Study Notes Topic 10 Ch14B-1

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Appendix II Victor's notes on Capital Gains Deduction Planning The following are certain notes of mine on the s.110.6 capital gains deduction, which you might find helpful when reviewing this chapter's material 1. An important consideration for the sale of shares is the potential eligibility for CGD, which is restricted to individual shareholders on shares that are qualified small business corporation shares. 1.1. s.110.6(2.1) permits a lifetime limit of $971,190 (2023) tax free capital gain on qualified small business corporation shares (on qualified farm and fishing properties the limit is $1,000,000). a. this exempt gain is subject to reduction if the taxpayer, has allowable capital losses, or net capital losses, or a cumulative net investment loss (CNIL) balance in the year the exemption is to be claimed. Recall that only property income, including dividends and taxable capital gains (on shares not eligible for the CGD), will reduce the CNIL balance. 1.2. At the time of the disposition, the shares must be qualified small business corporation shares (QSBC shares), which means they satisfy the following tests: a. THE SBC TEST ( s.110.6(1) “QSBC” (a)): at the time of disposition, the corporation must have been a small business corporation (SBC), which (as defined in s.248(1)) is a CCPC of which all, or substantially all (90 percent or more) of the fair market value of its gross assets is attributable to assets used:  Principally (more than 50 percent) in an active business carried on primarily (more than 50 percent) in Canada, by the corporation or a related corporation, or  shares or debt of a connected SBC b. THE HOLDING PERIOD TEST(s.110.6(1) “QSBC” (b)): the shares may not have been owned by anyone other than a related person in the prior 24 months. Newly issued treasury shares are

deemed by s. 110.6(14)(f) to have been owned by an unrelated person prior to their issue except in 3 instances: (a) the shares are issued as consideration for other shares; (b) the shares are issued as part of the process of rolling an active business into the corporation; or (c) where the shares are issued as payment of stock dividend. S. 110.6(14)(f) ensures that newly issued shares issued for cash must be held for 24 months prior to disposition. Newly issued shares issued in exchange for other shares will inherit the holding period and asset test characteristics of the shares they were exchanged for under s.110.6(1) “QSBC” (e) and (f). c. CCPC TEST (s.110.6(1) “QSBC” (c)): throughout the applicable 24- month period prior to disposition, the corporation was a CCPC. d. THE BASIC ASSET TEST (s.110.6(1) “QSBC” (c)): throughout the applicable 24 month period prior to the disposition, more than 50 percent of the fair market value of the corporation's assets must have been used principally in an active business (by the corporation or a related corporation) carried on primarily in Canada, and/or in shares or debt of a connected corporation which in turn, throughout the 24 month period prior to the disposition satisfy the holding period test and the basic asset test. e. THE MODIFIED ASSET TEST (s.110.6(1) “QSBC” (d)): When the basic asset test can only be met by relying on investments in another connected corporation, there are additional (complicated) conditions imposed such that at all times over past 24 months, one of the Holdco or the connected corporation must meet a 90% test, while the other meets a 50% test. In other words, if Holdco must rely on the FMV of its investment in the connected corporation to meet the Basic Asset test, then in order for Holdco to qualify as a QSBC, the connected corporation must have had 90% of the FMV of its assets in qualifying assets over the previous 24 months. f. These tests are based:

 on the FMV of assets, including unrecorded goodwill, and  do not take the amount of debt into account. 1.3. “Purification”, or ensuring a corporation's shares are QSBC shares, is an important planning issue for small businesses. a. Purification, as such, does not contravene GAAR, per IC-88- 2, para. 15. b. The simplest methods should be adopted before more complicated solutions are considered. For example:  use liquid nonbusiness assets to pay down liabilities.  pay a dividend or bonus to shareholders, distributing the non- business assets to the shareholders, possibly designating a Capital Dividend if there is a CDA balance, or possibly reducing PUC. c. An example of a more complicated method described in IC-88-2 as not contravening the GAAR is the following: the shareholders incorporate a corporation and transfer to this corporation shares of the operating corporation that have a fair market value equal to the fair market value of the assets that are not used in the active business of the operating corporation; the operating corporation then redeems its common shares from the new corporation and pays the purchase price of the shares by transferring the non-business assets to the new corporation. The operating corporation may have a tax liability arising from the disposition of the non-business assets. The new corporation may be subject to s.55(2) of the Act to the extent of any deemed dividend not attributable to safe income.

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Appendix III VW's personal notes on Section 84.1 and 55(2) 1. Section 84.1 Dividend Stripping Rules (See in text: Ch 19-II-C Sale to Family Members, pgs. 632 to 634. Also, see Ch 19-II-D Bill 208, pg. 634, for preview of pending changes, which we will not study in depth this term. ) 1.1. S.84.1 dividend stripping rules prevent individuals from converting dividends to capital gain, particularly a gain eligible for the CGD. 1.1.1. S.84.1 applies where the vendor is resident, not a corporation, sells shares of a resident Canadian corporation to a non-arm’s length purchasing corporation, and immediately after the transaction, the two corporations are connected. (Note that s.212.1 applies similar rules as s84.1 to non-residents.) a. Note that 84.1 has an extended definition of non-arm’s length when determining whether the purchasing corporation qualifies for s.84.1 treatment.  S.84.1(2)(b) asserts that a taxpayer selling shares in a subject corporation is non-arm’s length from a purchasing corporation if the taxpayer is one of a group of fewer than 6 persons who controlled the subject corporation before the transaction and who controlled the purchaser corporation after the transaction. S.84.1(2.2) has some deeming provisions concerning the constituents of this 6-person group. 1.1.2. This results in a PUC reduction and a deemed dividend a. PUC reduction equal to the amount by which the increase in legally stated capital exceeds the excess, if any, of the greater of the PUC or ACB of the transferred shares over the non-share consideration.  Conceptually, the reduced PUC of the new shares cannot exceed the PUC or ACB of the old shares not recovered from boot. This

contrasts with s.85(2.1) where the PUC of the new shares cannot exceed the EA not recovered from boot.  Note that when both s.85 and s.84.1 apply in the same transaction, because of the wording of s.85(2.1), the PUC reduction rules in s.84.1(1)(a) take precedence.  The purpose of this provision is to limit the PUC of the new shares, that is the amount that can be removed tax free from the corporation to the portion of the hard tax cost not already recovered through NSC. This contrasts to s.85(2.1), where the PUC of the new shares, that can be removed tax free from the corporation, is limited to the portion of the EA that is not recovered in the form of NSC. b. A deemed dividend of (A+D)-(E+F) where A is the increase in legally stated capital before reduction, D is the non-share consideration, E is the greater of the PUC or ACB of the transferred shares, and F is the amount of the PUC reduction.  Conceptually, the deemed dividend recognizes as income the excess of the value that can be removed from the corporation, now or in the future (in the form of NSC and reduced PUC), over the hard tax costs transferred in.  Note that the deemed dividend serves to reduce s.54 Proceeds of Disposition of the old shares. 1.1.3. When referring to the ACB of the old shares, a special rule in s.84.1(2)(a) (ii) reduces the ACB to the so called “hard ACB”, which is the ACB reduced by the amount of any capital gain on those shares that a related person who previously owned those shares had shielded from tax using the capital gains deduction. a. In other words, if a father owned the shares with an ACB of $1,000, and sold the shares to his son for $900,000, and if the father shielded his $899,000 capital gain from tax using the capital gains deduction,

although the son’s ACB on the shares will be $900,000, for purpose of s.84.1, the “hard ACB” on the shares will be the same $1,000 as the father’s original ACB. 1.1.4. The rule of thumb to avoid any deemed dividend is for the NSC not to exceed the greater of the ACB or PUC. 1.1.5. In June 2021, royal assent was given to amendments to 84.1(2)(e) and 84.1(2.3), which are aimed to exempt from 84.1 the sale of shares to a corporation controlled by children or grandchildren of the vendor. a. These amendments were intended to put intergenerational transfers of shares in a corporation on an equal footing to arm’s length transfers of shares in a corporation. b. Unfortunately, these amendments were sloppily written when introduced as a private member’s bill, and the government announced in the Fall of 2022 that they will be modified. c. Budget 2023 proposed changes to the rules introduced by Bill C-208 to ensure that they will apply only where a genuine intergenerational business transfer takes place. The details of these proposed changes, effective for transactions after December 31, 2023, can viewed in the PITA under the Proposed Amendments to 84.1(2.3) - (2.32). As these rules are subject to change until they are promulgated, we will not be studying them this year. 2. S. 55 Capital Gains Stripping Rules (pgs. 585 to 586 in the text) 2.1. s.55(2) capital gain stripping rules prevent corporations from converting capital gains into non-taxable inter-corporate dividends. 2.2. S.55(2) applies to recharacterize a tax free inter-corporate dividend into POD or capital gains where the following conditions are met: 2.2.1. A corporation has received a dividend deductible under s.112(1) as part of a transaction (or series of transactions) involving a disposition of shares

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[s.55(2.1)(a)], and 2.2.2. Any of three purpose or result tests listed below are met: a. One of the purposes of the dividend (or in the case of a s.84(3) deemed dividend, if one of the results of the deemed dividend) was to give effect to a significant reduction in any capital gain that, but for the dividend, would have been otherwise realized on the disposition of any shares at fair market value. [s.52(2.1)(b)(i)], or b. In the case of actual dividends (i.e. not deemed dividends under s.84(3) and s.84(2)): (A) if one of the purposes of the dividend is to effect a significant reduction in the FMV of any share; or (B) if one of the purposes of the dividend is to effect a significant increase in the cost of property of the dividend recipient [s.52(2.1)(b)(ii)], or c. The dividend cannot be attributed to safe income (which is income earned by any corporation since the shares had been acquired, after 1971). [s.55(2.1)(c)]  Note that when a corporation acquires a share on a rollover under s.85, the share acquired retains the portion of safe income attached to the share transferred.  Under s.55(5)(f), every dividend potentially subject to s.55(2) is automatically separated into a “safe income” and “non-safe income” dividend to which s.55(2) may apply, which means designation of a dividend as a “safe income” dividend is not optional. 2.2.3. A few comments on these purpose and results tests: a. In regard to 84(3) redemptions, every such redemption results in a deemed dividend that reduces the POD and thus the gain that would have been realized on the redeemed share but for the dividend. b. The purpose test in s.52(2.1)(b)(ii)(B), which is if one of the purposes of the dividend is to effect a significant increase in the cost of

property of the dividend recipient is intended to combat the following kind of abuse: ·1. Say A owns 100% of B with shares that have a FMV and ACB of $1 million. ·2. A incorporates a 100% owned subsidiary C with share capital of nominal ACB (assume $0). ·3. A sells its interest in B to C, for FMV of $1 million, in exchange for shares of C which have a FMV and ACB of $1 million. ·4. C then issues a $1 million dividend to A, paying the dividend by transferring the shares in B to A. In the absence of s.55, this dividend will be tax free to A. ·5. After this dividend, A owns 100% of B with shares that have a FMV and ACB of $1 million. It also owns 100% of C with a FMV of $0 (because C has distributed all its assets to A) but with an ACB of $1 million. If B and C were amalgamated into a new corporation D, the ACB of A’s shares in D would be $2 million. It looks like A has created $1 million worth of ACB as a result of the transactions. ·6. In CRA’s view, the purpose of the dividend to A from C was to increase the cost of A’s assets, with tax mischief in mind. c. Even if the primary purpose of a dividend is for non-mischievous purposes, such as part of a “creditor protection strategy” or a “QSBC purification strategy”, the dividend will nevertheless be subject to the “one of the purposes” tests in 55(2.1) which could trigger gains if the safe income exception is not available. d. A pattern of regular consistent payments of dividends may be adequate evidence that the 55(2.1) purpose tests have not been offended.

2.2.4. If 55(2) applies, then: a. If it is a s.84(3) or (2) deemed dividend, the dividend is deemed not to be a dividend received by the corporation, but additional proceeds of disposition of shares [s.55(2)(b)], or b. If it is normal course dividend, the dividend is deemed not to be a dividend received by the corporation, but a gain from the disposition of a capital property [s.55(2)(c)]. 2.3. There is a S.55(3)(a) safe harbour for non-arm’s length reorganizations: a. S.55(2) will not apply to deemed dividends (under s.84(2) or s.84(3)) where, as part of the series of transaction, there has not been a less than FMV disposition of property to an arm's length party, or there has not been a significant increase in the interest of an arm's length party in either corporation, even if the dividend exceeds safe income.  For this purpose, under s.55(5)(e), siblings are considered arm’s length. 2.4. There is also a s.55(3)(b) safe harbour that permits arm’s length shareholders to distribute the different types of assets of a corporation to its shareholders, on a strictly proportional basis, without s.55(2) applying. We are not studying this tax deferred divisive restructuring provision in this course. 2.5. Some comments on Safe Income a. Safe income is referred to in s.55(2.1)(c) as the income earned or realized by any corporation that contributes to the capital gain on a share. S.55(5)(a) then elaborates and states that the portion of a capital gain attributable to any income expected to be earned in the future is not included in safe income. The rules governing the computation of Safe Income are set out in s.55(5)(b), and (c), but CRA has overridden this statutory language with a significant body of

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administrative interpretation. For the purposes of our course, we will consider tax paid Retained Earnings to be a close proxy of what Safe Income is (however, I should point out that CRA has stated that they will consider anyone calculating Safe Income in this manner to be negligent, and they expect taxpayers to make a documented, best effort attempt to determine what safe income is if the taxpayer intends to rely on the safe income exception – all of which means more work for CPA’s.). b. One of the implications of the wording in s.55(2)(c) is that Safe Income attributable to a share cannot exceed the accrued capital gain in the share. In other words, if the FMV of the share is less than its ACB, the share is considered not to have any Safe Income attributable to it. To put this another way, the wording of s.55(2.1)(c) defines Safe Income to be the lesser of (a) the tax paid retained earnings Safe Income attributable to a share or (b) the accrued capital gain in the share. In some circumstances, this will mean that safe income will not truly reflect tax paid retained earnings. Nevertheless, this is how most commentators interpret CRA’s view of the rules, notwithstanding that it is not consistent with the meaning that Safe Income has historically been given, and in spite of Department of Finance’s explicit statements that it is has no intention of overturning the general policy that intercorporate dividends from tax paid retained earnings should flow tax free. This is a topic that we will have to watch developments of over time. 2.5.2. Part IV Exception a. in addition to dividends paid out of Safe Income not being subject to re- characterization, an exception is permitted for dividends that are subject to Part IV tax and that are not refunded as a consequence of a dividend payment to any person as part of the same series of transactions. At this stage of our studies, I wouldn’t worry too much about the effect of the Part IV Exception as most dividends that are eligible for the Part IV exception will at the same time be eligible for the Safe Income exception, unless Safe Income is deemed as

mentioned above to be less than its actual tax paid retained earnings due to a reduction in the accrued gain on the shares. 3. Generalizations: 3.1. Whenever there is a transfer of shares by an individual to a non-arm's length corporation, s.84.1 deemed dividends should be considered. 3.2. Whenever there is an inter-corporate tax-free dividend in excess of safe income, s.55 (2) should be considered.