A tale of small details.
On the sale of a business, advisors routinely look to shield tax through capital gains strips and/or using capital gains exemptions. The relevant rules are set out in Section 55 of the Income Tax Act. Important exceptions that permit, among other things, butterfly re-organizations are set out in Section 55(3).
Earnings retained by a corporation increase the fair market value of its shares and the potential gain to its shareholder on a share disposition. Where shares are earmarked for sale the ensuing gain in the shareholder’s hand may be significantly reduced by stripping the value of the corporation. This is often done by interposing a holding company through a Section 85(1) rollover. Thereafter, a series of tax-free, inter-corporate dividends are paid to Holdco to siphon off the value of the operating company before sale, converting the capital gain into a tax-free, inter-corporate dividend.
A series of dividends is frequently preferred to mitigate uncertainty in connection with safe income. Section 55(2) permits retained earnings to be stripped up to the value of after-tax income retained by the corporation, which is referred to as safe income. Safe income for a CCPC can be defined as aggregate net income for tax purposes earned or realized and attributable to the shares during the period owned by the taxpayer after 1971, less the aggregate of relevant losses and federal and provincial income taxes and, in general, dividends.
If a dividend is paid in excess of safe income the whole dividend is tainted and subject to capital gains re-characterization under Section 55(2), which is why practitioners routinely recommend a chain of separate dividends. To illustrate, assume safe income is determined to be $25,000,000, but there is uncertainty about a past tax position that is not yet statute-barred. It would be prudent to protect against possible reassessment by paying a series of dividends, perhaps starting with a $15,000,000 tranche and declaring smaller amounts thereafter.
The CRA generally does not take exception to planning aimed at both maximizing lifetime capital gains exemptions and stripping safe income, provided the concept of Section 55(2) is respected. Taxpayers and advisors run into trouble when the CRA disagrees with the calculation of safe income and/or how it has been attributed to a particular class of shares.
Consider, for example, a situation where: (i) the vendor has a nominal cost base in 1,000 common shares of a qualified small business corporation (QSBC); (ii) a purchaser is prepared to pay $5,000,000 for 100 per cent of the vendor’s shares; (iii) the vendor is the sole shareholder and she has held the shares since the QSBC was organized; (iv) safe income is determined to be $4,250,000; and (v) the vendor’s unused lifetime capital gains exemption is $750,000. Conceptually, each share has a $5,000 value attributable to safe income and unrealized asset appreciation in the amounts of $4,250 and $750, respectively.
Scenario 1:
Given these facts, the vendor could sell 15 per cent of her shares to the purchaser for $750,000 and fully shield the gain by using her lifetime capital gains exemption. She could transfer the balance of her shares to a holding corporation, with the parties electing nominal proceeds of disposition under Section 85(1). The QSBC could then redeem the shares held by Holdco for $4,250,000. The deemed dividend as a consequence of the share redemption would generally be tax-free. The end result gives the purchaser a 100 per cent interest in the QSBC.
Holdco could take the position that safe income attributable to the shares transferred is $4,250,000. While there may be technical arguments for that position, the CRA has stated it will challenge such a view and proportionally reduce safe income (to $3,612,500 in the example presented). The result under Section 55(2) is a deemed capital gain attributable to Holdco in respect of the difference, less Holdco’s ACB in the shares.
Scenario 2:
By changing the order of events and the structure slightly, a more desirable outcome is achieved. Assume the vendor organizes a Holdco and she then enters into a partnership agreement with Holdco where she initially owns 0.0005 per cent of the partnership and Holdco owns the balance. The partnership is interposed to avoid the valuation perils of Section 69(1)(b), as that provision only applies to “a person.” Each party pays a nominal and proportionate amount for their respective partnership interest. The vendor then transfers 999 shares of the QSBC to the partnership under Section 97(2), increasing her ownership in the partnership to 0.001 per cent. The parties elect cost under this roll-over. Immediately thereafter, the QSBC redeems the shares for $4,250,000. The vendor’s remaining share position is then sold for $750,000, so the buyer acquires 100 per cent of QSBC (stripped of $4,250,000 in value) for $750,000.
Under Section 55(2), $4,250 of the deemed dividend should be re-characterized as a capital gain because the dividend on the share redemption exceeds safe income. The transaction gives rise to no other current tax – save for a small capital gain to the vendor as a consequence of Section 69(1)(b) – assuming that the vendor’s capital gains exemption is used.
As the current Chief Justice of the Supreme Court of Canada once said “in the absence of a specific statutory bar to the contrary, taxpayers are entitled to structure their affairs in a manner that reduces the tax payable” (Shell Canada Ltd. v. Canada [1999] 3 S.C.R. 622). Slight modifications to structure can, at times, substantially change the outcome, the GAAR notwithstanding.