6 May 2004 External T.I. 2004-0057171E5 - Capital Gains Deferral

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: Taxpayer enquiry on whether existing shares & proposed replacement shares will qualify for the "small business investment" capital gains deferral where the original shares and the replacement shares are shares of farming corporations.

Position: Question of Fact - farming corporations may not qualify for such deferral.

Reasons: Subsection 44.1(10) excludes corporations where more than 50% of the FMV of property (net of related debts) is attributable to real property. Section 44.1 also contains a number of other conditions which must be met to qualify for the deferral.

		2004-005717
XXXXXXXXXX 	Karen Power, CA
(613) 957-8953
May 6, 2004

Dear XXXXXXXXXX:

Re: Capital Gains Deferral - Section 44.1

We are writing in reply to your facsimile of January 19, 2004, regarding the application of section 44.1 of the Income Tax Act (the "Act") to a specific situation.

The situation described in your letter was as follows:

1. The taxpayer, Mr. X owned XXXXXXXXXX common shares of XXXXXXXXXX ("Farmco"); XXXXXXXXXX of these shares were issued to Mr. X from treasury on XXXXXXXXXX. The remaining shares were acquired from Mr. X's father on XXXXXXXXXX.

2. Farmco has always been a Canadian-controlled private corporation as that term is defined in subsection 125(7) of the Act. Farmco operates a farming business in Canada.

3. In XXXXXXXXXX, Mr. X sold all of his common shares to a sister-in-law and a nephew at fair market value ("FMV"). Less than 50 per cent of the FMV of Farmco's property (net of debts incurred to acquire the property) was attributable to real property, at the time of the sale.

4. Mr. X intends to purchase, from treasury, the common shares of a newly incorporated Ontario corporation ("Newco") that operates an active farming business in start-up mode. The fair market value of Newco's total assets is approximately $XXXXXXXXXX. The majority of these assets are used in the farming business.

Our comments

The particular circumstances in your letter on which you have asked for our views appear to be a factual situation involving a specific taxpayer. As explained in Information Circular 70-6R5, it is not this directorate's practice to comment on transactions involving specific taxpayers other than in the form of an advance income tax ruling. As such, we are unable to definitively reply to your question until we have had the opportunity to review all the facts and related documentation. Such a review is conducted by the relevant tax services office where the query relates to a completed transaction, or by this directorate where the arrangement involves proposed transactions and is the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5. Although we cannot provide any specific comments with respect to the situation described in your letter, the following general comments may be of assistance.

Subsection 44.1(2) of the Act permits an individual that has a capital gain, determined without reference to section 44.1 of the Act, from a qualifying disposition in a taxation year to claim a permitted deferral of the individual in determining the individual's capital gain for the year from the disposition. Where the individual has a permitted deferral in respect of a qualifying disposition, the capital gain from the disposition is deemed to be the amount by which the individual's capital gain (determined without reference to section 44.1) exceeds the permitted deferral. The individual can establish a permitted deferral less than the maximum amount available by designating a lesser amount of replacement shares. In addition, under subsection 44.1(2) of the Act, the adjusted cost base to the individual of the replacement shares of the individual in respect of the disposition is reduced by the amount of the individual's ACB reduction in respect of such replacement shares. The terms "qualifying disposition", "permitted deferral", "replacement share" and "ACB reduction" are all defined in subsection 44.1(1) of the Act.

There are many restrictions and conditions to be met before taxpayers can avail themselves of the deferral of all or a portion of a gain from a qualifying disposition under subsection 44.1(2) of the Act. For example a "qualifying disposition" of an individual is defined in subsection 44.1(1) of the Act and refers to the disposition of a share that was an "eligible small business corporation share"("ESBC share") of the individual, and was throughout the period during which the individual owned the share, a "common share" of an "active business corporation" (these terms are discussed below). In, addition, the shares must have been owned by the individual throughout the 185-day period that ended immediately before the disposition. Subsection 44.1(9) also requires that the business be carried on primarily in Canada for at least 730 days (or throughout the ownership period if less than 730 days).

ESBC shares are common shares issued by a corporation to the individual, if at the time of the issue the corporation was an "eligible small business corporation", and the total carrying value of the assets (valued as per generally accepted accounting principles) of the corporation and corporations related to it did not exceed $50 million immediately before and after the issuance. A "common share" is defined as a share prescribed for purposes of paragraph 110(1)(d) of the Act (i.e., under section 6204 of the Income Tax Regulations).

In general terms, shares which have been acquired by an individual from purchase, otherwise than in situations described in subsections 44.1(4) to (7) of the Act, rather than from treasury are not eligible for the deferral provided in section 44.1 of the Act. Subsection 44.1(4) of the Act provides a special rule in cases where ESBC shares are acquired by an individual as a consequence of the death of a spouse, common-law partner or a parent of the individual. Paragraph 44.1(4)(b) of the Act essentially allows children to step into their parent's position for purposes of section 44.1 of the Act, with respect to shares of a family farm corporation where subsection 70(9.2) of the Act applied to the child on the parent's death. We have not been provided with sufficient information to determine whether subsection 44.1(4) of the Act would apply to the shares of Farmco acquired by Mr. X from his father, consequently we are unable to comment of whether these shares would be considered ESBC shares.

Under subsection 44.1(1) of the Act, an "eligible small business corporation" must be a Canadian-controlled private corporation (as defined in subsection 125(7) of the Act) where all or substantially all of the FMV of the assets is attributable to assets that are:

? used principally in an active business carried on primarily in Canada by the corporation or a related eligible small business corporation;

? shares or debt of other related eligible small business corporations; or

? a combination thereof.

Note that where the phrase "all or substantially all" is used, the Canada Revenue Agency has interpreted this to mean 90% or greater, and where the word "principally" is used the reference is to greater than 50%.

Under subsection 44.1(1), an "active business corporation" must be a taxable Canadian corporation (as defined in subsection 89(1) of the Act) where all or substantially all of the FMV of the assets is attributable to assets that are:

? used principally in an active business carried on by the corporation or by an active business corporation that is related to the corporation;

? shares or debt of other related active business corporations; or

? a combination thereof.

Subsection 44.1(10) provides a special rule for corporations that will not qualify as an eligible small business corporation or as an active business corporation and hence the owners of such shares cannot avail themselves of this tax deferral. The exclusions set out by subsection 44.1(10) are:

(a) a professional corporation;

(b) a specified financial institution;

(c) a corporation the principal business of which is the leasing, rental, development or sale, or any combination of those activities, of real property owned by it; or

(d) a corporation more than 50 per cent of the FMV of the property of which (net of debts incurred to acquire the property) is attributable to real property.

A farming corporation may in certain situations have more than 50 per cent of the net FMV of its property attributable to real property (land and buildings) and could not qualify as an eligible small business corporation or as an active business corporation by virtue of the exclusion cited above. You have indicated that at the time of disposition, less than 50 percent of the net FMV of Farmco's property was attributable to real property. However, as discussed above, to be entitled to the capital gains deferral, a taxpayer must have a "qualifying disposition". A "qualifying disposition" requires, inter alia, that throughout the period during which the individual owned the share, it must be a common share of an "active business corporation". Consequently, you would need to establish that throughout Mr. X's ownership period (and his father's ownership period if subsection 44.1(4), discussed above, applies), not more than 50 per cent of the net FMV of Farmco's property was attributable to real property, in addition to meeting the "all or substantially all" tests referred to above.

Subsection 44.1(1) describes the type of share that qualifies as a "replacement share" in respect of a qualifying disposition in a taxation year, as an ESBC share that is:

? acquired by the individual in the year or within 120 days after the year-end; and

? designated by the individual to be a replacement share in the individual's tax return for the year.

Once more, if greater than 50 percent of the net FMV of the replacement corporation's property is attributable to real property it cannot qualify as a "replacement share" (such may be the case with a farming corporation such as Newco). We also note that you indicate that the "majority" of Newco's assets are used in an active farming business. In this respect, it is unclear whether Newco meets the "all or substantially all" requirement of the definition "eligible small business corporation" discussed above (as the definition of replacement share refers to an ESBC share, which in turn refers to an eligible small business corporation). Finally, as you indicate that Newco is in start-up mode, you may which to refer to Interpretation Bulletin IT-364, Commencement of Business Operations, in determining whether the business has commenced, in which the corporation's assets are used.

We trust our comments will be of assistance to you.

Yours truly,

Milled Azzi, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Planning Branch