2011, Lea Blake transfers the shares of Dolly Ltd. to Balcon Ltd., a corporation of which she already owns 100% of the common shares. Lea had acquired all the issued and outstanding shares of Dolly Ltd. from her sister in 1990 for $100,000. Her sister had then realized a capital gain of $30,000 ($22,500 taxable), for which she had taken advantage of the Advanced Personal & Corporate Taxation Reading

106 CGD. Lea makes the election provided for in subsection 85(1) to transfer the shares of Dolly Ltd. to Balcon Ltd. The agreed amount is set at $100,000. Lea Blake, Dolly Ltd. and Balcon Ltd. are resident in Canada. Shares of Dolly Ltd. FMV $ 300,000 ACB $ 100,000 PUC $ 70,000 Consideration paid by Balcon Ltd. Cash $ 100,000 20,000 Class A preferred shares FMV $ 200,000 Legal PUC $ 200,000 Before the transaction, there were 5,000 Class A preferred shares of Balcon Ltd. issued to a person other than Lea, having a FMV of $50,000 and a PUC of $10,000. The Class A preferred shares are non-voting shares. Tax consequences Subsection 84.1(1) applies to the transfer of the shares, since all the conditions set out in it are met: The shares of Dolly Ltd. are a capital property for Lea. The vendor, Lea, is not a corporation. Lea and Dolly Ltd. are resident in Canada. The purchaser, Balcon Ltd., is a corporation. Lea and Balcon Ltd. do not deal with each other at arm s length, since Lea controls Balcon Ltd. as she holds 100% of the common shares of Balcon Ltd. After the purchase, Balcon Ltd. holds 100% of the shares of Dolly Ltd., and the corporations are therefore connected within the meaning of subsection 186(4). The fact that the transfer is carried out under the provisions of section 85 does not prevent subsection 84.1(1) from applying. Since Lea receives both a share consideration and a non-share consideration, paragraphs 84.1(1)(a) and (b) apply. Lea acquired the shares from her sister, a person with whom she does not deal at arm s length. Thus, the ACB of the shares of Dolly Ltd. held by Lea, for the purposes of subsection 84.1(1) only, must be reduced to take account of the amount of the CGD claimed by the sister on the gain that she realizes on the sale of the shares. The following is a breakdown of the tax consequences of the transaction for the parties involved: 1. ACB of Dolly Ltd. shares for purposes of 84.1(1) [84.1(2)(a.1)]: ACB for Lea $ 100,000 Less: Capital gain reported by her sister in respect of which the CGD was claimed (30,000) ACB for purposes of 84.1(1) $ 70, Reduction of PUC of Class A shares of Balcon Ltd. [84.1(1)(a)]: 12 Reading 3-1 Advanced Personal & Corporate Taxation

107 Computation of the reduction A = Increase in the PUC of all classes of shares of the capital stock of Balcon Ltd. as a result of the issue of new shares in consideration of the transfer $ 200,000 B = The greater of the following amounts relating to the transferred shares: (i) PUC $70,000 (ii) Amended ACB $70,000 $ 70,000 Less: FMV of the NSC (100,000) (cannot be negative) $ C = Increase in the PUC of the Class A shares $ 200,000 (A B) C = ($ 200,000 $0) $200,000 $ 200,000 A $200,000 Computation of the paid-up capital PUC of the Class A shares of Balcon Ltd. without reference to 84.1(1)(a) ($200,000 + $10,000) $ 210, For Lea: Less: PUC reduction (200,000) PUC for tax purposes $ 10,000 Deemed dividend [84.1(1)(b)] A = Increase in the PUC of all classes of shares of the capital stock of Beau Ltd. as a result of the issue of new shares in consideration of the transfer $ 200,000 D = FMV of the NSC $ 100,000 E = The greater of: (i) PUC $70,000 (ii) Amended ACB $70,000 $ 70,000 F = Reduction in the PUC under paragraph 84.1(1)(a) $ 200,000 Deemed dividend: (A + D) (E + F) ($200,000 + $100,000) ($70,000 + $200,000) $ 30,000 Under paragraph 82(1)(b), this deemed dividend must be grossed up by 25% or 41% when included in Lea s income, depending on whether the dividend is non-eligible or eligible. The dividend tax credit granted is equal to 13.33% or 16.44% of the grossed-up dividend at the federal level, and the provincial tax credit varies depending on Lea s province of residence. Advanced Personal & Corporate Taxation Reading

108 Capital gain on the disposition of shares of Dolly Ltd. [39(1)(a)] POD [54] Deemed POD [85(1)(a)] $ 100,000 Less: Deemed dividend [84.1(1)(b)] (30,000) $ 70,000 ACB of the shares transferred (100,000) Capital loss $ (30,000) The $30,000 loss is a superficial loss deemed to be nil under subparagraph 40(2)(g)(i), since Lea and Balcon Ltd. are affiliated immediately before the transfer. Note that the ACB for purposes of computing the capital loss is not the amended ACB used in computing the reduction in the paid-up capital and the deemed dividend under paragraphs 84.1(1)(a) and (b). ACB of the 20,000 Class A preferred shares of Balcon Ltd. [85(1)(g)] $ PUC of the 20,000 Class A preferred shares of Balcon Ltd. 20,000shares $10,000 $ 8,000 25,000shares 4. For Balcon Ltd.: ACB of the shares of Dolly Ltd. Cost [85(1)(a)] $ 100,000 Adjustment for Lea s superficial loss [53(1)(f)] 30,000 $ 130, For the person holding 5,000 preferred Class A shares: PUC of the 5,000 Class A preferred shares of Balcon Ltd. 5,000shares $10,000 $ 2,000 25,000shares Note that the PUC of the 5,000 preferred shares, which was $10,000 before the transaction, is now $2,000. ACB of the 5,000 Class A preferred shares of Balcon Ltd. The ACB of the shares for this person is not affected. PUC increase However, subsection 84.1(3) provides for an increase in the PUC of a class of shares if, on the redemption of shares of this class, the deemed dividend computed on the redeemed shares is due to a PUC reduction under subsection 84.1(1). The PUC increase is required because the reduction under paragraph 84.1(1)(a) applies to the entire class as long as there are shares issued from this class. On a partial redemption of the shares of the class, the effect of the PUC reduction on the redeemed shares must be removed so that the PUC of the remaining shares is affected only by their share of the PUC reduction. 14 Reading 3-1 Advanced Personal & Corporate Taxation

109 Similarly, if instead of a share redemption, the capital is reduced, resulting in a deemed dividend under subsection 84(4) because of the reduction provided for in paragraph 84.1(1)(a), it is necessary to provide for an increase in the PUC of the class in order to prevent double taxation in the future. The PUC increase is equal to the lesser of: (a) (b) the excess of: (i) over (ii) the total of all dividends deemed by subsections 84(3), 84(4), or 84(4.1) to have been paid after May 22, 1985, on shares of that class the amount of the deemed dividend that would have been determined if there had not been a PUC reduction under paragraph 84.1(1)(a), in computing the PUC of shares of that class the PUC reduction under paragraph 84.1(1)(a) for that class of shares Example 3-7 illustrates a PUC increase under subsection 84.1(3). EXAMPLE 3-7 Using the information in Example 3-5, assume that Beau Ltd. redeems one-half of the shares for $5,000 in Tax consequences 1. For Pat: Deemed dividend [84(3)] Amount received $ 5,000 PUC of the redeemed shares ( ) Deemed dividend $ 5,000 Under paragraph 82(1)(b), this deemed dividend must be grossed up by 25% or 41% when included in Pat s income, depending on whether the dividend is non-eligible or eligible. The dividend tax credit granted is equal to 13.33% or 16.44% of the grossed-up dividend at the federal level, and the provincial tax credit varies depending on Pat s province of residence. Capital gain Redemption value $ 5,000 Deemed dividend [84(3)] (5,000) POD [54] ACB ( ) Capital gain $ 2. Increase in the PUC of Class A shares of Beau Ltd. [84.1(3)] Deemed dividend if there had not been a PUC reduction under paragraph 84.1(1)(a): Amount received $ 5,000 PUC without the PUC reduction under 84.1(1)(a) (50% $100) (50) Deemed dividend without 84.1(1)(a) $ 4,950 Advanced Personal & Corporate Taxation Reading

110 Computation of the increase The lesser of the following amounts: a. The excess of the real deemed dividend over the deemed dividend if there had not been a PUC reduction $5,000 $4,950 = $50 b. The reduction of the PUC of the class: $100 $ 50 PUC of the outstanding Class A shares after the redemption Legal PUC of the remaining shares $ 50 Less: PUC reduction [84.1(1)(a)] (100) Plus: PUC increase [84.1(3)] 50 $ Difference in application between section 84.1 and subsection 85(2.1) EXHIBIT 3-1 Up to now you have studied two ITA provisions that affect the PUC of shares issued in consideration of a transfer of property, namely section 84.1 and subsection 85(2.1). Exhibit 3-1 should help you distinguish between these provisions as to the conditions under which they apply and their consequences. As this is a summary, aspects previously studied are not repeated (2.1) Conditions Transferor: any taxpayer residing in Canada, except for a corporation Purchaser: corporation not dealing at arm s length with the transferor Property transferred: a share of a corporation resident in Canada Any share transfer transaction: at FMV or rollover under section 85 or other provision of the ITA Immediately after the share transfer, the corporation whose shares are transferred is connected to the purchaser Consequences Reduction of the PUC of the shares issued as consideration Immediate taxable dividend if the consideration includes non-share property Transferor: any taxpayer or any partnership Purchaser: any taxable Canadian corporation Property transferred: any eligible property under 85(1.1) Subsections 85(1) or 85(2) must apply on the transfer of the property Does not apply where section 84.1 applies Reduction of the PUC of the shares issued as consideration For other comments and illustrations relating to section 84.1, read paragraphs 1 to 12 of IT-489R. 16 Reading 3-1 Advanced Personal & Corporate Taxation

111 Sale of shares by a non-resident to a corporation resident in Canada In the absence of section 212.1, a non-resident holding shares in a Canadian corporation could have sold his shares to another corporation resident in Canada with which he was not dealing at arm s length, and thus convert a dividend that he may have received from the first corporation into a capital gain. This planning technique would have been very advantageous because a number of tax conventions entered into by Canada provide that capital gains realized on the sale of shares are not taxable in Canada. Example 3-8 illustrates a situation contemplated by section EXAMPLE 3-8 Hans Herscovitch is a resident of a country with which Canada has signed a tax convention, which provides that the capital gain on the sale of shares of a Canadian corporation is not taxable in Canada for Hans. This tax convention also provides that the withholding tax rate on dividends is 15%. Hans is the sole shareholder of Canada Ltd., a Canadian corporation. He holds 1,000 common shares. The PUC and ACB of the shares is $10,000, and their FMV is $500,000. Canada Ltd. has excess cash of $300,000 that Hans would like to take out of the company personally. In order to transfer the cash to Hans, Canada Ltd. could pay him a dividend of $300,000. This dividend would be subject to Part XIII tax, with the result that Hans would receive $255,000 (after the withholding tax of 15%, stipulated in the tax convention). Planning In order to avoid payment of Part XIII tax on the dividend, Hans could incorporate a new Canadian corporation, Holdco Ltd., to which he would sell the shares of Canada Ltd. for $500,000, payable by the issuance of a $500,000 note. As a result of this transaction, Holdco Ltd. and Canada Ltd. would be connected corporations within the meaning of subsection 186(4). Advanced Personal & Corporate Taxation Reading

112 Were it not for section 212.1, the sale of the shares of Canada Ltd. to Holdco Ltd. would result in a taxable capital gain for Hans of $245,000 [($500,000 $10,000) 1/2] which, under the tax convention, would not be subject to tax in Canada. Canada Ltd. would then pay a dividend to Holdco Ltd. This dividend would not be subject to Part I tax, since it would be deductible under section 112. Nor would it be subject to Part IV tax, except insofar as Canada Ltd. was entitled to a dividend tax refund, since Holdco Ltd. and Canada Ltd. would be connected corporations. Holdco Ltd. would then pay Hans $300,000 of the $500,000 note. This payment would have no tax consequence in Canada for Hans. In the future, the balance of $200,000 could be paid in the same manner, at points when Canada Ltd. had cash available. To prevent this type of transaction, an anti-avoidance rule was introduced into the ITA. Under this rule, which is similar to section 84.1 (applicable only to Canadian residents), the non-resident may not withdraw, on a tax-free basis, more than the paid-up capital of the shares transferred. Section applies when (i) and (ii) a non-resident disposes of shares of a corporation resident in Canada to another corporation resident in Canada with which he does not deal at arm s length immediately after the disposition, the first corporation is connected, within the meaning of subsection 186(4), to the purchaser corporation Under subsection 212.1(3), the concept of not dealing at arm s length is extended, as in the case of section 84.1, to the following situation: (i) and (ii) the vendor was, immediately before the disposition, one of a group of less than six persons that controlled the corporation whose shares are transferred; the vendor was, immediately after the disposition, one of a group of less than six persons that controlled the purchaser corporation, each member of which was a member of the group referred to in (i). The same assumptions as were studied with respect to section 84.1 apply in determining whether the vendor was one of a group of less than six persons. 18 Reading 3-1 Advanced Personal & Corporate Taxation

113 Immediate dividend If the non-resident receives proceeds other than shares of the purchaser corporation, he will be deemed to have received a dividend equal to the difference between the fair market value of the non-share consideration and the PUC of the shares transferred. This dividend will be subject to Part XIII tax. Under paragraph (k) of the definition of proceeds of disposition in section 54, the amount of the dividend is excluded from the POD of the shares. Example 3-9 shows how subsection applies when the non-resident receives only non-share consideration. EXAMPLE 3-9 Assuming the facts are the same as in Example 3-8, apply the provisions of paragraph 212.1(1)(a) to the sale of the Canada Ltd. shares to Holdco Ltd. Tax consequences For Hans: Deemed dividend [212.1(1)(a)] Non-share consideration $ 500,000 PUC of transferred shares (10,000) Deemed dividend subject to Part XIII tax $ 490,000 Part XIII tax (15% pursuant to the convention) $ 73,500 Capital gain on the sale of the Canada Ltd. shares Selling price $ 500,000 Deemed dividend [212.1(1)(a)] (490,000) POD [54] 10,000 ACB (10,000) Capital gain $ Note that the application of paragraph 212.1(1)(a) has the effect of making $490,000 subject to Part XIII tax, whereas Hans has received only $300,000 in cash. This is because the remaining $200,000 that he may receive in the future as a result of the issuance of the note is taken into account immediately. Reduction of paid-up capital If the non-resident receives shares as consideration, the PUC of the class of shares that includes the shares received in exchange may be reduced. This reduction is equal to the excess of the increase in the PUC of the purchaser corporation less the excess of: the PUC of the shares transferred over the FMV of any non-share consideration received Advanced Personal & Corporate Taxation Reading

114 If the shares of more than one class of shares are issued in consideration of the transfer, the PUC reduction will be divided among the different classes on the basis of the increase in the PUC of the class in relation to the increase in the PUC of all the classes. The result of this PUC reduction is that, when the shares are redeemed, the non-resident will be taxed on a deemed dividend. Read paragraphs 13 to 19 of IT-489R which explain section Example 3-10 illustrates the effect of subsection 212.1(1) where the transaction involves both share and non-share considerations. EXAMPLE 3-10 Alain Chamonix, a non-resident of Canada, sells all his shares in Oxford Ltd. to Harper Ltd., a wholly-owned corporation of Alain. Oxford Ltd. and Harper Ltd., two corporations resident in Canada, are related following the transaction. You have obtained the following information with respect to the transaction: Sale price $ 250,000 Consideration received Cash $ 50, Class Z shares of Harper Ltd. having a legal PUC of $ 200,000 PUC and ACB of the shares transferred Oxford Ltd. $ 1,000 FMV of the shares transferred Oxford Ltd. $ 250,000 No other Class Z shares of Harper Ltd. were issued before the transaction. Tax consequences Subsection 212.1(1) applies, since the conditions set out in it are met: Alain is a non-resident. Alain transfers shares of a corporation resident in Canada, Oxford Ltd. The transfer is made to another corporation resident in Canada, Harper Ltd., with which Alain does not deal at arm s length, since he holds 100% of its shares. and Immediately after the transfer, Oxford Ltd. and Harper Ltd. are connected corporations. Since Alain receives both a share consideration and a non-share consideration, paragraphs 212.1(1)(a) and (b) apply. The following is a breakdown of the tax consequences of the transaction for the parties involved: 1. Reduction of the PUC of the Class Z shares [212.1(1)(b)]: Computation of the reduction Increase of the PUC in Harper Ltd. $ 200,000 Less: the excess of: PUC of the shares transferred $ 1,000 over FMV of the non-share consideration (50,000) ( ) Reduction of the PUC of the 100 Class Z shares of Harper Ltd. held by Alain $ 200, Reading 3-1 Advanced Personal & Corporate Taxation

115 Computation of the PUC PUC of the 100 Class Z shares of Harper Ltd. before reduction $ 200,000 Less: Reduction of the PUC [212.1(1)] (200,000) PUC of the 100 Class Z shares for tax purposes $ 2. For Alain: Deemed dividend [212.1(1)(a)] Non-share consideration $ 50,000 PUC of the shares transferred (1,000) Deemed dividend subject to Part XIII tax $ 49,000 Capital gain on the sale of the shares of Oxford Ltd. 1 Selling price $ 250,000 Deemed dividend [212.1(1)] (49,000) POD [54] 201,000 ACB (1,000) Capital gain $ 200,000 Taxable capital gain (1/2) $100, This taxable capital gain may be exempt from Canadian income tax if the shares are not TCP or the gain is exempted under a tax convention. If the shares of Oxford Ltd. are TCP, then the procedures under section 116 may have to be followed to avoid the withholding of 25% of the POD provided in that section. ACB of 100 Class Z shares received from Harper Ltd. $ 200,000 PUC of the 100 Class Z shares of Harper Ltd. Since Alain holds all the Class Z shares: 100% $0 $ 3. For Harper Ltd.: ACB of the shares of Oxford Ltd. $ 250,000 Subsection 212.1(2) provides for an increase in the PUC of the class where there is a redemption or purchase of a portion of the shares of the class whose PUC was reduced under subsection 212.1(1). This increase is necessary to eliminate the effect of the overall PUC reduction on the purchase or redemption. The increase is equal to the lesser of the excess of: deemed dividends computed on the shares of the class over the amount of deemed dividends, which would have been computed if there had not been a PUC reduction under section and the amount of the PUC reduction Advanced Personal & Corporate Taxation Reading

116 Example 3-11 shows how subsection 212.1(2) applies. EXAMPLE 3-11 Using the same information as in Example 3-10, assume that 50 Class Z shares received from Harper Ltd. are redeemed by the corporation at a price of $100,000. Tax consequences 1. For Alain: Deemed dividend [84(3)] Redemption price $ 100,000 PUC of the 50 shares redeemed ( ) Deemed dividend [84(3)] $ 100,000 This dividend is subject to Part XIII tax. Capital gain Redemption price $ 100,000 Deemed dividend [84(3)] (100,000) POD [54] ACB (100,000) Capital loss $ (100,000) This loss is subject to the provisions of subsection 40(3.6) since Alain is the only shareholder of Harper Ltd. and is therefore affiliated with Harper Ltd. Under this subsection, the loss is deemed to be nil and added to the ACB of the shares that Alain still owns in proportion to their FMV. 2. Increase in PUC of non-redeemable Class Z shares Computation of the addition [212.1(2)] The lesser of the following amounts: the excess of: the deemed dividend $ 100,000 over the deemed dividend if there had not been a PUC reduction ($100,000 $100,000) $ 100,000 and the PUC reduction [212.1(1)(b)] $ 200,000 $ 100,000 Computation of PUC Legal PUC of the remaining 50 Class Z shares $ 100,000 PUC reduction [212.1(1)(b)] (200,000) (100,000) PUC increase [212.1(2)] 100,000 PUC of the 50 Class Z shares $ 22 Reading 3-1 Advanced Personal & Corporate Taxation

117 The capital gain on the disposition of the shares of Oxford Ltd. in Example 3-10 and the capital loss on the redemption of 50 Class Z shares in Example 3-11 could have been avoided if an election had been made under subsection 85(1) and if the agreed amount had been set at $50,000, which is the amount of the non-share consideration. The POD would then have been: Amount agreed upon [85(1)(a)] $ 50,000 Deemed dividend (49,000) POD $ 1,000 which is an amount equal to the ACB of the transferred shares. In addition, the cost of the Class Z shares would then have been nil under paragraph 85(1)(g) or (h). Amount agreed upon [85(1)(a)] $ 50,000 Cost of the note [85(1)(f)] (50,000) Cost of Class Z shares $ Thus, when the Class Z shares were redeemed, there would not have been a capital loss. In Example 3-10, the deemed dividend under paragraph 212.1(1)(a) could have been avoided by limiting the non-share consideration to an amount less than or equal to the PUC of the transferred shares, namely, $1,000. In such a case, in order to avoid a capital gain, the agreed amount on the rollover under subsection 85(1) should have been set at $1,000, that is, the ACB of the transferred shares. Advanced Personal & Corporate Taxation Reading

118

119 READING 3-2 Reorganization of capital LEVEL 1 General rules The provisions governing reorganizations of capital are very important and are commonly used in tax planning. If it were not for these rules, the reorganization of a corporation s capital would often result in a disposition of the exchanged shares at their FMV at that time with all the resulting tax consequences. The rules in subsection 86(1) apply on the reorganization of capital of a corporation. This expression is not defined either in the ITA or in corporate law. However, it is recognized that the reorganization of capital entails modifying the share capital of the corporation in a manner approved by the shareholders. The modification is generally confirmed by an amendment to the articles of incorporation. Subsection 86(1) provides for a rollover where, in the course of a reorganization of capital, a taxpayer disposes of all his shares of any class of the capital stock of the corporation (the old shares) in exchange for other shares of the capital stock of the same corporation (the new shares). For the rollover to apply the taxpayer must dispose of all his shares of the class; the shares must be capital property of the taxpayer; the taxpayer must receive shares of the same corporation as consideration for the old shares. The consideration is not required to consist solely of shares. However, in order for the reorganization not to have any tax consequences, the non-share consideration must be equal to or less than the ACB and the PUC of the old shares; section 85 must not apply to the transaction. [86(3)] It is important to note that in order for subsection 86(1) to apply, it is not necessary that the corporation be a Canadian corporation or a corporation resident in Canada. Moreover, section 86 applies to all taxpayers whether or not they are resident in Canada. Section 86 applies automatically. It is not necessary to make an election or file a form for this purpose. Where all of the preceding conditions are met, the following rules apply to the taxpayer whose shares have been exchanged [paragraphs 86(1)(a), (b), and (c)]: The cost of any property (other than shares) received in exchange is equal to the FMV of the property at the time of the exchange. The cost of the new shares received in exchange is equal to the ACB of the old shares minus the FMV of the non-share consideration. If shares of more than one class are received, the cost is allocated in proportion to the FMV, immediately after the exchange, of the shares of each class. The POD of the old shares are equal to the cost of the new shares and any other property received in exchange. A capital gain will be realized only if the FMV of the non-share consideration is greater than the ACB of the old shares. No capital loss may be realized given that the POD cannot be less than the ACB of the old shares. Advanced Personal & Corporate Taxation Reading 3-2 1

120 Examples 3-12, 3-13, and 3-14 illustrate how the provisions of subsection 86(1) apply. EXAMPLE 3-12 Dynamite Ltd. is wholly owned by Rosa Rose. The authorized share capital of the corporation consists only of common shares. On incorporation, 1,000 common shares were issued to Rosa for $10,000. Today, the common shares of Dynamite Ltd. are worth $1,000,000. Rosa wishes to provide an incentive for the corporation s three key employees. These employees do not have the funds to purchase Rosa s shares at their current FMV. It was therefore agreed that a reorganization of capital would be carried out as follows: All the common shares currently issued would be converted to non-participating preferred shares having a legal PUC of $10,000 and fixed dividend, and they will be redeemable at the option of the corporation or shareholder for $1,000,000. New common shares would be created and issued to Rosa and the three employees in the desired proportions. Tax consequences Subsection 86(1) applies, since all the conditions set out in it are met: Rosa disposes of all her common shares of Dynamite Ltd. in a reorganization of capital. The common shares of Dynamite Ltd. are a capital property for Rosa. Rosa receives preferred shares of Dynamite Ltd. in exchange for her common shares of the same corporation. No election was made under section 85. The POD of the common shares disposed of are determined under subsection 86(1). It is then necessary to compute the capital gain on the disposition of the shares. The following is a breakdown of the tax consequences of the transaction for Rosa. For Rosa: Effect of subsection 86(1) Cost of the new preferred shares [86(1)(b)]: ACB of the old common shares $ 10,000 FMV of any non-share consideration ( ) $ 10,000 POD of the old common shares [86(1)(c)]: Cost of any non-share consideration $ Cost of the new preferred shares 10,000 $ 10,000 Capital gain on the disposition of the old common shares POD of the old common shares $ 10,000 ACB of the old common shares (10,000) $ 2 Reading 3-2 Advanced Personal & Corporate Taxation

121 EXAMPLE 3-13 Pierre Fortin and Chi Chong are equal shareholders of Salinex Corporation Ltd. Chi holds 1,000 common shares having a PUC of $50,000 and a FMV of $200,000. These shares have an ACB of $10,000 for Chi. Chi no longer wants to play an active role in the affairs of Salinex Corporation Ltd., and thus she no longer wishes to participate in its future profits. Chi needs only $30,000 in the short term. She does not require the balance of the FMV of her common shares immediately, provided that she obtains a reasonable return on that value. An agreement is reached on the reorganization of the share capital of Salinex Corporation Ltd. Chi will exchange her 1,000 common shares of Salinex Corporation Ltd. for: a $30,000 promissory note payable on demand, bearing interest at 6%; and 1,000 preferred shares of Salinex Corporation Ltd. with a legal PUC of $20,000 and a FMV of $170,000. Tax consequences Subsection 86(1) applies, since all the conditions set out in it are met: Chi disposes of all her common shares of Salinex Corporation Ltd. in a reorganization of capital. The common shares of Salinex Corporation Ltd. are a capital property for Chi. Chi receives preferred shares of Salinex Corporation Ltd. in exchange for her common shares of the same corporation. No election was made under section 85. The POD of the common shares disposed of are determined under subsection 86(1). It is then necessary to compute the capital gain on the disposition of the shares. The following is a breakdown of the tax consequences of the transaction for Chi. For Chi: Effect of subsection 86(1) Cost of the note [86(1)(a)] $ 30,000 Cost of the new preferred shares [86(1)(b)]: ACB of the old common shares $ 10,000 FMV of the note (30,000) (cannot be negative) $ POD of the old common shares [86(1)(c)]: Cost of the note $ 30,000 Cost of the new preferred shares $ 30,000 Capital gain on the disposition of the old common shares POD of the old common shares [86(1)(c)] $ 30,000 ACB of the old common shares (10,000) Capital gain $ 20,000 Taxable capital gain (1/2) $ 10,000 Advanced Personal & Corporate Taxation Reading 3-2 3

122 Example 3-13 shows that, when the non-share consideration exceeds the ACB (but not the PUC) of the old shares, the shareholder realizes a capital gain equal to the amount in excess of the ACB. If the non-share consideration exceeded the PUC of the old shares, there could be a deemed dividend under subsection 84(3), as will be illustrated in Example EXAMPLE 3-14 Suppose the facts are the same as in Example 3-13, but this time assume that the ACB of the old common shares for Chi is $250,000 rather than $10,000. Tax consequences For Chi: Effect of subsection [86(1)] Cost of the note [86(1)(a)] $ 30,000 Cost of the new preferred shares [86(1)(b)]: ACB of the old common shares $ 250,000 FMV of the note (30,000) $ 220,000 POD of the old common shares [86(1)(c)]: Cost of the note $ 30,000 Cost of the new preferred shares 220,000 $ 250,000 Capital gain on the disposition of the old common shares POD of the old common shares [86(1)(c)]* $ 250,000 ACB of the old common shares (250,000) $ * Note that the capital loss of $50,000 ($250,000 $200,000) accumulated on the old common shares is not recognized in the reorganization of capital because the POD of the old shares cannot be less than their ACB. Gift or benefit conferred If the old shares were held on December 31, 1971, the tax-free zone will be transferred to the new shares only if one class of shares of the corporation was received as consideration and if subsection 86(2) does not apply [ITAR 26(27)]. Accordingly, whenever a reorganization of capital concerns shares held on December 31, 1971, it is important that the consideration received for these shares be shares of a same class of the corporation in order to preserve the tax-free zone. Subsection 86(2) sets out a rule preventing the rollover under subsection 86(1) from being used to benefit a related person. Note that in the following comments we refer to the FMV of the non-share consideration, whereas the ITA refers to the cost of the property constituting the non-share consideration. Recall that under paragraph 86(1)(a) the cost of the property is equal to its FMV at the time of 4 Reading 3-2 Advanced Personal & Corporate Taxation

123 the exchange; hence there is no error in this reading. In our opinion, using the FMV makes it easier to understand the intent of subsection 86(2). Subsection 86(2) applies where the shares are exchanged in the course of a reorganization of capital to which subsection 86(1) applies the FMV of the old shares immediately before the exchange is greater than the total FMV of the consideration received in the form of shares and other property and it is reasonable to regard the excess calculated above as a benefit that the taxpayer desires to have conferred on a related person Where all of the preceding conditions are met, the following rules apply [paragraphs 86(2)(c), (d), and (e)]: the POD of the old shares are deemed to be equal to the lesser of the FMV of the non-share consideration plus the amount of the benefit previously computed the FMV of the old shares immediately before the exchange any capital loss incurred by the taxpayer on the disposition of the old shares is deemed to be nil the cost of the new shares received in exchange is deemed to be equal to the excess, if any, of the ACB of the old shares over the FMV of the non-share consideration plus the amount of the benefit conferred on a related person. If more than one class of shares is received, the cost is allocated among the shares of the various classes in proportion to the FMV, immediately after the exchange, of the shares of each class The result of these computations may give rise to an immediate capital gain or a reduction in the ACB of the new shares received, depending on the facts. Example 3-15 illustrates the rules that apply when a benefit is conferred on a related person in a reorganization of capital. EXAMPLE 3-15 Dan Farrell has been the sole shareholder of Atlas Ltd. since its incorporation in At that time, Dan had invested $1,000 to acquire 1,000 common shares of Atlas Ltd. Now, at age 65, Dan is considering retiring in favour of his daughter who is actively involved in the business operated by Atlas Ltd. The 1,000 shares of Atlas Ltd. are presently worth $200,000. Dan decides to reorganize the capital of Atlas Ltd. in order to have his daughter become a common shareholder of the corporation. Dan exchanges his 1,000 common shares for 1,000 retractable preferred shares that have a total legal PUC of $1,000 and a redemption value of $150,000. His daughter then acquires 100 common shares for $100. Tax consequences Subsection 86(2) applies, since Dan exchanges his common shares of Atlas Ltd. for preferred shares of Atlas Ltd. in a reorganization of capital; The FMV of the common shares was $50,000 more than that of the preferred shares received in exchange ($200,000 $150,000); and It is reasonable to believe that Dan wanted his daughter, a person with whom he has a nonarm s length relationship, to benefit in the amount of $50,000. Advanced Personal & Corporate Taxation Reading 3-2 5

124 The following is a breakdown of the tax consequences of the transaction for Dan. For Dan: Benefit [86(2)] FMV of old common shares $ 200,000 Less: FMV of non-share consideration $ FMV of new preferred shares 150,000 (150,000) Benefit $ 50,000 Capital gain on the disposition of the old common shares POD [86(2)(c)] The lesser of the following amounts: (i) FMV of the non-share consideration + amount of the benefit (0 + $50,000) $ 50,000 (ii) FMV of the old shares $ 200,000 $ 50,000 ACB (1,000) Capital gain $ 49,000 Taxable capital gain (1/2) $ 24,500 Cost of the new preferred shares [86(2)(e)] ACB of the old common shares $ 1,000 Less the total of: (i) FMV of any non-share consideration $ (ii) Amount of the benefit 50,000 (50,000) Cost of the preferred shares (cannot be negative) $ In Example 3-15, there is an immediate capital gain because the amount of the benefit exceeds the ACB of the old shares. Where the amount of the benefit plus the FMV of any non-share consideration is less than the ACB of the old shares, there is no immediate capital gain. However, the cost of the new shares is reduced by the amount of the benefit. Tax on the benefit conferred on a related person is thus deferred until the disposition of the new shares. Valuation and characteristics of the new shares In carrying out a reorganization of capital, one of the major tasks is valuation of the shares exchanged so that an appropriate consideration can be given in the exchange. Both in cases where the reorganization of capital is carried out in order to bring in new, unrelated shareholders, and in the case of related shareholders, this valuation enables the current shareholder to recover his due when the reorganization takes place. He is not interested in making a gift to unrelated persons, and he generally wants to avoid triggering the application of subsection 86(2) in the case of related persons. Also, the new shareholders do not want the shareholder whose shares are exchanged to receive more than his due. Valuation of the shares must be done according to the rules that apply to valuation of a business, and this task should be conferred on someone who is competent in valuation. The CGA must refrain from doing this valuation if he lacks the required expertise. Valuation by the client is generally not reliable, since the client tends to overvalue the business in many cases. It is the CGA s duty to inform the parties involved of the importance of having the most accurate valuation possible of the FMV in order to be fair to all concerned and avoid harmful tax consequences. 6 Reading 3-2 Advanced Personal & Corporate Taxation

125 Computation of paid-up capital The characteristics given to shares serve to determine their value. When the parties involved in the reorganization are not related, CRA is seldom concerned with the characteristics of the new shares, since subsection 86(2) does not apply in this case. On the other hand, if the parties are related, CRA looks at whether the characteristics are attractive enough for the person to be considered to have received a consideration equal to the FMV of the shares exchanged. CRA has at different times stated its position on the FMV of preferred shares. Thus, the redemption value of preferred shares will be considered to be their FMV when they have the following characteristics: The shares are retractable (at the option of the shareholder). The shares entitle the shareholder to a reasonable dividend. However, this dividend may be non-cumulative. The shares may or may not entitle the shareholder to vote in all circumstances. If they are non-voting shares, they must nevertheless provide for a right to vote with respect to any change affecting the class. The shares must have priority in the event of distribution of the assets of the corporation on a liquidation or dissolution. No dividend may be payable on the shares of the other classes if the amount of the dividend is such that the corporation cannot redeem the preferred shares for the amount stipulated for the redemption. No redemption or purchase of shares of another class may be carried out if this has the effect of making the corporation unable to redeem the preferred shares for the amount stipulated for the redemption. Because of the many problems that arise in valuing exchanged shares, a price adjustment clause should normally be included in the description of the shares received in exchange. This clause provides that if CRA disputes the FMV of the exchanged shares, the redemption value of the shares issued in exchange will be adjusted or there will be a share issue or cancellation, as the case may be. The conditions set out in IT 169 must be met in order for CRA to accept the price adjustment clause. Subsection 86(2.1) provides for adjustments to the PUC of the class of shares that includes the shares received as consideration in a reorganization of capital if, as part of the reorganization, there is an increase in the PUC of the shares of the corporation. This may occur if the PUC of the new shares was greater than the PUC, for tax purposes, of the shares exchanged. Without the adjustment provided for in subsection 86(2.1), such an increase in capital would have resulted in a dividend under subsection 84(1). Paragraph 86(2.1)(a) provides for a reduction in the PUC of the new shares of a particular class, to be computed as follows: A B where C A A = increase in the PUC of the classes of shares following the reorganization of capital B = excess of the PUC of the old shares over the FMV of the non-share consideration C = increase in the PUC of the particular class Advanced Personal & Corporate Taxation Reading 3-2 7

126 The second part of the calculation, expressed by the fraction C/A, has effect only when shares of more than one class are issued as consideration for the old shares in the reorganization. If shares of only one class are issued, the result of the fraction C/A is 1. Example 3-16 illustrates a situation in which paragraph 86(2.1)(a) applies. EXAMPLE 3-16 Anne Gauthier holds 10 common shares of Beta Inc., a CCPC. These shares have an FMV of $100,000 and a PUC and an ACB of $1,000. In a reorganization of capital to which section 86 applies, she exchanges her 10 common shares for 1,000 preferred shares retractable for $100,000, with a legal PUC of $100,000 ($100 per share). The 1,000 preferred shares are the only preferred shares issued by Beta Inc. Tax consequences 1. PUC of the preferred shares: Reduction of PUC [86(2.1)(a)] A C A $100,000 $ $ 99,000 $100,000 B = 100,000 1,000 Computation of the PUC of the preferred shares Legal PUC $ 100,000 PUC reduction [86(2.1)(a)] (99,000) PUC for tax purposes of the preferred shares $ 1,000 or $1 per share 2. For Anne: Effect of subsection 86(1) Cost of 1,000 new preferred shares [86(1)(b)]: ACB of the old common shares $ 1,000 FMV of any non-share consideration $ 1,000 POD of the old common shares [86(1)(c)]: Cost of any non-share consideration $ Cost of the 1,000 new preferred shares 1,000 $ 1,000 Capital gain on the disposition of the old common shares POD of the old common shares $ 1,000 ACB of the old common shares (1,000) $ PUC of the 1,000 new preferred shares Since Anne holds all the preferred shares: 100% $1,000 $ 1,000 8 Reading 3-2 Advanced Personal & Corporate Taxation

127 Paragraph 86(2.1)(b) provides for an increase in the PUC of the class of shares that underwent a reduction of PUC under paragraph 86(2.1)(a) where there is a subsequent deemed dividend on the redemption, cancellation, or reduction of capital of the shares in this class. The increase generally corresponds to the fraction of the deemed dividend attributable to the reduction of PUC. This adjustment is necessary since the reduction of PUC under paragraph 86(2.1)(a) affects this class across the board. If the shares are redeemed or cancelled, it is necessary to ensure that the PUC of the remaining shares is affected only to the extent of their share of the PUC reduction. Example 3-17 illustrates the increase in PUC under paragraph 86(2.1)(b) when there is a redemption of shares giving rise to a deemed dividend under subsection 84(3). EXAMPLE 3-17 Suppose the facts are the same as in Example 3-16, but assume that Beta Inc. redeems 500 preferred shares for $50,000 in Tax consequences 1. For Anne: Deemed dividend [84(3)] Amount received on redemption $ 50,000 PUC of preferred shares (500 $1) (500) $ 49,500 Under paragraph 82(1)(b), this amount must be grossed up by 25% or 41% when included in Anne s income, depending on whether the dividend is non-eligible or eligible. The dividend tax credit granted is equal to 13.33% or 16.44% of the grossed-up dividend at the federal level, and the provincial tax credit varies depending on Anne s province of residence. Capital gain POD [54] Amount received on redemption $ 50,000 Deemed dividend [84(3)] (49,500) $ 500 ACB of 500 preferred shares ($1, ,000) (500) Capital gain $ 2. PUC of the remaining 500 preferred shares of Beta Inc.: Increase in PUC [86(2.1)(b)] The lesser of: (i) Deemed dividend on redemption $ 49,500 Less: Deemed dividend if there had been no reduction under 86(2.1)(a) $ 49,500 $ 49,500 (ii) Reduction of PUC [86(2.1)(a)] $ 99,000 Advanced Personal & Corporate Taxation Reading 3-2 9

128 PUC of the 500 preferred shares remaining after the increase Legal PUC of remaining shares (500 $100) $ 50,000 Reduction of PUC [86(2.1)(a)] (99,000) Increase in PUC [86(2.1)(b)] 49,500 PUC for tax purposes of the 500 preferred shares $ 500 or $1 per share Deemed dividend under subsection 84(3) When a reorganization of capital is carried out by a corporation resident in Canada, the consideration received must be determined carefully if a deemed dividend under subsection 84(3) is to be avoided. A dividend may be deemed under subsection 84(3) if the FMV of the non-share consideration received in exchange plus the PUC of the new shares exceeds the PUC of the old shares, as illustrated in Example EXAMPLE 3-18 Ito Okamoto holds 1,000 common shares of Romance Ltd. that have an ACB and a PUC of $1,000. These shares have a FMV of $200,000. In a reorganization of capital to which section 86 applies, Ito receives the following in exchange for his 1,000 common shares of Romance Ltd.: a note for $50,000 preferred shares having a legal PUC of $1,000 and a redemption value of $150,000 No preferred shares were issued before the reorganization of capital. Ito and Romance Ltd. are resident in Canada. Romance Ltd. has a nil GRIP. Tax consequences For Ito: Effect of section 86 Cost of the note [86(1)(a)] $ 50,000 Cost of the new preferred shares [86(1)(b)] ACB of the old common shares $ 1,000 FMV of the note (50,000) $ POD of the old common shares [86(1)(c)] Cost of the note $ 50,000 Cost of the new preferred shares $ 50,000 PUC of the new preferred shares: Legal PUC $ 1,000 Reduction of PUC [86(2.1)(a)] 1,000 ($ 1,000 $0) 1,000 (1,000) $ 10 Reading 3-2 Advanced Personal & Corporate Taxation

129 Deemed dividend [84(3)] Amount paid Note $ 50,000 PUC of the new preferred shares [84(5)(b)] $ 50,000 PUC of the common shares cancelled (1,000) Deemed dividend [84(3)] $ 49,000 Under paragraph 82(1)(b), this amount must be grossed up by 25%. The dividend tax credit granted is equal to 13.33%, and the provincial tax credit varies depending on Ito s province of residence. It is not possible to elect an eligible dividend, since Romance s GRIP is nil. Capital gain on the disposition of the old common shares POD [54] POD [86(1)(c)] $ 50,000 Deemed dividend [84(3)] (49,000) $ 1,000 ACB (1,000) Capital gain $ Using a reorganization of capital Contrary to what one may believe from an initial reading of section 86, this example demonstrates that a transaction cannot be structured to create a capital gain eligible for the CGD on a reorganization of capital. The interrelationship among section 84, the definition of proceeds of disposition in section 54 and section 86 gives rise to a deemed dividend and a reduction in the POD of the old shares, thereby placing the shareholder in the same position as before the reorganization of capital with regard to the distribution of the surplus of the corporation. This means that the shareholder cannot receive funds from the corporation in the form of a capital gain rather than a dividend. A reorganization of capital is frequently used in acquiring an enterprise, chiefly where the purchasers are employees who have insufficient funds. It should be remembered, however, that the vendor who exchanges common shares for preferred shares will have a deemed dividend on the redemption of the preferred shares rather than a capital gain that may be eligible for the CGD. A reorganization of capital is most commonly used in an estate freeze. The taxpayer who wishes to transfer the future increase in value of a corporation to his children may freeze the value of his shares by exchanging his common shares for non-participating preferred shares. The children may then subscribe for new common shares. Advanced Personal & Corporate Taxation Reading

130

131 READING 3-3 Property convertible to shares of a corporation LEVEL 1 General rule under subsection 51(1) Generally, where a capital property is exchanged for another property and the provisions of section 85 or 86 do not apply, there is a disposition of that capital property at its FMV, and a capital gain or loss is immediately realized. Section 51 provides that such a disposition will not occur where a taxpayer exercises the right to convert certain securities of a corporation in exchange for shares of the share capital of the corporation. Where the conditions of section 51 are met, the rollover provisions apply automatically, and no election is required. This automatic rollover favours the issue of convertible securities, such as obligations convertible into common shares by public corporations. The section 51 rules apply to convertible securities of all corporations, whether public or private, and whether or not they are resident in Canada. Convertible property is often used in tax planning. The security may be issued with the conversion right attached or the right may be added on a subsequent amendment to the terms of the security. In the latter case, CRA has indicated in paragraph 5 of IT-448 that the addition of an optional conversion feature does not generally involve a disposition, and therefore no tax consequences result. If the shares of a corporation are exchanged for other shares of the same corporation, the rollover provided for in section 51 applies even if the terms relating to the shares exchanged do not confer the right to make the exchange. The conditions contained in subsection 51(1) are that the exchanged property is capital property of the taxpayer; the exchanged property is a share, bond, debenture or note of the corporation; the property received in exchange is shares of the share capital of the same corporation. These shares may be shares of one or more classes. A fraction of a share is sufficient to meet this condition, since the definition of the word share in subsection 248(1) states that a fraction of a share is considered a share for the purposes of the ITA; the exchange is made with the corporation; where the property exchanged is a bond or a note, the terms of the security confer on the holder the right to make the exchange. If all of these conditions are met, the following rules apply [paragraphs 51(1)(c), (d), and (e)]: the exchange is deemed not to be a disposition; the cost of the shares received is deemed to be equal to the ACB of the convertible property immediately before the exchange. Where shares of more than one class are received, the cost of the shares of each class is computed as follows: Advanced Personal & Corporate Taxation Reading 3-3 1

132 and ACB of the convertible property FMV, immediately after the exchange, of the shares of the class acquired on the exchange FMV, immediately after the exchange, of all the shares acquired on the exchange for purposes of the attribution rules contained in sections 74.4 and 74.5, the exchange is deemed to be a transfer of property to the corporation. You will note that, under ITAR 26(24), if the convertible property was held on December 31, 1971, the tax-free zone is transferred to the shares received in exchange. Generally, subsection 51(1) does not apply if, on the exchange, the taxpayer receives consideration other than shares. However, in IT-115R2, CRA states that it will agree to apply section 51 where a minimal payment ($200 or less) is made on the conversion to avoid issuing a fraction of a share. Refer to paragraphs 3 and 4 of IT-115R2 for details of the tax treatment of the amount paid. Under subsection 51(4), section 51 does not apply if the provisions of subsection 85(1), subsection 85(2), or section 86 apply. Example 3-19 explains the application of subsection 51(1). EXAMPLE 3-19 Since 2007, Jojo Reed has owned 2,000 Class A preferred shares in Public Ltd. for which she paid $10 per share. The shares are redeemable at $12 each at the holder s option and are entitled to a fixed annual dividend of 7%. In addition, the Class A shares are convertible to common shares of Public Ltd. at the rate of two Class A shares for one common share. In August 2011, the common shares of Public Ltd. were trading on a Canadian stock exchange at $25 per share. Jojo wishes to exercise her conversion option with respect to 1,000 of the Class A preferred shares. Tax consequences Subsection 51(1) applies, since all the conditions set out in it are met: The Class A preferred shares of Public Ltd. are a capital property for Jojo. The property exchanged consists of shares. The property received in exchange consists of shares of the capital stock of the same corporation, Public Ltd. The exchange is made by Public Ltd. Section 85 does not apply since no election was made to this effect, and section 86 does not apply since there was no reorganization of the capital of Public Ltd. This is an exchange allowed under the conversion privilege associated with the preferred shares. Furthermore, even if there had been a reorganization of capital, section 86 would not be applied, since there is no exchange of all the shares held by Jojo. The following is a breakdown of the tax consequences of the transaction for Jojo. For Jojo: No disposition of the 1,000 Class A shares [51(1)(c)] 2 Reading 3-3 Advanced Personal & Corporate Taxation

133 Cost of the common shares [51(1)(d)] ACB of the 1,000 Class A shares (1,000 $10) $ 10,000 Number of common shares received in conversion (1,000 2) 500 ACB per common share of Public Ltd. $ 20 Gift or benefit conferred under subsection 51(2) Subsection 51(2) contains rules to prevent using the provisions of subsection 51(1) to make a gift to or confer a benefit on a related person. Thus, if the FMV of the convertible property is greater than the FMV of the shares received in exchange and it is reasonable to regard any portion of such excess as a benefit that the taxpayer wished to confer on a related person, the following rules apply [paragraphs 51(2)(d), (e), and (f)]: the convertible property is deemed to have been disposed of for POD equal to the lesser of the ACB of the convertible property plus the portion of the excess considered to be a benefit the FMV of the convertible property immediately before the exchange the taxpayer s capital loss from the disposition of the convertible property, if any, is deemed to be nil the cost of the shares received in exchange is deemed to be the lesser of the ACB of the convertible property the total of the FMV of the shares received and the capital loss resulting from the disposition of the convertible property (before it is deemed to be nil) If shares of more than one class have been received, the cost will be allocated among the shares of the various classes based on their FMV immediately after the exchange. Example 3-20 illustrates the tax consequences of a share conversion conferring a benefit on related persons. EXAMPLE 3-20 Mira Desmarais is the sole shareholder of Fun Products Ltd. She owns 50 common shares that have an ACB of $5,000 and a FMV of $100,000. The common shares are convertible into 50 Class B preferred shares which have a FMV of $60,000. On September 1, 2011, Mira decides to exercise her conversion option. Her three children subscribe for new common shares of Fun Products Ltd. Tax consequences Subsection 51(2) applies, since Mira exchanges shares worth $100,000 for Class B preferred shares worth $60,000 and It is reasonable to believe that Mira wants her children persons with whom she has a nonarm s length relationship to benefit from the difference, namely $40,000 ($100,000 $60,000). The following is a breakdown of the tax consequences of the transaction for Mira. Advanced Personal & Corporate Taxation Reading 3-3 3

134 For Mira: Capital gain POD [51(2)(d)] The lesser of: (i) ACB + the excess of the FMV of the convertible shares over the FMV of the shares received $5,000 + ($100,000 $60,000) $ 45,000 (ii) FMV of the convertible property $ 100,000 $ 45,000 ACB (5,000) Capital gain $ 40,000 Taxable capital gain (1/2) $ 20,000 Cost of Class B preferred shares [51(2)(f)] The lesser of: (i) ACB of the convertible common shares $ 5,000 (ii) FMV of the Class B preferred shares $ 60,000 $ 5,000 As you can see, the effect of subsection 51(2) is to tax the amount corresponding to the benefit conferred, namely, $40,000, immediately and to defer taxation of the gain corresponding to the value converted into shares. Note that the proceeds of disposition are computed in such a way that the gain immediately taxable can never exceed the capital gain accrued on the convertible property as at the conversion date. Valuation and characteristics of the new shares Computation of paid-up capital The comments on valuation of the shares exchanged and the characteristics of the new shares in a reorganization of capital (Reading 3-2) also apply to an exchange of shares under subsection 51(1). Paragraph 51(3)(a) provides for a reduction of the PUC of new shares issued in an exchange of shares to which subsection 51(1) applies when the PUC of the new shares exceeds the PUC of the exchanged shares. The purpose of this reduction is to ensure that the exchange does not result in an increase in the PUC of the shares of the corporation. The reduction of the PUC with respect to a particular class is computed as follows: C (A B) A where A = increase in the PUC of all the classes of shares following the exchange B = the PUC of the shares exchanged C = increase in the PUC of the particular class 4 Reading 3-3 Advanced Personal & Corporate Taxation

135 Note, once again, that the second part of the operation, expressed by the fraction C/A, has effect only when shares of more than one class are issued in the exchange. If shares of only one class are issued, the result of the fraction C/A is 1. Example 3-21 illustrates a reduction of PUC under subsection 51(3). EXAMPLE 3-21 Boris Ostroff holds 1,000 preferred shares of Reno Ltd., a CCPC with which he deals at arm s length. These 1,000 preferred shares were acquired in 2000 in a transaction to which subsection 85(1) applied. They are retractable for $100,000 and are convertible to Class B common shares of Reno Ltd., until December 31, 2012, at the rate of one common share for 10 preferred shares. The ACB of the 1,000 preferred shares for Boris is $1,000. Their legal PUC is $100,000 but their PUC for tax purposes is $1,000 as a result of a reduction of PUC under subsection 85(2.1). On October 31, 2011, Boris decides to convert 500 preferred shares of Reno Ltd. to 50 Class B common shares with a legal PUC of $50,000 ($1,000 per share). Tax consequences 1. For Boris: No disposition of the 500 preferred shares [51(1)(c)] Cost of the 50 Class B common shares [51(1)(d)] ACB of the converted preferred shares: 500 $1,000 $ 500 1,000 Number of Class B shares 50 ACB of each of the Class B common shares $ PUC of the Class B common shares (assuming there are no other Class B common shares issued) Reduction in PUC [51(3)(a)] A C A $50,000 $ $ 49,500 $50,000 B = 50,000 $500 Computation of the PUC of the 50 common shares Legal PUC $ 50,000 PUC reduction (49,500) PUC for tax purposes of the 50 common shares $ 500 or $10 per share Paragraph 51(3)(b) provides for an increase in the PUC of the class that underwent a reduction of PUC under paragraph 51(3)(a) when there is a deemed dividend subsequent to the redemption, cancellation or reduction of capital of the shares of that class. The amount of the increase corresponds to the amount of the deemed dividend under subsections 84(3), Advanced Personal & Corporate Taxation Reading 3-3 5

136 84(4), or 84(4.1) that can be attributed to the reduction in PUC under paragraph 51(3)(a). The computation of the increase is identical to the computation provided for in subsection 85(2.1), subsection 84.1(3), and in paragraph 86(2.1)(b) all of which you studied previously. Example 3-22 illustrates an increase in PUC under paragraph 51(3)(b). EXAMPLE 3-22 Return to the facts of Example 3-21, but assume that Reno Ltd. purchases, with a view to cancellation, 10 Class B common shares held by Boris for $15,000 in December Tax consequences 1. For Boris: Deemed dividend [84(3)] Amount paid on purchase $ 15,000 PUC of 10 Class B common shares (10 shares $10) (100) Deemed dividend $ 14,900 Under paragraph 82(1)(b), this amount must be grossed up by 25% or 41% when included in Boris s income, depending on whether the dividend is non-eligible or eligible. The dividend tax credit granted is equal to 13.33% or 16.44% of the grossed-up dividend at the federal level, and the provincial tax credit varies depending on Boris s province of residence. Capital gain POD [54] Amount received $ 15,000 Deemed dividend [84(3)] (14,900) $ 100 ACB (10 shares $10) (100) Capital gain $ 2. PUC of the remaining 40 Class B common shares of Reno Ltd.: Increase in PUC [51(3)(b)] The lesser of: (i) Deemed dividend on purchase $ 14,900 Less: Deemed dividend if there had been no reduction of PUC under 51(3)(a) ($15,000 $10,000) (5,000) $ 9,900 (ii) Reduction in PUC [51(3)(a)] $ 49,500 $ 9,900 PUC of the 40 Class B common shares remaining after the increase Legal PUC of remaining shares (40 $1,000) $ 40,000 Reduction in PUC [51(3)(a)] (49,500) Increase in PUC [51(3)(b)] 9,900 PUC of the 40 Class B common shares $ Reading 3-3 Advanced Personal & Corporate Taxation

137 or $10 per share Using convertible property The provisions of section 51 may be used on a public offering to attract a certain type of investor. Thus, by offering fixed-yield shares convertible into common shares, a corporation may attract more conservative investors. Section 51 may also be useful to convert a shareholder s interest into shares of another class when the provisions of section 86 regarding reorganizations of capital do not apply. For example, Mario Lucia and Jane Bolton each own 100 common shares of Tremco Ltd. Mario wishes to gradually retire from Tremco Ltd., but he does not require all the funds immediately. It has therefore been agreed that Mario will immediately convert 50 common shares of Tremco Ltd. into fixed-dividend preferred shares, retractable by Mario at the FMV of the 50 common shares, and that he will convert the remaining 50 common shares in three years, when he has fully retired from Tremco Ltd. While the first conversion could be carried out through a reorganization of capital, section 86 does not apply since Mario did not exchange all the common shares that he held. Therefore, under section 51, the exchange may be carried out without tax consequences. Furthermore, section 51 may be used to carry out an estate freeze. Comparison between sections that apply in the case of an exchange of shares EXHIBIT 3-4 Subsection 85(1), section 86, and section 51 may apply where shares of a corporation are exchanged for shares of the same corporation. Exhibit 3-4 should help you distinguish between the different conditions under which each provision applies, as well as the consequences of their application. Since this is a summary for purposes of comparing the different provisions, not all points previously studied are repeated. Status of corporation Taxable Canadian corporation 85(1) Conditions Corporation resident in Canada or not Corporation resident in Canada or not Type of transaction Disposition of shares to the corporation [see 84(9)] Transferred shares Some or all of the shares are exchanged Possible consideration Shares of the same corporation and NSC Forms Election to be made in prescribed form (T2057) Priority Priority over sections 86 and 51 if the election is made Disposition of shares as part of a reorganization of capital All shares in the class are exchanged Shares of the same corporation and NSC No form to be filed Does not apply if the election under 85(1) is made and takes priority over section 51 Acquisition of shares of a corporation in exchange for another share of the corporation Some or all of the shares are exchanged Only shares of the same corporation No form to be filed Does not apply if subsection 85(1), 85(2) or section 86 applies Advanced Personal & Corporate Taxation Reading 3-3 7

138 Old shares Disposition of shares Total or partial rollover depending on agreed amount elected Agreed amount subject to specific limits Possibility of tax consequences if the NSC is greater than the ACB or PUC of the transferred shares Consequences Disposition of shares Total rollover if no NSC Possibility of tax consequences if the NSC is greater than the ACB or PUC of the transferred shares No disposition of shares Total rollover New shares ACB is equal to the ACB of the old shares less the FMV of the NSC ACB is equal to the ACB of the old shares less the FMV of the NSC ACB is equal to the ACB of the old shares PUC of the class of the new shares PUC: adjustment under PUC: adjustment under 85(2) 1 86(2.1) PUC: adjustment under 51(3) When seeking to create a capital gain in an exchange of shares of a corporation for shares of the same corporation, the best choice is an internal rollover using subsection 85(1). Only this provision entitles the taxpayer to select an agreed amount that will result in the desired capital gain. It is also the only provision that requires filing of a prescribed form. When subsection 85(1) is chosen, sections 86 and 51 become inoperative. 1 Subsection 84.1(1) does not apply, since the shares of one corporation are exchanged for shares of the same corporation. 8 Reading 3-3 Advanced Personal & Corporate Taxation

139 READING 3-4 Exchange of shares of one corporation for shares of another corporation LEVEL 1 Conditions The exchange of shares of a Canadian corporation for shares of another Canadian corporation is a type of transaction that is often used in the takeover of one corporation by another. In such a case, the corporation that wants to acquire control of the target corporation approaches the shareholders of the target corporation and offers to exchange shares of its share capital for their shares of the target corporation. Exhibit 3-5 illustrates a transaction to which section 85.1 applies. EXHIBIT 3-5 Generally, this type of exchange involves a disposition of the exchanged shares by the vendor for an amount equal to the FMV of the shares received in exchange and the acquisition of the shares of the target corporation by the purchaser corporation for the same amount. Section 85.1 provides for an automatic rollover (which does not require the filing of any prescribed forms) if all the following conditions are met: Advanced Personal & Corporate Taxation Reading 3-4 1

140 Tax consequences for the vendor There must be a disposition by the taxpayer of shares of a corporation (target corporation) in exchange for newly issued shares of the purchaser (purchaser corporation). The purchaser must be a Canadian corporation. The exchanged shares must be capital property of the vendor and must be shares of a taxable Canadian corporation. The vendor and the purchaser must be dealing at arm s length immediately before the exchange. After the exchange, the vendor and persons with whom the vendor does not deal at arm s length may not control the purchaser nor beneficially own more than 50% of the FMV of the outstanding shares of the purchaser. An election under subsections 85(1) or 85(2) must not have been made with respect to the exchanged shares. As consideration for the exchanged shares, the vendor must receive shares of a single class of the purchaser. Consideration other than shares must not have been paid. With respect to the last condition, where consideration other than shares is given to avoid issuing fractions of shares, CRA provides some flexibility similar to that outlined with respect to convertible property. The value of the consideration must not exceed $200. Review paragraph 6 of IT-450R for CRA s policy on this matter. In addition, under paragraph 85.1(2)(d), the transaction may be structured in such a way that the vendor exchanges one portion of his shares for shares of a particular class of the purchaser and another portion for consideration other than shares. The rollover applies only on the shares exchanged for shares of a particular class of the purchaser. In such a case, the exchange agreement should clearly establish the distinction between the shares exchanged for cash or other property and those exchanged for shares of a particular class of the purchaser. According to paragraph 7 of IT-450R, where the vendor receives shares and cash or other consideration, for each exchanged share, subsection 85.1(1) may be utilized with respect to the portion of each exchanged share for which only shares were received, provided the offer or exchange agreement clearly indicates that the share consideration will be exchanged for a particular portion of each share offered and that the non-share consideration will be allocated to the balance. Where the conditions just mentioned are met, the following tax consequences under paragraph 85.1(1)(a) apply to the vendor: (i) and (ii) the vendor is deemed to have disposed of the exchanged shares for POD equal to their ACB immediately before the exchange the vendor is deemed to have acquired the shares of the purchaser at a cost equal to the ACB of the exchanged shares immediately before the exchange and where the exchanged shares were taxable Canadian property of the vendor, the acquired shares will also be deemed to be taxable Canadian property. However, the vendor may choose not to take advantage of the rollover by including the gain or loss resulting from the disposition in his tax return for the year of the exchange. Where the vendor chooses to apply section 85.1 to shares owned on December 31, 1971, the tax-free zone of the old shares is transferred to the new shares under ITAR 26(26). 2 Reading 3-4 Advanced Personal & Corporate Taxation

141 Tax consequences for the purchaser corporation Under paragraph 85.1(1)(b), the purchaser corporation will be deemed to have acquired each share of the target corporation at a cost equal to the lesser of: (i) or (ii) the FMV of the share of the target corporation immediately before the exchange the PUC of the share of the target corporation immediately before the exchange Paid-up capital of the shares issued by the purchaser corporation For share-for-share exchanges after June 5, 1987, the PUC of the shares issued by the purchaser corporation may be adjusted under subsection 85.1(2.1). Under paragraph 85.1(2.1)(a), the PUC of the shares of a particular class issued by the purchaser corporation is reduced by the following amount: C (A B) A where A = the increase in the PUC of all the classes of shares of the capital stock of the purchaser after the issue B = the PUC of all the shares of the target corporation received by the purchaser on the exchange C = the increase in the PUC of the particular class of shares The effect of subsection 85.1(2.1) is to reduce the PUC of the shares issued by the purchaser corporation to an amount equal to the PUC of the shares of the target corporation. The purpose of this reduction is to prevent: the vendor from increasing the PUC of his shares on the exchange and thus converting a deemed dividend, such as on the redemption of shares, to a capital gain eligible for the CGD and the purchaser corporation from increasing the tax cost of the acquired shares by carrying out a series of share-for-share exchanges Under paragraph 85.1(2.1)(b), the PUC of the class of shares that has undergone a reduction of PUC under paragraph 85(2.1)(a) is increased where there is a subsequent deemed dividend on the redemption, purchase or reduction in the capital of the shares of the class, due to a reduction in the first computation. This adjustment is required because the PUC reduction affects the class of shares as a whole. Where shares of the class are redeemed or purchased, the effect of the PUC reduction on the redeemed or purchased shares must therefore be removed so that the remaining shares are affected only by their portion of the PUC reduction. The PUC increase is computed in the same manner as in subsections 84.1(3) and 85(2.1). The amount of the deemed dividend on the redemption, purchase or reduction of PUC that was caused by the PUC reduction under paragraph 85.1(2.1)(a) must normally be added to the PUC of the class. Examples 3-23 and 3-24 detail the tax consequences of a share-for-share exchange under section 85.1, including how the PUC of a class of shares is reduced and increased in connection with a share-for-share exchange pursuant to subsection 85.1(2.1). Advanced Personal & Corporate Taxation Reading 3-4 3

142 EXAMPLE 3-23 Micro Ltd., a taxable Canadian corporation that is a CCPC, wishes to acquire control of Video Ltd., another taxable Canadian corporation with which it deals at arm s length. Micro Ltd. makes an offer to the sole shareholder of Video Ltd. to acquire the common shares of this corporation. For each common share of Video Ltd., Micro Ltd. offers to issue one Class A share from its share capital which will have a FMV and a legal PUC of $25. No other share of this class is issued before the exchange. Luc Dubé, who owns the 10,000 common shares of Video Ltd., accepts the offer. Luc acquired his 10,000 common shares in 2001 for $10 per share. The PUC of the shares is equal to the price paid, or $10. After the Class A shares of Micro Ltd. are issued to Luc, he will hold less than 1% of the vote and the value of the issued shares of Micro Ltd. No election under section 85 has been made. Tax consequences Subsection 85.1 applies, since There is a disposition by Luc of shares of Video Ltd. in exchange for newly issued Class A shares of another corporation, Micro Ltd. Micro Ltd. is a Canadian corporation. The shares of Video Ltd. are a capital property for Luc. Luc and Micro Ltd. deal with each other at arm s length before the exchange. After the exchange, Luc neither controls Micro Ltd. nor holds shares representing more than 50% of the FMV of the outstanding shares of Micro Ltd. The following is a breakdown of the tax consequences of the transaction for the parties involved. 1. PUC of the 10,000 Class A shares of Micro Ltd.: PUC reduction [85.1(2.1)(a)] A C A $250,000 $ = $ 150,000 $250,000 B = 250,000 $100,000 Computation of the PUC of the Class A shares of Micro Ltd. Legal PUC of the Class A shares $ 250,000 PUC reduction (150,000) PUC for tax purposes of the 10,000 Class A shares $ 100,000 or $10 per share 4 Reading 3-4 Advanced Personal & Corporate Taxation

143 2. For Luc: Capital gain on the disposition of the shares of Video Ltd. POD of the 10,000 shares of Video Ltd. [85.1(1)(a)] (10,000 $10) $ 100,000 ACB of the 10,000 shares of Video Ltd. (100,000) Capital gain $ Cost of the 10,000 Class A shares of Micro Ltd. received in exchange $ 100,000 or $10 per share PUC of the 10,000 Class A shares of Micro Ltd. Since Luc hold all the Class A shares: 100% $100,000 $ 100,000 Luc may choose not to take advantage of the rollover and realize a capital gain of $150,000 ($250,000 $100,000). The cost of the shares of Micro Ltd. would then be $250,000. If the shares of Video Ltd. are qualified small business corporation shares, Luc may claim the CGD allowed for this type of property. 3. For Micro Ltd.: Cost of the shares of Video Ltd. [85.1(1)(b)] The lesser of: (i) PUC of the shares of Video Ltd. $ 100,000 (ii) FMV of the shares of Video Ltd. $ 250,000 $ 100,000 EXAMPLE 3-24 One year later, under a special agreement with Luc, Micro Ltd. redeems one-half of the Class A shares owned by Luc for $30. Micro s GRIP is nil. Tax consequences 1. For Luc: Deemed dividend [84(3)] Amount paid on redemption (5,000 $30) $ 150,000 PUC of the 5,000 Class A shares (5,000 $10) (50,000) Deemed dividend $ 100,000 Under paragraph 82(1)(b), this amount must be grossed up by 25%. The dividend tax credit granted is equal to 13.33%, and the provincial tax credit varies depending on Luc s province of residence. The eligible dividend election cannot be made, since Micro s GRIP is nil. Advanced Personal & Corporate Taxation Reading 3-4 5

144 Capital gain POD [54] Amount received $ 150,000 Deemed dividend [84(3)] (100,000) $ 50,000 ACB (5,000 $10) (50,000) Capital gain $ 2. PUC of 5,000 remaining Class A shares of Micro Ltd.: Increase in PUC [85.1(2.1)(b)] The lesser of: (i) Deemed dividend on the redemption $ 100,000 Less: Deemed dividend if there had not been a PUC reduction under 85(2.1)(a) [5,000 ($30 $25)] (25,000) $ 75,000 (ii) PUC reduction [85.1(2.1)(a)] $ 150,000 $ 75,000 PUC after the increase Legal PUC of shares remaining (5,000 $25) $ 125,000 PUC reduction [85.1(2.1)(a)] (150,000) PUC increase [85.1(2.1)(b)] 75,000 PUC of the 5,000 Class A shares $ 50,000 or $10 per share Using a share-for-share exchange Section 85.1 is used on the total or partial takeover of a corporation by a Canadian corporation. Even though this section is often used by public corporations, it also applies to private corporations. It is a relatively simple provision to apply for both the purchaser and the vendor, as there is no prescribed form to be filed. Nevertheless, remember that this section does not apply to transactions between persons not dealing at arm s length or to transactions where the vendor, either alone or with persons not dealing at arm s length, emerges from the transaction controlling the purchaser or beneficially owning shares representing more than 50% of the FMV of the shares issued. Sometimes, it will be more advantageous for a purchaser corporation to undertake an acquisition using the provisions of section 85 rather than section This is the case where the ACB and FMV of the shares of the target corporation for the vendor are greater than the PUC of the shares. In these circumstances, if section 85 is used, the purchaser corporation will have a higher cost for the shares acquired without any additional tax consequences for the vendor. There is also a lesser reduction in the PUC of the shares issued on the exchange. Example 3-25 shows a situation in which it would be more advantageous to use the provisions of section 85 rather than section Reading 3-4 Advanced Personal & Corporate Taxation

145 EXAMPLE 3-25 Omega Ltd., a Canadian corporation, wishes to acquire Target Ltd., another Canadian corporation. It makes an offer to the sole shareholder of Target Ltd. to purchase her shares in exchange for 5,000 of its own Class C shares, having a legal PUC and FMV of $200,000. Nicole Corbeil, Target Ltd. s sole shareholder, owns 1,000 common shares of Target Ltd. having a PUC of $1,000. The ACB of Nicole s shares in Target Ltd. is $50,000. Nicole accepts Omega Ltd. s offer. Nicole deals at arm s length with Omega Ltd. both before and after the exchange and the 5,000 Class C shares she receives represent 5% of the vote and the FMV of all the shares of the capital stock of the purchaser corporation. Tax consequences 1. For Nicole: Capital gain: under section 85.1, disposition at ACB $ Capital gain: under section 85, disposition at ACB, if the agreed amount is equal to the ACB of the shares of Target Ltd. $ ACB of the 5,000 Class C shares of Omega Ltd. received in exchange under both sections $ 50, For Omega Ltd.: Cost of the shares of Target Ltd. if section 85.1 applies The lesser of the following amounts: (i) PUC of the shares of Target Ltd. $ 1,000 (ii) FMV of the shares of Target Ltd. $ 200,000 $ 1,000 Cost of the shares of Target Ltd. if section 85 applies Equal to the agreed amount $ 50, PUC of the Class C shares of Omega Ltd.: If section 85.1 applies Legal PUC $ 200,000 PUC reduction [85.1(2.1)(a)] $200,000 $ 200,000 $1,000 (199,000) $200,000 PUC for tax purposes of the 5,000 Class C shares $ 1,000 Advanced Personal & Corporate Taxation Reading 3-4 7

146 If section 85 applies Legal PUC $ 200,000 PUC reduction [85(2.1)(a)] $200,000 $ 200,000 $50,000 (150,000) $200,000 PUC for tax purposes of the 5,000 Class C shares $ 50,000 In this example, Nicole incurs the same immediate consequences whether she uses the provisions of section 85 or However, it would be more advantageous for Omega Ltd. to use section 85, because its cost of the shares of Target Ltd. would then be $50,000 rather than $1,000 if the provisions of section 85.1 had been used. In addition, if section 85 is used, the PUC of the Class C shares would be $50,000 whereas if section 85.1 is used, the PUC of the shares will be only $1,000. The increased PUC could be advantageous to Nicole in the future if the Class C shares were redeemed or cancelled, since the deemed dividend would then be lower. 8 Reading 3-4 Advanced Personal & Corporate Taxation

147 READING 4-1 Amalgamation LEVEL 1 General The rules applying to the amalgamation of two or more taxable Canadian corporations facilitate the combination of Canadian corporations by limiting the tax consequences of amalgamations. From a legal standpoint, an amalgamation must be in accordance with the relevant corporate legislation. Under the Canada Business Corporations Act (a federal law), an amalgamation is possible only if all the corporations to be amalgamated are governed by this Act. Consequently, a corporation incorporated under the Canada Business Corporations Act may not be amalgamated with a corporation incorporated under provincial legislation, such as Quebec s Companies Act. In certain cases, this difficulty may be overcome. A corporation incorporated in one jurisdiction may be continued in another jurisdiction. The provisions of the relevant corporate legislation should be reviewed to determine if such continuance is possible. The ITA does not address the continuance of corporations. However, CRA has often expressed the opinion that the continuance of a corporation does not involve any tax consequences. When considering the amalgamation of corporations, it is essential to work with the legal advisors of the corporations involved in order to ensure that amalgamation is possible and that all legal procedures for carrying out the amalgamation are followed. Legally, the amalgamation is certified by a certificate of amalgamation issued by the appropriate authority, such as the Director of Corporations Canada for federal corporations. In an amalgamation of two or more corporations, the corporations are combined to form a single entity. The amalgamation may be horizontal or vertical. Under a horizontal amalgamation, two or more corporations whose shares are held by third parties are combined. Under a vertical amalgamation, a parent company is combined with one (or more) subsidiaries. Exhibit 4-1 provides an example of a horizontal amalgamation and a vertical amalgamation. EXHIBIT 4-1 Horizontal amalgamation Advanced Personal & Corporate Taxation Reading 4-1 1

148 Vertical amalgamation Conditions of section 87 On a horizontal amalgamation, the shareholders of the amalgamated corporation receive shares of the new corporation resulting from the amalgamation. On a vertical amalgamation, the subsidiary s shares are cancelled without the issuance of new shares, except to third parties that may have held shares in the subsidiary. From a tax standpoint, an amalgamation of two or more corporations is subject to the provisions of section 87 if the conditions set out in subsection 87(1) are met: 1. There must be a merger of two or more taxable Canadian corporations (predecessor corporations). 2. The purpose of the merger must be to form one corporate entity (new corporation). 3. All of the property (except amounts receivable from a predecessor corporation or shares of the capital stock of a predecessor corporation) of the predecessor corporations immediately before the merger becomes property of the new corporation under the merger. 4. All of the liabilities (except amounts payable to a predecessor corporation) of the predecessor corporations immediately before the merger become liabilities of the new corporation under the merger. 5. All of the shareholders (except any predecessor corporation) of the predecessor corporations immediately before the merger must receive shares of the new corporation because of the merger. 6. The merger must take effect otherwise than as a result of the acquisition of property of one corporation by another, pursuant to the purchase of such property by the other corporation, or as a result of the distribution of such property to the other corporation upon the winding-up of the corporation. There are few, if any, tax consequences under section 87 on an amalgamation. Consequently, it is important that the amalgamation of taxable Canadian corporations meet the preceding criteria. 2 Reading 4-1 Advanced Personal & Corporate Taxation

149 Under subsection 87(1.1), a short-form amalgamation that consists of: the merger of a corporation and one or more of its wholly-owned subsidiaries or the merger of two or more corporations, each of which is a wholly-owned subsidiary of the same corporation, is an eligible amalgamation provided conditions 1 to 4 and condition 6 are otherwise respected. Under subsection 87(1.1), any share of a predecessor corporation that is not cancelled in this type of amalgamation is deemed to be a share of the new corporation, received by the shareholder by virtue of the merger. According to this presumption, condition 5 is satisfied. A subsidiary wholly-owned corporation is defined in subsection 87(1.4). It is a corporation all the outstanding shares of which belong to (a) (b) or (c) the parent a corporation that is a subsidiary wholly-owned corporation of the parent any combination of persons each of which is a person described in (a) or (b) The amalgamation of Hall Inc. and Jenson Inc. illustrated in Exhibit 4-1 is a short form amalgamation. Tax consequences for the corporations Taxation year under paragraph 87(2)(a) For tax purposes, the corporation resulting from the amalgamation is generally considered to be a new corporation [paragraph 87(2)(a)]. However, it will be deemed to be a continuation of the predecessor corporations for certain purposes. [Refer to, for example: 87(1.2), 87(2)(f), 87(2)(j) to (j.93), 87(2)(l), 87(2)(z.1), 87(2.1).] This assumption enables the corporation resulting from the amalgamation to claim deductions that the amalgamated corporations were allowed, such as certain reserves or loss carryovers. But is also requires the new corporation to include in its income amounts that would have been taxable for the amalgamated corporations. Under the provisions of section 87, the tax accounts of the predecessor corporations as well as their assets and liabilities are generally transferred to the new corporation without tax consequences. Some of these rules follow. On an amalgamation, the taxation year of each predecessor corporation is deemed to have ended immediately before the amalgamation and the new corporation is deemed to have commenced its taxation year at the time of the amalgamation. The new corporation may select its year end without CRA s authorization. (See paragraph 10 of IT-474R2 for further detail.) Normally, the date on which the amalgamation takes effect is the first instant of the date stated on the amalgamation certificate. Thus, if the amalgamation certificate states that the amalgamation takes effect on December 1, the predecessor corporations have a taxation year ending November 30 and the new corporation has a fiscal period beginning on December 1. It is possible to state on the amalgamation certificate both the date and the time of the amalgamation. Thus, if the amalgamation certificate states that the amalgamation takes effect on December 1 at noon, the end of the fiscal period of the predecessor corporations is December 1 immediately before noon. Although this situation is rather rare, the time is sometimes indicated in complex fiscal planning involving multiple transactions taking place on the same day where their order is important. Advanced Personal & Corporate Taxation Reading 4-1 3

150 Example 4-1 illustrates the rule for the taxation year end when there is an amalgamation. EXAMPLE 4-1 Jupiter Inc. has a taxation year ending November 30 and Saturn Inc. has a taxation year ending August 31. These two corporations amalgamated on December 1, 2011 to form Solar Inc. Tax consequences For Jupiter Inc.: Under paragraph 87(2)(a), Jupiter Inc. has a taxation year that ends on November 30, 2011, its usual year end. For Saturn Inc.: Under paragraph 87(2)(a), Saturn has a taxation year that ends on November 30, Thus, Saturn Inc. has two fiscal periods ending in 2011: a 12-month fiscal period ending on August 31, 2011 and a 3-month fiscal period ending on November 30, This short fiscal period may have major consequences for some tax attributes, such as the carryforward period for losses, as you will see further on. For Solar Inc.: Solar Inc. can choose the date for the end of its taxation year like any other new corporation, without regard to the year ends of Jupiter Inc. and Saturn Inc. Thus, it might choose April 30, in which case its first taxation year would be for the period from December 1, 2011 to April 30, When choosing the date for the end of the taxation year, the rule that a corporation s fiscal period cannot extend beyond 53 weeks should be kept in mind. Inventory under paragraph 87(2)(b) The tax value of the inventory of the predecessor corporations at the end of the taxation year that ended immediately before the amalgamation becomes the value of the new corporation s opening inventory. That is, the closing inventory of the predecessor corporations is the opening inventory of the new corporation. If a predecessor corporation carried on a farming business that computed its income on the cash basis under section 28, the inventory acquired from this corporation by the new corporation is deemed to have been acquired at a nil value or any other value selected by the predecessor corporation under paragraph 28(1)(b) at the end of its taxation year that ended immediately before the amalgamation plus the mandatory adjustment to the inventory of the predecessor corporation, determined under paragraph 28(1)(c) at the end of the predecessor corporation s taxation year ending immediately before the amalgamation. As you will recall, an adjustment under paragraph 28(1)(c) is required only if there is a loss from a farming business. Method adopted for computing income under paragraph 87(2)(c) Paragraph 87(2)(c) ensures that if the method (cash or accrual) on which either of the predecessor corporations differs from that of the amalgamated corporation, adjustments will be made to income and deductions to ensure all income is fully recognized for tax purposes and no double taxation occurs. 4 Reading 4-1 Advanced Personal & Corporate Taxation

151 Depreciable property under paragraphs 87(2)(d) and (d.1) Property transferred to the new corporation in the course of the amalgamation is deemed to have a capital cost equal to that of the predecessor corporations. In addition, the UCC of the classes of property acquired by the new corporation on the amalgamation is equal to the total of the UCC of such classes for the predecessor corporations. Consequently, on a subsequent disposition of property acquired on the amalgamation, recapture of CCA will be computed on the original cost as if the new corporation had always owned the property. Thus, the new corporation may be taxed on the CCA it claimed as well as the CCA claimed by the predecessor corporations. When the new corporation acquires the property of a predecessor corporation with which it does not deal at arm s length at the time of the amalgamation [see subsections 251(3.1) and (3.2) to determine if they are related], the property acquired remains in the prescribed classes under REG 1102(14). Where the corporations are dealing at arm s length, the new corporation must include the property in the class applicable at the time of acquisition. The amount to be included in the class with respect to a given property is the cost amount of the property for the predecessor corporation. The new corporation may depreciate property acquired from a predecessor corporation starting in its first taxation year without regard to the half-year rule if the predecessor corporation and the new corporation do not deal at arm s length at the time of the amalgamation and the property was owned continuously by the predecessor corporation for the period from a day that was at least 364 days before the end of the new corporation s first taxation year and that ends on the day that it was acquired by the new corporation [REG 1100(2.2)] If the new corporation s first taxation year is less than 12 months, CCA must be prorated using the number of days in the taxation year divided by 365 [REG 1100(3)]. Predecessor corporations are not deemed to have disposed of the property immediately before the amalgamation; they may therefore claim CCA in computing their income for the taxation year ending immediately before the amalgamation. If this taxation year is less than 12 months, CCA must be prorated using the number of days in the taxation year divided by 365. Non-depreciable capital property under paragraph 87(2)(e) The ACB of each non-depreciable capital property for the predecessor corporations becomes the ACB of the property for the new corporation. If the property was owned by a predecessor corporation on December 31, 1971, the tax-free zone is transferred to the new corporation under ITAR 26(5.1). Eligible capital property under paragraph 87(2)(f) If the new corporation continues to carry on the business carried on by the predecessor corporation, the cumulative eligible capital (CEC) of the predecessor corporation immediately before the amalgamation is added to the CEC of the new corporation. In fact, under paragraph 87(2)(f), for purposes of determining any amount relating to CEC, a cumulative eligible capital amount (CECA), an eligible capital expenditure (ECE) or eligible capital property (ECP), the new corporation is deemed to be the same corporation as, and a continuation of, the predecessor corporations. Thus the new corporation is in the same tax position as the predecessor corporation with regard to the ECP of a business that the predecessor corporation carried on but which is now carried on by the new corporation. Advanced Personal & Corporate Taxation Reading 4-1 5

152 Where the ECP acquired is a government right (such as a licence) owned by the predecessor corporation on December 31, 1971, the new corporation may take advantage of the relief provided in ITAR 21(2.1) on the subsequent disposition of a right under ITAR 21(2.2). Predecessor corporations may claim a CECA deduction for their taxation year ending immediately before the amalgamation. If the business carried on by the predecessor corporation is not carried on by the new corporation, a deduction for the balance of the CEC may be claimed by predecessor corporations under subsection 24(1). Reserves under paragraphs 87(2)(g), (h), (i), (j), 87(2)(m), and 87(2)(ll) Reserves deducted by predecessor corporations are deemed to have been claimed by the new corporation. Consequently, the new corporation is required to include in its income for its first taxation year, the reserves claimed by the predecessor corporations at the end of the taxation year ending immediately before the amalgamation. The new corporation may deduct a new reserve for debts and loans acquired from the predecessor corporations under the regular rules relating to bad debts. With respect to capital gains reserves [subparagraph 40(1)(a)(iii)] and reserves for instalment sales or sales of land inventory [paragraph 20(1)(n)], the new corporation may continue to claim the reserve as if it had disposed of the property itself. Capital dividend account (CDA) under paragraph 87(2)(z.1) The new corporation is deemed to be the same as each predecessor corporation and the continuation of it. Thus, the new corporation should calculate its initial CDA by aggregating the individual components of each predecessor corporations CDA. Example 4.2 illustrates the application of paragraph 87(2)(z.1). EXAMPLE 4-2 Ball Inc. and Gum Inc. amalgamate to form Wad Inc. All the corporations are Canadian private corporations. Prior to the amalgamation, Ball Inc. has a CDA of $14,000 resulting from the excess of the non-taxable portion of capital gains ($44,000) over the non-deductible portion of capital losses ($30,000). For its part, Gum Inc. has a nil CDA (the CDA cannot be a negative amount), since the nondeductible portion of the capital losses that it incurred ($10,000) exceeds the non-taxable portion of the capital gains that it realized ($2,000). The CDA of Wad Inc. at the date of amalgamation will be equal to Total of the non-taxable portion of the capital gains of the predecessor corporations ($44,000 + $2,000) $46,000 less Total of the non-deductible portion of the capital losses of the predecessor corporations ($30,000 + $10,000) (40,000) $ 6,000 6 Reading 4-1 Advanced Personal & Corporate Taxation

153 Refundable dividend tax on hand under paragraph 87(2)(aa) Where the new corporation is a private corporation immediately before the amalgamation, the refundable dividend tax on hand (RDTOH) balances of the predecessor corporations at the end of their last taxation year, less any dividend refund received for that last year, are added to the RDTOH of the new corporation. No amount is added with respect to a predecessor corporation that was not a private corporation immediately before the amalgamation. Investment tax credits under paragraph 87(2)(oo) Unused investment tax credits of predecessor corporations are transferred to a new corporation that is deemed to be a continuation of the predecessor corporations. However, the rules applicable on the acquisition of control of a corporation should be reviewed to determine if they restrict the credits [subsections 127(9.1) and (9.2)]. General rate income pool (GRIP) and low rate income pool (LRIP) under paragraphs 87(2)(vv) and (ww) Instalments under REG 5301(4) Where the new corporation is a CCPC, its GRIP is determined according to the provisions of subsection 89(5). If a predecessor corporation was a CCPC, the GRIP of the new corporation is increased by the GRIP of the predecessor corporation at the end of its last taxation year less any eligible dividends that the predecessor corporation paid during that last year. If the predecessor corporation was not a CCPC, the GRIP of the new corporation is increased by an amount determined according to a complex calculation designed to determine the retained earnings, for tax purposes, that were taxed at the general rate. This calculation takes various factors into account, including but not limited to liquidities, the cost amount of the property, debts, the PUC of issued shares, loss carryforwards, the CDA, and the GRIP. Where the new corporation is not a CCPC, its LRIP must be determined in accordance with subsection 89(9). If a predecessor corporation is not a CCPC, the LRIP of the new corporation is increased by the LRIP of the predecessor corporation. If the predecessor corporation is a CCPC throughout the taxation year ending before the amalgamation, the LRIP of the new corporation is increased by an amount determined according to a complex calculation designed to determine the retained earnings, for tax purposes, that were taxed at the low rate. This calculation takes various factors into account, including but not limited to liquidities, the cost amount of the property, debts, the PUC of issued shares, loss carryforwards, the CDA, and the GRIP. The instalments of the new corporation are determined by taking into account the income tax payable by the predecessor corporations for the two taxation years preceding the amalgamation, adjusted to an annual basis. Therefore, an amalgamation cannot be used to reduce or eliminate instalments. Other Subsection 87(2) contains many other rules applicable to tax accounts and different situations. Generally, the new corporation will be deemed to be the continuation of predecessor corporations and the tax consequences that would have applied to the predecessor corporations will apply to the new corporation. Inter-company debts under subsection 80.01(3) Sections 80 to deal with the rules that apply where a debt of a taxpayer is settled or extinguished without any payment by the taxpayer or by a payment of an amount less than the principal amount. At this point, it is sufficient to keep in mind that, on an amalgamation, it sometimes happens that a debt of a predecessor corporation owing to another predecessor corporation is extinguished without any payment so that the settlement of debt rules can apply. However, Advanced Personal & Corporate Taxation Reading 4-1 7

154 under subsection 80.01(3), such a debt that is extinguished on amalgamation is deemed to have been settled immediately before the amalgamation for an amount equal to the creditor s cost amount of the debt. For purposes of subsection 80.01(3), the cost amount of the debt is equal to the ACB if it is a capital property, or the creditor s cost if it is any other property. Therefore, if the creditor s cost amount of the debt is equal to its principal amount, the settlement of debt rules contained in section 80 do not apply to inter-corporate debts settled upon amalgamation. However, they may apply to a debt extinguished on an amalgamation if the debt was acquired from a third party at a price lower than the principal amount of the debt. Example 4-3 shows the application of rules on the settlement of inter-company debts in an amalgamation. EXAMPLE 4-3 Brandy Ltd. owes Rummy Ltd. $15,000. Rummy Ltd. acquired the debt due by Brandy Ltd. (with a principal balance of $15,000) from Suzie Mak in 2009, at a cost of $5,000. In 2011, Brandy Ltd. and Rummy Ltd. amalgamate. No interest is owed on the debt at the time of the amalgamation. Tax consequences Settlement of the debt: Principal amount of the debt $ 15,000 Amount of the settlement, equal to the ACB of the debt under 80.01(3) (5,000) Amount subject to the settlement of debt rules (section 80) $ 10,000 Note that the unpaid interest on the debt included in computing the income of the predecessor corporation is added to the cost amount provided that it has not been deducted as a bad debt. Therefore, there is no consequence in terms of the settlement of debt rules on the portion of the debt represented by the unpaid interest that was included in the predecessor corporation s income for tax purposes. Losses carried forward under subsection 87(2.1) Amalgamation of Canadian corporations is often considered between a viable corporation and a corporation with accumulated losses, since it is possible under certain conditions for the new corporation created by the amalgamation to use the losses accumulated by the predecessor corporation. Subsection 87(2.1) governs the transfer of losses of predecessor corporations to the new corporation. Consequently, non-capital losses net capital losses farm losses restricted farm losses limited partnership losses 8 Reading 4-1 Advanced Personal & Corporate Taxation

155 of predecessor corporations are transferred to the new corporation which is deemed to be the same corporation as, and a continuation of, each predecessor corporation. As a result, the timing and nature of the losses transferred are retained. It should be noted that an amalgamation results in a year end for the predecessor corporations and reduces the carryforward period by one year, even if the taxation year was only one day. Consequently, if there are significant loss carryforwards, the amalgamation should take place at the end of the predecessor corporation s taxation year. In fact, the effective date of the amalgamation should be the day after the normal taxation year end of the predecessor corporation. Acquisition of control The rules applicable on the acquisition of control of a corporation may apply on an amalgamation. At this point it need only be noted that these rules may restrict or prevent the use of the losses of a predecessor corporation where there is an acquisition of control of that predecessor corporation in the context of the amalgamation. Under paragraph 256(7)(b), control of a predecessor corporation is deemed to have been acquired where the person who controls the new corporation immediately after the amalgamation did not control the predecessor corporation immediately before the amalgamation. This rule does not apply when the person who controls the new corporation immediately after the amalgamation would not have been considered to have acquired control of the predecessor corporation if he had acquired all of its shares immediately before the amalgamation. This exemption ensures that the benefit of paragraph 256(7)(a) applies to an amalgamation. Paragraph 256(7)(a) provides that there is no acquisition of control of a corporation in circumstances where the person acquiring control was related to the person from whom the shares were acquired; the person acquiring control was related [within the meaning of subsection 251(2)] to the corporation before the acquisition of control; shares fall into the estate of a deceased person by reason of that person s death; or, shares were inherited from a related person. For example, Morales Ltd. is controlled by Antonio Morales, and Blanco Ltd., a corporation with considerable non capital losses, is controlled by Antonio s child. Morales Ltd. and Blanco Ltd. amalgamate. After the amalgamation, the new corporation is controlled by Antonio. But for the exemption, Antonio would be considered as having acquired the control of Blanco Ltd. before the amalgamation. Under the exemption, Antonio will not be considered as having acquired the control of Blanco Ltd. If Antonio had acquired all the shares of Blanco Ltd. before the amalgamation, there would not have been an acquisition of control by Antonio as provided for in clauses 256(7)(a)(i)(A) and (B) since Antonio was related to Blanco Ltd. and the child. Example 4-4 illustrates the application of the rules governing the transfer of losses in an amalgamation and the importance of making a good choice as to the date of the amalgamation. EXAMPLE 4-4 Arnold Ltd. is a Canadian corporation incorporated under the Canada Business Corporations Act. Arnold Ltd. s taxation year ends on January 31 and its non-capital losses carried forward are as follows: 2005 $ 100, $ 8, $ 15, $ 12,000 Advanced Personal & Corporate Taxation Reading 4-1 9

156 Arnold Ltd. does not expect profits before 2015 or Georgia Ltd. is also a Canadian corporation incorporated under the Canada Business Corporations Act. Its taxation year ends on July 31 and it is a profitable company. Arnold Ltd. and Georgia Ltd. are controlled by Clément Simard, who decides to amalgamate Arnold Ltd. and Georgia Ltd. and apply Arnold Ltd. s losses against Georgia Ltd. s future income. The amalgamation takes place on March 1, Tax consequences 1. For Arnold Ltd.: The amalgamation on March 1, 2011, results in a one-month fiscal period, from February 1 to February 28, (See IT-474R2, paragraph 10.) Therefore, the carryforward period of all losses is reduced by one taxation year due to this short fiscal period. For the 2005 loss, which has a ten-year carryforward period, three years remain. Note: Losses that arise in 2006 and subsequent taxation years may be carried forward 20 years. The loss-carryforward period for non-capital losses that arise in taxation years that end after March 22, 2004 and before January 1, 2006 is ten years. The tenyear period does not apply to existing losses realized prior to March 23, 2004 for which the carryforward period remained at seven years. 2. For the new corporation: Because control of Arnold Ltd. was not acquired on the amalgamation (Clément controlled Arnold Ltd. before the amalgamation and the new corporation after the amalgamation), Arnold Ltd. s losses may be used to reduce the income of the new corporation without restriction, other than the reduction in the carryforward period of the losses. If the amalgamation had taken place on February 1, 2011, rather than March 1, 2011, the 2005 loss could have been applied against the income of the new corporation for its first taxation year and the three subsequent years. As this example illustrates, determining the amalgamation date is important. Effect on paid-up capital Note that there is no rule whereby losses incurred by the new corporation may be carried back and deducted from the income of the predecessor corporations, except for subsection 87(2.11), which allows losses of the new corporation to be carried back and deducted from the income of the parent in the amalgamation of a parent corporation and one or more wholly-owned subsidiaries. Subsection 87(2.11) will be studied further on. The PUC of a particular class of the capital stock of the new corporation is computed under subsection 87(3). The purpose of the computation is to restrict the PUC of the new corporation following an amalgamation to the total of the PUC of the predecessor corporations immediately before the amalgamation, without regard to the shares of a predecessor corporation owned by any other predecessor corporation and cancelled on amalgamation. 10 Reading 4-1 Advanced Personal & Corporate Taxation

157 The PUC of a share for tax purposes is generally equal to its legal PUC. However, sometimes the PUC is reduced by various provisions of the ITA, such as section 84.1 or subsections 51(3), 85(2.1), 85.1(2.1), and 86(2.1), which you have studied previously. From a legal standpoint, the capital of the new corporation is generally equal to the total capital of the predecessor corporations, after eliminating the shares owned by predecessor corporations. If the PUC of a predecessor corporation was reduced by any tax provision so that it does not correspond to the legal PUC, the legal PUC of the shares of the new corporation will be higher than the total PUC of the predecessor corporations. This is unacceptable to the tax authorities because the PUC may generally be paid to the shareholders tax free. Consequently, where the PUC of the shares issued by the new corporation on amalgamation exceeds the PUC of the predecessor corporations, the excess will reduce the PUC of the shares of the various classes of the capital stock of the new corporation. The reduction will be allocated among the classes of shares based on their respective PUC. On the redemption or cancellation of a share of a particular class of which the PUC has been reduced, an amount is added to the PUC of that class to avoid double taxation on the same amount as a dividend. The increase in the PUC is equal to the amount of the deemed dividend on the redemption that is attributable to the PUC reduction. Example 4-5 illustrates a situation in which it is necessary to reduce the PUC of the shares of the corporation resulting from the amalgamation. It shows how this reduction is attributed to the various classes of shares issued on the amalgamation. EXAMPLE 4-5 Lidor Ltd. and Falcon Ltd. were amalgamated to form Licon Ltd. The following information has been obtained with respect to the shares issued and the PUC of the predecessor corporations. Common shares Tax PUC Legal PUC Lidor Ltd. $ 80,000 $ 100,000 Falcon Ltd. 40,000 40,000 $ 120,000 $ 140,000 The difference between the tax PUC and the legal PUC of the shares of Lidor Ltd. is due to a reduction in the PUC under subsection 85(2.1) resulting from a previous transaction. On the amalgamation, Licon Ltd. issued 1,000 Class A shares and 1,000 Class B shares redeemable at $100. The legal PUC was allocated between the two classes of shares as follows: Class A shares $ 40,000 Class B shares 100,000 $ 140,000 Subsequently, Licon Ltd. redeemed 500 Class B shares. Advanced Personal & Corporate Taxation Reading

158 Tax consequences 1. PUC of the shares of Licon Ltd.: Reduction of PUC [87(3)(a)] Legal PUC of Licon Ltd. $ 140,000 Less: PUC of Lidor Ltd. and Falcon Ltd. (120,000) PUC reduction to be allocated to the Class A and Class B shares $ 20,000 Computation of PUC of Class A shares Legal PUC of the Class A shares $ 40,000 $40,000 Reduction: $20, 000 $140,000 (5,714) PUC of the 1,000 Class A shares $ 34,286 PUC of 1 Class A share $ Computation of PUC of Class B shares Legal PUC of the Class B shares $ 100,000 $100,000 Reduction: $20, 000 $140,000 (14,286) PUC of the 1,000 Class B shares $ 85,714 PUC of 1 Class B share $ Deemed dividend on the redemption of 500 Class B shares [84(3)]: Redemption amount (500 $100) $ 50,000 PUC of 500 redeemable shares (500 $85.71) (42,855) Deemed dividend $ 7, PUC of the remaining Class B shares following redemption: Increase in PUC [87(3)(b)] The lesser of: a. the excess of the deemed dividend on redemption $ 7,145 over the deemed dividend on redemption if there had not been a reduction under 87(3)(a) ($50,000 $50,000) $ 7, Reading 4-1 Advanced Personal & Corporate Taxation

159 b. reduction under 87(3)(a) $ 14,286 PUC of the remaining 500 Class B shares Legal PUC of the remaining 500 Class B shares $ 50,000 PUC reduction [87(3)(a)] (14,286) 35,714 Increase in PUC [87(3)(b)] 7,145 PUC of the 500 Class B shares outstanding $ 42,859 PUC of 1 Class B share $ The adjustment results in the PUC of the Class B shares of $85.72, being the amount of the PUC for each share held before the redemption. According to subsection 87(3), the reduction in the PUC is distributed among all the shares of the new corporation, as was seen in Example 4-5. This result is sometimes undesirable, especially when the PUC deficiency is attributable to a specific class of shares of a predecessor corporation. This situation may be avoided if each class of shares (other than classes of shares all of the shares of which were cancelled on the amalgamation) of each predecessor corporation is exchanged for a separate class of shares of the new corporation (substituted class); immediately after the amalgamation, the number of shareholders of each substituted class, the number of shares of each substituted class owned by each shareholder, the number of issued shares of each substituted class, the terms and conditions of each substituted class, and the legal PUC of each substituted class are identical to what they were for the exchanged class immediately before the amalgamation; and the new corporation makes the election provided for in subsection 87(3.1) in its first income and benefit tax return. If all the conditions are met and the election under subsection 87(3.1) is made, each class of shares of the new corporation is deemed to be the same as and a continuation of the exchanged class. In other words, each class retains its particular tax characteristics, with the result that a class of shares with a PUC deficiency is the only one to support this deficiency. In practice the election under subsection 87(3.1) is fairly limited, since in the amalgamation of two unrelated corporations it is seldom possible to arrange a share-for-share exchange that will meet the conditions set out in subsection 87(3.1), owing to the difference in the value and structure of the capital stock of the predecessor corporations. Advanced Personal & Corporate Taxation Reading

160 Exhibit 4-2 illustrates a situation in which it might be possible to use the provisions of subsection 87(3.1). EXHIBIT 4-2 Possible uses of subsection 87(3.1) If the election under subsection 87(3.1) is made, the PUC of the common shares would be $1,000 and the PUC of the preferred shares would be $1, since each class of shares of the new corporation is deemed to be the same and a continuation of the class of the predecessor corporation. If the election under subsection 87(3.1) is not made, subsection 87(3) will apply, and the $9,999 deficiency of the PUC on the preferred shares of Robson Ltd. will be distributed among the common shares and the preferred shares issued by Granville & Robson Ltd. as a result of the amalgamation. Tax consequences for shareholders and creditors Shares general rule Under subparagraph (b)(iii) of the definition of disposition in subsection 248(1), the conversion of shares on an amalgamation constitutes a disposition of property. Thus, in the absence of specific rules, a capital gain or loss could be realized on the amalgamation equal to the difference between the ACB of shares exchanged (old shares) and the FMV of the shares (or other property) received from the new corporation. 14 Reading 4-1 Advanced Personal & Corporate Taxation