23 February 2000 External T.I. 1999-0005645 - qsbc shares

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: The taxpayer is a XXXXXXXXXX licenced in the province of British Columbia and has a professional corporation Dr. A. Inc. He is the sole shareholder of XXXXXXXXXX which owns and operates a farming business. XXXXXXXXXX

Will the shares of XXXXXXXXXX qualify as qualified small business corporation shares and will the taxpayer be eligible to claim the $500,000 capital gains exemption on the capital gains realized on the disposition of the shares? Can the taxpayer claim all of the capital gains exemption resulting from the shares of XXXXXXXXXX for the XXXXXXXXXX taxation year even though he will be receiving payments for the sale of the shares over XXXXXXXXXX years. If after the sale of shares of XXXXXXXXXX , the loans to XXXXXXXXXX are declared to be defunct by the investor, can the taxpayer and Dr. A Inc. claim allowable business investment losses?

Position: Question of fact. General comments given.

Reasons: See 9805845, 9521185, 9613885, 9513305, 9510015, 9225255, 9004363, 9819816, 9502255, 9522580, 9809947, 9640437, 9802347, 9529667, 9726496, 9317905,

XXXXXXXXXX 1999-000564
G. Moore
February 23, 2000

Dear XXXXXXXXXX:

We are replying to your letter of October 17, 1999, in which you requested our comments regarding qualified small business corporation shares and allowable business investment losses.

You indicate that you are a XXXXXXXXXX licenced in the province of British Columbia since XXXXXXXXXX. You have a professional corporation, XXXXXXXXXX ("Dr. A. Inc."), which operates the XXXXXXXXXX. You are also the sole shareholder of XXXXXXXXXX which owns and operates a farming business.

XXXXXXXXXX

An arm's length investor is interested in purchasing all the shares of XXXXXXXXXX for $XXXXXXXXXX is indebted to Dr. A. Inc. for approximately $XXXXXXXXXX and to you for approximately $XXXXXXXXXX. The arm's length investor has offered to purchase the shares of XXXXXXXXXX for $XXXXXXXXXX. You will receive payments for the sale of shares of XXXXXXXXXX over the next XXXXXXXXXX years. You wish to make use of the capital gains exemption of $XXXXXXXXXX which is available in respect of the disposition of qualified small business corporation shares. You anticipate that after the sale of shares of XXXXXXXXXX to the investor, the investor will notify you and Dr. A Inc. that the nonsecured loans are defunct.

You are asking if the shares of XXXXXXXXXX qualify as qualified small business corporation shares and whether you would be eligible to claim the $500,000 capital gains exemption on the capital gains realized on the disposition of the shares. Secondly, you are asking if you can claim all of the capital gains exemption resulting from the shares of XXXXXXXXXX for the XXXXXXXXXX taxation year even though you will be receiving payments for the sale of the shares over XXXXXXXXXX years. Lastly, you are asking if, after the sale of shares of XXXXXXXXXX, and if the loans to XXXXXXXXXX are declared to be defunct by the investor, whether you and Dr. A. Inc. can claim allowable business investment losses ("ABIL"). You are also asking if the ABIL can be applied directly against your regular income and against that of the corporation, Dr. A. Inc., and whether the losses can be carried back 3 years and carried forward 7 years.

Further to the telephone conversation (Moore/XXXXXXXXXX) of October 27, 1999, it was discussed that your request relates to a specific proposed transaction with identifiable taxpayers. As indicated in Information Circular 70-6R3, Advance Income Tax Rulings, (copy enclosed) we do not express opinions on specified proposed transactions other than as a reply to an advance income tax ruling. You indicated that you did not wish to request an advance income tax ruling. You were advised during the telephone conversation that while we are unable to comment on the income tax consequences attendant on the specific facts described in your letter, we would provide general comments.

Our Comments

You are asking if the shares of XXXXXXXXXX are "qualified small business corporation shares" as defined in subsection 110.6(1) of the Income Tax Act (the "Act") and whether any capital gain arising on the disposition of these shares would qualify for the capital gains deduction under subsection 110.6(2.1) of the Act. Subsection 110.6(2.1) of the Act provides for a capital gains deduction in respect of capital gains arising on the disposition of qualified small business corporation shares. By virtue of the computation of the capital gains deduction in subsection 110.6(2.1), if a property is qualified farm property, the capital gains exemption, if any, must be calculated under subsection 110.6(2) of the Act first before determining if any capital gains deduction can be claimed under subsection 110.6(2.1). Subsection 110.6(2) provides a capital gains deduction in respect of capital gains arising upon the disposition of qualified farm property, as defined in subsection 110.6(1) of the Act.

Shares of Capital Stock of Family Farm Corporation

Pursuant to paragraph (b) of the definition of "qualified farm property" in subsection 110.6(1) of the Act, a property owned at that time by an individual that is a share of the capital stock of a family farm corporation of the individual qualifies as a "qualified farm property". "Share of the capital stock of a family farm corporation", as defined in subsection 110.6(1) of the Act, at any time means a share of the capital stock of a corporation owned by the individual at that time where throughout any 24-month period ending before that time, more than 50% of the fair market value of the property owned by the corporation was attributable to property that was used by the corporation or the individual (or certain other persons) principally in the course of carrying on the business of farming in Canada in which the individual (or certain others) was actively engaged on a regular and continuous basis. In addition, at the determination time, all or substantially all (90% or more) of the fair market value of the property owned by the corporation must be attributable to property that was used principally in the course of carrying on the business of farming in Canada by the corporation or a person or a partnership described in subparagraph (a)(i) of that definition.

Farm B - Used Principally in the Course of Carrying on the Business of Farming?

With respect to Farm B (tree farming operation), Interpretation Bulletin IT-373R2, Woodlots, (copy enclosed) discusses whether for income tax purposes a woodlot is operated as a farm. Whether a woodlot constitutes a farming operation is a question of fact. Where a taxpayer operates a woodlot as a business with a reasonable expectation of profit, it is generally referred to as a commercial woodlot. If the main focus of a business conducted with a reasonable expectation of profit (a commercial woodlot) is not lumbering or logging, but is planting, nurturing and harvesting trees pursuant to a forestry management or other similar resource plan and significant attention is paid to manage the growth, health, quality and composition of the stands, it is generally considered a farming business (a commercial farm woodlot).

Standing timber is not normally an asset distinct from the land on which it stands, thus when timber and land are sold together, the timber will generally be eligible for the lifetime capital gains exemption if the land on which it stands is considered "qualified farm property" as defined in subsection 110.6(1) of the Act. We cannot comment on whether the shares of XXXXXXXXXX are a "share of the capital stock of a family farm corporation" or whether such shares are "qualified farm property" as those terms are defined in subsection 110.6(1) of the Act. However, based on the information available regarding Farm B, we do not have enough information to determine whether there is a sufficient level of farming activity to demonstrate that a farming business has been commenced or is being carried on. Furthermore, even if an argument can be made that a farming business has commenced or is being carried on in Farm B, it is also not clear whether the farm land was used principally in the course of carrying on the business of farming in Canada. The fact that your intention was to apply to rezone XXXXXXXXXX acres of Farm B for commercial purposes raises the argument that the land in Farm B was not used principally in the course of carrying on the business of farming in Canada. The Canada Customs and Revenue Agency ("the Agency") would need more information concerning the background to the rezoned parcels as well as the value of the XXXXXXXXXX acres compared to the other acreage owned by XXXXXXXXXX.

Farm A - Used Principally in the Course of Carrying on the Business of Farming?

With respect to Farm A, we do not have sufficient details to determine if the parcels of land making up the XXXXXXXXXX operation were used by XXXXXXXXXX principally in the course of carrying on the business of farming in Canada. You indicate that Farm A is an operating XXXXXXXXXX farm and that the farmhouse is rented. You do not indicate if the corporation is operating Farm A or whether the corporation is renting out the land and farmhouse to someone else (other than someone described in subparagraph (a)(i) of the definition of "share of the capital stock of a family farm corporation") and the tenant is operating the farm. If XXXXXXXXXX is renting the land to someone else and is receiving rental income, it is possible that XXXXXXXXXX would not be using the parcels of land in Farm A principally in the course of carrying on the business of farming in Canada. Also, in an XXXXXXXXXX operation, the Agency would also need to scrutinize whether the owner carries on a sufficient level of farming to demonstrate that a farming business has been commenced or is being carried on. The Agency would also require more information regarding the gross and net revenue streams of both the rented home and the XXXXXXXXXX operation.

Qualified Small Business Corporation Shares

If, in fact, the shares of XXXXXXXXXX are not a "share of the capital stock of a family farm corporation" as defined in subsection 110.6(1) of the Act and therefore, not "qualified farm property" such that subsection 110.6(2) (capital gains deduction for qualified farm property) does not apply, then one must look to see whether subsection 110.6(2.1) (capital gains deduction for qualified small business corporation shares) applies and whether the shares of XXXXXXXXXX are qualified small business corporation shares. The definition of "qualified small business corporation share" of an individual, in subsection 110.6(1) of the Act, in part, is generally as follows:

Qualified small business corporation share of an individual means a share of the capital stock of a corporation that:

a) at the determination time, is a share of the capital stock of a small business corporation owned by the individual, the individual's spouse or a partnership related to the individual;

b) throughout the 24 months immediately preceding the determination time, was not owned by anyone other than the individual or a person or partnership related to the individual; and

c) throughout that part of the 24 months immediately preceding the determination time while it was owned by the individual, or person or partnership related to the individual, was a share of the capital stock of a Canadian-controlled private corporation more than 50% of the fair market value of the assets of which was attributable to (i) assets used principally in an active business carried on primarily in Canada by the corporation or a corporation related to it... .

It is a question of fact, to be determined after a review of all relevant circumstances, whether an asset is used principally in an active business. The term "principally" is not a defined term in the Act. Generally, the Agency considers that an asset is used principally in an active business if its primary or main use is in respect of that business. The used principally test is applied on a property by property basis. The actual use to which an asset is put in the course of the business, the nature of the business involved and the practice in the particular industry are relevant in the determination of whether assets are used principally in an active business.

We cannot provide definitive comments as to whether the assets held or used by XXXXXXXXXX, particularly the parcels of land in Farm A and Farm B, are active business assets without the opportunity to review all the relevant facts. The comments made above with respect to the shares of the capital stock of a family farm corporation apply equally here. Again, based on the information available, there is some doubt as to whether there is a sufficient level of business activity to demonstrate that a business has been commenced or is being carried on.

Capital Gain Reserve

You are asking if you can claim all of the capital gains exemption resulting from the shares of XXXXXXXXXX for the XXXXXXXXXX taxation year even though you will be receiving payments for the sale of the shares over XXXXXXXXXX years. If you are entitled to claim the capital gains exemption in respect of a capital gain arising on the disposition of shares of XXXXXXXXXX, you could choose to report the entire capital gain (or at least the portion that can be fully offset by a capital gains deduction) in the year the disposition occurred. Subsection 40(1) of the Act contains rules for determining a taxpayer's gain from the disposition of capital property and the general rules for deducting a reserve related to the proceeds of disposition that are not due to the taxpayer until after the end of the taxation year. A reserve claimed in one year becomes the capital gain on the particular disposition for the next year under subparagraph 40(1)(a)(ii) of the Act and a new reserve on that capital gain may be available in that later year. However, if you wish to claim an offsetting capital gains deduction in the year the disposition occurred, you simply would choose not to claim a reserve (or a portion of the reserve), which is optional. We should point out, however, that since subsection 110.6(2.1) of the Act refers to dispositions of shares "in the year or a preceding year", a mechanism is available where you can claim an offsetting capital gains deduction as the reserves are reported as capital gains.

ABIL

Lastly, you are asking if after the sale of shares of XXXXXXXXXX, and if the loans to XXXXXXXXXX from you and Dr. A. Inc. are declared to be defunct by the investor, whether you and Dr. A. Inc. can claim ABILs. You are also asking if the ABIL can be applied directly against your regular income and against that of the corporation, Dr. A. Inc. and whether the losses can be carried back 3 years and carried forward 7 years. An "allowable business investment loss" is defined in paragraph 38(c) of the Act as 3/4 of a "business investment loss" as defined in paragraph 39(1)(c) of the Act. To qualify as a business investment loss, an amount must first be a capital loss. In calculating income pursuant to section 3, an ABIL is not deducted from taxable capital gains under paragraph 3(b) of the Act but is deducted from all sources under paragraph 3(d) of the Act. Generally, any ABIL that cannot be deducted in the year it arises is treated as a non-capital loss as defined in subsection 111(8) of the Act. A non-capital loss may be carried back three years and forward seven years and deducted in calculating taxable income of such other years. Normally, an ABIL that is not deducted as a non-capital loss by the end of the seventh year of its carry-forward period becomes a "net capital loss" in that seventh year. This treatment allows the loss to be carried forward indefinitely to be deducted against taxable capital gains beginning in the eighth year.

A taxpayer's business investment loss may arise from the disposition of a share of a corporation that is a small business corporation; or a debt owing to the taxpayer (with one exception discussed below) by a Canadian-controlled private corporation ("CCPC"). A debt owed to a corporation by a non-arms length corporation is excluded from debts owing to a taxpayer from a CCPC and therefore any capital loss arising from such a disposition will never qualify as a business investment loss. For a loss on the disposition of a share of a corporation that is a small business corporation or a debt owing to the taxpayer by a CCPC, the disposition must be to an arm's length person or be deemed to have occurred under subsection 50(1) of the Act. The term "small business corporation" is defined in subsection 248(1) of the Act. In general, a small business corporation is a CCPC all or substantially all (90% or more) of the fair market value of which is attributable to assets used principally in an active business carried on primarily in Canada; or shares or debts of connected small business corporations or a combination of the two. In order for a business investment loss to arise on the disposition of a debt owing to a taxpayer by a CCPC, the CCPC has to be a small business corporation; a bankrupt (as defined by the Bankruptcy and Insolvency Act) that was a small business corporation when it last became a bankrupt; or a corporation referred to in section 6 of the Winding-up Act that was insolvent (within the meaning of the Act) and was a small business corporation at the time a winding-up order under that Act was made for that corporation.

Paragraph 6 of IT-484R2, Business Investment Losses, (copy enclosed) discusses the application of subsection 50(1) of the Act. Subsection 50(1) of the Act deems a taxpayer to have disposed of a debt at the end of a taxation year for nil proceeds and to have reacquired it immediately thereafter at a cost of nil if, in the case of a debt (other than a debt from the sale of personal use property), the debt is owing to the taxpayer at the end of the taxation year and it is established by the taxpayer to have become a bad debt in the year. If subsection 50(1) applies, the taxpayer is deemed to have disposed of the property for nil proceeds and a capital loss will arise. If the debt is owed by a CCPC (except for a debt owed to a corporation by a non-arm's length corporation) or the share is a share of a small business corporation, the loss will be considered to be a business investment loss.

The time at which a debt becomes a bad debt is a question of fact and any decision made must be dependent upon the circumstances in each case. A determination by a creditor that a debt has become bad in a particular taxation year must be supported by all relevant and material facts. Generally, a debt will not be uncollectible at the end of a particular taxation year unless the creditor has exhausted all legal means of collecting it or where the debtor has become insolvent and has no means of paying it. A debt is considered bad for the purpose of section 50 of the Act only when the whole amount is uncollectible or when a portion of it has been settled and the remainder is uncollectible.

Valuation of shares of XXXXXXXXXX

You have indicated that an investor has offered to buy the shares of XXXXXXXXXX for approximately $XXXXXXXXXX and that XXXXXXXXXX is indebted to Dr. A Inc. for $XXXXXXXXXX and to you for $XXXXXXXXXX. It is unclear to us how the fair market value of the shares of XXXXXXXXXX could be $XXXXXXXXXX when XXXXXXXXXX has debts totalling $XXXXXXXXXX. Pursuant to paragraph 251(1)(b) of the Act, it is a question of fact whether persons not related to each other deal with each other at arm's length. Accordingly, if the transaction between the investor and XXXXXXXXXX does not reflect commercial reality, it is possible that paragraph 69(1)(a) of the Act could apply to limit the investor's cost of the shares of XXXXXXXXXX to their fair market value. Furthermore, if XXXXXXXXXX still has assets after the sale of its shares to the new investor, it is unclear to us why the corporation's assets could not be used to pay off its debts to Dr. A Inc. and to you and it is unclear why the loans would be declared defunct if the corporation still has assets after the sale of the shares.

Without conducting a complete review of the situation, we cannot comment on whether the loans you and Dr. A. Inc. made to XXXXXXXXXX would be ABILs if after the disposition of the shares of XXXXXXXXXX, the purchaser of the shares subsequently declares the loans to be defunct. However, we would point out that in order to establish that a debt is bad (i.e., uncollectible) at the end of a particular taxation year, the creditor has to prove that it has exhausted all legal means of collecting the debt or that the debtor has become insolvent and has no means of paying it. In our view, to establish that a debt is uncollectible, it is not sufficient to simply indicate that the loan is defunct when in fact the corporation (XXXXXXXXXX) still has assets with which to pay the debt and the creditors have not exhausted all legal means of collecting the debt.

Based on the information provided, a more traditional transaction would generally have involved an investor purchasing the assets from the target corporation (this avoids the investor from being liable for the corporation's debts). The corporation would then use its proceeds to repay a portion of its debt. The remaining debt, assuming the target corporation is insolvent, should result in a capital loss to its non-arm's length corporate creditor and a business investment loss to the individual creditor (likely proportionately). Any structure to avoid these tax consequences would come under careful scrutiny by the Agency.

Summary

It appears that your request is more in the nature of a tax consultation and we have not addressed your request as such since the Agency does not provide tax planning advice. Considering the complexity of the issues involved with respect to the sale of shares of XXXXXXXXXX, we would suggest that you may wish to consult with a tax advisor. However, if you require additional information regarding your tax situation, we invite you to contact your local taxation service office.

We trust that the forgoing comments are of assistance to you.

Yours truly,

J. Wilson.

for Director
Business and Publications Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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