CAPITAL GAINS EXEMPTIONAND - Law Society of...
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Transcript of CAPITAL GAINS EXEMPTIONAND - Law Society of...
CAPITAL GAINS EXEMPTION ANDCORPORATE REORGANIZATIONS
by Beaty F. Beaubier
TABLE OF CONTENTSI. INTRODUCTION 1II. THE CAPITAL GAINS EXEMPI'ION 2
A. THE $100,000 CAPITAL GAINS EXEMPTION 31. QUALIFYING PROPERTY 32. THE ELIMINATION OF REAL ESTATE 33. THE ELIMINATION OF THE $100,000 CAPITAL GAINS EXEMPTION 5
B. THE $500,000 CAPITAL GAINS EXEMPI'ION 71. QUALIFIED FARM PROPERTY 72. QUALIFIED SMALL BUSINESS CORPORATION SHARES 10
C. TRAPS FOR THE UNWARY 121. CUMULATIVE NET INVESTMENT LOSS ("CNIL") 122. ALTERNATIVE MINIMUM TAX 133. OLD AGE SECURITY CLAW-BACK 144. OLD AGE TAX CREDIT 155. GST CREDIT 156. FAILURE TO REPORT THE CAPITAL GAIN 167. PROVINCIAL TAXES 17
III. CORPORATE REORGANIZATIONS - SECTION 85 OF THE INCOMETAX ACT (CANADA) 19
A. QUALIFYING ASSETS 20B. THE PURCHASER 21C. THE VENDOR 22D. CONSIDERATION 23
1. NON-SHARE CONSIDERATION ("BOOT") 232. PREFERRED SHARES 243. COMMON SHARES 244. PAID-UP CAPITAL 25
E. JOINT ELECTION 26F. THE "ELECTED AMOUNT" 27G. BENEFIT PROVISION 31H. PRICE ADJUSTMENT CLAUSES 33I. SHARE TRANSFERS AND SECTION 84.1 37
IV. PROPERTY TRANSFERS USING THE CAPITAL GAINS EXEMPTIONAND CORPORATE REORGANIZATION RULES 40
A. TRANSFERS OF PROPERTY BETWEEN SPOUSES 40B. TRANSFERS FROM PARENT TO CHILD 42C. TRANSFERS TO CORPORATIONS 44
V. CONCLUSION 47
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I.
CAPITAL GAINS EXEMPTION ANDCORPORATE REORGANIZATIONS
by Beaty F. Beaubier
INTRODUCTION
Prior to 1972, capital gains were tax free in Canada. From 1972 to 1988, 50% of capital
gains were included in income for tax purposes. In 1988 and 1989, the capital gains
inclusion rate increased from 50% to 66 2/3%. For 1990 and subsequent years, the
inclusion rate jumped to 75%. Given the ever-increasing amount of the capital gain
which is required to be included in income, making use of the Capital Gains Exemption
and "rollover" rules has become more important with the passage of time.
The Capital Gains Exemption was first proposed by the Federal Minister of Finance
Michael Wilson (as he then was) in his Budget Speech on May 23, 1985.
Unfortunately, what could have been a very simple set of provisions in the Income Tax
£kt. (Canada) has resulted in the addition of pages of legislation and, in the author's
opinion, unnecessary complexity. In the 10 years that have followed since the Capital
Gains Exemption was proposed, the Federal Department of Finance has introduced more
and more roadblocks to the use of the exemption. In the February 22, 1994, Federal
Budget, a portion of the capital gains exemption was eliminated, subject to certain
transitional rules (discussed below). There had been wide-spread speculation leading up
to the February 27, 1995, Federal Budget that what remained of the Capital Gains
Exemption would be eliminated. However, that did not happen.
What follows is a review of certain provisions of the Income Tax Act (Canada) dealing
with the Capital Gains Exemption and "rollovers" to corporations. These provisions have
certain benefits to taxpayers, and they can often be used together in various combinations.
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II. THE CAPITAL GAINS EXEMPTION
When first proposed, the Capital Gains Exemption was heralded as a means for
individuals resident in Canada to obtain $500,000 of capital gains on a tax free basis.
The exemption was to be phased in between 1985-19901• Michael Wilson (who was the
Finance Minister at the time) hoped that the capital gains exemption would "unleash the
full entrepreneurial dynamism of individual Canadians" in an effort to assist smaller
businesses in raising capital to expand and create jobs2• The introduction of the capital
gains exemption was very surprising. In fact, it was almost a throw-back to the years
prior to 1972 when capital gains were treated as a tax free receipt under the Canadian
income tax system.
The Capital Gains Exemption is only available for use by individuals resident in Canada.
Other taxpayers, such as corporations, are not eligible for the Capital Gains Exemption.
In June, 1987, significant changes were made to the Capital Gains Exemption:
1. $100,000 Capital Gains Exemption
With respect to capital gains on properties other than "qualified small business
corporation shares" and "qualified farm property", a ceiling was imposed such
that a maximum of $1 00,000 of Capital Gains Exemption could be claimed.
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Individual taxpayers resident in Canada were to have been able to realize up to $20,000 in capitalgains in 1985, $50,000 in 1986, $100,000 in 1987, $200,000 in 1988, $300,000 in 1989 and$500,000 in 1990. Qualifying fann property was eligible for the full $500,000 deduction for 1985and subsequent years. See Sheldon Goodman and Norman Tobias "The Proposed $500,000Capital Gains Exemption" in (July - August, 1985) 33 CTJ 721-758 at 726. Also see Hugh A.Gordon, "An Update on the Capital Gains Deduction" in 1990 Conference Report (Canadian TaxFoundation: Toronto, 1991) 5:1-55 at 5:1Goodman and Tobias, supra.
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$500,000 Capital Gains Exemption
A $500,000 Capital Gains Exemption was retained with respect to the disposition
by Canadian-resident individuals of "qualified small business corporation shares"
and "qualified farm property". To the extent that the $100,000 Capital Gains
Exemption was used, this would reduce the amount of the exemption available
with respect to "qualified small business corporation shares" and "qualified farm
property" with the result that the total Capital Gains Exemption could never
exceed $500,000.
A. THE $100,000 CAPITAL GAINS EXEMPTION
When the $100,000 Capital Gains Exemption limit was proposed in June, 1987, one
might have hoped that that would be the end of the changes to the Income Tax Act
(Canada) in this area. Unfortunately, that was not to be the case.
1. QUALIFYING PROPERTY
Until February, 1992, there was no limit to the types of property that would qualify for
the $100,000 Capital Gains Exemption. Thus, property could be sold with a capital gain
and qualify for this portion of the exemption regardless of whether it was personal or real
property, and whether the property was located inside or outside of Canada.
2. THE ELIMINATION OF REAL ESTATE
In February, 1992, capital gains on certain real property no longer qualified for the capital
gains exemption, subject to transitional rules. The definition of "non-qualifying real
property" (which is real property that does not qualify for the Capital Gains Exemption)
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extends not only to real property but also to shares of corporations, and interests in
partnerships or trusts where the fair market value ofthose entities is principally derived
from real property which is considered "non-qualifying real property".3 Capital gains on
certain types of real property are not restricted with respect to the Capital Gains
Exemption, namely qualified farm property and real property owned by an individual or a
spouse used in an active business carried on by that individual or a related person.4
Where non-qualifying real property is sold, the portion of the taxable capital gain which
is eligible for the capital gains exemption is limited by the following formula:
No. of months the real property is owned after 1971Taxable Capital Gain x and endin2 with February. 1992
No. ofmonths the real property is owned after 1971and ending with month ofdispositionS
The result is that while a portion of capital gains on non-qualifying real property may be
eligible for the capital gains exemption, not all of it will be.6
TAX TRAP
Where one of your clients has sold a cottage sinceFebruary, 1992, unless the cottage qualifies as a "principalresidence" under the Income Tax Act (Canada), thetaxable capital gain on the sale is unlikely to be entirelyoff-set by the Capital Gains Exemption.
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See the definition of"non-qualifying real property" in Subsection 110.6(1).Generally see the exceptions in the definition of "real property" in subparagraph (a) of thedefinition of"non-qualifying real property" in Subsection 110.6(1).See the definition of"eligible real property gain" in Subsection 110.6(1).Generally see Morley P. Hirsch, "Capital Gains Exemption and Real Property" in l222Conference Report (Canadian Tax Foundation: Toronto, 1993) 11:1-28.
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3. THE ELIMINATION OF THE $100,000 CAPITAL GAINSEXEMPTION
On February 22, 1994, Finance Minister Paul Martin announced the elimination of the
$100,000 lifetime capital gains exemption. However, the elimination of this portion of
the capital gains exemption is subject to certain transitional rules.
Individuals resident in Canada will be entitled to file an election with their 1994 income
tax returns to utilize any portion of the $100,000 capital gains exemption that they have
not previously used. The election will apply only to property that has unrealized capital
gains accrued to February 22, 1994. Property specified in the election is deemed to have
been disposed of and re-acquired at the amount designated in the election. The amount
designated can be anywhere between the adjusted cost base and fair market value of the
property. By making the election, the adjusted cost base of the property will be
increased, thereby reducing the capital gain that will be realized on its ultimate
disposition in the future.
To take an example, assume that you had previously acquired shares of a publicly traded
corporation for $10,000. On February 22, 1994, the fair market value of the shares was
now $110,000. You have not previously used the capital gains exemption.
Furthermore, there are no impediments to your use of the $100,000 capital gains
exemption. In your 1994 income tax return, you can elect that the shares were deemed
to have been disposed for $110,000. This will trigger a capital gain of $100,000 (i.e.
Fair Market Value of $110,000 less tax cost of $10,000). You will now hold the shares
at a tax cost of $110,000. Any gain or loss from a subsequent disposition of the shares
will be calculated with reference to the new tax cost of $110,000.
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Care must be taken in determining the fair market value of the properties that will be
subject to the election. There are adverse tax consequences for an individual who over
estimates the property's fair market value by an amount in excess of 110%.
The election should be filed no later than April 30, 1995.7 However, the election can be
"late filed" up to April 30, 1997, provided that an appropriate penalty is paid.8 The
election can be revoked in writing at any time before 1998 provided that there has been
no overestimation of any property's fair market value by an amount in excess of 110%.9
There are special rules dealing with situations where the capital gains election is made in
connection with flow-through entities such as mutual funds, partnerships and trusts. In
the case of these properties, the adjusted cost base of the individual's interest in them
will not be increased. Rather, the election results in an "exempt capital gains balance"
account for the individual in respect of each such entity. This exempt capital gains
balance may be used for 10 years to offset capital gains realized on the disposition of
those properties or capital gains allocated to the individual by any of those entities. I0 If
there is any balance in the "exempt capital gains balance" account on December 31, 2004,
it will be added to the adjusted cost base of the interest in the mutual fund, partnership
and/or trust, as the case may be. II
The election can also be made in connection with non-qualifying real property. The
election will not result in an immediate tax liability on the gain accrued between March,
1992 and February 22, 1994 (the "ineligible gain"). Instead, the ineligible gain is
deducted from both the gain realized on the election and the new adjusted cost base.
Consequently, the ineligible gain will be taxed on the ultimate disposition of the
property. 12
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Proposed Subsection 110.6(24).Proposed Subsections 110.6(26) and (20).Proposed Subsection 110.6(25).Proposed Section 39.1.Proposed Paragraph 53(1)(p).Proposed Subsection 110.6(21).
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This election can be made with respect to any type of property, including "qualified farm
property" and "qualified small business corporation shares".
TAX TIP
Clients should be encouraged to review their property anddetermine whether any property that they own would haveaccrued capital gains as at February 22, 1994. If so, andthe client is eligible for the $100,000 capital gainsexemption, consideration should be given to filing anelection with the client's 1994 income tax return in order toutilize the $100,000 capital gains exemption.
B. THE $500,000 CAPITAL GAINS EXEMPTION
The enhanced capital gaIns exemption applies to two types of properties, namely
qualified farm property and qualified small business corporation shares.
1. QUALIFIED FARM PROPERTY
The definition of "qualified farm property"l3 includes:
1. real property;
2. A share of the capital stock of a family farm corporation;
3. An interest in a family farm partnership; and
4. Eligible capital property used in the business of farming in Canada.
)/ 13 See the definition of "qualified fann property" in Subsection 110.6(1).
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Where the property in question is farm land, if it was acquired after June 17, 1987, it will
only be eligible as "qualified farm property" ifcertain revenue tests are satisfied:
1. In at least 2 years while the property was owned, the gross revenue of the owner
from his/her farming business carried on in Canada in respect of which that
person was actively engaged on a regular and continuous basis must have
exceeded his/her income from all other sources for the year; or
2. The property was used by a family farm corporation or family farm partnership
principally in the course of carrying on the business of farming in Canada
throughout a period of 24 months during which time the individual or related
person (Le. spouse, child or parent) was actively engaged on a regular and
continuous basis in the farming business in which the property was used.
Where the farm land was acquired prior to June 18, 1987, these gross revenue tests are
not applicable. However, the farm land must have been used in the business of farming
either in the year in which it was disposed of by the individual or, or in at least 5 years
during which the property was owned by the individual or a related individual (Le.
spouse, child or parent).
TAX TRAP
The $100,000 Capital Gains Election can be used inconnection with qualifying farm property. However, thereis a risk that where farm land is involved and the election ismade, it may result in farm land that had been acquiredbefore June 18, 1987, becoming farm land that is deemed tohave been acquired after June 17, 1987, the latter beingsubject to the more restrictive rules because of the "grossrevenue" tests outlined above.
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While the owner of the property, in order to be eligible for the capital gains exemption,
must be an Canadian resident individual, the user of the property need not be that
particular individual. Rather, the user of the property can extend to anyone of or a
combination of:
1. The individual and/or his/her spouse, children or parents;
2. A personal trust in respect of which the beneficiary was the owner of the property
or any of the related persons noted in the previous paragraph.
3. A family farm corporation of the individual, of a personal trust, or of a related
person referred to in the previous paragraphs.
4. A partnership in which the individual, or a related personal trust or a related
individual referred to in the previous paragraphs has an interest.
With respect to "family farm corporations,,14, these are corporations where "all or
substantiallyall,,15 of the fair market value of the assets of the corporation are attributable
to:
1. Property used principally in the course of carrying on a business of farming in
Canada by the corporation in respect of which the particular individual, spouse,
child or parent, or a family farm partnership, was actively engaged on a regular
and continuous basis; or
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IS
See the definition of "share of the capital stock ofa family fann corporation" in Subsection110.6(1).Revenue Canada has an assessing policy whereby the phrase "all or substantially all" is interpretedto mean "90% or more". See Wood y. MNR. [1987] 1 C.T.C. 2391 (T.C.C.) as an examplewhere the court did not impose a requirement of "90% or more" when interpreting the phrase "allor substantially all".
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2. Shares of the capital stock or indebtedness of one or more corporations all or
substantially all of the fair market value of whose property was used in the
business of farming in Canada; or
3. Combinations of the properties described in paragraphs 1 and 2 above.
As an additional test, throughout the 24-month period preceding the date of disposition,
more than 50% of the fair market value of the property owned by the corporation must
have been attributable to those items referred to in paragraphs 1-3 above.
A similar definition exists for "family farm partnerships". 16
TAX TIP
When considering whether the shares of a "farmingcorporation" qualify for the $500,000 capital gainsexemption, be careful of situations where the corporationhas an excessive amount of cash and investments. If thesetypes of assets comprise more than 10 percent of the fairmarket value of all assets of the corporation, it is unlikelythat the shares will be "qualified farm property" for thepurposes of the $500,000 capital gains exemption.
2. QUALIFffin SMALL BUSINESS CORPORATION SHARES
"Qualified small business corporation shares" (hereinafter "QSBC Shares") must meet
three main tests:
1.
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At the time of sale, the share must be that of the capital stock of a "small business
corporation".17 A "small business corporation" is:
See the definition of"interest in a family fann partnership" in Subsection 110.6(1).See the defmition of "small business corporation" in Subsection 248(1).
(a) a "Canadian-controlled private corporation,,18;
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(b) where "all or substantially all" of the fair market value of the assets are:
(i) used principally in an active business carried on primarily In
Canada by that corporation and one related to it; or
(ii) shares of the capital stock or indebtedness of one or more small
business corporations that are "connected,,19 with it; or
(iii) a combination thereof.
2. Throughout the 24 months preceding the disposition, the shares in question cannot
have been owned by anyone other than the individual, or a person or partnership
related to that individual.
3. In the 24 months preceding the disposition, the share must have been a share of
the capital stock of a Canadian-controlled private corporation more than 50% of
the fair market value of the assets of which were attributable to assets used
primarily in active business in Canada, shares of the capital stock or indebtedness
of "connected" corporations which meet the same asset tests, or some
combination thereof.
It is very easy for a corporation to be "off-side" for the purposes of these tests. For
example, if the cash and investment portfolio of a corporation exceed 10% of the fair
market value of all of the assets of the corporation, the corporation is unlikely to qualify
as a "small business corporation" at the time of sale. It is for these reasons that it quite
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19Subsection 125(7).Subsection 186(4).
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common to see companies being reorganized in order to "purify" them for the purposes of
the $500,000 capital gains exemption
TAX TIP
If an individual has carried on a business as aproprietorship, it is possible to sell that business and stillmake use of the $500,000 Capital Gains Exemption:
(a) The proprietorship can be sold to a corporation on a"rollover" basis in return for new shares of thecorporation using Section 85;
(b) Provided that the sale of the business comprises "allor substantially all of the assets used in an activebusiness carried on by that person", the shares willbe considered capital property, and therefore anygain on sale will be treated as a capital gain (Section54.2); and
(c) In these circumstances, the "treasury shares" issuedby the corporation are treated as having satisfied the"holding" test. (Paragraph 110.6(l4)(f)(ii))
C. TRAPS FOR THE UNWARY
One of the big problems in attempting to use the capital gains exemption is the number of
obstacles that must be hurdled. Some of these are as follows:
1. CUMULATIVE NET INVESTMENT LOSS ("CNIL")
In June, 1987, proposals were put forth (which were ultimately passed into legislation)
which stated that where an individual's investment expenses after 1987 exceeded his/her
investment income after 1987, that would result in a CNIL. To the extent that an
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individual had an CNIL, it would reduce the amount of taxable capital gains that would
have otherwise been eligible for the capital gains exemption.
"Investment Expenses" for these purposes include interest expense on money borrowed
to produce income from property, 50% of resource related expenses and deductions, and
property losses (including losses from renting MURBS and other real property).
Investment income includes things such as interest income, dividend income, leasing
income from real property and 50% of resource related income. While it is always
possible to "earn" your way out of a CNIL problem, it usually requires an addition of
income in a particular year that the taxpayer would prefer not to have. Thus, if your
investment expenses since 1987 have exceeded your investment income by $50,000, it
would be necessary to take an additional $50,000 in dividend income or some other
property-related income in a particular year to earn your way out of the CNIL so that your
taxable capital gains will be eligible for the capital gains exemption.
2. ALTERNATIVE MINIMUM TAX
The Income Tax Act (Canada) provides for an alternative minimum tax ("AMT")
calculation?O The policy reason behind the alternative calculation is the government's
concern that an individual not be able to eliminate or unduly reduce their income tax
obligations in any given year because of the existence of certain "preference" items.
These "preference" items include:
1. Pension and RRSP deductions;
2. The tax free portion of capital gains (currently 1/4);
3. Certain capital cost allowance deductions; and
,)20 Section 127.5-127.55.
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4. Certain resource - related expense deductions.
Once an individual's "adjusted taxable income" is determined, a basic exemption of
$40,000 is allowed. To the extent that any taxable income remains, an alternative tax
calculation is performed. If the tax resulting under the AMT rules is higher than the
individual's "regular" tax, the higher amount is paid.
Where an individual has had to pay AMT in any given year to the extent that the
individual's regular tax exceeds their AMT in any of the next 7 years, the individual may
"set-off' the amount paid on account of AMT against hislher regular tax liability in any
ofthe next 7 years?1
3. OLD AGE SECURITY CLAW-BACK
Generally speaking, Canadians who turn 65 years of age are entitled to a pension under
the OldAge SecuritJ!Act (Canada). Notwithstanding this entitlement to a pension, under
the Income Tax Act (Canada), where an individual's "net income' exceeds $53,215 (in
1994), 15 percent of the excess results in a repayment of the Old Age Pension (to a
maximum of the total amount received on account of the Old Age Pension in the year).
When a person receiving the Old Age Pension has taxable capital gains in the year, even
if the Capital Gains Exemption applies, the taxable portion of the capital gains will
increase the individual's net income. This could result in a "claw-back" of the Old Age
Pension22•
A similar consideration can arise in connection with guaranteed income supplement
payments. These payments are based on a person's net income as opposed to their
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22Section 120.2.Section 180.2.
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wealth. Where a person has substantial accrued but unrealized capital gains, and these
capital gains are triggered in a particular taxation year, that individual could find their
entitlement to guaranteed income supplement benefits in the following year reduced or
eliminated because of the "bump" in their net income in the previous year.
4. OLD AGE TAX CREDIT
Individuals resident in Canada who are 65 years of age or older are entitled to claim a
federal non-refundable tax credit of $592 (in 1994i3• As a result of changes made in the
February 22, 1994 budget, this credit will be reduced by 15% of an individual's net
income exceeding $25,921. The reduction is to be phased in over a two-year period. In
1994, the reduction will be 7.5% and in 1995 the reduction will be 15% in excess of the
income threshold amount of $25,921.
Where taxable capital gains are triggered in a particular taxation year by a person who
would otherwise be eligible for this age credit, you may find that his/her eligibility is
either reduced or eliminated because of the existence of taxable capital gains in that
particular year which have increased their net income.
5. GST CREDIT
Under the Income Tax Act (Canada), refundable GST credits are available for
individuals and qualified relations (i.e. a spouse or dependent under age 19 for whom an
equivalent-to-spouse credit is claimed) of$198. In addition, for each qualified dependent
there is an additional refundable GST credit of $105.24 However, to the extent that the
combined net income of the individual and his/her cohabiting spouse for the year exceeds
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24Subsection 118(2).Section 122.5.
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$25,921, there will be a reduction and/or elimination of the GST credit the person would
otherwise have been eligible for.
If taxable capital gains for that person or his spouse are triggered in a particular taxation
year, it could have the effect of reducing or eliminating the GST credits that the family
would otherwise have been eligible.
TAX TRAP
Where you are dealing with a taxpayer who is 65 years ofage or older, care must be taken in doing any income taxplanning with respect to the Capital Gains Exemption.Triggering taxable capital gains in the hands of a "seniorcitizen" could result in a claw-back of the Old Age Pension,a reduction or an elimination of the guaranteed incomesupplement, a reduction or an elimination of the Old Agetax credit and a reduction or an elimination of the GSTcredit.
6. FAILURE TO REPORT THE CAPITAL GAIN
It is not unheard of for a taxpayer who has had a capital gain to fail to report this in
his/her income tax return. Some people believe that because the Capital Gains
Exemption results in "tax free" capital gains, no reporting of any capital gain is
necessary. This can be a serious error for two reasons:
1. Firstly, pursuant to Subsection 110.6(6), where an individual has a capital gain in
a taxation year and knowingly or under circumstance amounting to gross
negligence fails to report the capital gain, the use of the capital gains exemption
can be denied by Revenue Canada.
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Secondly, in reassessing the taxpayer in these circumstances, Revenue Canada
will often impose a penalty under Subsection 163(2).
Essentially, the taxpayer ends up having to pay twice, firstly with a denial of the capital
gains exemption (and therefore having to pay the income tax on the taxable capital gain),
and secondly having to pay a penalty in connection with the taxable capital gain that the
taxpayer failed to report. The Court decisions in this area have been both for and
. d d' h' 25agamst taxpayers, epen mg on t e cIrcumstances .
7. PROVINCIAL TAXES
When an individual has a capital gain, the taxable portion (3/4) is included in "net
income". The Capital Gains Exemption is a deduction from net income to taxable
income.
Not all income taxes are calculated with reference to taxable income. Some are
calculated with reference to net income (which includes the taxable capital gain). For
individuals resident in Saskatchewan, the following must be considered:
1. Flat Tax
Saskatchewan imposes a "flat tax" of2% on net income.
2S David Ragobar y. The Queen (Tax Court Canada; July 29, 1994), where the Court held infavour of the taxpayer and allowed him to use the capital gains deduction even though he forgot toreport his capital gain; Bilodeau v. The Queen (Tax Court of Canada; September 4, 1992), wherethe Court allowed the taxpayer to use the capital gains exemption with respect to the capital gainon the disposition of property, and set aside the penalty that had been assessed by RevenueCanada for the taxpayer's failure to report the taxable capital gain; W.B. Dymond v. MNR,[1990] 2 C.T.C. 2509 (T.C.C.), where the Court dismissed the taxpayer's appeal and upheld thereassessment by Revenue Canada wherein the capital gains deduction was not allowed to thetaxpayer and penalties were assessed for failure to report the taxable capital gain.
2.
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Deficit Reduction Surtax
Saskatchewan imposes a 10% "deficit reduction surtax" on the basic
Saskatchewan tax (being 50% of basic federal tax) and the Saskatchewan flat
tax.26
3. High Income Surtax
Finally, to the extent that an individual's Saskatchewan tax liability exceeds
$4,000 (being the total of the basic Saskatchewan tax, the deficit reduction surtax
and the Saskatchewan flat tax), there is a high income surtax of 15% over this
$4,000 threshold.
It is important to keep these taxes in mind when advising someone about the use of the
capital gains exemption. A Saskatchewan resident will invariably be subject to a
Saskatchewan income tax liability on any taxable capital gains, regardless of whether the
capital gains exemption is available.
TAX TIP
When a creditor forecloses or takes title to a debtor'sproperty in a foreclosure or similar situation, it is notuncommon for capital gains to result because of theapplication of Section 79 of the Income Tax Act(Canada). In Saskatchewan, this has frequently occurredin farm foreclosure situations. In circumstances of farmforeclosures which have triggered capital gains, theSaskatchewan Government will remit (or repay) theSaskatchewan income tax that becomes payable inconnection with the taxable capital gains included inincome as a result ofa farm foreclosure.
26 As a result of the most recent Saskatchewan budget which was tabled on February 16, 1995,effective July 1, 1995, the deficit surtax will be eliminated for low-income earners and will besignificantly reduced for all other residents.
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III. CORPORATE REORGANIZATIONS - SECTION 85 OF TIlE INCOMETAX ACT (CANADA)
The area of corporate reorganizations and the related tax rules could be the subject of
several papers. This section of the paper will focus on Section 85 of the Income Tax
da (Canada), one of the most commonly used provisions both in corporate
reorganizations and property transfers to corporations. Often, this rule can be used in
conjunction with the Capital Gains Exemption.
Section 85 allows a "rollover" on property transfers to Canadian corporations. In using
Section 85, a number of things must be considered:
• What assets qualify for the rollover?
• The status of the purchaser.
• The status of the vendor.
• Consideration paid to the vendor by the corporation receiving the property.
• Filing the joint election.
• The "elected amount" to be chosen on the asset transfer.
• Whether any "benefit" is conferred on other shareholders.
• Price adjustment clause.
• Special rules involving sales of shares.
A. QUALIFYING ASSETS
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Only "eligible property,,27 can be transferred on a rollover basis using Section 85.
Eligible property consists of:
1. Capital property, other than real property or an interest in or option therein which
is owned by a non':resident person although:
(a) Real property held by a non-resident insurer in the course of carrying on
an insurance business in Canada is considered "eligible property"; and
(b) A further exception in connection with real property held by non-residents
is allowed in circumstances where the non-resident holds the real property
is a business carried on by that person in Canada.
2.
3.
4.
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Canadian resource properties.
Foreign resource properties.
Eligible capital properties.
Subsection 85(1.1).
5.
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Inventory (other than real property, an interest in real property or an option in
respect of real property).
TAX TRAP
Be very careful where you are dealing with land or otherreal property which may not be considered "capitalproperty". Where the real property is held as inventory itwill not qualify for a rollover under Section 85.28
6. Property (other than capital property or inventory) that is a security or debt
obligation used by the taxpayer in the year in, or held by it in the course of,
carrying on the business of insurance or lending money.
7. A NISA ("Net Income Stabilization Account") Fund No.2.
B. THE PURCHASER
The purchaser of the property must be a "taxable Canadian corporation,,29. This
expression means a corporation that:
1.
28
29
30
Is a "Canadian corporation,,30 , and
While there is a restriction on the rollover of real property that is inventory to a corporation, notethat there is no such restriction on rollovers of this type of property to Canadian partnerships. SeeSubsection 97(2).Subsection 89(1).Subsection 89(1). Essentially, this a corporation incorporated in Canada or resident in Canadathroughout the period that began June 18, 1971. It also includes a corporation formed by anamalgamation, merger, plan of arrangement or other corporate reorganization in respect of two ormore corporations if the reorganization takes place under the laws of Canada or a province, andeach of those corporations was, immediately before the particular time, a Canadian corporation.
22
2. Was not, by virtue of a statutory provisions, exempt from tax under Part I.
TAX TIP
Any corporation incorporated under the laws ofSaskatchewan or Canada should be a "taxable Canadiancorporation" as long as it is not exempt from tax under PartI of the Income Tax Act (Canada). Part I tax is the taxpaid by individuals and corporations on their income fromemployment, property, business or otherwise.
c. THE VENDOR
The person transferring the property to the corporation must be a "taxpayer". The
taxpayer need not be a resident of Canada. (It is to be noted that where non-residents are
transferring property, there are certain restrictions as to the types of property that they can
transfer. See the discussion above dealing with "Qualifying Assets".)
TAX TRAP
It is doubtful whether a "partnership" can transfer propertyto a corporation using Section 85. The vendor must be a"taxpayer". The phrase "taxpayer" is defined to includeany person whether or not liable to pay tax.3l Thedefinition includes a reference of "person" includes anytype of person, including a corporation. It makes noreference to a partnership. The definition of "person" inSubsection 248(1) has general application throughout theAct. Other provisions of the Act provide that a personincludes a partnership in dealing with certain specific
• • 32sItuations.
31
32Subsection 248(1) - see the definition of "taxpayer".Paragraph 33.1(2)(a) - "person" includes a partnership for international banking center rules;Subsection 66(16) - "person" includes a partnership for flow-through share rules; Subsections127.2(9) and 127.3(7)· "person" includes partnerships for the purposes of the share purchase tax
)
23
D. CONSIDERATION
The consideration paid by the purchasing corporation to the Vendor must include
"shares" of the capital stock of the purchasing corporation. It is not necessary that one
share be taken back for each and every individual asset being transferred. Revenue
Canada has indicated that as long as the consideration paid by the purchasing corporation,
includes at least one share of the capital stock of the purchasing corporation that will
satisfy the requirements of Subsection 85(1), notwithstanding that the statutory provision
refers to "shares" in its pluralized form.33
Usually, the purchasing corporation "pays" for the transferred property with three types
of consideration:
1. Non-share consideration (also known as "boot");
2. Preferred shares; and/or
3. Common shares.
1. NON-SHARE CONSIDERATION ("BOOT")
The cost of any "boot" received by the vendor is equal to the lesser of:
1.
33
The fair market value of the boot; and
credit and scientific research tax credit rules; Paragraph 187A(c) - "person" includes partnershipsfor the purposes of Part IV.l tax; Subsection 209(6) - "person" includes partnerships for thepurposes of tax on carved-out income; Subsection 227(15) - "person" includes partnership for thepurposes of non-resident withholding requirements.Interpretation Bulletin No. IT-29lR2: Transfer of Property to a Corporation under Subsection85(1) (dated December 16, 1994), Paragraph l(c).
24
2. The fair market value of the property disposed of to the corporation as allocated
on a pro-rata basis among all the boot received from the purchasing corporation
by the vendor.34
Most often, a promissory note or a credit in favour of the shareholders' loan account of
the vendor makes up the boot which is given to the vendor. If the property being
transferred has debt attached to it (for example, mortgages on land), those mortgages can
be assumed and form part of the boot.
2. PREFERRED SHARES
Where preferred shares are received as part of the consideration, the adjusted cost base of
those preferred shares in the vendor's hands will be the lesser of:
1. The fair market value of the preferred shares; and
2. The amount by which the "elected amount" exceeds the value of the boot which is
given to the vendor.35
3. COMMON SHARES
Finally, the adjusted cost base of any common shares received by the vendor as
consideration is the residual amount remaining after deducting from the elected amount
the value of the boot plus the deemed cost ofany preferred shares received the vendor.36
34
3S
36
Paragraph 85(l)(f).Paragraph 85(l)(g).Paragraph 85(l)(h).
)4. PAID-UP CAPITAL
25
One other thing that must be kept in mind when looking at the shares received by the
vendor from the purchasing corporation is the "paid-up capital,,3? (hereinafter "PUC") of
the shares. Where shares are taken back as part of the consideration in a Section 85
rollover, Subsection 85(2.1) will apply to calculate the PUC of the shares issued to the
vendor by the purchasing corporation. Normally, the PUC ofa share is equal to its stated
capital for corporate law purposes. Thus, this would usually lead to a result where the
stated capital of shares (and therefore their PUC for tax purposes) is equal to the fair
market value of the property transferred to the corporation in consideration for those
shares. However, for income tax purposes where the "boot" taken back by the Vendor
equals the "elected amount", there will be no allocation of any PUC to the shares taken
back by the vendor. Consider a situation where a taxpayer owns land having a FMV of a
$100,000 and an ACB of $1 ,000. The taxpayer sells the land using a Section 85 rollover
and takes back shares of the purchaser corporation. The elected amount on the sale is
$1,000. By virtue of Section 85(2.1) the following happens:
) 37
PUC of shares issued by a purchaser corporation(which will equal their corporatestated capital before any adjustment)
Less:
Increase in PUC (before adjustment)
Less:
Corporation's cost of landlessthe FMV of any non-share consideration
PUC of shares issued to vendor
Subsection 89(1).
$100,000
($1.000)
$100,000
99,000
$ 1.000
26
The reason for this provision is due to the Capital Gains Exemption. If the shares
received by the vendor had a PUC equal to their FMV (Le., $100,000), and a low adjusted
cost base (Le., $1,000), any repurchase or redemption of those shares by the corporation
would result in a capital gain (in this case, $99,000). Revenue Canada does not want this
to happen. By "grinding" the PUC, if the corporation proceeds to purchase or redeem
the shares, there will be a deemed dividend (rather than a capital gain) that results equal
to the consideration paid by the corporation in excess of the PUC of those shares38
(which in this case would be a deemed dividend of $99,000).
E. JOINT ELECTION
The vendor and purchasing corporation must file a joint election under Subsection 85(1)
in Form T2057. The election must be signed by the vendor and the purchaser and must
set out:
1. The "elected amount" (discussed below);
2. The number and description of shares being issued to the vendor;
3. The date of sale;
4. The value and description of property being disposed of (Le., the "qualifying
assets"); and
5.
38
The value and description of any non-share consideration (also known as "boot")
being received by the vendor.
Subsection 84(3).
)
27
The accuracy in filing the election is very important. Where it is intended that more
properties are being transferred to the purchasing corporation than are referred to in the
joint election filed with Revenue Canada, the rollover for the properties not referred to in
the election will be disallowed39• The election should be filed with Revenue Canada
before the date that any income tax return must be filed by either the vendor or the
purchaser for the taxation year in which the sale occurred.4o
TAX TIP
Often, a letter of instructions regarding a sale involvingSection 85 comes from the client's accountant. When thelegal documents have been completed by the lawyer, andthe lawyer is reporting out to the client, it is a good practiceto confirm in writing with the accountant that it is theaccountant's responsibility to ensure that any electionsand/or property dispositions are prepared, filed and reportedas required by the Income Tax Act (Canada).
F. THE "ELECTED AMOUNT"
The "Elected Amount" is one of the most important aspects of a rollover of property
under Section 85. The reasons for this are essentially twofold:
1. The "elected amount" determines the "proceeds of disposition" for income tax
purposes.
2. Secondly, the elected amount in connection with the property being sold to the
corporation will determine the "tax cost" of that property in the hands of the
purchaser-corporation.
)
39
40
Serge Eo Deconinck y. The Queen, [1990] 2.C.T.C. 464 (F.C.A.), affrrming [1988] 2 C.T.C. 213(F.C.T.D.). Also see John Stacey, "Transfer of Assets to and from a Corporation" in .!illConference Report (Canadian Tax Foundation: Toronto, 1989), 14:1-46 at 14:4-5.Subsection 85(6).
28
Take the following situation involving the transfer of land (which is capital property)
from an individual to his/her corporation. The tax characteristics of the land are as
follows:
Fair Market Value
Adjusted Cost Base
$150,000
$110,000
The corporation will pay $150,000 for the land. However, the "proceeds of disposition"
for tax purposes needs not be $150,000. Rather, an "elected amount" will be chosen.
This "elected amount" will determine the proceeds of disposition for income tax
purposes. In this particular situation, in order to defer any tax on the sale, the "elected
amount" would $110,000. This is equal to the adjusted cost base of the land being sold.
If the "elected amount" is $110,000, that will be the ACB of the land to the purchaser
corporation.
There are certain upper and lower limits to the elected amount that may be chosen in
connection with any particular transfer ofproperty:
Upper Limit
• Fair market value of property being transferred
Lower Limit not less than the lesser of:
• Cost amount of property being transferred
• Fair Market Value ofproperty being transferred
In any event, the lower limit of the elected amount cannot be less than the
"boot" (non-share consideration) paid to the vendor.
29
Dealing with the land transfer example noted above, the elected amount would range any
where between:
Fair Market Value of Land
Adjusted Cost Base ofLand
$150,000
$110,000
On the transfer of the property to the corporation, the vendor shall take back a promissory
note and shares having a total fair market value of $150,000 (being the fair market value
of the land). If the promissory note ("boot") is greater than $110,000, then the elected
amount will have to be at least equal to the amount of the promissory note. Assume that
the consideration taken back by the vendor is as follows:
Shares
Promissory Note
Total
$ 20,000
$130,000
$150,000
In these circumstances, the elected amount could be no less than $130,000 because the
"boot" is $130,000. As such, the proceeds of disposition for tax purposes will be
$130,000 and a capital gain of $20,000 (Le., $130,000 less the adjusted cost base of
$110,000) will have to be reported by the vendor. If the "elected amount" is $130,000,
that will result in the adjusted cost base of the land to the purchaser-corporation being
$130,000.
In some circumstances, the vendor may wish to chose an elected amount which will result
in a capital gain in order to use the capital gains exemption. (An example looking at a
situation like this is discussed later on in this paper.) The usual case, however,
particularly when dealing with depreciable properties which can have a "recapture,,41 of
capital cost allowance (or, in other words, tax depreciation) is that the "elected amount"
41 Subsection 13(1).
30
would be equal to the cost amount of the property sold (in the case of depreciable
property, its undepreciated capital cost) in order to avoid any tax consequences on the
sale to the corporation.
Under no circumstances may the elected amount ever be greater than the fair market
value of the property being transferred.42 This can be illustrated in the following
example:
ACB ofproperty
Fair Market Value of "boot"
Fair Market of transferred property
$100
$140
$ 75
The elected amount pursuant to Paragraph 85(1)(b) would normally be $140 (being the
amount of "boot" or non-share consideration). However, because the fair market value
of the property is only $75, Paragraph 85(l)(c) requires that the elected amount only be
$75. The excess of $65 (being the fair market value of the "boot" given to the vendor,
namely $140, in excess of the fair market value of the property transferred to the
corporation, namely $75) would be included in the vendor's income as a shareholder
benefit under Section 15 of the Act.
There are special Rules regarding the elected amount for the following types ofproperty:
1.
2.
3.
4.
42
43
44
4S
Inventory, a NISA Fund No.2, and capital property (other than depreciableproperty of a prescribed class)43;
Depreciable property of a prescribed class44 ;
Eligible capital property45 ;
Inventory of a farmer who computes income on a cash basis46 ; and
This limitation is set out in paragraph 85(1)(c), which overrides Paragraph 85(1)(b).Paragraph 85(1)(c.l).Paragraph 85(1)(e). It should be noted that when transferring assets which are part of a "pool" ofa depreciable property of a prescribed class, a special "ordering" and designation should be madeby the taxpayer. See paragraph 85(1)(e.l).Paragraphs 85(1)(d) and (d.l).
) 5. Passenger vehicles.47
G. BENEFIT PROVISION
31
It is extremely important, when doing property transfers to a corporation, to keep in mind
that the fair market value of the consideration paid by the corporation not be less than the
fair market value of the property transferred to the corporation. Otherwise, adverse tax
consequences will result where persons related to the vendor are shareholders of the
particular corporation. (Note that where the vendor is the sole shareholder of the
purchaser-corporation, we do not have to be concerned about conferring any "benefits".)
Consider the following situation where shares of an operating company ("OPCO") are
transferred by an individual resident in Canada to a holding company ("HOLDCO").
The tax characteristics of the shares are as follows:
ACB of OPCO shares transferred
FMV of OPCO shares transferred
Elected Amount (equals ACB ofthe sharestransferred in Holdco's hands)
Fair market value ofconsideration paid byHoldco to the vendor
(being made up of a promissory note of$600,000 and preferred shares of $250,000)
$ 600,000
$1,000,000
$ 600,000
$ 850,000
The vendor owns 20% of the common shares of Holdco and his/her children own the
remaining 80%. The benefit provision in paragraph 85(1)(e.2) will be triggered where:
1. The fair market value of the transferred property ($1,000,000) exceeds the fair
market value of the consideration paid by Holdco ($850,000), which in this case is
($150,000); and
)46
47Paragraph 85(l)(c.2).Paragraph 85(l)(e.4).
2.
32
It is reasonable to regard any part of the excess of $150,000 as a benefit conferred
on related persons.
The benefit would be 80% of the $150,000 excess,namely the sum of $120,000. (The
reason that we only focus on 80% is because the vendor owns 20% of HOLDCO.) The
result is as follows:
1. The elected amount for the purposes of the Section 85 rollover is deemed to be
equal to the aggregate of:
The amount originally elected
The benefit portion of the excess
(being 80% of $150,000)
Total
$600,000
$120,000
$720,000
This elected amount results in the ACB of the OPCO shares owned by HOLDCO
being $720,000, rather than the originally-elected amount of $600,000. The
vendor suffers an immediate capital gain of:
Proceeds of disposition for tax purposes
Adjusted cost base ofOPCO shares whensold by the vendor
Capital Gain
$720,000
$600,000
$120,000
2. There is no corresponding increase in the adjusted cost base of the consideration
taken back by the vendor from HOLDCO. In this particular example, the
preferred shares owned by the vendor will continue to have an ACB equal to $.0.
Any sale of those shares by the vendor will result in a capital gain to the extent to
the proceeds of disposition. Thus, the vendor essentially ends up in a position
33
where he/she can get taxed on the same capital gain twice. The first time was
one the transfer of the OPCO shares to HOLDCO (capital gain of $120,000), and
the second time will be on the sale of the preferred shares ofHOLDCO.
3. The increase in the elected amount from $600,000 to $720,000 appears to allow
for an increase in the paid-up capital of the preferred shares taken back by the
vendor. Previously, because the entire elected amount equaled the promissory
note, no PUC would have been allocated to the preferred shares. Now the elected
amount of $720,000 exceeds the "boot" by the sum of $120,000. This amount
should be able to be used to increase the PUC ofthe preferred shares by $120,000.
H. PRICE ADJUSTMENT CLAUSES
To minimize the risk of Revenue Canada assessing a "benefit" under paragraph
85(1)(e.2), a price adjustment clause is recommended in the agreement of purchase and
sale. If the vendor and the purchaser-corporation fail to estimate the fair market value of
the property being transferred accurately, the price adjustment clause effectively allows
for any variation in the sale price that results from a determination by Revenue Canada
and/or by a Court to be reflected with a corresponding increase or decrease to the
consideration paid by the purchaser-corporation. In Guilder News Co. (1963) Ltd. v.
MNR. 48 the Court considered the issue ofwhether or not a benefit or advantage had been
conferred by a corporation on one of its shareholders. There was a price adjustment
clause which the taxpayers attempted to rely on in support of their argument that no
benefit had been conferred on any shareholders. The sale price that had been used in the
transaction had obviously been less than fair market value. The court rejected the
taxpayers' arguments and held that from an examination of the agreement in question
including the price adjustment clause, the sale was to take place at a specified price with
an adjustment to be made subsequently should Revenue Canada ever issue a
48 73 D.T.e. 5048 (F.e.A.).
34
reassessment. The Court pointed out that this was significantly different from a sale
which is expressly made with a bona fide estimate of the fair market value of the property
being transferred. Given this decision of the Court, it would appear that the use of a
price adjustment clause will be allowed provided that the estimate of the fair market value
of the property being transferred is reasonable and the intention to rely upon the price
adjustment clause is genuine.
There are two ways to adjust the value of share consideration which is issued by the
purchaser-corporation to the vendor on a Section 85 rollover:
1. The number of shares issued to the vendor can be adjusted (either by issuing more
shares or cancelling some of the shares previously issued, depending upon
whether the sale price should be increased or decreased); or
2. The value of the shares issued can be adjusted.
Apparently, Revenue Canada prefers that the price adjustment clause is one which, in the
context of preferred shares, adjusts the redemption price. In other words, the articles of
incorporation should be drafted so as to place the price adjustment clause in the articles.
If Revenue Canada reassesses the particular transaction, the redemption price of the
shares would be adjusted pursuant to the price adjustment clause which is place in the
articles of incorporation. In the author's opinion, this is a rather odd way in which to
proceed. Consider the following situation:
1. Class "B" preferred shares are created with Articles of Amendment under IJu
Business Corporations Act (Saskatchewan) having the following characteristics:
(a) Non-voting;
35
(b) Preferred dividend entitlement which is no less than 3% and no less than
8% of the redemption value of the shares, on a non-cumulative basis;
(c) Preference to a repayment equal to the redemption price plus any declared
but unpaid dividends on a liquidation, winding-up or dissolution of the
corporation;
(d) Redeemable at the option of the corporation and retractable at the option
of the holder;
(e) The redemption price is set at $1.00 per share. However, the redemption
price is subject to a "price adjustment clause" which can increase or
decrease the redemption value depending upon a subsequent reassessment
by Revenue Canada in connection with any property transfer to the
corporation in circumstances where this particular class of shares has been
issued.49
2. A property transfer takes place where Mr. Anderson transfers land to a
corporation. The land has a fair market value of $1,000, and he takes back 1,000
Class "B" preferred shares having a fair market value of $1,000 (Le. a redemption
price of $1.00 per share). Mrs. Anderson has decided to invest money in the
corporation and she pays $5,000 in cash for 5,000 Class "B" preferred shares.
Subsequently, Revenue Canada reassesses Mr. Anderson on the basis of the fair
market value on the land was only $500 rather than $1,000. By virtue of the
price adjustment clause, the redemption value of the Class B shares now drop
49 For the "requirements" that Revenue Canada has stated that it would like to see with reference to"preferred" shares which are issued in a "rollover" or "estate freeze" situation, see Clifford R.Plume, Rollovers and Elections Under the Income Tax Act (The Canadian Institute of CharteredAccountants: Toronto, Loose-leaf) 4121-4123.
36
from a $1.00 per share to $.50 per share (resulting in Mr. Anderson having $500
worth of preferred shares, being a 1,000 preferred shares with a redemption of
$.50 per share). The problem with the price adjustment clause in these
circumstances is that as a matter of corporate law, the redemption characteristics
of the share must affect all of the shareholders in the same way. Therefore, Mrs.
Anderson, who actually paid $5,000 for shares, now holds 5,000 shares that only
have a redemption value of $.50 per share. In the author's opinion, she is has not
been dealt with fairly.
In fairness to Revenue Canada, there concern about having a price adjustment clause
which results in the cancellation of shares that had previously been issued (if the
estimated fair market value is too high) or the issuance of new shares pursuant to the
price adjustment clause (if the estimated fair market value is too low) carries with it a
host of technical difficulties. For instance, an intervening sale or redemption of shares or
a winding-up, amalgamation or re-organization of the purchaser-corporation before the
date that a price adjustment clause takes effect might make it impossible to issue
additional shares or cancel issued shares without payment.50 Notwithstanding Revenue
Canada's concerns it is the author's position that as many, if not more, problems can be
created by drafting a price adjustment clause that changes the redemption amount of the
issued shares.
Revenue Canada's position on price adjustment clauses is stated in Interpretation Bulletin
IT-169: Price Adjustment Clauses (dated August 6, 1974):
so Clifford R. Plume, supra, at 4135(quoting from the 1991 British Columbia Tax Study GroupRound Table).
37
"...the Department will recognize that agreement [which contains a priceadjustment clause] in computing the income of all parties, provided that allof the following conditions are met:
(a) The agreement reflects a bona fide intention of the parties totransfer to the property at fair market value and arrives at that valuefor the purposes of the agreement by a fair and reasonable method.
(b) Each of the parties to the agreement notifies the Department by aletter attached to his return for the year in which the property wastransferred
(i) that he is prepared to have the price in the agreementreviewed the Department pursuant to the price adjustmentclause,
(ii) that he will take the necessary steps to settle any resultingexcess or shortfall in the price,
(iii) that a copy of the agreement will be filed with theDepartment if and when demanded.
(c) The excess or shortfall in price is actually refunded or paid, or alegal liability therefore is adjusted.
Revenue Canada's position has been criticized with respect to the imposition of
condition (b). Revenue Canada is attempting to impose an onerous reporting
requirement which is not otherwise required under the Income Tax Act (Canada).
Most tax practitioners ignore this "administrative requirement" that Revenue
Canada is attempting "legislate" through Interpretation Bulletin.
I. SHARE TRANSFERS AND SECTION 84.1
Be very careful when transferring shares that you have in one company (for example
"OPCO") to a holding company ("HOLDCO"). A common situation is where an
38
individual takes shares in their OPCO and sells them to their HOLDCO and we end up
with a situation similar to the following:
Individual
100%
HOLDCO
100%
OPCO
Section 84.1 is essentially an anti-avoidance rule directed at surplus stripping. It applies
in the following circumstances:
1. A taxpayer resident in Canada (other than a corporation) disposes of shares;
2. The shares are capital property to the taxpayer and are shares of a corporation
resident in Canada;
3. The disposition is made to a corporation with which the taxpayer does not deal at
arm's length; and
4. Immediately after the disposition, the corporation whose shares have been
disposed of must be connected with the purchaser-corporation. To be connected,
the purchaser-corporation must either control the other corporation or must own
more than 10% of the voting shares and more than 10% of the fair market value of
all issued shares of the other corporation.
)
39
Consider a situation involving an individual owning shares of OPCO which he/she wants
to sell to HOLDCO. The tax characteristics of the OPCO shares are as follows:
Fair Market value
Adjusted Cost Base ("ACB")
Paid-up Capital ("PUC")
$100,000
$ 100
$ 100
On the sale of the shares to HOLDCO, the taxpayer receIves from HOLDCO a
promissory note in the amount of $100,000 (being the fair market value of the OPCO
shares). The taxpayer is the sole shareholder of HOLDCO. In these circumstances,
Section 84.1 applies. Because the non-share consideration paid by HOLDCO exceeds the
PUC ofthe OPCO shares, a deemed dividend results equal to:
Non-share consideration paid to taxpayer by HOLDCO
PUC of OPCO shares
Deemed Dividend
$100,000
100
$ 99.900
Had the non-share consideration paid by HOLDCO not exceeded the PUC of the OPCO
shares acquired by it (Le., $100), no deemed dividend would have resulted.
Section 84.1 is a trap for the unwary. A recent notice from the Alberta Institute of
Chartered Accountants states:
"For the period January 1, 1992, to December 31, 1994, those Canadianfirms insuring through the Association of Insured Chartered Accountants(AICA) have reported claims in the area of tax practice which comprised49% of the total claims reported to the insurer. The 600 insured Albertafirms have reported 59% of their claims in the area of income tax practice.One-Third of the Alberta tax claims related to corporate reorganizationsintended to create a tax-free capital gain by reorganization of share capital.The result, unfortunately, was a taxable dividend."
40
When ever you are dealing with the sale of shares from an individual to a corporation,
beware of Section 84.1. It could turn a capital gain into a dividend.
TAX TRAP
Tax advisors often forget about Section 84.1. Often, whena client owns shares of a corporation, a sale of those shareswill be used to realize a capital gain in order to use thecapital gains exemption. A sale of shares by an individualto a holding corporation in these circumstances may turninto a disaster when a deemed dividend results by virtue ofSection 84.1 rather than the anticipated capital gain.
IV, PROPERTY TRANSFERS USING THE CAPITAL GAINS EXEMPTIONAND CORPORATE REORGANIZATION RULES
The Capital Gains Exemption is there to be used by individuals resident in Canada.
Often, the exemption can be used in conjunction with various "rollover" and "corporate
reorganization" rules.
A, TRANSFERS OF PROPERTY BETWEEN SPOUSES
Generally speaking, capital property may be transferred between spouses on a "rollover"
basis. In other words, even though the fair market value of the property may exceed its
adjusted cost base, the property is deemed to be transferred between spouses at its
adjusted cost base. This rollover applies both with respect to inter vivos transfers51 as
well as transfers on death.52
51
52Subsection 73(1).Subsection 70(6).
41
Notwithstanding the "rollover" that would otherwise exist, it is possible to structure
transfers of capital property between spouses such that the rollover is avoided and any
inherent capital gains in the property being transferred is realized.53
When structuring a transfer of property between spouses in circumstances where the
objective is to realize capital gains that would be eligible for the Capital Gains
Exemption, the following should be kept in mind:
1. Sale AgreementlPrice Adjustment Clause
Consider transferring the property pursuant to a sale agreement. A reasonable
estimate of the fair market value of the property should be made. The sale
agreement should contain a "price adjustment clause".
2. Elect out of the Rollover
Normally, there is a "rollover" on property transfers between spouses.54 The
"vendor" spouse should elect in hislher income tax return not to have the rollover
apply.
3. Avoiding the Attribution Rules
With respect to the spouse buying the property, consider having the spouse either
pay for the purchase price with cash, or if the purchase price is going to remain
outstanding as a debt owed to the Vendor, consider having the debt bear a
commercial rate of interest or interest at the prescribed rate under the Income Tax
Act (Canada). All interest on the debt in respect of a particular taxation year
should be paid no later than 30 days following the end of the year. In these
)
53
54
With respect to inter vivos transfers, the rollover in Subsection 73(1) will automatically apply"unless the taxpayer elects in the taxpayer's return of income... for the taxation year in which theproperty was transferred not to have the provisions of this subsection apply ....". With respect totransfers between spouses which result from the death of a spouse, it is possible to elect out of therollover under Subsection 70(6.2).Subsection 73(1).
42
circumstances, any income or loss from the property while it is held by the
"purchaser" spouse, and any capital gain or capital loss on the ultimate disposition
of the property by that "purchaser" spouse will not be attributed back to the
vendor.55
B. TRANSFERS FROM PARENT TO CHILD
As the population in Saskatchewan gets older, we are likely going to see a great deal of
property transferred from parents to children in the next 20 years. This is already starting
to happen, particularly in the farm sector.
A typical situation, involving a transfer of farm land from a parent to a child involves the
following:
1. Sale AgreementlPrice Adjustment Clause
A parent will sell farm land to the child at fair market value. The agreement
should contain a price adjustment clause.
2. Controlling the Capital Gain
Farm land may be transferred on a "rollover" basis from a parent to a child in
circumstances where:
(a) The farm land is in Canada;
(b) The land is transferred to a child of the taxpayer who is resident in Canada
immediately before the transfer; and
ss Subsection 74.5(1).
43
(c) The land was, before the transfer, used principally in the business of
faiming in which the taxpayer, his/her spouse or any of the taxpayer's
children was actively engaged on a regular and continual basis.56
The sale price need not be the fair market value of the land. If the land was
merely gifted, it would simply "rollover" at its fair market value (provided that
the fair market value exceeds the adjusted cost base of the land). Essentially,
you can chose a sale price anywhere between the adjusted cost base and fair
market value of the land being transferred, and in those circumstances, the sale
price will determine the proceeds ofdisposition for tax purposes.
3. Tax Cost of Land to the Child
The tax cost of the land to the child will be equal to the proceeds of disposition.
Thus, if the sale price is the fair market of the land, then the tax cost to the child
will be the fair market value of the land.
4. Paying the Purchase Price
Usually, the parent who is selling the land takes back a promissory note (which
mayor may not be secured by a vendor's lien or mortgage against the land). The
promissory note mayor may not be interest-bearing, although there may be good
reason to make the promissory note interest-bearing if the farm land being
acquired by the child is merely going to be rented as opposed to being used by
that child in the business of farming. The reason for making the debt interest-
)
S6 Subsection 73(3). This provision was amended for transfers occurring after 1992. A number ofsignificant amendments were made to the provision including:(a) The present wording merely requires that the property was before the transfer used in the
business of farming by the taxpayer and/or his immediately family (as noted above).Previously, the wording required that the property be used in the business of fanningimmediately before the transfer in the business of farming by the taxpayer and/or hisimmediate family;
(b) A qualitative test has also been introduced which requires the taxpayer and/or hisimmediate family to be actively enl:aged on a rel:ular and continuous basis in thebusiness of farming.
44
bearing relates to the possible application of the attribution rules to the "property
income" that could result from the lease of the farm land by the child.57
The indebtedness can be structured so that it is payable on demand or a repayment
schedule can be set up. If the repayment schedule spreads the payment of the
purchase price over 10 years, capital gains reserves may be claimed. Essentially,
the use of these reserves allows the taxable capital gain to be included in income
over a 10 year period.58 Often, on the last of the particular parent and/or his
spouse to die, any debt remaining owing by the child is forgiven. 59
C. TRANSFERS TO CORPORATIONS
One other technique that is commonly used to gam access to the Capital Gains
Exemption is the transfer of property to a corporation. A simple example involves a
57
58
59
Traditionally, one only had to be concerned about the attribution of income or loss from property,when transferring or lending property to a child who is under the age of 18 years. [Subsection74.1(2).] However, in 1988, Subsections 56(4.1)-(4.3) were added to the Income Tax Act(Canada). These provisions essentially provide that where interest free loans or indebtednessoccurs between an individual (the creditor) and a person who does not deal at arm's length withthat individual (the debtor), such as in the relationship between a parent and child, and it can bereasonably considered that one of the main purposes for making the loan or incurring theindebtedness was to reduce or avoid tax, any income from the property transferred shall beattributed back to the transferor. In these circumstances, it does not matter whether the child isan adult (18 years or over) or a minor. If the indebtedness owing by the child to the parent bearsinterest at a commercial rate of interest or the prescribed rate under the Income Tax Act(Canada), and the interest is paid with respect to a particular taxation year within 30 days after theend of the year, these attribution rules will not apply.Subsections 40(1) and (1.1). Normally, capital gains reserves may only be claimed for 5 years.However, where there is a transfer of farm land from a parent to a child where the land wasimmediately before the disposition used by the taxpayer, taxpayer's spouse or any of thetaxpayer's children in the business of farming, it is possible to claim capital gains reserves for aperiod of up to 10 years. (Note that the land must be used in the business of farming"immediately" before the transfer of the taxpayer and/or his immediately family. This test isdifferent from the "rollover" rule in Subsection 73(3), the latter rule no longer using the word"immediately".)It is very important that the debt not be forgiven during the lifetime of the child. Otherwise, theamount of debt forgiven can result in a reduction of any tax losses that the child might otherwisehave available to himlher, a reduction in the "tax cost" of properties of various assets held by thechild and/or an income inclusion to the child. See proposed amendments to Section 80 andproposed Sections 80.01 - 80.04. However, where the debt is forgiven by way of bequest orinheritance, these "debt forgiveness" rules do not apply. See proposed Paragraph 80(2)(a).
45
situation where a farm land has the following tax characteristics:
Fair Market Value
Adjusted Cost Base
$1,000,000
$ 100,000
The individual in question can transfer the farm land and utilize the $500,000 Capital
Gains Exemption while at the same time controlling the capital gain so that no more than
is necessary to utilize the exemption is triggered. In doing this, the taxpayer effectively
makes use of the "rollover" provision under Section 85 and at the same time makes use of
the Capital Gains Exemption. The land is sold to a corporation for consideration equal to
the fair market value of the land (i.e. $1,000,000). The purchase price is paid as follows:
Promissory Note
Fair market value ofshare consideration
Total
$ 600,000
$ 400,000
$1,000,000
Section 85 allows the transfer of property by a tax payer to a "taxable Canadian
corporation,,60, such as a corporation incorporated under The Business Corporations Act
(Saskatchewan), on a "rollover" basis. Even though the property in question may have a
fair market value in excess of its tax cost, the vendor and purchaser-corporation may
jointly elect that the proceeds of sale for tax purposes are an amount somewhere between
the tax cost and fair market value of the property being transferred. The amount elected
can not be less than the amount of "non-share consideration" given by the corporation to
the vendor. In our particular example, the adjusted cost base of the farm land is $100,000
and its fair market value is $1,000,000. Thus, the "elected amount" can be anything
between these two numbers. However, our farmer is taking back a promissory note in the
amount of $600,000. As such, because we have non-share consideration of $600,000, the
60 Subsection 89(1).
46
elected amount, which determines the proceeds of disposition for income tax purposes, is
also $600,000:
1. Capital Gain
On the sale of the farm land to the corporation, the farmer will have a capital gain
of $500,000 calculated as follows:
Proceeds of sale for tax purposes ("elected amount")
Tax cost of land
Capital gain
$600,000
($100,000)
$500,000
This capital gain should be eligible for the $500,000 Capital Gains Exemption.
2. ACB of Farm Land to Corporation
The tax cost or "adjusted cost base,,61 of the farm land to the corporation will be
equal to the "elected amount" of $600,000.
3. ACB of Promissory Note and Shares to the Farmer
Once the elected amount of $600,000 is determined, it is allocated to the non
share consideration first, and thereafter to any preferred and common shares
issued by the corporation to the farmer. Because the fair market value of the
promissory note of $600,000 equals the elected amount, the promissory note will
have an adjusted cost base of $600,000. The promissory note can be repaid by
the corporation to the farmer tax free. The shares received by the farmer will have
61 Section 54.
47
an adjusted cost base of $0. Thus, any disposition of those shares in the future
for consideration in excess of $1 will have taxable consequences.
TAX TIP
The sale of capital property between family membersand/or to corporations can be an ideal way to realize capitalgains and use the capital gains exemption.
V. CONCLUSION
The Capital Gains Exemption can be a very useful tool as part of an overall tax or estate
plan for clients. The transfer of capital property can be accomplished in a number of
ways, either in arm's-length sales to third parties or in related-p8J."1ies transfers among
family members or to controlled corporations. In the context of related-party transfers,
there are often "rollover" provisions of the Income Tax Act (Canada) that can be used to
reduce or at least control the amount of the capital gain that may be triggered as a result
of the disposition of property. Making use of a combination of these "rollover"
provisions together with "fair market value" transfers can sometimes give you the best of
all possible worlds. You avoid or defer the recognition of some types of income but
allow the recognition ofcapital gains eligible for Capital Gains Exemption.
March 16. 1995\seminar\cge-sem.doc
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