29 May 2018 STEP Roundtable Q. 17, 2018-0744141C6 - S.84.1 and Capital Gains Reserve

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Whether subsection 84.1(2.1) will apply to deem a taxpayer to have taken a capital gains exemption in the event a taxpayer claims a subparagraph 40(1)(a)(iii) reserve on the disposition of shares to which section 84.1 applies, regardless of whether the taxpayer claims any capital gains exemption in respect of the disposition.

Position: Yes.

Reasons: See below.

2018 STEP CRA Roundtable – May 29, 2018

QUESTION 17. Section 84.1 and Capital Gains Reserve

Generally speaking, section 84.1 of the Income Tax Act (Act) applies to prevent the tax-free extraction of surplus of a corporation through a non-arm’s length transfer of share(s) by an individual resident in Canada to a corporation where the individual’s adjusted cost base (ACB) of the particular share(s) so transferred has been increased by the capital gains exemption (CGE) or V-Day value. However, we are aware that section 84.1 could apply in a situation where the individual’s ACB of the particular share(s) has not been increased by the CGE or V-Day value. More specifically, subsection 84.1(2.1) provides that, for purposes of determining ACB of the individual’s share for the purposes of section 84.1 (and in particular the ACB reduction under subparagraph 84.1(2)(a.1)(ii)), where a capital gains reserve is claimed under subparagraph 40(1)(a)(iii) by the individual or a non-arm’s length individual (herein referred to as the “transferor”) and it is possible for the transferor to claim the CGE, the CGE is deemed to be claimed by the transferor in the maximum amount irrespective of whether it is in fact claimed.

Can the CRA provide any comments with respect to this interpretation of subsection 84.1(2.1)? Specifically, can the CRA comment on whether the application of subsection 84.1(2.1) could result in a transferor being deemed to have claimed CGE in the maximum amount where the transferor claims a capital gains reserve under subparagraph 40(1)(a)(iii) but has not, and has no intentions of, claiming CGE even though there is unused CGE room available?

CRA Response

In very general terms, section 84.1 is an anti-avoidance rule designed to prevent the removal of taxable corporate surpluses as a tax-free return of capital through a non-arm’s length transfer of shares of one corporation (the “subject corporation”) by an individual resident in Canada to another corporation (the “purchaser corporation”). Section 84.1 achieves its purposes by: (1) reducing the paid-up capital of the shares of the subject corporation, which reduces the ability to return paid-up capital of the purchaser corporation as the excess would be taxed as a dividend, and (2) deeming the individual shareholder to have received a dividend where the purchaser corporation pays non-share consideration for the shares of the subject corporation that exceeds the greater of the paid-up capital and the “hard ACB” of the particular shares transferred. The Act provides specific rules for determining the “hard ACB” for the purposes of section 84.1. “Hard ACB” is a term commonly used to describe arm’s length ACB that was not created as a result of V-Day value or the utilization of the CGE.

In respect of this particular situation, the CRA’s views on the application of subsection 84.1(2.1) can be found in Technical Interpretation 2015-059446. In that Technical Interpretation we stated the following:

Paragraph 84.1(2)(a.1) was implemented in 1985 so that the benefit of the capital gains deduction on a gain realized on the disposition of a share would not also result in the additional benefit to the taxpayer or a person not dealing at arm’s length with the taxpayer to receive a distribution from the corporation tax-free.

At the time the Act was modified to allow capital gains reserves claimed under subparagraph 40(1)(a)(iii) to qualify for the capital gains exemption under section 110.6, there was no corresponding amendment to section 84.1. As a result, it was possible to circumvent the paragraph 84.1(2)(a.1) reduction in adjusted cost base for the purposes of section 84.1 by having the non-arm’s length transferor of the shares claim a capital gains reserve in respect of the transfer and subsequently claim a capital gains exemption when the amount is brought back into income.

Subsection 84.1(2.1) was introduced to address this unintended result. It provides a special rule for the purposes of subparagraph 84.1(2)(a.1)(ii) and applies where the transferor or an individual who does not deal at arm’s length with the transferor disposes of a share in a taxation year and claims a capital gains reserve under subparagraph 40(1)(a)(iii) on that disposition. This provision essentially treats the transferor as having claimed, to the extent that the transferor has unused capital gains exemption room in the year in which the disposition took place, a capital gains deduction on the disposition, irrespective of whether such exemption was actually claimed, because the reserve could potentially be eligible for a capital gains exemption when brought into income in the future. Whether the transferor intends to claim a capital gains exemption on the reserve in the future is not relevant. We understand that the effect of this rule is to treat a capital gain on a property to be sheltered by the capital gains exemption when there is unused capital gains exemption room in the year of the disposition regardless of whether such capital gains exemption room has been saved to cover a capital gain that could be realized on a disposition of other properties in a subsequent year.

In our view, these comments remain relevant and are supported by law and as such, remains the current position of the CRA.

The following examples illustrate the operation of subsection 84.1(2.1).

Example 1

Assume that a person who was not dealing at arm’s length with a taxpayer realized a $100,000 capital gain on the transfer of a share to the taxpayer. The non-arm’s length person claims a reserve under subparagraph 40(1)(a)(iii) in respect of $50,000 of the capital gain and pays no tax on the remaining $50,000 capital gain by claiming a $25,000 CGE under subsection 110.6(2.1). Assume also that the non-arm’s length person had $25,000 of unclaimed CGE remaining after the end of the year in which the transfer occurred. Under subsection 84.1(2.1), the amount of CGE deemed to have been claimed by the non-arm’s length person is determined as the lesser of (a) and (b) where:

(a) is the total of

(i) reserve under 40(1)(a)(iii)			$50,000
(ii) twice the amount deducted under
section 110.6						$50,000 (2 x $25,000 CGE)
								$100,000
and

(b) is twice the maximum amount that could
have been deducted under section 110.6
in respect of the taxable gain if no reserve
under 40(1)(a)(iii) had been claimed		$100,000 (2 x $50,000 CGE)

Pursuant to subsection 84.1(2.1), the non-arm’s length person is deemed for the purposes of subparagraph 84.1(2)(a.1)(ii) to have claimed CGE in respect of the entire $100,000 capital gain realized on the transfer of the share.

Example 2

Facts are the same as in Example 1 except that the non-arm’s length person had no unclaimed CGE remaining after the end of the year in which the transfer occurred. Under subsection 84.1(2.1), the amount of CGE deemed to have been claimed by the non-arm’s length person is determined as the lesser of (a) and (b) where:

(a) is the total of

(i) reserve under 40(1)(a)(iii)			$50,000
(ii) twice the amount deducted under
section 110.6						$50,000 (2 x $25,000 CGE)
								$100,000
and

(b) is twice the maximum amount that could
have been deducted under section 110.6
in respect of the taxable gain if no reserve
under 40(1)(a)(iii) had been claimed		$50,000 (2 x $25,000 CGE)

Pursuant to subsection 84.1(2.1), the non-arm’s length person is deemed for the purposes of subparagraph 84.1(2)(a.1)(ii) to have claimed CGE in respect of only $50,000 of the capital gain realized on the transfer of the share.

Example 3

Facts are the same as in Example 1 except that the non-arm’s length person had $10,000 CGE remaining after the end of the year in which the transfer occurred. Under subsection 84.1(2.1), the amount of CGE deemed to have been claimed by the non-arm’s length person is determined as the lesser of (a) and (b) where:

(a) is the total of

(i) reserve under 40(1)(a)(iii)			$50,000
(ii) twice the amount deducted under
section 110.6						$50,000 (2 x $25,000 CGE)
								$100,000
and

(b) is twice the maximum amount that could
have been deducted under section 110.6
in respect of the taxable gain if no reserve
under 40(1)(a)(iii) had been claimed		$70,000 (2 x $35,000 CGE)

Pursuant to subsection 84.1(2.1), the non-arm’s length person is deemed for the purposes of subparagraph 84.1(2)(a.1)(ii) to have claimed CGE in respect of only $70,000 of the capital gain realized on the transfer of the share.

It should be noted that, as indicated in the wording of the provision, the application of the deeming rule in subsection 84.1(2.1) to a taxpayer applies only for the purposes of subparagraph 84.1(2)(a.1)(ii). In other words, the application of the deeming rule in subsection 84.1(2.1) does not impact that taxpayer’s ability to claim a CGE exemption under the rules in section 110.6.

Tania Ng
2018-074414