Effect of expanded rule on post-mortem transfers (pp. 8-14)
The expanded s. 84.1 rule produces a greater impediment to the transfer of family businesses from one member to another, whether from one generation to another or between siblings (and during lifetime or post‐mortem), with the result that the tax system would favour third‐party sales. For instance, in Example 1 below, the daughter will have a disincentive to retain her common shares of Opco since substantial additional tax will be realized if the preferred shares bequeathed to her are redeemed rather than included in a third-party sale:
Example 1
On death, Mrs. X owned preferred shares in an Opco having a nominal PUC and ACB which she acquired on an estate freeze, with her daughter, who is active in the business, holding the common shares. Under proposed s. 84.1, neither the estate nor daughter is permitted to employ “pipeline” planning to avoid double tax on death, because for purposes of s. 84.1 the ACB to the estate or her will be reduced by the capital gain deemed to be realized by Mrs. X on death. It is possible that the estate could avoid the double tax if the preferred shares are redeemed within one year of death and an s. 164(6) election is made to carry back the capital loss to offset the capital gain realized on death. However, this planning may not be practical:
- It may not be possible to redeem the shares within the estate’s first taxation year, for example, because of required cooperation of other shareholders or insufficient liquid assets.
- The estate might be a graduated rate estate.
- Under draft s. 120.4(4), all or a portion of the capital gain arising on the deemed disposition of shares on death might be recharacterized as a taxable dividend and considered to be “split income.”
- Various stop loss rules like s. 40(3.6) also may limit the use of a loss carryback, for example, potentially as a result of the estate realizing other capital gains in its first taxation year, or where shares were previously left to a spousal trust or are held in an alter‐ego or joint partner trust.
Effect of expanded rule on inter vivos transfers (pp. 15-17)
Examples 3 (not summarized) and 4 (below) demonstrate the typical situation whereby (i) the current rules somewhat favour a sale of a corporate business to an arm’s length third party rather than to family members, and (ii) the proposed rules would make this tax incentive significantly larger.
Example 4
Bob sells the shares of Opco (having a FMV of $6 million and nominal PUC and ACB) directly to his children, and receives a $6 million promissory note as consideration. The value of Opco mostly is attributable to goodwill. The children subsequently transfer the Opco shares into a new holding company and repay the promissory note to Bob over time using cash flow and the debt capacity of Opco.
Under proposed section 84.1, if the children transfer the Opco shares into a holding company, the children’s ACB for s. 84.1 purposes would be reduced from $6,000,000 to nil because of the capital gain realized by Bob, a non‐arm’s length party. As a result, they would be deemed to receive a taxable dividend on the $6,000,000 ultimately paid to them to fund payments under the promissory note, and pay significantly more tax than on a sale by Bob of Opco directly to a third party.
Listing of issues under s. 246.1 (pp. 27-31)
It is unclear if, for example, there is receipt of, say, a promissory note, there is a deemed dividend on such receipt or only on subsequent distributions (principal payments).
The Explanatory Notes indicate that the amount receivable by an individual subject to s. 246.1 could be received indirectly through a trust. In many (or perhaps most) cases, though, the rule could apply to the trust itself, together with individual beneficiaries that receive a distribution from the trust, because the application of the rule is not limited to “individuals (other than a trust).”
Where the rule applies to an individual beneficiary who receives a distribution from a trust of a portion of a capital dividend, the trust should be deemed not to have received the capital dividend, to the extent of that portion, so that “stop‐loss” rules (e.g., s. 112(3.2)) will not apply inappropriately to the trust.
The description of inclusion in the individual’s “income for the year as a taxable dividend received” should be expanded to provide that it is also received “from a corporation resident in Canada,” in order to engage the dividend tax credit provisions.
It may not be clear that, under s. 246.1(2)(b), the non‐arm's length status of the parties is to be tested only at the time that the amount in question is received so that, for example, the receipt of amounts from a corporation operated and controlled by a bona fide arm's length party is not potentially subject to the proposed rule if the recipient had previously sold shares of the corporation to that arm's length person.
The non‐arm’s length standard also should apply to ss. 246.1(2)(c)(i) and (ii) relating to dispositions of property and changes in paid‐up capital. As currently drafted, it appears possible for arm’s length transactions to be the basis for the application of the proposed rule.
One of the purposes of the transaction or series must be to effect a significant “reduction or disappearance” of assets. The language of the provision suggests that assets for this purpose are to be determined on some type of consolidated or look‐through approach but there is no guidance on the manner in which this is to be done.
Does the test look to whether specific identifiable assets have been reduced or disappeared (an "asset tracing test"), or is the test of whether the corporation’s gross assets or aggregate net asset value has been reduced (a "value test")? The purchase of a business asset from the shareholder for fair market value consideration could be caught under an asset tracing test but not a value test.
Ss. 88(2) and 84(2) contemplate that a distribution of paid‐up capital occurs first and then (in the case of s. 88(2)) comes next out of the CDA. Therefore, the basis for concluding that a taxable dividend distribution will in all cases be the normative comparator is questionable.
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