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CHAPTER 16

Income Deferral: Rollover on Transfers to


a Corporation and Pitfalls
Solution 1 (Basic)
Land(1) .........................................................................................
Marketable securities(2) ................................................................
Building(3) ...................................................................................
Equipment(4) ................................................................................
Furniture and fixtures(5) ................................................................
Licence(6).....................................................................................

Min. elected
amount
$
60,000
60,000
70,000
45,000
7,000
80,000

Income
Nil
$
2,500
Nil
5,000
Nil
Nil

Max. boot
$
60,000
55,000
70,000
40,000
7,000
80,000

NOTES TO SOLUTION
(1) (a) Minimum elected amount:
Greater of:
(i) FMV of boot .....................................................................................................
(ii) Lesser of:
(A) FMV of property ................................................................. $ 75,000
(B) ACB ...................................................................................

50,000

60,000

60,000
(60,000)
Nil

60,000

55,000

$
$
$

60,000
55,000
5,000
2,500

55,000

70,000

70,000
(85,000)
Nil

70,000

60,000

(b) Income:
Proceeds ..........................................................................................................................
Cost.................................................................................................................................
Capital gain/loss ..............................................................................................................
(2) (a) Minimum elected amount:
Greater of:
(i) FMV of boot .....................................................................................................
(ii) Lesser of:
(A) FMV of property ................................................................. $ 65,000
(B) ACB ................................................................................... $ 55,000
(b) Proceeds ..........................................................................................................................
Cost.................................................................................................................................
Gain ................................................................................................................................
Taxable capital gain .........................................................................................................
(3) (a) Minimum elected amount:
Greater of:
(i) FMV of boot .....................................................................................................
(ii) Least of:
(A) FMV of property ................................................................. $ 95,000
(B) UCC of class ....................................................................... $ 70,000
(C) Cost of property .................................................................. $ 85,000
(b) Taxable capital gain:
Proceeds ..................................................................................................................
Cost .........................................................................................................................
Gain/Loss.................................................................................................................
Terminal loss/Recapture:
UCC ........................................................................................................................
Less: lesser of:
(i) Capital cost ......................................................................... $ 85,000

70,000
(ii) Proceeds .............................................................................

70,000
Nil

269

270

Introduction to Federal Income Taxation in Canada


(4) (a) Minimum elected amount:
Greater of:
(i) FMV of boot .....................................................................................................
(ii) Least of:
(A) FMV of property ................................................................. $ 50,000
(B) UCC of property.................................................................. $ 40,000
(C) Cost of property .................................................................. $ 65,000
(b) Taxable capital gain:
Proceeds ..................................................................................................................
Cost .........................................................................................................................
Recapture:
UCC ........................................................................................................................
Less: lesser of:
(i) Capital cost ......................................................................... $ 65,000

45,000

40,000

50,000
(65,000)
Nil

40,000
45,000

(ii) Proceeds ............................................................................. $ 45,000


Recapture .................................................................................................................
(5) (a) Minimum elected amount:
Greater of:
(i) FMV of boot .....................................................................................................
(ii) Least of:
(A) FMV of property ................................................................. $ 10,000
(B) UCC of class ....................................................................... $
7,000
(C) Cost of property .................................................................. $ 15,000
(b) Taxable capital gain:
Proceeds ..................................................................................................................
Cost .........................................................................................................................
Gain/Loss.................................................................................................................
Recapture/Terminal loss:
UCC ........................................................................................................................
Less: lesser of:
(i) Capital cost ......................................................................... $ 15,000

5,000

5,000

7,000

7,000
(15,000)
Nil

7,000
7,000

(ii) Proceeds ............................................................................. $


7,000
Recapture
(6) (a) Minimum elected amount:
Greater of:
(i) FMV of boot .....................................................................................................
(ii) Least of:
(A) FMV of property ................................................................. $ 100,000
(B) 4/3 of CEC ........................................................................... $ 80,000
(C) Cost of property .................................................................. $ 82,500
(b) CEC ................................................................................................................................
Proceeds: 3/4 $80,000 ....................................................................................................

Nil

15,000

80,000

60,000
60,000
Nil

Solutions to Chapter 16 Assignment Problems

271

Solution 2 (Basic)
Section 85 rollover
Elijah has only two assets eligible for a subsection 85(1) rollover: the office equipment and the goodwill. To
ensure that no income arises on transferring these assets to the corporation, the total elected amount to be agreed
on between him and the corporation should not exceed $10,001. The maximum non-share consideration that
Elijah can receive while deferring the maximum amount of gain is $10,001.
Asset
Office equip.
Goodwill

Tax Value
$10,000
Nil
$10,000

FMV
$12,000
20,000
$32,000

Elected
Amount
$10,000
1
$10,001

Assumed
Debt
$9,000
$9,000

New
Debt
$1,000
1
$1,001

Shares
$ 2,000
19,999
$21,999

Other transferred property (non-section 85)


Asset
Cash
Accounts receivable**

FMV Transfer
$ 5,000
$15,000
$20,000

Consideration received
$ 5,000 note payable to Elijah
$15,000 note payable to Elijah
$20,000

** An election should be filed under section 22 with regard to the transfer of the receivables. Failure to file the election will
result in any bad debts realized by the company being considered capital losses rather than losses on income account.

Elijahs income arising on the transfer


The only income realized by Elijah is the $1 from the disposition of the goodwill. The taxable portion of the
disposition of that, through the CEC account, is $0.50.
Tax Values of Assets Owned by the Corporation
Assets
Cash
Accounts receivable
Office equipment
Goodwill ( $1.00)

$ 5,000.00
15,000.00
10,000.00
0.75
$30,000.75

Note that transfer of the bank loan to the corporation requires the approval of the bank. If the bank did not
approve, a note payable to Elijah can be substituted in the rollover.

Introduction to Federal Income Taxation in Canada

272
Solution 3 (Basic)

The following assets cannot or should not be transferred using section 85:

Cash (not eligible) ...........................................


Inventory(1) ......................................................

Tax value
$ 22,000
44,000
$ 66,000

FMV
$ 22,000
39,500
$ 61,500

Transfer
price
$ 22,000
39,500
$ 61,500

Minimum
transfer
price
$
6,000
45,000
8,000
$ 59,000

Consideration
Debt
Shares
$ 6,000 $ 2,000
45,000
10,000
8,000
22,000
$ 59,000 $ 34,000

Debt
$ 22,000
39,500
$ 61,500

Income
Effect
Nil
$ (4,500)
$ (4,500)

The following assets should be transferred using section 85:

Furniture & fixtures .....................


Building ......................................
Land............................................
Total ...........................................

Tax value
$ 6,000
45,000
8,000
$ 59,000

FMV
$ 8,000
55,000
30,000
$ 93,000

Income
Effect
Nil
Nil
Nil

There should be no adverse tax consequences on this transfer, since the FMV of the consideration received
(i.e., debt and shares) was exactly equal to the FMVs of the transferred assets. In addition, the non-share
consideration did not exceed the tax values of the transferred assets.
Cost of shares received as consideration:
Elected transfer price .............................................................................................................. $ 59,000
Deduct: non-share consideration..............................................................................................
59,000
Adjusted cost base of shares ....................................................................................................
Nil
Legal stated capital before reduction..............................................................................................
$ 34,000
Subsection 85(2.1) reduction in PUC:
(a) increase in LSC ........................................................................................... $ 34,000 (A)
(b) elected amount ........................................................................ $ 59,000
less: boot ................................................................................
59,000
excess, if any ..............................................................................................
Nil (B)
PUC reduction (A B)...................................................................................................................
34,000
Tax PUC after reduction ................................................................................................................
Nil

The tax PUC after reduction reflects the fact that the tax-paid cost of the assets transferred has been
recovered through the debt assumed. The tax basis of all assets was $59,000, which was also the amount Pete
elected for the transfer price and was the amount of non-share consideration Pete wished to assume. This nonshare consideration reduces the tax PUC of the common shares to nil, which is a logical result, as all the tax-paid
value of the assets is now in the form of the debt which Pete can withdraw tax-free as he wishes and as funds
become available.
NOTE TO SOLUTION
(1) Since there is no possible income to defer on a transfer to the corporation, section 85 does not have to be
used. The transfer could be made through a direct sale, taking back debt consideration equal to the fair market
value, i.e., $39,500.

Solutions to Chapter 16 Assignment Problems

273

Solution 4 (Advanced)
Note: Ms. Hart must transfer the business assets to Hart Ltd. at FMV in order to avoid the application of
section 69. If the property is transferred at less than FMV, paragraph 69(1)(b) will still deem Ms. Harts proceeds
to be FMV.
(A) Income for tax purposes if section 85 not used:
Shares in public companies
[$6,000 $ 11,000 = $5,000 capital loss denied [par. 40(2)(g)], because it is a superficial
loss [sec. 54]; added to the adjusted cost base of the property owned by the corporation [par.
53(1)(f)] ..............................................................................................................................
Nil
Accounts receivable (capital property)
Include last years reserve .................................................................................................... $
1,000
[$10,000 $14,000 = $4,000 capital loss denied because it is a superficial loss, as
above]
Nil
Inventory Business income ..........................................................................................................
1,000
Land (inventory)
Business income ($220,000 $100,000)...............................................................................
120,000
Prepaid insurance
Business income (loss) ($600 $600) ..................................................................................
Nil
Building
Terminal loss denied [ssec. 13(21.2)] ...................................................................................
Nil
Land (capital property)
Taxable capital gain [1/2 ($160,000 $140,000)]................................................................
10,000
Goodwill
Business income [2/3 3/4 ($80,000 0)] ...........................................................................
40,000
Total income ............................................................................................................................... $ 172,000
(B) Items not transferred under section 85:
FMV
Shares .................................................................
(do not transfersee below)
Accounts receivable ............................................ $ 10,000 (use section 22 for full business loss of $4,000)
Land (inventory) .................................................
(do not transfersee below)
Prepaid insurance ................................................
600 (not capital property)
Building..............................................................
50,000 (unrealized terminal loss, no income to defer)
Total transfer price .............................................. $ 60,600 (take back debt consideration)

Items that should not be transferred to corporation:


Shares
If Ms. Hart intends to sell the shares, it might be more advantageous to keep them out of the company and
realize the loss personally rather than in the corporation. It is unlikely that she would need the shares to carry on
the business.
The shares would not be earning Canadian active business income. It may therefore make sense to keep the
shares out of the corporation to ensure that Hart Ltd. qualifies as a small business corporation [ssec. 248(1)] and
a qualified small business corporation [sec. 110.6]. Since Mr. Hart is a shareholder of Hart Ltd., section 74.4 may
apply if Hart Ltd. is not a small business corporation.
(If the shares are to be transferred, section 85 is not necessary because there is no gain. The shares should be
sold for $6,000 of debt consideration.)
Land inventory
Not eligible for section 85 since not a capital property
Do not transfer in since not needed for the businessbetter to postpone the realization of the $120,000
business income
(If the land inventory is to be transferred, the consideration should be debt of $120,000.)
Items transferred under section 85:
Consideration

Inventory .........................
Land (capital property) .....
Goodwill..........................

Tax value
$
8,000
140,000
Nil
$ 148,000

FMV
9,000
160,000
80,000
$ 249,000
$

Elected
Amount
$
8,000
140,000
1
$ 148,001

Assumed
Debt
$ 8,000
52,000
Nil
$ 60,000

New
Debt
Nil
88,000
Nil
$ 88,000

Shares
1,000
20,000
80,000
$ 101,000
$

Income
Nil
Nil
$ 0.50
$ 0.50

Introduction to Federal Income Taxation in Canada

274

ACB of shares received:


Elected transfer price ......................................................................... $ 148,001
Allocated to debt consideration
Debt assumed....................................................... $ 60,000
New debt issued ...................................................
88,000
148,000
ACB of shares ................................................................................... $
1
PUC of shares received:
LSC before reduction .........................................................................................................................
Subsection 85(2.1) reduction in PUC
(A) Increase in LSC of all shares ...................................................................... $ 101,000(A)
(B) Elected amount ................................................................... $ 148,001
Less: boot ...........................................................................
148,000
Excess, if any ....................................................................................................
1 (B)
Total PUC reduction (A) (B).....................................................................................................
Tax PUC after reduction .....................................................................................................................

101,000

$
$

100,999
1

Tax cost to corporation of assets transferred:


Shares* ......................................................

Tax cost
$ 11,000

Accounts receivable ...................................

14,000

Inventory ...................................................
Land inventory* .........................................
Prepaid ......................................................
Building.....................................................

8,000
220,000
600
50,000

Land ..........................................................
Goodwill....................................................

140,000
.50

Reason
$6,000 FMV transfer price plus $5,000 superficial loss
[par. 53(1)(f)]
Actual cost $14,000, before any reserve claimed by
purchaser corporation at its year end [sec. 22]
Elected amount [par. 85(1)(a)]
FMV transfer price
FMV transfer price
UCC is deemed to be $50,000 [par. 85(5)(b)]; Capital
cost is deemed to be $90,000 [par. 85(5)(a)]
elected amount [par. 85(1)(a)]
CEC = 3/4 $1 elected amount 1/2 $0.50
[par. 85(1)(a), ssec.14(5)]

* if these properties are transferred to the corporation

(C) Proceeds of disposition ............................................................


Less: Adjusted cost base ..........................................................
Capital gain.............................................................................
Taxable capital gain (1/2 $100,999) .......................................
(D) Proceeds of redemption ...........................................................
Less: PUC...............................................................................
Deemed dividend [ssec. 84(3)].................................................
Proceeds of disposition ............................................................
Less Deemed dividend [ssec. 84(3)].........................................
Adjusted proceeds of disposition [spar. 54(h)(x)] .....................
Adjusted cost base...................................................................
Capital gain (loss) ...................................................................

$ 101,000
1
$ 100,999
$ 50,500
$ 101,000
1
$ 100,999
$ 101,000
100,999
$
1
1
$
Nil

Solutions to Chapter 16 Assignment Problems

275

Solution 5 (Advanced)
(A) Shares of Supplyco Ltd. should not be transferred to the corporation, if they would jeopardize the
qualification of the shares of the new corporation as QSBCS. At this time, the FMV of the Supplyco Ltd. shares
is less than 10% of the FMV of all of the assets of the new corporation, but this could change in the future. There
is no advantage to having the corporation owning these shares.
Shares of Clientco Ltd. should not be transferred to the corporation. The accrued loss of $900 would be
denied as a superficial loss [par. 40(2)(g)] and added to the adjusted cost base of the Clientco Ltd. shares held by
the new corporation. There is also no advantage to having the corporation own these shares.
(B) Items not transferred under section 85:
Cash (not capital property [ssec. 85(1.1)]) .....................................................
Accounts receivable......................................................................................
Equipment (no income to defer; simpler not to use ssec. 85(1)) ......................
Total debt consideration to be taken ..............................................................

12,000
102,000(1)
40,000(2)
$ 154,000

(C) Items transferred under section 85:

Inventories ..............
Land .......................
Buildings ................
1990 Acura .............
Goodwill .................
Total................

Tax value
$ 90,000
96,000
42,000
1,000
Nil
$ 229,000

FMV
$ 100,000
103,000
144,000
5,000
90,000
$ 442,000

Minimum
transfer
price
$ 90,000
102,000
42,000
1,000
1(4)
$ 235,001

Consideration
Assumed
liabilities
Notes
Prefs.
$ 90,000
Nil
$ 10,000
61,000
41,000
1,000
Nil
42,000
102,000
Nil
1,000
4,000
Nil
Nil
90,000
$ 151,000(5) $ 84,000(5) $ 207,000

Effect on
income
Nil
$3,000 TCG(3)
Nil
Nil
0.50

(D) Cost of consideration received:


Elected transfer price (excluding benefit) ........................................... $ 235,001
less: debt assumed ............................................ $ 151,000
debt issued ................................................
84,000
235,000
ACB of preferred shares .................................................................... $
1
Tax PUC of shares received:
LSC before reduction...................................................................................................................... $ 207,000
Subsection 85(2.1) reduction:
(i) Increase in LSC of all shares ...................................................................... $ 207,000 (A)
(ii) Elected amount .................................................................. $ 235,001
Less: boot ...........................................................................
235,000
Excess, if any.............................................................................................
1 (B)
Total PUC reduction (A B) ....................................................................................
(206,999)
Tax PUC after reduction ................................................................................................................. $
1

(E) The FMV of the assets transferred to the corporation would be greater than the consideration received
and since his three children will own the common shares there is a problem with gifting [par. 85(1)(e.2]. Note
that the fair market value of assets transferred ($442,000) under section 85 is greater than the total fair market
value of consideration ($385,000) received by the transferor. Since the transferors children will own common
shares in the corporation, the excess of $57,000 can be considered a benefit. Thus, the elected amount must be
increased by the $57,000 to $292,001 for the purpose of determining the proceeds of disposition to the transferor
and cost to the corporation, but not the adjusted cost base of the consideration received. The $57,000 will have to
be added to the elected amount of various assets transferred under section 85. Thus, the elected amount of such
assets as the land and goodwill should be increased because only a portion of the increase will be subjected to
tax. If the increase had been made to the inventories or the building, the full increase would be taxed.
Minimum transfer price .....................................................................
Increase due to benefit .......................................................................
Elected transfer price after benefit ......................................................

$
$

235,001
57,000
292,001

Cost of share consideration received:


Elected transfer price (excluding benefit)
Less:
debt assumed
debt issued
ACB of preferred shares

$235,001
$151,000
84,000

235,000
$
1

Introduction to Federal Income Taxation in Canada

276
Tax PUC of shares received:
LSC before reduction
Subsection 85(2.1) reduction:
(i) increase in LSC of all shares
(ii) elected amount (including benefit)
less boot
excess, if any
Total PUC reduction
Tax PUC after reduction

$150,000
$150,000 (A)
$292,001
235,000
57,000 (B)
(92,999)
$ 57,001

The increase in the elected amount as a result of the paragraph 85(1)(e.2) benefit of $57,000 is reflected in the
PUC after reduction because subsection 85(2.1) uses the increased elected amount in item B. Since income is created
for the transferor by the $57,000 benefit, the $57,000 can be considered to be a tax-paid cost that was not recovered
through boot received, along with the $1 of tax-paid cost created by electing to transfer the goodwill at $1.
(F) The newly determined fair market value of the goodwill ($120,000) transferred to the corporation would
be greater than the total debt and share consideration ($90,000) received on the transfer. In order to ensure that
the subsequent valuation does not result in the benefit [par. 85(1)(e.2)] problem, discussed in (E) above, a price
adjustment clause should be added to the documentation of the transaction. The effect is to adjust the value of the
share consideration to $120,000, so that the total consideration reflects the newly determined value of the
goodwill. As suggested in the text, case law indicates that a price adjustment clause will only be recognized if the
parties have reasonably, and in good faith, attempted to determine values that equal fair market values.
NOTES TO SOLUTION
(1) Section 22 election is recommended on transfer of accounts receivable so that the purchaser is eligible
for a reserve for bad debts and a bad debt write-off of these accounts and the vendor incurs a business loss of
$18,000 rather than an allowable capital loss of $9,000. In order to qualify for this election, the vendors loss
must be taken into the purchasers income. If section 22 is not elected, then the loss will be a capital loss which is
denied as a superficial loss [sec. 54] by paragraph 40(2)(g) with an increase in the cost base of the receivables
owned by the corporation after the transfer [par. 53(1)(f)], whether or not section 85 is used for the transfer of the
receivables. The 2010 reserve of $10,000 must be included in 2011 income in either case.
(2) The accrued terminal loss is denied [ssec. 13(21.2)]. The UCC of the equipment in the corporation will
be $40,000. Joe will retain a UCC of $17,000 to be depreciated until SEL sells the amounts to an arms length
party.
(3) In order to use the net capital loss of $4,500, an elected transfer price of $102,000 should be chosen. This
amount will trigger a capital gain of $6,000 (a taxable capital gain of $3,000). The net capital loss of $4,500
realized in 1999 will be adjusted to $3,000 (i.e., $4,500 1/2 3/4).
(4) Goodwill must be transferred at a nominal amount of $1.00.
(5) New debt issued by corporation ($84,000) plus actual debts assumed ($151,000) total $1 less than the
maximum debt of $235,001, equal to the elected amount.

Solutions to Chapter 16 Assignment Problems

277

Solution 6 (Advanced)
(A) The shares in Public Co. should not be transferred to the corporation since the capital loss would be
denied under paragraph 40(2)(g) and the section 54 definition of superficial loss whether or not section 85 is
used on the transfer. These shares should be held personally so that capital loss can be realized on their
disposition to a third party.
Similarly, the land (Parcel II) should not be transferred to the corporation. Since this land would be land
inventory, it cannot be transferred on a tax-free basis on section 85 [ssec. 85(1.1)]. Any other form of transfer
must be at fair market value since Mr. Schminkie and the corporation do not deal at arms length, and will result
in triggering an income inclusion. Recommend that this parcel of land be held personally.
(B) Items which cannot or should not be transferred under section 85:

Asset
Cash...............................
A/R ................................
Inventory .......................
Equipment......................

Tax value
$ 20,000
96,000
86,000
35,000
$ 237,000

FMV
20,000
85,000
86,000
5,000
$ 196,000
$

Transfer
price
$ 20,000
85,000
86,000
5,000
$ 196,000

Consideration
Assumed
Income
debt
effect
$ 20,000
Nil
85,000 $ (5,000)(1)
86,000
Nil
5,000
Nil(2)
$ 196,000 $ (5,000)

Comment
not eligible
net of reserve
no inc. to defer
no inc. to defer

(C) Items transferred under section 85:


Asset
Land: Parcel I..
Building ..........
Auto ................
Goodwill .........

Tax value
$ 200,000
15,000
11,000
Nil
$ 226,000

FMV
$ 339,000
75,000
12,000
60,000
$ 486,000

Consideration
Elected
Assumed
amount
liabilities
$ 200,000
$ 46,000
15,000

11,000

$ 226,001 $ 46,000

Cl. A
New debt
shares
$ 154,000(3) $ 139,000
15,000
60,000
11,000
1,000

$180,000
$ 200,000

Cl. B
shares

60,000
$ 60,000

Income effect
Nil
Nil
Nil
.50

(D) Cost of consideration taken on section 85 transfer:


Elected amount.................................................................................................................................$ 226,001
Allocation of non-share consideration
assumed debt ........................................................................................ $ 46,000
new debt...............................................................................................
180,000
226,000
Cost of share consideration ......................................................................................................... $
1
PUC of share consideration taken:
Subsection 85(2.1) reduction in PUC:
Increase in LSC of all shares ($200,000 + $50,000)............................. $ 260,000(A)
Less: Elected amount ........................................................... $226,001
Less: Boot ................................................................... (226,000)
Excess, if any .............................................................................
1 (B)
Total reduction (A B)............................................................... $ 259,999
Redeemable preferred Retractable preferred
Increase in LSC for each class...........................................................................
$ 200,000(C)
$ 60,000 (C)
Reduction in each class [(A B) C/A]
$200,000
Redeemable pref. shares, $259,999
.......................................
(199,999)
$260,000

$60,000
.........................................
(60,000)
$260,000
Tax PUC after reduction for each class ..............................................................
$
1
Nil
The $1 total PUC after the reduction reflects the fact that all of the tax-paid cost in the assets transferred
(i.e., $226,000) has been recovered through assumed liabilities and new debt received.
(E) Proceeds of redemption ......................................................
$ 260,000
Less: PUC (total) ................................................................
1
Deemed dividend [ssec. 84(3)] ............................................
$ 259,999
Proceeds of disposition .......................................................
$ 260,000
Less: deemed dividend [ssec. 84(3)] ....................................
259,999
Adjusted proceeds of disposition .........................................
$
1
Adjusted cost base (total) ....................................................
1
Capital gain (loss)(3)............................................................
Nil
Retractable pref. shares, $259,999

Introduction to Federal Income Taxation in Canada

278

(F) An additional $10,000 of new debt should be taken to balance the FMV of assets transferred with total
FMV of consideration, to avoid a benefit under paragraph 85(1)(e.2) because of the wifes shares. The result is
an increase in the elected amount. The gain should be triggered on capital property or eligible capital property
which would result in an amount that is only taxable at . Note, also, that $196,000 of the $242,000 in
proprietorship liabilities were assumed as consideration for assets not transferred under section 85. This leaves
$46,000 (i.e., $242,000 $196,000) to be assumed as consideration for the land.
NOTES TO SOLUTION
(1) Section 22 election:
Proprietorship
Reserve................................... $ 6,000
Income ............................
Consideration..........................
85,000
Business loss on transfer
11,000
Accounts receivable .........

6,000

96,000

Corporation
Accounts receivable ................ $ 96,000
Consideration ....................
Income ..............................
can take a reserve.
can write off bad debts.

$ 85,000
11,000

(2) A terminal loss of $30,000 is not allowed to Mr. Schminkie by virtue of subsection 13(21.2). The
corporation will have a UCC of $5,000, and Mr. Schminkie will retain a UCC in that class of $30,000.
(3) Since Mr. Schminkie and his wife are affiliated with the corporation, had there been a capital loss, the
capital loss would have been denied and added to the cost base of the common shares held by Mr. Schminkie by
virtue of subsection 40(3.6).

Solutions to Chapter 16 Assignment Problems

279

Solution 7 (Basic)
This transaction will be subject to the provisions in section 84.1. In order for this section to apply, a number
of conditions must be met. An individual, resident in Canada (i.e., Mrs. Andrews), must dispose of shares of a
corporation resident in Canada (i.e., Plummer) to another corporation (VHL) with which the individual (i.e.,
Mrs. Andrews) does not deal at arms length. As Mrs. Andrews owns 100% of the shares of VHL, Mrs. Andrews
and VHL do not deal at arms length, since they are related [spar. 251(2)(a)(i)]. After the transaction Plummer
and VHL must be connected, within the meaning assigned by subsection 186(4). Plummer and VHL are
connected as VHL controls Plummer. Therefore, all the conditions for section 84.1 to apply are met.
Paragraph 84.1(1)(a) will apply to reduce the tax PUC of the shares Mrs. Andrews takes back from VHL.
This reduction is calculated as follows:
Increase in LSC of VHL shares ................................................................................................
Less: greater of:
PUC of Plummer shares ....................................................... $
1,000
Modified ACB of Plummer .................................................. $ 200,000 $ 200,000
Less: FMV of boot ....................................................................................
200,000
Excess, if any ..........................................................................................................................
PUC reduction (A B) ............................................................................................................
PUC after reduction ($800,000 $800,000)..............................................................................

800,000 (A)

Nil (B)
800,000
Nil

The nil PUC after reduction reflects the fact that all of the hard cost of the Plummer shares has been
recovered by the $200,000 note taken back as consideration on the transfer.
No deemed dividend will arise [par. 84.1(1)(b)], since the non-share consideration did not exceed the greater
of the PUC ($1,000) or modified ACB ($200,000) as shown below.
Deemed dividend equals:
Sum of:
(1) Increase in LSC of VHL shares .............................................................................
(2) FMV of boot ........................................................................................................

800,000
200,000
$ 1,000,000

Less: the sum of:


(3) Greater of:
(a) PUC of Plummer.............................................. $
1,000
(b) Modified ACB of Plummer .............................. $ 200,000 $ 200,000
(4) PUC reduction [par. 84.1(1)(a)] ......................................................
800,000
Deemed dividend.................................................................................................................

1,000,000
Nil

Mrs. Andrews should elect to transfer the Plummer shares to VHL for $600,000. This represents the
$200,000 cost base plus the $400,000 inherent capital gain that she wishes to crystallize to utilize her capital
gains deduction for qualified small business corporation shares.
Elected amount (deemed proceeds of disposition) ..........................................................................
Less: deemed dividend [par. 84.1(1)(b)] ........................................................................................
Adjusted proceeds of disposition [sec. 54] .....................................................................................
Adjusted cost base ........................................................................................................................
Capital gain equal to capital gains exemption ................................................................................
Mrs. Andrews has an adjusted cost base for the VHL shares of $400,000.
Elected amount .............................................................................................................................
Less: boot or non-share consideration ............................................................................................
Adjusted cost base of VHL shares .................................................................................................

$
$
$
$
$

600,000
Nil
600,000
200,000
400,000
600,000
200,000
400,000

If an arms length purchaser can be found, Mrs. Andrews will be able to reduce the potential capital gain on
such a sale by $400,000, with the adjusted cost base as determined above.

Introduction to Federal Income Taxation in Canada

280
Solution 8 (Advanced)
(A) PUC reduction [par. 84.1(1)(a)]:

1. increase in LSC of Sam Pickings shares.........................................................................


Less:
2. greater of:
(a) PUC of Low-Cal shares ........................................... $ 250,000
$ 250,000
(b) modified ACB of Low-Cal shares ............................ $ 250,000
Less: FMV of boot .................................................................................
750,000
Excess, if any ...............................................................................................................
PUC reduction (A B).........................................................................................................
PUC after reduction ($1,250,000 $1,250,000) ....................................................................

$ 1,250,000 (A)

Nil (B)
$ 1,250,000
$
Nil

The nil PUC after reduction reflects the fact that all of the hard cost of the shares of Low-Cal Limited has
been recovered through boot received from Sam Pickings Limited.
Deemed dividend [par. 84.1(1)(b)]:
Sum of:
1. increase in LSC of Sam Pickings ........................................................................... $ 1,250,000 (A)
2. FMV of boot .........................................................................................................
750,000 (D)
(A + D) $ 2,000,000
Less sum of:
3. greater of:
(a) PUC of Low-Cal shares ................................ $ 250,000
$ 250,000 (E)
(b) modified ACB of Low-Cal shares.................. $ 250,000
4. PUC reduction under par. 84.1(1)(a) ...............................................
1,250,000 (F)
(E + F)
1,500,000
Deemed dividend ...................................................................................... (A + D) (E + F) $ 500,000

The deemed dividend is effectively equal to the $750,000 of boot received in excess of the $250,000 of
hard cost of the Low-Cal shares transferred.
Capital gain on Low-Cal shares:
Elected under section 85 for Low-Cal shares (proceeds of disposition) ..................................
Less: sec. 54 exclusion for par. 84.1(1)(b) deemed dividend ..................................................
Adjusted proceeds of disposition for Low-Cal shares ............................................................
Less: ACB of Low-Cal shares ..............................................................................................
Capital gain (loss) ................................................................................................................
Taxable income of Mrs. Domm from capital gain:
Cost of Sam Pickings shares after allocation to boot [par. 85(1)(g)] (elected amount
$750,000 minus boot $750,000) ....................................................................................

$
$

750,000
500,000
250,000
250,000
Nil
Nil

Note how there is no capital gain eligible to offset the QSBC share capital gains deduction as a result of
section 84.1.
(B) Transfer the shares of Low-Cal Limited to Sam Pickings Limited and elect an amount of $750,000 under
section 85. Take back $250,000 in cash and $1,750,000 in preferred shares of Sam Pickings Limited.
The following will result:
PUC reduction [par. 84.1(1)(a)]:
(a) Increase in LSC of Sam Pickings shares ............................................................... $ 1,750,000 (A)
Less:
(b) Greater of:
(i) PUC of Low-Cal shares ............................
$ 250,000
$ 250,000
(ii) Modified ACB of Low-Cal shares .............
$ 250,000
less: FMV of boot...............................................................
250,000
Excess, if any ............................................................................................
Nil (B)
PUC reduction (A B) ............................................................................................
$ 1,750,000
PUC after reduction ($1,750,000 $1,750,000) ........................................................
Nil

The nil PUC reflects the fact that all $250,000 of hard cost in the Low-Cal shares has been recovered by
cash from Sam Pickings.

Solutions to Chapter 16 Assignment Problems

281

Deemed dividend [par. 84.1(1)(b)]:


Sum of:
(a) Increase in LSC of Sam Pickings shares .................................................................
(b) FMV of boot ..........................................................................................................
(A + D)..................................................................................................................
Less sum of:
(c) Greater of:
(i) PUC of Low-Cal shares............................. $
250,000
$ 250,000 (E)
(ii) Modified ACB of Low-Cal shares ............. $
250,000
(d) PUC reduction [par. 84.1(1)(a)] ..................................................
1,750,000 (F)
(E + F) ...................................................................................................................
Deemed dividend (A + D) (E + F) ................................................................................

$ 1,750,000 (A)
250,000 (D)
$ 2,000,000

2,000,000
Nil

There is no deemed dividend because the boot received from Sam Pickings does not exceed the hard cost of
the Low-Cal shares.
Taxable income of Mrs. Domm from capital gain:
Elected amount [sec. 85] for Low-Cal shares ....................................................................
Less: Sec. 54 exclusion for par. 84.1(1)(b) deemed dividend .............................................
Adjusted proceeds of disposition for Low-Cal shares ........................................................
Less: ACB of Low-Cal shares ..........................................................................................
Capital gain .....................................................................................................................
Taxable capital gain (1/2 $500,000) ................................................................................
Less: capital gains deduction ............................................................................................
Effect on taxable income of Mrs. Domm ..........................................................................
ACB of Sam Pickings shares:
Cost of Sam Pickings shares after par. 85(1)(g) allocation to boot (elected amount of
$750,000 boot of $250,000) ...................................................................................

$
$
$
$

750,000
Nil
750,000
250,000
500,000
250,000
250,000
Nil
500,000

Note what has occurred in this situation. Mrs. Domm has given up shares in Low-Cal Limited with a cost
base of $250,000 and a fair market value of $2,000,000. She has acquired cash of $250,000 and shares with a
cost base of $500,000 and a fair market value of $1,750,000. She has done so without immediate tax
consequences. Of the accrued gain of $1,750,000 on the shares of Low-Cal Limited, she has protected $500,000
from future taxation as a capital gain when the shares of Sam Pickings Limited are sold and deferred the other
$1,250,000 in the fair market value of the Sam Pickings shares in excess of their cost. The $500,000 cost base of
the shares of Sam Pickings Limited represents the $500,000 crystallization of the capital gains exemption.
(C) Mrs. Domm would have to sell 29 shares to realize a capital gain which would utilize all of the remaining
$500,000 QSBC share exemption:
($2,000,000 $250,000) 100 shares = $17,500
$500,000 $17,500 = 29 shares (rounded)
The conditions of section 84.1 would still be met by this outright sale to the non-arms length
corporation, Sam Pickings Limited. Since the holding corporation is paying only cash for the shares of LowCal Limited, no shares of Sam Pickings Limited are issued and, hence, no PUC reduction will occur.
However, there will be an immediate deemed dividend computed as follows:
Sum of:
(a) Increase in LSC of Sam Pickings shares ...................................................................
(b) FMV of boot (29 shares @ $20,000 per share) .........................................................
(A + D)..................................................................................................................
Less sum of:
(c) Greater of:
(i) PUC of Low-Cal shares (29 shares @ $2,500)
$ 72,500
$ 72,500 (E)
(ii) Modified ACB of Low-Cal shares (29 shares)
$ 72,500
(d) PUC reduction [par. 84.1(1)(a)] ........................................................
Nil (F)
(E + F) .....................................................................................................................
Deemed dividend (A + D) (E + F) .................................................................................

Nil (A)
$ 580,000 (D)
$ 580,000

$ 72,500
$ 507,500

Again, the $507,500 of deemed dividend reflects the $580,000 of boot received in excess of the hard
cost of $72,500 in the Low-Cal shares.

282

Introduction to Federal Income Taxation in Canada

Proceeds of disposition for the Low-Cal Limited shares will be reduced under section 54 so that there
will be no capital gains against which to offset the capital gains deduction, as follows:
Consideration in cash received on sale Proceeds of disposition .................................
Less: sec. 54 exclusion from proceeds for sec. 84.1 deemed dividend ............................
Adjusted proceeds of disposition ..................................................................................
ACB of Low-Cal shares ...............................................................................................
Capital gain .................................................................................................................

580,000
507,500
$
72,500
(72,500)
Nil

Note how $500,000 of the gain on the shares, which should have been protected by the capital gains
exemption, is taxed as a deemed dividend on the sale of the shares for cash.
(D) (i) Ultimate redemption of shares of Sam Pickings:
Proceeds on redemption............................................................................
Less: PUC ................................................................................................
Deemed dividend [ssec. 84(3)]..................................................................
Proceeds of disposition .............................................................................
Less: deemed dividend .............................................................................
Adjusted proceeds of disposition [sec. 54] .................................................
Less: adjusted cost base ............................................................................
Capital loss ..............................................................................................
Summary of income effects:
sec. 84.1 deemed dividend ................................................................
ssec. 84(3) deemed dividend .............................................................
capital gain (loss) on sec. 85 transfer Low-Cal ..............................
capital gain (loss) on redemption Sam Pickings .............................
net economic effect ...........................................................................

Part A
$ 1,250,000
Nil
$ 1,250,000
$ 1,250,000
1,250,000
Nil
Nil
Nil

Part B
$ 1,750,000
Nil
$ 1,750,000
$ 1,750,000
1,750,000
Nil
$ 500,000
$ (500,000)

Nil
1,750,000
500,000
(500,000)
$ 1,750,000

500,000
1,250,000
Nil
Nil
$ 1,750,000

Note how the full accrued capital gain on the Low-Cal Limited shares is subject to tax as a deemed
dividend, which would have resulted from a direct redemption of the Low-Cal shares by Low-Cal Limited
itself.
(ii) Ultimate sale of shares of Sam Pickings: ..................................................
Proceeds of disposition ............................................................................
Less: adjusted cost base ...........................................................................
Capital gain.............................................................................................
Summary of income effects: ....................................................................
sec. 84.1 deemed dividend ...............................................................
capital gain Low-Cal ...................................................................
capital gain Sam Pickings ............................................................
net economic effect ..........................................................................

Part A

Part B

$ 1,250,000
Nil
$ 1,250,000

$ 1,750,000
500,000
$ 1,250,000

500,000
Nil
1,250,000
$ 1,750,000

Note that the $1,750,000 represents the accrued capital gain on the Low-Cal shares.

Nil
500,000
1,250,000
$ 1,750,000
$

Solutions to Chapter 16 Assignment Problems

283

Solution 9 (Advanced)
Both Plan A and Plan B would result in an application of subsection 55(2) by the CRA, converting what
would have been a tax-free intercorporate dividend or a deemed dividend into proceeds of disposition for capital
gains purposes. Under Plan B, only part of the dividend would be a deemed dividend under subsection 84(3) on
the redemption of the Corporate Raider Inc. shares.
Subsection 55(2) applies in both of these scenarios because:
(a) Holden Limited and Corporate Raider Inc. are not related;
(b) Holden Limited received a dividend that was deductible under section 112; and
(c) one of the purposes of the dividend in Plan A and one of the results of the dividend in Plan B was to
effect a significant reduction in the capital gain on the ultimate sale of the shares of Profits Galore Inc.
The results of these two proposed transactions would be:
Plan A
Of the $1,900,000 dividend received by Holden Limited from Profits Galore Inc., $900,000 can be attributed
to post-1971 earnings; therefore, these $900,000 of dividends are excluded from the calculation of the deemed
proceeds of disposition of the Profits Galore Inc. shares for purpose of subsection 55(2). Since Profits Galore Inc.
has only active business income, there is no income subject to Part IV tax which would further shelter the
dividend paid to Holden Limited from the effects of subsection 55(2). The balance of the dividend (i.e.,
$1,000,000) will be deemed part of the proceeds of disposition and added to the actual proceeds of $500,000. As
a result, the following capital gain on the disposition of the Profit Galore shares would be computed:
Actual proceeds of disposition................................................................................................
Add: Deemed proceeds of disposition:
Dividend received ................................................................................ $ 1,900,000
Less: post-1971 earnings ......................................................................
900,000
Total proceeds of disposition ..................................................................................................
Less: Adjusted cost base ......................................................................................................
Capital gain ...........................................................................................................................

500,000

1,000,000
$ 1,500,000
500,000
$ 1,000,000

These results are equivalent to Holden Limited receiving a dividend from Profits Galore of $900,000 (equal
to the sheltered post-1971 earnings) and then selling the shares to Corporate Raider Inc. for their then fair market
value of $1,500,000, giving rise to a capital gain of $1,000,000 (i.e., $1,500,000 $500,000).
Plan B
Under this alternative, the Profits Galore shares are to be transferred to Corporate Raider using section 85
and electing a transfer price of $500,000 equal to the adjusted cost base of the transferred shares. Therefore, the
adjusted cost base of the shares accepted as consideration (i.e., the special shares of Corporate Raider) will also
be $500,000.
When Corporate Raider Inc. redeems these shares from Holden Limited there will be a deemed dividend
[ssec. 84(3)] calculated as:
Redemption/retraction price ...............................................................................................
Less: Paid-up capital ........................................................................................................
Deemed dividend [ssec. 84(3)] ...........................................................................................
Less: Amount deemed not to be a dividend but proceeds of disposition .......... $1,900,000
Less: post-1971 earnings(1) ...................................................................
900,000
Remaining deemed dividend under ssec. 84(3)....................................................................
Capital gain on the disposition of the shares:
Proceeds of disposition (redemption price) .........................................................................
Less: Remaining ssec. 84(3) deemed dividend as determined above(2) ...............................
Deemed proceeds of disposition .........................................................................................
Less: Adjusted cost base ..................................................................................................
Capital gain .......................................................................................................................

$ 2,400,000
500,000
$ 1,900,000

1,000,000
900,000

$ 2,400,000
900,000
$ 1,500,000
500,000
$ 1,000,000

NOTES TO SOLUTION
(1) Holden Limited would have to designate a separate dividend of $900,000 [par. 55(5)(f)]. Subsection
55(2) would deem the other $1,000,000 to be proceeds of disposition. The $900,000 dividend would not be
deemed to be proceeds of disposition since subsection 55(2) excludes post-1971 earnings.
(2) The definition of proceeds of disposition in section 54 would exclude the subsection 84(3) deemed
dividend on the redemption of shares.

Introduction to Federal Income Taxation in Canada

284

CHAPTER 17

Income Deferral: Other Rollovers and Use of


Rollovers in Estate Planning
Solution 1 (Advanced)
Part (A)
If Jason accepts the first alternative, section 85.1 will not apply, since one of the conditions (see (c), below)
of this provision has not been met:
(a) the vendors shares (Jasons shares of Quality Appliances) must be capital property to him (consistent
with the facts in this case);
(b) these shares must be shares of a Canadian corporation (i.e., Quality Appliances, which fits the
definition);
(c) the consideration for this exchange must be only issued shares of the purchaser (i.e., Big Distributors
Ltd.);
(d) there can be no capital gain on this exchange;
(e) the vendor (Jason) and the purchaser (Big Distributors Ltd.) must be at arms length before the share
exchange (given);
(f) after the share exchange the vendor may not control (de jure) the purchaser or may not own more than
50% of the FMV of the shares (given).
For section 85.1 to be operative, only share consideration can be received [par. 85.1(2)(d)]. Since cash is
received under this alternative, Jason will realize a capital gain of $75,000 ($125,000 $50,000). One half of this
gain, $37,500, will be a taxable capital gain. This gain may be eligible for the capital gains deduction if the
shares are qualified small business corporation shares. If Jason does not have his capital gains deduction
available, he will be required to pay tax on this capital gain, even though he has received cash of only $25,000 on
this disposition. Note that Jason is not eligible for a capital gains reserve, since he has received FMV
consideration in total [par. 40(1)(a)].
Jason may be able to minimize his tax cost under the first option if he could negotiate the restructuring of
the transaction as two separate dispositions. The first disposition would be a cash sale of shares for $25,000. A
proportionate amount of the ACB would be allocated to these shares. In this way, any tax on the capital gain
would not exceed the cash realized. The remaining shares, exchanged for shares of Big Distributors Ltd., would
qualify for the rollover under section 85.1.
Under the second alternative, section 85.1 will apply to the share exchange offered. Jasons proceeds of
disposition for the Quality Appliances shares, and the ACB of the Big Distributors shares received will be
$50,000. Therefore, no capital gain or loss to Jason arises.
Big Distributors addition to paid-up capital for the shares issued to Jason will be limited to the PUC of the
Quality Appliances shares ($25,000), through the PUC reduction mechanism [ssec. 85.1(2.1)]. The ACB to Big
Distributors Ltd. of the Quality Appliances shares acquired will be equal to the lesser of their fair market value
on the exchange ($125,000) and their PUC ($25,000). Therefore, the ACB will be $25,000.
Part (B)
Under the first alternative, a subsection 85(1) election would be advisable if Jason wishes to defer the capital
gain. As Jason is the only vendor, it is relatively easy to comply with the administrative requirement of filing the
joint election form. The elected amount could be set at $50,000 to fully defer the capital gain. The ACB to Jason
of the new shares in Big Distributors Ltd. would be set at $25,000 (i.e., elected amount of $50,000 boot of
$25,000), while their FMV would be $100,000. Big Distributors PUC of the shares issued to Jason would be
$25,000 [ssec. 85(2.1)]. This amount is calculated as:

Solutions to Chapter 16 Assignment Problems


LSC before reduction ...........................................................................................................
Less: Increase in PUC of all shares................................................................ $ 100,000
Elected amount ............................................................ $
50,000
Less: Boot ...................................................................
25,000
(25,000)
PUC after reduction .............................................................................................................

285
$

100,000

(75,000)
25,000

If a subsection 85(1) election is made for the second alternative, the accrued capital gain on the Quality
Appliances shares transferred would be fully deferred. The ACB to Jason of Big Distributors shares, issued to
Jason, would be equal to the elected amount of $50,000. The PUC of Big Distributors shares would be $50,000
after the reduction, reflecting the amount of the cost (i.e., $50,000) of the Quality Appliances Ltd. shares not
recovered by boot from Big Distributors Ltd.

Introduction to Federal Income Taxation in Canada

286
Solution 2 (Advanced)

(a) There is no deemed dividend [ssec. 84(1)] because of the PUC reduction [par. 86(2.1)(a)] to give a total
reduced PUC of $210,000 which is less than the PUC of the old shares of $300,000. There is also no deemed
dividend [ssec. 84(3)] because the redemption amount paid, consisting of boot of $90,000 and total reduced PUC
of shares issued, $210,000, does not exceed the PUC of the old shares of $300,000.
Issuance of New Shares
(1) PUC of new shares:
LSC increase for all new shares ..............................................................................
Less: PUC of old shares ................................................................. $ 300,000
Less: boot ($10K + $80K) .....................................................
90,000
PUC reduction........................................................................................................
Reduced PUC of all shares ($810K $600K) ..........................................................

810,000

$
$

210,000
600,000
210,000

Allocation of reduced PUC:

LSC increase by share class ..............................................................


PUC reduction:
$600,000

Class A preferred shares: $600,000


$810,000

Preferred
shares
$ 600,000

Common
shares
$ 210,000

444,444

$210,000

$810,000
Reduced PUC by class .............................................................. $ 155,556
(2) Cost of all new shares:
ACB of old shares ............................................................................ $ 300,000
Less: Cost of boot.............................................................................
90,000
Allocation of cost of new shares:
Class A preferreds: $600,000/$810,000 $210,000 .................................................
Class B preferreds: $210,000/$810,000 $210,000 .................................................
Cost of non-share consideration (=FMV) ......................................................................
Class B preferred shares: $600,000

Redemption of Old Shares


(1) Proceeds of redemption of old shares:
Reduced PUC of new shares ...................................................................................
FMV of non-share consideration (boot) ...................................................................
Redemption proceeds .............................................................................................
Deemed dividend [ssec. 84(3)]:
Redemption proceeds .............................................................................................
PUC of old shares...................................................................................................
Deemed dividend [ssec. 84(3)]................................................................................
(2) Proceeds of disposition of old shares:
Cost of all new shares .............................................................................................
Boot .......................................................................................................................
Total ......................................................................................................................
Less: ssec. 84(3) deemed dividend ..........................................................................
Proceeds of disposition of old shares .......................................................................
CG or CL on disposition of old shares:
Proceeds ................................................................................................................
ACB ......................................................................................................................
CG/CL ...................................................................................................................
Net economic effects:
Deemed dividend on reorganization ........................................................................
CG (CL) on disposition of old shares ......................................................................
Accrued CG on new shares:
FMV ........................................................................................ $ 810,000
ACB .........................................................................................
(210,000)

155,556
$

54,444

210,000

$
$
$

155,556
54,444
90,000

210,000
90,000
300,000

$
$

300,000
(300,000)
Nil

210,000
90,000
300,000
Nil
300,000

$
$
$

300,000
300,000
Nil
Nil
Nil

600,000

The accrued gain on the new shares reflects the same accrued gain on the old shares before the
reorganization.

Solutions to Chapter 16 Assignment Problems

287

The PUC of the new preferred shares and common shares will be equal to the reduced PUC calculated
above. These PUC values reflect the remaining tax-paid cost which has not been returned to the shareholder in
the form of non-share consideration (i.e., cash of $10,000 and a bond of $80,000).
(b) In this case, there will be no deemed dividend [ssec. 84(1)]. The PUC of the corporation has not
increased. Prior to the reorganization, the PUC of the corporation was $300,000 and after the reorganization PUC
is nil. A deemed dividend does arise, however, under subsection 84(3). This is because the redemption amount
paid, consisting of boot of $500,000 and total reduced PUC of shares issued of nil, exceeds the PUC of the old
shares of $300,000.
Issuance of New Shares
(1) Reduced PUC:
LSC increase for all shares......................................................................................
Less: PUC of old shares ................................................................. $ 300,000
Less: boot .............................................................................
500,000
PUC reduction........................................................................................................
Total reduced PUC ($400K $400K) .....................................................................
(2) Cost of new shares received:
ACB of old shares ..................................................................................................
Less: Boot ..............................................................................................................
Cost of new shares..................................................................................................
Cost of boot (= FMV) ..................................................................................................
Redemption of Old Shares
(1) Redemption proceeds of old shares:
Reduced PUC of new shares ...................................................................................
Boot .......................................................................................................................
Redemption proceeds .............................................................................................
Deemed dividend [ssec. 84(3)]:
Redemption proceeds .............................................................................................
Less: PUC of old shares ..........................................................................................
Deemed dividend [ssec. 84(3)]................................................................................
(2) Proceeds of disposition of old shares:
Boot .......................................................................................................................
Cost of new shares..................................................................................................
Total ......................................................................................................................
Less: Ssec. 84(3) deemed dividend [par. (j) of def. proceeds of disposition
in sec. 54]...........................................................................................................
Proceeds of disposition of old shares .......................................................................
Capital gain (loss) on disposition of old shares:
Adjusted proceeds of disposition .............................................................................
ACB of old shares ..................................................................................................
Capital gain (loss) ........................................................................................................

400,000

Nil
400,000
Nil

$
$

300,000
500,000
Nil
500,000

$
$

Nil
500,000
500,000

$
$
$

500,000
300,000
200,000

500,000
Nil
500,000

(200,000)
300,000

300,000
(300,000)
Nil

The PUC will be nil [ssec. 86(2.1)], since all of the PUC of the old shares of $300,000 has been recovered
through the cash consideration of $500,000.
Net economic effect:
Deemed dividend [ssec. 84(3)] ...............................................................................
Capital gain (loss) on old shares .............................................................................
Accrued capital gain on new shares:
FMV ........................................................................................ $ 400,000
ACB .........................................................................................
Nil
Net economic effect ...............................................................................................

200,000
Nil

400,000
600,000

The net economic effect is equal to the capital gain inherent in the old shares ($900,000 $300,000).

Introduction to Federal Income Taxation in Canada

288
Solution 3 (Advanced)

The following is a summary of the information for Mr. Fresser and his daughter.
ACB
Current Position:
Mr. Fresser
Daughter

Proposed Consideration:
Cash
Pref shares

80% $
20%
$

50,000
12,500
62,500

90,000
300,000
390,000

PUC
$
$

50,000
12,500
62,500

FMV
$
$

500,000
125,000
625,000

(A) Subsection 86(2) will apply to this situation because:


(i) the fair market value of the old shares ($500,000 = 80% $625,000) is greater than the sum of the cost
of the non-share consideration (equal to its fair market value of $90,000) plus the fair market value (i.e.,
the retraction value) of the new shares ($300,000); and
(ii) it is reasonable to regard the $110,000 excess as a benefit to a related person, Mr. Fressers daughter.
Issuance of New Shares
(1) Reduced PUC:
LSC increase in respect of new shares.........................................................................
Less: PUC of old shares ..................................................................... $
50,000
Less: boot .................................................................................
90,000
PUC reduction ...........................................................................................................
Reduced PUC ($300K $300K) .................................................................................
(2) Cost of new preferred shares received on reorganization [par. 86(2)(e)]:
Adjusted cost base of old shares..................................................................................
Less: Cost of non-share consideration ................................................. $
90,000
Benefit .....................................................................................
110,000
Cost of preferred shares (excess, if any) ......................................................................
Cost of new-share consideration (equal to its FMV) ............................................................
Redemption of Old Shares
There is a deemed dividend [ssec. 84(3)], as shown by the following calculation:
(1) Redemption proceeds:
Cash .................................................................................................... $
90,000
Reduced PUC of preferred shares received ............................................
Nil
Less: PUC of old shares .....................................................................................................
Deemed dividend [ssec. 84(3)] ...........................................................................................
The following results from the application of subsection 86(2):
(2) Deemed proceeds of disposition of old shares [par. 86(2)(c)]:
Lesser of:
(1) cost (equal to FMV) of non-share consideration ...........................................
plus: benefit ................................................................................................
(2) fair market value of old shares .....................................................................
Capital gain on disposition of old shares on reorganization:
Deemed proceeds of disposition (lesser of (1) and (2), above) ......................................
Less: Ssec. 84(3) deemed dividend .............................................................................
Adjusted proceeds of disposition ................................................................................
Adjusted cost base of old shares..................................................................................
Capital gain................................................................................................................

300,000

Nil
300,000
Nil

50,000

200,000
Nil
90,000

$
$

$
$
$

90,000
50,000
40,000

90,000
110,000
200,000
500,000

200,000
40,000
$ 160,000
(50,000)
$ 110,000

The final PUC after the exchange will be nil [ssec. 86(2.1)], since all of the PUC of the old shares of
$50,000 has been recovered through the boot of $90,000 cash.
The following net economic effect can be aggregated from the foregoing:
Deemed dividends [ssec. 84(3)] ..................................................................................................
Capital gain (loss) on disposition of common shares .................................................................

40,000
110,000

Solutions to Chapter 16 Assignment Problems

289

Potential accrued capital gain on new preferred shares:


FMV........................................................................................................................................................... $ 300,000
ACB ........................................................................................................................
Nil
Net economic effect ..................................................................................................................

300,000
450,000

This net economic effect of $450,000 reflects the accrued gain of $450,000 (i.e., $500,000 $50,000). Note
how Mr. Fresser has lost the ability to recover $60,000 in tax-paid cost, because he was or will be taxed on
$450,000 but only received $390,000 in value. In addition, the original tax-paid cost of $50,000 is lost due to the
benefit. Note also that the value of the common shares held by his daughter has increased by $110,000 with no
offsetting ACB increase. Therefore, she will realize an added $110,000 in capital gain on her disposition of the
shares. This is another penalty inherent in subsection 86(2).
(B) Redemption of preferred shares
Redemption proceeds ................................................................................
Less PUC ..................................................................................................
Deemed dividend [ssec. 84(3)] ..................................................................
Proceeds of disposition .............................................................................
Less: deemed dividend ..............................................................................
Adjusted proceeds of disposition ...............................................................
Less: adjusted cost base.............................................................................
Capital gain ..............................................................................................

$
$
$

300,000
Nil
300,000
300,000
300,000
Nil
Nil
Nil

Note how the deemed dividend of $300,000 equals the potential accrued gain on the new preferred shares
(i.e., $300,000 Nil = $300,000). However, he only received on the exchange a total fair market value
consideration of $390,000 and the common shares held by the daughter have increased in value by $110,000
(i.e., the amount of the benefit) and there is no offsetting increase in the adjusted cost base of these shares.
Therefore, the $110,000 will be taxed as a capital gain, again, on the disposition of the daughters shares. The
penalty inherent in subsection 86(2), where the shares acquired in the reorganization are redeemed, is the
potential taxation of the same amount of the capital gain twice. This result is, in essence, the same as the result if
the shares acquired on the reorganization are ultimately sold.

Introduction to Federal Income Taxation in Canada

290
Solution 4 (Advanced)

Jonsub Ltd. is deemed to have disposed of its assets for proceeds equal to the cost amount of the assets
immediately before the amalgamation or the winding-up and Normpar Ltd. is deemed to have acquired the
property at a cost equal to the deemed proceeds of the subsidiary.
Cash ................................................................................................................................
Marketable securities at cost ............................................................................................
Accounts receivable ($800,000 plus $30,000 reserve).......................................................
Inventory at lower of cost or market .................................................................................
Land at cost .....................................................................................................................
Building at UCC ..............................................................................................................
Equipment at UCC...........................................................................................................
Goodwill (4/3 Nil CEC balance).....................................................................................

80,000
300,000
830,000
920,000
1,200,000
300,000
200,000
Nil
3,830,000

Bump in ACB of non-depreciable capital property


Normpar Ltd.s ACB of Jonsub Ltd.s shares ...................................................................
Less cost amount of subsidiary net assets:
Cash ................................................................................................ $
80,000
Marketable securities at cost ............................................................
300,000
Accounts receivable ($800,000 plus $30,000 reserve) ......................
830,000
Inventory at lower of cost or market .................................................
920,000
Land at cost .....................................................................................
1,200,000
Building at UCC ..............................................................................
300,000
Equipment at UCC ..........................................................................
200,000
Nil
Goodwill (4/3 Nil CEC balance) ....................................................
Reserve ...........................................................................................
(30,000)
Accounts payable and accrued liabilities ..........................................
(709,000)
Loans payable..................................................................................
(1,000,000)
$ 2,091,000
Add: dividends paid by Subco to Parentco...............................................
500,000
Maximum bump

$ 4,000,000

2,591,000
$ 1,409,000

Limit of bump on non-depreciable capital property:


Fair market value of marketable securities at time Normpar Ltd. acquired control .............
ACB of marketable securities ...........................................................................................
Limit of bump on marketable securities ............................................................................
Fair market value of land at time Normpar Ltd. acquired control ......................................
ACB of land ....................................................................................................................
Limit of bump on land .....................................................................................................

800,000
300,000
$
500,000
$ 1,900,000
1,200,000
$
700,000

Because the building and the goodwill are not non-depreciable capital properties, the bump cannot be
allocated to these two assets.

Allocation of bump to securities and land


Since Normpar Ltd. plans to sell Jonsub Ltd.s marketable securities in the next few years, the
$1,409,000 bump should first be allocated to the marketable securities to the $500,000 limit. The remaining
$909,000 bump ($1,409,000 $500,000) should be allocated to the land to the $700,000 limit. This results
in the land and marketable securities having new ACBs as follows:
Land:
ACB before bump .................................................................................................................
Bump allocated .........................................................................................................
ACB after bump ....................................................................................................................
Marketable securities:
ACB before bump..................................................................................................................
Bump allocated .........................................................................................................
ACB after bump ....................................................................................................................

$ 1,200,000
700,000
$ 1,900,000
$
$

300,000
500,000
800,000

Whether the two companies are amalgamated or Jonsub Ltd. is wound up into Normpar Ltd., the results
should be the same, since the bump is also available on vertical amalgamations.

Solutions to Chapter 16 Assignment Problems

291

Deemed disposition of shares by Normpar Ltd.


Proceeds equal to greater of:
(a) lesser of:
(i) PUC of shares of Jonsub Ltd .
(ii) cost amount of net assets
(b) ACB of shares held by Normpar Ltd.
ACB
Capital gain (loss)

$
1,000 }
$2,091,000 }

1,000 }
}

$4,000,000

$4,000,000 }
(4,000,000)
Nil

Note from this formula that a gain will be rare, since PUC of the Jonsub Ltd. Shares would have to be greater
than their ACB to Normpar Ltd. A loss is impossible from this formula, because proceeds cannot be less than
ACB.

Introduction to Federal Income Taxation in Canada

292
Solution 5 (Advanced)

(A) Amalgamation under section 87,


(i) subsection 87(2.1) provides that for the purposes of determining non-capital and net capital losses of
Tetley it shall be deemed to be a continuation of Rose;
(ii) Rose and Tetley are deemed to have a taxation year-end on June 30, 2011,
this will count as one of the years available for the carryforward of non-capital losses,
the 2008, 2009, and 2010 non-capital losses will be available to Tetley in its 2012 (i.e., the
first taxation year of the amalgamated company) and subsequent taxation years until expiry
under the 20-year limitation,
all of the net capital losses will also be deductible.
(B) Winding-up under subsection 88(1),
(i) Roses non-capital losses and net capital losses are available to Tetley, but not until the first taxation
year of the parent commencing after the wind-up, i.e., the taxation year commencing February 1, 2012
and ending January 31, 2013.
Losses of
Losses of
Rose for its
Tetley for its
fiscal year
fiscal year
ended
become
ended1
Dec. 31, 10
Jan. 31, 11
Dec. 31, 09
Jan. 31, 10
Dec. 31, 08
Jan. 31, 09

12
X
X
X

13

Available for deduction by parent for fiscal years ended


January 31
14
15

28
29
30
31
32

expired

expired

expired

losses not available in year of wind-up

(ii) The 2008 and following losses of Rose would have been deductible in the 2012 taxation year which is
the year following the year of the beginning of the winding-up (2011).
(iii) Therefore, on the basis of the deductibility of losses, both provisions allow for the same deductions,
although the amalgamation may allow faster absorption of losses if the new corporation sets an early
fiscal year-end for its first year.
(C) Other factors
(i) The ACB bump on non-depreciable capital property is available on either an amalgamation or a
winding-up.
(ii) The short taxation years for Rose and Tetley on amalgamation will advance the period for loss
carryovers, investment tax credit carryovers, unpaid amounts, capital cost allowance, etc.,
any provision that depends on a taxation year will be affected in an amalgamation.
(iii) A winding-up under subsection 88(1) is generally more expensive to implement administratively than
an amalgamation under section 87.

For non-capital losses incurred in a taxation year that ends after March 22, 2004, the carryforward period is
10 years, and for taxation years that end after 2005, the carryforward period is 20 years.

Solutions to Chapter 16 Assignment Problems

293

Solution 6 (Advanced)
(A) Transfer of shares under sec. 85
The following represents the normal section 85 chart used to reflect the transfer of assets to a corporation.
FMV
KML common

1,800

TV
$

400

EA
$

800

Debt
$

800

Pref
$

Income

1,000 CG $400

ACB of KHL preferred shares


Elected amount equal to:
Greater of:
(a) fair market value of boot.............................................................................
(b) lesser of:
(i) fair market value of shares transferred (KML) ............. $ 1,800,000
(ii) ACB of shares transferred (KML) .............................. $ 400,000
Elected amount .......................................................................................................
Allocated to debt .....................................................................................................
Cost of preferred shares (KHL) ................................................................................

800,000

400,000

800,000
(800,000)
Nil

Paid-up capital of KHL preferred shares


PUC reduction [par. 84.1(1)(a)]:
(a) increase in LSC of holding company (KHL) .....................................................
less:
(b) greater of:
(i) PUC of KML shares............................... $ 100,000
$ 400,000
(ii) modified ACB of KML shares ............... $ 400,000
less: FMV of boot .....................................................................
800,000
excess, if any............................................................................
PUC reduction ......................................................................................... (A B)
PUC of KHL shares after reduction ..........................................................................
Deemed dividend [par. 84.1(1)(b)]:
Sum of:
(a) increase in LSC of holding company (KHL) ..............................................
(b) FMV of boot ............................................................................................
(A + D)
less sum of:
(c) greater of:
(i) PUC of KML shares ...................... $ 100,000
$ 400,000 (E)
(ii) modified ACB of KML shares ....... $ 400,000
(d) PUC reduction [par. 84.1(1)(a)] .........................................
1,000,000 (F)
(E + F)
Deemed dividend
(A + D) (E + F)

$ 1,000,000(A)

Nil (B)
$ 1,000,000
Nil

$ 1,000,000(A)
800,000(D)
$ 1,800,000

1,400,000
400,000

This deemed dividend could have been avoided by taking no more than $400,000 in non-share
consideration.
Capital gain/loss:
Elected amount under ssec. 85(1) for KML shares* .............................................................
$
Less: sec. 54 exclusion for par. 84.1(1)(b) deemed dividend ................................................
Proceeds of disposition for KML shares ..............................................................................
$
Less: adjusted cost base ......................................................................................................
Capital gain/loss.................................................................................................................

800,000
400,000
400,000
400,000
Nil

* Cannot be less than the boot consideration.

(B) (i) If these KHL preferred shares are sold in an arms length transaction for their fair market value of
$1,000,000, the following would result:
Proceeds of disposition .................................................................................................................
$ 1,000,000
Less: adjusted cost base (see the first calculation under Part (A)) .....................................................
Nil
Capital gain..................................................................................................................................
$ 1,000,000
This capital gain may be eligible for the QSBCS capital gains exemption, if Mrs. Knight has
not used all of her exemption and the shares meet the tests for qualifying small business
corporation shares.

Introduction to Federal Income Taxation in Canada

294

(ii) If, instead, the same shares were redeemed for $1,000,000, the following would result:
Redemption proceeds ...................................................................................................................
$ 1,000,000
Less: PUC (see par. 84.1(1)(a) calculation above) ...........................................................................
Nil
Deemed dividend [ssec. 84(3)] ......................................................................................................
$ 1,000,000
Proceeds on redemption ................................................................................................................
$ 1,000,000
Less: deemed dividend [ssec. 84(3)] ..............................................................................................1,000,000
Adjusted proceeds of disposition [sec. 54] ......................................................................................
Nil
Less: adjusted cost base ................................................................................................................
Nil
Capital gain/loss ...........................................................................................................................
Nil

(C) Insurance of New Shares


(1) Reduced PUC [par. 86(2.1)(a)]:
LSC ..................................................................................................................................
Less: PUC of old shares .........................................................................................$100,000
Less: boot .............................................................................................................. 800,000
PUC reduction ...................................................................................................................
Reduced PUC ($1,000K $1,000K) ....................................................................................
(2) Cost of new KML preferred shares:
Adjusted cost base of old shares ..........................................................................................
Less: FMV of non-share consideration .................................................................................
Cost of preferred shares [par. 86(1)(b)] ................................................................................
Cost of non-share consideration (equal to FMV) ...................................................................
Redemption of Old Shares
(1) Proceeds of redemption of old common shares:
Reduced PUC of new shares ...............................................................................................
FMV of non-share consideration .........................................................................................
Redemption proceeds .........................................................................................................
Deemed dividend [ssec. 84(3)]:
Proceeds of redemption.......................................................................................................
PUC of old common shares .................................................................................................
Deemed dividend ...............................................................................................................
(2) Proceeds of disposition of KML common (old) shares [par. 86(1)(c)]:
Cost of preferred shares [par. 86(1)(b)] ................................................................................
Add: cost of non-share consideration ...................................................................................
Total..................................................................................................................................
Less: exclusion for ssec. 84(3) deemed dividend in sec. 54 def. of P of D ...............................
Proceeds of disposition .......................................................................................................
Capital gain or loss on disposition of KML common (old) shares:
Proceeds of disposition .......................................................................................................
Less: ACB .........................................................................................................................
Capital loss of $300,000 denied [ssec. 40(3.6)] .....................................................................
(3) ACB of KML preferred shares (after denied loss):
ACB of preferred shares (above) .........................................................................................
Add: denied capital loss on disposition of old shares [par. 53(1)(f.2)] .....................................
ACB of preferred shares .....................................................................................................

$ 1,000,000
Nil
$ 1,000,000
Nil
$

400,000
800,000
Nil
800,000

$
$

Nil
800,000
800,000

$
$

$
$
$
$

$
$

800,000
100,000
700,000
Nil
800,000
800,000
700,000
100,000
100,000
400,000
Nil(1)
Nil
300,000
300,000

The PUC (final) of the new preferred shares will be nil since all the PUC of the old common shares of
$100,000 has been recovered through the debt consideration of $800,000.
(D) (i) If the KML preferred shares are sold in an arms length transaction for their fair market value of
$1,000,000, the following would result:
Proceeds of disposition .......................................................................................................
Less: adjusted cost base ......................................................................................................
Capital gain........................................................................................................................
This capital gain may be eligible for the QSBCS capital gains exemption, if Mrs. Knight has
not used all of her exemption and the shares meet the tests for qualifying small business
corporation shares.

$ 1,000,000
300,000
$ 700,000

Solutions to Chapter 16 Assignment Problems

295

(ii) If, instead, the same shares were redeemed for $1,000,000, the following would result:
Proceeds on redemption ......................................................................................................
Less: PUC .........................................................................................................................
Deemed dividend [ssec. 84(3)] ............................................................................................
Proceeds on redemption ......................................................................................................
Less: deemed dividend [ssec. 84(3)] ....................................................................................
Adjusted proceeds of disposition [sec. 54]............................................................................
Less: adjusted cost base ......................................................................................................
Capital loss ........................................................................................................................

$ 1,000,000
Nil
$ 1,000,000
$ 1,000,000
1,000,000
Nil
$ 300,000
$ (300,000)

(E) (i) Comparison of alternatives


(I)
Holdco Freeze
Ultimate arms
Ultimate
length sale
redemption
Summary of income effects
Par. 84.1(1)(b) deemed dividend ...............
$
400,000 $
400,000
Ssec. 84(3) deemed dividend on KML
old common shares...................................
N/A
1,000,000
Capital loss on KML common (old)
shares ......................................................
N/A
N/A
Ssec. 84(3) deemed dividend on KML
(new) shares.............................................
N/A
N/A
Capital gain (loss) on KHL/KML new
shares ...................................................... 1,000,000
Nil
Net economic effect .................................
$ 1,400,000 $ 1,400,000

(II)
Internal Freeze
Ultimate arms
Ultimate
length sale
redemption
N/A
N/A
$

700,000

Nil

Nil

Nil
$

700,000
1,400,000

700,000

1,000,000
$

(300,000)
1,400,000

While the nature and the timing of the income differ, the net economic effect is the same and it is
equal to the accrued gain on the original shares.
(ii) The deemed dividend in alternative (I) [par. 84.1(1)(b)] can be avoided by limiting the non-share
consideration to $400,000. Then, preferred shares with a fair market value of $1,400,000 should be
taken as consideration. Their PUC for tax purposes would be reduced to nil [par. 84.1(1)(a)]. However,
the elected amount under subsection 85(1) could remain at $800,000 and would thereby trigger a capital
gain of $400,000 since the section 84.1 deemed dividend has been eliminated. The adjusted cost base of
the preferred shares would be $400,000 (i.e., $800,000 $400,000).
The deemed dividends in alternative (II) [ssec. 84(3)] can be avoided by limiting the sum of the
PUC of the preferred shares and the non-share consideration to $100,000. Consideration in the
reorganization could consist of $100,000 in non-share consideration and preferred shares with one cent
in PUC and fair market value of $1,700,000. The adjusted cost base of the preferred shares would be
$300,000 [ssec. 86(1)]. It is not possible to elect to create a capital gain to use up the capital gains
deduction.
If the above steps are taken the following comparison would result:
(I)
Holdco Freeze
Ultimate arms
Ultimate
length sale
redemption
Summary of income effects
Capital gain on initial reorganization.........
$
400,000 $
400,000
Ssec. 84(3) deemed dividend ....................
N/A
1,400,000
Capital gain (loss) .................................... 1,000,000
(400,000)
Net economic effect .................................
$ 1,400,000 $ 1,400,000

(II)
Internal Freeze
Ultimate arms
Ultimate
length sale
redemption
N/A
N/A
N/A
$ 1,700,000
$ 1,400,000
(300,000)
$ 1,400,000 $ 1,400,000

NOTE TO SOLUTION
(1) This capital loss of $300,000 is denied by subsection 40(3.6), because Ms. Knight controls the
corporation after the reorganization and, hence, the corporation is affiliated with her. However, the denied loss
can be added to the adjusted cost base of the preferred shares she receives as consideration in the reorganization
[par. 53(1)(f.2)].

296

Introduction to Federal Income Taxation in Canada

Advisory Cases
Case 1: Georgette & Vitality Plus Canada Ltd.
ADVISORY CASE DISCUSSION NOTES
Memo to file:
Georgette & Vitality Plus Canada Ltd.
The objective for Georgette is to maximize her after-tax returns from her business and capital gains and
allow the transfer of ownership of her business to her children. Since Georgette is not ready to retire, she will
want to retain control of the corporation until her daughter(s) are ready to take over the business.
Issues:

Income splitting salary to Candice and corporate tax

Estate freeze and transfer of ownership

Accrued capital gains

RRSP
Corporate tax rate/Salary to Candice
Since Vitality Plus Canada Ltd. is a Canadian-controlled private corporation with active business income,
the company qualifies for the small business deduction on the first $500,000 of taxable income. The federal tax
rate on the first $500,000 of taxable income is 11%. Taxable income in excess of $500,000 is subject to the
general federal tax rate of 18%.
Even at the federal tax rate of 18% on income above $500,000, it may not be tax effective to remove that
income by dividends. As Candice is working for a nominal salary, it would be appropriate to increase her salary
to an amount that recognizes her economic contribution to the company. Her personal tax rate on that salary
would be less than that on any additional salary to Georgette. Additionally, Candice could then maximize her
RRSP contribution.
Estate freeze and transfer of growth
Georgette is interested in transferring the business to her daughters; yet, she is not ready to retire. There are
a few ways that she can complete this task. Georgette should first perform an estate freeze, with the objective of
freezing the value of her shares so that further increases in the value of the company accrue to the children.
To conduct the estate freeze, Georgette would incorporate a holding company and transfer her shares of
Vitality Plus to the holding company in exchange for non-participating, voting, non-cumulative, retractable
preferred/special shares. Her daughters, or a family trust, could then subscribe for common shares of the holding
company at a nominal amount. Any future growth will then accrue to other family members. As Georgettes
shares are voting, she retains control over the company. If the common shares are held by a family trust, she
would also have effective control over those shares by being the trustee.
As her three children are all over the age of 18, the kiddie tax would not apply to dividends received by
the trust and then paid out by the trust. The use of a trust, rather than having the children hold the shares directly,
may be preferred as there is some uncertainty about the interest of the two younger children in the business. A
discretionary trust might be ideal, as it would empower Georgette (the trustee) to eventually distribute the shares
to one or more of the children in any proportion she desired.
A similar result can be achieved with an internal freeze, using a section 86 capital reorganization. This
option has the advantage of having only one corporation, Vitality Plus Canada Ltd., to contend with. However, a
crystallization (see below) cannot be accomplished using section 86.
Georgette may also want to consider including the public utility shares she owns as part of the estate freeze.
In this way, all future growth in those shares will accrue to her daughters. The most effective way to accomplish
this is to transfer those shares to the holding company and file a joint section 85 election with the company.
While the dividend income from those shares will be taxed to the company, the tax will be 1/3 under Part IV, and
this is (likely) approximately the same tax Georgette currently pays on those shares. However, the danger in
combining the investment shares with the shares of Vitality Plus Canada Ltd. is that the shares of the holding
company may not qualify under the QSBCS tests.
Crystallization
As part of the estate freeze, Georgette should crystallize the capital gains deduction available on the Vitality
Plus Canada Ltd shares. By locking in the capital gains deduction, she ensures that the taxes to her estate are
minimized on any deemed disposition of her shares. The estate will not be taxed on up to $750,000 of capital
gain.

Solutions to Chapter 16 Assignment Problems

297

Retirement
After Georgette retires, she can redeem her preferred/special shares gradually over time. This will provide
her with a predictable and certain minimum level of retirement income. For tax purposes, the redemption will
result in dividend income, eligible for the dividend tax credit.
At age 71, Georgette must convert her RRSP into either an annuity or a RRIF. The RRIF offers the
advantage of capital retention and minimizes income in the early years after conversion. A recommendation as to
annuity or RRIF cannot be made at this time, as it would be premature. In the meantime, she might wish to
consider, depending on her wishes, to name her new spouse as the RRSP beneficiary. That way, should
Georgette die holding the RRSP, it can be rolled over to him on a tax-deferred basis.
Marriage
Georgette should visit a family law lawyer to settle a marriage contract prior to her marriage. Under family
law, Georgettes husband will have certain entitlements as her spouse. It would be most unfortunate if these took
precedence over her daughters entitlements.

Introduction to Federal Income Taxation in Canada

298
Case 2: Orillia Resorts Inc.

ADVISORY CASE DISCUSSION NOTES


The main focus of this case is on an estate freeze that doesnt work.
1. Valuation

How was the value of the shares arrived at, given that the value of the shares is based on the value of
the underlying real estate?
o Compare to the sale of shares versus assets type of problem.

What gives the preference shares their value?


o The fact that they are retractable.
2. Section 84.1
He took too much cash and this will result in a deemed dividend of $749,900.
3. Small business corporation
Do we know that Orillia Resorts Inc. is an SBC?
4. Connected corporations

Will Holdco and Orillia Resorts Inc. be connected to avoid Part IV tax on the dividends? It will
depend on whether the preference shares are voting which is not clear.
5. Associated corporations

Will Holdco and Orillia Resorts Inc. be associated to prevent the personal service business rules from
applying? Initially they will be associated regardless of the voting features of the preference shares
since Holdco owns virtually all of the value of Orillia and is therefore deemed to control
[par. 256(1.2)(c)].
6. Corporate attribution

If dividends are accumulated in Holdco causing it to cease to qualify as a small business corporation
then the corporate attribution rules may apply.

Solutions to Chapter 16 Assignment Problems

299

Case 3: Whyte Co. Inc.


ADVISORY CASE DISCUSSION NOTES
This case deals with succession planning for the business owner, which includes both retirement and estate
planning. It also includes non-tax issues. The following are the major topics within succession planning.
1. Retirement income
Relying on the company for retirement income.
Consider a holding company to accumulate dividends away from the risks of the business.
Retiring allowance.
Salary continuation in retirement.
Rent from the real estate.
2. Asset protection
Try to reduce or eliminate personal guarantees.
3. Estate liquidity

Assuming that the cost base of the shares and the real estate is low, there will be a significant tax
liability on the second death.
The tax on the Whyte Co. shares alone could be approximately $1,035,000 [($4,500,000 $100)
50% 46%].
o There will not be enough liquid assets in the estate to pay the tax.
o As a result, either the real estate used in the business will have to be sold or the company will
have to be sold.
You will need to calculate the potential tax on all accrued gains to determine the extent of tax
liability.
Life insurance could be taken out to cover this tax liability.
Consider an estate freeze to limit the tax liability.
4. Estate equalization

If the shares are divided equally, then Sandra will be out-voted on business decisions by Paul and
Joan who are not active in the business.
o This will set up a conflict that will be difficult to avoid.
Without life insurance, there will be little choice but to leave business assets to the two children who
are not active in the business, since all the other assets will be used up to pay the tax on death.
If the tax on death can be provided for, then, perhaps, the land and building could be left to Paul and
Joan with a long-term lease in place.
Can you equate the value of private company shares with cash, i.e., are shares valued at $4.5 million
worth the same as $4.5 million in cash?
5. Tax minimization

The tax that has accrued to this point cannot be avoided except for the tax on the capital gain eligible
for the capital gain exemption.
They might consider an estate freeze on Whyte Co. and even the real estate to limit tax to the amount
accrued to date.
6. Business survival

An important issue with all family-owned business is, will the business survive when the current
owner(s) die?
o Will the departure of Bill and Betty cause the business to decline in value due to a lack of
confidence in the successor by the customers, suppliers, employees and bankers?
7. Opportunities

The opportunity centres around the need for succession planning in all private business in order to
address the needs of the owner, the family and the business.