Tax II Chapter 14
Spring 2013
Chapter Fourteen Lecture Notes
Section 84.1 Individual Share Gains Deemed to be Dividends
David Christian
Spring Term 2013
Thorsteinssons LLP
UBC Faculty of Law
______________________________________________________________________________
Notes
This beats me.
Lord Bramwell (1891)
1.
The Chapter examines transactions that were originally designed to
remove profits from a company in the form of a capital gain to the
shareholder - rather than a dividend. Why would the shareholder want a
capital gain and not a dividend? In tax terms: a “dividend strip”. The
transactions are now prohibited by s.84.1. GAAR, as we see later in
Chapter 19, is also applicable.
2.
One cannot generally “extract” profits unless the shareholder disposes of
shares to a third party at the same time. Otherwise, you are looking at a
s.15(1) benefit, a deemed dividend under the specific rules in s.84, paying
salary, or paying any actual dividend.
3.
Consider one example to which s.84.1 is targeted.
Client
1 common
share
FMV
ACB
PUC
Corporate
Stated Capital
$760k
$10k
$10k
$10k
Opco.
<10%
$50k
Cash
$710k value in
Active Business
Assets
>90%
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Say the after-tax profit each year in Opco is $50. Client expects 15 years
of after-tax profits $50k, which would total $750k.
Client wants the $50k each year as a capital gain, and is prepared to take a
$750k capital gain this year to get $750k cash tax-free over the next 15
years.
The Client knows about the $750k capital gain exemption for QSBC
Shares. “Why not sell the one common share in Opco to my new holding
company for $760k?” Consider then: Holdco buys Opco for $760k cash.
The bank funds the $750k in a “daylight loan”.
$760k
Loan
$760k
repay
Client
common
share
$760k
purchase
price
cash
Bank
$760k
loan
Holdco
FMV
ACB
PUC
Corporate
Stated Capital
one
common
share
$760k
$760k
$10k
$10k
Opco
$50k
$710k
Active Business
Assets
The Client thinks: “I have an immediate capital gain on the sale of Opco
shares”.
Opco Common Share
Cash Proceeds $760k
ACB
(10k)
Capital Gain $750k
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“Furthermore, I can shelter this $750k gain with my $750k capital gain
exemption for QSBC Shares, right?” Section 84 does not apply, because
the transaction is not between the Client and Opco. The transaction is
between the Client and Holdco, a third party. Opco is not involved as a
party.
The Client thinks: “Now, I can extract profits from Opco tax-free, right?”
How? The transaction has set up the future extraction of profits out of
Opco without tax.
Client
$760k
loan
$760k as
repayment
of loan
Holdco
dividends (s.112 deduction,
no Part IV tax)
Opco
Cash
Active Business
Assets
Up to $760k of after-tax profits in Opco, taxed at 13.5% (Chapter 3), can
be paid to the Client free of any more tax? Opco can pay tax-free
intercorporate dividends to Holdco, which can then repay the shareholder
loan from the Client. The shareholder loan has a tax cost equal to its
value, so no tax. The Client has used the $750k capital gain exemption to
effectively shelter tax on future distributions from Opco, through Holdco,
up to $750k in our example, which would otherwise have been taxable
dividends out of Opco’s after-tax profits to the Client personally. (The
difference between $760k and $750k was $10k of tax PUC and ACB,
which could have been extracted from Opco before this transaction under
s.84 in any event.)
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Has the Client succeeded? If you stop at s.84, the answer is yes. Read
s.84.1. Imagine reading s.84.1 without any context.
4.
Section 84.1(1), as applied to the Client:
First, the preamble, which sets the preconditions:

a taxpayer other than a corporation (i.e., and individual),

disposes of shares that are capital property (these are the “subject
shares”),

the subject shares are shares of a corporation resident in Canada
(this is the “subject corporation”),

the shares are disposed of to another corporation (this is the
“purchaser corporation”),

the taxpayer “does not deal at arm’s length with” the purchaser
corporation (read s.251(1) again),

and, immediately after the transfer, the subject corporation is
“connected with” purchaser corporation “within the meaning
assigned by s.186(4)”. Read s.186(7).
If these preconditions are met, paragraph (a) and (b) will apply.
Look at paragraph (b) first.

a dividend is deemed paid to the Client by the purchaser
corporation (Holdco, in our example) in a formula amount = (A +
D) – (E + F).

Look at A, D, E & F separately:

A is zero. No “new shares” of the purchaser corporation
have been issued as consideration. (We come back to this
for paragraph (a) below.)
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
F is zero. (We come back to this for paragraph (a) as well
below.)

left with “D minus E”,

D is the “non-share consideration” received on the sale. $760k
cash

E is greater of:


the tax PUC of the subject shares (Opco shares),
“subject to s.84.1(2)(a) & (a.1)”, discussed below, the ACB
to the Client of the subject shares (Opco shares).

So “D minus E” is in this case is $760k - $10k = $750k. This
amount is deemed to be a dividend paid by Holdco to the Client.
This is taxable just as much as any other dividend the Client might
receive, at a top rate of 33.71%, assuming the dividend is not an
eligible dividend (Chapter 5).

What happened to the capital gain of $750k the Client thought had
been realized, and sheltered by the exemption? Look, again, at the
definition of “proceeds of disposition” in s.54: paragraph (k).
“Proceeds” does not include an amount that is deemed by s.84.1 to
be a dividend. The proceeds are $10k ($760k less $750k).
So, bad news for the Client. You pay tax (plus reassessment interest) on a
$750k dividend, and do not have a tax-exempt capital gain on QSBC
Shares.
Consider Willis Louis Insurance Ltd.
company. Same numbers as above.
Sale by father to son’s new
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Son
Holdco
Father
Bank
Sale
Opco
Active Business
5.
A “substantive business sale”, within the family, can trigger s.84.1
dividends. This is the heart of s.84.1. The other parts are equally
important, but revolve around this same idea.

First, the “PUC grind”. What if the Client did not get cash from
Holdco? Instead, the Client received one preferred share in
Holdco with a redemption value and corporate stated capital of
$760k as consideration from Holdco for the Opco shares?
Client
1
pref
share
FMV
ACB
Corporate
Stated Capital
Tax PUC
$760k
$760k
FMV
ACB
Corporate
Stated Capital
Tax PUC
$760k
$760k
$760k
$760k (?)
Holdco
1
common
share
$10k
$10k
Opco
The capital gain reported was $750k. No s.85(1) election is made.
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Proceeds
$760k
ACB
($10k)
Capital Gain $750k
What would you think the result is? How would the Client get at the
profits in Opco? Dividend to Holdco, reduce tax PUC or redeem preferred
shares of Holdco. Could this come out of Holdco tax-free?
Look at s.84.1(1)(a):

We know the pre-conditions are met, so go to paragraph (a)

Are shares of the purchaser corporation issued “as consideration
for” the Opco shares? Yes, Holdco issued the one preferred share
worth $760k.

In computing the tax PUC of the shares of the purchaser company,
you must deduct from that PUC a formula amount (another “PUC
grind”):
“(A – B) x C/A”

Look at “C/A” first. This is, simply, an allocation of the increase
in corporate stated capital of the purchaser company among
different classes of shares, if more than one class of shares of the
purchaser corporation is issued as consideration on the purchase.
Here there is one class of shares of Holdco issued as consideration,
so the ratio of C/A is 1/1, or 1.

Now, “A minus B”:

A is increase in corporate stated capital of the shares of the
purchaser company as a result of its purchase of the Opco
shares. That is $760k here.

B is greater of:

tax PUC of the Opco shares transferred.
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and

“Subject to s.84.1(2)(a) and (a.1)”, discussed below,
the ACB to the Client of the Opco shares
transferred,
less the FMV of any non-share consideration paid by the
purchaser company.

So, in computing the PUC of the one preferred share in Holdco
issued to the Client on the purchase, s.84.1(1)(a) says you deduct
“[A – B] x C/A”, or [$760k - $10k] x 1 = $750k. The “PUC
grind” is $750k.
The “PUC grind” to the one preferred share can be shown as
follows. The PUC of the Holdco preferred share is computed as
follows:
Start: Corporate Stated Capital
PUC grind s.84.1(1)(a)
tax PUC
$760k
$750k
$10k
Thus:
Client
1
pref
share
FMV
ACB
Corporate
Stated Capital
Tax PUC
$760k
$760k
FMV
ACB
Corporate
Stated Capital
Tax PUC
$760k
$760k
$760k
$10k (this is the key)
Holdco
1
common
share
$10k
$10k
Opco
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There is no immediate deemed dividend. Paragraph 84.1(1)(a) prevents
future distributions tax-free. There is not sufficient tax PUC in the Holdco
preferred share.
6.
Consider another example. Change the consideration to $200k cash and
$560k of one preferred share. Now apply s.84.1(1)(a) and s.84.1(1)(b).

s.84.1(1)(a): (A – B) x C/A. C/A is 1. Consider:
“A – B”

A = increase in PUC of 1 pref share in Holdco ($560k)

B = greater of:
o tax PUC of Opco share ($10k)
o ACB ($10k)
less the cash ($200k), or 0.


A – B = $560k. This is the “PUC grind” to the one preferred
share, bringing its tax PUC to zero.
s.84.1(1)(b): (A + D) – (E + F)


A = $560k
D = $200k
E = $10k
F = $560K

So the deemed dividend is =


o (560 + 200) – (10 + 560)
o or $190k.
7.
Consider ACB of the Opco shares. Can you see a potential further
transaction involving the sale of the Holdco share? Go back to the
“greater of” limitation in both s.84.1(a) and (b). What is the ACB to the
Client of the one preferred share of Holdco in the example in paragraph 5?
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“Subject to s.84.1(2)(a) and (a.1).” For example, read (a.1)(ii).
The focus is on any capital gain exemption previously claimed by
the taxpayer or a person not dealing at arm’s length with the
taxpayer. If there is any of that amount “built into” the ACB of the
share of the subject corporation sold, that amount is ignored for
s.84.1 purposes. Walk through an example where Client now sells
Holdco to, say, Holdco 2 for $760k cash.
Client
$760k
purchase
price
$760k
Loan
$760k
repay
Holdco
2
FMV
ACB
PUC
Bank
$760k
loan
$760k
$760k (soft)
$10k
Holdco
Opco
The apparent $760k ACB of the Client’s shares of Holdco is
reduced under s.84.1(2)(a.1) by the prior $750k capital gain
exemption claimed – so the apparent ACB protection disappears,
and s.84.1 causes a $750k dividend in this Holdco2 transaction.
Walk though the paragraph (b) dividend computation: (D-E).

8.
Read (a)(i) and (a.1)(i). These ignore the “V-day value bump”
(December 31, 1971) in computing ACB of the subject corporation
shares. Instead, you look at the historical or original cost. Recall
Tax I and V-day value bump to ACB.
Now consider the preamble preconditions in s.84.1 again: the taxpayer
“does not deal at arm’s length with” the purchaser corporation?
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9.
Spring 2013
Recall section 251: related persons do not deal with each other at arm’s
length (paragraph 251(1)(a)). It is a question of fact whether unrelated
persons do not deal with each other at arm’s length “arm’s length”
(paragraph 251(1)(c)). Read the Supreme Court of Canada decision in The
Queen v. McLarty, attached to this chapter.
Taxpayer
The test: taxpayer is not
dealing at arm’s length
with purchaser
corporation.
Purchaser
Company
Subject
Company
Read paragraph 84.1(2)(b): this is a specific deeming rule “for greater
certainty” that can be a trap:

test immediately before: Is the taxpayer one of a group of less than
6 persons who control the subject company?

test immediately after: is the taxpayer one of a group of less than 6
persons who control purchaser company, and each member of this
group was a member in of the group in (i)?
If so, the taxpayer is deemed not to deal at arm’s length with the purchaser
corporation. Read subsection 84.1(2.2): deeming rules for paragraph
84.1(2)(b).
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