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4562 Lecture 7 - Subsection 85(1) Election - Use in the Incorporation of
a Business
Last updated September 23, 2014
Readings
FIT Ch. 16; ITA 22, 85
Recommend
Review Questions 1 to 12, Exercises 2 to 7, all Multiple Choice questions
1. Basics
1.1. Purpose and Use of Subsection 85(1)
1.2 Conditions and deadline for election
1.3 Elected amount - limits
1.4 Cost of consideration and other rules
1.5 Paid-up capital and legal characteristics of shares received
2. Planning, Pitfalls and Special Rules
2.1 Comprehensive Example on Incorporation of a Business
2.2 Accounts receivable (s. 22 joint election)
2.3 Depreciable property and non-arm’s length transfers
-S. 85(5): original capital cost flows through
-If the EA > original capital cost: s.13(7)
-Exemption from 1/2 net amount rule for CCA
-Old CCA classes flow through: Reg. 1102(14)
2.4 Rules denying losses on transfers between "affiliated persons"
-Terminal Losses on Depreciable Property – The loss stays s. 13(21.2).
-Capital Losses on Non-Depreciable Property
(a) Individual transferors (Superficial Loss Rules)
– The loss moves; s. 40(2)(g), 53(1)(f)
(b) Corporate transferors
- The loss stays: s. 40(3.3), 40(3.4)
2.5 Incorporation of assets to use the $800k QSBC CG exemption (with no 24 month
holding test): s. 54.2, s. 110.6(14)(f)
2.6 When FMV in >FMV out: s. 85(1)(e.2)
2. 7 When FMV in < FMV out: s. 15(1) Benefit
3. Mini-cases
Case 1 - s. 85(1.1): eligible property
Case 2 - s. 85(1)(f),(g),(h), 85(2.1): PUC vs. ACB
Case 3 - s. 85(1)(b), 85(1) (c),15(1): elected amount & shareholder benefits.
Case 4 - s. 13(21.2), 40(2)(g): Rules denying losses
Case 5 - s. 85(1)(e.2), 74.4: Benefitting/gifting & corporate attribution
4. Summary: Golden Rules/ Test Yourself
5. GST/HST Rules (re: transfer of business assets)
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1.1
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BASICS of Section 85
PURPOSE AND USE OF S. 85(1)
Subsection 85(1) is an election (this means it is optional) - you elect (choose) a transfer
price for the transfer of assets to a corporation.
Usually the lawyer prepares the agreement of purchase and sale and the accountant
prepares the s. 85(1) election form
Major uses:
1. to incorporate a business or investments
(most of the problems deal with incorporation of a business)
2. to transfer assets from one company to another
3. to set up a holding company (to freeze an estate or defer tax on dividends)
s. 85(1) permits a tax-free rollover if
1. the transferor takes back shares and
2. tax cost of asset transferred in = elected amount (cost in = cost out)
3. FMV of the assets transferred in = FMV of consideration taken out
(FMV in = FMV out)
4. non-share consideration (“boot”) < elected amount
1.2
CONDITIONS AND DEADLINE FOR ELECTION: s. 85(1)
The transferee corporation must be a taxable Canadian corporation*
* Defined in subsection 89(1) of the Act
The consideration received by the transferor must include shares (of the transferee
corporation)
The property transferred must be eligible property under s. 85(1.1)
(excludes land inventory, cash, prepaid expenses)
Transferor (i.e., vendor) and transferee corporation (i.e., purchaser) must jointly elect
Due date for the election form
= tax return filing deadline of the party that has to file on the earliest date [s. 85(6)]
Example
On June 15, 2014 an individual transfers property to a corporation with a June 30th year
end. When is the s. 85(1) election due?
Answer:
December 31, 2014
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- you can file the election late (within 3 years of the due date with penalties) [s. 85(7) &
(8)]. Also, the Minister can accept an election and/or amendments to an election after 3
years if he/she considers it to be just and equitable to do so
1.3
ELECTED AMOUNTS - LIMITS
Exhibit 16-1 of FIT shows the ranges for elections for various assets. As long as you do
not take too much boot, any amount between the tax cost and the FMV of the assets
transferred can be elected.
- on a tax-free rollover, you elect at tax cost* and
ACB of assets transferred to corporation
= elected amount = ACB of consideration received (cost in = cost out)
FMV of assets transferred in
= FMV of consideration received (FMV in = FMV out)
* Note: for eligible capital property you will elect at [4/3 x cumulative eligible capital
(CEC) balance]. This is because when CEC is disposed of ¾ x proceeds of disposition is
subtracted from the CEC pool.
Tax cost is typically: (a) cost for inventory; (b) ACB for non-depreciable capital
property; and (c) UCC for depreciable capital property.
You can elect an amount higher than cost to trigger capital gains
(e.g. to use up CG deduction, losses, etc.)
You can take back non-share consideration such as cash, debt, assumed debt (this is
called "boot"). If you take too much boot the elected amount will automatically increase
and create negative tax consequences (discussed further below).
As an example of Exhibit 16-1 for depreciable property the maximum elected amount is:
FMV.
The minimum elected amount is:
The greater of: (1) FMV of boot; and
(2) the least of:
(a) FMV
(b) UCC; and
(c) ACB
The maximum boot on a tax-free rollover = tax cost of assets transferred in
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The elected amount determines:
1. The transferor's proceeds of disposition (POD) (and hence any income or capital gain)
(s. 85(1)(a))
2. The ACB of the transferor's consideration taken back (boot, if any, and shares). ACB
is allocated first to boot (s. 85(1)(f)), then to preference shares (s. 85(1)(g)), then to
common shares (s. 85(1)(h))
3. The PUC of the transferor's share consideration (s. 85(2.1))
4. The cost (i.e., ACB) of the property to the corporation (i.e., the purchaser) (s. 85(1)(a))
1.4
COST OF CONSIDERATION Received
As per item 2 in 1.3 above, the elected amount determines the cost (ACB) of the
transferor's consideration taken back (debt and share). The formula is
1. allocate to boot up to its FMV: s. 85(1)(f),
2. then (if there is anything leftover) allocate to preference shares up to their FMV: s.
85(1)(g)
3. then (if there is anything leftover) allocate to common shares up to their FMV: s.
85(1)(h)
If the transferor takes more boot than the elected amount (i.e., takes too much boot),
the elected amount is automatically increased due to s. 85(1)(b). It is deemed to equal the
boot and may create a capital gain. (There is an exception when the boot exceeds the
FMV of the asset transferred, since the elected amount cannot exceed the FMV of the
asset: s. 85(1)(c). Hence the elected amount would be increased but only up to FMV and
any excess is a s. 15(1) shareholder benefit (discussed below).
A common error is to forget that the boot includes assumed debt as well as new debt.
1.5
PAID-UP CAPITAL AND LEGAL CHARACTERISTICS OF SHARES
RECEIVED: s. 85(2.1)
As per item 3 in 1.3 above, the elected amount determines the PUC of the transferor's
share consideration. The formula is
PUC reduction = Increase in the legal stated capital (LSC) minus [elected amount
(EA) - Boot]
PUC = LSC - PUC reduction
Notes
1. Quite often, PUC will be same as the ACB of the shares and in a perfect s. 85(1)
rollover, both will be zero or $1 (for goodwill). Exception: when s. 85(1)(e.2) applies or
> one class of shares is issued.
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2. PUC is allocated to different classes on a pro rata basis based on the increase in LSC of
that class, whereas ACB is allocated first to preferred shares, then to common. (See Case
2 below)
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2.1
PLANNING, PITFALLS AND SPECIAL RULES (re: Section 85)
Comprehensive Example on Incorporation of a Business
Mrs. King, a Canadian resident, has provided you with the following balance sheet and
additional information related to her unincorporated office supply business. Effective
August 10, 2014, she wishes to transfer all of her business assets and liabilities to a
corporation (King Ltd.) in which her husband owns 100% of the common shares. She
wants to minimize her personal tax on the transaction and insists on receiving the
following package of consideration:
(a) The maximum amount of debt (rounded to the nearest $1,000); and
(b) Voting, redeemable, retractable preferred shares for the balance of the consideration.
Mrs. King has provided you with the following information concerning her unincorporated
business as at August 10, 2014:
Original Cost UCC or CEC Current FMV
Shares in public co. (note 1)
$10,000
$5,000
Accounts receivable (note 2)
12,000
9,000
Land (inventory)
100,000
200,000
Prepaid insurance
500
400
Building (Class 1)
80,000
60,000
50,000
Land (capital property)
150,000
160,000
Goodwill
0
0
100,000
Additional Information:
1. The shares are capital property to Mrs. King. Mrs. King owns less than 1% of each
public company. (This means that s. 84.1 will not apply. S. 84.1 is discussed in a future
lecture)
2. The tax reserve for doubtful accounts taken in the previous year was $2,000. The face
value of the accounts receivable before deducting the reserve was $12,000.
REQUIRED:
1. Identify the assets for which an election under subsection 85(1) cannot or should not be
made, stating your reasons. At what value are these assets transferred at? What type of
consideration should be taken back for them? If there any assets that should not be
transferred at all, indicate what they are and why they should not be transferred.
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ANSWER:
Shares – should not transfer
$5K loss denied/superficial loss moves with property. Hence, ACB of shares to corp. =
$5K FMV plus $5 K denied loss = $10k
Can realize loss personally if don’t transfer
Don't need shares to carry on business
Makes it less likely to meet SBC (QSBC) test
If transfer, don't bother using s. 85(1) because no gain
- sell at $5,000 FMV for debt consideration
A/R - use Section 22
Add back reserve = 2K business income to Mrs. King
Elect to transfer under s. 22 rather than s. 85(1) to get $3K business loss rather than
denied capital loss
Transfer qualifies under s. 22 since - all or substantially all of assets are being transferred
to a transferee who will be carrying on the business
Must jointly elect. If a s. 22 election is filed, King Ltd. will be able to claim a reserve;
transfer at 9,000 (FMV)
Land Inventory & Prepaid Insurance – not eligible property: s. 85(1.1)
Are not eligible for s. 85(1)
Don't transfer land inventory to avoid $100 K business income - if transfer, transfer for
$200K FMV for debt. Transferring land inventory (which may not be needed in the office
supply business) may make King Ltd. less likely to meet the SBC (QSBC) test; hence
should not transfer. Inventory is an active business asset; however, if the CRA felt that
this land was a capital asset (and not inventory) then this would make King Ltd. less
likely to meet the SBC (QSBC) test
Transfer prepaids at $400 (FMV) for debt, recognize $100 “loss” (i.e., expense)
Building – s. 85(1) does not apply because of 13(21.2)
No terminal loss. $10,000 terminal loss is denied and stays with Mrs. King
Mrs. King can claim CCA on denied loss and claim remaining loss when the corporation
sells the building to a (non-affiliated) third party
Transfer at $50,000 FMV for debt
Golden Rules:
1. Cash, prepaids and land inventory cannot be elected upon under s. 85(1) (they aren't
eligible: s. 85(1.1))
If there is a large amount of income on land inventory, perhaps it shouldn't be transferred
at all.
2. Accounts receivable should not be elected upon under s. 85(1). S. 22 is better
3. Depreciable property with terminal losses cannot be elected on. Losses are denied and
stay with the transferor (Mrs. King) (affiliated corporation rules). Mrs. King can claim
CCA on the denied loss and will be able to deduct the remaining loss when her company
sells the property to a non-affiliated third party.
4. Non-depreciable property with accrued capital losses need not be elected on. The
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capital loss is denied and moves with the property (for individual transferors)– the losses
are added to the ACB of the property to the transferee (superficial loss rules). Therefore,
if Mrs. King intends to sell the non-depreciable capital property and wants the loss
personally, perhaps it shouldn't be transferred to the company at all. Also, if transferred
to the company, it might hurt the SBC and QSBC tests.
2. For the assets where an election under subsection 85(1) can and should be made, indicate
for each asset the elected amount and the maximum amount of debt and preferred shares
that should be taken as consideration in order to avoid any taxes.
Asset
Land
Goodwill
Tax value
$ 150,000
$0
$150,000
FMV
$160,000
$100,000
$260,000
EA
$150,000
$1
$150,001
Boot (Debt)
$ 150,000
$0
$150,000
FMV Shares Income
$ 10,000
$0
$ 100,000
50 cents*
$110,000
* Gain on eligible capital property = $1 - $0 = $1; is ½ taxable (i.e., 50 cents) and it’s business
income
3. Calculate the cost of the debt and preferred share consideration to Mrs. King for items
elected under s. 85(1)
For the allocation of cost, the elected amount is first allocated to boot
cost of debt (ACB) = amount of debt = $150K
cost of preferred shares (ACB) = elected amount – debt (i.e., $150,001 - $150,000) = $1
4. Calculate the PUC of the preferred shares, showing all supporting calculations
PUC reduction = increase LSC minus (EA- boot); PUC = LSC minus PUC reduction
PUC reduction = $110K minus ($150,001 - $150,000) = 109,999;
PUC = $110,000 - $109,999 = 1
5. List the tax cost(s) of each of the assets transferred to King Ltd.
(ACB of Shares =$10K and land inventory = $200K, if transferred. ACB of Shares is
$10K because of superficial loss rules)
A/R=12K (using s.22) Note: if s. 22 is used, King Ltd. can claim an allowance for
doubtful accounts/bad debt expense
Prepaid insurance = 400
Bldg = 50K UCC. Will stay in the same CCA class that Mrs. King had it (since it’s a
non-arm’s length transfer). Original cost (ACB) will be 80k, i.e., Mrs. King’s ACB, due
to 13(21.2)(g)
Land= 150K
G/W: cost = 1; CEC = $0.50 ($0.75 - $0.25)
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[Computed as $1 x ¾ = $0.75 (3/4 adds to cumulative eligible capital account);
less ½ of the income inclusion (1/2 x $0.50) = $0.25 (since non-arm’s length
transfer of CEC]
6. What are the tax consequences if Mrs. King sells her preferred shares to a third party
for their fair market value?
$110K (FMV) - $1 (ACB) = $109,999 CG; 1/2 x CG = $54,999 TCG
7. What will be the tax consequences if King Ltd. redeems Mrs. King's preferred shares?
FMV - PUC = Deemed Div; POD - ACB = CG/CL
$110K FMV - $1 PUC = $109,999 Deemed Div; $1 Adjusted POD (i.e., $110,000 =
$109,999) - $1 ACB = 0 CG
8. Will s. 74.4 (i.e., corporate attribution) apply to King Ltd. in 2014? Why or why not?
Assume that King Ltd. has no other assets except those transferred in by Mrs. King.
Are s. 74.4 conditions met?
1. Transfer to corporation? - yes
2. Where spouse is specified shareholder? - yes
3. Is the purpose test is met (i.e., to reduce the transferor’s income and benefit and
designated person)? Probably
4. However, King Ltd. will be a small business corporation (SBC) if Mrs. King only
transfers in active business assets (and she should only transfer in active business assets)
and s. 74.4 will not apply as long as King Ltd. remains a SBC.
2.2
Accounts receivable (s. 22 joint election)
A section 22 election is only available for accounts receivable. A s.22 election is
preferable to a s. 85(1) election, if allowed. A s. 22 election is allowed only if all or
substantially all of the property used in the business is sold and the purchaser is carrying
on the business.
A s. 22 election is beneficial for the purchaser (i.e., purchaser can take a reserve for doubtful
accounts) and beneficial for the vendor (i.e., vender can get full (business) loss as opposed to a
(half-allowable) capital loss). Note: section 22 requires the purchaser to include the business
loss in income in the year of purchase.
If a s. 22 election is not made a capital loss will result (based on an old English case). If
the transfer is to a controlled company, the loss will be denied. Also recall that s.12(1)(d)
requires the add-back of last year's s. 20(1)(l) doubtful debts reserve to this year’s income
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Depreciable property and non-arm’s length transfers
(e.g., transfer by a controlling shareholder)
ACB s. 85(5): original capital cost flows through If elected amount (EA) < original
capital cost, the transferee's UCC = EA but the original capital cost flows through for the
purposes of determining recapture and capital gains (CGs) on future dispositions
[s.85(5)]. If elected amount (EA) > original capital cost then 85(5) is not applicable.
Note: this subsection applies to all transfers using subsection 85(1) of the Act and not just
non-arm’s length transfers.
The following three items only apply to non-arm’s length transfers.
UCC If the EA > original capital cost: s. 13(7) If the EA > original capital cost,
13(7)(e) applies to limit the UCC to original capital cost plus the taxable capital gain
(TCG). This rule has no effect on ACB
Note: A similar rule applies for cumulative eligible capital (CEC) non-arm’s
length transfers (recall: that gains on the disposition of CEC are only ½ taxable).
S. 14(5) applies to non-arm’s length transfers of CEC to limit the CEC account
balance to ¾ of the elected amount less ½ of the income inclusion.
- Exemption from 1/2 net amount rule for CCA There is an exemption from 1/2 net
amount rule for CCA if the property had been owned for 364 days or more by transferor
[Reg. 1100(2.2)]
- Old CCA classes flow through: Reg. 1102(14).
Examples:
Class 3(5%) for pre-1988 buildings vs. Class 1 (4%) for post-1987 buildings [10% CCA
rate, separate Class 1, for post-March 18, 2007 buildings used 90% or more in
manufacturing or processing in Canada; 6% CCA rate, separate Class 1, for post-March
18, 2007 buildings used for non-residential purposes]
Class 10 (30%) for pre-2005 computers; Class 45 (45%) for post-2004 to March 18, 2007
computers; 55% CCA rate, Class 50, for post-March 18, 2007 to pre-January 28, 2009
computers and for post January 31, 2011 computers; 100% CCA rate (Class 52) with no
½ net rule for post-January 27, 2009 and pre-February 2011 computers
2.4
Rules denying losses on transfers of property between "affiliated persons"
Purpose of the rules:
1. To deny a deduction for a loss on a sale when there is no change in beneficial
ownership. The loss which is denied is capitalized and is deductible later when the
property is eventually sold (or deemed to be sold) to a non-affiliated person.
2. The rules refer to transfers to "affiliated persons" (s. 251.1). The term includes
transfers to the taxpayer or his/her spouse or corporations controlled by him/her (or
his/her spouse).
- Terminal Losses on Depreciable Property – The loss stays (s. 13(21.2))
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The terminal loss is denied to the transferor (s. 13(21.2)). The transferor keeps the denied
loss in the CCA pool and can continue to claim CCA. The transferor recognizes the
terminal loss when the new owner eventually sells the property (or is deemed to have
disposed of it) to a non-affiliated person. The new owner’s original cost (ACB) is
deemed to be the same ACB as the affiliated seller, due to 13(21.2)(g)
- Capital Losses on Non-Depreciable Property
(a) Individual transferors – The loss moves; s. 40(2)(g); 53(1)(f)
(b) Corporate transferors - The loss stays: s. 40(3.3); 40(3.4)
(a) When an individual transfers non-depreciable property (e.g., shares or land) to an
affiliated person, the superficial loss rules apply to deny the accrued loss. The denied loss
moves with the property.
(In other words, the loss is capitalized as part of the cost of the property to the new
owner). These are the superficial loss rules you learned in AK/ADMS 3520: s. 40(2)(g)
denies superficial losses. A superficial loss is defined in s. 54 to be a loss realized when
the same or identical property is acquired by an affiliated person within 30 days of the
sale. Para. 53(1)(f) adds this loss to the ACB of the property owned by the affiliated
person.
(b) When a corporation transfers non depreciable property to an affiliated person, any
capital loss is denied and stays with the original owner (just as terminal losses do). This
rule prevents corporate taxpayers from moving losses to another company in the corporate
group.
Subs. 40(3.3) and 40(3.4) applies to transfers by corps, partnerships and trusts to
affiliated persons. If subs. 40(3.3) and 40(3.4) applies, the loss remains in the hands of
the transferor until the property is disposed of (or deemed disposed of) by the transferee
to a non-affiliated person
2.5
Incorporation of assets to use the $800k QSBC CG exemption
(with no 24 month holding test): s. 54.2, s. 110.6(14)(f)
If all or substantially all of the assets of a small business are sold to a corporation in
return for shares of that company, s. 54.2 deems any shares received from that company
to be capital property; and s. 110.6(14)(f) essentially allows those shares to qualify
for/meet the 24 month QSBC holding period test (even if those shares were sold before
24 months have passed). The QSBC CG exemption was discussed in lecture 5
2.6
When FMV in > FMV out: s. 85(1)(e.2)
s. 85(1)(e.2) will apply if FMV in > FMV out and it’s reasonable to conclude that the
difference is a "benefit" or gift that the transferor wished to confer on a related person
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Result: the elected amount is increased by the "benefit" except for the purposes of
determining the ACB of the share consideration received by the transferor
- i.e., the proceeds of disposition (and capital gains) increase and the cost of the property
acquired by the corporation increases, but the cost of any share consideration received by
the transferor does not increase
2.7
When FMV in < FMV out: s. 15(1) Benefit
If the boot and share consideration taken out by the transferor > FMV of the assets
transferred in by the transferor, there is a 15(1) shareholder benefit included in the
transferor’s income.
If shares are taken with too much PUC (i.e., PUC exceeds the FMV of net assets
transferred into the corporation) then there will be a s. 84(1) deemed dividend as
discussed in lecture 6. Any s. 84(1) deemed dividend is deemed not to be a s. 15(1)
benefit (to avoid double taxation).
3
MINI-CASES [Testing 85(1)]
Case 1: s. 85(1.1): eligible property: what can be transferred under s. 85(1)
Mr. Y, a Canadian resident, wishes to transfer land that he owns to a corporation in which he is
the sole shareholder. Assuming that the only consideration for the transfer of the land will be
common shares issued to him by the corporation and that the parties would otherwise properly
elect under S.85(1) of the Income Tax Act, what are the income tax implications of the following
unrelated transactions?
(a) The land being transferred to the corporation is a commercial rental property in Toronto and
has been owned by Mr. Y. for 20 years.
(b) The same facts as in "a", except that the land is in Switzerland.
(c) The land being transferred to the corporation is in downtown Toronto. It has been owned by
Mr. Y for two weeks. He is a real estate broker and frequently buys and sells real estate for
himself.
Answer - Case 1
(a) Held land for several years, no indication he is a trader in real estate.
Therefore capital property, s. 85(1) can apply
Result: EA = POD to Mr. Y = cost of land to corp. = cost & PUC of c/s to Mr. Y
(b) S. 85(1) is not restricted to property in Canada. Result: same tax consequences as (A)
(c) Since Mr. Y is a trader in land, land is inventory and not eligible property under s. 85(1.1).
Result: transfer at FMV (POD to Mr. Y, cost of land to corp. & PUC of c/s to Mr. Y= FMV).
S.69 will apply if the transfer is not at FMV
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Case 2: s. 85(1)(f),(g),(h), 85(2.1): calculation of PUC vs. ACB
Mr. Q transferred the following land (capital property) to his 100% owned taxable Canadian
corporation and took back the following consideration:
Cost amount of the asset transferred (ACB)
$16,000
Fair market value of the asset transferred
$26,000
Consideration received
Promissory note
$14,000
10 preferred shares (total LSC and
9,000
FMV)
10 common shares (total LSC and FMV)
3,000
Total
$26,000
The transferor, Mr. Q, and the transferee, his corporation, elected under s.85(1) and elected the
minimum amount.
Required
(a) What is the adjusted cost base of the debt and shares taken back by Mr. Q?
(b) What is the paid-up capital of the preferred and common shares after the transfer of the land?
Answer - Case 2
The minimum elected amount is the $16,000 tax cost (ACB) of the land. Since $16,000
of boot is not taken ($14,000 of boot is taken), $2,000 is left for the ACB and PUC of the
shares.
The $2,000 must be allocated between the preference and common shares. The
allocation formula is different for ACB and PUC.
(a) The ACB is allocated first to the boot (up to $14,000 FMV) and then to the preference
shares (up to their FMV or the remaining boot, whichever is less).
The entire $2,000 is allocated to the ACB of the preference shares and nothing is left for
the common
Elected amount
$16,000
1. Boot
(14,000)
s. 85(1) (f)
2. Preference shares
$ 2,000
s. 85(1) (g)
3. Common shares
Nil
s. 85(1) (h)
Therefore, the ACB of the consideration received by the transferor is: boot = $14,000;
preferred shares = $2,000; and common shares = nil (i.e., $0).
(b) The $2,000 PUC is allocated to the shares on a pro-rata basis.
Since 75% ($9K/$12K) of the LSC (FMV) is in the pref. shares, $1,500 (i.e., 75% x
$2,000) is allocated to the pref. shares. Since 25% ($3K/$12K) of the LSC (FMV) is in
the common shares, $500 (i.e., 25% x $2,000) is allocated to the common shares.
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The full s. 85(2.1) calculation is below.
Increase in LSC ($9K+$3K)
Elected Amount
Minus FMV boot
PUC reduction (A-B)
PUC of shares (LSC - PUC reduction)
= $12,000 minus $10,000
(A) $12,000
$16,000
($14,000)
(B) $ 2,000
$10,000
$2,000
PUC reduction allocation (A-B) x C/A
Preference shares, LSC = $9,000:
PUC reduction = $10,000 x 9K/12K
PUC of Pref. shares
(LSC - PUC reduction) = $9,000 minus $7,500
Common Shares, LSC = $3,000
PUC reduction = $10,000 x 3K/12K
PUC of Common shares
(LSC - PUC reduction) = $3,000 minus $2,500
$7,500
$1,500
$2,500
$500
Case 3: s. 85(1)(b), s. 85(1) (c), s. 15(1): calculation of elected amount and shareholder
benefits
Mr. I incorporated a taxable Canadian corporation. Mr. I is the only shareholder. He owns land (a
capital property) with an ACB of $30,000 and a fair market value of $90,000. He proposes to
transfer the land to the corporation and receive as consideration, cash in the amount of $50,000
and 40,000 common shares with a LSC and fair market value of $1 each. Mr. I and his
corporation will elect an agreed amount of $30,000 under s. 85(1). He thinks that by using s.85
he can receive part of the unrealized gain on the property without triggering an immediate capital
gain on the transfer of the property.
Required
(a) (s. 85(1)(b)) What are the income tax implications of this proposed transaction? How can Mr.
I minimize any income arising from this transaction.
(b) (s. 85(1)(c), s. 15(1)) Reconsider this case, assuming that Mr. I receives $100,000 cash
consideration [instead of $50,000] and that he receives 40,000 shares but with nominal FMV and
LSC. What are the income tax implications of this revised proposed transaction?
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Answer - Case 3
(a) S. 85(1)(b): EA must not < boot
- EA deemed to be $50K, CG = $20K (i.e., 50k – 30k)
- ACB: EA first allocated to boot [s. 85(1)(f)], then pref. [s. 85(1)(g)], then common [s.
85(1)(h)]
- result: all $50K EA allocated to boot, cost of the share consideration is nil.
- to prevent CG: take $30K cash and increase shares from $40K FMV to $60K FMV
(FMV in = FMV out): EA should be $30K; tax PUC of shares = nil
In part (a), he tries to recover > $30K cost and hence triggers a CG
(b) in part (b), he tries to recover >$90K FMV and triggers entire accrued CG of $60k
(i.e., 90k – 30k) [s. 85(1)(c)]
& taxed on excess under s. 15(1)
max. EA = $90K [s.85(1)(c)] results in $60K CG
$10K excess boot = income to Mr. I under s.15(1).
Cost of boot = $90K (i.e., elected amount)*, shares have nominal FMV & PUC
PUC = $0 due to the s. 85(2.1) PUC reduction; i.e., elected amount (90k) – boot (100k) =
0 (note PUC can’t be negative)
* The amount of the shareholder benefit (i.e., $10,000) is added to the cost of the boot
[ITA 52(1)]; however, this is beyond the scope of the course.
Case 4: s. 13(21.2), 40(2)(g): Rules denying losses
A taxpayer has two assets which the taxpayer would like to transfer to the taxpayer’s whollyowned company, C Ltd., a taxable Canadian corporation. Details concerning these two assets are
as follows:
Original Cost
Land (capital property)
$25,000
Equipment(Class 8)
$5,000
Current FMV
10,000
2,000
UCC
N/A
3,000
The consideration received will be common shares in each case. The two taxpayers wish
to elect under s.85(1) at $10,000 for the land and $2,000 for the equipment.
Required: What are the tax implications to the taxpayer and C Ltd. on the transfer if:
(a) The taxpayer is an individual. (b) The taxpayer is a corporation.
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Answer - Case 4
Land
The taxpayer controls C Ltd. immediately after disposition (and therefore is affiliated)
and capital loss of $15K is denied
(a) If the taxpayer is an individual, the superficial loss rules apply and the denied loss is
added to C Ltd.'s cost of land which becomes $25K ($10K elected amount + $15K from
s. 53(1)(f)).
Cost of the shares of C Ltd issued for the land will still be the $10K elected amount.
(b) If the taxpayer is a corporation, the superficial loss rules apply and the denied loss
stays with the taxpayer. $10k EA = POD to the taxpayer, cost of the land to C Ltd. and
the cost of the shares to the taxpayer. The taxpayer can claim the denied loss when C
Ltd. sells the land to a non-affiliated person.
Note: since there is a loss there is no reason to use s. 85(1). The taxpayer could just sell
the land for FMV (for share consideration)
Equipment
The answers are the same for (a) individual and (b) corporation:
s.85(1) is not applicable (i.e., it cannot be used) and the terminal loss is denied. The $1K
(i.e., 2k – 3k) denied terminal loss stays with the taxpayer and the taxpayer must wait
until C Ltd. sells the property (to a non-affiliated person) to deduct the loss. The denied
loss stays in the CCA pool and the taxpayer can continue to claim CCA. $2K FMV = the
POD received by the taxpayer, the UCC of the equipment to C Ltd. and the cost of the
shares of C Ltd. issued to the taxpayer. The taxpayer’s original cost (ACB) of the
equipment is $5k, i.e., it’s the same as the affiliated seller’s original cost, due to
13(21.2)(g)
Overall
The cost of taxpayer's total share investment in C Ltd. is $12,000 ($10,000 issued for
land + $2,000 issued for equipment). This cost will be averaged with the cost of other
shares of the same class owned by the taxpayer.
The increase in the PUC of the corporation will also be $12,000 and will be averaged
with the PUC of all the shares of the same class issued by the corporation.
Case 5:s. 85(1)(e.2), 74.4: Benefitting/gifting and corporate attribution
Mrs. G's husband owns all of the common shares of a taxable Canadian corporation. Mrs. G
owns inventory with a cost amount of $450,000 and a fair market value of $700,000. Mrs. G
knows that this inventory will be sold within the year and she will be taxed at the top tax bracket.
Mrs. G intends to transfer the inventory to the corporation under s. 85(1) and receive as
consideration, debt of $450,000 and preferred shares with an LSC and a fair market value of
$50,000. Mrs. G will elect $450,000 under s.85. She thinks that the assets of the corporation in
excess of $500,000 could be distributed to her husband as a dividend. He has a lower marginal
tax rate than she has. In effect, the inventory gain would be taxed in the hands of Mrs. G's
husband (as a dividend after the corporation pays corporate tax on its business income) rather
than in her hands.
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Required: What are the income tax implications of the above transaction to Mrs. G, her husband
and the corporation?
Answer - Case 5 s. 85(1)(e.2)
- FMV in > FMV out by $200K and this excess value accrues to (/benefits) the common shares
(/the owner of the common shares)
- Mrs. G conferred a benefit on her husband (she is related to her spouse) of $200K and it's
reasonable to assume that she wished to do so
Benefit =
FMV of inventory
Less:
FMV of consideration received ($450k +50k)
Benefit
$700,000
($500,000)
$200,000
Elected amount is increased by $200K for all purposes except for purposes of s. 85(1)(g)
and 85(1)(h)
Consequences of s. 85(1)(e.2)
1. $200K benefit increased the elected amount by $200K increases POD to Mrs. G to $650K
(i.e., the $450,000 elected amount plus the $200,000 benefit) & will result in business income in
her hands of $200k [i.e., $650,000 (E.A.) - $450,000 (cost)]
2. Company cost of inventory = $650K elected amount
3. Cost of Mrs. G's shares is not increased. Cost of debt consideration (ACB) is $450K (i.e.,
FMV of the debt). Cost of preference shares (ACB) is nil [i.e., $450k (original elected amount)
less ACB of boot ($450k) = $0].
4. PUC of preference shares remains at $50,000 LSC because PUC reduction is zero.
85(2.1)
PUC reduction = $50,000 LSC increase – ($650K EA - $450K boot)
= $50,000 - $200,000 = 0 (cannot be negative)
PUC = $50,000 LSC – zero PUC reduction = $50,000
5. No immediate effect on Mr. G- but his common shares have increased in FMV by $200K
without any increase in ACB. Therefore there is double tax (when he sells his common shares)
S. 74.4 implications
Four tests
1 Individual transfers (or loans) assets to a corporation - yes
2. Designated person is a specified shareholder (> 10% shares of any class) - yes
[designated person = spouse, related minor, minor niece/nephew]
3. Purpose - to reduce income of transferor and benefit a designated person - yes
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4. S. 74.4 does not apply if corporation is a SBC (during the period) - not clear
- depends whether corporation is carrying on an active business
If s. 74.4 applies
Outstanding amount
= FMV of property transferred minus consideration other than shares or debt
= $700K
S. 74.4 attributed amount (computed each year)
= prescribed rate x $700k minus [any interest and any taxable (i.e., grossed up) dividends
paid to Mrs. G]
4
Summary: Golden Rules / Test Yourself
1. FMV in = FMV out (for a tax-free rollover)
2. Cost in = Cost out (for a tax-free rollover)
3. Elect at tax cost to defer tax
4. Boot can't be > Elected Amount (s. 85(1)(b)): Case 3(a)
5. Elect at least $1 (e.g., for Goodwill)
6. Can't elect on cash, prepaids, land inventory. (S. 85 (1.1))
7. Use section 22 for A/R (or get a denied capital loss if transfer to an affiliated person)
8. Individuals can't realize a capital loss on a transfer to a corp. that you or your spouse control
(superficial loss): Case 4(a). The capital loss stays with the property
Individuals can't realize a terminal loss on a transfer to an affiliated corporation: 13(21.2)
applies and the terminal is denied and stays with the transferor. Case 4
9. Losses on depreciable and non-depreciable property can't be recognized on inter-corporate
transfers to affiliated corporations: Case 4. In the case of corporations, both terminal losses and
capital losses stay with the transferor
10. PUC reduction = Increase in LSC minus (Elected Amount - Boot) (s. 85(2.1)): Case 2
11. PUC reduction allocated to pref. and common on a pro-rata basis whereas ACB is allocated
first to pref. shares then to common shares. s. 85(1)(f),(g),(h), 85(2.1).: Case 2
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12. If FMV in > FMV out, gifting rule can apply to increase the elected amount except for the
purposes of the ACB of the shares taken back (s. 85(1)(e.2)): Case 5
13. If FMV in < FMV out, s. 15(1) applies: Case 3(b)
Test yourself:
1. When will the ACB of share consideration be different than their PUC?
Answer: When you have one of the following applying: s.85(1)(e.2), > one class of shares, s.
84.1 (discussed in a future lecture).
2. What assets cannot be transferred under s. 85(1)?
Answer: land inventory, cash, prepaid expenses.
5.
GST/HST Rules (re: transfer of business assets)
GST/HST will apply if the sale is a taxable supply (e.g., a sale of assets other than shares)
But you can make a joint ETA s. 167(1) election not to have GST/HST apply to the transfer of
assets if all or substantially all of the assets of a business are being sold and both the vendor and
purchaser are registered. Planning - make sure the purchaser company is registered for GST/HST
purposes before the transfer takes place
GST/HST does not apply on the sale of goodwill if all or substantially all of the assets of the
business are being sold.
Test Yourself: What two other election forms are usually filed on the incorporation of business
assets at the same time as a s. 85(1) election?
Answer: s. 22 for receivables, ETA s. 167(1)
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