20 October 1994 External T.I. 9404575 - FARM & CAPITAL GAINS

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:

VARIOUS FARM & CAPITAL GAINS ISSUES.

Position TAKEN:

VARIOUS

Reasons FOR POSITION TAKEN:

DEPARTMENT'S POSITION.

		940457
XXXXXXXXXX 	W.P. Guglich
(613) 957-2102

Attention: XXXXXXXXXX

October 20, 1994

Dear Sirs:

Re: Farming Income Tax Issues

This is in reply to your letter of February 17, 1994, concerning the income tax consequences arising from the various scenarios which you have described.

Unless as otherwise stated all references to statute are to the Income Tax Act S.C. 1970-71-72, c.63 as amended consolidated to June 10, 1993 (the "Act").

You have described the following hypothetical situations:

1.Scenario One

Mr. A sells his farm assets to a newly formed partnership and then immediately sells his partnership interest to a child.

It is your view that the gain on the sale of the partnership interest would qualify for the enhanced capital gain exemption. You point out that where a taxpayer transfers to a corporation all or substantially all of the assets used in an active business subsection 54.2 of the Act provides that the shares received in consideration shall be considered capital property of the taxpayer. Although there is no similar provision respecting transfers to a partnership, it is your view that the rationale underlying section 54.2 of the Act should be equally applicable.

Our Views

To qualify as an "interest in a family farm partnership" as defined in subsection 110.6(1) of the Act the partnership must be in existence for at least 24 months. If the partnership is not in existence for at least 24 months it could not meet the "throughout any 24 month period ending before" condition in paragraph (a) of the definition. The expression "throughout any 24 month period" is in sharp contrast to the expression "that part of the 24 months" in the definition of "qualified small business corporation share". "That part of the 24 months" contemplates a period of 24 months or less. "Throughout any 24 month period" requires a 24 month period.

Section 54.2 ensures the transferor gets capital gains treatment on a sale of shares where the transferor had previously transferred all or substantially all of the assets used in an active business to a corporation for consideration that included shares of the corporation. To claim the enhanced capital gain exemption the shares would have to qualify as "qualified small business corporation shares" as defined in subsection 110.6(1) of the Act. Section 54.2 of the Act does not ensure enhanced capital gain exemption.

2.Scenario Two

Mr. A transfers a remainder interest in farmland to his children and retains a life estate therein.

Issue

What would the tax consequences be under section 43.1 of the Act if Mr A disposes of the life estate at some point in the future.

Our Views

We agree that unless subsection 73(3) of the Act applies on the transfer of the remainder interest, subsection 43.1(1) of the Act would deem Mr. A to have disposed of the life estate for proceeds of disposition equal to its fair market value at that time and to have reacquired the life estate immediately after that time at a cost equal to the same fair market value. As a result, Mr. A would be required to account for the capital gain on the whole property (remainder interest plus life estate) on the transfer of the remainder interest even though he has not disposed of the life estate.

If Mr. A disposes of his life estate during his lifetime, he would be required to account for any gains or losses on such disposition of property. The provisions of section 43.1 of the Act do not apply to such a disposition.

Where as a result of Mr. A's death, the life estate to which subsection 43.1(1) of the Act applied is terminated (the child would now own the whole property), subsection 43.1(2) provides that the holder of the life estate immediately before death shall be deemed to have disposed of the life estate immediately before death for proceeds of disposition equal to its adjusted cost base ("ACB") at that time. Thus no capital gain or loss would arise in respect of such disposition.

Where Mr. A is the holder of the life estate immediately before death paragraph 43.1(2)(b) would apply in determining the child's ACB of the whole property.

3.Scenario Three

Mr. A, who has farmland which has appreciated in value, wishes to crystallize his capital gains and therefore proposes to transfer the land into a corporation or partnership at fair market value. The farmland may in future years be withdrawn from the corporation or partnership and specific land would be distributed to individual children.

Issue

Your general concern is that the subsequent withdrawal of the farmland would have an impact on the capital gains exemption on the original transfer, in particular you refer to the application of section 245 of the Act.

Our Views

The eligibility to the capital gains exemption respecting the original transfer of farmland to the corporation or partnership would be dependent on all the facts and details of the specific case. We are unable to express an opinion on the application of section 245 of the Act without a description of all the facts and details in the case.

4.Scenario Four

Mr. A owns farmland which he has used in the business of farming. He wishes to transfer this land to a family farm corporation. Specifically, Mr. A proposes to transfer part of his farmland to his children pursuant to subsection 73(3) of the Act. Shortly thereafter, Mr A and the children would transfer their land to the corporation thereby crystallizing the capital gains.

Issue

Your concern is that Mr A and the children be entitled to claim their respective capital gains exemption.

Our Views

Each person's entitlement to claim the capital gains exemption will be dependent on the farmland qualifying as a "qualified farm property" of the individual as defined in subsection 110.6(1) of the Act. Provided the farmland was owned throughout the period of at least 24 months immediately preceding that time (that time being the time of the transfer to the corporation) by the specific child, the child's spouse, or parent there is no further requirement that the child must also meet the minimum 24 month ownership period in subsection 110.6(1) of the Act. However, the conditions in clause (A) or (B) contained in the definition of "qualified farm property" in subsection 110.6(1) of the Act must be met.

The issue of whether the children act as principals or as agent of Mr. A on the transfer of the land to the corporation would be dependent on the specific facts and details of the case. The length of the children's holding period, whether the children are shareholders of the newly created corporation and whether they are actively involved in the farming operation may be factors in this determination. In making the determination, all the facts and details of the specific case would need to be considered.

5.Scenario Five

Mr. A raises purebred cattle. The cattle have a cost base of zero and a fair market value ("FMV") of $100,000. It is your view that a portion of the FMV (eg. $25,000) is attributable to goodwill derived from the reputation of Mr. A as a purebred cattle breeder. This value is determined as the amount by which the FMV of Mr. A's cattle exceeds the FMV of other commercial pure bred cattle.

Issue

Mr. A proposes to transfer his cattle inventory to his corporation in two components namely; $75,000 cattle inventory and $25,000 goodwill component thereby crystallizing his capital gain on the goodwill.

Our Views

There appears to be a valuation aspect to this question which we are not prepared to comment on. In our view, in the situation you described, paragraph 69(1)(b) of the Act would apply resulting in Mr. A being deemed to have received proceeds of disposition equal to the FMV of the cattle which in this case would be $100,000.

With respect to goodwill paragraphs 5 and 6 of IT-143R2 state:

5. The Courts have referred to several definitions of goodwill, two of which are:

(a) "Goodwill is the whole advantage, whatever it may be, of the reputation and connection of the firm which may have been built up by years of honest work or gained by lavish expenditures of money".

(b) It is "the privilege, granted by the seller of a business to the purchaser, of trading as his recognized successor; the possession of a ready-formed `connection' of customers, considered as an element in the saleable value of a business, additional to the value of the plant, stock-in-trade, book debts, etc.".

6. Goodwill cannot be divorced from the business itself. It follows the business, and may be sold with the business, but it cannot be sold separately. Generally, goodwill arises as a recognizable asset only when a business is acquired at a price in excess of the value, as a going concern, of its net assets.'

Mr. A would therefore only be able to crystallize a capital gain on the goodwill, if it is sold with the business.

6.Scenario Six

Mr. A owns farmland which he has been renting for a number of years. Mr. A wishes to transfer the land to his children pursuant to subsection 73(3) of the Act.

Issues

What period of time would Mr. A or his children have to be engaged in the business of farming to satisfy the requirement in subsection 73(3) of the Act. Would the requirement be met if immediately before the transfer Mr. A or his children commenced to use the land in a farming business for a short period of time?

Our Views

Subsection 73(3) of the Act requires inter alia, that the property, before the transfer, must be "used principally in the business of farming in which the taxpayer, the taxpayer's spouse or any of the taxpayer's children was actively engaged on a regular and continuous basis".

There is no time period specified in subsection 73(3) of the Act. However, the term "actively engaged on a regular and continuous basis" negates a short term and suggests that the shorter the term the more difficult it would be to qualify. Regular suggests a pattern of activity and continuous suggests a continuity of that activity. Consequently, in a short period it may not be possible for a taxpayer to establish that he qualifies. In specific situations the determination will be made on the basis of the facts and details of the particular case.

In regard to the reference to the property being "used principally in the business of farming, the property will meet this test where its use is primarily in the business of farming. That is, more than 50% of the asset's use must be in the business of farming.

7.Scenario Seven

Mr. A has purchased some purebred cattle. Under the mandatory inventory adjustment in paragraph 28(1)(c) of the Act he is precluded from creating a loss by purchasing cattle inventory at year end.

Issue

If the cattle are transferred to a partnership pursuant to subsection 97(2) of the Act, would the income inclusion under paragraph 28(1)(c) of the Act be avoided?

Our Views

The Department of Finance "Technical Notes" indicate that subparagraph 85(1)(c.2)(i) was enacted in part to prevent the avoidance of the mandatory inventory adjustment under paragraph 28(1)(c) of the Act on a transfer of purchased inventory by a taxpayer to a partnership pursuant to subsection 97(2).

You have assumed for purposes of paragraph 28(1)(c) of the Act that the loss is $30,000 and the value of the purchased inventory was $70,000. Therefore pursuant to paragraph 28(1)(c) of the Act the mandatory inventory adjustment under paragraph 28(1)(c) by the taxpayer would have been $30,000. Pursuant to paragraph 85(1)(c.2) of the Act the partnership's cost would be $30,000 and this is the amount that would for purposes of subsection 28(1.2) be considered the amount paid for that part of the partnership cattle inventory. If at the year end or a subsequent year end the above cattle inventory was still owned by the partnership, its value, for purposes of subparagraph 28(1)(c)(ii) of the Act, would be determined using in subsection 28(1.2) the amount paid {i.e., as determined under paragraph 85(1)(c.2)} referred to above.

8.Scenario Eight

Mr. A wishes to sell his partnership interest in a family farm partnership to his children. The adjusted cost base ("ACB") of his partnership interest is negative.

Issue

1.Can recognition of the capital gain be deferred by transferring the partnership interest to the children under subsection 73(4) of the Act for proceeds of disposition equal to the negative ACB?

2.Can Mr. A sell his partnership interest to a corporation and shelter the entire gain with the $500,000 exemption?

Our Views

1.We agree that subsection 40(3) of the Act does not apply to partnership interests. However, subsection 40(1) of the Act would apply in calculating the gain where a partnership interest with a negative ACB is disposed of. The deemed proceeds under subsection 73(4) of the Act and the resulting gain under subsection 40(1) would be computed as if the ACB of the partnership interest was nil. In addition subsection 100(2) of the Act would also apply. Therefore in computing Mr. A's gain on the disposition of his partnership interest he would have to include the amount determined under subsection 100(2) of the Act (that is the aforementioned negative ACB), in addition to the amount normally computed under subsection 40(1). Please refer to the comments in paragraph 25 of IT-268R3.

2.Our comments above respecting subsections 40(1) and 100(2) of the Act would also apply to a transfer of a partnership interest to a corporation.

9.Scenario Nine

Mr. A is a partner in a farm partnership. He has a $100,000 farming loan which is held in his personal name. The deductible interest expense has resulted in a growing CNIL account thus limiting his ability to claim his capital gain exemption. Therefore Mr. A proposes to transfer the debt into the partnership. To do so, the partnership borrows $100,000 for business purposes. Mr. A then takes a $100,000 drawing from the partnership which he uses to repay his personal loan.

Issue

You asked whether Revenue Canada would have any concerns with this transaction.

Our Views

There may be some concern as to the bona fide nature of the loan for business purposes. We are unable to comment further as you have not indicated the specific provisions of the Act that may concern you.

10.Scenario Ten

Mr. A and Mr. B operate a farm partnership. This partnership is dissolved and Mr. A and Mr. B each receive an undivided interest in each partnership asset including farmland. They jointly elect under subsection 98(3) of the Act to transfer the property on a tax free basis. Mr. A and Mr. B wish to have separate interest in the property.

Issue 1

Can Mr. A and Mr. B separate their interests in the property without tax consequences pursuant to subsections 248(20) and 248(21) of the Act in view of the requirement in subsection 98(3) that the partners receive an undivided interest.

Issue 2

Do subsections 248(20) and 248(21) of the Act apply to land only?

Our Views

Subsection 248(20) does not provide a mechanism for pro-rata distributions of partnership property. Subsection 248(20) clarifies the tax consequences of the partition of property previously owned jointly by two or more persons. For certain tax purposes including the computation of income, it is the Department's view that a partnership and not its partners is the owner of property used in the partnership. Accordingly, the joint ownership test in subsection 248(20) would not be met on a distribution of partnership property. On the other hand, subsection 98(3) requires that each partner be distributed an undivided interest in each property of a Canadian partnership which has ceased to exist. Any partition of such property which becomes jointly owned by the former partners after the distribution will be subject to the application of subsection 248(20). It is a question of fact as to whether all the requirements of paragraph 248(21) are satisfied so that it applies.

Subsections 248(20) and 248(21) may apply to any property, not otherwise excepted therein, that is the subject of a partition.

11.Scenario 11

A family farm corporation owns shares in a grazing corporation.

Issue

Will the shares in the grazing cooperative corporation be considered to be qualifying assets for purposes of the 90% test requirement under the capital gains exemption rules?

Our Views

Subparagraph (b)(i) of the definition of "share of the capital stock of a family farm corporation" in section 110.6 of the Act requires that in order to qualify all or substantially all of the fair market value of the corporation's property at that time was attributable property that was used principally in the course of carrying on the business of farming in Canada by the corporation or a person or partnership referred to in subparagraph (a)(i). The "used principally" test is a question of fact to be determined on the basis of the facts and details respecting the particular property. Ownership of a farm related property is not sufficient. It is the use of that property that is relevant.

Subparagraph (b)(ii) requires that all or substantially all of the fair market value of the property of the grazing cooperative corporation was attributable to property that was used principally in the course of carrying on the business of farming by the grazing cooperative corporation.

In order that the shares of the grazing cooperative corporation may be considered qualifying assets of the family farm corporation the grazing cooperative corporation must itself meet the used principally and the all or substantially all tests.

We trust our comments will be of assistance.

Yours truly,

for Director
Business and General Division
Rulings Directorate
Policy and Legislation Branch