2015-0602751E5 Capital gains deduction and section 84.1

Principal Issues: Tax policy issue regarding the potential application of section 84.1 in the context of a proposed transaction

Position: General comments provided.

Reasons: Tax policy issue.

Author: Mailhot-Gamelin, Annie
Section: 84.1; 110.6

August 10, 2015                                 Annie Mailhot-Gamelin
                                                           Yves Moreno
XXXXXXXXXX                                   2015-060275

Dear XXXXXXXXXX,

This is in response to your correspondence of July 2015, forwarded to us by your Member of Parliament, XXXXXXXXXX, wherein you describe what you consider to be a tax policy issue regarding the potential application of section 84.1 of the Income Tax Act (Canada) (the “Act”) in your particular situation and the impact on the capital gains deduction under section 110.6 of the Act.

Our understanding of your situation is the following. XXXXXXXXXX (the “Shareholder”) owns all the shares of a company carrying on XXXXXXXXXX (the “Corporation”). You and your wife wish to acquire all the shares of the Corporation through a holding company (“Holdco”). We assume that you and your wife would acquire the shares of the Corporation directly from XXXXXXXXXX in consideration for a promissory note having a principal amount equal to the fair market value of the shares of the Corporation. You and your wife would then transfer the shares of the Corporation to Holdco and use the funds of Holdco and the Corporation to repay the promissory note. We further assume that the shares of the Corporation are “capital property” within the meaning of section 54 of the Act and that they qualify as “qualified small business corporation shares” within the meaning of subsection 110.6(1) of the Act.

We understand that you are concerned about the potential application of section 84.1 of the Act to the proposed transactions which, in your view, could preclude the Shareholder from claiming the capital gains deduction under section 110.6 of the Act in respect of the capital gain realized upon the disposition of the shares of the Corporation to you and your wife.

The Canada Revenue Agency administers and enforces the Act. We can offer the following general comments regarding the relevant provisions of the Act in force as of the date hereof, namely section 84.1 of the Act and its interaction with the capital gains deduction in section 110.6 of the Act.  However, only a tax advisor would be in a position to provide tax advice and this letter should not be viewed in any way as suggesting a course of action or as confirming the application of the Act to any taxpayer.

We refer you to paragraph 1 of Interpretation Bulletin IT-489R, “Non-Arm’s Length Sale of Shares to a Corporation”, dated February 28, 1994 (“IT-489R”) for a detailed description of the conditions of application of section 84.1 of the Act. Generally, section 84.1 of the Act applies to a disposition by an individual resident in Canada, in a non-arm’s length transaction, of shares of a corporation resident in Canada to another corporation.

Section 84.1 of the Act does not prevent the Shareholder from claiming the capital gains deduction under subsection 110.6(2.1) of the Act where you or your wife subsequently dispose of the shares to a corporation with which you do not deal at arm’s length (Holdco).Section 84.1 of the Act is designed to ensure that a distribution of the retained earnings of the Corporation to you and your wife after the sale that would be taxed as a dividend if it had been paid directly to you remains taxed as a dividend after the transfer of the shares of the Corporation to Holdco (the conditions of application of section 84.1 would seem to be met because you and your wife would not deal at arm’s length with Holdco and both Holdco and the Corporation would be connected for purposes of that provision). 
Section 84.1 of the Act would achieve that result either:

•     by reducing the paid-up capital of the shares of Holdco received by you and your wife in consideration for the Corporation shares (this reduction reduces the ability to return paid-up capital of Holdco, which is basically the legal stated capital of the shares adjusted for tax purposes, as the excess would be taxed as a dividend);

•     by deeming you and your wife to have received a dividend where Holdco gives non-share consideration for the Corporation shares (for example, cash or a promissory note).

In essence, section 84.1 of the Act will not have any immediate incidence if the amount of the non-share consideration and/or the paid-up capital of the shares received by you and your wife in consideration for the shares of the Corporation does not exceed the greater of the paid-up capital and the adjusted cost base of the Corporation shares.  As described in paragraph 8 of IT-489R, paragraphs 84.1(2)(a) and 84.1(2)(a.1) of the Act provide rules for determining the adjusted cost base of Corporation shares for the purposes of determining the maximum non-share consideration or paid-up capital that you and your wife could receive from Holdco as consideration for the disposition of shares of the Corporation without any incidence under section 84.1 of the Act.

In the scenario described above, because you and your wife would acquire the shares from the Shareholder (i.e. a person with whom you are not dealing at arm’s length), subparagraph 84.1(2)(a.1)(ii) of the Act provides that the adjusted cost base, to you and your wife, of the Corporation shares would be reduced by the amount of capital gains deduction claimed under section 110.6 of the Act by the Shareholder.

We refer you to paragraphs 6 and 7 of IT-489R for a detailed description of the consequences of the application of section 84.1 of the Act and to the example described at the end of paragraph 8 of IT-489R for an illustration of the application of subparagraph 84.1(2)(a)(ii) of the Act in a situation which appears to bear some resemblance to the transactions described above.

If instead of selling the shares to you and your wife, the Shareholder had sold the shares of the Corporation to Holdco and received a note, subsection 84.1(1)(b) of the Act might apply to deem the Shareholder to have received a dividend on the disposition of the shares.  The amount of such deemed dividend would be excluded from the Shareholder’s “proceeds of disposition” of the shares under paragraph (k) of the definition of that term in section 54 of the Act. In such case, the capital gain that would otherwise have been realized by the Shareholder upon the disposition of his shares would be reduced to the extent of the amount of that deemed dividend. Consequently, the amount of capital gains deduction under section 110.6 of the Act claimed by the Shareholder in respect of the disposition of the shares could be reduced. The adjustment in subparagraph 84.1(2)(a)(ii) of the Act is aimed at adjusting the application of subsection 84.1 of the Act so that a distribution from Holdco on account of retained earnings of the Corporation that would have contributed to the value of the Corporation without being taxed in the hands the Shareholder (the Shareholder would claim a capital gains deduction on the portion of the gain that reflects such retained earnings) is not made tax-free but taxed in the form of a dividend.

Subparagraph 84.1(2)(a)(ii) of the Act was implemented in 1985 so that the benefit of the capital gains deduction on a gain realized on the disposition of a share would not also result in the additional benefit to the taxpayer or a person not dealing at arm’s length with the taxpayer to receive a distribution from the corporation tax-free. Interpretation Bulletin IT-489 dated June 23, 1982, was the object of a Special Release dated June 7, 1985 and was revised to its actual form on February 28, 1994.  Section 84.1 of the Act is discussed in numerous articles published in tax publications. 

We trust the information we have provided and the referral are helpful.

Yours sincerely,

Stéphane Prud'Homme, LL.B, M. Fisc.
Division Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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