Tax II Chapter 10
Spring 2013
Notes
Chapter Ten Lecture Notes
Section 86 & 51 Share Exchanges
David Christian
Spring Term 2013
Thorsteinssons LLP
UBC Faculty of Law
______________________________________________________________________________
Notes
It is well established that income tax legislation is to be interpreted in a textual,
contextual and purposive manner. It is meant as no unkindness to the drafters of
income tax legislation, but they have at times made this task exceedingly
difficult…
Miller J., Sommerer v. The Queen, 2011 DTC 1162
(T.C.C.)
1.
Consider the Crest Hotel.
Wilma
1k
common shares
FMV $1m
ACB $500k
PUC $1k
Crest Hotel
Active Business
Assets 90%+
2.
Wilma is married to Steve. They have an adult son Sean. They come to
us to reorganize the ownership of Crest Hotel Ltd. on a 40%, 40%, and
20% basis.

Wilma exchanges her 1,000 common shares for 1,000 new “Class
B preferred shares”, redeemable/retractable for $1m ($1k per
share) and entitled to that redemption amount on wind-up of Crest
Hotel Ltd.
Page 244
Tax II Chapter 10
Spring 2013
Notes

Wilma, Steve and Sean each subscribe for new “Class A” common
shares in the desired percentages (i.e., 40, 40, 20) that are “garden
variety” common shares (subject to the rights of the Class B
preferred shares) for $1 per share.
Steve
Wilma
1k Class B
FMV $1m
ACB (?)
PUC (?)
40 Class A
FMV $40
ACB $40
PUC $40
Sean
40 Class A
FMV $40
ACB $40
PUC $40
20 Class A
FMV $20
ACB $20
PUC $20
Crest Hotel
3.
What tax consequences apply to Wilma? Read s.86:

in the course of a “reorganization of capital” of a corporation;

a taxpayer has disposed of capital property;

that consists of all shares of a class owned by taxpayer (“old
shares”); and

property received includes shares of the same corporation (“new
shares”);

if the foregoing pre-conditions are present, the following rules
apply:

the tax cost of non-share consideration received by Wilma
is its FMV (none here);

the tax cost of the new shares received by Wilma is equal to
the ACB of old shares ($500k) less the non-share
consideration (nil here); and
Page 245
Tax II Chapter 10
Spring 2013
Notes

the proceeds of disposition to Wilma is the total cost of
new shares ($500k) and the non-share consideration (nil
here).
4.
So Wilma has “proceeds of disposition” of the old share equal to $500k,
and thus no capital gain or capital loss arises on the 1,000 common shares
exchanged. It’s a roll-over. Wilma’s tax cost of the 1,000 Class B
Preferred Shares received on the exchange is the ACB of the old shares:
$500k. The rules in s.86 are automatic. There is no election of the kind in
s.85, provided the above pre-conditions are met.
5.
What is the tax PUC of the 1k Class B Preferred Shares received by
Wilma? Read s.86(2.1) - a familiar tax PUC “grind” rule. Grind the PUC
by:
“A – B”
A = the increase in the corporate share capital (assume, for
example, $1m) on the exchange,
B = extent to which tax PUC of old shares ($1k) exceeds the nonshare consideration ($0 here).
A – B = $1m - $1k = $999k. Thus, the tax PUC of the new Class
B shares is the corporate share capital ($1m) less the PUC
grind in s.86(2.1) of $999k, resulting in tax PUC of $1k for
the Class B shares.
(It is common, in practice, that you only add to the corporate share capital
of the new shares an amount equal to the tax PUC of the old shares
exchanged less any non-share consideration.)
6.
Do you see the deemed dividend rules in s.84(3) applying here? Why?
Read it again.

The deemed dividend in s.84(3) is driven off of the “amount paid”
on the acquisition of the old shares by the corporation.
Page 246
Tax II Chapter 10
Spring 2013
Notes

What is the “amount paid” here? Is it the value of the new Class B
shares of $1m? Is there a deemed dividend “disaster” here = tax
owing of over $336k?
Read s.84(5). The value of the new shares issued for the old shares, for
purposes of s.84(3), is the tax PUC of those new shares. This is the
“amount paid”. In our case, this is $1k for the new Class B shares as just
computed under s.86(2.1). Thus, no s.84(3) deemed dividend arises on the
exchange. $1k “paid” - $1k tax PUC of the old common shares exchanged
= $0. No deemed dividend arises.
7.
8.
Change the facts. Wilma wants $100k of cash in the company, plus say
900 Class B Preferred Shares having a value of $900k. What is the result?

s.86(1)(a) – Wilma’s tax cost of the cash is $100k.

s.86(1)(b) – Wilma’s tax cost of the new 900 Class B shares is the
ACB of old shares ($500k) less the non-share consideration
($100k): or $400k.

s.86(1)(c) – Wilma’s “proceeds of disposition” is the total of the
cost of (a) & (b) = $100k plus $400k: or $500k.

The tax PUC of the new 900 Class B shares: assume the starting
PUC is say $900k. Compute the PUC grind in s.86(2.1): A - B =
$900k – ($1k – $100k = $0) = $900k. Thus, ending tax PUC is nil
by reason of the s.86(2.1) grind: Opening PUC $900 less PUC
grind of $900k, results in tax PUC of the Class B preferred shares
being $0.
On the face of it, Wilma has “proceeds of disposition” of $500k. Does she
have a capital gain? No:
proceeds
ACB
$500k
$500k
$0
Page 247
Tax II Chapter 10
Spring 2013
Notes
But remember s.84(3) – the “amount paid” on the acquisition of the
company’s own shares over the tax PUC of those shares is deemed to be a
dividend paid. And, the new Class B shares are valued at their ending tax
PUC for this dividend computation:
Amount paid
$100k
tax PUC of old $
dividend
1k
$ 99k
Thus, proceeds
of disposition: $500k
($99k)
Proceeds
analysis)
ACB
Capital Loss
$401k
($100k cash, plus $0 tax PUC of the
new Class B shares)
(tax PUC of the old common shares
acquired by the company)
(taxed as a deemed dividend to Wilma!)
(as computed above)
(remember the s.54 exclusion for any
deemed dividend amount in the proceeds
of disposition)
(proceeds of disposition for capital gain
$500k
$99k1
It is wise to compute the potential dividend under s.84(3) before any
capital gain or loss under s.86.
9.
Read s.86(3): s.86(1) does not apply if s.85(1) applies? The latter has
priority.
10.
Satisfy yourself that a s.85(1) election could be filed by Wilma and Crest
Hotel; “eligible property” (yes), disposed of to a taxable Canadian
corporation (s.84(9)) (yes), consideration includes shares of that
corporation (yes). Why would they want to use s.85(1)? Maybe trigger a
capital gain, and avoid a dividend, by selecting an elected amount?

1
Take the same facts as above. Wilma exchanges her old shares for
the Class B preferred shares worth $1m. The corporate share
capital of these Class B shares is limited to $1k (which is possible
under corporate statutes). Wilma and the company elect under
This loss may be subject to “stop loss” rules in section 112, which are beyond the scope of this course.
Page 248
Tax II Chapter 10
Spring 2013
Notes
s.85(1) at an agreed amount of $1m. Work through the s.85(1)
results:

proceeds to Wilma
$1m
(agreed amount)
gain to Wilma
$500k
($1m less $500k)
tax cost of new Class B pref
shares to Wilma
$1m
dividend to Wilma
$0
(work through s.84(3) and (5))
This is sometimes referred to as a “crystallization” transaction – if
Wilma can use her $750k capital gain exemption to shelter the gain
(Chapter 13). Why do it? Maybe worried the next federal budget
will take away the $750k capital gain exemption, or that the shares
may not qualify in the future. Here, she has used it and increased
the ACB of her new shares of the company.
11.
Change the facts. What if Wilma only receives 500 Class B Preferred
Shares worth $500k on the exchange for the old common shares. No
election is filed under s.85(1). Read s.86(2) preamble, then (a) and (b) and
the mid-amble. The “benefit” here is 60% of $500k ($300k) – being the
value indirectly conferred on Steve and Sean. Read paragraph 86(2)(c).
The solution to this valuation point is the same as the s.85(1) “benefit
rule”: namely, a “price adjustment clause” for the Class B Preferred
Shares.
12.
Read s.51(1): another internal share exchange rule.

a share is acquired “in exchange for”;

paragraph (a): a capital property that is another share of that
corporation (the exchanged share);

and no consideration is received other than these shares;
THEN:

paragraph (c): there is no “disposition” (at all);
Page 249
Tax II Chapter 10
Spring 2013
Notes

paragraph (d): the cost of the new shares received is the ACB of
shares given up (subject to the usual pro-rating rule).
13.
It’s a roll-over: automatic. Why have yet another roll-over rule here?
14.
Read s.51(4): s.51(1) is not applicable if s.85(1) applies (i.e., an election
is filed), or if s.86(1) applies. There is a ranking, in the case of overlap:
first s.85(1), then s.86(1), then s.51(1).
15.
When might s.51(1) be useful? When s.85(1) election is not filed, and
s.86(1) does not apply.
Example:
Public
common
shares
“Convertible”
Preferred Shareholders
preferred shares
(convertible)
Pubco
16.

Widely held: conversion right buried in the preferred share rights.
The holder is free to exchange, in a set ratio, at any time.

There may be no “reorganization of share capital” required (i.e.,
existing common and preferred).

Holder may not exchange all shares of the class held (as required
by s.86(1)).

Subsection 85(1) election may be impractical, or cumbersome at
best.

Thus, a s.51(1) roll-over could be very useful to these convertible
shareholders.
Read s.51(3) - a familiar tax PUC grind rule: “A - B”. The effective limit
is the tax PUC of shares exchanged.
Page 250
Tax II Chapter 10
Spring 2013
Notes
Page 251