Section 84.1

A CRA response at the 2005 APFF Roundtable (2005-0141061C6) dealt with the situation where Mr. X, an arm’s length shareholder owning 20% of the shares of OPCO (a private corporation), accomplished a sale of his shares so as to produce capital gains treatment as a result of OPCO subscribing $200,000 in cash for shares of a Newco (Subco), with Subco then buying the OPCO shares of Mr. X for such cash. CRA confirmed that its position that the individual potentially could realize the capital gain did not depend on there being a s. 87 or 88 merger of Newco and the corporation. The assumption of there being no merger was “aimed at situations that could involve taxpayers who, for example, would be tempted to use tax base created between Opco and Subco in an abusive manner.”

Would the capital gains deduction be available to an individual who disposes of all of the shares of "Opco") to another corporation ("Sonco") held by the individual’s adult son, in consideration for a 10-year interest-bearing note payable over 10 years/ CRA stated:

[A]ll the conditions for the application of subsection 84.1(1) would be satisfied … [thereby] result[ing] in a dividend rather than a capital gain … .

CRA largely repeated a statement made at the 2016 APFF Roundtable, Q.20 (also in response to the Poulin decision) respecting employee buyco arrangements, that the employee buyco could be established to be an accommodation party and, thus, not dealing at arm’s length with the employee-shareholder vendor, where, for example:

• the employee-buyco assumes no economic risks;
• the employee-buyco does not benefit from acquiring the Opco shares;
• the employee-buyco has no interest other than to enable the employee-shareholder to realize a capital gain and benefit from the capital gains deduction; or
• the employee-buyco has no role independent of the employee-shareholder or the operating corporation.

CRA went on to state that this position is consistent with its discussion at the 2012 Annual Conference.

CRA accepts the finding in Poulin that the structuring of a sale transaction so that the vendor secured a tax advantage (the capital gains deduction) “does not mean that the parties acted in concert without separate interests.” Respecting the accommodation party aspect of that case, it stated:

Hélie Holdco… incurred no economic risk in participating in the transaction, did not derive any benefit from the purchase of shares, had no interest other than to allow the employee/shareholder to realize a capital gain and benefit from the deduction, and had no function independent of the employee/shareholder or the operating corporation - and, in short, it only participated in the transaction as an accommodation for the benefit of the employee/shareholder.

In rejecting a submission that 2015-0610711C6 had improperly reversed 2005-0134731R3 F on the basis that the purpose of section 84.1 is only “to prevent persons from monetizing their lifetime CGD outside the context of an actual sales transaction occurring on a market basis,” whereas 2015-0610711C6 “involved a taxpayer who, with a view to retiring, embarked on a process of business succession with a family member similar to one that could be undertaken with an arm's length third party…[so] that the purpose of section 84.1 was not circumvented.,” CRA indicated that the purpose of s. 84.1 was stated more broadly in the Explanatory Notes and in Descarries, and added:

[W]e understand your concerns about the application of section 84.1 in the context of an intergenerational transfer of a family business between a parent and children. Nevertheless, the mandate of the Canada Revenue Agency is to administer the Act as drafted… .

In 2005-0134731R3 F, Mr. X realized a capital gain of selling all of the common shares of HOLDCO to his children in consideration for promissory notes, but did not claim the capital gains deduction (“CGD”) under s. 110.6(2.1). On a redemption by HOLDCO of all of the HOLDCO preferred shares owned by Mr. X, which had nominal paid-up capital (“PUC”) and a high adjusted cost base (“ACB”) as a result of a previous crystallisation of the CGD, Mr. X realized a deemed dividend and a capital loss. A portion of the capital loss was applied to offset the capital gain that arose on the earlier sale of the HOLDCO common shares to the children.

Following the Descarries decision (2014 TCC 75) would CRA still issue such a ruling? CRA responded:

In Descarries…the individual shareholders of…OKA… exchanged their OKA shares for shares of another corporation (“NEWCO”), some of which (the “NEWCO V-day Shares”) had low PUC and a high ACB equal to the FMV of the OKA shares on V-Day (December 22, 1971). As a result, the V-Day value of the OKA shares became isolated/crystallized in the ACB of the NEWCO V-day Shares.

The NEWCO V-day Shares were repurchased, giving rise to a deemed dividend to the individual shareholders as well as a capital loss that was applied to offset a capital gain realized earlier in the same series of transactions. ...

The [2005-0134731R3] transactions result in the extraction of corporate surplus as capital gains. Furthermore, such capital gains are offset or reduced by capital losses realized on a disposition of shares whose ACB was increased by the CGD or V-day value.

In these circumstances and based on the Descarries decision, the CGD or the V-day value has been used to enable corporate surplus to be distributed to the shareholders tax-free, in a manner contrary to the object, spirit and purposes of section 84.1.

An estate of B, and a spousal trust for which B had been the spouse, which on death acquired (Class F) preference shares of a portfolio investment company (Investmentco) at a stepped-up tax cost, will effectively step-up the paid-up capital of their shareholdings by selling their its preference shares to a Newco for Newco preference shares with a high PUC. After a specified period, Newco will amalgamate with Investmentco, and the estate will start gradually retracting its (high PUC/basis) preference shares.

Ruling respecting non-application of s. 84.1 to the transfer of the preference shares.

See detailed summary under s. 84(2).

Employees of Opco received Opco shares as incentives under an Opco employee share ownership plan ("ESOP"). Under the terms of the ESOP, on retirement or other termination of employment, the employees would be required to dispose of these shares. To facilitate the disposition of such shares on retirement or other termination, Opco incorporates another corporation ("Buyco"), and Buyco purchase the departing employee's Opco shares. CRA stated:

[G]iven the degree of accommodation provided by Buyco to the departing employees and the parties' lack of separate interests, the better view is that the employees and Buyco are generally not dealing at arm's length. This view is consistent with several of our published documents (2007-0243171C6, 2002-0166655, and 2004-0103061E5) as well as the jurisprudence (Petro-Canada v. The Queen (2003 DTC 94) (confirmed by the Federal Court of Appeal (2004 DTC 6329)) and RMM Canadian Enterprises Inc. et al. v. The Queen (97 DTC 302)). Accordingly, in ruling requests on this type of transaction, considered in 2012, we refused to confirm that section 84.1 would not apply to deem employees to receive a dividend from a Buyco on the disposition of their Opco shares.

A and B are Canadian-resident spouses who have not utilized their capital gains exemption and who each hold 50 Class A shares (the only issued and outstanding shares) of their family farm corporation ("Milkco," a CCPC which has carried on a dairy farming business for 20 years) having an fair market value of $500,000 an adjusted cost base and paid-up capital of $50, and qualifying under s. 110.6(1) as shares of the capital stock of a family farm corporation. They also each hold a 1/2 "interest in a family farm partnership" as defined in s. 110.6(1), namely, in a general partnership (“Grainco”), which has operated a cereal growing farm for three years, with each such 1/2 interest having an ACB of $50.

A and B each roll their shares of Milkco into Grainco for additional partnership interests in Grainco.

Five years later, after the FMV of the interests in Grainco have appreciated to $1.5 million and such interests continue to qualify as interests in a family farm partnership, A (and then B several days later) transfers his or her partnership interest in Grainco to a newly-incorporated corporation (“Holdco,” or "Managementco") - in which each of A and B holds common shares with an ACB of $50) in consideration for a note receivable of $750,000 and claims the capital gains exemption. As Grainco now only has one partner (Holdco), it is dissolved by operation of law (with a view to the application of s. 98(5).)

In noting that s. 245(2) could apply on the basis of an abusive avoidance of s. 84.1, CRA stated:

With respect to the potential application of section 84.1 to the transactions described above, we are of the view that this provision could be applicable, in particular, where, for example, the legal existence of the partnership is not recognized or the partnership acts as agent or nominee for the ownership of shares of the capital stock of a corporation. Thus, if the legal existence of Grainco could be called into question or if the latter acted as an agent of A and B, section 84.1 could apply to the disposition of the shares of the capital stock of Milkco to Holdco. …

[A]s noted in the Explanatory Notes of the Department of Finance, section 84.1 is “an anti-avoidance rule designed to prevent the removal of taxable corporate surplus as a tax-free return of capital through a non-arm’s length transfer of shares by an individual resident in Canada to a corporation.” A scheme that allows an individual to strip a private corporation of its surpluses through a reorganization that would result in indirect holding of its shares through a partnership appears to circumvent the application of section 84.1. …

[A]llowing a taxpayer, other than a corporation, to carry out a reorganization allowing a change in ownership of the shares of a private corporation by transferring them to a partnership in order to subsequently dispose of the partnership's interest to another corporation with which the taxpayer does not deal at arm's length could be a stratagem to strip the surplus of a corporation and circumvent section 84.1.

Where shares with a high PUC and low ACB are transferred by an individual under s. 85(1) to Holdco for shares with the same high-low attributes, s. 84.1(1) takes precedence over s. 85(2.1), so that a "grind" of paid-up capital will not occur under the s. 85(2.1) formula given the satisfaction of all the conditions for the application of s. 84.1(1), even though the grind under s. 84.1(1)(a) is nil (i.e., s. 84.1 is still considered to "apply" in that circumstance).

Scenario (a)

Mr. X, who holds all of Opco, exchanges all of his Opco common shares for retractable preferred shares of Opco. Mr. X then subscribes to 65% of the common shares of Opco, and a newly-incorporated corporation held by key employees (“Employeeco”) subscribes to 35% of the common shares of Opco. Mr. X disposes of 35% of his preferred shares to Employeeco, with Employeeco paying the purchase price by retracting the preferred shares so acquired by it.

Scenario (b)

Employeeco uses funds borrowed from a financial institution to acquire the 35% of the Opco common shares held by Mr. X, with the loan being repaid out of dividends paid out of future profits.

Scenario (c)

Same as (b) except that the purchase price is owing by Employeeco to Mr. X until paid off out of OPco dividends.

Scenario (a)

CRA indicated that (similarly to 2014 APFF Roundtable, Q. 2.4) it did not appear that Employeeco had a separate economic interest in acquiring the Opco preferred shares held by Mr. X, other than to accommodate Mr. X, and that the funds required for this acquisition would invariably come from Opco, which was and would continue to be controlled by Mr. X. Accordingly, it was “very likely that Mr. X and Employeeco would not, factually, be dealing at arm's length in respect of Mr. X's disposition of the Opco preferred shares” so that a dividend would be deemed to be paid by Employeeco to Mr. X under s. 84.1(1)(b). As a secondary position, CRA would consider applying s. 245(2) on a surplus-stripping rationale.

Scenarios (b) and (c)

CRA stated that “nothing would lead us to believe, at first glance, that Mr. X and Employeeco would not be dealing with each other at arm's length’ given that “Employeeco seems to have a separate economic interest in acquiring 35% of the common shares of the capital stock of Opco from Mr. X and such transaction does not seem to have been effected to accommodate Mr. X” so that’s. 84.1(1) would probably not apply. A review of s. 245(2) would require more facts.

Under transactions in which Mr. A sells a portion of his shares of a family farm corporation ("Farmco") to a newly incorporated subsidiary ("Xco") of an unrelated individual (Mr. X) for a cash consideration of $500,000 which Mr. A then lends to Farmco, with Farmco using the loan proceeds to redeem the Farmco shares held by Xco, would be considered to be non-arm's length transactions that were subject to s. 84.1(1)(b). Such transactions also could be subject to s. 245(2).

A farming partnership between a husband and wife transfers its business to a newly-incorporated corporation ("Opco") whose common shares are held by the husband and wife and which issued promissory notes and preferred shares in consideration for the acquired business. Later, the husband and wife transfer their partnership interests in the partnership to a Newco for consideration that includes a note with a principal amount that is in excess of the adjusted cost base of the transferred partnership interest by $500,000 each, and receives redeemable retractable preferred shares for the balance of the consideration.

Respecting whether s. 84.1 would apply to the transfer of the partnership interests, the Agency questioned the validity of the partnership following the transfer of its business to Opco and also indicated that the application of s. 245 to the series of transactions would be considered.

Mr. and Mrs. A, and Mr. and Mrs. B, hold 26%, 12%, 26% and 12%, respectively of the common shares of a small business corporation (“OPc”) and two unrelated individuals (X and Y) each hold 12% of the Opco shares. X and Y incorporate “Xyco,” roll their Opco shares into Xyco and Xyco uses a bank borrowing to fund the purchase of the Opco shaes of Mrs. A and Mrs. B. If Xyco and Opco do not amalgamate, Xyco will service its debt through dividends on its Opco shares.

In indicating that s. 84.1 may apply, CRA stated:

While there may be arm's length bargaining concerning the price to be paid for the shares of Opco, the shareholders appear to be acting in a highly interdependent manner to avoid tax on the transactions. In our view, Xyco may be viewed as merely accommodating the shareholders by structuring the transactions in this manner, since it does not appear to have any independent interest in acquiring the shares of Opco.

A partnership that transfers shares will be considered to be a person and a taxpayer for purposes of s. 84.1.

RC's practice is to apply s. 84.1 where the conditions for its application are present given that its provisions do not give RC any administrative discretion in its application. Accordingly, s. 84.1 will apply where a son of the taxpayer incorporated a holding company which purchased the taxpayer's shares for a promissory note payable over a ten-year period even when it is clear that the purchase price was equal to the fair market value of the shares and the purchased corporation had minimal retained earnings.

The sale by Mr. and Mrs. A of all the shares of Holdco to a corporation owned by their daughter and son-in-law in consideration for a promissory note bearing a commercial rate of interest gives rise to a deemed dividend under s. 84.1(1)(b) equal to the amount by which the principal amount of the promissory note exceeds the greater of the paid-up capital of the shares of Holdco and their adjusted cost base.

An estate which acquires shares of a deceased person under a testamentary trust acquires the shares from a person with whom it was not dealing at arm's length.

s. 84.1 does not apply to the disposition by an individual of 1/2 of his common shares of Opco to Opco in exchange for preference shares of Opco because the common shares of Opco would not thereby be disposed of to another corporation.

Where a transferor has acquired a subject share from a non-arm's length individual, the amount of any capital gain realized by the non-arm's length individual on the disposition, which is exempt from taxation in Canada by virtue of an exemption contained in a treaty between Canada and another country, will not normally be a capital gain included in s. 84.1(2)(a.1)(ii).

An individual owns all the voting shares of a corporation ("Opco") and shares (including non-voting special shares) of Opco representing approximately 65% of the equity of Opco. A group of 20 arm's length employees own the balance of the non-voting special shares.

Ss.84.1(2)(b) and (e) would apply to deem the employees not to deal at arm's length with a new holding company ("Holdco") to which all the shareholders of Opco transferred their shares in exchange for shareholdings in Holdco which mirrored their shareholdings in Opco notwithstanding that, in fact, only the one individual controlled Opco and Holdco.

S. 84.1(2.1) indicates that for purposes of the adjusted cost base reduction under s. 84.1(2)(a.1)(ii)) respecting a non-arm’s length transfer of shares by a resident individual to a corporation, where a capital gains reserve is claimed under s. 40(1)(a)(iii) by the individual or a non-arm's length individual (herein referred to as the "transferor") and it is possible for the transferor to claim the capital gains exemption (“CGE”), the CGE is deemed to be claimed by the transferor in the maximum amount irrespective of whether it is in fact claimed. Could the application of s. 84.1(2.1) result in a transferor (e.g., a father transferring to his children’s corporation) being deemed to have claimed CGE in the maximum amount where the transferor claims a capital gains reserve under s. 40(1)(a)(iii) but has no intention of claiming the CGE even though there is unused CGE room available?

For example, Father transfers shares of Opco (a small business corporation whose shares are eligible for the CGE) to his children in consideration for a note that is payable over 10 years, claims the capital gains reserve, but does not claim the CGE. The children transfer the Opco shares to a new Holdco in consideration for a note of Holdco, with a view to Opco dividends funding note repayments.

CRA indicated that it is irrelevant to the application of s. 84.1(2.1) that the transferor may have room that he wishes to retain for future use. S. 84.1(2.1) does not look to such plans for using the capital gains exemption, and effectively deems all the available room to be used. In the example, the children are deemed to receive a dividend on their receipt of the Holdco note.

CRA provided three examples illustrating the interrelationship between the s. 84.1(2) ACB adjustment, the amount of CGE actually claimed and the amount of unutilized CGE at the end of the year of the transfer.

Example 1

The non-arm’s length transferor realized a $100,000 capital gain, claimed a $50,000 reserve and claimed a $25,000 CGE while still having $25,000 unclaimed CGE at the year end. Result: the transferor is deemed to have claimed a CGE re the entire $100,000 capital gain.

Example 2

Same as example 1, except that the transferor had no unclaimed CGE at the year end – resulting in the CGE deemed to have been claimed only re $50,000 of the capital gains.

Example 3

Same as Example 1, except that the transferor had $10,000 of unclaimed CGE at the year end – resulting in the CGE deemed to have been claimed only re $70,000 of the capital gains.

Does the phrase “the amount in respect of which a deduction under section 110.6 was claimed in respect of the transferor’s gain from the disposition shall be deemed to be” deem a transferor to have claimed a capital gains exemption where a capital gains reserve is taken in respect of the disposition of shares to which section 84.1 applies, even where the transferor does not claim or intend to claim in the future any capital gains exemption in respect of the disposition?

CRA responded:

Subsection 84.1(2.1)…essentially treats the transferor as having claimed, to the extent that the transferor has unused capital gains exemption room in the year in which the disposition took place, a capital gains deduction on the disposition, irrespective of whether such exemption was actually claimed, because the reserve could potentially be eligible for a capital gains exemption when brought into income in the future. … [T]he effect…is to treat a capital gain on a property to be sheltered by the capital gains exemption when there is unused capital gains exemption room in the year of the disposition regardless of whether such capital gains exemption room has been saved to cover a capital gain that could be realized on a disposition of other properties in a subsequent year.