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LECTURE 5 PROBLEM SET
Last updated September 23, 2014
It is now early March, 2015 and you, CPA, have just finished meeting with your client,
Mr. Paulson. Mr. Paulson has received an unsolicited offer to purchase all his shares of P
Ltd. and is seriously considering the offer.
Mr. Paulson is the sole-shareholder of P Ltd, a company incorporated in Canada that
manufactures furniture for sale in Ontario and Quebec. Details on the purchase offer are
provided in Exhibit I and additional information about P Ltd. is provided in Exhibit II.
Mr. Paulson says that P Ltd.’s asset values have remained stable for the past several years
and he has never used any of his capital gains exemption.
Mr. Paulson wants you to draft a report to him letting him know if his gain on sale will be
taxable or not. Mr. Paulson also wants to know if he should do anything in advance of the
possible sale to reduce income tax on the sale.
Exhibit I
Purchase Offer
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

On February 25 Mr. Paulson received an offer from Ms. Edwards a long-time
senior employee of P Ltd. to purchase all of Mr. Paulson’s shares of P Ltd.
Ms. Edwards comes from a wealthy family and would pay cash of $1,707,000 for
all of Mr. Paulson’s P Ltd. shares
Mr. Paulson agrees that this offer is a fair price
Exhibit II
P Ltd.
Balance Sheet
As at December 31, 2014
Assets
Marketable securities (FMV $250,000; see note 1)
Accounts receivable (FMV $90,000)
Inventory (FMV $710,000)
Fixed assets (FMV $100,000)
Investment in S Ltd. (FMV $857,000; see note 2)
Liabilities and Shareholder’s Equity
Account payable and accrued liabilities
Retained earnings
Share capital (see note 3)
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$200,000
90,000
410,000
125,000
175,000
$1,000,000
$300,000
699,000
1,000
$1,000,000
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Note 1
The marketable securities are public company investments in Canadian stocks, bonds and
mutual funds.
Note 2
P Ltd. purchased all of the issued and outstanding shares of S Ltd. (a private Canadian
corporation) in 1999 for $175,000. 95% of the FMV of S Ltd. assets are used directly in
an active business carried on in Canada.
Note 3
Mr. Paulson has owned all of the P Ltd. shares since 2001 and he is a Canadian resident.
Mr. Paulson bought the shares from the original shareholder, in 2001, for $1,000,000
which was their FMV at the time.
Solution
Report
To: Mr. Paulson
From: CPA
Re: P Ltd.
If Mr. Paulson were to sell all of his P Ltd. shares he would have the following initial
income tax consequences:
P of D
Less ACB
Capital gain
Taxable capital gain (1/2)
$1,707,000
$1,000,000
$707,000
$353,500
Since Mr. Paulson has never used his $800,000 capital gains exemption, he can earn this
capital gain of $707,000 tax-free if his P Ltd. shares are QSBC shares. To be QSBC
shares P Ltd. must: 1) be a SBC at the time of sale; 2) meet the holding period test; and 3)
meet the basic asset test.
1) SBC Test
At the time of sale, P Ltd. must be a SBC. A SBC is a CCPC having all or substantially
all (i.e., 90% or more) of the FMV of its assets used either:
(i) principally in an active business carried on primarily in Canada;
(ii) or invested in shares or debt receivable of a connected SBC; or
(iii) a combination of (i) and (ii)
The FMV of the assets of P Ltd. are:
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AR
Inventory
Fixed assets
Subtotal
Investment in S Inc.
Subtotal
Marketable securities
Total
%
FMV FMV
90,000
710,000
100,000
900,000 44.8%
857,000
1,757,000 87.5%
250,000 12.5%
$ 2,007,000 100%
P Ltd. is a CCPC since Mr. Paulson, who is a Canadian resident, controls it since he owns
more than 50% of the shares (he owns 100%); however, as can be seen in the chart
above, P Ltd. has 87.5% of its assets used in an active business carried on in Canada
and/or invested in shares of a connected SBC, not 90% or more.
Hence P Ltd. does not meet the SBC test.
S Ltd. is a connected SBC since it is a CCPC. S Ltd. is controlled by P Ltd. directly (a
Canadian resident) and it is indirectly controlled by Mr. Paulson (a Canadian resident).
P Ltd. is connected to S Ltd. because P Ltd. controls S Ltd. since it owns more than 50%
of the shares (it owns 100%).
However, steps can be taken in advance of the sale of shares to purify P Ltd. and meet
test 1. See below.
2) Holding Period Test
Throughout the 24 months preceding the sale, the shares cannot be owned by anyone
other than Mr. Paulson or a related person in order to meet this test.
Since Mr. Paulson has owned the shares of P Ltd. continuously since 2001, i.e.,
throughout the past 24 months, this test is met.
3) Basic Asset Test
P Ltd. needs to be a CCPC and to have > 50% of the FMV of its assets used in an active
business carried on primarily in Canada for the 24 months preceding the sale to meet this
test.
P Ltd. is a CCPC (as mentioned above); however, as can be seen in the chart above, P
Ltd. has only 44.8% (not more than 50%), of its assets used in an active business carried
on it Canada. Hence, the basic asset test is not met.
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Since, P Ltd. has shares invested in a connected CCPC we can try the modified basic
asset test. As long as either the basic asset test or the modified basic asset test is met then
test 3 will be met.
Modified Basic Asset Test
This is the same as the basic asset test (described above) except it also allows shares or
debt receivable invested in a connected CCPC to be included (along with active business
assets) to determine if the more than 50% test is met.
There is also a stipulation that must be met in order to use the modified basic asset test;
i.e., either P Ltd. meets a 90% test and S Ltd. meets a more than 50% test or vice versa.
This stipulation is met since:
i) P Ltd. has met the more than 50% test since 87.5% of its assets are used throughout the
24 month holding period in an active business in Canada and/or are shares or debt
receivable of a connected SBC; and
ii) S Ltd. has met the 90% test since 95% of its assets are used throughout the 24 month
holding period in an active business carried on in Canada.
The modified basic asset test has been met since throughout the 24 month holding period
more than 50% (i.e., 87.5% see chart above) of P Ltd. assets (at FMV) are used in an
active business and/or are shares or debt receivable of a connected CCPC.
Purify P Ltd. (to meet test 1)
In order to meet the SBC Test and pay less income tax Mr. Paulson should purify P Ltd.
by selling the marketable securities and removing the cash.
Calculation of minimum amount of marketable securities that must be sold:
= $2,007,000 – ($1,757,000/90%) = $54,778.
Note: the sale of marketable securities will cause a capital gain that is taxable (to P Ltd.)
in the year of the sale as follows: (i)½ of capital gain is a taxable capital gain subject to
tax; and (ii) ½ of capital gain is an addition to P Ltd.’s capital dividend account.
The after-tax cash received by P Ltd. must be used to invest in active business assets; pay
off liabilities; and/or pay dividends. Capital dividends can be received tax-free (as long as
an election is filed) but all other dividends result in personal tax to Mr. Paulson.
The FMV of the marketable securities (and other assets) can change which would change
the amount required to sell. This amount would need to be verified and adjusted for on
the day of the sale. Due to the risk of fluctuation of asset values, Mr. Paulson may wish to
sell more than the minimum amount computed above (and do something with the cash) to
ensure the SBC test is met.
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