4 April 1990 Income Tax Severed Letter 90M04441 F - Taxation Issues of Family Companies

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.

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April 4, 1990

"Taxation Issues of Family Companies"

1. Qualified Small Business Shares; Corporate Reorganizations; Life Insurance

Fact Situation I:

In March, 1988 A started up a business in a building which he bought for the purpose.  The business immediately looked as if it would be successful and so he brought his two younger brothers, B and C, into it.  In August, 1988 A, B and C transferred everything but the building (which was still owned by A) into a new corporation, X Co. in which A owned 60% of the shares and B and C owned 20% each.  The three brothers entered into a buy-sell agreement under which the survivors had the option to buy the deceased's shares and the deceased's widow had the option to "put" his shares to the survivors.  They arranged for X Co. to purchase the insurance necessary to fund this agreement.

In July, 1989 A was diagnosed as suffering from a terminal illness and died in July, 1990.  Under his will all of his assets passed to his widow.

Questions:

1.     The normal rule is that to qualify for the $400,000 exemption in respect of shares they cannot have been owned by an unrelated person within the previous 24 months.  New shares issued by a corporation are deemed to have been owned by an unrelated person unless they were issued in exchange for substantially all of the assets used in an active business.  By retaining the building in his own name, has A denied himself the protection of this exclusion?

2.       Why isn't there an exception from the "2-year hold" rule in the case of death?  Even the press couldn't consider this a loophole of which the rich would try to take advantage!

3.a)     Are the shares of X Co. rolled over to Mrs. A on A's death? If the buy-sell agreement required that A's Estate must sell his X Co. shares and B and C must buy them, would there be a rollover?  In other words could it be said that the shares vested indefeasibly in the spouse?  Or, does Revenue Canada still take the view that the Parkes Estate case was properly decided.

b)      Had Mr. A died four months later, could his executors use his $400,000 exemption in his year of death?  The concern here is that while the insurance proceeds would not come into X Co. until after A's death the value of the insurance immediately prior to his death would exceed its cash surrender value with the result that it represents more than 10% of the assets in X Co.  If the insurance policy is not considered to be an asset used in carrying on an active business, then substantially all of X Co.'s assets would not be used in the business, and it would no longer be a qualified small business corporation.

4.     Assuming that the shares of X Co. do rollover on A's death to Mrs. A, can she use her $400,000 capital gains exemption when she sells the shares to B and C?  Or will the insurance proceeds have put X Co. "off side"? Even if the proceeds were paid out before the sale, she would not get the $400,000 exemption for 2 years if the proceeds represented over 50% of the total assets in X Co.

5.     If each of A, B and C had used a holding corporation to hold his shares of X Co. and also to hold his insurance on the lives of the others, could Mrs. A trigger a $400,000 capital gains exemption by transferring the holding corporation shares in September 1990 and only subsequently, having the holding corporation transfer the shares of X Co. to the other corporations?

6.     It may be attractive to try to use both A's and Mrs. A's $400,000 exemption.  Could Mrs. A, as A's executor, elect out of the rollover to her in respect of some of his X Co. shares and not others?  Is each share a separate property for purposes of subsection 70(6.2)?

Fact Situation II:

The fact situation is the same as I, except that:

(i)     A had transferred the building to X Co. at the beginning, but

(ii)     no insurance or buy-sell agreement was in place at his death.

B, C and Mrs. A agree that they would like to distribute the building to Mrs. A in satisfaction of the 60% interest in X Co. which she inherited from A.  The building represents 60% of X Co.'s total assets.

Questions:

1.     May the building be "butterflied" to a new corporation controlled by Mrs. A?

2.     If the answer to Q. 1 would be "yes", because the building and the other assets of X Co.  were all business assets, would the answer be different if two months before A died, X Co. moved to rental premises and leased the building to an arm's length tenant? Or would the butterfly rules not apply here because:

(i)     the building is now an investment property and a pro rata portion is not being distributed to each shareholder, as required to meet the exclusion under paragraph 55(3)(b), and

(ii)     the parties cannot rely upon the non-arm's length exemption in paragraph 55(3)(a), since the brothers are deemed to deal with each other at arm's length for purposes of the butterfly rules and Mrs. A ceases to be related once A dies?

3.     Suppose, faced with the fact that the reorganization described in Q. 2 could not be accomplished tax-free, A redrew his will before he died to name his father, F, as his executor and left his shares of X Co. to a spouse trust for his wife.  Could F, who doesn't deal with B or C at arm's length, carry out a butterfly using the non-arm's length exemption?

4.     A non-arm's length butterfly is not exempt under paragraph 55(3)(a) if it leads to the sale of assets to an arm's length person.  Does this mean any sale in the future or simply one that was specifically contemplated when the butterfly began?  In our facts, A's executor was not certain whether he would hold on to the building or sell it when the butterfly was carried out.

2. Salaries, Bonuses, Use of Corporate Assets

Questions:

1.     Does Revenue Canada consider that there is any limit on the size of bonus which the sole owner/manager of a corporation may pay to himself?

2.     Does Revenue Canada have any guidelines as to what is reasonable for salaries for members of the family, e.g. spouses who come in once a week to sign cheques or children who have summer jobs at the company?

3.     Revenue Canada has said that, except in the case of a corporation used solely to hold a U.S. personal-use residence, when a corporation allows a shareholder to have the use of a corporate-owned asset, the shareholder must pay market rental. Where the market rental is not easily ascertainable, he must pay a percentage of value.  This may be appropriate where the company bought the property with retained earnings.  Where, though, the shareholder contributed the capital to acquire the asset, could one look at the advantage gained by the shareholder to determine the benefit and not to a return on the value of the property?  In other words, compare the difference in the cost to the shareholder of owning the asset personally with the cost to him of having the corporation own it.

4.     While Revenue Canada stated at the 1989 Round Table that there has been no change to the rules regarding corporations set up to hold U.S. personal-use real estate, we keep hearing rumours that Revenue Canada now takes the position that these rules do not apply where the Canadian previously owned the property and transferred it to his company.  Is this rumour correct?

3. Pension Fund Investments

Questions

1.     Is either the Department of Finance or Revenue Canada aware of any situation in which a small business has attempted to access funds in RRSPs or pension plans by way of Small Business Investment Corporations, Small Business Investment Trusts or Small Business Investment Limited Partnerships?  Is it possible that more direct access to these funds could be introduced?

JMF/tw

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