Tax Planning for Small Business Guide DIFFERENT THAN A DOT.COM BILLIONAIRE SO ARE HIS TAX PLANNING NEEDS EXCERPT #1

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1 DIFFERENT THAN A DOT.COM BILLIONAIRE SO ARE HIS TAX PLANNING NEEDS EXCERPT #1 Tax Planning for Small Business Guide Excerpt: [ 1104] Assets used in an active business

2 TAX PLANNING FOR SMALL BUSINESS GUIDE A REAL LIFE EXAMPLE Determine for yourself whether or not the Tax Planning for Small Business Guide is worth the investment. Check out the following pages that have been reproduced in their entirety from the Guide. You ll be impressed by their thoroughness and applicability. Written by Experts The Tax Planning for Small Business Guide is the collaborative product of some of Canada s leading tax experts. David Louis JD, CA and Samantha Prasad Weiss BA, LLB, both with the law firm Minden Gross LLP, along with Robert Spenceley BA, MA, LLB, analyst with CCH Canadian, and Joseph Frankovic LLB, LLM, PhD, CFA tax lawyer and member of the adjunct faculty of Osgoode Hall Law School, lead a host of contributors whose expertise make this Guide truly indispensable. David Louis JD, CA Samantha Prasad Weiss BA, LLB Robert Spenceley BA, MA, LLB Joseph Frankovic LLB, LLM, PhD, CFA TRY BEFORE YOU BUY Take advantage of our free trial offer, available on CD-ROM or over the Internet. For more information or to place an order, simply call customer service at Please quote Promo Code TA

3 TAX PLANNING FOR SMALL BUSINESS GUIDE The capital gains exemption on the sale of shares of a Canadian controlled private corporation is a widely-known concept. However, like most corporate tax concepts, there are a number of technical issues surrounding the availability of this exemption that need to be analyzed. By searching the Tax Planning for Small Business Guide you will be able to properly advise your clients as to their eligibility for the capital gains exemption, in addition to a variety of other issues. [ 1104] ASSETS USED IN AN ACTIVE BUSINESS A key requirement in respect of the capital gains exemption is that the asset must be used in an active business. Issues arise (for example) where assets which might otherwise relate to active business are dormant. The following are some assets on which the CRA has commented: Cash Technical Interpretation No states the following: Cash or near cash property is considered to be used principally in the business if its withdrawal would destabilize the business. The test is not whether the taxpayer was forced to use the property to do business; the test is whether the property was used to fulfil a requirement which had to be met in order to do business. Cash which is temporarily surplus to the needs of the business and is invested in short-term income producing investments could be considered to be used in the business. Cash balances which accumulate and are depleted in accordance with the annual seasonal fluctuations of an ongoing business will generally be considered to be used in the business but a permanent balance in excess of the company's reasonable working capital needs will generally not be considered to be so used. The accumulation of funds in anticipation of the replacement or purchase of capital assets or the repayment of a longterm debt will not generally in itself qualify the funds as being used in the business. Cash or near cash property is considered to be used principally in the business if its retention fulfils a requirement which had to be met in order to do business, such as certificates of deposits required to be maintained by a supplier. The Department recognizes that prudent financial management requires businesses to maintain current assets (including inventories and accounts receivables, as well as cash and near cash properties) in excess of current liabilities and will consider this requirement in assessing whether cash or near cash assets are used principally in a business. In the Department's view, cash and near cash assets held to offset the non-current portion of long term liabilities will not generally be considered to be used in the business. In Skidmore v. The Queen, 2000 DTC 6186 (F.C.A), the taxpayer was denied the exemption because of the excessive amount of term deposits held in the company, notwithstanding rainy day arguments that these cash reserves were a necessary asset in its tree growing business due to the fact they would be required in the event the company experienced certain misfortunes in its business operations, such as a crop failure. It was held that the cash reserves were not an integral aspect of the business operations nor was there a relationship of significant financial dependence between the business and the amounts in question. Loans to Employees Loans described under subparagraphs 15(2)(a)(ii), (iii) and (iv) (to enable employees to acquire dwellings for their habitation, to acquire shares of the corporation or to acquire automobiles to be used in the performance of their duties, respectively) would not qualify as assets used in an active business. Interest in a Partnership The CRA has stated on a number of occasions that a partnership interest and a loan to a partnership would both be considered to be assets used in an active business carried on by the corporation where all or substantially all of the assets 3

4 of the partnership were used in an active business carried on by the partnership. In a number of Technical Interpretations, the CRA has stated that a corporation's interest in a limited partnership would also qualify, provided that all or substantially all of the assets of the limited partnership are used in an active business. Assets for Future Use Real estate developers may, in certain circumstances, bank land inventory where it is not profitable to immediately develop it. In such cases, there is a concern as to whether such assets are used in an active business. The CRA has stated that it will consider plots of land that are land inventory to be used in an active business provided that it is obvious that these plots have been acquired and are held for the purpose of being sold, or developed and sold in the course of the business. Where a corporation acquires property for the purposes of developing a facility for use in its own business (i.e., a new manufacturing facility), the CRA has stated that the property will generally be considered an asset used in the active business of the company from the date of acquisition so long as the new facility was in fact used in the active business within a reasonable time after completion and not for any other purpose. (See 1990 CRA Round Table, Q. 18) Land Generally, the CRA is of the view that, in order for land to be considered used in an active business, it must be subjacent to any building or structure affixed to the land or immediately contiguous land used as a parking area, driveway, yard, garden or similar land that is necessary for the use of the building (paragraph 18(3)(a)). Undeveloped land, the carrying costs of which would have to be capitalized pursuant to subsection 18(2), would not be considered to be used in an active business. (See Technical Interpretation No , February 3, 1993.) However, the CRA has not been unfavourable to situations where taxpayers are required to acquire more land than is actually used in the business. (See Technical Interpretation No , March 16, 1998) Single Venture (adventure in the nature of trade) Another common issue is whether an asset held as an adventure in the nature of trade is used in an active business. An example might be the case where a corporation holds a parcel of land with a view to flipping the property for a quick gain. An issue is whether the activity is significant enough that business is being carried on by the corporation. In Capital Gains Exemption Refresher (Hermann, C., 2000 Conference Reports, p 29:7), the following is stated: The concern stems from cases such as Tara Exploration and Development Company Limited v. M.N.R., 70 DTC 6370 (Ex. Ct.), where the engagement in an adventure, or concern in the nature of trade, was not considered to be carrying on an active business, which is required if an asset used therein is to be regarded as a good asset. CRA has commented that it is a question of fact that will determine how this issue is to be resolved. [See Interpretation Bulletin IT-459, paragraph 3.] However, they have commented that inventory, including land inventory of a real estate corporation, would normally be considered used in an active business (CRA Document No. AC59482, March 13, 1990). One would therefore expect that an isolated land flip by a corporation might not be accorded such treatment. Mortgages Receivable Mortgages having normal commercial terms and conditions and held as investments are not considered to be assets used in an active business. As well, the income earned from the mortgages is considered income from property and subject to the specified investment business rules in paragraph 125(7)(e). Mortgages taken back by a developer in order to facilitate sales may initially be assets used in an active business, but if such mortgages are retained for more than a short period, they may become investments. (See Technical Interpretation No , February 9, 1993.) Amounts received from the sale of assets The CRA is of the view that an amount receivable which arises on the disposition of an asset would not be an asset used principally in an active business, regardless of whether the asset disposed of had been used in an active business. The only receivables that may be considered to be assets used in an active business of a corporation are trade accounts receivable that arise from sales by the corporation in the course of its active business. (See Technical Interpretation No , February 9,1993, as well as Technical Interpretation No , March 31, 1995.) Share investment as part of active business In Technical Interpretation No , April 28, 1993, based on the Ensite case, the CRA was favourable toward shares of an investee company which was a 4

5 long-established sales and distribution co-operative doing all of the marketing and distribution for all companies involved in the corporation's particular type of business. Non-arm's length receivables The CRA has indicated that, in a non-arm's length situation, two factors which could indicate that the assets (receivables) are not used in the business would be where the receivables remain outstanding for an extended period of time or are converted into inter-corporate advances on a regular basis. (See Technical Interpretation No , March 26, 1998.) Pension surpluses The CRA has indicated that a pension surplus is an inactive asset if the company cannot withdraw the excess from the plan and use the funds in its active business. (See Technical Interpretation No , December 2, 1998.) Replacement insurance proceeds Insurance proceeds used to replace the destroyed/insured asset that had been used in the business will be considered an active business asset, even if the insurance proceeds result in significant short-term cash reserves in the corporation. (See Technical Interpretation No , October 13, 1994.) Assets required as security for loan Technical Interpretation No states: Where a financing arrangement that is fundamental to the business operations requires certain security to be maintained and it is reasonable to conclude from the facts that the security is employed and at risk in the business, the security may be considered to be used in the business. In order to draw this conclusion in a factual situation, there would have to be a financial relationship of dependence of some substance between the security and the business. If there is no real expectation that the security will be resorted to, one could conclude that the security was not used in the business. In our view, the employment of marketable securities merely as collateral is not generally sufficient to enable it to be considered to be used in a business. Qualico Developments Ltd. v. The Queen, 84 DTC 6119 (F.C.A.). In that case, he suggested that unsold inventory was not used in the business and that it is only used when it is employed in the business in some way. The majority decision in that case offered a more liberal approach to the concept of using property in a business. The all or substantially all requirement is, in a very real sense, antithetical to the policy implicit in the small business deduction itself, since the latter encourages reinvestment at the corporate level. In fact, the very situations in which the enhanced exemption may become critical will typically involve successful businesses which have built up surplus assets. Additionally, it will be more difficult for such businesses to qualify for the all or substantially all requirement as the corporate tax rate decreases, which would result in the tendency to retain surpluses at the corporate level. As a result, it is typically necessary to undergo structural reorganizations in order to allow the purification of a corporation's assets. It should be noted, however, that some purification reorganizations (i.e., tax-deferred spinoffs of corporate assets to a transferee corporation) generally cannot be successfully effected in contemplation of a sale to an arm's-length third party. If such a sale is contemplated, the flexibility to jettison corporate assets is greatly restricted. Generally speaking, purification in these situations will involve taxable dispositions by the corporation of assets which are being stripped; in addition, the ability to jettison assets to other corporations on a tax-free dividend basis will generally be dependent upon the safe income (i.e., for the purposes of subsection 55(2)) attaching to shares on which the dividends are received. The bottom line is that, unless purification methods are used in advance of a contemplated disposition, the alternatives become limited: meeting the all or substantially all test may be difficult or impossible without incurring a substantial tax liability. The commentary on this topic is current as of January 2nd, In all cases, it is a question of fact as to whether an asset is used in an active business. The CRA has stated that it is not the intention to adopt a restrictive view of the term used. A very restrictive interpretation of the word used was suggested by Hugessen, J., in the case Note: For a list of selected Technical Interpretations pertaining to active business assets, reference should be made to Appendix B of The Capital Gains Deduction a Checklist Approach, Len Vandenberg, 2000 British Columbia Tax Conference (Vancouver. Canadian Tax Foundation 2000) p 8:

6 TAX PLANNING FOR SMALL BUSINESS GUIDE See inside for excerpt: [ 1104] Assets used in an active The Tax Planning for Small Business Guide is available both online and on CD-ROM. Other tax planning guides available from CCH Canadian Limited: Canadian Wealth Management Guide Canadian Estate Planning Guide 92M3-2-07