THIS EXAMINATION CONSISTS OF 7 PAGES PLEASE ENSURE THAT YOU HAVE A COMPLETE PAPER PETER A. ALLARD SCHOOL OF LAW UNIVERSITY OF BRITISH COLUMBIA FINAL EXAMINATION APRIL 2018 TAXATION OF CORPORATIONS AND SHAREHOLDERS Professor Duff TOTAL MARKS: 100 TIME ALLOWED: 3 HOURS PIus 30 minutes reading time * * ********** * NOTE: 1. This is an open book examination. 2. THIS EXAMINATION CONSISTS OF 2 QUESTIONS 3. PLEASE ANSWER ALL QUESTIONS 4. THE FIRST QUESTION IS WORTH 40 MARKS. 5. THE SECOND QUESTION IS WORTH 60 MARKS 6. ALLOCATION OF MARKS WITHIN EACH QUESTION IS INDICATED IN SQUARE BRACKETS AFTER THE QUESTION
Page 2/7 QUESTION 1 Casey and Marge Irving reside in St. John, New Brunswick, where they carry on an appliance retail business through a Canadian corporation called Irving Appliance Limited ( IAL ), the 100 voting common shares of which they hold through a Canadian corporation called Irving Holdings Ltd. ( IHL ), of which they each own 50 of the company s 100 issued and outstanding common voting shares. Established by Casey and Marge in the early 1990s, IAL s business prospered until 2008, when the global fmancial crisis caused many consumers to delay purchases of expensive items like appliances. In order to sustain the business from 2008 to 2010, Casey and Marge loaned almost $400,000 to IAL, which was recorded as a debt on the company s balance sheet. Facing increasing competition from big box stores, Casey and Marge decided that IAL s business could thrive only if it became a franchise of a larger retail operation that could provide competitive pricing and brand recognition. In 2011, therefore, JAL entered into a franchise agreement with a Canadian company called Canada Appliance Ltd. ( CAL ), the shares of which are listed on the Toronto Stock Exchange. According to the terms of this agreement: (1) IAL was required to carry on its appliance retail business under the name Canada Appliances which was to be prominently displayed in all signs and advertising; (2) IAL was required to purchase all its inventory exclusively from CAL and pay CAL a percentage of its revenue as a royalty; and (3) IAL was required to maintain a minimum reserve of $200,000 as security against the risk that purchasers of appliances on credit would default on payments. Under this arrangement, IAL s business recovered quickly, particularly as economic conditions improved and low-interest rates encouraged consumers to borrow and spend. For each of its taxation years from 2012 to 2015, JAL reported substantial profits, which allowed it to repay most of its debt to Casey and Marge and accumulate a substantial reserve of $800,000, $600,000 of which it used to acquire widely-held shares of publiclytraded companies and $200,000 of which it invested in interest-bearing securities. The company s profits also allowed IAL to pay dividends to IHL, which in turn paid dividends to Casey and Marge, who spent most of this income on a major kitchen renovation in 2016. When Casey and Marge purchased appliances from IAL as part of this renovation, they told the company s accountant to debit their outstanding loan accounts, but the accountant, who was new to the position and unfamiliar with IAL s accounts, neglected to do so. For its 2016 taxation year, which ended December 31, IFL reported total net income of $800,000, comprising net income of $500,000 from the sale of appliances after deducting payments to CAL, $200,000 interest income from furniture sales on credit, $50,000 in dividends on publicly-traded shares, $5,000 interest income from interest-bearing securities, and taxable capital gains of $45,000 from dispositions of publicly-traded shares.
Page 3/7 Question 1 (continued) In computing its taxable income, IAL deducted the full amount of the dividends received under subsection 112(1) of the ITA, resulting in taxable income of $750,000. In computing its federal tax payable for 2016, IAL included $285,000 under subsection 123(1) of the ITA (38% of $750,000), against which it deducted $75,000 under subsection 124(1) (10% of $750,000), $87,500 under subsection 125(1) (17.5% of $500,000) $32,500 under subsection 123.4(2) (13% of $250,000), resulting in net federal tax payable of $90,000. It also added $180,000 to its general rate income pool (GRIP), which was zero at the end of its 2015 taxation year, and paid eligible and capital dividends of $180,000 and $45,000. In computing its income and taxable income for its 2016 taxation year, which also corresponded to the calendar year, IHL included eligible dividends of $180,000 under paragraph 82(1)(a) of the ITA, in respect of which it claimed a deduction under subsection 112(1). It also added $180,000 to its GRIP, which was zero at the end of 2015, and $45,000 to its capital dividend account, and paid eligible and capital dividends of $180,000 and $45,000. In computing their federal income taxes for their 2016 taxation years, Casey and Marge reported eligible dividends of $90,000 each, to which they each added $34,200 under subparagraph 82(1)(b)((ii) of the ITA (38% of $90,000), in respect of which they each claimed a federal dividend tax credit of $18,654.55 under subparagraph 121 (b)(iv) (6/ of $34,200). In addition to owning 50% of the voting common shares of IHL, Mrs. Irving also owns 20% of the voting common shares of Teal Gallery Limited ( TGL ), a Canadian company that was originally established by her mother, the shares of which were bequeathed in equal portions to Marge and her four siblings when her mother passed away in 2015. Although three of Marge s siblings reside in the United States, the gallery is managed by Marge s youngest sister Patti, who resides in St. John. Under a unanimous shareholders agreement entered into by all of Marge s siblings in December 2015, Patti is the sole director of TGL. In computing its income for its 2016 taxation year, which ended on December 31, TGL reported active business income of $200,000 in respect of which it claimed the small business deduction under subsection 125(1) of the ITA. The Irvings have one child named Jeff who was born in December 1997, and began working for IAL part-time at the age of 14. After graduating from high school in June 2014, Jeff began working for IAL full-time as the company s deliveries manager, the responsibilities of which included scheduling deliveries, driving the company s delivery truck and physically loading and unloading furniture. In March 2015, Jeff persuaded his parents to let him carry on these activities through a separate corporation called Irving Deliveries Limited ( IDL ), which was incorporated on April 1, 2015, with its first fiscal year ending on March 31, 2016. Immediately after the company was incorporated, Jeff acquired all 100 voting common shares of IDL for $1 each, and IAL transferred its delivery truck to IDL on a tax-deferred
electing Page 4/7 Question 1 (continued) basis under subsection 85(1) $20,000 (its fair market value) as the proceeds of disposition of the truck (which IAL had purchased a few years earlier for $45,000 and depreciated for tax purposes to $24,000), and receiving 100 non-voting, non-convertible and non-exchangeable preferred shares, each of which was redeemable for $200 ($20,000 in aggregate) and were entitled to an annual dividend of $2 per share or 1% of the redemption amount (which was the prescribed rate at the time). DL then entered into a contract with L&L to provide exclusive delivery services to IAL in exchange for a fixed fee of $10,000 per month. In computing its income for its taxation year ending March 31, 2016, IDL included these monthly payments, deducted salary payments and operating costs and reported net active business income of $50,000, in respect of which it claimed the small business deduction under subsection 125(1) of the ITA. The Canada Revenue Agency (CRA) has asked you to review these facts in order to determine how IAL, IHL, TGL and IDL as well as Casey and Marge should be assessed for tax purposes. In particular, the CRA would like to know: (1) whether these companies are Canadian-controlled private corporations (CCPCs) [8 marks]; (2) which, if any, of these companies are associated for tax purposes [12 marks]; (3) how the different kinds of income that IFL received in 2016 should be characterized for tax purposes, and the implications of this characterization for the dividends that it paid to IHL and the dividends that IHL paid to Casey and Marge [12 marks]; (4) whether IFL could elect $20,000 as proceeds of disposition of the delivery truck that it transferred to IDL [2 marks]; and. (5) whether Casey and Marge can be assessed on the basis that they received a shareholder benefit when they purchased appliances from IAL and IAL s accountant failed to debit their outstanding loan accounts [6 marks]. In your answers, please refer to relevant statutory provisions and judicial decisions. END OF QUESTION 1
Page 5/7 QUESTION 2 Tatyana Petrograd is a graphic designer, who used to reside in Toronto, Ontario, where she carried on a graphic design business through a company called Liberty Village Studios Limited ( LVS ), the 1,000 common voting shares of which she purchased in an arm s length transaction in 2002 for their fair market value, which was $300 per share ($300,000 in total). Incorporated in 1992 with an initial capital investment of $30,000, the paid-up capital of the LVS shares was $30 each ($30,000 in total). With Tatyana s energy and creative flair, the graphic design business thrived, and Tatyana was able to expand the business by investing after-tax profits in sophisticated computer design equipment and hiring more employees. By the end of 2011, LVS employed twelve people, and the company s assets were worth $1.2 million, of which $900,000 was attributable to computer equipment and $300,000 to office furniture. In early 2012, however, LVS lost two important clients, resulting in decreased revenues and substantial losses in computing its income for its 2012 and 2013 taxation years (which coincided with the calendar year). Although the business returned to profitability in 2014 when the company obtained a lucrative contract with the Government of Ontario, the losses in 2012 and 2013 were so substantial that the company still had a non-capital loss of $250,000 at the end of its 2014 taxation year. As a result of the negative experience in 2012 and 2013, moreover, Tatyana decided not to reinvest the company s profits in new equipment or employees, but instead to accumulate a fmancial reserve in order to better withstand future business risks. By the spring of 2015, the company s assets were valued at $1.5 million, of which $700,000 was attributable to computer equipment, $200,000 to office furniture, and $600,000 to shortterm securities. In the fall of 2014, Tatyana met Anton Pavlovich, a Russian émigré residing in London, England, with whom she became romantically involved. After conducting a long-distance relationship for several months, Tatyana decided to sell the graphic design business and move to London, where she and Anton planned to marry. In February 2015, a group of employees indicated that they would like to purchase the business, and they and Tatyana contacted the company s tax advisors to fmd out how to carry out the transaction in the most tax-efficient way. Based on this advice Tatyana and the employee group (the Employees Group ) carried out the following transactions in March 2015: (1) On February 16, Tatyana incorporated a private company called Petrograd Holdings Limited ( PHL ) and the Employees Group incorporated a private company called Studio Holdings Limited ( SHL ).
Page 6/7 Question 2 (continued) (2) On February 17, Tatyana sold her 1,000 LVS shares to PHL in exchange for 500 non-voting preferred shares with an aggregate paid-up capital of $300,000 ($600 per share) and 1,000 voting common shares with zero paid-up capital. (3) On February 18, LVS cashed in its short-term securities and paid a dividend of $500 on each of its 1,000 common shares ($500,000 in total). (4) Immediately thereafter, Tatyana redeemed her 500 preferred shares of PHL for $500,000. (5) On February 19, the Employees Group invested $300,000 in SHL, which borrowed $700,000 from the Canadian Imperial Bank of Toronto ( CIBT ) and purchased Tatyana s 1,000 voting common shares of PHL for $1 million. (6) Immediately thereafter, LVS paid a dividend of $100 on each of its 1,000 common shares held by PHL ($100,000 in total), which paid a dividend of $100 on each of its 1,000 common voting shares held by SHL, which repaid $100,000 of the loan from CIBT. (7) On February 20, LVS paid another dividend of $400 on each of its 1,000 common shares ($400,000 in total), in the form of a promissory note. (8) Immediately thereafter, PHL sold its 1,000 LVS shares to SHL for $500,000, PHL and LVS were amalgamated as New Liberty Village Studios Ltd. ( NLVS ), and SHL exchanged its PHL and LVS shares for 1,000 common voting shares of NLVS with a paid-up capital of $30 each ($30,000 in total). When Tatyana filed her Canadian tax return for her 2015 taxation year, Tatyana and PHL jointly elected $500,0000 as the proceeds of disposition of her LVS shares to PHL. In computing her income for tax purposes, she: (1) included a (non-eligible) taxable dividend of $200,000 on the redemption of her 500 preferred shares in PHL, in respect of which she added $34,000 (17%) under 82(1)(b)(i) and deducted $24,620.69 (21/29 x $34,000) in computing federal tax payable under paragraph 121(a); (2) deducted an allowable capital loss of $100,000 (capital loss of $200,000) from the disposition of her 500 preferred shares in PHL; (3) reported a taxable capital gain of $500,000 (capital gain of $1 million) from the disposition of her 1,000 common shares of PEIL; and
Page 7/7 Question 2 (continued) (4) claimed a lifetime capital gains deduction of $400,000. In computing its income for each of its two 2015 taxation years (ending February 19 and February 20), PHL reported taxable dividends of $500,000, in respect of which it claimed deductions under subsection 112(1). In computing its income for its 2015 taxation year, which ended on December 31, NLVS reported income from the graphic design business against which it deducted non-capital losses incurred by LVS in 2013. The Canada Revenue Agency (CRA) recently issued notices of reassessment to Tatyana, PHL and NLVS which: (1) increased the amount of the deemed dividend on the redemption of Tatyana s preferred shares in PHL from $200,000 to $470,000, and increased the allowable capital loss on the disposition of these shares from $100,000 to $235,000 (capital loss of $470,000) on the basis that paragraph 84.1(1)(a) reduced the paid-up capital of the 500 preferred shares that she received from PHL from $300,000 to $30,000 [12 marks]; (2) disallowed Tatyana s lifetime capital gains deduction on two alternative grounds: (a) that the PHL shares were not qualified small business corporation shares [10 marks], or (b) that the sale of these shares to SHL was subject to specific anti-avoidance rules in subsection 84(2) or section 84.1 or resulted in abusive tax avoidance subject to the general anti-avoidance rule (GAAR) in section 245 of the ITA [12 marks]; (3) re-characterized the $500,000 in dividends that PHL paid to SHL as capital gains under former subsection 55(2) [10 marks]; (4) reduced the paid-up capital of the NLVS shares issued on the amalgamation of PHL and LVS to nil on the grounds that the paid-up capital of the LVS shares ought to have been eliminated on its amalgamation with PHL [8 marks]; and (5) disallowed the deduction of non-capital losses by NLVS in its 2015 taxation year and by on the basis that the carry-forward of these losses was prohibited under subsections 87(2.1) and 111(5) [8 marks]. Please advise Tatyana, PHL and NLVS on the merits of these reassessments, referring to relevant statutory provisions and judicial decisions. END OF EXAMINATION