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Chartered Accountants of B.C.€¦ · Chartered Accountants of B.C. Beyond Numbers · January 2013 Tax Traps & Tips: Section 84.1 – The Trap That Commonly Trips By …

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Page 1: Chartered Accountants of B.C.€¦ · Chartered Accountants of B.C. Beyond Numbers · January 2013 Tax Traps & Tips: Section 84.1 – The Trap That Commonly Trips By …

Chartered Accountants of B.C. Beyond Numbers · January 2013

Tax Traps & Tips: Section 84.1 – The Trap That Commonly Trips

By Sindy Wong, CA

Section 84.1 of Canada's Income Tax Act (the Act) has been described as "both subtle in its application and severe in

its consequences."[1] The purpose of section 84.1 is to prevent "surplus stripping"—the tax-free extraction of surplus

from a corporation by a non-corporate taxpayer. The danger of section 84.1 is how commonly advisors are caught

unaware, and how often this lack of awareness leads to punitive results for the taxpayer.

A detailed review of the technicalities of section 84.1 is beyond the scope of this article. Instead, this article discusses

some common examples of transactions caught by section 84.1, and the punitive

results.

Application

In very general terms, section 84.1 applies when all of the following conditions are met:

Shares of any class (the "subject shares") of a Canadian resident corporation (the "subject corporation") are

disposed of;

The disposition is made by a non-corporate taxpayer (an individual or trust) that is a resident of Canada;

The subject shares are capital property to the taxpayer;

The taxpayer disposes of the subject shares to another corporation (the "purchaser corporation") with which

the taxpayer does not deal at arm's length[2]; and

Immediately after the disposition, the subject corporation is connected with the purchaser corporation.[3]

Where section 84.1 is found to apply, one or both of the following consequences may result:

Paid-up capital reduction[4]

The paid-up capital (PUC) reduction found in section 84.1 is intended to prevent the artificial creation of

PUC, which can later be extracted by shareholders as a tax-free return of capital.

Generally, shares issued to acquire property begin with PUC equal to the fair market value (FMV) of the

property less any non-share consideration paid, unless otherwise reduced by specific provisions in the Act.

Where section 84.1 applies and shares of the purchaser corporation ("new shares") are issued as

consideration for the subject shares, the PUC of the new shares is limited to the greater of: a) the PUC of

the subject shares, and b) what is commonly referred to as "hard ACB," less any non-share consideration

received by the taxpayer on the disposition.

Hard ACB[5] is essentially the adjusted cost base (ACB) of the taxpayer's subject shares, immediately

before disposition, reduced by the amount of any capital gains exemption (CGE) claimed by either the

taxpayer or a non-arm's length party on the subject shares (or shares for which the subject shares have

been substituted).

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Deemed dividend[6]

To the extent that the taxpayer receives non-share consideration that exceeds the greater of the PUC and

hard ACB of the subject shares, the taxpayer is deemed to have received a dividend equal to the amount of

that excess.

Common scenarios in which section 84.1 may apply

The application and implications of section 84.1 are best explained using sample scenarios. The following examples

illustrate two common situations in which section 84.1 may apply, and the resulting tax

implications in each case. These examples are by no means exhaustive, as there are many other situations in which

section 84.1 may apply.

Example 1: Selling shares to the next generation

Dad, as the founder of Opco, is preparing to retire and pass the reigns to Son. The ACB and PUC of Dad's Opco

shares are $100. Dad sells his Opco shares to Son at FMV of $1 million, and intends to claim his full CGE of

$750,000 on this disposition.

Son needs to finance his Opco share purchase with a bank loan, and has decided to incorporate Holdco to be the

borrower and purchaser of the Opco shares. The plan is to amalgamate Holdco with Opco subsequent to the share

purchase, so that Son may service the bank loan with pre-tax profits earned by Opco. All taxpayers involved are

residents of Canada.

In this example, section 84.1 would apply because all of the five conditions are met. Given that no Holdco shares

were issued as consideration for the Opco shares, no PUC reduction would apply to the Holdco shares. However,

since Dad received $1 million in cash as consi-deration for the Opco shares, Dad will be deemed to have received a

dividend of $999,900 ($1 million non-share consideration less $100, being the greater of PUC and hard ACB).

For capital gains purposes, the deemed dividend will be excluded from Dad's proceeds for his Opco shares.[7]

Therefore, Dad will be deemed to have disposed of his Opco shares for proceeds equal to the cost of $100, resulting

in no capital gain or loss.

In this example, rather than realizing a capital gain of $249,900 as intended, Dad realized a dividend of $999,900, as

a result of the application of section 84.1.

Example 2: Post-mortem planning

Dad, as the founder of Opco, dies holding all the issued and outstanding shares of Opco. Opco has a FMV of $1

million on Dad's death, and Dad's ACB in his Opco shares equals PUC of $100. Dad will be deemed to have

disposed of his Opco shares for $1 million immediately before his death. Dad's estate will claim his full CGE of

$750,000 on this deemed disposition, thereby reducing Dad's capital gain on death to $249,900.

The estate, which will be deemed to have acquired the Opco shares at an ACB of $1 million, would like to access this

"bumped-up" ACB. The estate incorporates new Holdco with nominal ACB and PUC, then sells the Opco shares to

Holdco for a promissory note of $1 million. The intention is to allow the estate to extract funds from Opco—first as a

tax-free inter-corporate dividend paid to Holdco; then as a tax-free repayment of the promissory note by Holdco to the

estate. All taxpayers involved are residents of Canada.

In this example, as a result of the application of section 84.1, the estate will be deemed to have received a dividend

equal to $750,000 ($1 million non-share consideration less $250,000, being the greater of PUC and "hard ACB"). The

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estate will also realize a capital loss of $750,000 ($250,000 being the actual proceeds of $1 million reduced by the

deemed dividend of $750,000, less $1 million ACB). However, this capital loss will be suspended in the hands of the

estate until such time that the Opco shares are sold outside the affiliated group.[8] As no Holdco shares were issued

as consideration for the Opco shares, no PUC reduction will apply to the Holdco shares.

In this example, restructuring that was intended to provide the estate with tax-free access to the high ACB, instead

resulted in a deemed dividend of $750,000 to the estate.

Closing comments

As these two basic examples illustrate, section 84.1 can create significant adverse tax implications for the unwary.

Therefore, where a non-corporate taxpayer is planning to sell shares to a corporation, consideration should be given

to the potential application and implications of section 84.1.

Sindy Wong, CA, is a senior manager in tax at Smythe Ratcliffe LLP in Vancouver.

Footnotes

1. Paul Bleiwas and John Hutson, Taxation of Private Corporations and Their Shareholders, 4th ed., 4:29.

2. "Arm's length" is defined in subsection 251(1) of the Act, and is further expanded for the purposes of section

84.1 by paragraphs 84.1(2)(b) and (d) and subsections 84.1(2.01) and (2.2).

3. The meaning of "connected" is assigned by subsection 186(4); for the purposes of section 84.1, all

references therein to "payer corporation" and "particular corporation" are to be read as "subject corporation"

and "purchaser corporation" respectively.

4. Paragraph 84.1(1)(a).

5. Subsection 84(2). ACB is also reduced for certain V-day adjustments where the subject shares were either

held since 1971 or acquired from a non-arm's length vendor who held those shares (or substituted shares)

since 1971.

6. Paragraph 84.1(1)(b).

7. Paragraph 54(k), definition of "proceeds of disposition."

8. Subsection 40(3.4).