LAW 665 – CORPORATE TAXATION

H MICHAEL DOLSON

Fall 2018

Case Law Ratios and Names (for visibility)Case Law Tests

Statutory Provisions (for visibility)Statutory Tests

General Principles

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LAW 665 – CORPORATE TAXATION.............................................................................................IH Michael Dolson ....................................................................................................................................................................... i

Fall 2018................................................................................................................................................................................. i

I: TAXATION OF PARTNERSHIPS....................................................................................................1I–I: TAX TREATMENT OF PARTNERS AND PARTNERSHIPS...................................................................................1

The Legal Status of Partnerships – General Principles ............................................................................................................. 1

Partnership Property..............................................................................................................................................................1Partnership Income................................................................................................................................................................1Transfers to and from Partnerships........................................................................................................................................1Tax-Deferred Transfers of Property to Partnership...............................................................................................................1Advantages and Disadvantages of Partnership Taxation.......................................................................................................2

Types of Partnerships ................................................................................................................................................................ 3

Basic Principles.....................................................................................................................................................................3Canadian Partnerships...........................................................................................................................................................3Professional Partnerships.......................................................................................................................................................3SIFT Partnerships..................................................................................................................................................................3Limited Partnerships..............................................................................................................................................................4Corporate Law Characteristics of the Partnership.................................................................................................................4

Taxation of Income or Loss as Realized Through a Partnership ............................................................................................... 5

Taxation of Partnership Income.............................................................................................................................................5Determining the Fiscal Period of a Partnership.....................................................................................................................6Reporting Partnership Income – The Impact of Capital Cost Allowance.............................................................................6Reporting Partnership Income – Accounting for Salaries, Rents, Leases, and Other Entitlements......................................7

Partnership Interests ................................................................................................................................................................... 8

The Basic Nature of the Partnership Interest.........................................................................................................................8Other Adjustments to ACB for Partnership Interests............................................................................................................9Calculating Adjusted Cost Base At the End of a Fiscal Period...........................................................................................10Disposal of a Partnership Interest During the Fiscal Period................................................................................................11

II: CORPORATE TAXATION – GENERAL PRINCIPLES: CLASSIFICATION, RATES AND DEDUCTIONS, ASSOCIATIONS AND RELATION........................................................................12

II–I: CHARACTERIZATION AND RATES OF TAXATION OF THE CORPORATION..............................................12

The Corporation as a Separate Taxable Entity ........................................................................................................................ 12

The Corporation as Taxpayer..............................................................................................................................................12Theories Underlying the Taxation of Corporate Income.....................................................................................................12

Classification of Corporations ................................................................................................................................................. 12

Classification of Share Ownership and Corporations..........................................................................................................12The Concept of Control.......................................................................................................................................................13The Concept of Residence...................................................................................................................................................14

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Corporate Tax Rates ................................................................................................................................................................ 14

Process for Reaching the End Tax Rate..............................................................................................................................14Summary of Combined Federal-Provincial Tax Rates........................................................................................................15The General Federal Tax Rate, the Provincial Abatement, and the General Rate Reduction.............................................15Exceptions to the General Rates – Investment Income, Personal Services Businesses, and Specified Investment Business Income.................................................................................................................................................................................15

II–II: THE SMALL BUSINESS DEDUCTION............................................................................................................18

The Small Business Deduction – Availability and Amount .................................................................................................... 18

Exceptions to the General Rules – The Small Business Deduction....................................................................................18Conditions for the Small Business Deduction.....................................................................................................................18The Effect of Associated Corporations on the Small Business Deduction.........................................................................18

Specified Partnership Income .................................................................................................................................................. 19

Calculating Specified Partnership Income...........................................................................................................................19Supporting Rules.................................................................................................................................................................19Calculating SPI – Deducting Business Losses and Expenses.............................................................................................20

Other Adjustments to SBD Base ............................................................................................................................................. 22

Specified Corporate Income................................................................................................................................................22Taxable Corporate Capital and Investments........................................................................................................................22

II–III: ASSOCIATION AND RELATIONSHIP............................................................................................................23

Relationship ............................................................................................................................................................................. 23

Relatedness Generally.........................................................................................................................................................23Relatedness..........................................................................................................................................................................23

Association .............................................................................................................................................................................. 24

Modelling Ownership and Association...............................................................................................................................27

III: CORPORATE TAXATION – DIVIDENDS AND CORPORATE DISTRIBUTIONS.................31III–I: REFUNDABLE DIVIDEND TAX ON HAND (RDTOH).................................................................................31

Investment Income – Dividend Refunds and Refundable Tax on Hand (RDTOH) ................................................................ 31

Principles Underlying the RDTOH.....................................................................................................................................31The ITA’s RDTOH Mechanism..........................................................................................................................................31Breaking Down the Application of the Dividend Refund/RDTOH....................................................................................32Calculating RDTOH............................................................................................................................................................33Present Day RDTOH Regime..............................................................................................................................................35

III–II: TYPES OF CORPORATE DISTRIBUTIONS....................................................................................................36

Corporate Capital Structure – Debt and Equity ....................................................................................................................... 36

Distinguishing Debt and Equity...........................................................................................................................................36

Taxable Events for Debt, Equity, Options, Interest & Dividends ........................................................................................... 36

Issuing Debt or Equity.........................................................................................................................................................36Issuing Options....................................................................................................................................................................36

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Cancelling Debts..................................................................................................................................................................37Cancelling Shares................................................................................................................................................................37Paying Interest or Dividends...............................................................................................................................................37Receiving Interest or Dividends..........................................................................................................................................37Summary..............................................................................................................................................................................38

III–III: TAXATION OF DIVIDENDS TO SHAREHOLDERS......................................................................................39

Canada’s Integration Approach to Taxation of Dividends ...................................................................................................... 39

Integration of Corporate Profits...........................................................................................................................................39The Income Tax Act’s Approach to Integration..................................................................................................................39

Dividend Integration ................................................................................................................................................................ 40

Dividend Integration – CCPC’s...........................................................................................................................................40Dividend Integration – Non-CCPC’s...................................................................................................................................41Dividend Integration – GRIP...............................................................................................................................................41Dividend Integration – LRIP...............................................................................................................................................41Designations and Excesses..................................................................................................................................................41Calculating the Dividend Tax Credit...................................................................................................................................42Principles Behind the Dividend Tax Credit.........................................................................................................................43

III–IV: TAXATION OF DIVIDENDS BETWEEN CORPORATIONS..........................................................................44

Treatment of Inter-Corporate Dividends ................................................................................................................................. 44

Exempting Inter-Corporate Dividends from Taxation........................................................................................................44

Part IV Tax on Intercorporate Dividends ................................................................................................................................ 45

Part IV Tax as an Anti-Deferral Mechanism.......................................................................................................................45Mechanism for Part IV Tax and Part IV Tax Refund..........................................................................................................45Qualifying for the Part IV Tax and Part IV Tax Refund.....................................................................................................45Further Details on Part IV Tax............................................................................................................................................46Calculating Part IV Tax Consequences...............................................................................................................................47

III–V: CAPITAL DIVIDENDS , IN SPECIE DIVIDENDS, AND STOCK DIVIDENDS.............................................50

Tax on Split Income (“TOSI”) ................................................................................................................................................ 50

Policy Rationale Behind TOSI............................................................................................................................................50Who is Subject to TOSI?.....................................................................................................................................................50

Capital Dividends and the Capital Dividend Account ............................................................................................................. 50

Defining Capital Dividends.................................................................................................................................................50Capital Dividends as Tax-Free Dividends...........................................................................................................................50The Capital Dividend Account............................................................................................................................................51Constituent Elements of the CDA.......................................................................................................................................52Calculating CDA.................................................................................................................................................................53

Dividends in Kind and Stock Dividends ................................................................................................................................. 53

Dividends in Kind (In Specie) and Stock Dividends...........................................................................................................53Tax Effects of an In Specie Dividend..................................................................................................................................55Tax Effects of Stock Dividends...........................................................................................................................................55Subsection 15(1.1)...............................................................................................................................................................57

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IV: CORPORATE TAXATION – DEEMED DIVIDENDS...............................................................58IV–I: SHARE ATTRIBUTES – PAID-UP CAPITAL AND SURPLUS STRIPPING...................................................58

Paid-Up Capital ....................................................................................................................................................................... 58

Distinguishing Capital Payments and Dividends................................................................................................................58Paid-Up Capital...................................................................................................................................................................58Calculating PUC..................................................................................................................................................................59

IV–II: SECTION 84 – STANDARD DEEMED DIVIDENDS FOR SURPLUS STRIPPING........................................61

Section 84: The Deemed Dividend Rules ................................................................................................................................ 61

Section 84(1) – General Deemed Dividend Rule................................................................................................................61Section 84(2) – Winding-Up, Discontinuance, or Reorganization of a Corporation’s Business........................................62Section 84(3) – Redeeming, Acquiring, or Cancelling of Shares........................................................................................62Section 84(4) – Reduction of PUC in Shares......................................................................................................................63Application of the Deemed Dividend Rules........................................................................................................................63

IV–III: SECTION 84.1 – DEEMED DIVIDENDS ON NON-ARM’S LENGTH SHARE SALES..............................66

Section 84.1 – Bright-Line Deemed Dividends ....................................................................................................................... 66

The Purpose of Section 84.1................................................................................................................................................66Conditions of Application for Section 84.1.........................................................................................................................67Section 84.1(b) – Non-Share Consideration........................................................................................................................69Section 84.1(2)(a.1) – Adjustments to Calculation of ACB................................................................................................70Sections 84.1(2)(b) & 84.1(2.2) – Determining Non-Arm’s Length Status........................................................................71Matrix of Section 84.1 Scenarios.........................................................................................................................................72Section 84.1 Plan.................................................................................................................................................................73

V: CORPORATE TAXATION – TRANSFERS OF PROPERTY......................................................74V–I: ROLLOVER TRANSACTIONS............................................................................................................................74

Rollover of Property under Section 85 .................................................................................................................................... 74

Rollover Transactions Generally.........................................................................................................................................74Conditions for Application of Section 85............................................................................................................................74

Elected Amounts for Allocating Cost for Typical Rollover Transactions .............................................................................. 75

Sections 85(1)(b), 85(1)(c), 85(1)(c.1) & 85(1)(e.3) – Determining the Elected Amount..................................................75Sections 85(1)(f)–85(1)(h) – Allocating Cost to Received Consideration..........................................................................76Elections in Excess of Statutory Maximums.......................................................................................................................76

Rollovers of Other Property ..................................................................................................................................................... 77

Elections Under the Minimum Amount, Rollovers of Inventory, and Treatment of Accrued Losses................................77Rollover of Depreciable Capital Property...........................................................................................................................78Tax Consequences of an Overpaid Rollover Transaction...................................................................................................79Issuing Subsidiary Shares as Consideration in a Rollover Transaction..............................................................................80Isolating Accrued Capital Gains..........................................................................................................................................81

Supplementary Rules for Rollover Transactions ..................................................................................................................... 81

Section 85(1)(e.2) – Targeting Non-Arm’s Length Section 85(1) Elections......................................................................81

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Section 85(5) – Rollover Transactions of Depreciable Property.........................................................................................82Section 85(2.1) – The “Gap-Filler” Rule.............................................................................................................................83Consolidated Application of Surplus Stripping Rules.........................................................................................................84

Stop-Loss Rules ....................................................................................................................................................................... 86

Sections 13(21.2), 40(3.4) & 40(3.6)...................................................................................................................................86

V–II: SHARE EXCHANGES........................................................................................................................................88

Capital Reorganizations and Share-for-Share Exchanges: Sections 51, 86 & 85.1 ................................................................ 88

Share Exchange Rationale...................................................................................................................................................88

Section 51 – Basic Share Exchanges ....................................................................................................................................... 89

Section 51(1) – Conditions..................................................................................................................................................89Section 51(1) – Effects........................................................................................................................................................89Section 51(2) – Anti-Avoidance Rule for Shortfall of Transferred Property......................................................................89Section 51(3) – PUC Reduction Rule..................................................................................................................................90Applying Section 51............................................................................................................................................................90

Section 86 – Share-for-Share Exchanges During Reorganization of Capital .......................................................................... 91

Section 86(1) – Conditions..................................................................................................................................................91Section 86 – Effects.............................................................................................................................................................92Sections 86(2) & 86(2.1) – Shortfall of Consideration and PUC Reductions.....................................................................92

Section 85.1 – External Share Exchanges ............................................................................................................................... 94

Section 85.1 – Conditions....................................................................................................................................................94Section 85.1 – Effects..........................................................................................................................................................95Section 85.1(2.1) – PUC Grind on External Exchanges......................................................................................................95Application of Section 85.1.................................................................................................................................................95

VI: FLOWCHART................................................................................................................................IIs the Income Taxable? ............................................................................................................................................................... i

Classification of Income......................................................................................................................................................... i

Taxation of Corporate Income .................................................................................................................................................... i

Usual Rate............................................................................................................................................................................... iSmall Business Rates.............................................................................................................................................................. iInvestment Income................................................................................................................................................................ iiOther Exceptions to General Rates........................................................................................................................................ii

Distribution of Corporate Earnings ........................................................................................................................................... ii

Tax Effects for Individual When Dividend Received...........................................................................................................iiTax Effects for Corporations When Dividend Received......................................................................................................iiiConsiderations for Corporation Issuing Dividend................................................................................................................iii

Deemed Dividends ................................................................................................................................................................... iii

Section 84............................................................................................................................................................................. iiiSection 84.1.......................................................................................................................................................................... iv

Transfers of Property ................................................................................................................................................................ iv

Rollover of Non-Share Property........................................................................................................................................... iv

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Share Exchanges....................................................................................................................................................................v

General Considerations .............................................................................................................................................................. v

VII: KEY PROVISIONS..................................................................................................................VII

II–I: CHARACTERIZATION AND RATES OF TAXATION OF THE CORPORATION..............................................VII

Corporate Tax Rates ................................................................................................................................................................ vii

Process for Reaching the End Tax Rate..............................................................................................................................viiSummary of Combined Federal-Provincial Tax Rates........................................................................................................vii

II–II: SMALL BUSINESS DEDUCTIONS..................................................................................................................VII

The Small Business Deduction – Availability and Amount .................................................................................................... vii

Conditions for the Small Business Deduction.....................................................................................................................vii

Specified Partnership Income ................................................................................................................................................. viii

Calculating Specified Partnership Income.........................................................................................................................viiiCalculating Specified Partnership Losses..........................................................................................................................viii

III–I: REFUNDABLE DIVIDEND TAX ON HAND (RDTOH)...............................................................................VIII

Investment Income – Dividend Refunds and Refundable Tax on Hand (RDTOH) .............................................................. viii

RDTOH Calculation...........................................................................................................................................................viii

III–III: TAXATION OF DIVIDENDS TO SHAREHOLDERS......................................................................................IX

Dividend Integration ................................................................................................................................................................. ix

Integration of CCPC Dividends/LRIP Dividends/Non-Eligible Dividends.........................................................................ixIntegration of Non-CCPC Dividends/GRIP Dividends/Eligible Dividends.........................................................................ixCalculating LRIP/GRIP Accounts........................................................................................................................................ ix

III–IV: TAXATION OF DIVIDENDS BETWEEN CORPORATIONS...........................................................................X

Part IV Tax on Intercorporate Dividends .................................................................................................................................. x

Part IV Tax and Part IV Tax Refund.....................................................................................................................................x

III–V: CAPITAL DIVIDENDS , IN SPECIE DIVIDENDS, AND STOCK DIVIDENDS...............................................X

Capital Dividends and the Capital Dividend Account ............................................................................................................... x

The Capital Dividend Account..............................................................................................................................................x

IV–II: SECTION 84 – STANDARD DEEMED DIVIDENDS FOR SURPLUS STRIPPING.........................................X

Sections 84 – The Deemed Dividend Rules .............................................................................................................................. x

Section 84(1) – General Deemed Dividend Rule..................................................................................................................xSection 84(2) – Winding-Up, Discontinuance, or Reorganization of a Corporation’s Business.........................................xiSection 84(3) – Redeeming, Acquiring, or Cancelling of Shares........................................................................................xiSection 84(4) – Reduction of PUC in Shares.......................................................................................................................xi

IV–III: SECTION 84.1 – DEEMED DIVIDENDS ON NON-ARM’S LENGTH SHARE SALES.............................XII

Section 84.1 – Bright-Line Deemed Dividends ...................................................................................................................... xii

Conditions of Application for Section 84.1.........................................................................................................................xiiSection 84.1(b) – Non-Share Consideration........................................................................................................................xii

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V–I: ROLLOVER TRANSACTIONS...........................................................................................................................XII

Rollover of Property under Section 85 .................................................................................................................................... xii

Section 85 – Rollover Transactions Generally....................................................................................................................xii

Elected Amounts for Allocating Cost for Typical Rollover Transactions ............................................................................. xiii

Sections 85(1)(b), 85(1)(c), 85(1)(c.1), 85(1)(e.3) & 85(1)(e) – Determining the Elected Amount.................................xiiiSections 85(1)(f)–85(1)(h) – Allocating Cost to Received Consideration.........................................................................xiii

Supplementary Rules for Rollover Transactions .................................................................................................................... xiv

Section 85(1)(e.2) – Targeting Non-Arm’s Length Section 85(1) Elections.....................................................................xivSection 85 – Rollover Transactions of Depreciable Property............................................................................................xivSection 85(2.1) – The “Gap-Filler” Rule............................................................................................................................xiv

Stop-Loss Rules ...................................................................................................................................................................... xiv

Affiliation Rules for Stop Loss Rules.................................................................................................................................xivThe Stop Loss Rules...........................................................................................................................................................xiv

V–II: SHARE EXCHANGES.......................................................................................................................................XV

Section 51 – Basic Share Exchanges ....................................................................................................................................... xv

Section 51(1) – Conditions..................................................................................................................................................xvSection 51(1) – Effects........................................................................................................................................................xvSection 51(2) – Anti-Avoidance Rule for Shortfall of Transferred Property......................................................................xvSection 51(3) – PUC Reduction Rule.................................................................................................................................xvi

Section 86 – Share-for-Share Exchanges During Reorganization of Capital ......................................................................... xvi

Section 86(1) – Conditions.................................................................................................................................................xviSection 86 – Effects............................................................................................................................................................xviSections 86(2) & 86(2.1) – Shortfall of Consideration and PUC Reductions....................................................................xvi

Section 85.1 – External Share Exchanges .............................................................................................................................. xvi

Section 85.1 – Conditions...................................................................................................................................................xviSection 85.1 – Effects........................................................................................................................................................xviiSection 85.1(2.1) – PUC Grind on External Exchanges...................................................................................................xvii

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I: TAXATION OF PARTNERSHIPS

I–I: TAX TREATMENT OF PARTNERS AND PARTNERSHIPS

THE LEGAL STATUS OF PARTNERSHIPS – GENERAL PRINCIPLES

Partnership Property

- Partnership property encompasses all property entrusted into the partnership, with each partner holding a property interest in that property.

o The law therefore treats a partnership as an entity which could own property, with each partner holding an indirect property interest in the partnership’s property based on their contribution.

o The Income Tax Act treats the transfer of property to and from a partnership as if a partnership were an entity separate from the partners.

- Each partner’s partnership interest is a property interest separate from the underlying partnership assets.o This separate partnership interest may be acquired and disposed of by the partners in the same manner as shares

in a corporation.o Adjustments to the cost base of a partnership interest must be made to preserve the conduit approach to the

taxation of income as earned through the partnership. These adjustments are designed to ensure that income or loss is recognized only once in the hands of

the partners and not again on the disposition of partnership interests.

Partnership Income

- The partnership will also compute its income and loss as if it was a separate taxpayer to the partner; the partnership essentially acts as a “conduit” with income calculated at the partnership level and thereafter the income is allocated to the partners, who will then pay tax on their share of the partnership income as earned.

o The partnership will compute its income and losses separately, and then allocate income and losses to the individual partners based on the terms set out in the partnership agreement.

The rate of tax on the partnership will thus be the aggregate of each partner’s rate of tax, and not some individual rate of tax that applies first to the partnership.

Transfers to and from Partnerships

- Absent any deferral rule, any transfer to and from partnerships are considered a taxable disposition.- A partner transferring their partnership interest are giving up their interest in the property.

o The recipient of the disposition acquires a partnership interest in the asset (which is then partnership property).o The nature of the property rights in the partnership asset transferred necessitates a taxable event.

Tax-Deferred Transfers of Property to Partnership

- Transfer to partnership under ss. 97(2) of the ITA.o Part of the consideration received by the transferor must consist of the property interest, and the transfer must

be made under an election to ss. 97(2).o Allows for a tax-free transfer to partnership where the recipient receives a partnership interest for all or part of

the transfer’s consideration. The extent to which the transfer is tax-deferred depends on the extent to which the consideration

consists of partnership interest or partnership units.o Without the ss. 97(2) election, ss. 97(1) applies and deems a taxable disposition to occur at fair market value.

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o Under ss. 97(2)(b), if the disposition includes consideration other than the property interest, the appropriate adjustments to the ACB to the disposing partner will be made:

Any proceeds received for the partnership interest which are worth more than the FMV of the consideration received will be added to the ACB of the partner’s partnership interest.

The FMV of any consideration received by the transferor (other than any partnership interest) in excess of the FMV of the partnership property will be deducted from the ACB of the partner’s partnership interest.

Both sides agree that paragraph 97(2)(b) increases the ACB of the transferor's partnership interest by an amount equal to the elected amount (subparagraph 97(2)(b)(i)), less any non-share consideration or boot (subparagraph 97(2)(b)(ii)).

Iberville Developments Ltd v The Queen, 2018 TCC 102

o ACB will be increased by the elected amount, minus the value of any consideration (excluding the partnership interest) received for the asset. If the FMV of the consideration received is greater than the FMV of the asset, that difference will be deducted from ACB.

- Winding-up of the partnership under ss. 98(3) of the ITA.o Where an election to the subsection is filed, each partner who was a partner immediately prior to the winding-

up of the partnership receives an undivided interest in the partnership property in accordance to their apportioned interest in the partnership.

- Dissolution by operation of law under ss. 98(5) of the ITA.o Disposition whereby only one partner (individual or corporation) remains.

The sole partner acquires all of the interest and property of the partnership, and is treated as disposing of their partnership interest in a tax-free disposition.

Advantages and Disadvantages of Partnership Taxation

1) Partners receive the benefit of flow-through of losses incurred at the partnership level.o Any losses from a partnership are considered business losses and may be deducted by the partner against other

income earned outside of the partnership.o Corporations do not flow-through losses; in essence, the losses incurred by a corporation cannot be deducted by

a shareholder against their employment income, while the losses incurred by a partnership may be.2) Income earned through the partnership is not taxed at the level of the partnership and again in the hands of the partners

(i.e. double taxation). There is only one level of taxation for partnership income .o Corporations and shareholders are taxed at two levels.

Persons at the lowest marginal tax rates would prefer to earn business income through a partnership, while persons at the highest marginal tax rates would prefer to earn income through a corporation.

3) Winding-up a partnership on a tax-free basis is easier with partnerships with the transfer of property from a partnership to partners than with corporate property transferred to shareholders.

o In general, whenever a corporation is wound up to shareholders in circumstances other than the creation of a 90% shareholder, the winding-up of the corporation will be a taxable event.

o Therefore, winding-up of partnership is comparatively easier on a tax-free basis.4) As a disadvantage, a partnership is not entitled to the low rate of tax on active business income or manufacturing and

processing profits – both of which are unique to corporations.o The small business deduction reduces the rate of corporate tax to 12% (from 27%) for the first $500,000 of

corporate income, allowing for massive tax savings and deferrals; not available to partnerships.5) Subject to anti-avoidance rules (ss. 103(1) & 103(1.1)), a partnership has a lot of flexibility to change how income is

allocated to partners on a year-to-year basis.

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o If partners have different tax situations or the business involvement of each partner in a partnership varies, the partnership is advantageous due to allowing easy adjustment of the partnership income.

With corporations, dividends paid are firmly fixed on the allocation of shares to shareholders, which cannot be readily adjusted.

o However, s. 103(1) of the ITA prevents partnerships from adjusting their partnership agreements such that otherwise payable tax is reduced or postponed.

o Section 103(1.1) applies for non-arm’s length agreements between partners to apportion income or losses in unreasonable proportions, and as with s. 103(1), adjusts the agreement such that the apportioning of income or losses will “be deemed to be the amount that is reasonable in the circumstances”.

6) Having a flow-through of income on an annual basis reduces opportunities to defer the realization of income.o With corporations, there are greater options for deferral of income (i.e. not issuing dividends so as to take

advantage of the 27% corporate tax rate rather than the 48% marginal tax rate).

TYPES OF PARTNERSHIPS

Basic Principles

- Four relevant types of partnerships:o Limited partnerships.o Canadian partnerships.o Professional partnerships.o Specified investment flow-through (SIFT) partnerships.

- A partnership may be more than one type of partnership at once.o Most limited partnerships are Canadian partnerships.o Most professional partnerships are Canadian partnerships (but are often not limited partnerships).

Canadian Partnerships

- The Canadian partnership is a partnership in which every member of the partnership is a Canadian resident (s. 102(1)).o All of the tax-deferred transfers discussed above are only available with Canadian partnerships.o Availability of the tax deferral rules only to Canadian partnerships goes back to the idea that partnerships are

not subject to entity-level tax. Canada has no means to tax at the partner-level the realization of assets of foreign partners.

Solution is to simply not allow a tax-free disposition of partnership assets to foreign partners.

Professional Partnerships

- Professional partnerships are less important (ss. 34 & 96(1)) and are generally defined as people carrying on some sort of professional practice.

SIFT Partnerships

- A SIFT partnership is defined in s. 197(1) and describes a publicly-traded partnership which owns a non-portfolio property (business asset, real estate, or interest in another entity).

o Captures partnerships which are substituted for corporations to take advantage of flow-through losses. - In 2006, many corporate and real estate assets with predictable income established business structures – income trust

structures (with mutual funds, trusts, etc) – which basically eliminated the corporate tax base.o Part 9.1 of the ITA establishes SIFT tax: a SIFT trust or SIFT partnership is subject to a proxy of corporate tax

which is imposed on the income of a partnership.o Sections 96(1.11) & 197(2) apply dividend treatment to income from the partnership’s non-portfolio properties.

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Limited Partnerships

- At least one partner will have unlimited liability for the debts or losses of the partnership ( general partners), and another partner will have liability limited only to their capital contribution to the partnership (limited partners).

- Usually used when one partner wants to be protected from losses (like a corporation), but another partner wants to take advantage of flow-through of losses.

- Very important and common partnership subtype.- For the most part, limited partners are taxed the same as a non-limited partnership.

o Limited partnerships are subject to ss. 96(2.1–2.7) “at-risk” rules, which restrict flow-through losses based on the ACB computation and the partner’s contribution, sans loans and non-recourse debt incurred by the partners.

Sections 96(2.1)(b)(i) & 96(2.2)(a) are the principal sections which create the “at-risk” rule: Section 96(2.2) provides the definition for “at-risk amount” – the ACB of the partnership

interest, as adjusted by ss. 53(1)(e)(i) & 53(1)(e)(viii) (further infra).o The at-risk amount is the amount the partner may lose if the partnership fails.

Section 96(2.1)(b)(i) provides as the upper limit for any deductible losses the at-risk amount. Aims to prevent flow-through losses in excess of a partner’s cash contribution to the partnership (as

noted in s. 96(2.2), this contribution is the ACB of the partner’s partnership interest). Ex. A partner invests $10,000 for their partnership interest. They may only realize up to that

amount for flow-through loss for, say, a $100,000 loss by the partnership.o Deemed disposition of interest (ss. 40(3.1) & 40(3.11)).

Once allocated to a partner’s ACB computation, realized capital gains may cause the partner’s ACB computation to become negative.

General partners may carry a negative ACB indefinitely; limited partners cannot carry a negative ACB. If they do, at the end of the fiscal period, s. 40(3.1) will apply and treat the limited partner as

having made a taxable disposition equal to the absolute value of the ACB which is then added to the value of the limited partner’s partnership interest, thus bringing the ACB of the interest to zero. This is a taxable event and thereby realizing of a capital gain.

Section 40(3.11) provides the calculation for the value of this deemed disposition as being essentially a capital gain; “any negative adjusted cost base of a limited … partner is deemed to be a capital gain”.

A limited partner’s ACB adjusts from contributions, withdrawals, and income/loss allocation. If it becomes negative, the limited partner could realize a capital gain.

Corporate Law Characteristics of the Partnership

- When does a partnership exist for income tax purposes?o A partnership exists for income tax purposes if the partnership exists for commercial law purposes.

Two or more persons carrying on business in common with a view to profit. “Business” has a very broad meaning and encompasses things that usually are not business for

income tax purposes (ex. Owning a rental property). “View to profit” may be ancillary to another purpose, so long as it exists. “In common” is the least well-developed portion of the test.

o Usually established where there is an agreement to split the net profits/losses in a previously agreed-upon manner.

o CRA states, administratively, that they look for joint contributions to the partnership, joint ownership of property via the partnership, shares in the profits, mutual control in the business of the partnership, and whether the partners assist one another as partners.

- What distinguishes a partnership from a joint venture or joint tenancy?

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o Defining a “joint venture” is difficult, but CRA defines it through the following attributes: joint interest in the property of the venture, mutual control ins the property or enterprise, and a limited objective.

CRA does not note that joint ventures must not hold themselves out as partners, and they must indicate that they are joint ventures and not partners.

o Partnerships can delegate authority to a managing partner to conclude things (which joint ventures cannot), partnerships can bind other partners to contracts without the bound partner’s awareness, and partnerships can carry on indefinitely and change business.

o There are material tax differences between partnerships and joint ventures. Partnerships compute net income and loss first, and then allocates to partners per the partnership

agreement (or the Partnership Act). Joint ventures allocate to each constituent party component revenue and expenditures, rather than a

single combined sum. Joint ventures are not entities or even quasi-entities, which means there is no possibility to transfer

property on a tax-free basis to or from a joint venture (i.e. there is no equivalent concept of “joint venture property”).

TAXATION OF INCOME OR LOSS AS REALIZED THROUGH A PARTNERSHIP

Taxation of Partnership Income

- Partnerships function as a flow-through: computes income or loss and then allocates the income or loss to the partners.o The partnership is an intermediary through which income is flowed rather than as a separate taxable entity with

the capacity to bear the burden of taxation: income or loss is calculated at the level of the partnership and is allocated and taxed in the hands of the persons for whom it is earned.

- Partners are taxed based on allocation and not based on distributions.o Distributions do impact ACB, but are otherwise not at all relevant to the computation of a partner’s tax payable.

- Partnerships are not “taxpayers”.o Section 248(1) sets out definitions for “taxpayer” as being a “person”. Partnerships are not included as

“persons”. As a result, partnerships are not taxpayers.- Section 96(1) applies where a taxpayer is a member of a partnership.

o Section 96(1.01) causes s. 96(1) to apply to a person who is no longer a member of a partnership, but was at some previous time.

- The application of s. 96(1) requires a member of a partnership to include in his/her income his/her share of partnership income as if he/she had earned that income directly.

o Section 96(1)(a) requires a partnership to compute its income as if it were a person. o Section 96(1)(b) requires the partnership to use its accounting period as its fiscal period and as its taxation year.o Section 96(1)(c) deems a partner to be a person who has carried on every business activity, and to have realized

every gain or loss (whether capital or business) as realized by the partnership.o Section 96(1)(f) deems a partner to have earned their share of the partnership’s income for the partnership’s

taxation year from the same source or place as the partnership did and in that taxation year. Important for the purposes of the small business deduction and foreign tax credits.

o Section 96(1)(g) deems a partner to incur any loss from the same source or place as the partnership did.- Sections 110.1(4) & 118.1(8) deal with charitable donations, which are not realized at the partnership level.

o These sections push the donation to the partnership level, and each partner is thereafter considered to have made the appropriate share of the donation, and each party will thereafter enjoy a credit or deduction (as applicable).

For individuals, a tax credit is created against the tax payable following a charitable donation. Corporations receive a deduction which cannot exceed 75% of the corporation’s annual income.

- Section 127(8) is a similar rule to the charitable donation, but apply instead to investment tax credits.

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Determining the Fiscal Period of a Partnership

XL Partnership has a February 1-January 31 fiscal period. In what taxation year must partnership income or loss be recognized by partners who are individuals? How must partner A Co, with an October 1-September 30 fiscal period, recognize partnership income or loss?

- Absent a rule to the contrary, income or loss is realized by each partner at the end of the partnership’s fiscal period.o To prevent deferral of tax with an “off-calendar fiscal period” maintained under s. 249(1)(f), individual partners

must include as income an estimate of the income earned in the calendar year per s. 34.1. Generally, the administrative and accounting inconvenience of maintaining an off-calendar fiscal period

means that partnerships tend to synchronize their fiscal periods with the calendar year.- Section 34.1 & 34.2 require any corporate partner that has a significant interest (>10%) in a partnership and a taxation

year different from the partnership’s fiscal period to include an estimate of the accrued partnership income such that the deferral no longer exists.

o Calculated by multiplying the partnership’s previous annual income by the time elapsed in the calendar year. The difference between the end of the partnership’s fiscal period and the remaining time left in the

corporation’s fiscal period is referred to as the stub period. The proportion of income the corporation earned from the partnership thus far in the corporation’s

fiscal period is referred to as the adjusted stub period accrual.o Helps to force all partners in a partnership to maintain the same fiscal period as the partnership.

While it is possible to maintain an off-calendar fiscal period, s. 34.2 will require the corporation to include in its income a formulaically-determined estimate of the partnership’s income earned during the corporation’s relevant taxation year.

Reporting Partnership Income – The Impact of Capital Cost Allowance

AB Partnership (a general partnership) has the following revenue and expense items for its 2018 fiscal period:Net business income (excluding CCA) $100,000CCA $25,000Taxable capital gains $10,000 ($20,000 gross gains)Dividends received $10,000Charitable donation $10,000

Partner A has a 60% entitlement to partnership income and partner B has a 40% entitlement. Both A and B are individuals. What income, loss or tax credit amounts must be reported by the partners in which taxation year? What if the net business income in the first line of revenue and expense items above is a loss (i.e. ($100,000) net business loss)?

- CCA is capital cost allowance; essentially, depreciation.o Each partner can claim a deduction against their business income based on CCA; CCA rates tend to vastly

exceed the rate of actual economic depreciation.o However, CCA tends not to apply for property.

- CCA is an expense in computing business income, and as such it must be deducted against business income.o Therefore, there is only $75,000 of business income.

- Each amount must be allocated to the partners per ss. 96(1)(c) & 96(1)(f).o The character of each amount must be maintained, and each partner must report on their returns the proportion

of partnership income afforded to them under the agreement.- Partner A (gain):

o $45,000 business income.o $6,000 taxable capital gain.o $6,000 dividends received.

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o $6,000 charitable donation as tax credit.- Partner B (gain):

o $30,000 business income.o $4,000 taxable capital gain.o $4,000 dividends received.o $4,000 charitable donation as tax credit.

- If the partnership instead reported a $100,000 business loss, the CCA allowance may still be applied.o The partnership’s total reported business income would instead be a ($125,000) non-capital loss.

- Partner A (loss):o $75,000 business loss.o $6,000 taxable capital gain.o $6,000 dividends received.o $6,000 charitable donation as tax credit.

- Partner B (loss):o $50,000 business loss.o $4,000 taxable capital gain.o $4,000 dividends received.o $4,000 charitable donation as tax credit.

- Since AB Partnership is a general partnership, these losses may be deducted freely.o Limited partnership may only allow for a limited deduction of the losses.

Reporting Partnership Income – Accounting for Salaries, Rents, Leases, and Other Entitlements

Partnership business income $100,000Partner A - 60% income entitlementPartner B - 40% income entitlement plus $25,000 salary

How must the $100,000 of business income earned at the partnership level be reported by A and B?What if the partnership was a limited partnership and B was a limited partner?

- First, is it legally possible for a partnership to contract to pay a salary to a partner in a partnership?o In theory, a partner’s salary is a contract between themselves (as an ‘employee’) and as partner of the

partnership; common employment law states that one cannot contract with themselves. CRA’s position is that partnership salaries cannot be deducted.

o The $25,000 should not be deducted from the partnership. There is therefore $100,000 of net partnership income (notwithstanding that $25,000 of that income has

been lost to pay for B’s salary).- Without deduction, there are two options:

o Cash distribution will not match the income allocation (as must be reported on the tax returns). A will only receive $45,000 in cash, but will be required to report $60,000 of partnership income.

o Preferential income allocation and cash distribution of $25,000 to B (serving as salary), and the remainder will be split 60/40.

- If this were a limited partnership, s. 28(f) of the Partnership Act prevents limited partners from being employees.

What if partner B has a 40% income and no salary entitlement, but has leased equipment to the partnership and is owed $25,000 in rent in respect of the fiscal period of the partnership?

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Alternatively, what if the partnership has leased the equipment from a stranger, with partner B lending the partnership the necessary funds for which he is owed $25,000 in interest for the current fiscal period of the partnership.

- If the $25,000 allocated to B is instead rental (for providing leased equipment) or interest (for leasing equipment from a stranger) payment, that amount would be deducted from net partnership income.

o The allocation 60/40 would thereafter be done to $75,000, and not to $100,000, without any need for a preferential payment system.

If partners wish to create a preferential payment system for a partnership, this would be better done through management fees, rents, or interest.

PARTNERSHIP INTERESTS

The Basic Nature of the Partnership Interest

- The rules for partnership interests are premised on two assumptions:o A partnership interest is property separate from the partnership’s assets.o Every partnership interest in a partnership property is a capital property, and as such every disposition will

incur a capital gain or capital loss. The partnership interest may be acquired when: Each partner pays into the partnership a sum which creates a partnership interest. A person buys a partnership interest from an existing partner, and gains an interest equal to their

payment.- Due to flow-through taxation of partnerships, the partnership interest’s ACB must be adjusted.

o This is necessitated by the ability to buy or sell partnership interests for tax purposes.o The result of non-adjustment would be double taxation or non-taxation upon disposition.

- In general:o ACB should be increased if avoiding double taxation is the goal.

If an adjusting event is already taxed or the partner receives something, ACB should be increased.o ACB should be decreased if avoiding non-taxation is the goal.

If an adjusting event is not taxed or the partner provides something, ACB should be decreased.o The capital gain upon disposing of a partnership interest is equal to the difference between sale price and ACB.o Higher ACB will indirectly result in less tax, as the realized capital gain upon disposing of the partnership

interest will be taxed less due to less capital gain.o Lower ACB will indirectly result in more tax, as the realized capital gain upon disposing of the partnership

interest will be taxed more due to more capital gains.- Section 53 requires five important adjustments:

o Addition for previously allocated income. Income previously allocated to a partner and taxed in the hands of a partner; avoids double taxation

when the interest is later disposed.o Subtraction for previously allocated losses.

Losses previously allocated to a partner and deducted in the hands of a partner; avoids double deduction when the interest is later disposed.

o Addition for value of contributed property.o Subtraction for value of distributed property.o Adjustment for non-taxable or non-deductible amounts realized by partnership.

These amounts must be added or subtracted such that the partner is not indirectly taxed on the non-taxable or non-deductible amount upon disposition of a partnership interest.

However, certain non-taxable items may nonetheless require increasing ACB (see ss. 53(1)(e)(ii) & 53(1)(e)(iii), infra).

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Partnership XYZ earns $300 of business income. Partner X’s share of the income is $100, which is taxable in his hands under subsection 96(1). However, X does not withdraw the $100 share of income and therefore it remains in the partnership to be reinvested.

- First, in not withdrawing their $100 share of income, the ACB of X’s partnership interest decreases by $100, and thus X will be required to report a $100 capital gain (with a $50 taxable capital gain) when they do dispose of the interest.

o If X instead withdrew their share of income, they would report that as business income, and would be taxed immediately. Their ACB would need to be increased, so that they are not indirectly taxed again upon disposition of their interest.

(a) What is the tax result when X sells the partnership interest and X’s $100 share of partnership income is not added to the cost of the interest? What result if the share is added to the ACB of the interest?

- If the appropriate adjustment is not made to the ACB of X’s partnership interest, then when X does sell their partnership interest, they would be taxed again on the increase of the value of the partnership interest.

o X should only be taxed on the $100 of business income allocated but not distributed when it is re-invested into the partnership. This re-investment is reflected in a decrease to the ACB of X’s partnership interest.

(b) What should the tax result be if all of the facts are the same as in (a) above, but the $300 of business income is a ($300) business loss? How might that result be realized?

- The results would be mirrored if the loss was instead a $300 business loss to the partnership.o Without ‘withdrawing’ the business loss (i.e. deducting it against other income), the ACB of X’s partnership

interest increases by $100: this is because X is essentially deferring his deduction from the business loss to when he disposes of his interest, at which point he will pay less tax due to having less of a capital gain.

(c) What should the tax result be if the $300 of business income is a non-taxable amount or the ($300) business loss is a non-deductible amount? How might that result be realized?

- If the $300 business income was non-taxable, or the $300 business loss non-deductible, no adjustments are necessary to the ACB of X’s partnership interest, unless the income was due to capital dividends or a life insurance policy.

Other Adjustments to ACB for Partnership Interests

What is the purpose of the adjustments to the ACB of a partnership interest in subparagraphs 53(1)(e)(i)-(iv) and 53(2)(c)(i), (iii), (v) and (vi)? What is the effect of clauses 53(1)(e)(i)(A) and 53(2)(c)(i)(A)? What is the reason for ignoring the relevant fractions?

- Section 53(1)(e)(i): Increases ACB of a partnership interest by the partner’s share in the partnership’s profits before a fiscal period has ended.

- Section 53(1)(e)(ii): Increases ACB of a partnership interest by any capital dividend received by a partnership and distributed to a partner.

o Capital dividends are non-taxable when received by an individual.- Section 53(1)(e)(iii): Increases ACB of a partnership interest by the allocable portion of any life-insurance policies.- Section 53(1)(e)(iv): Increases ACB of a partnership interest by the amount of any capital contributions made by the

partner to the partnership.o Instantaneous change to the ACB; does not need to wait until the end of a fiscal period.

This is due to the wording in the section of “received by the partnership before that time”, with “time” referring to the end of the fiscal period.

- Section 53(2)(c)(i): Reduces ACB of a partnership interest based on the partner’s share in the partnership’s losses (i.e. loss allocation) before a fiscal period has ended.

o As noted supra, if this reduces a general partner’s ACB below zero, a deemed capital gain is not incurred. A deemed capital gain and taxable event would be incurred for a limited partner.

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- Section 53(2)(c)(iii): Reduces ACB by the share of the partnership’s charitable donations as allocated to partner.- Section 53(2)(c)(v): Reduces ACB by amount of any partnership allocations received from a partnership.- Section 53(2)(c)(vi): Reduces ACB by amount of any investment tax credit that may “reasonably be attributed”.- Section 53(1)(e)(i)(A) & 53(2)(c)(i)(A): Allocating capital gains or losses to partners in their full amount. Will increase

the ACB of the partnership interest by the full amount of the capital gain or loss and not just the allocable portion of the gain or loss (both of which are treated as 50%).

o Wording in the ITA notes that the capital gains or losses are to be added to ACB “as if [the ITA] were read without reference to … [ss] 38(a.1) to (a.3)”. These sections are what sets out capital gains and losses to only be treated as half.

Calculating Adjusted Cost Base At the End of a Fiscal Period

X acquired a partnership interest in XYZ partnership for a $10,000 cash contribution. The fiscal period of the partnership is January 1 - December 31. For the 2018 fiscal period (January 1 - December 31, 2018) of the partnership, X's partnership account reads as follows.

business income share $30,000taxable capital gain share $7,500share of capital dividends received $5,000charitable donation share $5,000withdrawals $10,000

(a) What is the ACB of X's partnership interest as of December 31, 2018 and January 1, 2019?

- December 31, 2018:o Opening ACB due to cash contribution of $10,000.o Capital dividend and cash distributions apply immediately:

+$5,000 (capital dividends) and -$10,000 (cash withdrawals) at some point on or prior to December 31, 2018.

o ACB is now $5,000 on December 31, 2018.- January 1, 2019:

o Opening ACB of $5,000.o Increased by business income: +$30,000.o Increased by capital gain: +$15,000.

Ignores the applicable fraction: $7,500 * 2.o Reduced by charitable donation: -$5,000.o New ACB of $45,000.

- Whether or not a partner sold a unit of a partnership before or after the end of a fiscal period can therefore have a dramatic impact on the tax implications.

(b) What if X is permitted to make $75,000 in withdrawals, instead of $10,000, for the 2018 fiscal period?

- If $75,000 of withdrawals are applied in the 2018 fiscal period, the ACB will turn negative. Section 40(3.1) may thereafter apply.

o Consequences then depend on whether the partnership is a limited partnership or a general partnership. For a general partnership, ACB may be negative and remain negative without a deemed disposition. For a limited partnership, ACB turning negative will create a deemed disposition and thus a capital

gain.o If the ACB may be negative, ACB for a general partner on December 31 will be ($60,000) and on January 1

will be ($20,000). Compared to the above examples, the cash withdrawal has increased by $65,000, and as such each ACB

must be decreased by ($65,000).

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If the partner then disposes of the partnership interest at any point thereafter (as a general partner), they will realize a $60,000 capital gain.

If the partner was instead a limited partner, they may not maintain a negative ACB, and thus at the end of the fiscal period will be deemed to have disposed of their partnership interest and realize a deemed capital gain of $60,000.

Disposal of a Partnership Interest During the Fiscal Period

Assume that X disposes of his partnership interest to A on July 1, 2019 for $75,000. At the time of the sale X's share of the partnership business income for the 2019 fiscal period was $15,000. On the basis that all other facts are the same as set out above (including a $10,000 withdrawal prior to this date), what are the income tax consequences of the sale?

- Under s. 53(1)(e)(i), the income is not allocated until the end of the fiscal period.o The 2016 income to date will not be added to the ACB before the sale, at which point the partner will realize a

$30,000 capital gain. The ACB of the partnership interest is $45,000. Due to s. 53(1)(e)(i), the ACB is not increased by the

$15,000 of business income from the 2019 fiscal period. The partnership interest is sold for $75,000. The difference between this and the ACB of the partnership

interest is $30,000, so X has realized a $30,000 capital gain.- However, s. 96(1.01) may apply as a special deeming rule, which allows for a partnership to allocate income to a

retiring partner.o The fiscal period will end immediately before the time immediately before the realization of the sale (i.e. before

the application of s. 53(1)(e)(i)). Therefore, if the sale proceeds as above with the same numbers, Partner X will instead realize a

$15,000 capital gain, as the ACB of his interest has increased by $15,000 from the 2019 fiscal period’s business income.

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II: CORPORATE TAXATION –GENERAL PRINCIPLES: CLASSIFICATION, RATES

AND DEDUCTIONS, ASSOCIATIONS AND RELATION

II–I: CHARACTERIZATION AND RATES OF TAXATION OF THE CORPORATION

THE CORPORATION AS A SEPARATE TAXABLE ENTITY

The Corporation as Taxpayer

- To tax corporations, the corporation needs to be subject to the ITA first.o Section 248(1) of the ITA defines a taxpayer as any person whether or not that person is liable to tax. The

section also defines a person to include a corporation; a corporation is a taxpayer for income tax purposes.- As a taxpayer, a corporation calculates its income and taxable income using the general income calculation rules

applicable to individuals.o However, some rules are only applicable to individuals or corporations, thus making the income base somewhat

different for corporations and individuals. In general, the two income bases are largely the same.

- A corporation is liable for tax on the basis of residency or non-residency, with the tax period being the taxation year.o Section 249 defines the taxation year for a corporation as its fiscal period, as defined under s. 249.1(1).o The corporation may therefore choose its own taxation year, within the limits described in s. 249.1(1).

Theories Underlying the Taxation of Corporate Income

- Following application of the corporate tax rate, income earned and taxed at the corporate level is then taxed again when the income is distributed to an individual shareholder.

o Likewise, losses incurred by a corporation may be deducted only by the corporation as a separate taxpayer, and cannot generally be flowed-through to shareholders.

- The corporation will be taxed at the corporate rate regardless of the taxation rates applicable to the shareholder.o Shareholders may not deduct losses from a corporation against their other losses .

CLASSIFICATION OF CORPORATIONS

Classification of Share Ownership and Corporations

- The ITA includes the following six major types of corporation, with some overlap between the categories:o Public Corporation: A “resident corporation with a class of shares traded on a designated stock exchange”.

Under s. 89(1), even a corporation that is not traded on a designated exchange may elect to be considered a public corporation if it complies with the conditions in the relevant regulation.

o Private Corporation: A resident corporation that is not a public corporation and that is not controlled by either a public corporation, a Crown corporation, or any combination thereof (s. 89(1)).

o Non-Public, Non-Private Corporation: A corporation whose shares are not traded, does not have enough shareholders to elect to be a public corporation, but is owned by public corporations, Crown combinations, or any combination thereof so that the corporation is also not a private corporation.

Any rule that is not specifically applicable only to public or private corporations would apply to a non-public, non-private corporation.

However, such a corporation may still be a Canadian corporation or a CCPC if those rules apply.

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o Canadian Corporation: Any corporation incorporated in Canada is a Canadian corporation (s. 89(1)). If a corporation was incorporated outside of Canada before June 18, 1971, a corporation may be a

Canadian corporation provided it was resident in Canada for all dates after June 18, 1971. In the event of an amalgamation or merger, the merged corporation will be deemed to not be a

Canadian corporation if the amalgamation or merger was not governed by Canadian law, or if the combined corporations were not all considered Canadian corporations.

Would apply even if the amalgamated corporation was incorporated in Canada.o Taxable Canadian Corporation: A Canadian corporation not exempt from the Part 1 income tax (s. 89(1)).o Canadian-Controlled Private Corporation (“CCPC”): A Canadian corporation not controlled by some

combination of non-residents, public corporations, or enlisted corporations, and which is not listed on a designated exchange (s. 125(7)).

The ‘hypothetical shareholder corporation test’ takes every one of the prohibited grounds and attributes all shares to a particular person, and then gauges the test based on that one person.

A corporation may elect to not be a CCPC for certain purposes.

The Concept of Control

- The classification of corporations depends on the concepts of control and residence.- Control may be either de jure or de facto.

o De jure control, as defined in the case law, means control of a corporation on the basis of legal rights of particular persons.

Has been interpreted to mean ownership of a sufficient number of shares to elect the majority of the corporation’s Board of Directors, since such persons are ultimately in control of the corporation.

Case law has also held that de jure control includes “indirect control” – a person who controls a particular corporation controls all other corporations controlled by the particular corporation.

See Vineland Quarries & Crushed Stone Ltd v MNR (Exch Ct). A corporation is ultimately controlled by the person who controls any parent corporation.

See Parthenon Investments Ltd v R (FCA), where the rule applied in a ‘bottom-up’ approach.o The impugned corporation was controlled by a US corporation, which was controlled

by a Canadian corporation, which was in turn controlled by Canadian residents. Court held that the corporation was a CCPC, as the ultimate control was held

by a Canadian resident – the person highest in a chain of control. However, s. 256(6.1) of the ITA permits simultaneous control by both its immediate

shareholder and its ultimate shareholder.o Intended to overrule Parthenon Investments; if s. 256(6.1) was applied, Parthenon was

controlled simultaneously by its US parent and its ultimate Canadian resident controller, and Parthenon would not be a CCPC.

o De facto control is defined in s. 256(5.1) and requires examining factors other than the ability to elect a majority of the board.

Whether the person could do something that would be equivalent to changing the Board of Directors, or influencing shareholders in such a way to change the Board of Directors.

Capability is all that matters , not whether the de facto controller ever exercises the influence. Section 256(5.11) notes that this test is purely a question of fact, and that the form of control does not

need to be rooted in a legal right. Section 256(5.1) contains carve-outs for normal arm’s-length business arrangements, such as franchise

agreements and leases, which would otherwise likely be found to be de facto control relationships. Ex. For franchises, franchise agreements tend to be very onerous, and without the carve-out,

would be considered to de facto controlled by the franchisor corporation.

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- For the purposes of the ITA, whenever the phrase “controlled directly or indirectly in any matter whatever” is used, the concept of de facto control in ss. 256(5.1) & 256(5.11) is relevant.

- Whenever the word “controlled” is used instead, the concept of de jure control applies.- The definition of a Canadian-controlled private corporation uses the control in fact phrase, while the definition of a

private corporation incorporates the traditional de jure concept of control.o Section 251(5)(b) is included as an anti-avoidance rule.

Applies to rights under contract, including contingent rights, to acquire shares, control voting rights, or to cause a corporation to redeem/acquire shares owned by others.

Section 251(5)(b) deems the party who holds these rights to have always exercised them when considering questions of control.

o Section 256(5.1) concerns whether a corporation is a CCPC, and whether corporations are associated. Applies anywhere in the ITA where control is raised.

o Both ss. 251(5)(b) & 256(5.1) relate to legal rights that are tantamount to control, but are not actually control.

The Concept of Residence

- The concept of corporate residence is a common element in all corporate definitions.o Under s. 250(4), a corporation incorporated in Canada after April 26, 1965 is deemed to be resident in Canada.o Section 250(5) will deem a corporation to not be resident in Canada if the corporation is not resident in Canada

due to an international tax treaty. With the United States, place of incorporation is the tie-breaker rule in the tax treaty.

o In the case law, corporate residence is a question of fact.- The common law test for corporate residence is set out in the case law in the decision of De Beers Consolidated Mines

Ltd v Howe (UKHL 1906) – the central management and control test:

In applying the conception of residence to a company, we ought, I think, to proceed as nearly as we can upon the analogy of an individual. A corporation cannot eat or sleep, but it can keep house and do business. We ought, therefore, to see where it really keeps house and does business… A company resides for purposes of income tax where its real business is carried on … I regard that as the true rule, and the real business is carried on where the central management and control actually abides. [Emphasis added]

o To determine where a corporation’s “central management and control” is exercised, courts will typically look to where a corporation’s Board of Directors meets and makes decisions.

Where the Board resides is irrelevant; the test concerns where they meet to make decisions.o In most of Canada’s tax treaties, the one tiebreaker rule is for a place of effective management.o However, for Canada’s treaty with the US, place of incorporation is the tiebreaker rule.

The US does not like the place of effective management, viewing it as too easily manipulated.

CORPORATE TAX RATES

Process for Reaching the End Tax Rate

- Start with the default federal tax rate (38%).o Subtract provincial abatement (–10% 28%).

Subtract general rate reduction percentage, if applicable (–13% 15%); or Subtract small business deduction, if applicable (–18% 10%); or Add investment income tax, if applicable (10.6…% 38.6…%); and

Subtract federal rate reduction upon distributing dividends (30.6…% 8%).o Add provincial tax rate (12%/2% (SBD) 27%/12% (SBD)) / (20% for investments).

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Summary of Combined Federal-Provincial Tax Rates

- The combined federal-provincial corporate rate for small business earned income allocable to a permanent establishment in Alberta in 2018 is 12%.

- The general combined federal-provincial corporate rate for other businesses on income allocable to a permanent establishment in Alberta in 2018 is 27%.

- The combined federal-provincial corporate tax rate on income from a personal services business is 45% (further infra).- For investment income, the combined federal-provincial corporate tax rate at the pre-refund rate is 50.6…% and post-

refund rate is 20% (further infra).

The General Federal Tax Rate, the Provincial Abatement, and the General Rate Reduction

- Under s. 123(1), the general corporate tax rate for federal purposes is 38% of taxable income.o This rate is reduced, however, by 10% of the taxable income of a corporation earned in a province (as defined

by s. 124(4) and the Regulations as where a corporation has a permanent establishment). The “provincial abatement” established by s. 124(1).

o Section 123.4(2) provides a further reduction of 13% for business income not subject to the special tax treatment described below; this reduction is a product of the “general rate reduction percentage” established by s. 123.4(1) and “full-rate taxable income” as defined by s. 123.4(1).

Full-rate taxable income is business income that does not qualify for the small-business deduction and which is not earned from a personal services corporation.

If a corporation is a CCPC, then the corporation’s income from property and its taxable capital gains are also excluded from full-rate taxable income.

- The federal tax rate of eligible corporate income is thus 15%.- Alberta then tops off its provincial abatement with a tax rate of 12% in 2018.- The provincial abatement depends on a determination of “taxable income earned in a province”.

o ITA Regs 400–402 set out a series of allocation rules dependent on the concept of a “permanent establishment”.

For a corporation which has a permanent establishment in only one particular province, Regulation 402(1) deems the whole of the corporation’s taxable income to occur in that province.

Regulation 402(2) states that if a corporation has no permanent establishment in a province, no portion of its taxable income shall be deemed to have been earned in that province.

Regulation 402(3) provides how to distribute income for a corporation with permanent establishments in more than one province.

o Assume that all corporations earn income from a single permanent establishment in Alberta, and all corporate income is from that permanent establishment: all income will be assumed to qualify for the abatement.

Exceptions to the General Rates – Investment Income, Personal Services Businesses, and Specified Investment Business Income

- Investment income (other than intercorporate dividends) of a CCPC is subject to an additional special tax of 10.6…% under s. 123.3 and does not qualify for the general rate reduction (as it is not full rate taxable income) or the small business deduction.

o The additional special tax is applied after the provincial abatement (38% – 10% + 10.6…%).o As such, investment income is subject to a federal rate of 38.6…%, along with the 12% provincial tax rate.o When the income is distributed as a dividend, a federal rate reduction of 30.6…% applies.o On distribution, such income earned is thus subject to a federal rate of 8% (38.6…% minus the 10% provincial

abatement and the 30.6…% “refundable tax”, offsetting the earlier 10.6…% increase from the federal special tax), and then the 12% provincial rate applies.

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o The combined federal-provincial corporate rate on this type of income allocable to Alberta is therefore 50.6…% before the rate reduction applies, and 20% after it applies.

- Income from a “personal services business” (i.e. an incorporated employee) is excluded from the definition of “full rate taxable income” due to the application of ss. 123.4(1)(a)(iii) & 123.4(1)(b)(i).

o Although the provincial abatement applies, such income is ineligible for the small business deduction.o Defined as a corporation where services are being carried out by a specified shareholder who owns 10% or

more of any class of shares in the corporation where the shareholder would be an employee of the recipient of the services but for the corporation.

o “Personal services business” and “active business carried on by a corporation” are both defined in s. 125(7).o Section 123.5(7) imposes an additional tax of 5%; the federal tax rate on a personal services business is 33%.o The combined federal-provincial corporate tax rate on income from a personal services business is 45%.

- Under s. 125(7), specified investment business income is income from a business whose principal purpose is to earn interest, dividends, rents (other than rents for personal property), and royalties, and which does not have more than five full-time employees in that business (i.e. to earn interest, dividends, rents, and/or royalties).

o The employee carve-out is so that even ‘passive’ income has enough of a human input to convert such income to business income.

o As held in 489599 BC Ltd v The Queen (TCC 2008), “more than five full-time employees” does not mean at least six full-time employees: five full-time employees plus one part-time employee would be sufficient.

o For such business, the small business deduction does not apply, and the income is taxed as investment income.

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II–II: THE SMALL BUSINESS DEDUCTION

THE SMALL BUSINESS DEDUCTION – AVAILABILITY AND AMOUNT

Exceptions to the General Rules – The Small Business Deduction

- In 2018, the federal rate on active business income of a Canadian-controlled private corporation (“CCPC”) eligible for the small business tax credit is reduced to 10% (38% minus the 10% provincial abatement and the 18% federal small business credit, as set out in ss. 125(1) & 125(1.1)).

o The amount of active business income eligible for this reduced rate is $500,000, which must be shared by associated corporations.

For the purposes of the course, assume that all business income has been earned by a corporation with a calendar year fiscal period, and that the corporation’s relevant taxation year is 2018.

o Section 125(1) sets when the small business credit applies, and s. 125(1.1) sets out the rate.o Cannot be combined with the general rate percentage.

- The provinces also tax active business income of CCPCs at reduced rates.o For Alberta, the small business rate is currently 2% (due to a 10% deduction), with the exact same

qualifications and monetary limit as the federal rates.- Between the two small business deductions, the combined federal-provincial tax rate for the first $500,000 of business

income for a CCPC which qualifies for the credit is 12%.

Conditions for the Small Business Deduction

- Corporation must be a CCPC throughout the taxation year in which the deduction is claimed (Preamble of s. 125(1)).o Essentially only requires determining a corporation to be a CCPC at the start of a taxation year; the ‘check’ for

the classification is at the end of a taxation year. - Section 125(1) sets out ‘caps’ on how the deduction may be applied, with the smallest applying:

o Section 125(1)(a) caps the deduction to income from active business carried out in Canada, its “specified partnership income”, its “specified corporate income”, less non-partnership Canadian active-business losses and specified partnership losses. In other words, includes all of:

Income from active business carried out by the corporation, minus income described in the definition of “specified corporate income” or “specified partnership income” or income received from a corporation that made a s. 256 election;

The “specified corporate income”; and The “specified partnership income”.

o Section 125(1)(b) caps the deduction to a corporation’s taxable income that is not exempt from Canadian tax by virtue of either a statutory exemption or by virtue of a foreign tax credit.

“Taxable income” includes all deductions, such as non-capital losses carried forward or carried back, or charitable donations.

o Section 125(1)(c) caps the deduction to a corporation’s business limits for the year. Section 125(2) defines a corporation’s business limit as $500,000, subject to deduction.

o The deduction may apply at most to $500,000, but may apply to less depending on ss. 125(1)(a) & 125(1)(b).

The Effect of Associated Corporations on the Small Business Deduction

- Sections 125(3) & 125(4) restrict an associated group to one small business deduction.o The entire associated group shares a single business limit of $500,000, and the group allocates a percentage of

the small business deduction to each member of the associated group.- Together, ss. 125(1)(c) & 125(2) limit the SBD base to a maximum of $500,000 for a group of eligible corporations,

determined on the basis of association.

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- For partnerships formed by CCPCs, ss. 125(6)–125(6.3) apply to limit the SBD base to $500,000 between all constituent CCPCs to the partnership.

SPECIFIED PARTNERSHIP INCOME

Calculating Specified Partnership Income

- The “specified partnership income” mechanism prevents manipulation of the SDB limit through partnerships (ss. 125(1)(a) & 125(7)).

o Divides partnership businesses from businesses carried on by the CCPC directly.o Income from a partnership is by default excluded from the SBD base – the income eligible for the SBD – unless

it is income not described in the definition of specified partnership income. If there is an amount described is in the definition of specified partnership income, the amount is re-

added into s. 125(1)(a).- Specified partnership income is equal to the amounts A + B, where:

o A is the lesser of: Partner’s net partnership income allocation (share of income deducting expenses); and

Section 34.2 also applies, as an anti-deferral mechanism. The prorated share of $500,000 that the partner’s net income allocation is of all partnership income.

Take the partner’s partnership income, divide it by the total partnership income, and multiply the decimal by $500,000.

o Adjustments are also necessary for annual pro-ration.o B is the lesser of (allows for a greater amount of SPI where the taxpayer has business losses in the same year):

The sum of the partner’s specified partnership losses and business losses; and The amount by which the partner’s income allocation exceeds its prorated share of $500,000.

- Variable A + B will never exceed the actual income allocation to each partner.

Supporting Rules

- Section 125(6): Prevents the creation of additional sources of specified partnership income if people try to cause a business to be carried on by multiple partnerships.

o If members of an associated group, and it can be reasonably conceived that one of the main reasons for the creation of that group is to increase the SBD base, then s. 125(6) applies.

Identify the partnership that has the greatest SPI for the associated group, and then that amount will be the specified partnership income for the constituent corporation and the SPI from all other partnerships is deemed to be nil.

- Section 125(6.1): Clarifies how stacked partnerships are dealt with.o Stacked partnerships are partnership where the members of the partnership are other partnerships.o Deems a partner of a top-tier partnership to be a member of the lower-tier partnership, and the partner’s income

from the lower-tier partnership is deemed to be the income allocated to the partner from the higher-tier partnership (effectively deems that the top-tier partnership does not exist).

- Section 125(6.2): Prevents a corporation from earning SPI if it is controlled by non-resident or public corporation.o If a partnership is controlled de facto by non-residents or public corporations (or other party not entitled to the

SBD), then the partner’s SPI from that partnership is deemed to be nil.- Section 125(6.3): For the purposes of s. 125(6.2), a partnership is controlled de jure if the controlling party’s share of

partnership income exceed half of the partnership’s income.o Requires grouping and establishing where a partnership’s income comes from.o If one partner’s share exceeds 50%, none of the partners receive SPI from the partnership.

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- Previously very common for LLP’s to have all of their constituent professionals each incorporate two professional corporations: one as a member of the LLP, and one outside.

o The two associated PC’s would share an SBD base.o The LLP would allocate partnership income to the constituent PC, and then the constituent PC would assign its

$500,000 business limit to the non-constituent PC. The non-constituent PC has no SPI, and therefore may retain a $500,000 SPD base.

- The definition of SPI was revised to combat this mischief: if a party directly or indirectly receives a payment originally from partnership income from a non-arm’s length party, then that amount is deemed to be SPI.

o The default allocation is that the non-constituent corporation has a $0 business limit, and the constituent corporation has whatever business limit is determined by s. 125.

The entire corporate/partnership scheme can have no more than a single $500,000 SBD base.o Non-constituent corporation is deemed to be part of the partnership, and to have received partnership income.

Calculating SPI – Deducting Business Losses and Expenses

Xco, a CCPC, has a one-quarter partnership interest in XYZ partnership. For its 2018 taxation year (fiscal period Jan. 1 - Dec. 31), the partnership earns $1,000,000 of business income from an active business carried on in Canada. What amount of business income from the partnership may Xco add to its SBD base for its 2018 taxation year (calendar-year fiscal period)?

- B is zero, as there are no losses; A is the only concern.o A has two possibilities:

$250,000 – share of partnership income otherwise determined. $125,000 – share of pro-rated limit of the business limit.

o Take the lesser of the two amounts – $125,000 – to be the amount of A.o B must be the lesser of the sum of losses ($0) or the income allocation from the partnership otherwise

determined ($250,000) – $0.o SPI is therefore $125,000 – that amount will be added to XCo’s SPD base under s. 125(1)(a).

What if Xco has also incurred a ($50,000) loss from an active business carried on in Canada?

- Variable A is not impacted by the addition of non-partnership losses, as it examines the share of partnership income, rather than taxable income.

o Variable A remains $125,000.o Variable B will be impacted and now has an amount: must be the lesser of the sum of losses ($50,000), or the

income allocation from the partnership otherwise determined ($125,000) – $50,000.o With A + B ($125,000 + $50,000), SPI will equal $175,000.

What if the loss is ($300,000)?

- With a $300,000 loss, A remains unchanged, but B will change.o B is the lesser of two amounts – sum of losses ($300,000), or income allocation from the partnership otherwise

determined ($125,000) – $125,000 is the lesser amount (income allocation otherwise determined).o With A + B ($125,000 + $125,000), SPI will equal $250,000.

Aco, a CCPC, has a one-half interest in each of partnerships X, Y and Z. For the 2018 fiscal period, the partnerships earn or incur the following amounts.

X $200 ABI from a business carried on in CanadaY $1,000 ABI from a business carried on in CanadaZ ($200) loss from an active business carried on in Canada

For its 2018 taxation year in which each of the fiscal periods of the partnerships ends, Aco deducts $300 in respect of expenditures (e.g. an interest deduction) made by it for the purpose of earning income from its business carried

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on as a member of partnership Z. What amount of partnership income may Aco add to its SBD base? See the definitions of “specified partnership income” (variable H) and “specified partnership loss” (variable B) in subsection 125(7). What is the effect of these provisions? What if Aco deducts the $300 of expenditures in respect of its business carried on as a member of partnership Y or X?

- Specified partnership losses must first be determined.o An A + B formula:

A is the amount of the loss allocated to the partner by the partnership (here being $100, half of $200). B is equal to G – H:

G is the amount of the deduction claimed from the partnership in a year (here being $300). H is the amount of income from any source allocated to the partner by the partnership (here

being $0). o There is in this example from Partnership Z a SPL of $400 ($100 + $300).

- From Partnerships X & Y, there is an SPI instead:o Variable A is the lesser of net partnership income allocation ($100 from X, and $500 from Y) or the prorated

share of the business limit ($250,000 for X and Y). Lesser is $100 for X and $500 for Y.

o Variable B is the lesser of the sum of SPL and business losses ($0), and pro-rated share of business limit ($250,000).

B equals nil for both partnerships, as there are no losses for X and Y.- These amounts will sum into s. 125(1)(a), so the summed SPI (from X and Y) is $600, and the loss allocated from Z’s

SPL will be $400.o The SBD base is therefore $200 .

ABCco, a CCPC, has the following income and loss amounts for its 2018 taxation year.ABI from a business carried on in Canada $100,000Canadian investment income $20,000foreign investment income (“FII”) $20,000foreign business income (“FBI”) $10,000foreign tax credit related to FII $2,250 (grossed up is $9,000)foreign tax credit related to FBI $3,200 (grossed up is $12,800)non-capital loss carried forward from previous taxation year and deducted in 2018 $60,000

(a) What is the SBD base of ABCco for 2018?(b) What if the non-capital loss carried forward and deducted in 2018 is

(i) $90,000?(ii) $30,000?

- Sections 125(1)(a) & 125(1)(b) interact here.o Section 125(1)(b) is the CCPC’s taxable income.

- The only amount that may be included in s. 125(1)(a) is the ABI from a business carried on in Canada – $100,000.o Section 125(1)(c) will always be $500,000 and s. 125(1)(a) is $100,000; the SBD may only go down.

- For s. 125(1)(b), sum income from all sources, deduct non-capital losses from that amount (bringing the number to the base taxable amount), gross the foreign deductions up by various provisions, and deduct that from taxable income.

o Section 125(1)(b)(iii) covers sheltered income.o “Relevant factor” is defined in s. 95(1), and for a corporation, is usually 4.

- Without deductions, income from all sources is $150,000.o With a $60,000 non-capital loss carried forward, the summed deductions are $81,800.

SBD base is therefore either $100,000 or $68,200.o With a $90,000 non-capital loss carried forward, the summed deductions are $111,800.

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SBD base is therefore either $100,000 or $38,200.o With a $30,000 non-capital loss carried forward, the summed deductions are $51,800.

SBD base is therefore either $100,000 or $92,200.

(c) What if ABCco’s ABI from a business carried on in Canada is $500,000 and the non-capital loss is $60,000?

- Summed deductions are $81,800.o Section 125(1)(b) produces $468,200, which is less than $500,000.

(d) What if ABCco’s ABI from a business carried on in Canada is $500,000 and the non-capital loss is $140,000?

- Summed deductions are $161,800.o Section 125(1)(b) produces $388,200, which is less than $500,000.

OTHER ADJUSTMENTS TO SBD BASE

Specified Corporate Income

- If a corporation is providing services indirectly or directly where a non-arm’s length person indirectly or directly has an ownership interest, that amount is considered corporate income.

- Shareholders at a non-arm’s length relationship to the CCPC may be folded into specified corporate income easily.- Two requirements for SCI:

o At any point during the year the corporation (or a related party) or one of its shareholders (or related party) holds a direct or indirect interest in another private corporation; and

o The corporation derives more than 10% of its income for the year from non-arm’s length parties.- The resultant income is only eligible for one small business deduction rather than the opportunity to multiply the SPD

across corporations.

Taxable Corporate Capital and Investments

- Section 125(5.1) reduces the business limit of a CCPC on a straight-line basis based on the amount of taxable capital of the corporation, as determined by Part 1.3 of the ITA.

o The reduction begins when taxable capital exceeds $10,000,000. Reduces the business limit by $0.10 for every $1 that the CCPCs taxable capital employed in Canada

exceeds $10,000,000.o If a corporation is a member of an associated group in either the current year or the preceding year, it is the

taxable capital of the associated group which is pertinent.o Under the formula in s. 125(5.1), the benefit of the SBD is eliminated for CCPCs with taxable capital of

$15,000,000 or more.- Taxable capital employed in Canada includes:

o The meanings assigned by ss. 181.2(1), 181.3(1) & 181.4. Based on a corporation’s financial statements – the corporation’s retained capital, non-deductible

reserves, and debt or unpaid dividends, as displayed on the balance sheet, and all as reduced by the investment allowance.

- Effective January 1, 2019, s. 125(5.1) will be re-designated as s. 125(5.1)(a), and a new s. 125(5.1)(b), such that the SBD ‘grind’ starts at the lesser of two amounts.

o Section 125(5.1)(b) is a new investment income grind – adjusted aggregate investment income exceeding $50,000 in the preceding taxation year, there is a $5 reduction in the business limit for every $1 in excess, such that the business limit is nil once the adjusted aggregate investment income exceeds $150,000.

Adjusted aggregate investment income is a further adjustment to the s. 129(4) aggregate investment income amount.

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- Section 125(5.1) as a whole is premised on the assumption that the equations measure passive income which is not being re-invested appropriately into the business.

II–I II: ASSOCIATION AND RELATIONSHIP

RELATIONSHIP

Relatedness Generally

- Relationship is defined in s. 251(2).o Relationship between individuals is set out in s. 251(2)(a).o Relationship between corporations is set out in ss. 251(2)(b) & 251(2)(c).o Relationship between individuals and corporations is set out in s. 251(2)(b).o In determining whether two or more parties are related, the supporting rules set out in ss. 251(3)–251(6) & 252

must also be considered.

Relatedness

- Individuals are related to one another under s. 251(2)(a).o Individuals are related to one another if they are connected by blood (parent, child, sibling, etc., but only

lineally – no connection to nieces or nephews or cousins) or marriage (deems the individual to be in the position of their spouse, relating them to their immediate in-laws).

- For corporations, the basic rules are set out in s. 251(2), particularly ss. 251(2)(b) & 251(2)(c).o Section 251(2)(b) aims to relates corporations to its shareholders.

Deems the corporation to be related to a person who controls the corporation (s. 251(2)(b)(i)). Deems the corporation to be related to every member of a related group that controls the corporation (s.

251(2)(b)(ii)). Deems any person who is related to a person described in ss. 251(2)(b)(i) & 251(2)(b)(ii) to also be

related to the corporation (s. 251(2)(b)(iii)). Would capture persons who are not shareholders of the corporation.

o Section 251(4) deems a related group where every person in the group is related to one another. An unrelated group is every group that is not a related group. “Group” is not defined in the ITA.

A group at common law is defined – there must be some sort of sufficient common connection between persons to establish a group.

o Some reasonable expectation that people will act in concert in control of a corporation.o Section 251(2)(c) captures relation of corporation where the corporations do not control one another.

Section 251(2)(c)(i): Corporations are related if they are controlled by the same person or the same group of persons.

Section 251(2)(c)(ii): Two corporations are related if they are controlled by persons who are related to each other.

Ex. Wife owns Corp A, Husband owns Corp B; Corp A and B are related. Section 251(2)(c)(iii): Corporations are related if one of the corporations is controlled by one person,

who is related to any member of a related group that controls the other corporation. Ex. Person holds Corp A; brother and nephew own Corp B; Corp A and Corp B are related.

Section 251(2)(c)(iv): Corporations are related if every member of an unrelated group controlling one corporation is related to at least one member of unrelated group controlling the other.

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Ex. X and Y own Corp A. Corp B is controlled by X’s brother and X’s child; X is related to both, but the brother and child are not related.

o X, one member of an unrelated group controlling Corp A, is related to every member who controls Corp B; as a result, Corp A and B are related.

Section 251(2)(c)(v): If any member of a related group that controls one of the corporations is related to each member of an unrelated group that controls the other corporation.

Ex. X and X’s sister own Corp A. X’s wife, brother, and uncle own Corp B. Corp A and Corp B are related.

Section 251(2)(c)(vi): If each member of an unrelated group that controls one of the corporations is related to at least one member of an unrelated group that controls the other corporation.

Ex. Five people form Corp A; their spouses form Corp B. Corp A and Corp B are related.o Two supporting rules:

Section 251(3) considers two corporations that would otherwise be unrelated; if both are related to a third corporation, then the two corporations are deemed to be related.

Ex. Corp A and Corp B are not related. Both Corp A and Corp B are both related to Corp C. Corp A and Corp B are deemed related.

Section 251(5)(b) deems parties who would not superficially be related to be related – rights under contract, etc.

ASSOCIATION

- Basic rules set out in s. 256(1).o Similar to, but not the same as related.

- Turns on both de facto and de jure control (s. 256(5.1)), rather than de jure control (which applies to relatedness).o Does not preclude being associated by de jure control.o Section 256(1)(a): Two corporations are associated if one corporation has de facto control over the other.o Section 256(1)(b): Two corporations are associated if both of the corporations are controlled de facto by the

same person or group of persons.o Section 256(1)(c): If two related persons each control (de facto) separate corporations, and at least one owns

25% of any class of share in the other’s corporation, the corporations are associated. Not enough for the shareholders to be related; there must be some degree of cross-ownership by one.

Only needs one person to own 25% of the shares of any class; not 25% of total shares.o Section 256(1)(d): Similar to s. 256(1)(c), but applied to a group. Requires cross-ownership one way and for

the person with cross-ownership to be related to every person in the controlling group of the other corporation.o Section 256(1)(e): Requires every member of a related group to be related to every member of another related

group and for the groups to have cross-ownership. Ex. Corporations with identical shareholders, or Corp A with Husband/Brother (to wife) and Corp B

with Wife/Sister (to Husband), with cross-ownership.- Association ignores “specified class” shares, as defined by s. 256(1.1).

o Redeemable, retractable non-voting preferred share with fixed dividend entitlement equal to the prescribed rate at time of issuance.

Preferred share that is so similar to debt that if granted creditor’s rights would be considered debt.- Section 256(1.2) effectively override common law rules surrounding de jure control.

o Section 256(1.2)(a): A group exists in respect to a corporation where two or more persons own shares in a corporation; that group only exists in respect to the corporation with common ownership of shares.

No need to look for a connection; Billy in Sarnia is in a group with John in Edinburgh if they both own shares in Corp A, despite no other connections between the two.

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o Section 256(1.2)(b): If there are multiple potential groups that could control a corporation, or a single person that could control a corporation, notwithstanding the potential for larger groups to control the corporation, all are considered to control the corporation.

Ex. Five shareholders (1, 2, 3 are brothers – 1 owns 51%, 2 owns 9%, 3 owns 10%; 4 and 5 are unrelated and own the remainder 30%). 1 owns the corporation; if all the evidence shows that 1, 2, 3 make all decisions together, then 1, 2 & 3 as a group also own the corporation.

Corporations are controlled simultaneously by both the smaller group and the larger group.o Section 256(1.2)(c): An entirely new test for control based on FMV – a person or group of persons controls a

corporation if they own more than 50% of the value of a corporation’s shares. The 50% may be of all shares, or 50% of all common shares.

- Association deems ownership of shares in certain circumstances.o Section 256(1.2)(d): Deems shareholders of a holding corporation to own shares of a lower-tiered corporation

based on the proportional FMV of those shares.o Section 256(1.2)(e): Allocates shares to partnerships based on current fiscal period income allocation.o Section 256(1.2)(f): Deems each beneficiary of a discretionary trust to own 100% of the shares of a corporation

which the trust has invested in; deems each beneficiary of a fixed trust to own proportionate FMV of the trust interests.

Fixed trusts clearly set out the beneficiaries and the amounts entitled to each. Trustee only holds discretion as to when to allocate income and what to invest in; no discretion

to decide what the beneficiaries receive. Discretionary trusts sets out classes of beneficiaries (income/capital), and the trustee have the power to

appoint any or all of the income or capital of the trust to the appropriate class of beneficiaries.- Section 256(1.3) deems parents to own shares held by minors to held by parents for the purpose of determining control

of a corporation by a group that includes parents.o This rule ‘stacks’ with s. 256(1.2)(f), which deems beneficiaries of a discretionary trust to own 100% of a

corporation. Ex. A Co is owned by husband. B Co is owned by wife. They establish a discretionary trust for their

children, which owns shares in A Co. Section 256(1.2)(f) deems all of the children to have a 100% share in A Co. Section 256(1.3) applies to deem the wife to have all the shares of her children. A Co and B Co are now associated.

- Section 256(1.4) deems certain rights to be exercised.o Practically indistinguishable from s. 255(1)(b), but applies only for association.

- Section 256(2.1) is an anti-avoidance rule, deeming corporations to be associated if there is no reason for their separate existence.

o If there is some reason for the corporations to do something, aside from the tax consequences, the rule will not apply even if there are tax benefits.

o The rule revolves around the main reason test.- Section 256(2) deems corporations to be associated with one another if they are each associated with a third

corporation.o Effectively the same rule as s. 251(3), except for association instead of relation.

Unlike s. 251(3), there is a possibility for an election out in s. 256(2): if the election is taken, for all purpose of the Act the corporations are not considered associated, except for s. 125, wherein if the third corporation is a CCPC, the third corporation’s business limit is deemed to be nil.

If the third corporation elects its business limit to be nil, the two other corporations are no longer associated with one another.

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Likewise, a separate provision states that if the third corporation has a nil business limit, s. 256(2) will not apply; s. 256(2) applies this provision to a corporation which would otherwise have a business limit.

A and B each own 40% of the fully voting common shares of ABCco, a CCPC. C owns the remaining 20%. B and D each own 45% of the fully voting common shares of BDEco, a CCPC. E owns the remaining 10%. A, B and C are brothers. A is married to D. E is not related to A, B, C or D.

- Who controls what?o Anyone who has shares in ABC is deemed to be one group; anyone who has shares in BDE is another group.o ABC is controlled by a related group (A+B, and A+B+C).o BDE is controlled by a related group (B+D).

D is related to B by virtue of being married to A; D subsumes A’s relationships; A is related to B due to being siblings (s. 251(2)(a)).

o Everyone in group A+B is related to everyone in group B+D. Cross-ownership requirement is satisfied by B (who owns at least 25% of shares in both corporations).

Association requirement made out.o Under common law, start with smallest group.

A+B and B+D. Both are related groups. With two related groups

Mr. A and his brother's spouse, Ms. B, each own 50% of the issued voting shares of ABco. The shares are the only outstanding shares of ABco, which carries on an active business in Canada. Mr. A also owns all of the outstanding shares of Aco, while Ms. B owns all of the outstanding shares of Bco. Aco and Bco carry on an active business in Canada in partnership. The two corporations share all income and losses on a 50/50 basis. ABco, Aco and Bco were all incorporated in Canada in 1985 and none of the issued shares are traded on a Canadian stock exchange. Mr. A is a Canadian resident. Ms. B is a U.S. resident.

- A and B are related by marriage (s. 251(2)(a)).- For association purposes, partnership allocation is irrelevant.

o Would be highly relevant if the partnership owned shares of a corporation of interest.- Not relevant here that B is a non-resident.- Since ACo and BCo are controlled by an individual, and ABCo is controlled by a related group, ACo is associated.

o A controls BCo; ACo is associated with ABCo; ABCo is associated with BCo.- No cross-ownership of shares between ACo and BCo.

o No attributed ownership of shares.o However, both corporations are associated with ABCo; under s. 256(2) they are deemed to be associated with

each other. Both are associated with a third corporation.

- B, despite being a non-resident, only owns 50% of the shares in ABCo, which is insufficient for control.o ABCo will remain a CCPC.o For all purposes of the Act, ACo and BCo will be associated with one another under s. 256(2).

All corporations will need to share a SBD, but s. 125 maintains the option for ABCo to elect to have a nil business limit, disassociating ACo and BCo from one another but maintaining their association of ACo and Bco with ABCo.

- If B was a non-resident and controlled ABCo, ABCo would no longer be a CCPC, and would automatically disassociate ACo and BCo.

o Due to a separate provision independent of the opportunity to elect.

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Modelling Ownership and Association

- ACo and BCo are related. Sections 256(1)(c) & 256(1)(d) could apply to associate the corporations.o Section 256(1)(c) requires two related persons to each control de

facto separate corporations, and for one of the two to also havea 25% interest in the other corporation.

Section 256(1)(d) has the cross-ownership requirement,but applies where the person with cross-ownership isrelated to every member of the related group controllingthe other corporation.

o A is deemed to own all of the shares owned by Aco.o As a result, he is deemed to own 25% of the shares of BCo,

satisfying the cross-ownership requirement. He is related to B, creating a relation requirement; the

result is that Aco and Bco are associated.- ACo and BCo are associated.

o A and B are related under s. 251(2)(a) because they are connected by blood.

Under s. 251(2)(c)(ii), Aco and Bco are related becausetheir owners are related.

o There is no cross ownership of shares; absent a deeming rule, no section of s. 256(1) could apply.

o CCo is controlled by the related group A and B, and the related groupACo and BCo.

Section 256(1)(c) applies to consider ACo to be associated with CCo,and BCo with CCo.

o ACo and BCo are associated due to the application of s. 256(2) –they both are associated with CCo.

- Under ss. 256(1)(a) & 256(1)(b), A and B are both a group in relation to ACo and BCo.o They are both part of the control group

of each corporation, notwithstanding that A has enough sharesto control ACo on his own, and B likewise for BCo.

o Section 256(1)(b) associates the two corporations despite lackof cross-ownership.

o Section 256(1.2)(a) operates to deem A and B to be a group in respect toACo, as well as with respect to BCo.

- OPCo1 and OPCo2 are associated.o Section 256(1.2)(a) applies to create a group X/Y for OPCo1

and a group X/Y for OPCo2.o Section 256(1)(b) creates deemed association between OPCo1

and OPCo2, as both are controlled de facto by the same group.

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- XCo and YCo are associated.o Mr A and Mrs A each own 5%

of XCo, due to the trust established for Junior. Section 256(1.2)(f) deems Mr and Mrs A

to own a proportionate FMV share of thefixed trust’s holdings.

o Since both Mr A and Mrs A are shareholders of XCoand YCo, both are controlled by the same group, notwithstandingthat one controls one corporation and one the other.

Control is made out for the same group of persons, andtherefore under s. 256(1)(b) the corporationsare associated.

- All are associated (ACo, XCo, ZCo).o Pre-attribution, XCo and ACo should not be associated.

Absent a deeming rule, XCo and ZCo shouldnot be associated.

In both cases, it is because XCo does not controleither corporations.

o Section 256(1.2)(d) is the relevant deeming rule, whichlooks through ACo.

ACo’s ownership of share in ZCo needs to beallocated to XCo in proportion to XCo’sownership of ACo (.4 * 30% + 40% = 52% =XCo’s sum of ownership in ZCo).

After the deeming rule, XCo has sufficientownership of ZCo for de jure control.

o XCo and ACo are associated by virtue of being controlled by the same group of persons (XCo + Unrelated shareholders) (Section 256(1)(b)).

Section 256(1.2)(a) deems XCo and the unrelated shareholders to be a group for ACo.o ACo and ZCo are associated because they are controlled by the same group of person (XCo + Unrelated

shareholders, following the application of thedeeming rules) (Section 256(1)(b)).

XCo and unrelated shareholders are a group for ZCo due to the attribution rules under s. 256(1.2)(d) transferring 60% of ACo’s 30% interest in ZCo to theunrelated shareholders.

- All the corporations are associatedo Corporations can be deemed to be controlled de facto even if the

corporation is controlled de jure by another party. YCo has de jure control of ZCo – YCo and ZCo are

related under s. 256(1)(a). Section 256(1.2)(c)(i) applies to deem XCo to

control ZCo because it owns shares of ZCo with morethan 50% of the FMV of all of ZCo’s shares (60% equity).

XCo therefore has de facto control of ZCo. XCo and ZCo are associated.

XCo and YCo are associated due to both being in control of

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ZCo, a third corporation (Section 256(2)).- All the corporations are associated.

o A and B are both shareholders of PubCo, and are thus a group for PubCo due to s. 256(1.2)(a). A and B and the unrelated shareholders are also a group for PubCo.

o A and B are related due to blood and thus become a related group. They are deemed to control PubCo due to s. 256(1.2)(c)(i).

o A controls ACo due to 100% ownership; B controls BCo due to 100% ownership.o Section 256(1)(d) associates ACo and PubCo.

A controls ACo, and A is related to every member of related group AB, which controls PubCo, and in turn s. 256(1.5) causes A to be related to himself.

There is cross-ownership due to A owning at least 25% of PubCo. The exact analysis applies to B/BCo.

o Because ACo and BCo are both associated with PubCo, they are associated with each other due to s. 256(2). However, the deemed association is ignored for s. 125 due to PubCo not being a CCPC.

The effect of association is therefore minimal in these circumstances.o Section 256(1)(b) cannot be used because Group ABPub only exists in relation to PubCo.

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III: CORPORATE TAXATION – DIVIDENDS AND CORPORATE DISTRIBUTIONS

III–I: REFUNDABLE DIVIDEND TAX ON HAND (RDTOH)

INVESTMENT INCOME – DIVIDEND REFUNDS AND REFUNDABLE TAX ON HAND (RDTOH)

Principles Underlying the RDTOH

- The dividend refund and RDTOH mechanism attempts to ensure that the tax system is neutral as to the decision to hold investment properties directly or through a corporation.

o This goal is realized when the tax burden on the investment income of an individual earned through a corporation is equal to that on investment income earned directly by the individual.

o This mechanism also ensures that tax is payable at the same time that it would be payable if the investment income were earned directly by an individual.

- Under the ITA, the investment income of certain corporations is taxed at the general corporate rate as earned, but on distribution as a dividend, a refund of tax is provided to the payer.

o The refund is intended to reduce the corporate tax rate on investment income to a level at which integration is realized, taking into account the dividend tax credit.

o The investment income is initially taxed at the general corporate rate. A deferral benefit can arise, however, where the highest marginal tax rate for individuals exceeds the

general rate of corporate tax.

The ITA’s RDTOH Mechanism

- Section 123.3 imposes an additional corporate tax of 10.6…% on investment income of CCPCs other than intercorporate dividends, following the application of the provincial abatement.

o This additional tax is intended to increase the general corporate rate on such investment income to more closely approximate the highest marginal rate for individuals.

o The tax is added to the RDTOH account of the corporation.- Under the ITA, integration is realized for the eligible income of CCPCs where the income distributed as a dividend is

taxed at a 20% corporate rate.o The dividend refund/RDTOH mechanism attempts to realize this rate by providing a federal corporate tax

refund equal to 20% of investment income along with the 10.6…% special tax when the income is distributed as a dividend, totalling a 30.6…% refund on distribution.

- Total tax rate works out to 50.6…% on non-dividend CCPC investment income before refund.o However, this is reduced to 8% federal tax and 12% provincial tax when equivalent dividends paid.o The refundable tax for non-dividend investment income is high due to no general rate reduction, the provincial

corporate income tax applying, and the additional s. 123.3 10.6…% tax.o Fully recovering the tax paid on $100 of corporate income is possible with an $80 dividend.

- However, when people flow investment income, the integrated tax works out to 52% – significantly higher than if the person had earned the investment income personally.

o This is mainly due to assumptions about provincial corporate tax rates and federal corporate tax rates which are not matched by the investment provisions.

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- Sections 129(1) & 129(3) both concern the integration of CCPC eligible income:o Section 129(1) sets out the dividend refund mechanism.o Section 129(3) defines RDTOH, which in turn determines the type and amount of income eligible for a

dividend refund as well as the type of corporation eligible for the refund.- Section 129(4) provides a definition for aggregate investment income – an excess of taxable capital gains over

allowable capital losses, summed with property income other than deductible inter-corporate dividends.o Specified investment business income does not qualify for the SBD and is thus aggregate investment income.

Income earned from a specified investment business – a business which has five or fewer full time employees that principally derives its income from royalties, rents, or capital gains.

- Section 123.4(1) defines full rate taxable income.o Aggregate investment income is excluded from this definition under s. 123.4(1)(b)(iii).

Consequently, there is no general rate reduction on aggregate investment income.- Section 123.3 provides an additional tax, which is equal to 10.6…% of investment income .

o Investment income is equal to the lesser of AII, or taxable corporate income (with all applicable deductions).o Based on a flawed assumption that the provincial tax rate is 10%.o Following this additional tax, the combined federal-provincial rate on AII is 50.6…% .

- Section 129(3) defines RDTOH, which is computed at the end of taxation year.o If a corporation is a CCPC, RDTOH is equal to the sum of:

30.6…% of the CCPC’s AII or maximum of corporate tax payable (whichever is lesser); plus Part IV tax payable; plus RDTOH at the end of preceding year; less Dividend refund for preceding year.

These last two essentially equate to non-refunded RDTOH from the last taxation year.o RDTOH is a notional account; there does not actually need to be cash flow.o Not a point-in-time test.o Private corporations that are not CCPC’s do maintain an RDTOH account.

RDTOH is Part IV tax payable, plus the non-refunded RDTOH from the end of the last taxation year.- Section 129(1) provides a dividend refund.

o If a corporation has filed its return for a year within three years of the end of the year, then: Dividend refund equal to 38.3…% of all taxable dividends paid in the year while a private corporation,

to a maximum of the RDTOH account at year-end; OR RDTOH account, whichever is less. $1 of dividend refund for every $2.61 of dividends paid to the maximum of the RDTOH limit.

o Dividend refund is not dependent on the dividends being paid; it is the dividend being logged in the tax return which triggers the refund.

- Ideally, $20 is left with the corporation in cash; $20 is paid in tax; and $80 is given to the shareholder in dividends received, to then be taxed personally under the dividend integration scheme (see further infra).

Breaking Down the Application of the Dividend Refund/RDTOH

- What corporations are eligible for a dividend refund?o Private corporations are eligible for a dividend refund.

As a result, whenever a private corporation seeks to go public, it should pay out all RDTOH, as once it becomes public it no longer has a RDTOH pool.

- Why is the amount of a corporation’s dividend refund limited to the lesser of 38.3…% of taxable dividends paid and its RDTOH?

o Causes dividend refund to not exceed RDTOH at the end of the year. Would be refunding tax that was never paid in the first place.

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- What does RDTOH represent?o Section 129(3) notes that RDTOH is a notional amount equal to tax payable on investment income in excess of

20% of that amount, in addition to Part IV taxable income.- What kind of income earned and distributed as a taxable dividend generates a dividend refund?

o Passive income classified as AII, and dividends that are subject to Part IV tax.

Calculating RDTOH

Assume that Xco, a CCPC, earns $1,000 of interest income. What are the tax consequences to Xco when it pays a taxable dividend of $800 in the taxation year?

- XCo earns $1,000 of interest income, which is clearly AII.- Tax rate of 50.6…% pre-refund, and tax payable of $506.7.- Add $302.3 to RDTOH account (30.6…% * $1000).- Under s. 129(1), the corporation becomes eligible for a dividend refund equal to the lesser of either 38.6…% of the

dividends paid or the RDTOH account at the end of the year.o $1 refund for every $2.61 of dividends paid to a maximum of the RDTOH balance at the end of the year.

- XCo issues a $800 taxable dividend, and is liable to $200 non-refundable tax ($506.7 of tax payable on the original dividend offset by $306.7 recovered from the RDTOH account); shareholder’s $800 of dividends then taxed personally.

Assume that Xco, a CCPC, acquired a capital property for use in its business at a cost of $1,000. In 2018, Xco sells the property for $2,000. What amount is included in the RDTOH account of Xco? How may Xco recover the RDTOH in full?

- Property had ACB of $1,000; proceeds had $2,000 – capital gain of $1,000.o Under s. 38(a), there is a one-half inclusion rate for capital gains - $500 taxable capital gain.

- The $500 taxable capital gain is AII.o Tax liability of $253.33 (50.6…% * $500).o Add $153.33 to RDTOH account at the end of the taxation year (30.6…% * $500, per s. 129(3)).o XCo recovers the RDTOH in full by paying a dividend of $400.

$153.33 dividend return (38.3…% * 400), leaving XCo’s tax payable at $100.

Assume that Xco, which is a CCPC, realizes the following amounts in its 2018taxation year:Active business income earned in Canada (“ABI”) $100,000interest (CII) $10,000taxable capital gain (CII) $20,000

What amount is included in Xco's RDTOH under paragraph 129(3)(a) for its 2018 taxation year? What is Xco's SBD base?

- Active business income is not considered AII.- AII is only $20,000 taxable capital gain and $10,000 interest.- $30,000 AII.

o Tax liability of $15,180 (50.6…% * $30,000).o Add $9,180 to RDTOH account at the end of the taxation year (30.6…% * $30,000, per s. 129(3)).o XCo recovers the RDTOH in full by paying a dividend of $24,000.

Dividend refund of $9,192 (38.3…% * $24,000), leaving XCo’s tax payable at $5,988.- Per s. 125(1), SBD base is equal to the least of:

o Net income from active business - $100,000 (s. 125(1)(a)).o Taxable income - $130,000 (s. 125(1)(b)).o Business limit - $500,000 (s. 125(1)(c)).

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- SBD base is equal to net ABI - $100,000.- The SBD base is subject to tax at the 12% rate, leaving corporate tax payable on ABI of $12,000.- Between the tax on AII and the SBD-eligible ABI, XCo’s total corporate tax payable is $17,988 if a dividend of at least

$24,000 is paid out, and total corporate tax payable is $27,180 if no dividend is paid.

Assume in the above example that Xco also has a net capital loss of $10,000, a noncapitalloss of $10,000 and a charitable donation of $10,000, all of which were deducted in 2018. What amount is included in Xco's RDTOH under paragraph 129(3)(a) for its 2018 taxation year? What is Xco's SBD base?

- Net capital loss (($10,000)) and taxable capital gain ($20,000) must be compiled – AII is the net of both ($10,000).- Deduct from the taxable income the non-capital loss (s. 111(1)(a)) and the charitable donation.

o Taxable income was originally $130,000 before application of losses. First, netting of capital gain from above (-$10,000). Second, deductions from charitable donations and from non-capital losses (-$20,000).

- Per s. 125(1), SBD base is equal to the least of:o Net income from active business - $100,000 (s. 125(1)(a)).o Taxable income - $100,000 (s. 125(1)(b)).o Business limit - $500,000 (s. 125(1)(c)).

- The SBD base is subject to tax at the 12% rate, leaving corporate tax payable on ABI of $12,000.- Section 159(3)(a) then applies to take the least of:

o Corporation’s investment income.o Corporation’s taxable income in excess of the SBD base.

$100,000 taxable income, SBD base is $100,000. No excess, leaving a $0 addition to RDTOH in the current taxation year.

No income subject to refundable tax.o Section 123.3 notes that all income qualifies for the SBD.

- When there are deductions from taxable income when there is income eligible for the SBD, the deductions are first taken from income not subject to the SBD, and then finally from the SBD base.

- Section 123.3 & 129.3 interact to have deductions against non-SBD income first.- SBD base remains $100,000, and only the corresponding tax on ABI will be considered, as the $30,000 AII from

taxable capital gains and interest has been entirely offset by deductions, leaving corporate tax payable at $12,000.

What effect does a change in the status of a corporation have on its RDTOH account? How might that effect be alleviated?

- The starting point of RDTOH is to identify what status is changing.o The definition of RDTOH applies to every type of corporation; what may change is whether the RDTOH

becomes useless (i.e. the corporation becomes public).- If a corporation ceases to be a CCPC, no amounts may be added to RDTOH due to s. 129(3)(a).

o No more additions to RDTOH due to investment income; additions due to Part IV tax (infra) still possible.- If a corporation ceases to be private, any RDTOH balance that remains at the end of the taxation year is not carried

forward under s. 129(3)(c), and more importantly, it can no longer acquire dividend refunds under s. 129(1).o Dividend refunds are only available to private corporations.

- There is a deemed year end when a corporation ceases to be a CCPC; it is impossible for corporation to both be and not be a CCPC in a taxation year.

Aco and Bco are two associated CCPCs. They enter into an agreement whereby each corporation leases its business premises from the other for a basic rent of $500 per month plus 10% of all income in excess of the lessee's business limit up to a maximum of $100,000. For the 2018 fiscal periods of the two corporations, the profit participation right of each under the lease agreement is the maximum $100,000. What are the income tax

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consequences of this arrangement for the 2018 fiscal periods of the two corporations? In particular, consider the possible application of subsection 129(6). What is the purpose and effect of this provision?

- Two associated corporations each leasing their building to the other corporation.o $100,000 of rent being paid to each other.

- Assume each corporation has more than $106,000 of full rate taxable income in excess of their business limits.o The payments are deducted as a business expense to an amount of $106,000; no effect on the SBD base.

- From the recipient’s perspective, the corporations are receiving rental income, which is usually undesirable due to raising the taxation rate from 27% to 50.6…% (full rate taxable income converted to investment income).

o Section 129(6) does two things for investment incomes paid between associated corporations: Deems the rental income to not be AII for the purposes of s. 129(4); Deems the rental income to be business income for the purposes of s. 125.

- The income, not being AII, is not subject to RDTOH.o The rental income would also be subject to the SBD.

- Section 129(6) allows for deductions against ABI and avoids having non-arm’s length parties have to pay RDTOH on what would have normally been business income, but for the payments.

- Here, the rental income will be taxed at 27%, as the amount is over the SBD base.

Present Day RDTOH Regime

- Refundable tax is recovered at a rate of $1 for every $2.61 of all taxable dividends paid (eligible or non-eligible, infra).- For taxation years that begin after 2018, the RDTOH account will be replaced with two separate RDTOH accounts:

o “Eligible refundable dividend tax on hand”; ando “Non-eligible refundable dividend tax on hand”.

- Section 129(3) will be repealed, to be replaced with s. 129(4) with the above two definitions.- RDTOH mechanics stay the same.

- Eligible RDTOH will track Part IV tax paid by a particular private corporation in respect of:o Eligible dividends received from non-connected corporations; ando Eligible dividends received from a connected corporation that resulted in an eligible RDTOH refund to the

payor corporation.- Non-eligible RDTOH will track Part IV tax paid by a particular private corporation in respect of:

o Refundable Part I tax paid by a particular CCPC in respect of its investment income;o Part IV tax paid in respect of dividends received from connected corporations (other than Part IV tax arising

from payor’s corporation’s eligible RDTOH refund); ando Part IV tax paid in respect of non-eligible dividends received from non-connected corporations.o Essentially the same as current RDTOH with a carve-out for some Part IV tax which is now captured by

eligible RDTOH.

- Upon paying an eligible dividend, there is a refund of the lesser of 38.3…% of eligible dividend paid or the corporation’s eligible RDTOH at the end of the year.

o No refund from the non-eligible RDTOH pool.- Upon paying a non-eligible dividend, 38.3…% of the dividend paid, or the corporation’s non-eligible RDTOH at the

end of the year.o Non-eligible dividend will also recover eligible RDTOH if the 38.3…% of the dividend paid is in excess of the

corporation’s non-eligible RDTOH pool. This is not possible in the inverse: using eligible dividends to recover non-eligible RDTOH.

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III–II: TYPES OF CORPORATE DISTRIBUTIONS

CORPORATE CAPITAL STRUCTURE – DEBT AND EQUITY

Distinguishing Debt and Equity

- Tax treatment of debt instruments and interest payments is different from the treatment of shares and dividend payments.

o Important to distinguish between the two.

o For smaller corporations, there is a very strong incentive to take on debt rather than equity.

o Difference between the two comes in whether there are creditor rights: if there are, it is likely to be debt, if not, it is likely to be equity.

TAXABLE EVENTS FOR DEBT, EQUITY, OPTIONS, INTEREST & DIVIDENDS

Issuing Debt or Equity

- Issuing debt or equity is essentially a non-event for a corporation:

o No disposition of any type on issuing debt, due to the definition of “disposition” under s. 248(1)(l).

o No disposition of any type on issuing a share, also due to the definition of “disposition” under s. 248(1)(l).- Shareholder might have tax consequences if the share or debt is acquired using property other than money.

o Absent any deeming rule, the shareholder will have ACB in their share or debt equal to the FMV of the property.

Issuing Options

- Issuing options are also a non-event for a corporation.o Section 49(1)(b) deems a corporation which has issued an option to have not disposed anything, even if cash

was received.o Also a non-event for a shareholder if the option was acquired using money.o However, consequences may arise on expiry (s. 49(2)) or exercise (s. 49(3)).

With expiry, the corporation is deemed to have disposed of a property with a nil ACB for proceeds of disposition equal to the amount that the option was auctioned for, producing a capital gain.

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Section 49(2)(a) may instead apply to produce a deemed disposition for nil proceeds, and therefore a capital loss will be realized equal to the ACB of the option (assuming ACB is greater than nil).

When options are exercised, there are no tax consequences for the corporation; for the individual, s. 49(3)(b) adds the cost of the auction for the option to the ACB of the individual’s shares in the corporation.

Cancelling Debts

- Cancelling debts are a taxable event for a corporation.o If a corporation pays the debt in full, there is no taxable event.o If a corporation paid the creditor less than face value, s. 80 characterizes this as debt forgiveness.

Always a poor tax outcome, with severity dependent on the tax characterization of the corporation at the time.

o If a creditor bought debt on the open market, s. 39(3) provides either a capital gain or loss. If the debt was acquired at less than the face value, a capital gain results. If the debt was acquired at more than its face value, a capital loss results. Open market exchanges of debt occur due to different interest rates and re-financing.

o For the creditor, the creditor is deemed to have disposed of the debt, received proceeds of disposition, and then realization of a capital gain or loss equal to the difference between the proceeds and the ACB of their interest in the debt.

Due to paragraph (b) of the definition of “disposition” under s. 248(1).

Cancelling Shares

- Cancelling shares are dealt with by s. 84(3), and are generally a non-event for a corporation.o Corporations do not realize gains or losses when they cancel shares.o However, significant consequences for the shareholder.

Between s. 84(3), 84(9) & paragraph (j) of the definition of “proceeds of disposition” under s. 54, the shareholder is deemed to have transferred a share to the corporation on its cancellation, and the shareholder is deemed to have proceeds of disposition equal to the stated capital of the share, and will have received a dividend equal to the difference between cash received and stated capital of the share.

Result is a potential deemed dividend or a capital gain or loss.o Deemed dividends may be much worse than a capital gain or loss.

A corporation may obtain a dividend refund in the event of a deemed dividend.o However, if the shareholder is a non-resident, it is possible for a double withholding

tax to result.

Paying Interest or Dividends

- When paying interest or dividends, corporations are usually permitted to deduct interest when calculating taxable income, so long as s. 20(1)(c) is satisfied.

o However, corporations cannot deduct dividends due to s. 18(1)(b).o Debt financing can thus be used to push down taxable income considerably.

Equity financing, due to s. 18(1)(b), does not enjoy the same possibility.

Receiving Interest or Dividends

- Shareholders are taxed on interest received or receivable under s. 12(1)(c).o If a shareholder is not exempt from tax, and are not fully aligned in interests with the corporation, dividends are

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With closely associated-in-interest entities, the deduction from debt and the interests will generally equal out to a result that does not matter.

o Interest is fully included in an individual’s income, and pay the full personal income tax.- Shareholders are also taxed on dividends under ss. 12(1)(j) & 82(1).

o However, dividends from resident corporations are taxed at a lower rate than interest.- Corporation shareholders can also deduct dividends received – s. 112(1).

Summary

Event Consequence for Corporation Consequence for Shareholder/Creditor

Issuing Debt/Equity Non-taxable (s. 248(1) definitions). Taxable if debt/equity acquired using non-money property; ACB of shares increases by FMV of property.

Issuing Options Non-taxable (s. 49(1)(b)). Non-taxable if acquired with money.

Expiry of Options (s. 49(2))Deemed disposition, with proceeds equal to amount paid to the corporation for the option, and ACB deemed nil – capital gain results.Section 49(2)(a), if applicable, deems disposition for nil proceeds, and thus a capital loss if ACB greater than nil.

--

Exercise of Options (s. 49(3)) Non-taxable. Cost paid for the option at auction is added to the ACB of the individual’s shares in the corporation.

Cancelling Debts Non-taxable if debt paid in full.Debt forgiveness event if debt repaid in part and remainder forgiven (s. 80).

Taxable as capital gain or capital loss for creditor (s. 39(3)).Capital gain if debt acquired at less than face value.Capital loss if debt acquired at more than face value.Deemed to have disposed of the debt, received proceeds of disposition, and then realized capital gain/loss equal to difference between proceeds and ACB of interest in debt.

Cancelling Shares Non-taxable (s. 84(3)). Deemed to have transferred share to corporation when cancelled, and to have received proceeds of disposition equal to stated capital of the share and to have received a dividend equal to difference between cash received and stated capital (ss. 84(3), 84(9), paragraph (j) of “proceeds of disposition”, s. 54).Results in deemed dividend, dividend refund, or a capital gain/loss.

Paying Interest/Dividends Interest may be deducted (s. 20(1)(c)). --

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Dividends paid may not be deducted (s. 18(1)(b)).

Receiving Interest/Dividends Deductible (s. 112(1)). Taxable (ss. 12(1)(c), 12(1)(j), 82(1)).

III–III: TAXATION OF DIVIDENDS TO SHAREHOLDERS

CANADA’S INTEGRATION APPROACH TO TAXATION OF DIVIDENDS

Integration of Corporate Profits

- Integration refers to the attempt to integrate the corporate and personal income taxes, such that the tax paid on income earned through a corporation is no greater than if earned directly by an individual.

o What is the policy rationale for integrating corporate and shareholder taxes? Neutrality principle – Discourage individuals from adopting sub-optimal corporate structures just to

minimize taxation.- As dividends are not deductible, it is necessary to have an integration mechanism to ensure that total tax rates

approximate individual rates.o Without this approach, dividends would be taxed at a roughly 60% rate.

- With classical systems to corporate taxation, high corporate tax rates will annihilate the corporate tax rate.o Resident individuals and business are highly motivated to create flow-through structures and unusual corporate

structures to avoid double taxation on dividends. For example, California had a roughly 70% end taxation rate on dividends – approximately 38%

corporate tax rate (state – 5%; federal – 35%) and 35% personal tax rate (state – 12%; federal – 21%).- There are two primary types of integration:

o Full Integration: Income or losses earned or incurred through a corporation is calculated at the corporate level and then allocated to shareholders at the end of each taxation year.

The corporation is treated as a conduit for income tax purposes, which fully integrates the corporate and shareholder taxes by ignoring the corporation as a separate taxable entity.

o Partial Integration: Corporate tax is levied on retained income, while income distributed as a dividend is either deductible by the payer or taxed at the corporate level, but with a credit provided to shareholders for corporate tax on the income out of which the dividends are paid.

Attempts to integrate corporate and shareholder taxes only when income earned through a corporation is distributed as a dividend.

The Income Tax Act’s Approach to Integration

- The ITA fully integrates income or losses earned or incurred through a partnership.o However, the ITA instead uses partial integration for corporations and shareholders.

- With partial integration, there are an abundance of assumptions about how much the corporation paid as tax.o No real inquiry into the actual amount paid by the corporation.

- The ITA’s partial integration system is referred to as an imputation system.o Dividends are taxed to individual shareholders, along with a tax credit for taxes paid at the corporate level on

the distributed income.

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o Effectively, the imputation system treats the corporate tax on dividend income as a type of withholding tax, whereby a notional amount of corporate tax on income out of which a dividend is paid is ‘imputed’ to individual shareholders as having been paid on their behalf.

- An imputation system is often contrasted with a classical system, under which income earned through a corporation is taxed at the corporate level and again at the shareholder level on distribution as a dividend, but without any tax credit for the corporate tax paid.

- Under the ITA, individuals resident in Canada must include in income the amount of all dividends received, along with another 16% or 38% of all dividends received from a taxable Canadian corporation.

o The “gross up” percentage generally depends on two factors: The identity of the payer corporation as either a CCPC or a non-CCPC; and The relevant corporate tax rate applied to the income pool out of which the dividend is considered to

have been paid. Section 89(1) provides the relevant definitions: Eligible Dividend: Taxable dividends which are designated by the grantor corporation under s.

89(14) as eligible dividends. Subject to 38% gross-up, a 25.02% credit, and a 31.71% tax rate . Non-Eligible Dividend: Taxable dividends which are not designated as eligible dividends.

Essentially tracks dividends from income which already enjoyed the lower rates from the small business deduction. Subject to 16% gross-up, a 12.10% credit, and a 41.64% tax rate .

General Rate Income Pool: The pool from which eligible dividends are paid out from. Eligible dividends paid out in a taxation year may not exceed the GRIP account; any dividends paid in excess are considered excessive eligible dividends.

Low Rate Income Pool: The pool from which non-eligible dividends are paid out from. Must be drained before a corporation may pay out eligible dividends.

The dividend designation mechanism is also applicable (ss. 89(4)–89(14.1)). LRIP is a blocker which prevents payment of eligible dividends until non-eligible dividends drain out

the LRIP account. GRIP is the general account which is the balance of the CCPC’s non-SBD-eligible income and which

eligible dividends may be paid up to.o The amount of the grossed up dividend is then subject to income tax for an individual, along with a federal tax

credit and a provincial tax credit. Aggregated together, this is roughly equal to the gross up in respect of the dividends received.

- This approach to taxation is often referred to as a “gross-up and credit” mechanism.o It requires dividends to be “grossed-up” to reflect an assumed amount of corporate tax paid on behalf of an

individual shareholder.o The difference between that amount and the individual’s personal tax owed is compensated through a dividend

tax credit equal to the gross-up.

DIVIDEND INTEGRATION

Dividend Integration – CCPC’s

- The default rule is that a CCPC pays out taxable dividends as non-eligible dividends.o Non-eligible dividends will be paid by a CCPC to the extent that its income has been subject to tax at the small

business rate and dividend rate. If making less than $500,000, all dividends will be non-eligible unless a s. 89(11) election not to be a

CCPC is made. Investment income or income subject to the SBD rates do not generate LRIP.

- Dividends are always non-eligible unless the corporation designates them as eligible.- Dividend scheme:

o Section 82(1)(a) sets out income inclusion to include the cash received as taxable income.41 | P a g e

o Section 82(1)(b)(i) sets out a 16% gross-up . The gross-up accounts for the amount of cash the shareholder would have received if there had been no

corporate tax imposed.o Calculate tentative tax payable from regular dividend amount combined with gross-up.

Applying the 48% top personal rate.o Section 121(a) prescribes a 10.03% credit.

Section 21(i) of the APITA provides a 2.07% Alberta credit. Both apply as credits against the grossed-up amount, producing a 12.10% credit.

o An effective personal income tax rate of 41.64% on non-eligible dividends results from this scheme.- This scheme also applies to non-CCPC’s paying dividends from LRIP.

Dividend Integration – Non-CCPC’s

- Default rule is that a non-CCPC pays out eligible dividends.o While the non-CCPC still needs to make the designation, one can assume that they will designate their taxable

dividends as eligible dividends.o Section 82(1)(a) sets out income inclusion to include the cash received as taxable income.o Section 82(1)(b)(ii) sets out a 38% gross-up.

138% of dividend is reported on the return as taxable income.o Calculate tentative tax payable from regular dividend amount combined with gross-up.

Applying the 48% top personal rate.o Section 121(b) then provides a 15.02% credit.

Section 21(h) of the APITA provides a 10% Alberta credit. Both apply as credits against the grossed-up amount, producing a 25.02% credit.

o An effective personal income tax rate of 31.71% on non-eligible dividends results from this scheme.

Dividend Integration – GRIP

- GRIP is a pool maintained by CCPC’s from which eligible dividends are paid from.o Computed at the end of a taxation year.

- CCPC’s may pay taxable dividends to the extent that they have a positive GRIP balance at the end of the year.- To calculate (under the s. 89(1) definition):

o Begin with the CCPC’s GRIP at the end of prior year; PLUSo 72% of adjusted taxable income (Section 89(1)); PLUS

Essentially taxable income minus SBD-eligible income and AII. Leaves the business income subject to tax at the 27% rate.

o Eligible dividends received; LESSo Eligible dividends paid.

- Due to this formula, a non-CCPC’s taxable income will generally always pool into GRIP.

Dividend Integration – LRIP

- LRIP is the pool maintained by non-CCPC’s from which non-eligible dividends are paid.o The amount, if any, that a non-CCPC must pay as non-eligible dividends before they may resume paying out

eligible dividends.o Computed at point in time.

Thus, the corporation must calculate LRIP whenever they wish to pay out dividends.- To calculate (under the s. 89(1) definition):

o Begin with the non-CCPC’s LRIP at the end of prior year; PLUS

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o Non-eligible dividends received; PLUSo If corporation would have been a CCPC but elected to not be a CCPC, 80% of AII; PLUSo 80% of an amount in respect of SBD income earned while not a CCPC; LESSo Non-eligible dividends paid.

- LRIP for a “hard non-CCPC” would only result from lingering LRIP accounts prior to conversion, or if the corporation received a non-eligible dividend and failed to pay out equal amounts in non-eligible dividends.

o “Soft non-CCPC” (elected non-CCPC’s) may have an LRIP pool due to AII.

Designations and Excesses

- Eligible and non-eligible dividends distinguished by the corporation characterizing dividends when paying them out.- Corporations must designate any eligible dividend at the time it is paid, per s. 89(14).

o Failure to designate results in a non-eligible dividend. Private corporations must take active steps to designate; public corporations may simply make a public

statement to presume dividends paid are eligible unless stated otherwise.o Late designations may be accepted where it would be “just and equitable” to do so.

- Must be very careful about ensuring there is adequate GRIP/no LRIP when dividends paid.o If a corporation pays out an eligible dividend which exceeds the GRIP pool, excessive eligible dividend results,

which can result in Part III.1 tax of 20% of dividend under s. 185.1(1). Artificial manipulation of GRIP/LRIP pools raises the tax to 30%.

o Can elect out of this, but best to avoid problem. Can elect under s. 185.1(2) to have the excessive part of the eligible dividend to be a separate non-

eligible dividend. However, this requires all shareholders to agree to the election, which is difficult with larger

corporations.

Calculating the Dividend Tax Credit

(a) Xco is a CCPC. It earns $100 of income, which it distributes after-tax to its sole shareholder, Mr. X. The distribution is not made from Xco’s GRIP. The income is subject to a combined federal-provincial tax rate of 12%. Dividends received by Mr. X are subject to a combined federal-provincial marginal rate of 48%.

- $100 of income in the corporation, subject to tax at 12%, leaving $88.o $88 is starting cash as the dividend paid.o Gross-up of $14.08: 16% * $88.

Taxable income of $102.08.o Tax payable of $49: 48% * $102.08.

Pay tax out of cash from dividends: $88 - $49. $39.00 cash balance.

o Credit of $12.35: 12.1% * $102.08.o Net tax payable of $36.65: $49 - $12.35.o Net cash balance of $51.35: $88 - $36.65.

(b) Yco is a non-CCPC. It earns $100 of income, which it distributes (not out of LRIP) after tax to its shareholders who are individuals. The income is subject to a combined federal-provincial tax rate of 27%. Dividends received by individuals are subject to a combined federal-provincial marginal rate of 48%.

- $100 of income in the corporation, subject to tax at 27%, leaving $73.o $73 is starting cash as the dividend paid.o Gross-up of $27.74: 38% * $73.

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Taxable income of $100.74.o Tax payable of $48.36: 48% * $100.74.

Pay tax out of cash from dividends: $73 - $48.36. $24.64 cash balance.

o Credit of $25.21: 25.02% * $100.74.o Net tax payable of $23.16: $48.36 - $25.21.o Net cash balance of $49.84: $73 - $23.16.

What do these two examples illustrate regarding the gross-up and credit mechanism and the rate of corporate tax? Why are CCPCs and non-CCPCs treated differently? What is the relevance of GRIP and LRIP?

- Difference due to underlying assumptions on the corporate taxes paid by the CCPC/non-CCPC.o Gross-ups and credits are different due to the difference in taxes paid by each.

- LRIP is a blocker which prevents payment of eligible dividends until non-eligible dividends drain out the LRIP account.- GRIP is the general account which is the balance of the CCPC and which eligible dividends may be paid up to.

Principles Behind the Dividend Tax Credit

- Why is the gross-up and credit mechanism limited to shareholders who are resident individuals?o Corporations are generally not taxed for dividends they receive from other corporations.

Only individuals will have to bear personal tax on dividends received, and thus only they receive dividend tax credits.

o Apply only to residents due to uncertainty as to how other countries treat corporate tax income and how their resident shareholders are taxed on dividends.

- Why is it limited to “taxable dividends” as defined in s. 89(1)?o If a dividend is not subject to tax, integration is entirely unnecessary as there is no tax to relieve against.o Non-taxable dividends are generally paid from special pools which are subject to no additional tax; offering

relief following that is unnecessary.- Why must the corporate payer be a “taxable Canadian corporation”, as defined in s. 89(1)?

o Stems from the taxability of the corporation.o If a corporation is not a taxable Canadian corporation, it is unlikely that the corporation’s income has ever been

subject to Canadian corporate tax. As a result, integration is unnecessary as there is nothing in Canadian tax to integrate against.

- Why are the DTC rates in section 121 different? Particularly, see ss. 121(a) & 121(b).o Due to assumptions about underlying corporate tax rates.o For eligible dividends, the assumption is that tax has been paid at 27%, and as a result both a larger gross-up

and a larger DTC are necessary for proper integration.o For non-eligible dividends, assumption is 12% corporate tax rate, meaning that lesser amounts are required to

gross-up and integrate. Dividends paid from investment income, which are subject to 27% tax after RDTOH is refunded, are

still considered non-eligible dividends. However, the assumptions behind non-eligible dividends assume a 12% corporate tax rate,

meaning that shareholder-corporate structures receiving dividends paid from investment income are over-taxed.

- The DTC is generally “unfunded”: it is provided without regard to the actual tax paid at the corporate level.o What does this imply about the purpose of the DTC?

Integration will never be perfect. DTC does not account for the actual amount of corporate income tax paid.

o If the corporation reduced its effective tax rate, the integrated tax rate will be less.

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Also possible that too little tax payable has been assumed, raised the integrated tax rate. Federal rates assume federal DTC and provincial tax rates and DTC.

Not all provinces provide a DTC which corresponds to their provincial corporate tax rate.o Is it an integration mechanism?

Not fully due to the reliance on so many assumptions.o Does our system for the taxation of income earned through a corporation and distributed as a dividend to an

individual achieve integration by accident or design? Roughly in between. If the integration systems works perfectly, it is by accident due to the reliance on assumptions. Design is for simplicity and to ensure tax compliance.

o How is the DTC unfunded if it is limited to GRIP and LRIP? Eligible dividend is unfunded because GRIP and LRIP only account for the types of taxable income

earned by the corporation, and not the actual tax paid. If a CCPC has GRIP received in some way, the corporation is never taxed on that amount but

the CCPC has a GRIP account nonetheless.- Is the amount of the dividend on which the DTC is calculated net of any related expenses?

o No. It should not, actually, as it is based solely on the amount included in the individual’s shareholder

income and the underlying assumptions.o Shareholder expenses have no bearing on the corporate income tax paid, and there are other means of crediting

for those costs.- Is the DTC refundable?

o If a credit is refundable, the legislation enacting the credit will deem there to have been an overpayment of tax to the extent that the credit reduces tax payable to 0 or less than zero.

The deemed overpayment of tax results in an amount which could be refunded.o A non-refundable tax credit would not have the same wording.

Absent that wording, the deeming rule will deem a negative amount to be nil and thus no refunds possible.

o The DTC is not refundable, due to s. 121. No specific language included to cover deemed overpayments. Integration aims to be ‘close enough’ and not perfect.

If it was meant to be perfect, the DTC would need to be refundable, but it would also require some system to claw it back if overpaid.

The current regime does not account for actual corporate tax.

III–IV: TAXATION OF DIVIDENDS BETWEEN CORPORATIONS

TREATMENT OF INTER-CORPORATE DIVIDENDS

Exempting Inter-Corporate Dividends from Taxation

- A corporation must include in income all dividends received per ss. 82(1)(a) & 12(1)(j).o However, in calculating its taxable income, a corporation may deduct an amount equal to the taxable dividends

received in the year from a taxable Canadian corporation (s. 112(1)(a)). Dividend must be taxable dividend. Payer of the dividend must be taxable Canadian corporation or a corporate resident in Canada and

controlled by a dividend recipient. Must be de jure control.

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o This deduction ensures that income earned in a corporation is taxed once at the corporate level as earned and again only on distribution as a dividend to an individual.

- Effectively, these deductions avoid multiple levels of corporate tax where income is earned in a corporate structure that includes one or more holding corporations, wherein the holding corporations receive dividends from operating subsidiaries.

- Why are inter-corporate dividends not just excluded from income?o Keeps the individual and corporate tax base broadly aligned, where the amount of income included is generally

the same. A deduction is simply enjoyed by corporations which individuals do not have access to.

- Why is section 112 limited to taxable dividends?o Supposed to zero out dividend income.o If a corporation does not receive a taxable dividend, nothing is included in income and it is therefore pointless

to include a deduction against that.- What must the status of the corporate payer be? Why?

o If a corporation receives something that is not from one of the two enumerated payers, then it is very likely that corporate tax was never paid on that income.

One layer of corporate tax helps to ensure some tax is recovered.

PART IV TAX ON INTERCORPORATE DIVIDENDS

Part IV Tax as an Anti-Deferral Mechanism

- Deduction from income for inter-corporate dividends creates a potential deferral benefit.o Could invest in portfolio shares through corporation, and defer tax on dividends until holding corporation pays

dividends.- Part IV tax eliminates the deferral benefit.

o Refundable tax on dividends that piggybacks off RDTOH mechanism.o Individuals will pay tax as if they received the dividend directly.

- In certain circumstances, inter-corporate dividends are subject to a special tax under Part IV of the ITA.o This tax is designed to prevent individuals from incorporating their “investment portfolios”, and then take

advantage of the inter-corporate dividend deduction deferring to defer the shareholder-level tax on dividends received.

“Investment portfolios” is used here as a collective term for all the equity securities held by an individual.

- Part IV tax accomplishes this goal by imposing a tax rate that approximates the highest marginal rate for individuals on dividend income.

o The tax is then refunded when a corporate recipient pays a dividend to an individual.

Mechanism for Part IV Tax and Part IV Tax Refund

- Sections 129(1), 129(3)(b) & 186 operate together to implement this mechanism.- Part IV tax is primarily imposed by s. 186(1):

o If dividend recipient is a private corporation (s. 186(3)); THEN EITHER Tax equal to 38.3…% of assessable dividends from non-connected corporations (s. 186(1)(a)); OR Portion of connected payer’s RDTOH refund that the assessable dividend received is of all taxable

dividends paid in the year (s. 186(1)(b)). Assessable dividend is a taxable dividend under s. 112(1).

o Almost every taxable dividend will be an assessable dividend, as a result.- Section 186(1)(c) allows a recipient to apply current year non-capital losses to reduce Part IV tax.

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- Section 186(1)(d) allows otherwise deductible non-capital losses to reduce Part IV tax.o Both reductions are to 38.3…% of assessable dividends.

- The amount of Part IV tax that will be paid depends on whether the dividend recipient and payer are connected.- Part IV tax is added to the RDTOH account under s. 129(3)(b). May be:

o Added to eligible RDTOH to the extent that the Part IV tax was applicable to a dividend which recovered eligible RDTOH or was paid on an eligible dividend recovered from a public corporation; or

o Added to non-eligible RDTOH.- Section 129(1) provides for a refund equal to 38.3…% of all taxable dividends paid by the corporation in the year

while a private corporation.o $1 of dividend refund for every $2.61 taxable dividends paid.o Deliberate symmetry between Part IV tax rate and Part IV tax refund.

Qualifying for the Part IV Tax and Part IV Tax Refund

- Section 186(1) sets out the circumstances in which Part IV tax is payable, as well as the tax base and the amount of tax.o Section 186(1)(a) adds to the tax base any tax-free dividends between corporations that are not connected.o Section 186(1)(b) includes tax-free dividends between connected corporations, to the extent that the payer

generates a dividend refund with the payment. - Section 186(1)(a) & 186(1)(b) are distinguished by the nature of investment which they address.

o Part IV tax is designed to address the deferral problem that might otherwise arise on the incorporation of an individual’s “portfolio” investment.

Economists refer to “portfolio investments” as a “non-controlling interest”. Due to this lack of control, an investor is interested in the return on securities issued by the corporation.

o Portfolio investments are usually contrasted with direct investments, whereby the investor has a “controlling interest” in the corporation.

Because of this control position, a direct investor is interested in the return on the underlying assets owned by the corporation.

- The ITA uses “connection” to distinguish between a portfolio and direct investment with respect to Part IV tax.o Section 186(1)(b) effectively permits dividends received on a direct investment to be paid free of Part IV tax.

This is due to the assumption that, in the context of a direct investment, the income earned in the corporation belongs to the direct investor and may be shifted to other corporations owned by the investor free of Part IV tax.

o Section 186(1)(b) also permits income earned in an operating subsidiary to be moved within a “corporate group” (as defined in terms of “connection”) free of any Part IV tax.

However, the group cannot reduce the corporate tax payable on investment income simply by distributing the income to another group member.

That distribution generates a dividend refund for the payer. When this occurs, Part IV tax must be paid by the recipient to ensure that the corporate group pays tax

on investment income initially at the general corporation rate. The reduction in that rate only occurs on distribution as a dividend to an individual who is the

ultimate direct investor.- Section 186(4) sets out two means of “connection”:

o Dividend payer is controlled by dividend recipient; or De jure control, as modified by s. 186(2).

o Dividend recipient owns more than 10% of the voting shares and more than 10% of the value of the shares of the dividend payer.

Two unrelated arm’s length corporations would be connected in this way. A “votes and value test”.

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As a “more than 10%” share, exactly 10% ownership is not sufficient. Cf wording of “10% or more”, which does allow for exactly 10% ownership.

- Section 186(2) modifies ‘control’ – dividend payer is not only controlled by the dividend recipient if the recipient owns more than 50% of voting shares; if a combination of the dividend recipient and non-arm’s length parties own more than 50% of voting shares, then they control.

o As a result, if corporations are members of a related group, the corporations are likely to be connected; there is likely deemed de jure control due to a common party.

Further Details on Part IV Tax

- Because the Part IV tax rate is lower than the personal income tax rate, there would theoretically be a strong incentive to leave the RDTOH amounts in the corporation if Canadian taxation was perfectly integrated.

o However, due to dis-integrated investment taxation rates, interest would need to be very high.o Generally, B would just flow-through the dividend.

- What kinds of corporations are subject to Part IV tax and on what type of dividends?o Private corporations and subject corporation (s. 186(3)) both are subject to Part IV tax.

Effectively the type of corporations which would be ‘pocketbook’ deferral corporations. Unless a public corporation was a subject corporation, it would be very difficult to use that corporation

as a deferral vehicle.- Why are only these corporations subject to these taxes? Recall that a corporation must be a private corporation at the

time that a dividend is paid to be eligible for a dividend refund under s. 129(1).o In order to claim a dividend refund from RDTOH, the corporation must be a private corporation when they

issue a dividend to its shareholders.- How might this condition affect the refundability of Part IV tax?

o If a corporation has paid Part IV tax, has a large RDTOH balance, and then somehow loses its private corporation status, it cannot recover its Part IV refund.

- How does the status of a corporation affect the amount of Part IV tax added to RDTOH under s. 129(3)(b)?o In theory, any corporation may have an RDTOH balance; only private corporations could use it.o Only private corporations and subject corporations an add to RDTOH balance through Part IV tax.

Subject corporations can notionally maintain a RDTOH balance even though it is entirely useless until it becomes a private corporation.

- At what point is the ‘connectivity’ determination made?o “At that time” denotes a point in time test.

- Is the threshold for connection too low?o Depends on the absolute size of the investment.

For smaller corporations, a passive investor with sufficient interest to clear the votes and value test could nonetheless be subject to the Part IV tax.

o A 10.01% ownership share in a public corporation is very likely a controlling interest in the corporation. The ITA uses the 10% number throughout – either “10% or more” or “more than 10%”.

- What are the purposes of ss. 186(1)(c) & 186(1)(d)?o Allows taxpayers to use their non-capital losses for Part I purposes to reduce their Part IV tax payable.

- Why would a corporation deduct these amounts from its Part IV tax base?o Deferral on Part I tax is permissible to the extent the corporation has losses.o Also helps to capture corporations which had large amounts of ‘banked’ losses to be able to use those losses

against immediately payable taxes.- When is the payment of Part IV tax due?

o Section 187(3) provides that certain provisions of Part I are made applicable to Part IV, with necessary modifications.

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o Balance due date for a CCPC is two months from the end of the taxation year. As this comes before Notice of Assessments and filing of returns, many corporations will pay tax at an

interim basis to avoid interest on the Part IV tax payable.- How might a corporation gain a one-year deferral of the tax?

o On or prior to December 31 (the year end for XCo), XCo pays a dividend to YCo, and recovers its RDTOH.o However, assume YCo has a December 30 year end.

The dividend is now included for the subsequent taxation year for YCo.o Had the dividend been left with XCo, Part IV tax would have been payable for February 28 of the current year.

With the dividend being paid to YCo, Part IV tax would then be payable on February 27 of the following year.

This accomplishes a 364 day deferral.o Usually, this sort of scheme is not necessary.

However, if there are clear indications and likelihood of tax rate changes, a one-year deferral would accomplish very material tax savings.

o This will usually be done only for one year before GAAR applies.

Calculating Part IV Tax Consequences

A and B, two individuals, have the same shareholding in Xco (less than 10% of the outstanding shares on a “votes and value basis”). A receives a dividend of $100 directly from Xco that is paid from Xco’s LRIP. B incorporates her shareholding in Xco. B's holding corporation, Bco, receives her dividend from Xco that is paid from Xco’s LRIP. Compare the federal tax consequences to A and B on receipt of the $100 dividend. What are the tax consequences when Bco distributes the $100 dividend to B as a taxable dividend?

- Payment of both dividends from LRIP means that they are non-eligible.- A receives $100 taxable dividend.

o Included in income.o Dividend is non-eligible so gross-up of 16%, leaving taxable income of $116.

Tentative tax payable of $55.68 (48% of $116). Federal DTC of $11.63 and provincial DTC of $2.41; combined $14.04 (12.10% of $116).

o A pays $41.64 ($55.68 - $14.04) of personal income tax on the $100 dividend.- BCo receives dividend.

o Must include dividend for Part I purposes.o A s. 112(1) deduction also applies.o BCo will have nil income due to receiving the dividend.o Are BCo and XCo connected?

No evidence that BCo and non-arm’s length parties control XCo. Facts stipulate BCo does not meet the votes and value test.

o All Part IV tax conditions satisfied. BCo is a private corporation. Dividend is a taxable dividend and is thus an assessable dividend.

o Section 186(1)(a) applies. 38.3…% tax rate for a $100 dividend: $38.33 Part IV tax liability for BCo.

o That amount will be added to non-eligible RDTOH (or simply RDTOH if 2018) for BCo. BCo, in 2018, would pay a taxable dividend greater than or equal to $100 to recover the RDTOH. In 2019, BCo would pay a non-eligible dividend of $100 or more.

o Once BCo pays out the dividend, B would go through the same tax liability as A - $41.64 of personal income tax payable.

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Assume that Yco owns 10% of the voting shares of Xco and that those shares also represent 10% of the fair market value of the outstanding shares of Xco. Xco earns $100 of ABI eligible for the SBD (combined federal-provincial rate 12.5%) and distributes the after-tax cash to Yco. What are the tax consequences to Yco?

- YCo does not clear the votes and value test.o YCo and XCo are not connected under s. 186(4)(b).

- Unless people who do deal at non-arm’s length with YCo own sufficient shares in XCo, the corporations will not be connected.

- May assume that YCo is a private corporation and that the dividend paid is a taxable dividend.o Conditions for Part IV tax satisfied.

- Section 186(1)(a) applies due to non-connected corporations.o 38.3…% of dividend received paid as Part IV tax.

$38.33 tax payable.o Addition to non-eligible RDTOH which may be refunded with a $100 non-eligible dividend.

What if Yco distributes the amount received from Xco as a dividend to its sole shareholder, an individual?

- YCo’s issuing of a dividend would entitle YCo to a dividend refund equal to 38.3…% of the dividend paid.o Y receives $100 non-eligible dividend and needs to pay tax on that dividend.

- The usual gross-up mechanism applies to calculate Y’s tax payable:o Dividend is non-eligible so gross-up of 16%, leaving taxable income of $116.

Tentative tax payable of $55.68 (48% of $116). Federal DTC of $11.63 and provincial DTC of $2.41; combined $14.04 (12.10% of $116).

o Y pays $41.64 ($55.68 - $14.04) of personal income tax on the $100 dividend.

What if Yco's shareholding in Xco represents 25% of the outstanding “votes and value” of Xco?

- If YCo owned at least 25% of XCo’s shares, the calculation is fundamentally changed.o XCo and YCo will be connected under s. 186(4)(b), and thus s. 186(1)(b) Part IV tax applies.

Assuming no existing RDTOH account, no dividend refund for XCo when paying out dividend. ABI is not AII and will not add to RDTOH.

Therefore, dividend received by YCo will not be subject to Part IV tax. Technically, Part IV tax payable is nil.

Assume in the above example that Xco earns $100 of interest income (“Canadian investment income”) instead of ABI. Xco pays a taxable dividend of $80 to Yco, which holds shares of Xco representing 25% of the outstanding “votes and value”. What are the tax consequences of the dividend payment to Xco and Yco?

- 25% of outstanding “votes and value” is sufficient to connect XCo to YCo.o Section 186(1)(b) then applies.

- XCo is a taxable Canadian corporation, and will pay taxable dividends which will qualify for the s. 112(1) deduction.- Assuming that YCo is a private corporation, the dividend will be an assessable dividend when received by YCo, leading

to Part IV tax.o Further, due to connection from s. 186(1)(b), the amount of Part IV tax will depend on certain things.

- Assume that XCo has multiple classes of shares, such that the $80 of dividend is the only dividends paid in the year and YCo is the only recipient of dividends in the year.

o This is necessary for the simple application of s. 186(1)(b), which accounts for portions of dividends issued.- Due to having earned AII (interest income), XCo would need to add $30.67 to its RDTOH account in 2018, the amount

applicable from the $100 AII, pursuant to s. 129(3).o The $80 dividend is sufficient to completely recover its RDTOH account (38.3% * $80 = $30.67).

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- All $80 of the dividend is received by YCo, and therefore under s. 186(1)(b), the Part IV tax applicable to the dividend received is $30.67 – the amount of XCo’s RDTOH refund.

o That amount will be added to RDTOH for YCo when received. When YCo receives that dividend, there will be no Part I tax, due to s. 112(1). Only tax payable by YCo at time of receipt will be Part IV tax.

- If YCo wishes to receive a refund for Part IV tax, they simply need to repay a dividend to its shareholders.o An $80 dividend to shareholder Y will be sufficient to recover the Part IV tax.o YCo pays the dividend and becomes applicable for a Part IV refund under s. 129(1).

- For Y, an $80 dividend will be included under s. 82(1)(a).o The dividend will not be eligible (an assumption by XCo receiving only interest income, and no other mentions

that the dividend was designated as eligible).o Section 82(1)(b) grosses up by 16%, bringing up taxable income to $92.80.

Tax payable will be $44.54 (48% of $92.80). Combined DTC of $11.24 ($9.31 tax credit federally and a $1.93 provincial tax credit). $33.30 net tax payable from the $80 dividend. $46.70 cash remaining after payment of personal tax.

What if Yco holds shares of Xco representing 10% of the “votes and value”?

- If YCo only owned 10% of the shares (and assuming connected parties to YCo do not own sufficient shares to deem ownership), s. 186(1)(b) would not apply as 10% is not more than 10%.

o Section 186(4)(b) does not connect the two corporations, resulting in a dividend being paid by a Canadian corporation to a non-connected Canadian corporation.

This will be an assessable dividend and tax under s. 186(1)(a). 38.3…% of Part IV tax will apply.

Section 129(3)(b) will add the Part IV tax payable to RDTOH.

III–V: CAPITAL DIVIDENDS, IN SPECIE DIVIDENDS, AND STOCK DIVIDENDS

TAX ON SPLIT INCOME (“TOSI”)

Policy Rationale Behind TOSI

- Planning idea for TOSI is to pay dividends to or realize capital gains by related shareholders who are not involved in a business so that they pay tax on a lower, unused marginal tax rate.

o E.g. Stay-at-home dad receives dividends from oral surgeon wife’s professional corporation income.o Validated in two SCC cases in late 1990’s.

Amalgamates the individual tax unit into a family tax unit.- Solution to stop this is to tax this amount at the highest marginal tax rate.

o Introduced for 2018.o Extends the ‘kiddie tax’ rules to adult children and spouses, rather than just minor children.o An addition to Part I tax, rather than a reduction in tax rates; consequently, tax credits do not apply.

Who is Subject to TOSI?

- Individual needs to be a specified individual.o Virtually all Canadian residents.

- Is the income or gain considered split income?o All income with the exception of employment income and income from marketable securities.o Exception if the income or gain is an excluded amount – a complex list of situations.

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- Very difficult to use a private corporation to split income with someone not involved in the corporation’s operations.

CAPITAL DIVIDENDS AND THE CAPITAL DIVIDEND ACCOUNT

Defining Capital Dividends

- Corporations may sometimes receive tax-free amounts; neutrality requires tax-free integration of those amounts.o Capital dividends serve this function.

Amounts are specifically excluded from income under s. 83(2). No corresponding negative adjustments to shareholder’s other tax attributes.

- Sections 82(1)(a) & 12(1)(j) require shareholders to include in their income all taxable dividends received from Canadian-resident corporations.

o As defined in s. 89(1), a taxable dividend is any dividend other than a capital dividend (as defined in s. 83(2)), a qualifying dividend, and a surplus pots dividend (as defined in s. 83(1)).

Qualifying dividends and surplus pots dividends are both narrow and historical exceptions. Conceptually and practically, taxable dividends are the most important.

Capital Dividends as Tax-Free Dividends

- A capital dividend is excluded from a shareholder’s income under s. 83(2) . o Furthermore, the amount of a capital dividend does not reduce the ACB of the shares on which it is paid.

If such a reduction were required, a capital dividend would only be tax-deferred because, on the disposition of the shares, the reduction in the ACB would be effectively taxed as gain.

o The exclusion from income and the lack of an ACB adjustment means that a capital dividend is truly non-taxable and not just tax-deferred.

- A capital dividend is a dividend in respect of which a corporation has elected under s. 83(2) to the extent of its capital dividend account (CDA) on hand immediately before the dividend became payable.

o Characterization as a capital dividend depends on a corporation’s CDA, as defined in s. 89(1).o The CDA includes certain amounts that are not taxable generally.

Those amounts are not taxable as realized by a corporation.o The CDA and the election mechanism in s. 83(2) maintain the non-taxable character of the particular amounts

when they are paid as a dividend to a shareholder. In effect, there is perfect integration of these non-taxable amounts.

o A corporation must elect to pay a capital dividend under s. 83(2). This requires a filing of CRA Form T2054 on the earlier of:

The date the capital dividend was elected; or The date the dividend was paid.

Late filing carries a minor monetary penalty (essentially a filing fee).- Paying capital dividends in excess of CDA results in Part III tax equal to 60% of the amount by which capital dividend

exceeds CDA (s. 184(2)).o Can elect to have the excess portion of the capital dividend be treated as a separate dividend (s. 184(3)).

Akin to the excess eligible dividend election. Requires the concurrence of all shareholders in the corporation, aside from tax-exempt entities.

o Under s. 89(14), all or part of a dividend may be designated as an eligible dividend.o In comparison, all or none of a dividend must be designated as a capital dividend.

- As a result of the Part III tax, it is safer to simply take time to file the CRA Form T2054 and ensure that the CDA account is accurately calculated.

o The Part III tax is much greater than the monetary penalty for late filing.

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- What type of corporation may pay a capital dividend? Why?o Only a private corporation may pay a capital dividend.

Not limited to CCPC’s; a private corporation that is not a CCPC may still pay a capital dividend.o Under s. 83(2), only a private corporation may make a designation for a capital dividend.

- What are the elements of the CDA?o The capital dividend account is the total by which three amounts exceed capital dividends paid prior to a

particular time (point in time test, immediately before the dividend is paid): Amount if any by which the total of the corporation’s non-taxable portion of its capital gains exceeds

the non-allowable portion of its capital losses; The amount of any capital dividend received from another corporation; The amount received as death benefit under a life insurance policy that is received upon the death of a

person who is the insured person of the policy in excess of the adjusted cost basis of the policy.o These amounts would not be taxed if received by an individual shareholder directly.o Exact determination of CDA would be difficult under various circumstances:

Uncertain of the nature of amounts received. Realization of a capital gain (proceeds of disposition less selling expenses and ACB of asset) may be

uncertain immediately following disposition. Calculation of a death benefit.

- When may a corporation’s CDA be calculated?o A point-in-time test, calculated immediately prior to the payment of the dividend.

- For what period are the amounts in s. 89(1) taken into account (when are each of the amounts added to CDA)?o Each amount adjusts CDA immediately (post-2017).

Prior to 2017, eligible capital property would be included in business income. Captured things like trade secrets or goodwill. CDA addition due to eligible capital property did not occur when the property was disposed,

but instead at the end of the taxation year in which the eligible capital property was disposed.- What happens to the CDA if a corporation loses its status as a private corporation?

o In the definition of CDA, a private corporation does not lose its CDA when it ceases to be a private corporation. However, s. 83(2) allows only private corporations to pay out capital dividends. Hence, a private corporation should pay out its CDA before ceasing to be a private corporation.

Non-private corporations may hold a CDA but cannot pay capital dividends.- May a corporation have a negative CDA balance?

o No; if CDA could be computed to less than zero, it would simply be zero. However, CDA is computed as a series of separate ‘pots’.

Pot 1 is non-taxable capital gains less allowable capital losses. Pot 2 is capital dividend received. Pot 3 is life insurance benefits received.

For considering whether a negative CDA balance is possible, only Pot 1 is relevant. Pot 1 could become negative, and no positive balance could be found in that pot until the

capital losses are ‘offset’ by capital gains. Pot 1 can also ‘drag down’ the other pots by being negative.

o Not possible for a negative CDA balance, but the balance can be complicated by the negative balance in the capital gain/capital loss pot.

Constituent Elements of the CDA

- What does the amount in paragraph (a) of the CDA definition in s. 89(1) represent?o Indicates the capital gain/capital loss pot.

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o Will not actually become negative, but will functionally impair other pots by becoming negative. Has timing implications: if a negative is to be realized with capital losses, all gains should be realized to

boost CDA and capital dividends paid out before the capital losses are realized.- What does the amount in paragraph (c.2) of the CDA definition in s. 89(1) represent?

o Addition for non-taxable capital gain from an eligible capital property.o Previously a CDA pot, which accounted for the amounts realized from disposition of capital property at the end

of the taxation year, rather than at time of disposition.o While repealed in 2018, any amounts lingering in this pot would remain in the CDA account.

- What do the amounts in paragraphs (b) & (d) of the CDA definition in s. 89(1) represent? Why are these amounts included in the CDA of a corporation?

o Paragraph (b) represents capital dividends received from another corporation.o Paragraph (d) deals with death benefits under a life insurance policy.o Both amounts are included as both would be received tax-free if received directly by an individual shareholder

rather than the corporation.- How does the election mechanism in s. 83(2) operate?

o Earlier of the date of: Dividend was elected; Any part of the dividend was paid.

o Reg 20101 prescribes CRA Form 2204 as the prescribed form, and requires a director’s resolution to be included with the form designating the dividend as a capital dividend, and a computation of the corporation’s CDA account immediately prior to the dividend being declared.

Declaration must be in respect to the entire dividend paid.- What if a corporation elects under s. 83(2) in respect of the full amount of a dividend, which amount exceeds its CDA

immediately before the dividend is declared? How are ss. 83(2), 184(2) & 184(3) relevant?o The dividend is subject to a 60% tax to the extent that it exceeds the corporation’s CDA account at the time.o Fixing excess capital dividends is for the corporation and the shareholders who received the excess dividend to

elect under s. 184(3) to have the excess amount be a separate taxable dividend. Conditions for election are set out in ss. 184(3) & 184(4). Must elect within 90 days of the Minister sending an Assessment for Part III tax, and all shareholders

who received the taxable dividend (who are not tax-exempt) must concur with the election.o If the election is made within 30 months of the date the dividend is paid, and a shareholder has no reachable

address, the election is not necessary.o Non-statutory fix is a rectification order.

Convince a Superior Court Justice that there was a mistake in documenting something that does not reflect the true intention of the parties ,and the parties had a continuing intention to adhere to the original (mis-documented) intention, a Court of Equity may modify the agreement to reflect the true intention of the parties.

Prior to 2016 and the Fairmont decision from the SCC, this was straightforward.

Calculating CDA

Xco, a CCPC, realizes a taxable capital gain of $1,000 in 2018. What amount is included in the CDA of Xco? What if Xco instead realized a $750 allowable capital loss in 2018 and then a taxable capital gain of $7,500 in 2019?

- $1,000 taxable capital gain is added to capital gain/capital loss CDA pot.o An allowable capital loss of $750 means that there was a gross capital loss of $1,500, a non-allowable capital

loss of $750, and thus a negative addition of $750 to the capital gain/capital loss CDA pot.o Without other taxable gains, the negative $750 amount do nothing in 2018, but will do something in 2019.

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o Taxable capital gain of $7,500 in 2019 means a gross $15,000 capital gain, and a non-taxable capital gain of $7,500, resulting in a $7,500 additional to the capital gain/capital loss CDA pot.

o The capital gain/capital loss pot in 2019 (after realizing the capital gain) will be $6,750. This is the amount XCo may pay out as a capital dividend. Must account for lingering $750 from 2018 – the non-allowable portion of 2018’s capital loss.

DIVIDENDS IN KIND AND STOCK DIVIDENDS

Dividends in Kind (In Specie) and Stock Dividends

- While dividends are generally paid in cash, they can be paid by distributing an asset other than cash.o For instance, a corporation may pay a dividend by distributing property it owns or by issuing more of its shares.

The former type of dividend is commonly referred to as a dividend in kind (in specie) and the latter type a stock dividend.

In specie Dividend: Transfers of corporate property to shareholders.o A common example is that a business will sell its shares and pay its dividends by

distributing its land to its shareholders.o For public corporations, in specie dividends arise often when corporations spin off its

subsidiaries, and issues shares of its subsidiaries to its shareholders. Stock Dividends: Issuance of new securities to shareholders with FMV equal to dividend.

o For private corporations, stock dividends tend to be common with estate freezes.o Many public corporations will allow their shareholders to take dividends through

shares rather than through cash. Common when public corporations pay out a larger dividend for optics. Generally, public corporations today tend to do stock buybacks, rather than

issuing additional shares.- Recall that the definition of a dividend in s. 248(1) specifically includes a stock dividend, which is defined in the same

to include any dividend paid by the issue of shares of the payer.o Section 43(1) of the Alberta Business Corporations Act provides the private law authority for the payment of a

dividend in kind as well as a stock dividend.- The provisions of the ITA governing the tax consequences of a stock dividend are intended to ensure that after-tax

income earned by a corporation cannot be “capitalized” and returned to the shareholders as a capital receipt.o Deemed dividend rules and paid-up capital (both infra) help to effect this result.

- Per s. 82(1)(a), all the “amounts” of dividends must be included as income, including in specie and stock dividends.o What is the “amount” of a dividend in kind and a stock dividend?

Sections 12(1)(j) & 82(1)(a) do not distinguish between cash and non-cash dividends. In either case, these sections only require the amount of the dividend to be included in income.

o How is the definition of “amount” in s. 248(1) relevant? Section 248(1) defines the “amount” of either type:

For an in specie dividend, the amount is the money value of the thing received. For a stock dividend, the amount by which paid-up capital (PUC) is increased because of the

stock dividend.o PUC is the amount that would be added to the corporation as a result of the payment of

the stock dividend (further infra).- The payment of a dividend in kind is economically equivalent to a disposition of the particular asset by the corporation

followed by the distribution of the cash proceeds as a dividend.o The provisions of the ITA governing the payment of a dividend in kind recognize this economic equivalence.

- Section 52(2) deems cost of property received in satisfaction of an in specie dividend to be equal to FMV.

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o Cost of the property is both what is included in income and what the shareholder has foregone in receiving an in specie dividend rather than cash.

- Section 52(3) generally deems cost of stock dividend shares to be equal to the amount of stock dividend.o Due to the application of s. 55(2), there is a deemed proceed or gains on the disposition of a stock dividend,

even though that disposition is non-taxable.o Cost of the new shares will be equal to the amount of the dividend, as defined in s. 248(1).o Amount of a stock dividend is the amount added to PUC as a consequence of the stock dividend; as a result,

ACB of the shares will be equal to the amount added to PUC as a consequence of the stock dividend.- Deeming rules apply to the dividend payer.

o Section 52(2) applies to the in specie dividend payer, and deems the corporation to have disposed of distributed property for proceeds equal to FMV.

Will result in a capital gain/capital loss, depending on the proceeds of disposition and ACB of the property (assuming the property is capital property).

o No tax implications for the dividend payer on issuance of stock dividend. Not a “disposition” within the meaning set out in s. 248(1).

- However, when a corporation pays an in specie dividend or a stock dividend, they still have paid out a dividend.o If that dividend is a taxable dividend, a private corporation may recover its RDTOH, and could designate the

dividend as a capital dividend, at the time the dividend is paid.o Conversely, if the dividend is paid to a private corporation, the private corporation could still have Part IV tax

equal to 38.3…% of the amount included in income.

Tax Effects of an In Specie Dividend

Aco owns a parcel of land with an ACB of $500 and a FMV of $1,000. Aco declares a dividend of $1,000 on certain shares held by A, an individual. Aco pays the dividend by transferring the parcel of land to A.

- When ACo declares and pays the in specie dividend, s. 52(2) deems ACo to have disposed of the land at FMV of $1,000, leading to realization of a $500 capital gain and a $250 taxable capital gain.

o Tax payable of $126.67. $76.67 (30.6…% * $250) will be added to ACo’s RDTOH balance, and will be refunded as a consequence of the payment of the in specie dividend to A.

o Add $250 to ACo’s CDA (non-taxable portion of capital gain).- ACo has tax payable of $50, following the RDTOH refund (20% of the taxable capital gain ($250)).

o Cannot elect to have capital dividend, as the full amount of dividend is $1,000, in excess of the CDA of $250.- A has received a $1,000 taxable dividend equal to the FMV of the property, with s. 248(1) defining the amount.

o Following the gross-up and credit mechanism, tax payable is $416.40.o Assuming the dividend is not an eligible dividend.o Section 52(2) has A’s costs in distributed land going forward equal to $1,000 – the amount of the dividend.

What if, in the above example, Aco sells the land to a third party and distributes the $1,000 of cash proceeds to A as a dividend?

- ACo has realized a capital gain of $500 and a taxable capital gain of $250.o $250 non-taxable capital gain added to CDA.o Same addition of $76.67 to RDTOH, to be refunded upon payment of the dividend.

- ACo has tax payable of $50, following the RDTOH refund (20% of the taxable capital gain ($250)).- ACo can either pay a $1,000 dividend, or two separate dividends – one of $250 and one of $750.

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- Assuming the latter, A receives a $750 taxable dividend (which, subject to the gross-up and credit mechanism, results in tax payable of $309.68).

o The separate $250 dividend can be assumed to be designated as a capital dividend under s. 83(2) and that the appropriate CRA procedures are followed, such that A receives a capital dividend to be received tax-free.

Reduction in ACo’s CDA balance by $250.- The result in tax payable should be the same, subject to the possibility for CDA and capital dividends.

Tax Effects of Stock Dividends

Aco declares a dividend of $1,000 on certain shares held by A, an individual. Aco pays the dividend by issuing to A more of the same shares. On the issue, Aco adds $1,000 to the paid up capital (“PUC”) of the relevant class.

- Addition of $1,000 to PUC means that the amount of the dividend will be $1,000.- From ACo’s perspective, the payment of the stock dividend is a non-issue (paragraph (m) of the definition of

“disposition” in s. 248(1) deems no disposition).- However, there is a dividend in the amount of $1,000, meaning if ACo had a CDA balance of $1,000, ACo could

designate this as a capital dividend.o Alternatively, if ACo had an RDTOH balance, and did not designate the dividend as a capital dividend, it could

receive a RDTOH refund of $383.33.- From A’s perspective, they have received a $1,000 dividend which must be included in income.

o Through the gross-up and credit mechanism, this requires tax payable of $416.40.o Section 52(3) deems an addition of $1,000 of cost in the new shares of ACo.

What if, in the above example, Aco transfers shares of its subsidiary, Bco, in payment of the dividend? The following are the relevant tax values of the Bco shares to Aco.

ACB $500 PUC $500 FMV $1,000

- Stock dividends are as shares of the corporation’s own capital which it issues in satisfaction of a dividend (s. 248(1)).o Rather than ACo issuing shares of its own stock, it has distributed stock of its subsidiary.

This is therefore an in specie dividend, creating a taxed cash liability.- Tax consequences are the exact same as issuing land.- ACo paying out the in specie dividend is deemed by s. 52(2) to have disposed of its share in BCo at $1,000 (the FMV),

realizing a $500 capital gain, a $250 taxable capital gain, an addition of $250 to CDA, and $76.67 (30.6…% * $250) added to RDTOH which is immediately refunded by the payment of the in specie dividend.

- ACo has tax payable of $50, following the RDTOH refund (20% of the taxable capital gain ($250)).- Whole dividend is $1,000, and assuming no CDA balance at time of dividend payment, no amount of the dividend may

be designated as a capital dividend.- The whole amount is therefore taxable when received by A.- A receives a non-eligible dividend with an effective tax rate of 41.16% and a tax liability of $416.40.- A now has a cost in the shares of BCo of $1,000 – the amount of the dividend.

What if, in the above examples, Aco splits its outstanding shares instead of issuing more shares in the form of a stock dividend?

- Describes a stock split.- Nothing happens in this case.

o CRA has very consistently taken the position that a stock split is a non-event for income tax purposes, provided no amount is added to the stated capital in respect of the stock split.

Courts have been consistent in adopting this administrative position.

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- Section 27.1 of the ABCA does not allow for any additions of capital to a stock split.o As a result, if a stock split complies with the ABCA, there is likely to be a good stock split for income tax

purposes.- If there is addition of capital, additional issuance of share, or re-distribution of proportional ownership of shares, what

has actually occurred (as a matter of corporate law), then a stock dividend has been issued rather than stock split.

What if, in the above examples, Aco declares a dividend in the amount of $1 and satisfies the dividend by issuing to A preferred shares that are redeemable/retractable for $1,000 in the aggregate? Aco adds $1 to the PUC of the preferred shares. Is such a dividend permitted by corporate law? See subsections 26(2) and 43(2) of the ABCA. What are the tax consequences of doing so?

- Permissible under the ABCA.o Section 43(2) was enacted for this specific purpose, allowing corporations to declare stock dividends satisfied

by the issuance of shares which is greater than the amount of stated capital. May add any or all of the amount of stated capital to the shares.

- Cost on the shares issued by the stock dividends are $1.o Reduced FMV of common shares by doing this but increased accrued gain on the preferred shares.o Same tax position, but changing of the nature of the shares in doing so – a high-low stock dividend.

- Only $1 is added to PUC as a result, and therefore only $1 is added.o No potential for tax payable for ACo.o Could theoretically be designated as a capital dividend worth $1.

- From A’s perspective, A must include a dividend of the amount of $1.o Gross-up and credit mechanism for a non-eligible dividend leads to tax of $0.41, rounding down to $0.

- This mechanism helps to affect an estate freeze.- Say FMV of some shares are $10 million.

o Use a high-low stock dividend to bloat up the accrued gain of the preferred shares, such that they will soak up all of the value of the corporation. The common shares are then purchased by the shareholder’s children.

Subsection 15(1.1)

- Anti-avoidance rule to prevent value shifting using stock dividends.- Applies if any one of the purposes of a stock dividend was to alter the value of the interest of a 10% shareholder.- The FMV of stock dividend in excess of s. 82(1)(a) inclusion in income from the dividend is included in income as

shareholder benefit.o A full income inclusion immediately between the value of original shares and FMV of stock dividendo Full value of the shares is included as income rather than as a capital gain, effectively doubling tax payable.

Also potential for double tax, due to no adjustment to cost of shares.- Say A owns 99% of shares, and B owns 1% of shares.

o A flips B to a different class of shares (which is a non-taxable event), then pay a high-low stock dividend to B’s new class of shares.

o Transfers all of the value of the corporation to B’s class of shares. When A dies and his shares realize capital gain, there will be minimal tax, if at all. Shifts entire capital gain and tax payable on the capital gain for an entire generation.

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IV: CORPORATE TAXATION – DEEMED DIVIDENDS

IV–I: SHARE ATTRIBUTES – PAID-UP CAPITAL AND SURPLUS STRIPPING

PAID-UP CAPITAL

Distinguishing Capital Payments and Dividends

- The ITA does not contain a comprehensive definition of a dividend.o Section 248(1)’s definition of a dividend does include a stock dividend.o Due to the lack of a comprehensive statutory definition, Canadian courts have accepted the old English case law

holding that any pro rate distribution from a corporation to its shareholders is a dividend, unless the distribution is made on liquidation or an authorized reduction of corporate capital.

The latter two instances are characterized as capital payments and not as dividends. See e.g. Hill v Permanent Trustee of New South Wales (UKPC 1930); IRC v Burrell (UKCA 1924).

- For tax purposes, characterization as a capital payment means that distribution may give rise to a capital gain or loss on shares rather than a dividend.

o Due to this, taxpayers will attempt to ensure that corporate distributions are characterized as capital payments, to the extent that there is a tax preference for capital gain over dividend treatment.

o Effectively, taxpayers attempt to convert what would otherwise be a dividend distribution into a capital gain.- Economically, the effect of a capital or dividend payment is the same – a distribution from a corporation to a

shareholder – but for tax purposes, the effect may be significant different depending on the form of the transaction.- Canadian tax practitioners, administrators, and policy-makers refer to the conversion of a dividend distribution into a

capital gain as surplus stripping, as the relevant transaction ‘strips’ corporate surplus at capital gain tax rates.- To prevent surplus stripping, ss. 84(1) – 84(4.1) deem a dividend to be paid and received in certain circumstances.

o Generally, the circumstances are those in which a distribution might be considered a capital payment on the basis of the aforementioned English cases.

o These deemed dividend rules were enacted in 1972, and permit a shareholder to receive a return of contributed capital at any time; however, to the extent that a payment exceeds capital contribution, it is deemed a dividend.

- In applying the deemed dividend rules, three basis questions must be answered:o When do the rules apply generally and in what circumstances does a specific rule apply?o What is the paid-up capital (PUC) of the relevant class of shares?o What is the effect of the application of a particular deemed dividend rule?

- Various avoidance techniques exist for surplus stripping and return of capital:o A return of capital is not a dividend, and is generally a tax-deferred event as a result.

Will reduce ACB, and can therefore result in a capital gain if ACB is reduced to a negative amount.o While poorly defined, surplus stripping is generally a conversion of a dividend into a capital gain.

Results in a rate deduction that is significantly less (24% vs. 31/71%/41.29% (eligible/non-eligible), or even a complete reduction of tax if there are capital gain deductions or a sheltering of capital gains.

Paid-Up Capital

- The application of all of these rules turn on the concept of PUC.o Designed to represent aggregate direct equity investment in a corporation.

Changes if property is contributed to a corporation or withdrawn from the corporation. Limits the amount of money which can be withdrawn; aim is to not allow withdrawal on a tax-free or

tax-deferred basis which is more than what was originally invested.

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- PUC is the amount of money contributed to the corporation to acquire new shares from the treasury.o Money contributed is after-tax resources contributed by the taxpayer.

Whatever the PUC is on the share, that amount can be returned to whoever the shareholder is and there will be no tax associated with it (i.e. a return of capital).

o To the extent a corporate capital distribution exceeds PUC, that amounts to a dividend, which is taxable.- Some definitions in s. 89(1) are of assistance by defining how PUC may be calculated in certain cases.

o PUC of a class of shares (paragraph (b)); Subject to adjustment in paragraph (b), this is the ABCA stated capital of that class of shares.

Aggregate share of capital is the starting point, absent any other adjustments, for the PUC of a class of shares.

Starting point is figuring out the PUC of the entire class of shares.o PUC of a share of a class (paragraph (a)); and

A pro-rata approach: take the number of shares issued and outstanding of a particular class, and multiplying that fraction against the PUC of the entire class of shares.

o PUC of all shares of all classes (paragraph (c)). Only applicable in some cases; unimportant for most surplus stripping rules.

- What is the PUC of a share?o The PUC of a share is defined in s. 89(1), and is equal to the amount determined when dividing the PUC of the

entire class of share by the amount of number of issued and outstanding shares of that class at that time.o PUC of the entire class will be the stated capital of the class as set out under s. 26 of the ABCA.

- What does PUC represent for tax purposes? See ss. 89(1) & 248(6) ITA and s. 26 ABCA.o Shareholders cannot extract more than PUC without being deemed to have received a dividend.

Any extraction that exceeds PUC, as reduced by the distributions, essentially extracts retained earnings. Proper integration would not be achieved without taxation of retained earnings at dividend rates.

o Section 248(6) is a deeming rule. Every series of every class is deemed to be a separate class of shares.

For income tax purposes, a series is essentially a class.- What is the relationship between the PUC and ACB of a share?

o Practically, there is no relationship between PUC and ACB.o Where a share is acquired from treasury, and the share is the only share of the class that is issued and

outstanding, PUC and ACB are the same. Only outcome where they are related.

o PUC and ACB are not defined in terms of one another.o Only relationship, aside from the one above, is where adjustments must be made.

- Can the two amounts be different in respect of the same share?o Yes, and they will be different, except where the only class of shares were issued on incorporation, and there

has never been any change in ownership or issuing of additional shares.- Why may they be different?

o PUC averages across the shares of a class, which can cause subsequent purchases or transfers to a corporation by another party to affect the PUC, but not the ACB, of an original shareholder.

o PUC tracks contributions to the corporation, not amounts paid to third parties for the shares.

Calculating PUC

- Consider the following two examples:

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(a) In 2008, A paid Aco $100 for the issue of 100 class A shares. The 100 shares were the only issued and outstanding class A shares until 2018, when a further 100 class A shares were issued to B for $200. What is the PUC and ACB of the class A shares owned by A and B?

o When A subscribes to shares in 2008, ACB and PUC are both $100. Since stated capital of the shares under the ABCA is $100, PUC is also $100.

With only one shareholder and 100 shares, each share’s PUC is $1. A has paid $100 for the shares, which means the ACB is $100.

“Cost otherwise determined for the property”.o In 2018, B subscribes for 100 shares, but for $200.

Indicates value of shares in ACo has gone up in the 10 year period. B has paid $200 for the shares, which means their ACB is $200. Since A has no disposed or acquired anything, A’s ACB is still $100.

There is now a mis-match between ACB between A & B.o Stated capital account for Class A shares is now $300, due to B’s purchase, in respect of 200 issued and

outstanding Class A shares. PUC is then divided by 200 – the number of shares issued or outstanding. PUC is now $1.50 per share.

PUC of both A and B’s shares is now $150.o A’s PUC has increased without any action by his part, and B’s PUC is $50 less than

what he invested in the corporation.o As a result of averaging, neither’s PUC is equal to ACB: A’s ACB is $100; B’s ACB is $200.o PUC is calculated according to the stated capital account of the entire class of shares; the effect an individual

shareholder has on PUC only comes in their purchase of shares (adding to PUC of the entire class/series) and the number of shares they hold (which will be the denominator when determining the PUC of a single share).

What if the 100 shares issued to B were class A shares, series 2?

o If B subscribed for a different series, then s. 248(6) would deem B’s shares to be of a separate class. PUC would be $200 for the entire ‘class’. PUC for B’s shares is $1 per share, and ACB is $200. Nothing would happen to A’s PUC and ACB by this issue.

o With new investors, contemplate issuing a separate series, if not class of shares, for the new investor. Contributions of material amounts of cash may come with a later withdrawal without a dividend.

For commercial reasons, especially with long-term investments, parties may not care.

(b) In 2019, C purchases all of the class A shares owned by A and B for their fair market value of $500. What are the income tax consequences to A, B and C, assuming that the class A shares are not issued in series? What if the shares are issued in series?

o PUC has no bearing on the capital gain or loss realized on disposition of shares. Manipulation of PUC may cause adjustments to ACB, which could have an impact.

Without such a deemed adjustment, PUC is irrelevant.o First, resolve proceeds of disposition.

All Class A shares have consistent value between shareholders, and each bloc splits the FMV of $500. A and B both have $250 as proceeds of disposition, as each own half of the total shares.

o A will realize $150 capital gain on disposition ($250 (proceeds) - $100 (ACB)). o B will realize $50 capital gain on disposition ($250 (proceeds) - $200 (ACB)).o C will own 200 Class A shares with an ACB of $500 and PUC of $300.

PUC of shares immediately before the transaction is $300.

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o If the shares were in separate series, s. 248(6) applies. C would be indifferent after the purchase that there were multiple series, as he owns all the shares.

IV–II: SECTION 84 – STANDARD DEEMED DIVIDENDS FOR SURPLUS STRIPPING

SECTION 84: THE DEEMED DIVIDEND RULES

Section 84(1) – General Deemed Dividend Rule

- In the absence of a specific anti-avoidance rule, taxpayers could engage in surplus stripping by transferring shares of one corporation to another, non-arm’s length corporation.

o The transfers converts what would otherwise be a dividend distribution of a corporation’s retained earnings into a capital gain realized on the transfer and avoid the deemed dividend rules in ss. 84(1)–84(4.1).

- Section 84(1) applies to the most blatant things that would otherwise give rise to a deemed dividend.- For the section to apply:

o Must be a corporation resident in Canada.o Corporation must have increased the PUC of its shares.

- There may be a deemed dividend under s. 84(1), unless one of the enumerated exceptions applies.- Deemed dividends emerge if a corporation has increased the PUC of a class except if:

o It has paid a stock dividend; Rules already exist to deal with stock dividends to deem the shareholder to have received a dividend.

o The FMV of its assets less liabilities has increased or the amount of liabilities less assets has decreased in connection with the PUC increase;

If a shareholder contributes property to the corporation for no consideration, assumes a liability of the corporation for no consideration, or discharges a liability for no consideration, the corporation may add an amount to PUC equal to the value of the asset or liability assumed or discharged.

Essentially, if the FMV of assets has increased, and/or liabilities have decreased, s. 84(1) will not apply due to this exception.

o The PUC of another class of shares was reduced in connection with the PUC increase; or Can shift PUC between classes of shares essentially at will (for tax purposes), so long as the aggregate

PUC of the shares of a corporation is not increased by shifting PUC in this manner. For corporate law purposes, it would require a shareholder’s resolution to shift PUC; very

difficult with many shareholders.o The PUC was formerly contributed surplus.

Contributed surplus is an accounting concept which tracks contributions to a corporation by shareholders not recorded on the balance sheet.

As set out in s. 84(1)(c.3), contributed surplus must be created on a non-tax deferred exchange of shares, acquisition of property from a shareholder of no consideration or consideration not including shares, or on reduction of PUC which does not result in increase of PUC of shares of another class.

Section 84(1)(c.3) allows contributed surplus to offset a later addition to the corporation without a deemed dividend.

- If addition to stated capital occurs without any exception applies, the corporation is deemed to have paid a dividend to every class of shareholders who benefit from the increase in stated capital.

- If s. 84(1) applies, corporation is deemed to have paid a dividend on that class of shares equal to:o Excess of PUC increase over net improvement in fiscal position;o Excess of PUC increase over corresponding PUC decrease; and

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o Excess of PUC increase over contributed surplus.- Normally, only one of these considerations applies at once.- Adding some amount to PUC due to s. 84(1) may increase ACB due to s. 53(1)(b).

o This ACB increase is limited, particularly where the shareholder is a corporation. Amount of ACB increase equals the portion of the deemed dividend which is equal to income-on-hand.

o For an individual, a corresponding ACB increase would occur unless it was a shift of contributed surplus added to stated capital already.

Section 84(2) – Winding-Up, Discontinuance, or Reorganization of a Corporation’s Business

- Section 84(2) applies if property of a corporation is distribution or appropriated by shareholders on a winding-up, discontinuance, or reorganization of a business of the corporation.

o Will apply in broader circumstances than just the winding-up of the corporation (will also apply here), due to the use of “a business of the corporation”.

o Use of language “of any matter whatever” is very broad and highly litigated. Section 84(2) is applicable to a series of actions or a process, rather than single event or action.

May apply so long as there is some kind of connection between a distribution and a winding-up, discontinuance, or reorganization of a business.

o As an example, a professional corporation with $500,000 of assets is wound-up (MacDonald v R (FCA 2013)). Shareholder’s brother-in-law incorporated a corporation. Shareholder sold shares to NewCo for a $495,000 promissory.

ProfCo is transferred as a subsidiary to NewCo, for another promissory note of $495,000. ProfCo is wound-up and its cash moving to NewCo.

NewCo is paid, and then pays that out to shareholder, who realizes a $500,000 capital gain. Deemed dividend received, as a result of application of s. 84(2).

Shareholder’s capital gain was reduced to $0, and then was taxed at dividend rates.- If s. 84(2) applies, corporation is deemed to pay a dividend on class of shares equal to excess of appropriate over PUC

reduction in respect of class.o Value/quantity of dividend determined:

How much did shareholders of the class receive (the amount or value of funds/property distributed/appropriated)?

o Identify amount, if any, by which PUC of the shares of that class was reduced in connection with the distribution or appropriation.

o Deemed dividend for a class of shares is the amount by which the value of funds/property exceeds amount by which PUC is reduced (effectively first variable minus second variable).

- Each shareholder of the class of shares which benefited from the distribution or appropriation is deemed to have received the dividend in proportion to their shareholdings.

o Received immediately prior to the particular time. Reference is to the person who is attempting to avoid the dividend.

- Shareholders of class deemed to receive dividend in proportion to shareholdings.- Due to paragraph (j) of the definition of “disposition” under s. 54, any amount received as a deemed dividend under s.

84(2) is not considered a proceed of disposition.- After a PUC reduction under s. 84(2), s. 53(2)(a)(ii) applies to reduce ACB of shares by the amount of the distribution.

Section 84(3) – Redeeming, Acquiring, or Cancelling of Shares

- Section 84(3) applies if a corporation has redeemed, acquired, or cancelled any of its issued and outstanding shares.o Applies to corporation resident in Canada.o Does not apply for a transaction to which s. 84(2) applies.

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o If s. 84(3) applies, Corporation is deemed to have paid a dividend on each class of shares repurchased equal to the amount

that repurchase price for those shares exceeds PUC; and Former shareholder of repurchased shares is deemed to have received this dividend in proportion to

their ownership of the repurchased shares of that class.- Section 84(9) is a supporting rule, which deems shareholders who have redeemed, acquired, or cancelled their shares to

have disposed of shares to the corporation.

Section 84(4) – Reduction of PUC in Shares

- Section 84(4) applies if a corporation has at any time reduced the PUC of the shares of a class in its capital.o Does not apply if the reduction occurs:

In relation to a redemption, cancellation, or repurchase of shares (where s. 84(3) applies); or In relation to a transaction to which ss. 84(2) or 84(4.1) applies.

o Only applies to a straight-up return of capital to a corporation resident in Canada, in respect to which there is no cancellation of a share or winding-up or reorganization of a business.

o If s. 84(4) applies: The corporation is deemed to pay a dividend on shares of the class equal to amount by which PUC

reduction exceeds PUC of the class; and Shareholders of class deemed to receive this dividend in proportion to shareholdings immediately

before the reduction. Prevents pushing of PUC of a class of shares below zero.

o Under s. 53(2), there is normally a reduction of ACB where there is a reduction in PUC. Section 53(2)(a)(iii) prevents any amount which ss. 84(4) & 84(4.1) deems a dividend from decreasing

ACB, despite a decrease in PUC normally decreasing ACB, as effected by s. 53(2)(a)(ii).- Section 84(4.1) is applicable to public corporations only.

o Generally, public corporation returns of capital are deemed to be dividends unless connected with a non-ordinary course transaction that occurred the 24 months preceding the reduction of capital.

o Public corporations cannot return capital to their shareholders without a deemed dividend, with two exceptions: An amount under s. 86 is issued. Corporation or subsidiary of the corporation realized proceeds of disposition outside the ordinary

course of business of corporation or subsidiary, within 24 months of when cash was paid out, provided the corporation has not already distributed those funds to the shareholders.

Application of the Deemed Dividend Rules

- Apply the deemed dividend rules to the following examples. In each case, think about the mischief that the particular rule is designed to address:

(a) A and B each own 100 class A shares of Aco with PUC and ACB of $1 per share. In 2018, A contributes $100 to Aco. No new shares are issued to A, while $200 is added to the stated capital of the outstanding class A shares.

o Addition to stated capital greater than increase in ACo’s net assets (as defined under s. 84(1)(b)).o Stated capital before contribution was $200 (sum of cash contributions), and now is $400.

Net contributions by shareholders is $300 following A’s $100 addition, but stated capital is $400.o The difference between this amounts is the deemed dividend, per s. 84(1) - $100 ($400 - $300).o Each shareholder is deemed to receive the dividend in proportion to their ownership of Class A shares.

As both A and B own 50% of shares, each is deemed to have received a $50 deemed dividend due to this contribution in excess of stated capital.

o Mischief is the potential for over-addition to stated capital of shares in a corporation.

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(b) Assume in the above example that A is the sole shareholder of Aco. A originally contributed $200 for the issue of 100 class A shares, but on issue only $100 was added to the stated capital of the class. In 2018, A contributes a further $100 to Aco. No new shares are issued to A, but $200 is added to the stated capital of the outstanding class A shares.

o Nothing occurs due to s. 84(1)(c.3), and no mischief exists in this scenario.o A’s contribution of $200 on incorporation, but added only $100 to stated capital, the other $100 become

contributed surplus under s. 84(1)(c.3)(ii). o When a further $100 is contributed (increase in net assets) and a $200 is added to stated capital, the amount

added to stated capital does not exceed the sum of net assets plus contributed surplus on hand (s. 84(1)(c.3)(ii)). $100 comes from the second cash contribution of $100, while the other $100 comes from contributed

surplus on hand from the original cash purchase.o Deemed dividend computes to nil.

(c) B owns 100 class B shares of Bco with PUC and basis of $1 per share. In 2018, Bco winds-up the operation of one of its divisions and distributes $2,000 to the class B shareholders. At the time of the distribution, there are 1,000 class B shares outstanding. There is no reduction in the PUC of the class B shares on the distribution. As well, none of the shares is purchased for cancellation by Bco.

o There is winding-up, discontinuance, or reorganization, and a subsequent distribution of cash to Class B shareholders in connection to that event, leading s. 84(2) to apply.

o Corporation is deemed to have paid a dividend equal to the amount by which the $2,000 distributed to Class B shareholders exceeds PUC reduction in respect of the Class B shares.

Amount of PUC reduction is $0. Deemed dividend is $2,000 ($2,000 distribution - $0 PUC reduction).

o B receives a deemed dividend at the commencement of the winding-up. B owns 100 of 1,000 Class B shares, and is deemed to receive 10% of the $2,000 deemed dividend. B is deemed to receive a dividend of $200.

o Mischief prevented is distribution of money/property by means other than a dividend or return of capital. Without s. 84(2), it would be difficult to determine how B would be taxed on this contribution.

(d) Assume in the above example that the PUC of the class B shares is reduced in full on the $2,000 distribution or, alternatively, that all of the outstanding class B shares are purchased for cancellation by Bco.

o PUC for the entire class above was $1,000. Now, instead of not reducing the capital of Class B shares, the capital is reduced by $1,000.

o As a theoretical matter, with the PUC reduction and s. 84(2) superseding s. 84(3), the result would be the same if s. 84(3) would apply or if s. 84(2) would apply with an equivalent reduction to PUC.

Practically, the TCC has ignored the wording in s. 84(2) which would allow this.o Under s. 84(3), result is a $1,000 deemed dividend, with each shareholder receiving deemed dividend equal to

the difference between the PUC of their shares and the repurchase price of their shares ($2,000 - $1,000).o Reduction of capital in Class B shares at the time of distribution or appropriate by the Class B shareholders now

exists compared to above. Deemed dividend under s. 84(2) is reduced to $1,000, due to how it is calculated and this fact.

o Shareholder B only has a $100 dividend instead of a $200 dividend.o Sections 84(1)–84(4) generally all operate similarly, despite ‘hierarchy’ of ss. 84(2), 84(3) & 84(4).o B’s ACB will also be impacted.

Due to s. 53(2)(a)(ii), B’s ACB in Class B shares would be $0 as a result of the $100 reduction in ACB from the deemed dividend.

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If there was a re-purchase or cancellation of the shares (not ss. 84(2) or 84(4), but a s. 84(3) event, or a s. 84(2) event with a disposition under s. 84(9)), B would have proceeds of disposition of $200 and ACB of $100 on that disposition, which would normally produce a capital gain of $100.

However, paragraph (j) of the s. 54 definition of “proceeds of disposition” will reduce proceeds of disposition by the amount of any deemed dividend.

o Result with a cancellation of shares is that B has proceeds of disposition of $100 and ACB of $100, resulting in no capital gain, and a $100 deemed dividend.

The ACB reduction prevents a ‘double-up’ – both a deemed dividend and a capital gain in respect of the same amount of money.

(e) Assume in the example in 7(c) that the business which is wound-up is the only business of Bco and the cash distribution was made on the liquidation of the corporation. What if the cash distribution was made on the purchase for cancellation of shares by Bco other than on liquidation?

o Does not matter that there is a liquidation, since the issue is whether there is a winding-up, discontinuance, or reorganization of a business of the corporation.

This may include winding-up of the entire corporation.o Same result from application of s. 84(2) as above.o If there was a share repurchase rather than liquidation, still no change.

So long as s. 84(2) applies, s. 84(3) does not apply, as s. 84(2) is paramount.

(f) C owns 100 of the 1,000 issued and outstanding class C shares of Cco. C has PUC and ACB in the shares of $1 each. In 2018, Cco purchases for cancellation all 1,000 of the outstanding class C shares for $2,000. What if the class C shares are traded on the Toronto Stock Exchange, and Cco effects the purchase for cancellation by buying the outstanding class C shares through the Exchange?

o No facts indicating application of s. 84(2). Can conclude from repurchase, acquisition, or cancellation that s. 84(3) is applicable.

o CCo is deemed to pay dividend on Class C shares equal to amount of repurchase amount ($2,000) exceeds PUC of repurchased shares ($1,000).

o The amount of the deemed dividend under s. 84(3)(a) must be $1,000. Difference between amount paid on repurchase of shares of that class and the PUC of the shares

immediately before the repurchase ($2,000 - $1,000).o Section 84(3)(b) then deems each shareholder of the shares to receive a dividend equal to pro rata ownership of

the class of shares. C owns 10% of Class C shares, and therefore receives a deemed dividend of $100 (10% of $1,000

dividend paid on whole class).o C also has $200 as proceeds of disposition of the sale of the shares ($2,000 / $1,000 * 100 = $200).

Paragraph (j) of the s. 54 definition of “proceeds of definition” applies to reduce proceeds by the amount of the deemed dividend, leaving only $100 proceeds.

$100 proceeds, $100 deemed dividend, and $100 ACB, with no gain or loss on this transaction.o If the Class C shares were publicly traded, s. 84(6) will apply.

Provided shares are acquired in the same manner by which a member of the public would acquire shares, s. 84(6) would apply to find no deemed dividend paid by CCo.

Instead, CCo will have paid $2,000 to the Class C shares (the ordinary result), and every shareholder who sold their shares on the public exchange will receive proceeds of disposition equal to the selling price on the public exchange.

o Assume C sold shares for the same price as all others on the public exchange.

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(g) Assume in the above example that, instead of purchasing the class C shares for cancellation, the directors of Cco pass a resolution to reduce the stated capital of the class in full on the $2,000 distribution. What if Cco is a public corporation?

o Only s. 84(4) could apply.o CCo is deemed to pay a dividend on Class C shares equal to the amount, if any, by which the reduction in PUC

exceeds PUC of shares immediately before the return of capital.o Three is a deemed dividend of $1,000 under s. 84(4)(a) ($2,000 - $1,000).o Under s. 84(4)(b), every shareholder of Class C shares is deemed to receive a dividend equal to pro rata

ownership of Class C shares. C receives a deemed dividend of $100 (10% of $1,000 deemed dividend for the entire class).

o Section 53(2)(a)(ii) would ordinarily push ACB negative and capital gain would result, but s. 53(2)(a)(ii) does not apply to any amount deemed to be a dividend.

Reduction of ACB is limited to $100. When C recomputes ACB in shares, ACB is nil.

o Difference with a public corporation is that s. 84(4) may not apply; instead, s. 84(4.1) applies .o Section 84(4.1) deems the entire reduction in stated capital to be a dividend, unless an exception is met.

No applicable s. 86 transaction, and no non-ordinary course of business transaction. o C is deemed to have received 10% of the dividend paid under s. 84(4.1) – $200 deemed dividend.o Again, s. 53(2)(a)(ii) does not apply due to there being a deemed dividend under s. 84(4.1).

C will continue to have $100 ACB in her shares.

IV–III: SECTION 84.1 – DEEMED DIVIDENDS ON NON-ARM’S LENGTH SHARE SALES

SECTION 84.1 – BRIGHT-LINE DEEMED DIVIDENDS

The Purpose of Section 84.1

- Surplus stripping fundamentally aims to take advantage of cheaper taxation of capital gains compared to receiving dividends.

- Section 84.1 is intended to prevent situations where share sales to corporation would enable surplus stripping and capital gains.

- Section 84.1 is best illustrated by the following example (see right):

A is the sole shareholder of Aco. A owns 100 class A shares of Aco with PUC and ACB of $100 and a FMV of $500. A incorporates Bco and transfers to it the class A shares of Aco in return for redeemable class B shares of Bco. The stated capital and redemption amount of the class B shares is $500. Immediately after the transfer of the Aco

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shares, Aco pays a $500 dividend to Bco. The dividend is then distributed to A on the redemption of the relevant Bco shares.

- What is the tax result of these transactions, ignoring s. 84.1? o Entire amount is retained earnings.o A sells his shares in ACo to BCo in exchange for redeemable preferred shares in BCo (FMV/PUC of $500).

This produces a $400 capital gain ($500 proceeds in BCo share FMV - $100 ACB in ACo shares). Actual taxation rate is still 48%, but as only $200 of the capital gain is taxable, the rate ‘halves’ to 24%.

o ACo then pays a $500 cash dividend to its shareholder – BCo. Assume no RDTOH (refund of $191.67 for ACo) or Part IV tax (addition of $191.67 to BCo’s eligible

RDTOH, and Part IV tax payable of $191.67).o BCo then redeems the preferred shares held by A, and pays $500 on the repurchase of the preferred shares.

As this equals the ACB of $500, no capital gain results.o Section 84(3) then applies, but the shares have a PUC of $500, which equals proceeds/FMV, and as such no

deemed dividend results.o A has not received a dividend, but has instead realized a capital gain on this disposition.

If A had a capital loss or was entitled to a capital gains deduction, but at very worst (for the taxpayer), they have paid tax on this transaction at 24% instead of 41.64%.

Very desirable to prevent this when a taxpayer may claim a capital gains deduction.- What if, instead of issuing the Class B shares to A on the transfer of the Class A shares, BCo issues A a promissory note

with a principal amount of $500, again ignoring s. 84.1?o Same result, so long as the promissory note is redeemed following the initial transfer of $500 to BCo.

- Section 84.1 is a specific anti-avoidance rule designed to prevent the ‘artificial’ realization of gain on certain non-arm’s length sales of shares.

o The provision permits an individual to artificially realize corporate surplus as proceeds on the non-arm’s length disposition of shares only to the extent of the ACB of the relevant shares.

Surplus stripping is prevented by reducing the PUC of the shares issued for the shares of the transferor, as well as forcing recognition of an immediate dividend where non-share consideration is received.

Conditions of Application for Section 84.1

- No purpose test in s. 84.1: bright-line conditions of application:o Taxpayer resident in Canada who is not a corporation;o Disposes of shares of a corporation to another corporation;o The shares disposed of were capital property;o The shares disposed of are shares of a corporation resident in Canada;o The taxpayer and purchaser corporation did not deal at arm’s length; and

If two parties are not related, s. 251(1)(c) determines whether parties are dealing at arm’s length, and states that is an issue of fact.

Party exercises de facto control over the other. One party acts a common mind for both parties. If the two parties lack any identifiable and separate interests.

Are dealings between two parties reflective of ordinary commercial dealings? General, fact-based inquiry.

Only non-bright line element .o After the disposition, purchaser corporation and subject corporation are “connected”.

10% of votes and values test may apply after the transaction to determine whether the corporations are controlled by the same group of persons.

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- If share consideration is received, then s. 84.1(1)(a) applies to create a PUC grind for class of shares issued.o Tax-free transactions only work if PUC exists on shares.o Grind is equal to increase in PUC addition for all shares as a result of transfer (Variable A); LESSo Excess of greater of PUC or ACB of transferred shares over FMV of non-share consideration received

(Variable B); MULTIPLED BYo Fraction obtained when PUC addition for class is divided by PUC addition for all shares (Variable C).

Reflects the proportion of the PUC of the transferred shares to all shares.- The formula contains several variables:

o Variable A is equal to the increase in PUC amount of all classes of shares.o Variable B is equal to the greater of the PUC of the transferred class of shares, or the ACB of the transferred

class of shares, less any non-share consideration received.o A and B defines the amount for the grind, and it is multiplied by a fraction which represents the proportion of

the PUC of the transferred shares relative to all shares (C/A).- What is the effect of s. 84.1 if applied to the above example? Specifically, consider the conditions of application for s.

84.1, and how those conditions reflect the mischief that the government has attempted to address.o A will be in the exact same situation as if they never made BCo.

ACB does increase, but A is unable to withdraw the gains from ACo without incurring a deemed dividend and a decrease in PUC.

o A had incorporated a new corporation (HoldCo), sold his shares in OPCo to HoldCo. Shares in OPCo had $100 ACB, $100 PUC, and $500 FMV. A received preferred shares from HoldCo with a FMV of $500, PUC of $500, and ACB of $500.

Without s. 84.1, this will allow A to extract $400 at either capital gains rates or a tax-free basis.o Not a dividend, which is the only way A could recover the cash from OPCo.

The exchange in shares itself produces a $400 capital gain ($500 proceeds in disposition from the FMV of the HoldCo shares, minus the $100 ACB in OPCo shares).

o To move the surplus money to be stripped, OPCo pays a $500 inter-corporate dividend to HoldCo. HoldCo then repurchases the preferred shares using that $500 cash, which goes to A.

o Are the conditions for s. 84.1 satisfied? Assume all actors involved are resident in Canada, and that the OPCo shares are capital property.

A is an individual who is not a corporation, and does not deal at arm’s length with either HoldCo or OPCo, per the definition in s. 251(1)(a).

HoldCo and OPCo are related due to a single individual having de jure control of both. Immediately after the transaction HoldCo and OPCo are connected because HoldCo will

control OPCo at that point in time.o The 10% vote and value test would also obviously be satisfied.

Section 84.1’s conditions are satisfied. Tax consequences will be determined under s. 84.1(1)(a).

Maximum potential grind to PUC of new preferred shares of HoldCo equal to the $500 addition to stated capital of the preferred shares of HoldCo, less the amount, if any, by which the greater of PUC or ACB of the shares of OPCo (both $100) exceeds the amount, if any of any non-share consideration received ($0).

o $500 - $100 = $400 grind under s. 84.1(1)(a). Since there is only one class of shares, the C/A formula will compute to 1/1.

o The entire $400 of PUC grind will apply to the preferred shares of HoldCo issued to A in exchange for the shares of OPCo.

As a result of this grind, the preferred shares of HoldCo will have a FMV of $500, ACB of $500, and PUC of $100.

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When the shares are re-purchased, there will be a $400 deemed dividend (s. 84(3)) as calculated by the excess of the repurchase price over the PUC of the repurchased shares.

Paragraph (k) of the definition of “proceeds of disposition” will cause the proceeds of disposition to be reduced by the amount of the s. 84(3) deemed dividend ($400), leading to a proceeds of disposition of $100 and a capital loss of $400 ($100 proceeds - $500 ACB).

Result will be that a capital loss will be available to apply against the capital gain realized by the sale of OPCo shares to HoldCo.

o Effect of s. 84.1 applying will be the same as if A had just received a $400 dividend from OPCo.- Any dividend received under s. 84.1 can allow for recovery of RDTOH or CDA.

o If the dividend is taxable, the corporation may recover from the RDTOH account, or if the dividend is designated as a capital dividend, then the shareholders will not be taxed.

Section 84.1(b) – Non-Share Consideration

- When non-share consideration is received, then s. 84.1(1)(b) will apply to create a deemed dividend to the selling shareholder, as they have received money from the corporation or received something that is tantamount to money without the opportunity for any future income tax consequences to arise ( (A + D) – (E + F) ).

o Dividend is equal to increase in PUC addition for all shares as a result of transfer plus FMV of all non-share consideration (A + D); LESS

o Greater of PUC and ACB plus the amount of the s. 84.1(1)(a) PUC grind (E + F).- A + D

o Variable A is equal to PUC addition in respect to all shares of the corporation in connection with the transaction.

Same as variable A in s. 84.1(1)(a). If there is no share consideration received, variable A will equal nil.

o Variable D is equal to the FMV of any non-share consideration received in exchange for the shares of the transferred corporation.

Variable D is equal to the maximum amount of any potential deemed dividend.- E + F

o Variable E is the greater of the PUC or ACB of the transferred shares.o Variable F is the amount of the s. 84.1(1)(a) PUC grind.

As a result, s. 84.1(1)(a) must always be calculated first.- There should be a net amount resulting, which equals the amount of the deemed dividend received by the shareholder.- Result if HoldCo issues a promissory note to A rather than preferred shares?

o Conditions of application of s. 84.1(1)(a) satisfied, as only difference is promissory note instead of shares.o Variable A will be 0, as there are no additions to PUC of any share from this transaction.o Variable D will equal the FMV of the promissory note ($500).o Variable E will be equal to $100 (both PUC and ACB of transferred shares is $100).o Variable F is the amount of the s. 84.1(1)(a) PUC grind ($0).o Subtract $100 from $500, resulting in a $400 deemed dividend.o Important distinction is how to avoid double tax.

Individual is stuck with a capital gain of $400 from transfer of shares from OPCo to HoldCo, as well as $400 deemed dividend from the promissory note.

Paragraph (k) of the definition “proceeds of disposition” states that any deemed dividend received under s. 84.1(1)(b) will reduce proceeds of disposition accordingly.

Proceeds of disposition of shares sold from OPCo to HoldCo is reduced to $0.o Individual realizes no gain or loss as a result of the exchange of shares, and only has

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No implications for HoldCo, or for the ACB of the promissory note received by A. No gain or loss when the note is repaid.

Due to reducing the proceeds of disposition, A’s only tax liability is the s. 84.1(1)(b) deemed dividend.

Apply s. 84.1 to the above example, but assume that A receives from BCo the following two types of consideration on the transfer of the Class A shares of ACo.

Class B shares of Bco with a stated capital amount (PUC), redemption amount and FMV of $300.Promissory note for debt of Bco with a principal amount and FMV of $200.

- Conditions of application satisfied for s. 84.1(1).- Starting with s. 84.1(1)(a):

o Variable A is the addition of the PUC of the shares of HoldCo as a result of the transaction. $300 addition to the preferred shares.

o Variable B is the amount, if any, by which the rate of PUC or ACB of shares of OPCo exceeds the amount of any non-share consideration received.

$100 of PUC and $100 of ACB in OPCo shares, while $200 of non-share consideration received. Subtract from PUC/ACB of OPCo shares ($100) FMV of any non-share consideration received ($200).

The negative result computes to nil. Variable B is nil.

o (A – B) reduces to $300.o Variable C/A fraction will be 1/1, as there is only one class of shares at issue.o Full $300 PUC grind is applied to the preferred shares of HoldCo.

HoldCo shares now have a PUC of $0.- Then apply s. 84.1(1)(b):

o Variable A is $300. Amount of PUC addition to all shares in the capital of HoldCo.

o Variable D is equal to the FMV of non-share consideration. $200.

o (A + D) reduces to $500.o Variable E is equal to greater of PUC or ACB of transferred shares of OPCo.

PUC and ACB were both $100. Variable E equals $100.

o Variable F is equal to PUC grind under s. 84.1(1)(a). PUC grind is $300, so F is $300.

o (E + F) reduces to $400.o Result under s. 84.1(1)(b) is $100.

- The deemed dividend received is $100.o PUC grind of $300.o At minimum, taxable income of $100 with the dividend taxed at GRIP rates.o Shares of HoldCo FMV of $300, ACB of $300, and PUC of $0.

Any purchase of those shares will result in a deemed dividend of $300. A “locked-in” amount.

o A will realize a capital gain on the sale of the shares on OPCo to HoldCo. Due to the deemed dividend under s. 84.1(1)(b), there will be a $100 reduction in the proceeds of

disposition (originally $500; now $400), so that the re-computed proceeds of disposition will result in a capital gain of $300, in addition to the $100 deemed dividend ($400 proceeds - $100 ACB).

Section 84.1(2)(a.1) – Adjustments to Calculation of ACB

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- ACB for s. 84.1 is not determined as it is in the rest of the ITA.- Section 84.1(2)(a.1) sets out how ACB is to be calculated for the purposes of s. 84.1.

o If one acquires a share from a non-arm’s length person, including from a chain of non-arm’s length persons, or were received before the recipient was born, the ACB of the share does not include any ACB attributable to valuation day increment, or any ACB attributable to a capital gain claimed by a non-arm’s length person (capital gains deduction).

ACB could be considerably lower than in the remainder of the ITA. Also termed soft ACB, while ACB for the rest of the ITA is hard ACB.

Valuation day increment concerns the pre-1971 capital gain regime, where capital gains were not taxed. Requires that ACB be calculated for property in 1971. ACB on valuation day (17 Dec 1971) will be ACB for the ITA after 1971.

o On 1 Jan 1972, every person who owned a property had ACB in that property equal to the ACB in 17 Dec 1971.

o This amount will be soft ACB for s. 84.1, and cannot be used to extract any kind of surplus from the corporation.

If a share may be qualified as a qualified farm property or a qualified small business share, the share may be disposed of with the first $1,000,000 or $848,000 will be tax-free.

The “life-time capital gains deduction”.o Over the course of one’s lifetime, only that amount may be claimed.

This amount will also be considered soft ACB. Common with gifts of shares from parents to children, or post-mortem dispositions.

o As a result of this section, if s. 84.1 is to apply, calculating ACB for a property requires very diligent calculation.

Sections 84.1(2)(b) & 84.1(2.2) – Determining Non-Arm’s Length Status

- Section 84.1(2)(b) adds additional approaches to determining non-arm’s length status.- Most s. 84.1 cases which have been litigated have been related to arm’s length determinations.- In addition to the usual ways which parties may be deemed to not deal at arm’s length, s. 84.1(2)(b) considers:

o If a group of six or fewer persons, including the transferor, controls the vendor corporation after the disposition, and control the recipient corporation immediately prior to the disposition.

- Section 84.1(2.2) applies to provide additional rules.o Shares owned by a taxpayer’s minor child or a spouse are deemed to be owned by the taxpayer (s. 84.1(2.2)(a)

(i));o Corporations controlled by the taxpayer’s minor child or spouse are deemed to be controlled by the taxpayer (s.

84.1(2.2)(a)(iii));o A trust where the taxpayer, the taxpayer’s minor child, or the taxpayer’s spouse (or a corporation they control)

is the beneficiary is deemed to be owned by the taxpayer (s. 84.1(2.2)(a)(ii));o A group of persons means two or more persons who are shareholders of a corporation regardless of whether or

not there is a sufficient common connection between those shareholders (s. 84.1(2.2)(b)). A corporation is deemed to be controlled by not only the smallest possible group, but also by every

other possible group that would control the corporation (ss. 84.1(2.2)(c) & 84.1(2.2)(d)).- Group of persons control OPCo.

o Taxpayer at issue was not controlling shareholder.o Another shareholder incorporated HoldCo to buy all shares in OPCo.o The other two shareholders, including taxpayer, sold all shares to HoldCo.o After this transaction, taxpayer received as consideration a mix of cash and shares in HoldCo.

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Taxpayer became a minority shareholder in HoldCo, while the third shareholder was controlling shareholder in HoldCo.

o Sections 84.1(2)(b) & 84.1(2.2) applied due to a group of six or fewer persons which controlled the two corporations at the appropriate times.

The taxpayer was deemed to be part of the group that controlled HoldCo.o The entire transaction was deemed not to be arm’s length under s. 84.1(1)(b), and the taxpayer received a

deemed dividend. Crucial issue was the receipt of shares.

Matrix of Section 84.1 Scenarios

Attributes of OPCo Shares I II III IV V VI VII VIII

PUC of transferred OPCo shares (B)

(E)

100 100 100 100 100 100 100 100

ACB of transferred OPCo shares (C)

100 1,000 1,000 1,000 1,000 1,000 1,000 1,000

Consideration Received for OPCo Shares I II III IV V VI VII VIII

FMV of non-share consideration received for transferred OPCo shares (D)

0 900 1,000 1,100 0 1,000 2,500 1,500

PUC of purchased HoldCo shares (H) 100 100 100 100 5,000 4,000 2,500 0

PUC Reductions (s. 84.1(1)(a)) I II III IV V VI VII VIII

Increase in PUC of all shares (A) 100 100 100 100 5,000 4,000 2,500 0

Amount, if any, by which the greater of PUC/ACB of OPCo shares exceeds FMV of non-share consideration (E – D)

100 100 0 0 1,000 0 0 0

PUC grind on purchased HoldCo shares(s. 84.1(1)(a) result) (A – (E – D) = F)

0 0 100 100 4,000 4,000 2,500 0

PUC of purchased HoldCo shares after reduction (H – F)

100 100 0 0 1,000 0 0 0

Immediate Dividend (s. 84.1(1)(b)) I II III IV V VI VII VIII

Aggregate of PUC increase of all shares and FMV of non-share consideration(A + D)

100 1,000 1,100 1,200 5,000 5,000 5,000 1,500

Aggregate of the greater of PUC/ACB of transferred OPCo shares plus PUC grind on purchased HoldCo shares (E + F)

100 1,000 1,100 1,100 5,000 5,000 3,500 1,000

Immediate dividend ((A + D) – (E + F)) 0 0 0 100 0 0 1,500 500

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- Scenario I is a fair exchange – the shares of OPCo are being exchanged for HoldCo shares of equal value.o No potential for surplus stripping.

- Scenario II still results in a fair exchange of value, but instead of the exchange being a direct share-for-share exchange, the more valuable OPCo shares are exchanged for less valuable HoldCo shares along with non-share consideration.

o No initial capital gain results, as the FMV of the consideration received is equal to the ACB of the OPCo shares.

- Scenario III involves an overpayment of consideration for the OPCo shares. Due to the overpayment in non-share consideration, a PUC grind on the HoldCo shares results to reflect capital already returned.

o However, the consideration received (as aggregated from the FMV of non-share consideration and the PUC increase to shares (A + D under s. 84.1(1)(b))) can be sufficiently ‘offset’ by the taxpayer’s existing PUC and ACB, so no deemed dividend results as no surplus is being transferred.

- Scenario IV increases the non-share consideration received over the point of equilibrium.o The taxpayer’s capital investment after the transfer (as reflected in the PUC of HoldCo shares and any non-

share consideration received) is greater than the amount prior, so a deemed dividend will result.- Scenario V reflects the classical application of s. 84.1.

o The PUC of the shares of HoldCo being distributed are vastly in excess of the invested capital of the OPCo shares. Consequently, s. 84.1 grinds the PUC of the HoldCo shares down to their appropriate value.

- Scenario VI is similar to Scenario V, but with a mix of consideration; rather than purely HoldCo shares with PUC in excess of the OPCo shares, there is also non-share consideration.

o Sum of the capital investment (as reflected in PUC of HoldCo shares and FMV of non-share consideration) remains the same.

o Difference is in the PUC grind applied to the HoldCo shares. Since there is non-share consideration effectively serving as a capital return, the PUC is ground down.

- Scenario VII demonstrates an over-return of capital. Although the PUC grind is similar to Scenarios V & VI, the considerable increase in non-share consideration effectively amounts to a large return of capital.

o Even after PUC of HoldCo shares is ground down, there is still capital return left over in excess of the PUC of the OPCo shares which warrants a deemed dividend.

- Scenario VIII is a pure share-for-consideration exchange.o Since the consideration received is in excess of the invested capital, a deemed dividend results.

Section 84.1 Plan

- Shareholder wants to sell their shares in a corporation.- Incorporate a new corporation (SaleCo).- Section 85 tax-free transfer of 50% of the shares in OPCo to SaleCo.

o Sell those shares to buyer for cash.o SaleCo now has a large amount of cash, has realized a capital gain, and Buyer owns 50% of shares in OPCo.

- Sell the last 50% of shares of OPCo to SaleCo.o Non-arm’s length transfer will trigger a deemed dividend immediately.o Designated the deemed dividend as a capital dividend.

The dividend is thus tax-free. Recovers all CDA which existed by the sale of SaleCo’s shares in OPCo to buyer.

- SaleCo then sells shares to buyer.- A large amount of cash sitting in SaleCo with no further tax liability, with individual having roughly half the cash, some

recovered with CDA.o Effectively defers the tax on about half the gain to SaleCo.

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V: CORPORATE TAXATION – TRANSFERS OF PROPERTY

V–I: ROLLOVER TRANSACTIONS

ROLLOVER OF PROPERTY UNDER SECTION 85

Rollover Transactions Generally

- As corporations are taxpayers, any transfer of property to a corporation is, absent any other rule, a taxable transaction.o For income tax purposes, the transfer of property to a corporation is generally considered a disposition, with the

tax consequences depending on the FMV of the property exchanged between the parties. Gifts and all transfers of property between non-arm’s length parties are captured by s. 69(1).

- Rollover transactions occur when a person exchanges property for other property with identical tax attributes.o Tax attributes may be adjusted if any gain or loss has to be realized on the transfer.o Section 85 generally works on this principle.o “Rollover” describes a provision that provides this deferral benefit, as the cost of the transferred property to the

transferor is “rolled over” to the transferee and “rolled into” the property received by the transferor.- Deemed to dispose for proceeds of distribution equal to the cost of the transferred property, with cost in the new

property equal to the cost of the transferred property.o The taxpayer will have the same locked-in gain in the new property as they did in the old property at the time

that it was transferred.o To avoid any tax benefit, particularly for non-arm’s length, the cost acquired by the transferee will be reduced

to the transferor’s proceeds of disposition.- Section 85 permits a transfer of property to a corporation to be effected on a “rollover” basis.

o The particular transfer remains a disposition for tax purposes, but: The proceeds for the transferor are deemed to be equal to the cost of the transferred property, as elected; The cost of the consideration to the transferor becomes the cost for the transferee; and The cost of the consideration received by the transferor is deemed to be equal to the cost of the

transferred property. - In effect, the transfer is done at “tax cost”, thereby deferring the tax consequences that would otherwise have occurred

to the time at which the exchanged property is disposed of by the transferor or transferee.

Conditions for Application of Section 85

- Taxpayer must have disposed of an eligible property.- Transferee must be a taxable Canadian corporation (as defined in s. 89(1), a Canadian corporation not exempt from tax).

o A standard ABCA corporation will be a taxable Canadian corporation.- Consideration for the transfer must include at least one share in the transferee corporation.- Parties must elect in the prescribed form (T2057) and manner on or before the day which the transferee corporation is

required to file its tax return for the year the transfer occurred.o The filing due date for the transferee is always six months after the end of the taxation year in which the

transfer occurred.o For an individual transferor, the filing due date is April 1 of the subsequent year, while if the transferor is a

corporation it is six months after the end of the taxation year.- Eligible property is defined in s. 85(1.1):

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o Where the transferor is an individual resident in Canada, eligible property includes capital property, resource property, non-land business inventory, or financial instruments.

Land inventory is not included; real estate may only be transferred if the real estate is capital property of the transferor.

- Section 85(1) applies on a property-by-property basis.o Necessary for consideration received for all of the properties must be allocated between the different properties

which were transferred to the transferee corporation.o If there is depreciable property, the transferor must designate the order in which the properties were disposed of

by the corporation in the transfer.o Reduce UCC by the lesser of the consideration that has been received, the original capital cost of the property,

or the UCC remaining in respect of the class at the time. Order in which property is transferred can have tax consequences on both transferee and transferor.

ELECTED AMOUNTS FOR ALLOCATING COST FOR TYPICAL ROLLOVER TRANSACTIONS

Sections 85(1)(b), 85(1)(c), 85(1)(c.1) & 85(1)(e.3) – Determining the Elected Amount

- Determine under subsection 85(1) the proceeds to the transferor and the cost to the transferee on the following property transfers.

(a) A transfers land held as capital property to Aco. On the transfer Aco assumes $125,000 of outstanding liabilities of A and issues to A one common share. The land has an ACB of $100,000 for A and a FMV of $150,000 at the time of the transfer.

- Land is now owned by the corporation and individual has shares in the corporation, and no longer owns the debt.- Assume all corporations are taxable Canadian corporations and that a timely election will be filed.

o Assume that amount maximizes tax deferral; can elect an amount that is less than tax deferral.- Land is a capital property of the individual.- Conditions of application are met, and s. 85(1) will apply.- Sections 85(1)(b), 85(1)(c) & 85(1)(c.1):

o Section 85(1)(b) requires that the minimum elected amount must not be less than the FMV of any non-share consideration.

Here, non-share consideration is debt relief – FMV being $125,000.o Section 85(1)(c) requires that the maximum elected amount not be more than the FMV of the property

transferred. FMV of the property transfer is $150,000 – maximum elected amount is $150,000.

o Section 85(1)(c.1) requires that the minimum elected amount not be less than the cost amount of the property. Actually a lesser of two amounts – FMV or cost amount. FMV is $150,000 and cost amount is $100,000 – lesser is $100,000.

o Conflict between ss. 85(1)(b) & 85(1)(c.1) as to what minimum elected amount is. Section 85(1)(e.3) notes that where these sections conflict, the larger amount is paramount.

Minimum elected amount therefore is the s. 85(1)(b) amount, that being $125,000.- Section 85(1)(a) deems the elected amount to be the transferee’s cost in the property, and as thus the transferor’s

proceeds of disposition.o Elected amount range is $125,000 – $150,000.

Assume parties elect for maximum deferral of tax benefit – $125,000. Elect for the low value of the range: less capital gain will be realized on the transfer with the

lower amount than with the higher amount. Maximum deferral equals lowest value in the range of elected amounts.

o Individual A realizes a $25,000 – proceeds of disposition of $125,000 and cost of the land of $100,000.77 | P a g e

Sections 85(1)(f)–85(1)(h) – Allocating Cost to Received Consideration

- Sections 85(1)(f–h) set out hierarchical rules for allocating cost of the elected amount to consideration received.o Start with elected amount and allocate to non-share consideration (f).o For any elected amount which exceeds non-share consideration, allocate to preferred share consideration (g).o Residual amount from these allocations are to be allocated to common shares (h).

- $125,000 elected amount and $125,000 non-share consideration.o First allocate to non-share consideration; as the two are equal in value, there is $0 remaining and no cost will be

allocated to new shares issued to A.- A is holding shares of ACo that has a FMV of $25,000 and a cost of $0.

o An accrued $25,000 gain on the shares, just as there was on the land prior to the transfer.

Determining Minimum Elected Amount

Determining Maximum Elected Amount

Allocating Elected Amount as ACB to Consideration Received

Section 85(1)(b) – FMV of non-share consideration received.

Section 85(1)(c) – FMV of transferred property.

Section 85(1)(f) – Non-share consideration.

Section 85(1)(c.1) – Lesser of FMV or ACB of transferred property.

Due to wording of ss. 85(1)(b) & 85(1)(c), if the minimum is greater than the maximum, s. 85(1)(c) will prevail and set out the minimum and maximum.

Section 85(1)(g) – Preferred share consideration

Section 85(1)(e.3) – Larger minimum is paramount in determining minimum.

Section 85(1)(h) – Common share consideration.

Section 85(1)(e) – Least of UCC, capital cost, or FMV of a depreciable property.

Elections in Excess of Statutory Maximums

What if, instead of the assumption of liabilities, A receives a promissory note of Aco with a FMV of $175,000?

- ACo is issuing more consideration than the FMV of the land.o Assume debt relief is gone and this is the only non-share consideration.

- Demonstrates application of s. 85(1)(c), which is the maximum elected amount.o Maximum elected amount cannot be more than the FMV of the transferred property ($150,000).

- The minimum elected amount under s. 85(1)(b) (with the tie-breaker from s. 85(1)(e.3)) is $175,000.o Wording of s. 85(1)(b) is subject to s. 85(1)(c).

In the event of a conflict, s. 85(1)(c) prevails and places the minimum as the maximum. The only acceptable elected amount is $150,000, as both the maximum and minimum are $150,000.

- Under s. 85(1)(a), A’s proceeds of disposition are $150,000 and cost in the promissory note is $150,000.o ACB of one common share issued is $0, as nothing is left over to be allocated.

- ACo is deemed to have paid for the transferred property an amount equal to the elected amount:o Cost in the land of $150,000, notwithstanding ACO has paid $175,000 for the property.

- What happens to the remaining $25,000?o Section 15(1) is a shareholder benefit provision – any attempt by an individual to extract or appropriate assets

from the corporation, except in circumstances expressly carved out s. 15(1), will be included equal to the amount included in the benefit extracted or appropriated.

A full income inclusion with no corresponding deduction for the corporation and the shareholder has a taxable benefit – economic double taxation.

- In addition to the $50,000 capital gain, the shareholder has a straight income inclusion of $25,000.

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o Since that amount is included under s. 15(1), A can add that amount to the ACB of the promissory note. However, ACo receives no credit for this additional payment in excess of the FMV of the land.

- Best for corporation and shareholder agree to transact at FMV, and they believe the amount to be $175,000.o Include a price adjustment clause which would kick in later if the FMV was actually $150,000, and everything

would be reduced to that amount.o A still has to realize the $50,000 capital gain, but no shareholder benefit and thus no potential for double tax.o However, case law has held that price adjustment clauses are ineffective against the CRA and the TCC.

ROLLOVERS OF OTHER PROPERTY

Elections Under the Minimum Amount, Rollovers of Inventory, and Treatment of Accrued Losses

(b) B transfers inventory, other than land, to Bco. On the transfer, B receives one common share of Bco. The cost of the inventory to B is $115,000. At the time of the transfer, the property has a FMV of $125,000. B and Bco elect under subsection 85(1) to effect the transfer at $100,000.

- Assume taxable Canadian corporations, timely election filed, everyone elects for maximum deferral, and property is non-land business inventory eligible property for transfer – conditions for application satisfied.

- Section 85(1)(c) & 85(1)(c.1) apply:o Maximum elected amount – $125,000 FMV of property.o Minimum elected amount – Cannot be less than the lesser of FMV of inventory ($125,000) and cost of

inventory ($115,000).- Section 85(1)(b) limits minimum of elected amount to FMV of non-share consideration, which is $0.

o Section 85(1)(e.3) resolves in favour of s. 85(1)(c.1), as it is the greater of the two. Minimum elected amount of $115,000, following s. 85(1)(c.1).

- Maximum elected amount of $125,000 under s. 85(1)(c).- Stipulated fact of election of $100,000, which is chosen without relation to the prescribed rules.- Election form is overridden and elected amount is deemed to be $115,000 – the minimum.- Under s. 85(1)(a), B receives proceeds of disposition of $115,000, resulting in no gain or loss on the transfer.- BCo is deemed to have acquired property at a cost of $115,000, which is the same as the proceeds of disposition.

o BCO has an accrued $10,000 gain on the business inventory.o Cost of property received by individual transferor.

No non-share consideration. No preferred shares issued as a consequence of the transaction. Only amount the elected amount can flow into is the one common share, under s. 85(1)(h).

New common share has cost of $115,000.- Do not want parties electing at a loss, unless there is actually a loss on the property.

What if the inventory was land?

- If the inventory is land, the condition precedents for s. 85(1) are defeated, as land property is not eligible property.- A s. 85(1) election was made for a non-eligible property, which means the election is invalid.- The usual tax consequences for disposition will take effect.- B realizes $10,000 gain and have $10,000 of business income on disposition of the land inventory of BCo.- BCo has costs of $125,000 in the property, and will have no gain or loss if it resells.

What if B held the property on capital account?

- Any kind of capital property is eligible property, and the results would be the same as the base facts.

What if the FMV at the time of transfer was $100,000?

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- Section 85(1)(b), 85(1)(c) & 85(1)(c.1) will return different results.- Sections 85(1)(c) & 85(1)(c.1) agree that the minimum and maximum amount is the FMV of the property - $100,000.

o Section 85(1)(b) lists the minimum as $100,000.- Elected amount is permitted at $100,000.- Section 85(1)(a) deems B to have proceeds of $100,000, realizing a $15,000 non-capital loss on the disposition.- Allocate elected amount to consideration received by B.

o No non-share consideration.o No preferred share consideration.o Full elected amount of $100,000 is allocated to BCo common shares issued as consideration for land inventory.

Cost going forwards of $100,000 in common shares.- Combination of ss. 85(1)(c) & 85(1)(c.1) will force a realization of loss.- Forcing parties to elect at FMV, and thus realize a loss, when there is an accrued loss effectively bars “trading” of losses

between transferors and transferees.

Rollover of Depreciable Capital Property

(c) D transfers a depreciable capital property to Dco for one common share of the transferee. The property was the sole property in the relevant class owned by D. At the time of the transfer the undepreciated capital cost (“UCC”) of the class was $8,000, the FMV of the property was $6,000, and its capital cost was $9,000.

- Depreciable property has three different amounts:o Original acquisition cost of a piece of depreciable property.o Undepreciated capital cost (UCC) of the class of property will persist throughout the use of a property in a

business.- Usual assumptions – all parties are taxable Canadian corporations, election is filed timely, maximum possible deferral

amount elected, and property is eligible property.- Section 85(1)(b) limits minimum of elected amount to be equal to the FMV of non-share consideration.

o No non-share consideration.- Section 85(1)(c) maximum of elected amount cannot be more than the FMV of property transferred.- Section 85(1)(e) states that the minimum elected amount must be equal to least of the UCC of the class of the property

($8,000), capital cost ($9,000), or FMV ($6,000) – least is FMV at $6,000.o Take the least amount - $6,000.

- With only common share consideration and no non-share or preferred share consideration – all elected amount will be allocated, resulting in a cost in the common shares of DCo equal to $6,000 going forwards.

o Cost in common share of DCo equal to $6,000 going forwards.- $6,000 terminal loss realized by DCo.

o Terminal loss exists upon disposing of all property in a class, but there is a remaining UCC balance which has not been deducted.

o Since D and DCo are affiliated, the terminal loss is suspended.- For DCo, there is a deemed cost in the property of $6,000.

What if the FMV was $10,000?

- Section 85(1)(b) will provide a minimum elected amount of $0.- Section 85(1)(c) will provide a maximum elected amount of $10,000 – FMV of transferred property.

o Greatest possible range is $0 - $10,000.- Section 85(1)(e) will provide a minimum elected amount – least of UCC of $8,000, capital cost of $9,000, and the FMV

of $10,000.o Minimum elected amount is $8,000.

- Elect at minimum - $8,000.80 | P a g e

- D deemed to have disposed of property for $8,000.o UCC will reduce by $8,000 as no property left in the class.

No gain or loss realized as a result of the transfer.- Allocate cost to consideration: only common shares to allocate to - $8,000 cost in common shares.- For DCo, deemed acquisition cost in property of $8,000.- What is the purpose of s. 85(1)(e.1)?

o Section 85(1)(e.1) applies for when a taxpayer transfers depreciable property to a corporation. Allows the taxpayer to designate the notional order of disposition of the properties transferred out of the

same class of depreciable property when transferred out of s. 85(1). Necessary because of the elected amount minimum in s. 85(1)(e.3), which applies on a property-by-

property basis but creates a pool concept due to creation of UCC. Allows for taxpayer to designate order in such a way that best tax results. UCC is a pool concept which disposes of things in classes.

- What is the purpose of s. 85(1)(e.3)?o Section 85(1)(e.3) is an ordering rule which applies when s. 85(1)(b)’s minimum amount is greater or less than

another section’s elected minimum amount. A hierarchy rule which provides certainty.

o Maximum amount will always be under s. 85(1)(c), as ss. 85(1)(b) & 85(1)(e.3) is subject to that section. Applies if s. 85(1)(b)’s minimum amount is greater than the maximum under s. 85(1)(c) or otherwise.

Tax Consequences of an Overpaid Rollover Transaction

- How is the cost of the consideration received by a transferor determined under s. 85(1)? Why?o Cost to be allocated to consideration is determined first by the elected amount under s. 85(1).o The elected amount is then allocated to non-share consideration, preferred shares, and common shares, in that

order (ss. 85(1)(f)–85(1)(h)). Each type of consideration may only have cost allocated up to its FMV.

o This allocation of consideration will only occur if at least some share consideration of the transferee corporation is included, as that is a necessary condition for s. 85(1) to apply.

- Consider the above in context of the following examples:

X transfers land held as capital property to Xco. On the transfer, X receives a promissory note with a FMV of $300,000. At the time of the transfer, the ACB of the land for X was $100,000 and its FMV was $200,000.

- Base case scenario is that land with FMV of $200,000 is transferred only for consideration of $300,000.o No share consideration received – s. 85(1) does not apply.

- Default to general income tax principles.o Notwithstanding FMV of note is greater than FMV of land, there will be no ordering rule which would deem

proceeds of disposition to be less than the note. Proceeds of disposition of $300,000, and a capital gain of $200,000 (equal to proceeds – ACB

($300,000 - $100,000)).- Section 69(1)(a) will apply to XCo as it has received land with a cost in excess of FMV, and will reduce the cost of the

land acquired by XCo from $300,000 to $200,000.o No impact on computing X’s proceeds of disposition in the land.

Some degree of double tax in the future – X has paid tax on $300,000. o No adjustment necessary for X and their receipt of a promissory note.

However, an overpayment by a corporation for land may result in s. 15(1) applying: the corporation will be deemed to have conferred a benefit as they have paid consideration over the FMV of the received property, notwithstanding there has also been an income inclusion.

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May result in triple tax on the same $100,000.- Price adjustment clause would help to avoid this problem.

What if X also receives one common share of Xco?

- If one common share was received in addition to the promissory note, overpayment still occurs.o Assuming a valid election, s. 85(1) would apply.o Section 85(1)(b) would set out a minimum elected amount of $300,000 (FMV of consideration).o Section 85(1)(c.1) would set out a minimum elected amount of $100,000 (ACB of land).o Section 85(1)(e.3) resolves conflict in favour of s. 85(1)(b) – minimum elected amount of $300,000.o Section 85(1)(c) sets out maximum at $200,000 (FMV of land).

Since s. 85(1)(c) is lower than s. 85(1)(b), s. 85(1)(c) prevails – maximum and minimum are $200,000.- Section 85(1)(a) proceeds of disposition equal to $200,000 (elected amount) compared to ACB in the land of $100,000,

resulting in a $100,000 capital gain.- Cost must then be allocated to consideration.

o Section 85(1)(f) will require elected amount to be allocated to promissory note to the extent of proceeds or FMV (whichever less) of the note: all $200,000 of deemed costs is allocated to the promissory note.

o No preferred share consideration (s. 85(1)(g) does not apply).o Section 85(1)(h) will compute to nil as no remaining cost after application of s. 85(1)(f).

- XCo has paid more with the note ($300,000) than the FMV of the land.- Section 15(1) will apply and include $100,000 in X’s income as a straight income inclusion, taxable at 48%.

o Section 52(1) will deem the s. 15(1) benefit to increase the cost of the note to $300,000. X will have a cost in the note of $300,000.

- No adjustment to XCo as a result of the shareholder benefit being included – cost of the land remains at $200,000.- Same end result for XCo, but worse result for X – traded out an overstated capital gain (taxed at capital gain) for a

shareholder benefit (taxed at individual rates).- Section 85(1) would only help where there is a bona fide attempt to value the land.

Issuing Subsidiary Shares as Consideration in a Rollover Transaction

Assume in the above example that X receives a promissory note of Xco (FMV - $50,000) as well as 100 class A preferred shares of Xco (FMV - $150,000).

- This scenario allows for a useful s. 85(1) election.o Conditions of application should be satisfied.

- Determine elected amount:o Section 85(1)(b) sets out minimum as equal to FMV of non-share consideration (promissory note) - $50,000.o Section 85(1)(c.1) sets out minimum as equal to lesser of FMV or ACB of transferred property - $100,000.o Conflict resolved by s. 85(1)(e.3) and sets out the greater amount – $100,000 through s. 85(1)(c.1) – to prevail.o Section 85(1)(c) sets out maximum amount as equal to FMV of transferred property – $200,000.o Range may be from $100,000 - $200,000; $100,000 maximizes capital gain deferral.

- Proceeds of disposition for X will be $100,000.o No capital gain realized, as proceeds of disposition minus ACB in the land reduces to nil.

- XCo’s cost of the transferred property will also equal $100,000.- X will have cost to allocate to consideration received of $100,000.

o Section 85(1)(f) first allocates cost to the maximum of the FMV of the non-share consideration - $50,000.o Section 85(1)(g) allocates the remaining $50,000 to the preferred share consideration - $50,000.

ACB of the preferred shares issued to X will be $50,000.o Section 85(1)(h) will not allocate anything, as there is neither cost leftover or common shares.

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What if the preferred shares are those of Yco, a wholly-owned subsidiary of Xco?

- If XCo issued shares of its subsidiary, YCo, as consideration, s. 85(1)’s conditions of application would not be satisfied.o Section 85(1) requires the transferor corporation to issue its own shares to the vendor of the property.

- Ordinary tax principles will then apply:o $200,000 FMV of land, $200,000 as proceeds of disposition, $100,000 ACB.o X will realize $100,000 capital gain, immediately.o Cost will be $200,000 allocated to the preferred shares of YCo and note issued by XCo.

$50,000 ACB in note, and $50,000 of cost in YCo preferred shares.- For XCo, they will have $200,000 ACB in the land moving forwards.

o XCo would only be taxed if YCo’s shares had accrued gain on it which would cause tax consequences to XCo.- No double tax here, but X will have tax payable on $50,000 taxable capital gain in the taxation year.

Isolating Accrued Capital Gains

Assume in the example in paragraph 6(a) that X receives a promissory note (FMV - $50,000) as well as 100 class A preferred shares of Xco (FMV - $25,000) and 50 common shares of Xco (FMV - $125,000).

- If X received a $50,000 note, 100 XCo preferred shares (FMV - $25,000), and 50 XCo common shares (FMV - $125,000) as consideration, net FMV of consideration is still $200,000.

- Section 85(1) would apply, as only the transferee’s shares are being issued. - Determine elected amount (same analysis as if only note and preferred shares are issued):

o Section 85(1)(b) sets out minimum as equal to FMV of non-share consideration (promissory note) - $50,000.o Section 85(1)(c.1) sets out minimum as equal to lesser of FMV or ACB of transferred property - $100,000.o Conflict resolved by s. 85(1)(e.3) and sets out the greater amount – $100,000 through s. 85(1)(c.1) – to prevail.o Section 85(1)(c) sets out maximum amount as equal to FMV of transferred property – $200,000.o Range may be from $100,000 - $200,000.

To maximize capital gain deferral, elect at $100,000.- X realizes no gain or loss, as s. 85(1)(a) deems proceeds of disposition at $100,000, equal to $100,000 ACB.- Difference compared to above is allocation of cost to the consideration received by X.

o Section 85(1)(f) allocates $50,000 as cost to the promissory note. $50,000 left to allocate to other consideration.

o Section 85(1)(g) allocates $25,000 of cost to preferred shares with FMV of $25,000. $25,000 of cost left to allocate.

o Section 85(1)(h) allocates the remaining proceeds of disposition to the cost of the common shares. FMV of $125,000 and cost of $25,000; accrued gain works out to $100,000.

- Same $100,000 of accrued capital gain on the shares, but all $100,000 accrued gain is locked into the common shares.- This scheme demonstrates how accrued capital gains can be locked into one class of shares.

SUPPLEMENTARY RULES FOR ROLLOVER TRANSACTIONS

Section 85(1)(e.2) – Targeting Non-Arm’s Length Section 85(1) Elections

- What is the purpose of s. 85(1)(e.2)? When does it apply? What is the effect of its application?o Intended to prevent indirect transfers of property to related persons.o Without s. 85(1)(e.2), s. 85(1) could be abused easily.

Say X owns a piece of land with massive accrued gain. X incorporates HoldCo, and his children subscribe for common shares of HoldCo.

HoldCo is worth nothing at this point.

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X then transfers his land to HoldCo in exchange for some notional amount of preferred shares and a note equal to the ACB of the land.

Minimum elected amount under s. 85(1) would be equal to ACB of land, and maximum would be FMV of land.

o The range does not account for value of share consideration.o Notwithstanding adequate consideration has not been withdrawn, and ACB being much

less than FMV. X has transferred all value of the land in excess of the ACB of the note to HoldCo.

Deferred tax on the accrued capital gain for at least a generation.o Section 85(1)(e.2) applies where the FMV of the property transferred to the corporation is greater than the

FMV of the consideration received and the elected amount, and it is reasonable to assume that one of the reasons that the shortfall was created was to confer a benefit onto a related person.

o Section 85(1)(e.2) does not apply where the transferee corporation is wholly owned by the transferor. Even if a shortfall is created, the shares of the transferor will catch up with the value of the property

transferred as there is only one owner.- Consider s. 85(1)(e.2) in context of the following example:

A incorporates Aco and receives one common share for $1 on the incorporation. A's children then subscribe for 9,999 common shares at an issue price of $1 per share. After the share capital structure is in place, A transfers to Aco a capital asset with an ACB to A of $10,000 and a FMV at the time of the transfer of $100,000. As consideration for the transfer, A receives from Aco a promissory note with a FMV of $10,000 as well as preferred shares of Aco with a FMV of $40,000. A and Aco elect to effect the transfer of the capital asset under subsection 85(1) (assume maximum deferral election at $10,000).

- $50,000 shortfall created in the above facts.o Absent any other rule, that amount would shift to the children’s common shares.

- Initial result of s. 85(1)(e.2) is that excess of FMV of transferred property over FMV of consideration received – $50,000 – is added to the elected amount (now $60,000).

o A will realize a capital gain of $50,000 on this transaction.o ACo will have cost in the transferred asset of $60,000, which is equal to the elected amount.

- Furthermore, s. 85(1)(e.2) will work with ss. 85(1)(f – h).o The increased amount in elected amount will not apply to the calculations to ss. 85(1)(f – h).o All $10,000 will be allocated to promissory note, and there is no more cost to allocate.o A therefore still has an accrued capital gain on the shares of ACo and will need to pay tax on the $40,000

capital gain when disposing of their shares.- Not double tax, but an acceleration of tax payable which would not occur if adequate consideration was received.- Same result as if A gifted a property with appreciated gains.

o However, A’s children will not receive an adjustment in ACB of their shares. Section 69(1)(c) would normally apply to provide ACB of the shares equal to the FMV of the property

received as a gift.o Accrued gain would be locked into A’s children’s shares.

Combine $50,000 deemed gain, $40,000 accrued gain on A’s shares, and the $50,000 accrued gain in the HoldCo shares, there is now more than $100,000 of tax payable due to s. 85(1)(e.2).

More than if A had simply gifted the property to the children.

Section 85(5) – Rollover Transactions of Depreciable Property

B owns a depreciable capital asset that is the only asset of its class. B transfers the asset to Bco in return for common shares of the transferee. At the time of the transfer, the UCC of the relevant class is $500 and the FMV

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of the asset is $1,500. B acquired the asset for $1,000. B and Bco elect to effect the transfer under subsection 85(1). What is the effect of subsection 85(5)?

- Determine elected amount (same analysis as if only note and preferred shares are issued):o Section 85(1)(b) sets out minimum as equal to FMV of non-share consideration - $0.o Section 85(1)(e) sets out minimum elected amount for depreciated capital property must equal the least of the

UCC of the class ($500), the capital cost of the property ($1,000), and the FMV of the property ($1,500) - $500.o Section 85(1)(c) sets out maximum amount as equal to FMV of transferred property – $1,500.o Section 85(1)(e.3) deems the higher of the two amounts as minimum - $500.o Range may be from $500 - $1,500; capital gain deferral maximized with $500 election.

- Second 85(1)(a) provides property’s ACB is $500 (the elected amount), and deemed proceeds of disposition also $500.- No gain or loss on disposition, as the UCC pool will be zeroed out by the transfer.- No non-share consideration or preferred shares, and as such full $500 cost allocated to common shares.- Section 85(5) then applies as a special rule for depreciable property.

o Intended to preserve potential for recapture income after a transfer of depreciable property to a corporation for less than the original capital cost of the property.

o Applies where transferor has transferred a particular depreciable property for proceeds of disposition less than the capital cost of the particular property.

- Transferee deemed to have a capital cost in the transferred property equal to the transferor’s capital cost in the property.o Difference in original capital cost and elected amount will be deemed to have been previously deducted by the

transferee corporation as depreciation (a CCA deduction).- Assuming UCC has not changed since the rollover, the transferee corporation will realize the same accrued gain or loss

when they sell the property as if the original transferor had sold the property.- Difference between capital cost of $1,000 for B and the amount that would have been the capital cost for BCo ($500).

o Section 85(5) applies so that BCo will have a deemed capital cost in the asset transferred of $1,000, notwithstanding elected amount was only $500.

Difference between the two amounts will be deemed to have been previously claimed CCA by BCo. BCo will still have UCC of $500 in the asset class, but can depreciate that property.

Section 85(2.1) – The “Gap-Filler” Rule

- What is the role of s. 85(2.1)? What is its relationship with ss. 15(1), 84(1) & 84.1?o Section 85(2.1) aims to ensure PUC of shares issued by transferee corporation under s. 85(1) does not exceed

cost of the property transferred, less FMV of any non-share corporation given by the transferee corporation. Without s. 85(2.1), the transferee corporation could add an amount to PUC equal to FMV of transferred

property, notwithstanding that the elected amount is lower (test and effect infra). The shareholder could then use that PUC to extract surplus at capital gain rates, and if they had

ACB otherwise, ACB and PUC could allow for cash too be extracted at a tax-free basis.o Section 85(2.1) does not apply to a transaction if s. 84(1) applies.

Section 85(2.1) will not apply to a transfer of shares to another corporation unless all of s. 84(1)’s conditions are not satisfied.

o Section 15(1) does not apply to every s. 85(2.1) exchange. To the extent of excessive non-share consideration, s. 85(2.1) may not apply, but s. 15(1) would. If an amount is added to stated capital on an internal exchange of shares which is more than the stated

capital of the exchanged shares, s. 84(1) would apply to produce a deemed dividend.o Say OPCo has one shareholder who owns 100 Class A shares, and another shareholder who also owns 100

Class A shares. Aim is to flip A to another class of shares and to claim a capital gain deduction.

Want to realize a gain on the transfer.85 | P a g e

A exchanges Class A shares to Class B shares. Transaction results in cancellation of Class A shares, and is thus a disposition.

o Section 84(9) will then deem a transfer of shares to OPCo. If PUC is then increased to compensate, s. 84(1) would apply to produce a deemed dividend.

o Section 85(2.1) is a gap-filler where the other surplus stripping provisions do not apply.

A owns a non-depreciable capital asset with an ACB of $100,000 and a FMV of $150,000. A transfers the asset to Aco in return for $75,000 cash and preferred shares of Aco with a FMV and stated capital amount of $75,000. A and Aco do not make an election under subsection 85(1).

- Section 85 is not automatic, and only applies with an election. Without an election, normal tax principles apply.o Capital gain realized by transferor of $50,000 and taxable capital gain of $25,000.o Note is a liability of the corporation.o Increase on the assets of the balance sheet of $150,000 (FMV of the land) and increase on the liabilities due to

the promissory note by $75,000 (FMV of the promissory note). Enough room to add $75,000 to the preferred shares without producing a deemed dividend.

o Individual will realize $50,000 capital gain, will have cost in the note of $75,000, and PUC and ACB in the preferred shares of $75,000.

What if the stated capital of the preferred shares is increased by $100,000 on the transfer?

- If the PUC addition was increased, there will be a deemed dividend under s. 84(1) of $25,000, received by A.o A will have the capital gain of $50,000 and also realizes a deemed dividend of $25,000 on the PUC addition.

Consolidated Application of Surplus Stripping Rules

In 2018 Mr. Y purchased for $100,000 all of the issued shares (one class) of Aco owned by Ms. A, an arm's length stranger. The shares have a stated capital amount of $50,000.

In January 2019, Mr. Y transfers the shares to his wholly-owned corporation, Yco. At the time of the transfer the shares of Aco have a FMV of $150,000. As consideration for the transfer, Mr. Y receives 100 class B preferred shares of Yco with a FMV of $75,000. The 100 shares are the only issued shares of the class. Yco also assumes a $75,000 debt that Mr. Y owes to the Bank of Montreal on a personal line of credit. Because of the assumption of debt, only $75,000 is added to the stated capital account of the class B shares for corporate law purposes. Mr. Y and Yco elect under subsection 85(1) to effect the transfer at $100,000 (ACB of transferred shares).

Mr. Y has always been a Canadian resident. As well, both Aco and Yco were incorporated in Canada, the former in 1976 and the latter in 1989.

- Section 85(2.1) does not immediately apply.- However, s. 84.1 would apply, as an individual is transferring shares from one corporation to another corporation.

o Two Canadian resident corporations.o Not dealing at arm’s length.o Share are capital property.o Corporations will be connected after transfer is connected – one corporation wholly owns the other.

- Section 84.1(1)(a) amount.o Only A – B must be considered.o A is equal to PUC addition of $75,000.o B is equal to greater of PUC ($50,000) or ACB ($100,000) of the transferred shares - $100,000 – less FMV of

non-share consideration received - $75,000.o A – B is $50,000, which is equal to the PUC grind.

- PUC grind applies to preferred shares, reducing the PUC of the shares from $75,000 to $25,000.86 | P a g e

- Section 84.1(1)(b) amount.o A is PUC addition of $75,000.o B is equal to $75,000 – FMV of debt relief.o A + B = $150,000.o E is equal to greater of PUC ($50,000) or ACB ($100,000) of the transferred shares - $100,000.o F is equal to the amount of the PUC grind - $50,000.o E + F = $150,000.o Section 84.1(1)(b) computes $0, and thus no deemed dividend received.

- The entire result for Y is a $50,000 PUC grind . - Determine elected amount:

o Section 85(1)(b) sets out minimum as equal to FMV of non-share consideration (debt foregiveness) - $75,000.o Section 85(1)(c.1) sets out minimum as equal to lesser of FMV or ACB of transferred property - $100,000.o Section 85(1)(e.3) sets out the greater of the two amounts as prevailing - $100,000 as set out by s. 85(1)(c.1).o Section 85(1)(c) sets out maximum amount as equal to FMV of transferred property – $150,000.o Range may be from $100,000 - $150,000: $100,000 election maximizes capital gain deferral.

- Y has deemed proceeds of disposition of $100,000, which is also deemed cost of property received as consideration.o Also deemed cost of consideration received by Y.

- Cost allocated first to debt relief - $75,000.o $25,000 left to allocate and put towards the preferred shares, with no cost left over for common shares.

- Y will own shares of YCo with FMV of $75,000, ACB of $25,000, and PUC of $25,000, and will have received debt relief with a FMV and ACB of $75,000.

- No deemed dividend results.

What if Mr. Y receives $125,000 in cash and 100 class B preferred shares of Yco with a FMV and stated capital amount of $25,000?

- $125,000 cash consideration and $25,000 addition to stated capital of shares.- Section 85(2.1) will not apply and ss. 84.1 & 85(1) will, assuming all the conditions of the latter are satisfied.- Determine elected amount (same analysis as if only note and preferred shares are issued):

o Section 85(1)(b) sets out minimum as equal to FMV of non-share consideration (cash) - $125,000.o Section 85(1)(c.1) sets out minimum as equal to lesser of FMV or ACB of transferred property - $100,000.o Section 85(1)(e.3) sets out the greater of the two amounts as prevailing - $125,000 as set out by s. 85(1)(b).o Section 85(1)(c) sets out maximum amount as equal to FMV of transferred property – $150,000.o Range may be from $125,000 - $150,000; $125,000 election maximizes capital gain deferral.

- Under s. 85(1)(a), corporation deemed to acquire shares at $125,000 (elected amount).- Y has proceeds of disposition of $125,000, which is also deemed cost of property received as consideration.

o Allocate full $125,000 to non-share consideration – cash (FMV of $125,000). Cash has cost of $125,000 moving forwards.

o New preferred shares will have ACB of $0, as there is no proceeds left to allocate as cost.- Section 84.1 then considered.- Start with s. 84.1(1)(a).

o A is PUC addition for all shares of the corporation - $25,000.o B is the excess of the greater of PUC ($50,000) or ACB ($100,000) - $100,000 – over FMV of non-share

consideration - $125,000. Computes to nil ($100,000 - $125,000).o A – B (the PUC grind) will equal to $25,000.

- PUC of preferred shares ground to $0. - Section 84.1(1)(b).

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o A is PUC increase of all shares - $25,000.o B is FMV of non-share consideration - $125,000.o A + B = $150,000.o E is greater of PUC ($50,000) or ACB ($100,000) – $100,000.o F is the PUC grind from s. 84.1(1)(a) – $25,000.o E + F = $125,000.o (A + B) – (E + F) = $25,000. $25,000 left over as a deemed dividend.

Heavy cash consideration results in a deemed dividend realized by Y as a result of the share transfer.o If YCo could declare a $25,000 capital dividend, they could.o They could also recover from RDTOH.

Z transfers land held as capital property to Zco. Z receives as consideration for the transfer a promissory note of Zco with a FMV of $10,000 as well as preferred shares of the transferee with a FMV and stated capital of $90,000. At the time of the transfer the ACB of the land to Z is $10,000 and the FMV $100,000. Z and Zco elect under subsection 85(1) to effect the transfer at $10,000.

- Section 85(2.1) may apply, as s. 84(1) would not (no transfer of shares).- Conditions of s. 85 satisfied.

o Eligible property transferred in exchange for shares of the transferee corporation, and a timely election made.- Section 85(2.1)(a) is the main concern – applies where PUC of shares issued by the transferee corporation exceeds the

ACB of the property transferred, as reduced against the FMV of any non-share consideration provided by the transferee.o Resembles s. 84.1(1)(a).o PUC reduction on a class-by-class basis if s. 85(2.1) applies.o A is the PUC addition to all classes of shares – here $90,000.o B is the amount, if any, by which the ACB of the transferred property ($10,000) exceeds the FMV of any non-

share consideration received ($10,000) – $0.o C is the PUC addition in respect to the particular class of shares to which the PUC grind will be applied to.o A – B reduces to $90,000, and with the C/A fraction reducing to 1, the full $90,000 PUC grind is applied to the

preferred shares: preferred shares will go from $90,000 of PUC to $0 of PUC.- Remaining s. 85(1) consequences:

o Transferred land has FMV of $10,000 and ACB of $10,000.- Determine elected amount:

o Section 85(1)(b) sets out minimum as equal to FMV of non-share consideration (promissory note) - $10,000.o Section 85(1)(c.1) sets out minimum as equal to lesser of FMV or ACB of transferred property - $10,000.o No conflict to be resolved by s. 85(1)(e.3).o Section 85(1)(c) sets out maximum amount as equal to FMV of transferred property – $100,000.o Range may be from $10,000 - $100,000; $10,000 election maximizes capital gain deferral.

- Cost in the land is $10,000; $90,000 accrued gain preserved.- No gain or loss realized on disposition of land, with proceeds equal to elected amount - $10,000.- $10,000 of cost to allocate to consideration.

o Full $10,000 allocated to the promissory note.

STOP-LOSS RULES

Sections 13(21.2), 40(3.4) & 40(3.6)

- What is the purpose of ss. 13(21.2), 40(3.4) & 40(3.6)? When do these provisions apply?o All three rules are stop-loss rules.

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Sections 40(3.4) & 40(3.6) deal with capital properties to prevent realization of capital losses. Section 13(21.2) deals with business property.

o Parties are affiliated when they are deemed to be affiliated under s. 251.1(1). Much more stringent rules than for relatedness, association, or arm’s length. Partnerships and trusts are not disregarded for affiliation rules.

They are treated like people. Section 251.1(1)(a) affiliates individuals with their spouse.

Only way for two individuals to be affiliated.o Not affiliated with nuclear family; much narrower than relatedness

Section 251.1(1)(b) affiliates corporations with the individual who controls the corporation. A corporation is affiliated with every member of an affiliated group which controls the

corporation. If a person is affiliated with every member of an affiliated group which controls the

corporation, they are affiliated with the corporation. Section 251.1(1)(c) affiliates two corporations if they are controlled by the same person, or if they are

controlled by an affiliated group. If a corporation is affiliated with every member of an affiliated group which controls the

corporation, they are affiliated with the corporation. Section 251.1(3) sets out de facto (and de jure) control as the test for the other sections.

De jure control also permissible. However, most provisions ignore s. 251.1(3), thus for beneficial provisions only de jure control

is used in those provisions.o Section 40(3.4) is the operative provision for the suspended loss rules.

Suspended loss rules, if applicable, preclude the transferor who would otherwise realize a loss from realizing that loss until a later time.

Conditions for application of s. 40(3.4) set out in s. 43: Section 43(a) – Taxpayer other than an individual dispose of non-depreciable capital property

in a transaction which is not:o A change of use;o The expiry of an option;o The disposition of a debt of a related person;o Transaction where loss would be denied because a loss restriction event occurred; oro A transaction preceding a person becoming a non-taxable person.

Section 43(b) requires an affiliated person to have within a period beginning 30 days before the disposition date and ending 30 days after the disposition date acquired the same property or acquired identical property, and that at the end of that period, the affiliated person continues to own the property or the identical property.

Section 40(3.4) then would apply to suspend the loss.o Section 40(3.6) requires a share repurchase or share redemption, realization of a loss on that transaction, and if

the individual is affiliated with the corporation after the transaction, the loss is denied. If the individual still owns shares of the corporation after the repurchase, there is an addition to the

individual’s ACB in the other shares equal to the denied loss. Section 40(3.6) would be most damaging where an individual disposes of all shares but is still affiliated

(ex. spouse owns the corporation), as a permanently denied loss results. Leave at least one share outstanding in the corporation.

- Section 40(3.4), if applicable, would deem the corporation to have realized a loss after the expiry of a 30 day period, which triggers when the affiliated persons no longer own the corporation.

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o Loss is suspended until that event.- Consider the following example.

What is the purpose of subsections 13(21.2), 14(12) and 40(3.4) and (3.6)? When do the provisions apply? Consider the following example. C transfers a non-depreciable capital asset to Cco. At the time of the transfer C owns 51% of the voting shares while his spouse owns 49%. The transfer is effected under subsection 85(1) and recorded as follows:

Non-depreciable capital property $1,000 ACB (as held by C)Consideration received by C from CCo – preferred shares of CCo

$500 FMV

Elected amount under s. 85(1) $500- Elected amount only option due to operation of s. 85(1).- Loss is denied for C.

o Even if the loss would be realized ordinarily due to s. 85(1), the loss is deemed due to s. 40.o That $500 denied loss is added to CCo’s ACB in the land, under s. 53(1)(f).

Notwithstanding deemed cost of land of $500, CCo will have a cost in the land of $1,000. Accrued loss in the land of $500.

- Superficial loss rules different from suspended loss as they transfer the loss to the transferee, rather than keeping the loss with the transferor.

- What is the relationship between ss. 13(7)(e) & 85(1)?o Section 13(7)(e) is meant to prevent creation of UCC at capital gain rates in non-arm’s length transactions.

Deems capital cost of property to be equal to prior capital cost plus one half of capital gain realized on non-arm’s length disposition of the property.

Only 75% of the elected amount (or regular FMV without election) will be added to the UCC of the property, with the other 25% discarded.

- What is the purpose of s. 22? What is its relationship with s. 85(1)?o For all taxpayers but farmers, accrued amounts generate for accounts receivable when the bill is sent.o Absent s. 22, the vendor would have included accounts receivable upon selling something, but the purchaser

would collect the cash. The person paying tax and receiving cash would be different people.

o Section 22 allows for buyer and vendor to elect (T2022) to allow for the extent to which the buyer did not pay cash for the AR, the vendor may deduct from their income the amount of the AR they did not pay cash for, and the buyer includes in their income a corresponding amount.

The purchaser is deemed to be the same person as the vendor, so that the purchaser may take a deduction as if they included the AR in their income.

o No real connection with s. 85(1). However, as a practical manner, if a person is incorporating a business for the first time and they had

AR in that sole proprietorship, s. 22 election is highly desirable. Corporation will have income inclusion for the AR, will likely qualify for SBD in respect to the

income, and will pay 12% tax on the AR.

V–II: SHARE EXCHANGES

CAPITAL REORGANIZATIONS AND SHARE-FOR-SHARE EXCHANGES: SECTIONS 51, 86 & 85.1

Share Exchange Rationale

- Sections 51 & 86 apply for internal share exchanges, and s. 85.1 applies for external share exchanges.o Existing shareholders of a particular corporation all withdraw shares, and for consideration receive shares of the

purchaser corporation.

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- Gains and losses should only be realized where there is a change in investment.o As long as people remain invested in the same property, there is no basis for taxing them.o Internal share exchanges do not particularly change the nature of the investment for income tax purposes,

leaving the same risks and rewards. No real cashing out of interest in the corporation from a share exchange. No fixing of gains or losses of the shares; value still relies on the corporation’s whole value.

- Taxing share exchanges would create liquidity problems for taxpayers who are not receiving cash.o Taxes must be paid in cash money; persons engaging in share exchanges do not actually obtain money.o Imposing tax on share exchange could create a material solvency risk.

- Unlike s. 85, there are no forms that must be filed with these elections.o All sections apply automatically and no need to provide CRA with notice for the sections to apply.

SECTION 51 – BASIC SHARE EXCHANGES

Section 51(1) – Conditions

- Most basic exchange provision and only applies to the most basic exchanges.- Section 51(1) provides the conditions for application:

o Taxpayer must receive a share of the capital stock of the corporation;o In exchange for either:

Another share of the corporation that was taxpayer’s capital property; or A bond or debenture of the corporation that was the taxpayer’s capital property and had terms granting

the holder the right to convert;o No non-share consideration is received; ando Sections 85(1), 85(2) & 86 must not apply to the exchange.

Affirmatively electing under s. 85 would disable s. 51, despite both provisions being satisfied. Section 86 has slightly different conditions of application, but also disables s. 51.

- Section 51(1) can apply to the conversion of a bond, and thus is not a pure share-for-share exchange like s. 86.o However, the bondholder may only access s. 51(1) if the bond itself provides for a bond-for-share exchange.o Bonds with share conversion rights are relatively common and have the same economic upside as a share, and

can thus be treated the same. Has the same capped downside as a creditor, but with the unlimited upside that a shareholder would

have.- A dealer or trader in securities would not be able to rely on s. 51(1), as the share must be capital property.- Any other consideration received aside from a share or bond with share conversion rights would disable s. 51(1).- Section 51(4) prescribes the lack of hierarchy for s. 51(1) relative to other share exchange provisions.

Section 51(1) – Effects

- There are two material effects of s. 51(1) applying:o Exchange is deemed not to be a disposition; and

The only share exchange provision that does not deem or create a disposition. Sections 85.1 & 86 both create a disposition. As there is no disposition, nothing needs to be reported under s. 51(1).

o With every other share exchange, since they are dispositions, despite there being no gain or loss the exchange must still be reported.

o Helps to minimize detection risk.o The ACB of the shares acquired is equal to the prorated portion of ACB of property exchanged, with proration

based on the relative FMV of the shares acquired.

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If multiple classes of shares are exchanged, the historical ACB of old share or old bond is prorated between new shares of the different classes based on the relative FMV of each class received by the shareholder on the exchange.

- Section 51(1)(d)–51(1)(f) are not relevant for this course.

Section 51(2) – Anti-Avoidance Rule for Shortfall of Transferred Property

- An anti-avoidance rule similar to s. 85(1)(e.2), working in a substantively similar manner.- If the property received is worth less than the old shares or the old bond, then s. 51(2) can apply if it is reasonable to

conclude that some portion of the shortfall is a benefit conferred on a related person by the taxpayer.o The same purpose test as s. 85(1)(e.2).o The shortfall of consideration is referred to as the “gift portion”.

- If the purpose test is satisfied, then s. 51(2)(d) will provide for a disposition of property by the exchanging shareholder equal to the lesser of:

o The ACB of the share exchanged plus the gift portion; oro The FMV of the convertible property.

- Due to the “lesser of” format, it is possible for a capital loss to result.o Section 51(2)(e) however denies the possibility for a capital loss, and thus s. 51(2) only allows for capital gain.

- Section 51(2)(f) deems the ACB of the shares received on the exchange to not be increased unless the FMV of those shares are less than their ACB, potentially creating double tax in the future.

o Usually, the transferor is not double taxed due to the decrease in the value of the shares transferred. The double tax comes when the related person disposes of the shares, due to no adjustment in ACB.

Deemed gain under s. 51(2) has already had tax payable by the transferor which would then also be taxed by the transferree’s disposal.

- Section 51(2) can be avoided through price adjustment clauses which set out a right to adjust consideration if the parties erred in evaluating FMV of the shares, so long as the clause was a bona fide attempt to value the shares.

Section 51(3) – PUC Reduction Rule

- A PUC reduction rule which is substantively similar to s. 85(2.1), albeit simpler due to no non-share consideration.- Applies on a class-by-class basis and requires the PUC of each individual class to be reduced by a formula:

o Amount by which the PUC of all of the shares was increased by the exchange less the PUC of the old shares prior to the exchange.

o Reduction is allocated pro-rata to each class of shares based on the proportion of stated capital of each class.- Section 51(3) does not apply to the conversion of a bond.

o If there is a bond conversion, the amount added to PUC will be the permissible amount under the ABCA. Potential for a s. 84(1) deemed dividend if too much is added to the stated capital of the shares issued in

exchange for the bond. The principal amount of the bond is the amount by which the corporation’s liabilities will

decrease due to the redemption of the bond – easy to avoid a deemed dividend as a result.

Applying Section 51

A owns 100 preferred shares of Aco. The shares are convertible into common shares of Aco and have PUC and ACB of $100 for A. In 2018, A exercises the conversion right and exchanges all of the preferred shares (FMV $130) for common shares of Aco with a FMV of $130 and stated capital of $100.

- What are the tax consequences to A if s. 51 did not apply?o Disposition of old shares under paragraph (e) of the definition of “disposition”.o Gain or loss would need to be computed on the disposition as a result.

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o Since the corporation is cancelling shares, s. 84(3) could apply. In theory, if there were not rules to the contrary, the cancellation of the shares in exchange for share

consideration could result in a deemed dividend of $30. Section 84(3) is generally disabled on share-for-share exchanges.

o Therefore likely only gain or loss computed under basic principles. Proceeds of disposition of $130 (FMV) against an ACB of $100, resulting in a gain of $30.

o Moving forwards, since A disposed of preferred shares worth $130 for the common shares, ACB in the new shares should be $130.

- What is the effect of s. 51?o Assume the shares are capital property.o Exchange shares of capital property solely for shares of a different class of the same corporation.

As there is no election under s. 85, and s. 86’s conditions are not satisfied, s. 51 likely applies.o No gain or loss realized by A, and no disposition at all by A due to s. 51(c) applying.o Only one class of shares is being received on the exchange.

Under s. 51(1)(d), the ACB of the new shares is deemed to be the same as the FMV of the old shares. Section 51(3) then allocates the PUC of the old shares to the new shares.

o The amount of any possible grind computes to $0.o As there is no shortfall of consideration and no related persons, s. 51(2) does not apply to the exchange.o Results in a completely tax-deferred transaction.

- What if the preferred shares are debentures of ACo with a principal amount and FMV of $130?o Theoretically would change nothing so long as the bonds (debentures) had a conversion right attached.

If A has a right to force the conversion, s. 51(1) would apply and the result would be exactly the same as before with no disposition under s. 51(1)(c).

o As long as the PUC attribution to the bond is limited to $130, there should be no potential under s. 84(1) for a deemed dividend. Likewise, the s. 84(3) deemed dividend does not apply for bond-for-share conversions.

o If there was no conversion feature, the analysis is somewhat difficult due to not knowing the ACB of the bonds.- What if A receives common shares of ACo (FMV and stated capital - $110) and $20 cash on the conversion?

o Receipt of cash (non-share consideration) violates the s. 51(1) conditions. Therefore, a taxable exchange occurs unless s. 86 applies or a s. 85(1) election was made.

o A will realize a $30 gain on the share exchanged (as also occurs if s. 51(1) applies), holds ACB in shares of $110, PUC would be affected, and s. 84(1) will produce a $10 deemed dividend.

- What if A receives only the common shares with a FMV and stated capital of $110?o First determine whether s. 51(1) is applicable – it should be.o Section 51(1) has no requirement for the FMV of the new shares be equal to the FMV of the exchanged shares.

Still no deemed gain or loss on the share.o Section 51(1)(d) will still apply to deem the FMV of the new shares to be $100 (same as before).o Section 51(3) will compare the PUC of the old shares ($100) to the new shares (PUC of $110).

There will a PUC grind of $10 – the difference between the two – and thus grind the PUC of the new shares down to $100.

o Section 51(2) will then require a factual inquiry into whether the shortfall in consideration occurred to confer a benefit on a person related to the transferor.

Likely result is that there is a deemed gain of $20 – the amount of the gift portion – but ACB in the new shares remains at $100.

- What if A is a trader or dealer in corporate securities?o Section 51 would likely not be applicable as the exchanged shares would likely be business property rather than

capital property: CRA’s position is that all shares owned by a trader or deal are business property.

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o Still possible for s. 51 to apply, but would require proof on the facts the exchanged shares are capital property.o Result is a fully taxable exchange, but with the realization of a business gain/loss rather than a capital gain/loss.

- Is a conversion feature excerisable by the issuer within s. 51?o Usually occurs with bonds, and only a risk with bonds.o Section 51’s wording requires the right of bond-for-share conversion must be conferred on the boldholder

rather than the corporation; if the corporation is exercising its conversion right, s. 51 may not necessarily apply.o Section 51(1)(a) is silent on share conversion rights, and whether a right is required at all.

Say there are preferred shares which can be exchanged for a certain number of common shares upon satisfaction of some conditions, that would always be under the ambit of s. 51.

SECTION 86 – SHARE-FOR-SHARE EXCHANGES DURING REORGANIZATION OF CAPITAL

Section 86(1) – Conditions

- Requires a pure share-for-share exchange.- Similar result to s. 51, but with slightly different conditions of application.- Conditions:

o Exchange must occur in the course of a reorganization of capital of the corporation;o Property disposed of must be capital property; o Property disposed of must be all of the shares of any class owned by the taxpayer;

Under s. 51, a taxpayer could exchange only part of their shares.o The property received from the corporation includes shares in the capital of the corporation; ando Sections 85(1) & 85(2) do not apply.

- Section 86 takes priority over s. 51 due to the application of s. 51(d).o However, if a s. 85 election is made, s. 86 would not apply either.

- Unlike s. 51, s. 86 does not apply to bonds: bonds may only be exchanged on a tax-deferred basis through s. 51.- Requirement for reorganization of capital is difficult to discern.

o Compare to reorganization of business under s. 84(2), which is very broadly interpreted (supra).- CRA has established a bright-line administrative rule for this determination:

o If as a consequence of the series of transactions, there are articles of amendment filed with the corporate registry to change some condition attached to the shares of the corporation, there is a reorganization of capital.

Potential for a capital reorganization to actually be broader than this bright-line rule.- Section 51 is still available, so long as no non-share consideration is received.- If not all shares are exchanged and non-share consideration is received, only a s. 85(1) election is available.- Section 86 allows some non-share consideration to be received, so long as its other conditions are satisfied.

o A more flexible provision provided that the shareholder exchanges all of their shares, and there is a reorganization of capital in the exchange.

Section 86 – Effects

- Taxpayer is deemed to have cost in the non-share consideration equal to FMV;- Taxpayer is deemed to have cost in the new shares equal to the amount that ACB of the old shares exceeds FMV of

non-share consideration;o ACB of new shares allocated pro-rata between classes based on relative FMV.o A disadvantage of s. 86 relative to s. 51, due to no possibility to decide where the cost of consideration will go.o Cost of the new shares is the amount, if any, by which the ACB of the new shares exceed the FMV of any non-

share consideration received. Say old shares have ACB of $100 and FMV of $120 are exchanged for cash consideration of $20 and

new shares with FMV of $100.

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ACB of new shares will be the amount, if any, by which the ACB of the old shares exceeds the FMV of any non-share consideration received ($100 - $20) - $80.

- Taxpayer is deemed to dispose of old shares for proceeds equal to cost of new shares plus cost of non-share consideration.

o Unlike s. 85(1), there is no possibility to elect within a range.o The only way to control the amount would be to control the amount of non-share consideration received.

Shares with ACB of $100 is exchanged for $20 cash and $80 shares – exchange is still totally deferred. However, say shares with ACB of $100 is exchanged for $120 cash and shares (deemed ACB of $0) –

deemed gain of $20.

Sections 86(2) & 86(2.1) – Shortfall of Consideration and PUC Reductions

- Section 86(2) provides for realization of a gain if there is a shortfall of consideration.o Requires the shortfall to be a benefit conferred on a related person.o Materially similar to s. 51(2), but also accounts for the value of non-share consideration.

If combined FMV of the new shares and non-share consideration is less than the FMV of old shares: There is a gift portion equal to the difference; and The transferor is deemed to have disposed of the old shares for the lesser of the FMV of the old

shares or the ACB of the old shares plus the gift portion.o If a loss is realized, the loss can be attributed to the ACB of the new shares.

No change for the related person’s consideration; when they dispose of their shares, tax will be paid on an increase of value despite that same increase already being taxed with the transferor.

- Section 86(2.1) provides for a PUC reduction for the new shares.o Virtually indistinguishable from s. 85(2.1).o Should not be allowed to add an amount to the stated capital of the new shares except to the extent that the

amount is equal to the stated capital of the old shares less the FMV of any non-share consideration received.o The PUC grind will be allocated pro-rata to classes of shares with the cumulative grind equaling:

Any amount of the PUC of the new shares which exceeds; The PUC of the old shares, less the FMV of any non-share consideration received.

B owns 100 class B shares of Bco. The shares have PUC and ACB for B of $1,000. As part of a restructuring, Bco issues to B 50 class C shares and a promissory note in exchange for the class B shares. At the time of the exchange, the FMV of the class B shares is $10,000. The FMV and stated capital of the class C shares is $9,000. The principal amount and FMV of the promissory note is $1,000.

- What are the tax consequences of the exchange to B, ignoring s. 86 and assuming that the class B shares are not convertible?

o Due to cash consideration, s. 51 would not apply.o Section 84(3) only has potential application to the extent of the $1,000 of non-share consideration.

PUC of old shares was $1,000 and value is $1,000, there should be no deemed dividend under s. 84(3), but there will be a $9,000 capital gain as this is a taxable transaction.

o In addition to the capital gain, there will be a deemed dividend under s. 84(1). Only $1,000 of stated capital in old shares compared to $9,000 of stated capital in new shares.

- What is the effect of s. 86?o Assuming Class B shares are capital property, other conditions should be met.o ACB of note will equal FMV of the note.o ACB of the new shares will equal to amount, if any, by which the ACB of the old shares ($1,000) exceeds the

FMV of the note ($1,000) - $0.

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o B’s proceeds of disposition equals to the total of cost of non-share consideration ($1,000) and cost of share consideration ($0) - $1,000.

Since ACB of old shares was $1,000, B realizes no gain or loss.o Section 86(2.1) applies to grind PUC of new shares by excess of the PUC of new shares ($9,000) over PUC of

old shares ($1,000) minus non-share consideration ($1,000), thus reducing PUC of new shares by $9,000 to $0.o No shortfall of consideration.

- What if B receives a promissory note with a FMV and principal amount of $5,000 as well as class D shares of Bco (FMV and stated capital - $5,000)?

o ACB in note of $5,000.o Any amount by which ACB of old shares ($1,000) exceeds FMV of any non-share consideration received

($5,000) will be the ACB of the new shares - $0.o Proceeds of disposition will equal the ACB of the note ($5,000) and ACB of the new shares ($0) - $5,000.o B realizes a capital gain of $4,000 ($5,000 - $1,000).o Since a share was cancelled, s. 84(3) may apply.o Section 86(2.1) will apply a PUC grind.

PUC in old shares of $1,000 and PUC in new shares of $5,000. Received $5,000 of non-share consideration. PUC addition was $5,000, less any amount by which PUC in old shares exceeds value of non-share

consideration ($1,000 - $5,000 = $0). PUC grind of $5,000 ($5,000 - $0), resulting in PUC of the new shares at $0.

- What if B receives a promissory note with a FMV and principal amount of $500 as well as class E shares of Bco (FMV and stated capital - $500)?

o Theoretically permissible as it is not required for FMV of shares exchanged to equal consideration received.o Deemed cost in the note of $500; deemed cost in new shares of $500 ($1,000 ACB of old shares minus $500

deemed cost in non-share consideration); proceeds in disposition of $1,000 (combined ACB of new shares and non-share consideration).

Theoretically no gain or loss for this transaction ($1,000 proceeds - $1,000 combined ACB).o However, there is a shortfall of consideration, requiring a factual inquiry into whether a benefit was conferred

on a related person: only $1,000 consideration for $10,000 FMV shares. In which case s. 86(2) would apply.

Section 86(2)(c) would deem the shareholder to have disposed of the old shares for proceeds of disposition equal to the lesser of the FMV of the old shares ($10,000) or the amount of the gift portion ($9,000) plus ACB of old shares ($1,000) - $10,000 disposition either way.

Deemed disposition should result with a gain of $9,000 ($10,000 proceeds - $1,000 ACB).- What is the meaning of the phrase “in the course of a reorganization of the capital of a corporation” used in s. 86(1)?

o Bright line test is that articles of amendments were filed in addition to the exchange of shares.o File articles of amendment if s. 86(1) is to be relied upon.

SECTION 85.1 – EXTERNAL SHARE EXCHANGES

Section 85.1 – Conditions

- A share-for-share exchange provision where the shares exchanged are shares of one corporation and the shares received for the shares of a different corporation.

o External share exchange.o If s. 85.1 applies, no elections are necessary.

Very helpful with public corporations, where filing elections for every shareholder is unfeasible.- Only applies for arm’s length transactions.

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- Requires:o Canadian corporation must issue shares to the taxpayer;o The shares must be issued in exchange for shares of any particular class in the capital of a taxable Canadian

corporation; Target corporation must be a taxable Canadian corporation – a corporation that is not exempt from tax

for any part of its income (should be most corporations).o The exchanged shares must be capital property of the vendor; and

Applies on a vendor-to-vendor basis.o The vendor cannot include in its income any portion of the gain or loss otherwise attributable to the disposition

of the shares. Vendor must report the disposition in their return but cannot return any portion of the gain or loss. Cannot choose some ‘middle ground’ – if anything is reported the section does not apply. Only if

nothing is reported will s. 85.1 apply.- Section 85.1(2) provides further conditions:

o Vendor and purchaser must deal at arm’s length prior to exchange; Section 251(5)(b) deemed rights are disregarded.

Can ignore options in determining whether parties are dealing at arm’s length.o After the exchange, vendors and persons not at arm’s length with vendor cannot:

Control the purchaser ; or Own more than 50% of the FMV of the shares of the purchaser.

o No election can be made under s. 85; and If a particular vendor had losses on their shares, they might wish to elect to either realize a gain due to

other capital losses or realize a loss to use against other gains. Applied for a vendor-by-vendor basis.

o The vendor cannot receive non-share consideration for the exchanged shares. There is a carve out in s. 85.1(2)(d) for a “dirty 85.1”.

Say A has 100 shares with a FMV of $1,000. Purchaser has $500 shares and $500 cash.o They sell 50 shares for the shares and another 50 shares for cash.

If a separate transaction involves non-share consideration, the pure share-for-share exchange may still fall under s. 85.1.

Section 85.1 – Effects

- Vendor is deemed under s. 85.1(1) to (s. 85.1(1)(a)):o Have disposed of the old shares for proceeds equal to ACB (s. 85.1(1)(a)); ando Have acquired the new shares at a cost equal to the ACB of the old shares.

No potential for anything but a tax-deferred outcome.- Purchaser is deemed to have acquired the purchased shares at a cost equal to the lower of their FMV and PUC (s.

85.1(1)(b)).o Potential for interesting results for the acquirer.

If the PUC of the shares is greater than the FMV of the shares, the acquirer will effectively create an accrued capital loss out of thin air.

Section 85.1(2.1) – PUC Grind on External Exchanges

- A PUC reduction provision that applies if the PUC of the new shares exceed the PUC of the old shares.o Materially similar to s. 51(3).

- Applies on a class-by-class basis and requires the PUC of each individual class to be reduced by a formula:

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o Amount by which the PUC of all of the shares was increased by the exchange less the PUC of the old shares prior to the exchange.

o Reduction is allocated pro-rata to each class of shares based on the proportion of stated capital of each class.

Application of Section 85.1

X owns 500 class A shares of Yco (ACB - $1,000; PUC - $500; FMV - $10,000). X transfers the shares to Zco in exchange for 100 class Z shares of the transferee (stated capital - $10,000; FMV - $10,000).

- What are the tax consequences of the exchange to X and Zco, ignoring s. 85.1?o Assume no s. 85(1) election.o Transaction is taxable; ss. 84 & 86 will not apply as those are only for internal share exchanges.o Receiving consideration with FMV of $10,000 – proceeds of disposition – less ACB of $1,000.

X realizes capital gain of $9,000.o No PUC reduction on a taxable sale.o No deemed dividend as the assets of ZCo have increased by $10,000 from the acquisition of shares.o Only issue for X to pay tax on the $9,000 capital gain; may be liquidity issue due to having no cash received.o Cost in the new shares of $10,000 – the value of the shares given up as consideration.

- What is the effect of s. 85.1?o Conditions of application are abundant:

Assume YCo is a taxable Canadian corporation. Assume ZCo is a Canadian corporation. Assume Class A shares of YCo are capital property of X. Assume X does not report any portion of the accrued gain on the transaction. Assume X and ZCo deal at arm’s length. Assume X does not control ZCo, either alone or with non-arm’s length persons. Assume X does not control more than 50% of the value of ZCo’s shares, either alone or with non-arm’s

length persons. Examine consideration received: no non-share consideration received – pure share-for-share exchange.

o Section 85.1(1)(a) will deem X to have disposed of YCo shares for ACB of $1,000. No gain or loss realized. X will have cost in the ZCo shares equal to the cost of the old shares of $1,000.

o Section 85.1(1)(b) will deem ZCo to have acquired YCo shares for the lesser of their PUC or FMV. That will be the ACB of their shares going forwards.

o Addition of PUC requires examination of s. 85.1(2.1). PUC in old shares of $500 and PUC in new shares of $10,000 – the difference is the grind amount -

$9,500. Reduce PUC of shares from $10,000 to $500. Class Z shares held by X will have PUC of $500, ACB of $1,000, and FMV of $10,000.

- May X choose to realize all or part of the accrued gain on the class A shares?o No; vendor cannot report any part of the gain or loss on the disposition for s. 85.1 to apply.o If the vendor wished to apply an accrued gain or loss, they would need to elect under s. 85(1).

- What if X receives cash of $1,000 and class Z shares of ZCo (stated capital - $9,000; FMV - $9,000)?o Depends on how the agreement between X and ZCo is worded.o If the agreement provides in a single agreement that X is disposing of the 500 Class A shares for consideration

of $1,000 cash and $9,000 of shares, s. 85.1 would not apply.o If the agreement provides for two separate transaction – X disposes of 50 Class A shares for $1,000 cash and is

selling 450 Class A shares in exchange for ZCo’s shares – s. 85.1(2)(d) would apply with reasonable certainty to deem the transaction as a dirty 85.1 and appropriate.

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Pro-rate ACB and PUC between the 50 shares sold for cash and the 450 shares sold for shares. Immediately prior to the sale, X would do an internal s. 85, where they exchange the existing 500

common shares of YCo for 1,000 preferred shares of YCo with a redemption amount of $1,000 and 9,000 common shares of a different class of YCo.

The full $1,000 of the elected amount would be allocated to the preferred shares, with the 9,000 common shares having an ACB of $0.

X would in the share purchase agreement that the 1,000 preferred shares would be sold for cash and the 9,000 common shares for the ZCo shares: isolates ACB to the preferred shares.

Could also on the internal exchange allocate all the PUC to the common shares.o As the aggregate PUC is not increased, s. 85(2.1) would not apply a PUC grind.

No PUC in the preferred shares, $1,000 PUC in the common shares. When vendor purchases, they have $1,000 in the ACB of the shares they

bought for cash and $1,000 of ACB in the shares they bought with shares. Effectively doubles up the ACB.

o CRA will in some circumstances allow token cash consideration, despite the wording of s. 85.1 where the acquirer corporation does not wish to issue fractional shares.

As long as the cash received does not exceed $200 per vendor, CRA will allow s. 85.1 to go forwards. If the shares have incredibly high value per share, this exception would not apply.

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VI: FLOWCHART

IS THE INCOME TAXABLE?

Classification of Income

Is the income employment income?InclusionDefinition

3(d)5 – 8

Is the income business income?InclusionDefinitionInclusion

3(d)912(1)

Is the income property income?InclusionInclusion

3(d)12(1)

Is the income a net capital gain?InclusionDefinition

3(b)(i)(A)38

Is the income a dividend?Inclusion as income

Inclusion as dividendDefinition

12(i)(j)82(1)248(1)

Has the dividend been designated as an eligible dividend?DefinitionElection

89(1)89(14)

Is the dividend an intercorporate dividend?Inclusion as dividendDeduction if received

82(1)112(1)

Is the dividend an in specie dividend?Inclusion as dividend

ACB of property received (=FMV)82(1)(a)52(2)

Is the dividend a stock dividend?Inclusion as dividendInclusion as dividend

ACB of new stocks (=Amount)

82(1)(a)248(1)52(3)

What is the “amount” of the in specie dividend or stock dividend?

Definition 248(1)

Is the dividend a capital dividend? Exclusion as income 83(2)

TAXATION OF CORPORATE INCOME

Usual Rate

Does the income not qualify for any deductions or special rates?Taxable at 27%

Default federal rate (38%)Provincial abatement (–10%)General rate reduction (–13%)

123(1)124(1)123.4(2)

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Add provincial tax (12%) APITA

Small Business Rates

Does the income qualify for the small business deduction?Taxable at 12%

Default federal rate (38%)Provincial abatement (–10%)

Small business deduction (–13%)Add provincial tax (2%)

123(1)124(1)1235(1.1)APITA

What is the small business deduction base?Active business income less SCI/SPI

Taxable incomeBusiness limit

125(1)(a)125(1)(b)125(1)(c)

Is there specified partnership income?Exclusion from SBD baseDefinition and calculation

Supplementary rules

125(1)(a)125(7)125(6), (6.1–6.3)

Is there specified partnership losses? Definition and calculation 125(7)

Is there specified corporate income? Definition and calculation 125(7)

Is there taxable capital in the corporation?Reduction of SBD base

Definition of taxable capital125(5.1)181.2–181.4

Was there more than $50,000 AII earned in the last taxation year?

Reduction of SBD baseAII definition

125(5.1)129(4)

Does the SBD base need to be split with associated corporations?

Association rulesSBD base split between group

256125(1)(c), (2)–(4)

Investment Income

Is the income investment income?Taxable at 50.6% before refund; 20% after 30.6% refund

Default federal rate (38%)Provincial abatement (–10%)

Investment income tax (10.6%)Add provincial tax (12%)

Dividend refundDefinition of investment incomeExclusion from general reduction

123(1)124(1)123.3APITA129(1)129(4)123.4(1)(b)(iii)

What is the corporation’s RDTOH account? Definition and calculation 129(3)

Is the RDTOH and dividend eligible or ineligible?Effect on refund

Definition129(3) & (4)129(4)

Other Exceptions to General Rates

Is the corporation a personal services business?Taxable at 45%

DefinitionAdditional PSB tax (5%)

125(7)123.5(7)

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Exclusion from general reduction 123.4(1)(a)(iii), (b)(i)

DISTRIBUTION OF CORPORATE EARNINGS

Tax Effects for Individual When Dividend Received

Is the dividend paid out by a CCPC or a non-CCPC, and is it eligible or non-eligible?

Does the CCPC have a GRIP balance, allowing it to declare and pay out eligible dividends?ORIs the eligible dividend paid out by a non-CCPC?

Effective personal tax rate of 31.71%

Income inclusion for taxpayerGross-up (38%)Credit (25.02%)

Calculation of GRIPDesignation of eligible dividend

Excessive eligible dividendElection to separate excessive

eligible dividend

82(1)(a)82(1)(b)(ii)121(b), APITA89(1)89(14)185.1(1)185.1(2)

Otherwise, is a CCPC paying out a non-eligible dividend? ORDoes a non-CCPC have an LRIP balance it must clear with non-eligible dividends before resuming eligible dividends?

Effective personal tax rate of 41.64%

Income inclusion for taxpayerGross-up (16%)Credit (12.10%)

Calculation of LRIP

82(1)(a)82(1)(b)(i)121(a), APITA89(1)

Has the individual received a capital dividend?Infra for capacity of corporation to issue capital dividend

Exclusion from incomeRequirement to elect

83(2)83(2)

Tax Effects for Corporations When Dividend Received

Has a corporation received a dividend from another corporation?Inclusions as income

Deduction from taxable income12(1)(j), 82(1)(a)112(1)(a)

Is the intercorporate dividend an assessable dividend?Part IV tax from non-connected corporations of 38.3%Part IV tax from connected corporation equal to RDTOH refund received by connected corporation

Definition of assessable dividendMust be private corporation

Imposition of Part IV taxRates for non-connected corporations

Rates for connected corporationsDetermination of “control”

Determination of “connection”Date payable for Part IV tax

Addition of Part IV tax to RDTOH

186(3)186(3)186(1)186(1)(a)186(1)(b)186(2)186(4)187(3)129(3)(b)

Does the corporation have any losses to deduct against Part IV tax?

Current year’s non-capital lossesOther year’s non-capital losses

186(1)(c)186(1)(d)

Was the intercorporate dividend eligible or non-eligible? Addition to RDTOH 129(3)(b)

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Has the corporation paid out a dividend for an RDTOH refund?May recover from RDTOH 38.3% of taxable dividends paid when private corporation

Dividend refund 129(1)

Considerations for Corporation Issuing Dividend

What is the corporation’s RDTOH balance?May recover from RDTOH 38.3% of the value of a taxable dividend: recovers $1 for every $2.61 of dividends paid

Dividend refund 129(1)

If issuing a capital dividend, is the corporation a private corporation?

Must be private corporation to issue 83(2)

If issuing a capital dividend, does the corporation’s capital dividend account have sufficient value?

Three constituent ‘pots’ of CDA 89(1)

Has the corporation paid a capital dividend without having sufficient CDA?

Part III tax imposed (60% of excess)Elect to treat excess separately

Shareholder concurrence for election

184(2)184(3)184(4)

Has the corporation issued a dividend in kind?Proceeds for disposition of property

(=FMV)52(2)

Has a stock dividend been issued to alter the value of a 10% shareholder’s interest?

Anti-avoidance rule 15(1.1)

DEEMED DIVIDENDS

Section 84

What is the paid up capital on the disposed shares? Calculation of PUC 89(1)

Has PUC of a class of shares increased through means other than a stock dividend, an increase in FMV of corporate assets or decrease in liabilities, the reduction of PUC in another class of shares, or to offset formerly contributed surplus?

Exceptions against general deemingValue of deemed dividend

Formerly contributed surplusPriority over other sections

84(1)84(1)84(1)(c.3)84(6)

Has the corporation distributed capital on the winding-up, discontinuance, or reorganization of a business of the corporation?

Conditions for deemed dividendValue of deemed dividend

Reduction of proceeds of disposition

84(2)84(2)54, para (j)

Has the corporation redeemed, acquired, or cancelled shares?

Conditions for deemed dividendValue of deemed dividend

Reduction of proceeds of dispositionDeemed disposition for shareholders

on application

84(3)84(3)54, para (j)84(9)

Has the corporation reduced PUC of its shares, except in relation Condition for deemed dividend 84(4)

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to a redemption, cancellation, or repurchase of shares, a winding-up, discontinuance, or reorganization of corporate business, or where a public corporation realizes gains outside its ordinary business.

Value of deemed dividendExceptions where not applicableException for public corporations

84(4)84(8)84(4.1)

Section 84.1

Are the conditions of application of s. 84.1 satisfied?Is the recipient taxpayer resident in Canada?Have they disposed of shares to another corporation?Were the shares capital property?Were the shares of a corporation resident in Canada?Did the taxpayer and purchaser not deal at arm’s length?

Does one exercise de facto control over the other?Does one party act as a common mind for both?Do they lack any identifiable, separate interests?

Are the two corporations connected after disposition?

Conditions of applicationValue of PUC grind on new shares

Value of deemed dividendDetermining arm’s length

Reduction of proceeds of dispositionAdjustments to calculation of ACB

Determining arm’s length

84.1(1)84.1(1)(a)84.1(1)(b)251(1)(c)54, para (k)84.1(2)(a.1)84.1(2)(b), (2.2)

TRANSFERS OF PROPERTY

Rollover of Non-Share Property

Are the conditions for a s. 85 rollover satisfied?Has the taxpayer disposed of an eligible property?Is the transferee a Canadian corporation?Does the received consideration include at least one share in the transferee corporation?Have the parties elected under the prescribed form?

Conditions of applicationEffects of rollover

Definition of eligible propertyDefinition of Canadian corporation

858585(1.1)89(1)

What is the permissible range of elected amounts for the rollover?What is the FMV of any non-share consideration? (Min)What is the FMV of the eligible property transferred?What is the ACB of the eligible property transferred?

Non-share consideration FMV as minACB of property as minFMV of property as max

Resolving conflict between min’sElected amount deemed as ACB in property for transferee and proceeds

of disposition for taxpayer

85(1)(b)85(1)(c.1)85(1)(c)85(1)(e.3)

85(1)(a)

How should the elected ACB be allocated to consideration received?

First to non-share considerationSecond to preferred sharesThird to common shares

85(1)(f)85(1)(g)85(1)(h)

Have the parties elected at less than the minimum range? Minimums override election 85(1)(b), (c.1)

Is there an accrued loss on the transferred property? Immediate realization of loss 85(1)(c), (c.1)

Has the transferee paid more than the FMV of the property?Deemed benefit/income inclusionEqual increase to property’s ACB

15(1)52(1)

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Has the taxpayer transferred depreciable property?

Least of UCC, capital cost, and FMV will be minimum elected amount

CCA for difference in original capital cost and elected amount

85(1)(e)

85(5)

Has the taxpayer attempted to transfer property to related persons?Is there a shortfall of consideration – FMV of transferred property is greater than combined FMV of consideration received and the elected amount?

Conditions of applicationShortfall added to elected amountAllocation of recalculated ACB

85(1)(e.2)85(1)(e.2)85(1)(f–h)

Does the PUC of the received shares, less FMV of any non-share consideration, exceed ACB of the transferred property?

Application of PUC grind 85(2.1)

Are any stop loss rules applicable?Loss suspended

Conditions of applicationAffiliation rules

40(3.4)43251.1(1)

Share Exchanges

Are the shares being exchanged only for shares or bonds?

Conditions of applicationACB of new shares equal to FMV of

old sharesNo disposition created

Anti-avoidance rule for shortfallDeemed disposition if shortfall

PUC grind if PUC increased

51(1)51(1)

51(1)51(2)51(2)(d)51(3)

Are the shares being exchanged as part of a reorganization of capital?

Conditions of applicationEffects of exchange

Realization of gain if shortfallPUC grind if new PUC greater than old PUC plus FMV of non-shares

86(1)86(1)86(2)86(2.1)

Is the share exchange an external share exchange?

Conditions of applicationEffects of provision for vendor

Effects of provision for purchaserPUC grind if PUC increased

“Dirty” external share exchanges

85.1(1), (2)85.1(1)(a)85.1(1)(b)85.1(2.1)85.1(2)(d)

GENERAL CONSIDERATIONS

Are adjustments to ACB necessary?Increases in ACBDecreases in ACB

53(1)53(2)

Are adjustments to PUC necessary? Unwarranted reduction of PUCGeneral PUC grind

PUC grind – Gap-filler rulePUC grind – Pure share-for-share

84(4)84.1(1)(a)85(2.1)51(3)

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PUC grind – Capital reorganizationPUC grind – External share exchange

86(2.1)85.1(2.1)

What are the proceeds of disposition?

Definition and adjustmentsReduction for deemed dividend

Proceeds = elected ACB for rolloverRollovers with accrued loss

No disposition on share-for-shareAvoidance rule deeming disposition

Proceeds for FMV of non-share ACBProceeds = ACB for external shares

5454, paras (j), (k)85(1)(a)85(1)(c), (c.1)51(1)51(2)8685.1

Will there be a deemed dividend?

Unwarranted increase in PUCEnding of a business

Cancellation of sharesDecrease in PUC without returnNon-arm’s length share transferPriority rules ((1), (2), (3), (4))

84(1)84(2)84(3)84(4)84.184(6)

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VII: KEY PROVISIONS

II–I: CHARACTERIZATION AND RATES OF TAXATION OF THE CORPORATION

CORPORATE TAX RATES

Process for Reaching the End Tax Rate

- Start with the default federal tax rate (38%).o Subtract provincial abatement (–10% 28%).

Subtract general rate reduction percentage, if applicable (–13% 15%); or Subtract small business deduction, if applicable (–18% 10%); or Add investment income tax, if applicable (10.6…% 38.6…%); and

Subtract federal rate reduction upon distributing dividends (30.6…% 8%).o Add provincial tax rate (12%/2% 27%/12%) / (20% for investments).

Summary of Combined Federal-Provincial Tax Rates

- The combined federal-provincial corporate rate for small business earned income allocable to a permanent establishment in Alberta in 2018 is 12%.

- The general combined federal-provincial corporate rate for other businesses on income allocable to a permanent establishment in Alberta in 2018 is 27%.

- The combined federal-provincial corporate tax rate on income from a personal services business is 45% (further infra).- For investment income, the combined federal-provincial corporate tax rate at the pre-refund rate is 50.6…% and post-

refund rate is 20% (further infra).

II–II: SMALL BUSINESS DEDUCTIONS

THE SMALL BUSINESS DEDUCTION – AVAILABILITY AND AMOUNT

Conditions for the Small Business Deduction

- Section 125(1) sets out ‘caps’ on how the deduction may be applied, with the smallest applying:o Section 125(1)(a) caps the deduction to income from active business carried out in Canada, its “specified

partnership income”, its “specified corporate income”, less non-partnership Canadian active-business losses and specified partnership losses. In other words, includes all of:

Income from active business carried out by the corporation, minus income described in the definition of “specified corporate income” or “specified partnership income” or income received from a corporation that made a s. 256 election;

The “specified corporate income”; and The “specified partnership income”.

o Section 125(1)(b) caps the deduction to a corporation’s taxable income that is not exempt from Canadian tax by virtue of either a statutory exemption or by virtue of a foreign tax credit.

“Taxable income” includes all deductions, such as non-capital losses carried forward or carried back, or charitable donations.

o Section 125(1)(c) caps the deduction to a corporation’s business limits for the year. Section 125(2) defines a corporation’s business limit as $500,000, subject to deduction.

o The deduction may apply at most to $500,000, but may apply to less depending on ss. 125(1)(a) & 125(1)(b).

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SPECIFIED PARTNERSHIP INCOME

Calculating Specified Partnership Income

- The “specified partnership income” mechanism prevents manipulation of the SDB limit through partnerships (ss. 125(1)(a) & 125(7)).

o Divides partnership businesses from businesses carried on by the CCPC directly.o Income from a partnership is by default excluded from the SBD base – the income eligible for the SBD – unless

it is income not described in the definition of specified partnership income. If there is an amount described is in the definition of specified partnership income, the amount is re-

added into s. 125(1)(a).- Specified partnership income is equal to the amounts A + B, where:

o A is the lesser of: Partner’s net partnership income allocation (share of income deducting expenses); and

Section 34.2 also applies, as an anti-deferral mechanism. The prorated share of $500,000 that the partner’s net income allocation is of all partnership income.

Take the partner’s partnership income, divide it by the total partnership income, and multiply the decimal by $500,000.

o Adjustments are also necessary for annual pro-ration.o B is the lesser of (allows for a greater amount of SPI where the taxpayer has business losses in the same year):

The sum of the partner’s specified partnership losses and business losses; and The amount by which the partner’s income allocation exceeds its prorated share of $500,000.

- Variable A + B will never exceed the actual income allocation to each partner.

Calculating Specified Partnership Losses

- An A + B formula:o A is the amount of the loss allocated to the partner by the partnership.o B is equal to G – H:

G is the amount of the deduction claimed from the partnership in a year. H is the amount of income from any source allocated to the partner by the partnership.

III–I: REFUNDABLE DIVIDEND TAX ON HAND (RDTOH)

INVESTMENT INCOME – DIVIDEND REFUNDS AND REFUNDABLE TAX ON HAND (RDTOH)

RDTOH Calculation

- Section 129(3) defines RDTOH, which is computed at the end of taxation year.o If a corporation is a CCPC, RDTOH is equal to the sum of:

30.6…% of the CCPC’s AII or maximum of corporate tax payable (whichever is lesser); plus Part IV tax payable; plus RDTOH at the end of preceding year; less Dividend refund for preceding year.

- Section 129(1) provides a dividend refund.o If a corporation has filed its return for a year within three years of the end of the year, then:

Dividend refund equal to 38.3…% of all taxable dividends paid in the year while a private corporation, to a maximum of the RDTOH account at year-end; OR

RDTOH account, whichever is less. $1 of dividend refund for every $2.61 of dividends paid to the maximum of the RDTOH limit.

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- Following 2018, eligible dividends will create an eligible RDTOH account, and non-eligible dividends a non-eligible RDTOH account.

o While the calculations for the dividend refund remain the same: Eligible dividends may only refund from the eligible RDTOH pool; and Non-eligible dividends refund first from the non-eligible RDTOH account, and then from the eligible

RDTOH account.

III–III: TAXATION OF DIVIDENDS TO SHAREHOLDERS

DIVIDEND INTEGRATION

Integration of CCPC Dividends/LRIP Dividends/Non-Eligible Dividends

- Dividend scheme:o Section 82(1)(a) sets out income inclusion to include the cash received as taxable income.o Section 82(1)(b)(i) sets out a 16% gross-up .

The gross-up accounts for the amount of cash the shareholder would have received if there had been no corporate tax imposed.

o Calculate tentative tax payable from regular dividend amount combined with gross-up. Applying the 48% top personal rate.

o Section 121(a) prescribes a 10.03% credit. Section 21(i) of the APITA provides a 2.07% Alberta credit. Both apply as credits against the grossed-up amount, producing a 12.10% credit.

o An effective personal income tax rate of 41.64% results from this scheme.

Integration of Non-CCPC Dividends/GRIP Dividends/Eligible Dividends

- Default rule is that a non-CCPC pays out eligible dividends.o While the non-CCPC still needs to make the designation, one can assume that they will designate their taxable

dividends as eligible dividends.o Section 82(1)(a) sets out income inclusion to include the cash received as taxable income.o Section 82(1)(b)(ii) sets out a 38% gross-up.

138% of dividend is reported on the return as taxable income.o Calculate tentative tax payable from regular dividend amount combined with gross-up.

Applying the 48% top personal rate.o Section 121(b) then provides a 15.02% credit.

Section 21(h) of the APITA provides a 10% Alberta credit. Both apply as credits against the grossed-up amount, producing a 25.02% credit.

o An effective personal income tax rate of 31.71% on non-eligible dividends results from this scheme.

Calculating LRIP/GRIP Accounts

- To calculate GRIP (under the s. 89(1) definition):o Begin with the CCPC’s GRIP at the end of prior year; PLUSo 72% of adjusted taxable income (Section 89(1)); PLUS

Essentially taxable income minus SBD-eligible income and AII. Leaves the business income subject to tax at the 27% rate.

o Eligible dividends received; LESSo Eligible dividends paid.

- To calculate LRIP (under the s. 89(1) definition):

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o Begin with the non-CCPC’s LRIP at the end of prior year; PLUSo Non-eligible dividends received; PLUSo If corporation would have been a CCPC but elected to not be a CCPC, 80% of AII; PLUSo 80% of an amount in respect of SBD income earned while not a CCPC; LESSo Non-eligible dividends paid.

III–IV: TAXATION OF DIVIDENDS BETWEEN CORPORATIONS

PART IV TAX ON INTERCORPORATE DIVIDENDS

Part IV Tax and Part IV Tax Refund

- Part IV tax is primarily imposed by s. 186(1):o If dividend recipient is a private corporation (s. 186(3)); THEN EITHER

Tax equal to 38.3…% of assessable dividends from non-connected corporations (s. 186(1)(a)); OR Portion of connected payer’s RDTOH refund that the assessable dividend received is of all taxable

dividends paid in the year (s. 186(1)(b)). Assessable dividend is a taxable dividend under s. 112(1).

o Almost every taxable dividend will be an assessable dividend, as a result.- Part IV tax is added to the RDTOH account under s. 129(3)(b). May be:

o Added to eligible RDTOH to the extent that the Part IV tax was applicable to a dividend which recovered eligible RDTOH or was paid on an eligible dividend recovered from a public corporation; or

o Added to non-eligible RDTOH.- Refunded pursuant to s. 129(1) in amount equal to 38.3…% of all taxable dividends paid by the corporation in the year

while a private corporation.o $1 of dividend refund for every $2.61 taxable dividends paid.o Deliberate symmetry between Part IV tax rate and Part IV tax refund.

III–V: CAPITAL DIVIDENDS, IN SPECIE DIVIDENDS, AND STOCK DIVIDENDS

CAPITAL DIVIDENDS AND THE CAPITAL DIVIDEND ACCOUNT

The Capital Dividend Account

o The capital dividend account is the total by which three amounts exceed capital dividends paid prior to a particular time (point in time test, immediately before the dividend is paid):

Amount if any by which the total of the corporation’s non-taxable portion of its capital gains exceeds the non-allowable portion of its capital losses;

The amount of any capital dividend received from another corporation; The amount received as death benefit under a life insurance policy that is received upon the death of a

person who is the insured person of the policy in excess of the adjusted cost basis of the policy.

IV–II: SECTION 84 – STANDARD DEEMED DIVIDENDS FOR SURPLUS STRIPPING

SECTIONS 84 – THE DEEMED DIVIDEND RULES

Section 84(1) – General Deemed Dividend Rule

- For s. 84(1) to apply: o Must be a corporation resident in Canada.o Corporation must have increased the PUC of its shares.

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- Deemed dividends emerge if a corporation has increased the PUC of a class except if:o It has paid a stock dividend;o The FMV of its assets less liabilities has increased or the amount of liabilities less assets has decreased in

connection with the PUC increase;o The PUC of another class of shares was reduced in connection with the PUC increase; oro The PUC was formerly contributed surplus.

- If s. 84(1) applies, corporation is deemed to have paid a dividend on that class of shares equal to:o Excess of PUC increase over net improvement in fiscal position;o Excess of PUC increase over corresponding PUC decrease; ando Excess of PUC increase over contributed surplus.

Section 84(2) – Winding-Up, Discontinuance, or Reorganization of a Corporation’s Business

- Section 84(2) applies if property of a corporation is distributed or appropriated by shareholders on a winding-up, discontinuance, or reorganization of a business of the corporation.

- If s. 84(2) applies, corporation is deemed to pay a dividend on class of shares equal to excess of appropriate over PUC reduction in respect of class.

o Value/quantity of dividend determined: How much did shareholders of the class receive (the amount or value of funds/property

distributed/appropriated)?o Identify amount, if any, by which PUC of the shares of that class was reduced in connection with the

distribution or appropriation.o Deemed dividend for a class of shares is the amount by which the value of funds/property exceeds amount by

which PUC is reduced (effectively first variable minus second variable).- After a PUC reduction under s. 84(2), s. 53(2)(a)(ii) applies to reduce ACB of shares by the amount of the distribution.

Section 84(3) – Redeeming, Acquiring, or Cancelling of Shares

- Section 84(3) applies if a corporation has redeemed, acquired, or cancelled any of its issued and outstanding shares.o Applies to corporation resident in Canada.o Does not apply for a transaction to which s. 84(2) applies.o If s. 84(3) applies,

Corporation is deemed to have paid a dividend on each class of shares repurchased equal to the amount that repurchase price for those shares exceeds PUC; and

Former shareholder of repurchased shares is deemed to have received this dividend in proportion to their ownership of the repurchased shares of that class.

Section 84(4) – Reduction of PUC in Shares

- Section 84(4) applies if a corporation has at any time reduced the PUC of the shares of a class in its capital.o Does not apply if the reduction occurs:

In relation to a redemption, cancellation, or repurchase of shares (where s. 84(3) applies); or In relation to a transaction to which ss. 84(2) or 84(4.1) applies.

o If s. 84(4) applies: The corporation is deemed to pay a dividend on shares of the class equal to amount by which PUC

reduction exceeds PUC of the class; and Shareholders of class deemed to receive this dividend in proportion to shareholdings immediately

before the reduction. Prevents pushing of PUC of a class of shares below zero.

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- Section 53(2)(a)(iii) prevents any amount which s. 84(4) deems a dividend from decreasing ACB, despite a decrease in PUC normally decreasing ACB, as effected by s. 53(2)(a)(ii).

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IV–III: SECTION 84.1 – DEEMED DIVIDENDS ON NON-ARM’S LENGTH SHARE SALES

SECTION 84.1 – BRIGHT-LINE DEEMED DIVIDENDS

Conditions of Application for Section 84.1

- No purpose test in s. 84.1: bright-line conditions of application:o Taxpayer resident in Canada who is not a corporation;o Disposes of shares of a corporation to another corporation;o The shares disposed of were capital property;o The shares disposed of are shares of a corporation resident in Canada;o The taxpayer and purchaser corporation did not deal at arm’s length; ando After the disposition, purchaser corporation and subject corporation are “connected”.

- If share consideration is received, then s. 84.1(1)(a) applies to create a PUC grind for class of shares issued.o Tax-free transactions only work if PUC exists on shares.o Grind is equal to increase in PUC addition for all shares as a result of transfer (Variable A); LESSo Excess of greater of PUC or ACB of transferred shares over FMV of non-share consideration received

(Variable B); MULTIPLED BYo Fraction obtained when PUC addition for class is divided by PUC addition for all shares (Variable C).

Reflects the proportion of the PUC of the transferred shares to all shares.

Section 84.1(b) – Non-Share Consideration

- When non-share consideration is received, then s. 84.1(1)(b) will apply to create a deemed dividend to the selling shareholder, as they have received money from the corporation or received something that is tantamount to money without the opportunity for any future income tax consequences to arise ( (A + D) – (E + F) ).

o Dividend is equal to increase in PUC addition for all shares as a result of transfer plus FMV of all non-share consideration (A + D); LESS

o Greater of PUC and ACB plus the amount of the s. 84.1(1)(a) PUC grind (E + F).- A + D

o Variable A is equal to PUC addition in respect to all shares of the corporation in connection with the transaction.

Same as variable A in s. 84.1(1)(a). If there is no share consideration received, variable A will equal nil.

o Variable D is equal to the FMV of any non-share consideration received in exchange for the shares of the transferred corporation.

Variable D is equal to the maximum amount of any potential deemed dividend.- E + F

o Variable E is the greater of the PUC or ACB of the transferred shares.o Variable F is the amount of the s. 84.1(1)(a) PUC grind.

As a result, s. 84.1(1)(a) must always be calculated first.

V–I: ROLLOVER TRANSACTIONS

ROLLOVER OF PROPERTY UNDER SECTION 85

Section 85 – Rollover Transactions Generally

- Section 85 permits a transfer of property to a corporation to be effected on a “rollover” basis.o Taxpayer must have disposed of an eligible property.

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o Transferee must be a taxable Canadian corporation (as defined in s. 89(1), a Canadian corporation not exempt from tax).

A standard ABCA corporation will be a taxable Canadian corporation.o Consideration for the transfer must include at least one share in the transferee corporation.o Parties must elect in the prescribed form (T2057) and manner on or before the day which the transferee

corporation is required to file its tax return for the year the transfer occurred.- The particular transfer remains a disposition for tax purposes, but:

o The proceeds for the transferor are deemed to be equal to the cost of the transferred property, as elected;o The cost of the consideration to the transferor becomes the cost for the transferee; ando The cost of the consideration received by the transferor is deemed to be equal to the cost of the transferred

property.

ELECTED AMOUNTS FOR ALLOCATING COST FOR TYPICAL ROLLOVER TRANSACTIONS

Sections 85(1)(b), 85(1)(c), 85(1)(c.1), 85(1)(e.3) & 85(1)(e) – Determining the Elected Amount

- Section 85(1)(b) requires that the minimum elected amount must not be less than the FMV of any non-share consideration.

- Section 85(1)(c) requires that the maximum elected amount not be more than the FMV of the property transferred. o Wording of s. 85(1)(b) is subject to s. 85(1)(c).

In the event of a conflict, s. 85(1)(c) prevails and places the minimum as the maximum.- Section 85(1)(c.1) requires that the minimum elected amount not be less than the cost amount of the property.

o Actually a lesser of two amounts – FMV or cost amount.- Conflict between ss. 85(1)(b) & 85(1)(c.1) as to what minimum elected amount is.

o Section 85(1)(e.3) notes that where these sections conflict, the larger minimum is paramount.- Section 85(1)(a) deems the elected amount to be the transferee’s cost in the property, and as the transferor’s proceeds of

disposition.- Section 85(1)(e) states that the minimum elected amount for a depreciable property must be equal to least of the UCC

of the class of the property ($8,000), capital cost ($9,000), or FMV ($6,000).

Sections 85(1)(f)–85(1)(h) – Allocating Cost to Received Consideration

- Sections 85(1)(f–h) set out hierarchical rules for allocating cost of the elected amount to consideration received.o Start with elected amount and allocate to non-share consideration (f).o For any elected amount which exceeds non-share consideration, allocate to preferred share consideration (g).o Residual amount from these allocations are to be allocated to common shares (h).

Determining Minimum Elected Amount

Determining Maximum Elected Amount

Allocating Elected Amount as ACB to Consideration Received

Section 85(1)(b) – FMV of non-share consideration received.

Section 85(1)(c) – FMV of transferred property.

Section 85(1)(f) – Non-share consideration.

Section 85(1)(c.1) – Lesser of FMV or ACB of transferred property.

Due to wording of ss. 85(1)(b) & 85(1)(c), if the minimum is greater than the maximum, s. 85(1)(c) will prevail and set out the minimum and maximum.

Section 85(1)(g) – Preferred share consideration

Section 85(1)(e.3) – Larger minimum is paramount in determining minimum.

Section 85(1)(h) – Common share consideration.

Section 85(1)(e) – Least of UCC, capital cost, or FMV of a depreciable property.

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SUPPLEMENTARY RULES FOR ROLLOVER TRANSACTIONS

Section 85(1)(e.2) – Targeting Non-Arm’s Length Section 85(1) Elections

- Section 85(1)(e.2) applies where the FMV of the property transferred to the corporation is greater than the FMV of the consideration received and the elected amount, and it is reasonable to assume that one of the reasons that the shortfall was created was to confer a benefit onto a related person.

o Section 85(1)(e.2) does not apply where the transferee corporation is wholly owned by the transferor.- If applicable, s. 85(1)(e.2) adds the excess of FMV of transferred property over FMV of consideration received to the

elected amount under s. 85(1).o Essentially accelerates tax payable by increasing the elected amount, decreasing the capital gain tax deferral.

Section 85 – Rollover Transactions of Depreciable Property

- Section 85(5) then applies as a special rule for depreciable property- Transferee deemed to have a capital cost in the transferred property equal to the transferor’s capital cost in the property.

o Difference in original capital cost and elected amount will be deemed to have been previously deducted by the transferee corporation as depreciation (a CCA deduction).

Section 85(2.1) – The “Gap-Filler” Rule

- Section 85(2.1) aims to ensure PUC of shares issued by transferee corporation under s. 85(1) does not exceed cost of the property transferred, less FMV of any non-share corporation given by the transferee corporation.

o Without s. 85(2.1), the transferee corporation could add an amount to PUC equal to FMV of transferred property, notwithstanding that the elected amount is lower.

o Applies where PUC of shares issued by the transferee corporation exceeds the ACB of the property transferred, as reduced against the FMV of any non-share consideration provided by the transferee

- Section 85(2.1) does not apply to a transaction if s. 84(1) applies.o Section 85(2.1) will not apply to a transfer of shares to another corporation unless all of s. 84(1)’s conditions

are not satisfied.- Section 15(1) does not apply to every s. 85(2.1) exchange.- Similar to s. 84.1(1)(a) in that it applies a PUC grind on a class-by-class basis.

o (A – B) * C/A.o A is the PUC addition to all classes of shares.o B is the amount, if any, by which the ACB of the transferred property exceeds the FMV of any non-share

consideration received.o C is the PUC addition in respect to the particular class of shares to which the PUC grind will be applied to.

STOP-LOSS RULES

Affiliation Rules for Stop Loss Rules

- Section 251.1(1)(a) affiliates individuals with their spouse.- Section 251.1(1)(b) affiliates corporations with the individual who controls the corporation.- Section 251.1(1)(c) affiliates two corporations if they are controlled by the same person, or if they are controlled by an

affiliated group.- Section 251.1(3) sets out de facto (and de jure) control as the test for the other sections.

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The Stop Loss Rules

- Section 40(3.4) is the operative provision for suspend loss rules, which if applicable, precludes the transferor which would otherwise realize a loss from realizing that loss until a later time.

o The loss is suspended for the corporation until 30 days after all of the affiliated persons no longer own the corporation,

- Section 43(a) provides the conditions for s. 40(3.4)’s application: a taxpayer other than an individual disposes of non-depreciable capital property in a transaction which is not:

o A change of use;o The expiry of an option;o The disposition of a debt of a related person;o Transaction where loss would be denied because a loss restriction event occurred; oro A transaction preceding a person becoming a non-taxable person.

- Section 43(b) requires an affiliated person to have within a period beginning 30 days before the disposition date and ending 30 days after the disposition date acquired the same property or acquired identical property, and that at the end of that period, the affiliated person continues to own the property or the identical property.

- Section 40(3.6) requires a share repurchase or share redemption, realization of a loss on that transaction, and if the individual is affiliated with the corporation after the transaction, the loss is denied.

o If the individual still owns shares of the corporation after the repurchase, there is an addition to the individual’s ACB in the other shares equal to the denied loss.

- Section 251.1 provides various affiliation rules necessary for ss. 40 & 43:o Section 251.1(1)(a) affiliates individuals with their spouse.o Section 251.1(1)(b) affiliates corporations with the individual who controls the corporation.o Section 251.1(1)(c) affiliates two corporations if they are controlled by the same person, or if they are

controlled by an affiliated group.o Section 251.1(3) sets out de facto (and de jure) control as the test for the other sections.

V–II: SHARE EXCHANGES

SECTION 51 – BASIC SHARE EXCHANGES

Section 51(1) – Conditions

- Section 51(1) provides the conditions for application:o Taxpayer must receive a share of the capital stock of the corporation;o In exchange for either:

Another share of the corporation that was taxpayer’s capital property; or A bond or debenture of the corporation that was the taxpayer’s capital property and had terms granting

the holder the right to convert;o No non-share consideration is received; ando Sections 85(1), 85(2) & 86 must not apply to the exchange.

Affirmatively electing under s. 85 would disable s. 51, despite both provisions being satisfied.

Section 51(1) – Effects

- Exchange is deemed not to be a disposition; and- The ACB of the shares acquired is equal to the prorated portion of ACB of property exchanged, with proration based on

the relative FMV of the shares acquired.

Section 51(2) – Anti-Avoidance Rule for Shortfall of Transferred Property

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- If the purpose test is satisfied, then s. 51(2)(d) will provide for a disposition of property by the exchanging shareholder equal to the lesser of:

o The ACB of the share exchanged plus the gift portion; oro The FMV of the convertible property.

Section 51(3) – PUC Reduction Rule

- Applies on a class-by-class basis and requires the PUC of each individual class to be reduced by a formula:o Amount by which the PUC of all of the shares was increased by the exchange less the PUC of the old shares

prior to the exchange.o Reduction is allocated pro-rata to each class of shares based on the proportion of stated capital of each class.

SECTION 86 – SHARE-FOR-SHARE EXCHANGES DURING REORGANIZATION OF CAPITAL

Section 86(1) – Conditions

- Conditions:o Exchange must occur in the course of a reorganization of capital of the corporation;o Property disposed of must be capital property; o Property disposed of must be all of the shares of any class owned by the taxpayer;

Under s. 51, a taxpayer could exchange only part of their shares.o The property received from the corporation includes shares in the capital of the corporation; ando Sections 85(1) & 85(2) do not apply.

Section 86 – Effects

- Taxpayer is deemed to have cost in the non-share consideration equal to FMV;- Taxpayer is deemed to have cost in the new shares equal to the amount that ACB of the old shares exceeds FMV of

non-share consideration;- Taxpayer is deemed to dispose of old shares for proceeds equal to cost of new shares plus cost of non-share

consideration.

Sections 86(2) & 86(2.1) – Shortfall of Consideration and PUC Reductions

- Section 86(2) provides for realization of a gain if there is a shortfall of consideration.o If combined FMV of the new shares and non-share consideration is less than the FMV of old shares:

There is a gift portion equal to the difference; and The transferor is deemed to have disposed of the old shares for the lesser of the FMV of the old shares

or the ACB of the old shares plus the gift portion.- Section 86(2.1) provides for a PUC reduction for the new shares.

o The PUC grind will be allocated pro-rata to classes of shares with the cumulative grind equaling: Any amount of the PUC of the new shares which exceeds; The PUC of the old shares, less the FMV of any non-share consideration received.

SECTION 85.1 – EXTERNAL SHARE EXCHANGES

Section 85.1 – Conditions

- Requires:o Canadian corporation must issue shares to the taxpayer;o The shares must be issued in exchange for shares of any particular class in the capital of a taxable Canadian

corporation;

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o The exchanged shares must be capital property of the vendor; ando The vendor cannot include in its income any portion of the gain or loss otherwise attributable to the disposition

of the shares.- Section 85.1(2) provides further conditions:

o Vendor and purchaser must deal at arm’s length prior to exchange;o After the exchange, vendors and persons not at arm’s length with vendor cannot:

Control the purchaser ; or Own more than 50% of the FMV of the shares of the purchaser.

o No election can be made under s. 85; ando The vendor cannot receive non-share consideration for the exchanged shares.

If a separate transaction involves non-share consideration, the pure share-for-share exchange may still fall under s. 85.1.

Section 85.1 – Effects

- Vendor is deemed under s. 85.1(1) to (s. 85.1(1)(a)):o Have disposed of the old shares for proceeds equal to ACB (s. 85.1(1)(a)); ando Have acquired the new shares at a cost equal to the ACB of the old shares.

No potential for anything but a tax-deferred outcome.- Purchaser is deemed to have acquired the purchased shares at a cost equal to the lower of their FMV and PUC (s.

85.1(1)(b)).

Section 85.1(2.1) – PUC Grind on External Exchanges

- Applies on a class-by-class basis and requires the PUC of each individual class to be reduced by a formula:o Amount by which the PUC of all of the shares was increased by the exchange less the PUC of the old shares

prior to the exchange.o Reduction is allocated pro-rata to each class of shares based on the proportion of stated capital of each class.

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