Non-Arm’s Length Sales of Shares

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

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 - 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)

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

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

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

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.