SELECTED TOPICS RELATEDTO THE TRANSFER OF A BUSINESS

Transcription

1 SELECTED TOPICS RELATEDTO THE TRANSFER OF A BUSINESS Dwayne Anderson Mel/or & Anderson 2(J2 2(J22 Oornwall SI. Regina, Sask. S4P 21(6 Ph: Fax: / Dwayne Anderson BIOGRAPHICAL INFORMATION Dwayne received a B. Comm. (Honours from the Univer~lty of Saskatchewan in 1985 and an LL.B., also from the University of Saskatchewan In He was called to the Saskatchewan ~ar h His area of practice is in Taxation inoludlng objections and appeals, estates and trusts, corporate reorganizations, and tax planning. Dwayne Is Chair of. the Tax South Section of the CBA (S.sk. Branch. In 1990 h. received C.A. designation and is a member of the Institute of Chartered Accountants Discipline Committee. Dwayne is a partner in the firm Mellor & Anderson In Regina.

2 TABLE OF CONTENTS ROLLOVER OF PROPERTY OF SPOUSE DURING LIFETIME AND ON DEATH.."""".""""."".. ""'"""." """"",,"",,"""" """. 1 A. Rollover to Spouse During Lifetime""""""""""""""""""""""""""""."",,,,,,, 1 B. Rollover to Spouse on Death""""""""""""""".""""""""""""""""""""""". 4 ROLLOVER OF FARM PROPERTY TO CHILDREN DURING LIFETIME AND ON DEATH""""""". """" """ ",," """"""" """ """ """""" 7 A. Rollover of Farm Property to Children During Lifetime""""."".""""""."""."." 7 B. Rollover of Farm Property to Children on Death" "" "" """"."""" """"""""""" 11 EST ATE PLANNING... """...,... ""...,... """.. "... "."""...,... "... ""..,,,.,,,,...,,' 12 A Objectives of an Estate Freeze B. Estate Freeze Techniques... "... """... "... ""... """"""... ""...,... "".. "".,,,,.. 13 C. Section 51 Share Conversion D. Section 85 Share Exchange""."" """"",,"".".".,,""""".""""".,,,,",,"""""""". 15 E. Holding Corporation Freeze.. ".. """.,,,,,..,,...,,...,,,,,..,,,,,,,,...,,,.,,,,,,,,,,,,,,..,,, F. Asset Freeze"... "...""... "..."""""",."...""... ".,,,,,,,,,,,..,,,,...,...,,,,..,,,,.,,, G. Preferred Share Attributes...".""""""""."... ""...,'''"..."''''''".,'".. ""...,,.,,.. 20 H. Estate Melt or Thaw """""""""".""""""""""".""."""""""."."""""""".""." 21 SECTION 84.1.,... ".. "... "...""...,.".,.. "... "...""..."..."."..."...". 23 A. Purpose and History"...,..."...,... "..."".. "...,...""..."",,...," 23 B. Application.. "..."".. ""...".."""...,..."...,,,.,""",,...,.,,"""",,...,'" 24 C. Implications of Section 84.1 ",,""""""",,"""".,,""",,""""""""""""""""".",," 25,

3 ROLLOVER OF PROPERTY OF SPOUSE DURING LIFETIME AND ON DEATH A. ROLLOVER TO SPOUSE DURING LIFETIME Often property exchanges can be effected between spouses in order to attempt to utilize the capital gains exemption and in turn increase the adjusted cost base of the property transferred. In transferring property between spouses, one must be aware of the provisions of section 73 of the Income Tax Act (the "Act" and, in particular, subsection 73(1 which provides an exception to the general rule set out in section 40 which requires gains and losses to be recognized on the disposition of capital property. Subsection 73(1 provides that where capital property has been transferred to a spouse, unless the transferor elects in his or her return of income for the taxation year in which the property was transferred not to have the provisions of the subsection apply, the particular. property shall be deemed to have been disposed of by the transferor for proceeds of disposition equal to the adjusted cost base and to have been acquired by the transferee for an amount equal to those proceeds and generally, the realization of any accrued gains and losses is postponed until the transferee disposes of the property. The election under subsection 73(1 is advantageous and will generally be used in cases where the transferor has gains or losses which can be offset by the realization of a gain or loss in respect of the property transferred to the transferee. As a result of our progressive tax rates, there is an advantage to a taxpayer who reduces tax payable by assigning or transferring income producing property to another taxpayer who is taxable at a lower marginal rate. The attribution rules in section 74.1 to 74.5 of the Act are designed to stop an individual from splitting unearned or investment income with his or her -spouse or minor, by transferring or lending income producing property to the spouse or minor. Generally, the rules deem any income or loss from the property or substituted property to be the income or loss of the transferor and not the spouse or minor. In the case of a transfer or loan of

4 2 property by an individual to his or her spouse, the rules also attribute any taxable capital gain or allowable capital loss on the disposition of the property or substituted property to the individual. Many of the current rules were introduced as a result of the May 23, 1985 budget, and in particular, as a result of the introduction of the capital gains exemption. When effecting an inter vivos transfer of property to a spouse or a minor, the following provisions are relevant: (a Subsection 74.1(1: Where an individual has transferred or loaned property to, or for the benefit of another person who is, or has become a spouse, any income or loss derived from property, or from property substituted therefor, is deemed to be the income or loss of the transferor. Certain exemptions exist, most notable that being for transfers for fair market value consideration. (b Subsection 74.1(2 Where an individual has transferred or loaned property to, or for the benefit of another person who is under the age of eighteen years who does not deal with at arms-length with the individual, or is the niece or nephew of the individual, any income or loss derived from the property, or from property substituted therefor, is attributed back to the transferor. However, any income or loss that relates to a period within a year in which the recipient attains the age of eighteen is not attributed back to the lender or transferor. (c Subsection 74.1(3: This subsection ensures that the attribution rules will apply to a loan which is used either, to repay borrowed money that was used to acquire property, or to reduce an amount payable in respect of the property in the same manner as the rules

5 3 would apply if the property had been acquired directly for the proceeds of the loan. The subsection also ensures that if a loan to a spouse that is exempt from the attribution rules because it is made on an anns-iength, commercial basis is used to repay a prior loan to that spouse, the attribution rule will nevertheless continue to apply to the income from the previously loaned property. Of for the property substituted therefor. (d Subsection 74.2(1: Generally, this subsection extends the rule in subsection 74.1(1 by attributing to an individual any taxable capital gains and allowable capital losses realized by a spouse on the disposition of property, other than listed personal property, that was loaned or transferred by the individual to, or for the benefit a person who is, 'or has become a spouse, or that was substituted for such property. Unlike the attribution rules relating to income and losses the rules generally do not apply to in respect of transfers or loan to individuals under the age of 18. (e Subsection 74.2(2: Generally, the subsection ensures that the taxable capital gains and allowable capital losses on dispositions of property in a year which are attributed to an individual may be included in computing the individual's lifetime capital gains exemption. This subsection also treats the gain or loss as having arisen in respect of property disposed of by an individual in that year. (I Subsection 74.3(1: Subsection 74.3(1 applies where an individual has loaned or transferred property to a trust in which a designated person, which is defined by subsection 74.5(5 as the individual's spouse or a person under the age of eighteen (18 years who does

6 4 not deal at arms-length with the individual, or is the individual's niece Of nephew who is under the age of eighteen (18 years, is beneficially interested in at any time. The income attributed back to the individual is determined under subsection 74.3(I(a. (g Subsection 74.4: Where subsection 74.4 applies. the impact is punitive and can lead to double taxation. Subsection 74.4 applies where an individual has directly or indirectly loaned or transferred property to a corporation, provided that one of the main reasons for the transfer may reasonably be considered to reduce the individual's income, and benefit, directly or indirectly, a designated person as defined in subsection 74.5(5. Where section 74.4 applies in respect of the individual's loan or transfer to a corporation, 74.4(2 deems the individual to have received the amount as interest income. The main exception from the application of the subsection is that it does not apply in the case of loans or transfers to a "small business corporation" as defined by subsection 248(1 of the Act. B. ROLLOVER TO SPOUSE ON DEATH Subsection 70(5 sets out a number of rules which apply on the death of an individual. Prior to 1993, paragraph 70(5(b deemed all depreciable property to be disposed of at the mid point between fair market value and undepreciated capital cost. As a result, only half the recapture of terminal loss was triggered on death, and where fair market value exceeded capital cost, only a portion of the capital gain was recognized. For dispositions after 1992, subsection 70(5 provides that a taxpayer is deemed to have disposed of all capital properties, including depreciable properties, at fair market value.

7 5 Paragraph 70(5(b provides that the beneficiary of the estate is deemed to have acquired the property at a cost equal to its fair market value at the time of the deemed disposition. Subsection 70(6 provides an exception to the rules set out in subsection 70(5, and allows a rollover to a spouse, or qualitying spousal trust, if the deceased was resident in Canada immediately before the death and the assets go directly to the spouse resident in Canada, or qualifying spousal trust resident in Canada. In relation to the spousal trust, the assets must vest indefeasibly in the spousal trust within 36 months, or longer, if considered reasonable by the Minister. As a result, any capital gain or recapture can be deferred, unless the estate elects to realize the capital gain or recapture, or the surviving spouse disposes of the assets. A qualifying spousal trust is one which the spouse is entitled to all trust income while alive, and no other person may receive any income or capital while the surviving spouse is alive. A spousal trust will be "tainted" if the will provides that all the assets go to the spousal trust without first providing for discharge of liabilities of the deceased's estate. However, subsection 70(7 provides for a method of "untainting" a spousal trust with respect to the payment of testamentary debts. Subsection 70(7 allows the trustee to select specified properties with a fair market value greater than, or equal to non-qualifying debts. These selected properties are then deemed to be disposed of at fair market value and where the fair market value of the selected properties exceeds the value of the debts to be paid, and deems the proceeds of disposition of the specified properties to be reduced by a formula to allow a rollover on the excess value. This election must be made in the terminal return. A spousal trust can also be tainted by another beneficiary having a right to income or capital during the surviving spouse's lifetime. Once again, a spousal trust can be untainted by a beneficiary disclaiming his or her rights to the capital or the income. In relation to the disclaimer. subsection 248(8 considers property subject to a disclaimer not to have been disposed of by the party making the disclaimer, and to have been received by the resulting beneficiary under the original terms of the will.

8 6 It is suggested that in order to ensure that an untainted spousal trust will be settled, that the will allows for the executors to have full discretion to make any tax elections. In addition it may be useful to create one or more spousal trusts in the will if the possibility exists that one may by tainted and one will qualify as a spousal trust. The tenn vested indefeasibly is not defined in the Income Tax Act. However, Interpretation Bulletin IT -449R sets out Revenue Canada's views, and the courts have defined vested indefeasibly as being, a vested interest that is not subject to divestment upon the happening of some future event. Examples where ownership will not vest indefeasibly are as follows: (1 where rights cease as upon remarriage of surviving spouse; (2 property must be sold subject to compulsory buylsell agreement; and (3 property received is a result of a disclaimer by another beneficiary.

9 7 ROLLOVER OF FARM PROPERTY TO CHILDREN DURING LIFETIME AND ON DEATH A. ROLLOVER OF FARM PROPERTY TO CHILDREN DURING LIFETIME In planning for an inter vivos transfer of farm property to a child, there are three types of property which can be transferred and are eligible for a rollover. The three types of properties are farm land, depreciable property of a prescribed class, and eligible capital property. To be eligible for the rollover all tbree types of property must have been used principally on a regular and continuous basis by the transferor, his spouse or any of his children in the business of farming immediately before the transfer. In some cases, subsection 70(9.8 will deem property owned by a taxpayer to be used in the business of farming if the property is used by a family farm corporation or a family farm partnership. In relation to a transfer of fann property to a child, one must look at the definitions of a child which, for the transfer of farm property, is extended by subsection 252(1 ofthe Act. The definition ofa child as set out in subsection 70(10 oftbe Act includes grandchildren, great grandchildren or any person wbo before the age of nineteen (19, was wholly dependent on the taxpayer for support and for whom the taxpayer had, at that time custody and control. Subsection 252(1 extends the definition ofa child to include a child of the taxpayer's spouse, an adopted child of the taxpayer and the spouse of a child. Subsection 73(3 provides for an inter vivos rollover to a child oftbree types of property similar to the rollover available on the death of a taxpayer under subsection 70(9. In general the three types of property can be transferred anywhere between its fair market value and its adjusted cost base.

10 8 The general rules for the transfer the three types of property are as follows: (1 if the consideration given by the child exceeds the greater of both the fair market value and its undepreciated capital cost, then the proceeds of disposition is deemed to be the greater of the two; (2 if the consideration given by the child is less than the lesser of, the fair market value of the property, and its undepreciated capital cost, then the transferor's proceeds of disposition is deemed to be the lesser of the two; and (3 in any other case the transferor is deemed to received proceeds of disposition equal to the consideration given.by the chilrl. In transferring eligible capital property, the limits are changed slightly, in that the undepreciated capital cost for the purposes of the above is 4/3 of the cumulative eligible capital balance. Pursuant to subsection 73(4 where a family rann corporation or a partnership is transferred inter vivos to a child, the proceeds of disposition can be anywhere between the transferor's fair market value and the adjusted cost base. Where the consideration given by the child is greater or lesser than the two, the rules set out above will apply to determine the proceeds of disposition of the transferor. If the property is farm property that would rollover under subsection 73(3, qualitying farmlands or buildings, or under subsection 73(4, shares of the family farm corporation or the partnership, is simply gifted to a child, a capital gain will not result since the property will automatically rollover at its cost base pursuant to these subsections. A taxpayer can structure the transaction to realize the capital gains exemption available by ensuring that the sale takes place at 'fair market value by the child giving the transferor a noninterest bearing note payable, which is payable thirty (30 days after demand. Thereafter any future capital gains will be taxed in the hands of the child, subject to the post June 17, 1987 acquisition rules. Where a parent continues to fann the transferred property by leasing the fann

11 9 land from the child, the child must pay fair market value for the farm property to avoid the attribution on the lease income. Where depreciable property is transferred to a child, if the capital gains exe~ption has been claimed by a non-arms length transferor there is no step-up in the cost base of depreciable property for capital cost allowance purposes. Where there has been an inter vivos transfer of farm property, or shares in a famity fann corporation of an interest in a family farm partnership to a child who is a minor who subsequently disposes of such property in a year before the year the child attains the age of eighteen, pursuant to section 75.1 the full amount of the gains Of losses will be attributed back to the transferor. In order to qualify for the enhanced capital gains exemption, fann land acquired before June 17, 1987 must meet a different set of rules than farm land acquired after June 17, In relation to property purchased before or after July 17, 1987 the Act refers to qualified users. A qualified user is defined as: (i (ii (iii (iv (v the individual; the beneficiary of the trust if the trust is a personal trust; the spouse, child or parent ofthe individual; a family farm corporation owned by the individual, the personal trust or a person referred to in (iii; and a family farm partnership in which an interest is owned by the individual, the personal trust or a person referred to in (iii. Farm land acquired before June 17, 1987 must be used by a qualified user in the course of carrying on the business offarming in the year of disposal, or in any five years during the period when such farm land was owned by a qualified user. Farm land acquired after June 17, 1987 is subject to two tests which are more difficult to meet, an ownership test and a gross revenue or usage test. To satisfy the ownership test the farm

12 10 land must be owned throughout the immediately preceding twenty four month period by one of the following: (i the individual; (ii the beneficiary of the trust if the trust is a personal trust; (iii the spouse, child or parent of the individual; and (v a family farm partnership in which an interest is owned by the individual, the personal trust or a person referred to in (iii. The more difficult test to satisfy is the gross revenue or property usage test. This test requires an eligible user's gross revenue from farming operations must exceed income from all other sour~es for at least two years of ownership where the property was principally used by an one of the above mentioned who was actively engaged on a regular and continuous basis in the business off arming. Farm property used in the farming business by the family farm corporation or partnership carrying on the business of farming throughout a period of at least twenty four months where the owner of the share or the partnership unit or an eligible user is engaged on a regular and continuous basis in the business of fanning in which the farm land is used will also be qualified farm property eligible for the capital gains deduction. In either case, the "Crow" Payment will likely effect the amount of the gain since in most cases it will reduce the adjusted cost base of the farm land. Machinery and equipment are not qualified farm property. therefore it is not possible to shelter any gain utilizing the capital gain exemption. Qualified farm property also includes a share in the capital stock of a family farm corporation or an interest in a family fann partnership. A share or partnership interest will qualify for the capital gains exemption if, at the time of disposition, substantially all of the fair market value of the property owned by the corporation or the partnership was used principally in the

13 11 course of carrying on the fanning business by a qualified user, as set out above, who was actively engaged on a regular and continuous basis. Also, throughout any twenty four month period ending before the disposition, greater than fifty (50% percent of the fair market value of the assets of the corporation or partnership must have been used in qualifying farm business by a qualified user. Finally. the deemed capital gains resulting from the disposition of eligible capital property used in the course of carrying on the business of fanning by a qualified user as outlined above would also be eligible for the capital gains deduction in respect of qualified farm property. B. ROLLOVER OF FARM PROPERTY TO ClllLDREN ON DEATH,. In order to qualify for a rollover the fann property must have been used immediately before death in the business of farming by the a qualified user. In addition, the property must vest in indefeasibly with the child within thirty-six (36 months of the date of death. In relation to depreciable property, it is deemed to be disposed of for proceeds of the disposition equal to the undepreciated capital cost and at the adjusted cost base. In the event that the legal representative wishes to utilize the_ capital gain exemption and bump up the cost base of the property an election in the final return of the deceased to have the deemed proceeds at any value between the fair market value and undepreciated capital cost for depreciable assets is available and any value between fair market value and the adjusted cost base for land. In relation to the transfer, the election must be made on a property by property basis.

14 12 ESTATE PLANNING A. OBJECTIVES OF AN ESTATE FREEZE An estate freeze is generally undertaken when the value of small business corporation shares. or capital assets, are likely to increase substantially in value over the long term. Often there are varied purposes for implementing an estate freeze however, the primary purpose is to "freeze" or fix the value of the assets owned by an individual at a particular time, with future growth attributing to the children or grandchildren ofthe individual. The primary income tax objectives on an estate freeze are as follows: (1 minimize income tax arising on the freeze transaction itself; (2 minimize income tax on the individual's death; and (3 income splitting through the distribution of income or property during the individual's lifetime, to his spouse, children or grandchildren. Other non-tax objectives and considerations include allowing the individual to maintain control over his assets during his Jifetime, to receive a satisfactory level of income and to provide the individual with flexibility to change the allocation of his wealth if circumstances in the future change. The following represents a Jist, although not comprehensive, are some factors which should be considered prior to effecting an estate freeze: (l age offreezor; (2 future income of the freezor; (3 future impact of inflation on freezor; (4 valuation of assets; (5 freeze share attributes;

15 13 (6 use of non-participating voting shares; (7 small business corporation status; (8 use of capital gains exemption; (9 application of attribution rules; (10 trust as recipient of growth shares; and (II 21 year deemed disposition in trusts. B. ESTATE FREEZE TECHNIQUES An estate freeze can be achieved in a number of ways. Typically an estate freeze can be effected as follows: (I a gift of assets by the parent; (2 sale of assets by the parent; (3 a share conversion or exchange of common shares into a company into preferred shares; (4 transfer of common shares of an operating company to a holding company in exchange for preferred shares; or (5 transfer of assets of an operating company to a new operating company In exchange for preferred shares. The first two methods referred to above are the simplest methods of achieving an estate freeze however, neither is effective from an income tax point of view nor are they effective vis a vis the parent's right to control the assets to ensure future flow of future income. C. SECTION 51 SHARE CONVERSION A common method whereby an estate freeze can be effected is by utilizing section 51 of the Act. Subsection 51(1 of the Act allows a tax deferred conversion of common shares to preferred shares.

16 14 Subsection 51 (1 requires that a share of the capital stock of the issuer be issued in exchange for a convertible security. In the context of subsection 51(1 the word "exchange" contemplates that a share or debt obligation is disposed of by for shares of the capital stock, with no other form of consideration (i,e. boot being pennitted. In addition, subsection 51(1 requires that the convertible property must be capital property as defined by section 54 of the Act. If the requirements of the section are met, the rollover under section 51 is automatic. Thus, no elections are required section 51 of the Act unless a taxpayer desires to trigger a gain, in which case the taxpayer can do so by making a joint election with the corporation under subsection 85(1 of the Act Where the requirements of section 51 are fulfilled, the shares converted afe deemed not to be disposed of, and the adjusted cost base of the new shares is equal to the adjusted cost base of the converted shares. Where shares of more than one class are issued, paragraph 51(1(d apportions the cost among the shares of the various classes according to their fair market values. An important consideration in determining whether section 51 will be utilized is determining, whether the individual wishes to effect a full or partial freeze. Section 51 allows for a partial freeze since it is not necessary to convert all shares owned by the taxpayer. However, one negative aspect of using section 51 is that there is no provision to receive non-share consideration of the conversion. In utilizing section 5 I, one must be aware of section 51(2 which provides that if the fair market value of the shares converted exceeds the aggregate fair market value of the shares received by the taxpayer, the transaction may be a taxable transaction if it is reasonable to consider any portion of the excess is a benefit that the taxpayer desires to have conferred on a related person. Where subsection 51(2 applies, the taxpayer who converts the property is deemed to dispose of the shares for proceeds of disposition equal to the lesser of:

17 15 1 the aggregate of its adjusted cost base to the taxpayer who converted immediately before the exchange and the gift portion; and 2 the fair market value of the shares immediately before the exchange. The advantages of utilizing section 51 are as follows: (1 avoids double taxation that arises on the transfer ofopco to a Holdco; (2 the transaction is relatively straight forward; and (3 no elections are required to be filed. The disadvantages of conversion utilizing section 51 are as follows: (1 there may be some advantage to utilizing a holding company in order to segregate investment income from active business income and to defer tax on dividend income; and (2 non-share consideration cannot be received on the conversion. D. SECTION 86 SHARE EXCHANGE Subsection 86(1 has been used most frequently as a method for freezing the value of the shares of a private corporations and to facilitate the participation of future generations or employees in the business. Generally section 86 allows the tax-deferred exchange of shares by the freezor, of all ofhis or her common shares, in consideration for fixed value preference shares of the same corporation. Subsection 86(1 of the Act sets out five requirements which must be fulfilled in order for a taxpayer to receive a tax deferred rollover in respect of shares: (1 the shares must be "capital property"; (2 the shares must be "disposed" of by the taxpayer; (3 the transaction must occur "in the course of reorganization of the capital of the corporation";

18 16 (4 the shares must constitute "all the shares of a particular class ofthe capital stock of the corporation that were owned by the taxpayer at the time of the disposition"; and (5 the consideration received must include "other shares in the capital stock of the corporation". If all of the provisions of subsection 86(1 are met the provision will apply automatically. In regard to the requirements of the subsection, one requirement is that the old shares must be "capital property" as the term is defined by section 54 of the Act. In essence the shares must be property that, if disposed of, would produce a capital gain. The words "in the course of a reorganization of the capital of the corporation" are not defined. It is generally accepted that any amendment of the articles of the corporation is considered a reorganization of capital for the purposes of subsection 86(1. Sectio~ 86 will provide a rollover for capital gains purposes on the exchange as long as the non-share consideration, if any, does not exceed the adjusted cost base of the "old shares". Generally, the adjusted cost base ofthe new shares equals the adjusted cost base of the old shares exchanged. If any non-share consideration is paid, then the adjusted cost base of the new shares would equal the adjusted cost base of the old shares less the fair market value of the nonshare consideration. If more than one class of shares is issued as consideration, the adjusted cost base of the old shares is apportioned between the classes of the new shares relative to the new shares fair market value. The proceeds of disposition for the old shares will equal the fair market value of the nonshare consideration received and the adjusted cost base of the new shares issued on the exchange. In relation to the paid-up capital, subsection 86(2.1 automatically reduces the paid-up capital of the new shares to that of the old shares. As a practical matter, it is quite unusual to receive nonshare consideration on a section 86 reorganization

19 17 It is possible, and may be advantageous to make an election under section 85 where a shareholder will not otherwise obtain rollover treatment under subsection 86(1. This may result where the shares are not capital property, or because fewer then all of the shares are the subject of the reorganization. Subsection 86(3 of the act stipulates that where subsections 85(1 or (2 apply then subsection 86(1 and 86(2 will not apply. Section 86 enables the shareholder to accept the proceeds of disposition at any amount between the adjusted cost base and fair market value of the old shares. Assuming the paid up capital of the new shares equals the paid up capital of the old shares, the shareholder should only have a capital gain and not a dividend on the transaction. The capital gain on the old shares may be eligible for the capital gains exemption, and the new shares would have an increased adjusted cost base. This is commonly referred to as an "internal section 85(1". Subsection 86(2, like subsection 51(2 denies a tax deferred rollover to the extent that a shareholder, who would otherwise would be entitled to rollover treatment receives new shares whose fair market value is less than the aggregate fair market value of the shares exchanged and the non-share consideration received by the taxpayer, and it is reasonable to consider that any portion of the excess is a benefit that the taxpayer desires to have conferred on a related person the transaction may be taxable. Where this is the case, subsection 86(2 operates in the same fashion as subsection 51(2 in that proceeds of disposition of the exchanged shares will be the aggregate of the adjusted cost base of the excess referred to above (not to exceed the fuir market value ofthe shares. Since these proceeds exceed the adjusted cost base of the old shares, there is a gain on the transaction. Note, however, that this gain does not increase the adjusted cost base of the new shares. Thus, in effecting a subsection 86(1 reorganization a calculation of reasonable value of the shares exchanged using acceptable business valuation principles should be completed and a price adjustment clause should fonn part of the documentation effecting the exchange. The advantages of utilizing a subsection 86(1 exchange are as follows: (I it avoids double taxation that arises with the use of a holding company; (2 again, the procedures to implement the transaction are relatively straight forward;

20 18 (3 no elections are required to be filed with Revenue Canada; and (4 non~share consideration may be received on the exchange. The disadvantages of utilizing subsection 86(1 are as follows: (1 subsection 86(1 results in a complete freeze rather than a partial freeze since the taxpayer must transfer all shares of a class; and (2 there may be some advantage to utilizing a holding company to segregate investment income from active business income and to defer tax on dividend income. E. HOLDING CORPORATION FREEZE A holding corporation (Holdco freeze is a common method of completing an estate freeze in spite of the fact that it is more expensive and more complicated and costly. In addition, it requires special tax elections to be filed. In order to effect a holding corporation freeze, the transferor and the holding company must jointly elect to have the provisions of subsection 85(1 apply to the transfer and will generally elect that the transfer take place at the adjusted cost base of the operating corporation (Opec shares. The elected amount under subsection 85(1 will then be the proceeds of disposition of the OpeD common shares and the adjusted cost base of the preferred shares of the Holdco acquired in exchange. The terms and conditions of the special shares and the preferred shares issued by the Holdco are significant in that they must have certain rights to ensure that the freeze is effective from both a tax a commercial point of view. In effecting a holding corporation freeze one must be aware of paragraph 85(1(e.2 which will consider a benefit to have been conferred on a person related to the disposing share holder if the consideration received is less than the fair market value ofthe Opco common shares transferred. In addition, section 84.1 may apply to the transfer and may reduce the paid-up capital of the preferred shares to an amount equal to the paid-up capital

21 19 of the OpeD common shares, or may deem a dividend to have been paid on the transfer to the extent that any non~share consideration on the transfer has a value greater than the adjusted cost base and the paid~up capital of the common shares. The main disadvantage of a holding corporation freeze is the potential for double taxation. > For example. a capital gain will arise on the deemed disposition of preferred shares of Holdco on the death of the holder ofthe preferred shares, assuming the shares are left to his estate to be held in trust for his children. In addition, if Roldco were to subsequently dispose of all the shares of OpeD, the capital gain will also result assuming the shares of Opec will have not increased in value. Assuming that the preferred shareholder's estate owns the preferred and special shares and children own the common shares, the double taxation may be avoided by the following: (I ensuring that any future sale ofopco is accomplished by selling Roldco; (2 liquidating Roldco within one year of the date of death; (3 transferring the preferred shares of Hold co to a new company after death following by a liquidation ofroldco. F. ASSET FREEZE The asset freeze is similar to the holding corporation freeze in that it utilizes section 85(1 to make a taxndeferred transfer of assets in exchange for preferred shares to accompjish the freeze. Once again. the valuation of the assets transferred and terms and conditions of the preferred shares and special voting shares of new Opco are significant from a tax and commercial point of view. Once again, utilizing an asset freeze one must be aware of, and ensure not to contravene subsection 85(2.1 and section 84.1 of the Act.

22 20 In addition, generally the same consequences and problems related to double taxation arise on an asset freeze as a holding corporation freeze, although a solution may be easier with respect to an asset freeze. The advantage of utilizing an asset freeze is the flexibility in allowing specific assets to be frozen. The disadvantages of an asset freeze are as follows: (1 the possible incidence of other taxes on the transfer; and (2 costs of transferring business asset name changes that may be required. G. PREFERRED SHARE ATTRIBUTES Since an estate freeze is usually undertaken by exchanging common shares for fixed valued preferred shares, it is essential that the fair market value of the preferred shares be equal to the fair market value of the common shares. Each of subsection 85(1, section 86 and section 51 contain benefit provisions that will result in the transfer, exchange and conversion being a taxable transaction if it is reasonable to consider that a benefit has been conferred by virtue of the transaction on a person related to the transferor. A benefit will generally be considered to have been conferred if the value of the preferred shares is less than the value of the Opco common shares. Revenue Canada has established guidelines (see 1980, 1981, and 1990 Canadian Tax Foundation - Revenue Canada Round Table for share attributes that they consider to be necessary in order to ensure that the fair market value of the preferred shares is equal to the redemption amount of such shares. These attributes are as follows: (1 the shares must be redeemable at the option ofthe holder (i.e. retractable; (2 shares should be entitled to a dividend which should not exceed a reasonable rate. Revenue Canada, however, has indicated that the absence of the dividend entitlement would not in itself create a benefit problem. The dividends may therefore be non-cumulative~ (3 the shares mayor may not have voting rights. However, they should at least have voting rights on significant matters relating to the corporation which are provided in the Saskatchewan Business Corporations Act;

23 21 (4 the shares must have preference on any distribution of assets on liquidation or winding up of the corporation; (5 there must not be restrictions on the transferability of the shares other than as required by law; and (6 the issuing corporation must undertake that no dividends will be paid on the other classes of shares which will result in the corporation having insufficient assets to redeem the preferred shares at the redemption amount. Often on an estate freeze the preferred shares will be voting and have sufficient votes to enable the freezor's to control OpeD however. it may provide additional flexibility to have control of the corporation provided by the existence of a separate class of shares to avoid change of control and a redemption of the freezor's preferred shares. Generally, the preferred shares would be non-participating, would be redeemable for the amount paid for the shares and would be voting. The special shares would be issued for nominal consideration and the shares would have sufficient votes to control Opco. or Holdco. By using these "scout" shares, the preferred shares of Opco or Holdco may be redeemed by a parent without being concerned about losing control of the corporation. More importantly, on the preferred shareholder's death, the beneficial ownership ofthe preferred shares may be split equally, however, control may be transferred only to one child if appropriate. H. ESTATE MELT OR THAW In order to allow the freezor flexibility in the estate plan it is prudent to consider, and plan for the possibility of a "melt" of the estate freeze. A melt of the estate is effected when some of the vale of the property in the estate freeze is withdrawn for the benefit of the freezor. Some of the more common techniques utilized to effect an estate melt are as follows: (I pay additional salary to the freezor; and (2 pay additional dividends on preferred shares.

24 22 Alternatively an estate thaw can be effected where the freezor wishes to retroactively be put back in the same position he or she would have been had the estate freeze not been effected. Once again, this possibility must be contemplated at the time of the freeze and can be effected by either, the freezor repurchasing the common shares for fair market value, or the freezor converting the preferred shares which he of she received for common shares.

25 23 SECTION 84.1 A PURPOSE AND HISTORY For non-arm's length transfers of shares prior to May 23, 1985, section 84.1 resulted in either a capital gain, or a reduction in the adjusted cost base of any non-share consideration. Substantial amendments were made to section 84.1 effective for transactions occurring after May 22, 1985, as part of the amendments the Act related to the introduction of the lifetime capital gains exemption. The purpose of section 84.1 is to prevent the "artificial" creation of paid-up capital and/or the artificial stripping out of retained earnings as capital proceeds. Specifically, section 84.1 prevents the removal of corporate surplus as a tax-free capital gain where there is a non-arm's length transfer of shares. Typically, it will prevent the creation of paid up capital, or the stripping out of retained earnings as capital proceeds by means of reorganization, related party sales or other transactions. Generally, if the provision applies, paragraph 84.1(1(a provides for a reduction in the paid-up capital of any shares issued by the purchaser corporation and thereby prevents the extraction of the surplus of the subject corporation through the latter redemption of the new shares to produce a capital gain. Paragraph 84.1(1(b deems any non-share consideration received from the purchaser corporation to be a dividend (after allowing a deduction to the extent there has been a reduction in paid-up capital under paragraph 84.I(1(a. It is the latter, the deemed dividend which is more dangerous. and can trap the unwary.

26 24 B. APPLICATION For section 84.1 to apply the following conditions must exist: (1 shares (the subject shares of a corporation resident in Canada (the subject corporation, which are capital property must have been disposed of to another corporation (the purchaser corporation; (2 the shares must be capital property to the transferor; (3 the transfer must have taken place after May 22, 1985; (4 the transferor must be an individual or a trust (i.e. the provision does not apply to transfers by a corporation; (5 immediately after the transfer, the subject corporation and the purchaser corporation must be connected within the meaning of subsection 186(4; (6 subsection 84.1(2 will expand circumstances under which a taxpayer will be considered to not deal at arms length with the purchaser corporation; (7 immediately after the transfer, the subject corporation and the purchaser corporation must be connected with the meaning of 186(4. Generally speaking, the subject corporation and the purchaser corporation will be connected if the purchaser corporation controls the subject corporation either alone, or together with non-anns length parties, or the purchaser corporation owns shares of the subject corporation representing more than 10% oflhe votes and value attaching to all shares of the subject corporation. Where section 84.1 applies, it does not require that the transferor elect under section 85 with respect to the transfer, nor does it require that shares of the purchaser corporation fonn part of the consideration for the transfer of the subject shares. Where all the circumstances above are satisfied, section 84.1 will apply automatically.

27 25 The following decision tree illustrates the criteria which must be fulfilled before section 84.1 will apply: Are shares (the "subject shares" of a corporation (the "subject corporation" being transferred to another corporation (the "purchaser corporation"? I YES Is the transferor a taxpayer other than a corporation? NO NO Section 84.1 does not apply Section 84.1 does not apply I YES Is the transferor resident in Canada? I YES Are the subject shares capital property? NO NO Section 84.1 does not applybut see section Section 84,1 does Dot apply I YES Is the subject corporation resident in Canada? I YES rue the transferor and the purchaser corporation not at ann's length taking into consideration the rules in I paragraph 84.1(2(b-through (e? I YES Is the subject corporation connected to the purchaser corporation immediately after the transfer within the meaning of subsection 186(41 I YES SECTION 84.1 APPLIES. I I NO NO NO Section 84.1 does not apply Section 84.1 does not apply Section 84.1 does not apply C IMPLICATIONS OF SECTION 84.1 Paragraph 84.1(1(a applies only if shares are issued as consideration for the transfer of the subject shares. Where shares are issued as part of the consideration for the transfer of the subject shares. paragraph 84.1(1 lea reduces the paid up capital increase to the greater of the paid up capital ofthe shares transferred and a specially defined adjusted cost base of the subject shares. In both cases, the allowed increases are reduced by the fair market value of any non~share consideration taken back by the transferor. Where there is more than one class or shares taken

28 26 back by the transferor, the paid up capital is allocated between the classes of shares based on the increase in paid up capital of each particular class. Paragraph 84.1(1(b will deem the recipient to receive a dividend equal to the formula: (A + D - (E +F The variables of the formula are as follows: A = is the increase in the paid-up capital of the purchaser corporation. D = the fair market value of any non-share consideration received by the taxpayer from the purchaser corporation. E ~ the greater of (i the paid-up capital of the subject shares; and (ii adjustments to the adjusted cost base dictated by paragraphs 84.1(2(a and (a. I. F ~ the amount which was computed pursuant to paragraph 84.1(1(a. Paragraphs 84.1(2(a and (a. I are crucial to the outcome of the formula as set out in The purpose of these paragraphs is to adjust the adjusted cost base to the "hard" adjusted cost base. The "hard" adjusted cost base can be though of as an adjusted cost base from an annslength third party or that has not been increased by transactions within the transferor's economic group. Paragraph 84.1(2(a applies to shares on prior to 1972 and is designed to stop the stripping of pre-valuation capital gains through non-arms length transactions. Paragraph 84.1(2(a.l deals with shares acquired after 1971 and is designed to reduce the adjusted cost base by the amount of any increase due to the use of the lifetime capital gains exemption by persons not dealing at armsmlength with the vendor. As a result of the Income Tax Amendments Act, 1996, certain amendments have been made and paragraph 84.1(2(a.2 of the act will be repealed and replaced by new subsection 84.1(2.01 which treats a share as having acquired by a taxpayer in a nonmarms length transaction for the purposes of paragraph 84.1(2(a.l where the taxpayer has elected under subsection (19 to recognize all of a part of the gain accrued to February 22, 1994 on the share this amendment ensures that an election

29 27 under 110.6(19 in respect of the share will not increase the holder's adjusted cost base of the share for the purposes of section In addition new paragraph 84.1(2.01(c ensures, amongst other things, that the test for non-arm's length status is continuous running from generation to generation with that continuity being severed only upon an arm's length disposition. Section 84.1 prevents the realization of a capital gain on a n~n-arms length transfer of shares. Therefore, where a taxpayer purchases shares from an arms-length vendor, which shares have a low paid-up capital and high adjusted cost base, 84.1 allows the individual to remove the adjusted cost base. The fact that the arms-length vendor may have used the capital gains exemption to shelter his or her gain is not relevant. In conclusion where section 84.1 applies the outcome can be disastrous to the unwary, however, where a taxpayer has "hard" adjusted cost base a taxpayer may be able to extract the "hard" adjusted cost base without any adverse tax consequences.

30 NOTES (For: Selected Topics Related to the Transfer of a Business Dwayne Anderson \, ' / '~,

31 ROLLOVER OF PROPERTY TO A SPOUSE DURING LIFETIME AND ON DEATH A. ROLLOVER TO SPOUSE DURING LIFETIME Any capital property can be transferred to a spouse or spouse trust without tax consequences; the transfer at tax cost is automatic under subsection 73(1 Election can be made to transfer property at fair market value., Election will usually be made where transferor has gains or losses which can be offset by the realization of the gain or loss on the property transferred Must be concerned with attribution of rules 74.1 to 74.5 which may attribute income back to transferor where transferee is, or has become a spouse or an infant related to the transferor general exception is for transfers for fair market value consideration 2

32 B. ROLLOVER TO SPOUSE ON DEATH - 70(6 accruaito date of death - 70(1 deemed disposition at fair market value "immediately before" death - 70(5 Rollover provided under 70(6 if property transferred (A directly to Canadian resident spouse, or (B to Canadian resident trust created by will - vested indefeasibly within 36 months - spouse entitled to all income and no one else can encroach on capital before spouse's death Can elect out under - 70(6.2 Spousal trust deemed to dispose of all assets at fair market value on surviving spouse's death 3