2022-0928721C6 2022 CALU - Q3 - Recent Changes to Section 84.1

Principal Issues: Application of amendments to section 84.1 by Bill C-208.

Position: See below.

Reasons: See below.

Author: Prescott, Patrick
Section: 84.1(2)(e), 84.1(2.3)

CALU Roundtable - May 2022

Question 3 – Recent Changes to Section 84.1

Background

Bill C-208, An Act to amend the Income Tax Act (transfer of small business or family farm or fishing corporation), received Royal Assent on June 29, 2021. Subsequently the Department of Finance (Finance Canada) confirmed that the legislative changes were effective as of the date of Royal Assent. However, Finance Canada also indicated that it planned to bring forward additional legislative amendments that would honour the spirit of Bill C-208 while safeguarding against unintended tax avoidance loopholes that may have been created by Bill C-208. Budget 2022 announced the commencement of a consultation process on this matter. Budget 2022 also indicated that proposed legislation to address these issues may be introduced in the fall of 2022.

In general terms, Bill C-208 amends section 84.1 of the Income Tax Act (the “Act”) to provide that the deemed dividend treatment under subsection 84.1(1) does not apply in certain family business transfers. We understand that a number of family business transfers have now taken place in reliance on these legislative changes. The purpose of the questions that follow is to confirm the CRA’s view on how these changes will be interpreted based on the following fact pattern which involves two dispositions.

Facts

Mr. Smith, age 65, (Taxpayer) was the owner of all the shares in Opco (Subject Shares). The adjusted cost base (ACB) of the Subject Shares to Taxpayer and their paid-up capital (PUC) is $100,000. The Subject Shares were qualifying small business corporation shares within the meaning of subsection 110.6(1) of the Act (QSBC Shares). In the summer of 2021, Taxpayer decided to retire and sell the business to his adult daughter, Joan, who has been actively engaged in Opco’s business. Taxpayer engaged an independent valuator who determined his Subject Shares had a fair market value (FMV) of $2 million. Joan incorporated a wholly owned company (Purchaser Corporation), to acquire the Subject Shares, on the advice of her accountant. She capitalized Purchaser Corporation with $200,000, and Purchaser Corporation purchased from Taxpayer all of the Subject Shares for proceeds of disposition (POD) of $2 million. The purchase agreement required Purchaser Corporation to make an immediate payment of $200,000 to Taxpayer, with Purchaser Corporation providing a promissory note for the remaining $1.8 million. The promissory note required annual payments of $200,000 (plus interest on the outstanding balance) on each anniversary of the sale for the following nine years. The sale transaction was finalized on October 30, 2021 (First Disposition).

Based on the foregoing facts it would appear that the criteria in paragraph 84.1(2)(e) of the Act have been satisfied so that Taxpayer is deemed to deal at arm’s length with Purchaser Corporation on October 30, 2021 (with the possible exception of the requirement that Purchaser Corporation not dispose of the Subject Shares within 60 months of their date of purchase as the 60 months have yet to expire). As a result, paragraph 84.1(1)(b) of the Act should not apply to deem Taxpayer to have received a dividend equal to the purchase price less $100,000 (the PUC and ACB of the Subject Shares – assume that the ACB is not subject to any adjustments provided by paragraphs 84.1(2)(a) and (a.1) of the Act). Taxpayer therefore plans to file his 2021 personal income tax return by reporting a disposition of the Subject Shares for $2 million, resulting in a capital gain of $1.9 million, on the basis that subsection 84.1(1) of the Act did not apply to the disposition of the Subject Shares to Purchaser Corporation.

Preliminary comments from the CRA

The provisions of Bill C-208, which modify section 84.1 of the Act, are, in some respects, difficult to apply. Despite the existence of certain legislative gaps and inconsistencies in Bill C‑208, the CRA will endeavor to apply those provisions to any particular situation in a manner that is consistent with the overall purpose of Bill C‑208, section 84.1, and other relevant provisions of the Act.

In general terms, section 84.1 of the Act applies where a taxpayer resident in Canada (other than a corporation) disposes of shares that are capital property of the taxpayer (subject shares) of any class of the capital stock of a corporation resident in Canada (subject corporation) to another corporation (purchaser corporation) with which the taxpayer does not deal at arm’s length and, immediately after the disposition, the subject corporation would be connected (within the meaning assigned by subsection 186(4) of the Act) with the purchaser corporation. Paragraph 84.1(1)(b) of the Act provides that all or a portion of the non-share consideration received by the taxpayer from the purchaser corporation may be deemed to be a dividend paid by the purchaser corporation to the taxpayer, and received by the taxpayer from the purchaser corporation.

New paragraph 84.1(2)(e) of the Act provides that, for the purposes of section 84.1, if the subject shares are QSBC shares or shares of the capital stock of a family farm or fishing corporation, the taxpayer and the purchaser corporation are deemed to be dealing at arm’s length if the purchaser corporation is controlled by one or more children or grandchildren of the taxpayer who are 18 years of age or older and if the purchaser corporation does not dispose of the subject shares within 60 months of their purchase.

Paragraphs 84.1(2.3)(a) to (c) of the Act contain rules that apply for the purposes of paragraph 84.1(2)(e) of the Act. Specifically, paragraph 84.1(2.3)(a) provides that, for the purposes of paragraph 84.1(2)(e):

(a) if, otherwise than by reason of death, the purchaser corporation disposes of the subject shares within 60 months of their purchase:

(i) paragraph 84.1(2)(e) of the Act is deemed never to have applied,

(ii) the taxpayer is deemed, for the purposes of [section 84.1 of the Act], to have disposed of the subject shares to the person who acquired them from the purchaser corporation, and

(iii) the period of 60 months applicable to the operation that is deemed to have taken place under subparagraph 84.1(2.3)(a)(ii) of the Act is deemed to have begun when the taxpayer disposed of the subject shares to the purchaser corporation;

Question 3.1 - Death of Taxpayer and sale by Purchaser Corporation within 60 Months

Assume that Taxpayer dies in March 2025 and Joan subsequently causes Purchaser Corporation to sell the Subject Shares to an arm’s length purchaser (ALP) for POD of $3 million (ALP Disposition).

(a) Can the CRA confirm whether the rules in paragraph 84.1(2.3)(a) of the Act apply as a consequence of the ALP Disposition?

(b) If paragraph 84.1(2.3)(a) of the Act does apply, what would be the impact on the tax positions of Taxpayer and Purchaser Corporation in 2021 and 2025?

Response

Paragraph 84.1(2.3)(a) of the Act does not specify whose death is relevant for the purposes of applying this paragraph. Since the phrase “by reason of” is not defined in Bill C-208, or otherwise in the Act, we would look to the ordinary meaning of the phrase for guidance. Merriam-Webster defines “by reason of” as meaning “because of”, or “due to”. As such, we would look for a causal link between the death and the subsequent disposition of the shares by the purchaser corporation. For example, the death of an individual may make it impractical or difficult to continue under the current ownership and may precipitate the subsequent sale of the subject shares. In any particular case, such a determination could only be made upon a review of all the facts and circumstances.

If the ALP Disposition was not by reason of death, subparagraph 84.1(2.3)(a)(i) of the Act provides that paragraph 84.1(2)(e) of the Act is deemed to never have applied in respect of the First Disposition. In this case, Taxpayer and Purchaser Corporation would not be deemed by paragraph 84.1(2)(e) of the Act to be dealing at arm’s length. However, Taxpayer would be deemed, for the purposes of section 84.1 of the Act, to have disposed of the Subject Shares to the person who acquired them from Purchaser Corporation (i.e. ALP). Although the purpose and scope of subparagraph 84.1(2.3)(a)(ii) of the Act is not entirely clear, we are prepared to apply this provision such that, if Taxpayer had disposed of the Subject Shares directly to the subsequent purchaser and section 84.1 of the Act would not have applied to that disposition, the First Disposition will not be subject to section 84.1.

Paragraph 84.1(2.3)(a) of the Act does not impact the tax consequences to Purchaser Corporation relating to the ALP Disposition or the tax position of Taxpayer in 2025.

Question 3.2 – Death of Joan and Sale of the Subject Shares within 60 Months

Assume that in March 2025 Joan dies and her estate obtains an independent valuation which determines that the Subject Shares are worth $2.5 million. Taxpayer decides to reacquire the Subject Shares personally from Purchaser Corporation for a cash payment equal to the difference between the $2.5 million FMV and the outstanding promissory note owed by Purchaser Corporation to Taxpayer (Taxpayer Disposition).

(a) Can the CRA confirm whether the rules in paragraph 84.1(2.3)(a) of the Act apply as a consequence of the Taxpayer Disposition?

(b) If paragraph 84.1(2.3)(a) of the Act does apply, what would be the impact on the tax positions of Taxpayer and Purchaser Corporation in 2021 and 2025?

Response

As stated in Response 3.1 above, we would look for a causal link between Joan’s death and the Taxpayer Disposition. In this particular situation (the death of the sole shareholder of Purchaser Corporation), we would be willing to accept that the Taxpayer Disposition was by reason of death with the result that, although Purchaser Corporation disposed of the Subject Shares within 60 months of their purchase, the Taxpayer Disposition will not impact the application of paragraph 84.1(2)(e) of the Act to the First Disposition. However, we would emphasize that in cases where there is more than one shareholder of the purchaser corporation, the question of whether the subsequent disposition of the subject shares was by reason of the death of one of the shareholders could only be made upon a review of all the facts and circumstances.

If the Taxpayer Disposition was not by reason of death, subparagraph 84.1(2.3)(a)(i) of the Act provides that paragraph 84.1(2)(e) of the Act is deemed to never have applied in respect of the First Disposition. In this case, Taxpayer and Purchaser Corporation would not be deemed by paragraph 84.1(2)(e) of the Act to be dealing at arm’s length. However, Taxpayer would be deemed, for the purposes of section 84.1 of the Act, to have disposed of the Subject Shares to the person who acquired them from Purchaser Corporation (himself). As noted in the response to Question 3.1, we are prepared to apply this provision such that, if Taxpayer had disposed of the Subject Shares directly to the subsequent purchaser and section 84.1 of the Act would not have applied to that disposition, the First Disposition will not be subject to section 84.1 of the Act. In this case, Taxpayer would be deemed to have disposed of the Subject Shares to himself and, therefore, section 84.1 of the Act would not apply.

Paragraph 84.1(2.3)(a) of the Act does not impact the tax consequences to Purchaser Corporation relating to the Taxpayer Disposition or the tax position of Taxpayer in 2025.

Question 3.3 – Interpretation of Paragraph 84.1(2.3)(b)

Paragraph 84.1(2.3)(b) of the Act appears to provide for a reduction in the capital gains deduction calculated in subsections 110.6(2) or (2.1) of the Act based on the taxable capital employed in Canada by the corporation. However, this rule is to apply only for purposes of paragraph 84.1(2)(e) of the Act and would therefore not appear to be effective in reducing the capital gains deduction available to any taxpayer.

(a) Can the CRA confirm this is a correct interpretation of this provision?

(b) Could the CRA also confirm that irrespective of the application of this provision, in determining a taxpayer’s access to the capital gains deduction, paragraph 84.1(2.3)(b) of the Act does not otherwise affect a taxpayer’s ability to rely on the exception to subsection 84.1(1) contained in paragraph 84.1(2)(e) of the Act?

Response

We confirm that paragraph 84.1(2.3)(b) of the Act, as drafted, does not apply for the purposes of section 110.6 of the Act and, therefore, it does not reduce a taxpayer’s capital gains deduction. In addition, paragraph 84.1(2.3)(b) of the Act does not otherwise affect a taxpayer’s ability to rely on the deeming rule in paragraph 84.1(2)(e) of the Act.

Question 3.4 – Interpretation of Paragraph 84.1(2.3)(c)

Paragraph 84.1(2.3)(c) of the Act states that the taxpayer must provide the Minister with an independent assessment of the FMV of the subject shares and an affidavit signed by the taxpayer and a third party attesting to the disposal of the shares. What are the implications to the taxpayer if the required information is not provided or the information provided is deficient in any respect?

Response

The CRA has provided guidance concerning the documentary evidence required by paragraph 84.1(2.3)(c) of the Act on the Government of Canada website: Affidavits and valuations for the transfer of a small business, family farm or fishing corporation (Bill C-208) - Canada.ca

It is our view that the documentary requirements are integral to the application of paragraph 84.1(2)(e) of the Act. That is, these requirements must be met for paragraph 84.1(2)(e) to apply.



Patrick Prescott
2022-092872
May 3, 2022

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