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September 1, 2020 | Blog
Non-Arm’s Length Sales of Shares
From tax expert Gerry Vittoratos
Section 84.1 – Non-Arm’s Length Sales of Shares
In the previous instalment of the blog, we spoke about estate freeze techniques. Within that instalment, we mentioned about the potential negative effects of section 84.1 of the ITA when performing an estate freeze. How does section 84.1 potentially penalize a taxpayer? What are the technical rules? This article will explain.
Section 84.1 Defined
Section 84.1 is an anti-avoidance rule [ITA 245] that was set up by the federal government to prevent what it deems as surplus stripping. The purpose is to prevent shareholders from withdrawing profits generated by the corporation through a tax-preferred return on capital instead of a taxable dividend. For example, an exchange of shares of an operating company to a holding company owned by related persons for the purpose of crystallizing the capital gains deduction.
Conditions
Here are the conditions that trigger section 84.1
Conditions |
|
1- |
Taxpayer resident in Canada (other than a corporation) |
2- |
Disposes of shares that are capital property of the taxpayer (“subject shares”) |
3- |
Shares disposed are capital stock of a corporation resident in Canada (“subject corporation”) |
4- |
Shares are acquired by another corporation (“purchaser corporation”) |
5- |
Taxpayer and purchaser corporation does not deal at arm’s length [ITA 251(1)/251(2)] (Note 1) |
6- |
Purchaser corporation and subject corporation are connected corporations after the transaction [ITA 186(4)] |
Note 1 – An extension of the definition of related persons and arm’s length [ITA 251(1)/251(2)] is applied for the purposes of section 84.1. A taxpayer will be deemed not to be dealing at arm’s length with the purchaser corporation if the taxpayer was, immediately before the disposition, one of a group of fewer than 6 people that controlled the subject corporation, and was, immediately after the disposition, one of a group of fewer than 6 people (same people as in the subject corporation) that controlled the purchaser corporation [ITA 84.1(2)(b)].
Consequences
As mentioned in the introduction, transactions that fall into the conditions above will be subject to the consequences mentioned below.
Decrease in the Paid-Up Capital on New Shares – ITA 84.1(1)(a)
The paid-up capital (PUC) of the new shares received in exchange of the old shares in an estate freeze is reduced by the following formula:
A – Increase, if any, determined without reference to this section as it applies to the acquisition of the subject shares, in the paid-up capital in respect of all shares of the capital stock of the purchaser corporation as a result of the issue of the new shares |
X
|
|
B – is the amount, if any, by which the greater of: (i) the paid-up capital, immediately before the disposition, in respect of the subject shares, and (ii) subject to paragraphs 84.1(2)(a) and 84.1(2)(a.1), the adjusted cost base to the taxpayer, immediately before the disposition, of the subject shares, MINUS: FMV of non-share consideration (boot) received
|
X or X
(X) |
(X) |
(A – B) |
XX |
|
Multiplied by: |
||
C - the increase, if any, determined without reference to this section as it applies to the acquisition of the subject shares, in the paid-up capital in respect of the particular class of shares as a result of the issue of the new shares |
XX
|
|
Reduction of PUC (A – B) x C |
XXX |
|
(A - B) × C/A
This reduction in PUC will increase the deemed dividend under ITA 84(3) in a case of a buyback of shares by the purchaser corporation in the future.
Deemed Dividend – ITA 84.1(1)(b)
Another consequence of this section is a deemed dividend, which is determined by the following formula:
(A + D) – (E + F)
A - is the increase, if any, determined without reference to this section as it applies to the acquisition of the subject shares, in the paid-up capital in respect of all shares of the capital stock of the purchaser corporation as a result of the issue of the new shares, |
X |
|
D - is the fair market value, immediately after the disposition, of any consideration (other than the new shares) received by the taxpayer from the purchaser corporation for the subject shares, |
X |
|
(A + D) |
XX |
|
LESS: |
||
E – Greater of: (i) the paid-up capital, immediately before the disposition, in respect of the subject shares, and (ii) subject to paragraphs 84.1(2)(a) and 84.1(2)(a.1), the adjusted cost base to the taxpayer, immediately before the disposition, of the subject shares,
|
X Or X |
X |
F – is the total of all amounts each of which is an amount required to be deducted by the purchaser corporation under paragraph 84.1(1)(a) in computing the paid-up capital in respect of any class of shares of its capital stock by virtue of the acquisition of the subject shares. |
X |
|
(E + F) |
(XX) |
|
Deemed Dividend (A + D) – (E + F) |
XXX |
|
The dividend deemed received can be a non-eligible, or an eligible dividend as long as the purchaser corporation has a general rate income pool (GRIP) balance [TI-2012-0454091C6].
Example case of Section 84.1 application
John Smith owns shares in Opco and wants to pass on his common shares to his successors. He would also like to crystallize his capital gains deduction on those shares. He decides to sell the shares in Opco to a holding company owned by his successors through the section 85 rollover (link) and receives preferred shares of Holdco in exchange. The transaction is as follows:
Common shares of Opco:
FMV= $100,000
PUC/ACB= $1,000
John wants, in exchange for his common shares of Opco, $90,000 worth of Holdco preferred shares, and $10,000 in cash. What are the consequences of this transaction?
If section 84.1 did not apply
PUC of new shares= FMV of new shares= ACB of new shares = $100,000
Capital gain of sale of old shares= $100,000 -$1,000 = $99,000*
*This amount would be exempt from taxation should Opco’s shares be qualified small business corporation shares at the time they’re sold.
Application of Section 84.1
Since the transaction meets the conditions listed above, this transaction will be subject to both a PUC reduction and a deemed dividend. Here’s the calculation of these amounts:
PUC Reduction
A – Increase, if any, determined without reference to this section as it applies to the acquisition of the subject shares, in the paid-up capital in respect of all shares of the capital stock of the purchaser corporation as a result of the issue of the new shares |
$90,000
|
|
B – is the amount, if any, by which the greater of: (i) the paid-up capital, immediately before the disposition, in respect of the subject shares, and (ii) subject to paragraphs 84.1(2)(a) and 84.1(2)(a.1), the adjusted cost base to the taxpayer, immediately before the disposition, of the subject shares, MINUS: FMV of non-share consideration (boot) received
|
$1,000 or $1,000
($10,000) |
0 |
(A – B) |
$90,000 |
|
Multiplied by: |
||
C - the increase, if any, determined without reference to this section as it applies to the acquisition of the subject shares, in the paid-up capital in respect of the particular class of shares as a result of the issue of the new shares |
$90,000
|
|
Reduction of PUC ($90,000 - $0) x $90,000/$90,000 |
$90,000 |
|
PUC of new shares = $90,000 - $90,000 = $0
We see the first consequence of section 84.1; the PUC of the shares received from Holdco has been reduced from $90,000 to zero. Should there be a share buyback in the future, John Smith will have to declare a deemed dividend of $90,000 under ITA 84(3).
Deemed Dividend
A - is the increase, if any, determined without reference to this section as it applies to the acquisition of the subject shares, in the paid-up capital in respect of all shares of the capital stock of the purchaser corporation as a result of the issue of the new shares, |
$90,000 |
|
| D - is the fair market value, immediately after the disposition, of any consideration (other than the new shares) received by the taxpayer from the purchaser corporation for thesubject shares, |
$10,000 |
|
(A + D) |
$100,000 |
|
LESS: |
||
(i) the paid-up capital, immediately before the disposition, in respect of the subject shares, and (ii) subject to paragraphs 84.1(2)(a) and 84.1(2)(a.1), the adjusted cost base to the taxpayer, immediately before the disposition, of the subject shares,
|
$1,000 Or $1,000 |
$1,000 |
F – is the total of all amounts each of which is an amount required to be deducted by the purchaser corporation under paragraph 84.1(1)(a) in computing the paid-up capital in respect of any class of shares of its capital stock by virtue of the acquisition of the subject shares. (see previous calculation) |
$90,000 |
|
(E + F) |
($91,000) |
|
Deemed Dividend ($90,000 + $10,000) – ($1,000 + $90,000) |
$9,000 |
|
John Smith has to declare a deemed dividend of $9,000 on his personal tax return. As mentioned above, this dividend can be designated as eligible as long as the purchaser corporation has a general rate income pool (GRIP) balance.
Capital Gain of the Opco shares
Proceeds of disposition |
$100,000 |
Less: Deemed dividend [ITA 84.1(1)(b)] (Note 2) |
($9,000) |
Deemed disposition amount |
$91,000 |
Less: ACB of Opco shares |
($1,000) |
Capital gain (Note 3) |
$90,000 |
Note 2 - Deemed dividends received under ITA 84.1(1)(b) reduce the proceeds of disposition [definition “proceeds of disposition” ITA 54(k)].
Note 3 - This amount would be exempt from taxation should Opco’s shares be qualified small business corporation shares.
The effects of section 84.1 in this example are evident: without this section, John Smith can transfer his shares with the possibility of paying no tax for the transaction should the shares be eligible for the capital gains deduction and collecting $10,000 cash tax-free as well. With the application of section 84.1, he now has a taxable dividend to declare on his personal return.
By analyzing the formulas, we can observe that section 84.1 is really set up to prevent shareholders from withdrawing cash or other non-share considerations in a tax-free manner. If John Smith’s transaction were to be done as an all-stock transaction, without the $10,000 in cash, there would be no deemed dividend computed under ITA 84.1(1)(b). There would also be $1,000 value assigned to the PUC of the new shares, compared to zero with the non-share considerations.
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