Companies typically use corporate reorganizations to achieve shareholder planning objectives, such as creditor protection or income splitting. But what appear to be straightforward transactions can lead to unforeseen income tax consequences when dealing with non-arm’s-length (NAL) parties.
Generally speaking, people are considered non-arm’s length to their spouses, direct ascendants and descendants, and companies they control.
A taxpayer is NAL to children, grandchildren, great-grandchildren and spouses (married or common-law) of each of these descendants. Ascendants include the person’s parents, grandparents, great-grandparents and their respective spouses. Added into the NAL mix are siblings (and their spouses) of the taxpayer, together with siblings of the taxpayer’s spouse.
Consider the example of Bob, who transfers his shares of Opco to a newly established Holdco, which he also owns. By electing under section 85 of the Income Tax Act, Bob can complete the transaction on a rollover basis. He’s also entitled to elect a transfer price. It’s common to elect a transfer price that allows the shareholder to crystalize the available capital gain exemption as an additional outcome. If Bob elects to use a transfer price of $750,000 (which is equal to the lifetime capital gains exemption in 2013), he can trigger a capital gain and crystallize his CGE, assuming a nominal adjusted cost base (ACB) and paid-up capital. Assume, then, that Holdco issues a $750,000 promissory note together with its own shares as payment for the Opco shares (fair market value in equals fair market value out).
All of these steps appear to fit within section 85. But Bob and Holdco are NAL and the transaction would trigger adverse tax consequences. That’s because it meets the conditions of section 84.1, which is a provision in Canada’s tax regime that’s structured to ensure that NAL transactions cannot artificially achieve preferential tax results. At a high level, the policy intent of section 84.1 is to prevent taxpayers from converting their capital gains into cash as an outcome of a NAL transaction.
Why this happened
Bob has transferred shares of one company (Opco) to another (Holdco) that is NAL to Bob, and the two companies are connected afterward. When section 84.1 applies, the provision limits access to non-share consideration (i.e., cash) to the greater of paid-up capital and adjusted ACB. In general terms, adjusted ACB is the regular ACB less the amount of capital gain exemption claimed by the taxpayer and NAL parties in respect to the shares being disposed of.
By taking back a $750,000 promissory note, a deemed dividend of $750,000 arises, creating an immediate and unanticipated tax consequence for Bob. If consideration (payment) had been limited to Holdco shares only, Bob could have crystallized his capital gains exemption and embedded it into the ACB of his Holdco shares ($750,000).
Bob’s example is straightforward because he was crystallizing his capital gains exemption. But consider the example of Stan, who buys the shares his mother, Mary, holds in Opco. The shares have a nominal ACB and paid-up capital (i.e., close to zero). If Stan pays Mary $1,000,000, she triggers a capital gain on the disposition against which she can utilize her available capital gains exemption. Stan’s ACB of the Opco shares is $1,000,000, while the paid-up capital remains unchanged. Stan needs to be wary of section 84.1 if he subsequently undertakes transactions involving these shares when dealing with NAL parties. If Stan were to undertake a section 85 transaction, he would normally take back a promissory note for the ACB of the transferred shares. But Stan needs to keep in mind the historical ownership of the Opco shares involves a NAL person (his mother, Mary), who claimed her capital gains exemption.
For example, if Stan were to use section 85 to transfer his Opco shares to Holdco (a corporation he owns), the package of consideration on the transfer would be limited to a $250,000 promissory note in 2013 (or $200,000 if the purchase from Mary occurs in 2014), with the remainder of the value in Holdco shares in order to avoid any immediate tax consequences. Any non-share consideration above $250,000 (the greater of paid-up capital and adjusted ACB) will trigger immediate tax consequences because of section 84.1.
Stan’s example highlights the need to analyze a client’s ACB and determine if any NAL parties have claimed their capital gains exemptions in respect to the shares. Without careful analysis, it’s easy to miss the fact the transaction meets the conditions of section 84.1, which limits the amount of non-share consideration permitted before triggering immediate tax consequences.
To determine the capital gains exemption claimed by NAL individuals relative to the current owner, you need to trace ownership of the shares backwards through the chain of NAL transactions until it’s broken by an arm’s length transaction. Consider the scenario where Jack purchases shares of ABco from his brother Ben, who purchased the shares from his father, Ned. Ned had purchased the shares from his Aunt Betty. In this case, Jack should track any capital gains exemptions claimed by Ben, Ned or himself with respect to the ABco shares. The chain is broken at Aunt Betty because she is not NAL to Ned.
This can be a difficult exercise because information about income tax filings isn’t publicly available. So, you’ll have to rely on your client’s records. Ensure that income tax is not triggered unexpectedly by overlooking an anti-avoidance provision of the Income Tax Act.
James Kraft, CPA, CA, MTax, TEP, CFP, is vice president of Wealth Planning Services at BMO Financial Group. Deborah Kraft, MTax, TEP, CFP is director of the Master of Taxation Program at the University of Waterloo.