Canadian Tax Planning via the Lifetime Capital Gains Exemption (LCGE)

Canadian Tax Planning using the Lifetime Capital Gains Exemption (LCGE): Beware Section 84.1 Tax Trap of the Income Tax Act – A Canadian Tax Lawyer’s Analysis

Introduction – The Mischief Targeted by Section 84.1: Surplus Stripping (a.k.a. Dividend Stripping)

Section 84.1 prevents an individual shareholder from converting what would otherwise be a taxable dividend into a tax-free return of capital by using non-arm’s-length transactions. These transactions are often called surplus-stripping transactions or dividend-stripping transactions.

These impugned surplus-stripping transactions sometimes rely on the lifetime capital gains exemption (LCGE). For example, an individual owns an operating corporation with a $1 million surplus (retained earnings). Instead of drawing the $1 million as a taxable dividend, the individual transfers his shares to a holding company for $1 million in additional equity in the holding company. By claiming the LCGE, the individual avoids the taxable capital gain that would otherwise have arisen when disposing of the shares in the operating corporation. In addition, the individual may now draw the $1 million from the holding company as a tax-free return of capital.

Section 84.1 prevents this result by ensuring that the individual can’t draw a return of capital from the holding company that exceeds the return of capital that the individual could have drawn from the original operating company. In addition, if the individual had received non-share consideration from the holding company—for example, a promissory note or cash—section 84.1 deems the individual to have received a dividend in the amount of the non-share consideration. By converting these proceeds into a dividend, the rule disqualifies the individual not only from the lifetime capital gains exemption but also from the favourable tax treatment on capital gains. Dividend income doesn’t qualify for the lifetime capital gains exemption, and, unlike a capital gain, which is only half taxable, the deemed dividend is fully taxable.

Although many surplus-stripping transactions rely on the lifetime capital gains exemption, section 84.1 tax trap doesn’t solely target transactions involving the lifetime capital gains exemption (since, over the years, there have been many different surplus-stripping transactions set up by creative Canadian tax lawyers). It potentially applies anytime an individual transfers shares to a holding corporation. And when it applies, section 84.1 can lead to severe tax costs. Yet the section 84.1 tax trap often goes unnoticed by tax advisers when structuring a share-sale transaction or a corporate reorganization. This is why you should consult one of our experienced Canadian tax lawyers to review pending transactions or for advice on reducing the risk of triggering section 84.1.

After examining the important background concepts of stated capital, paid up capital, deemed dividends, and adjusted cost base, this article details the application and effects of section 84.1

Important Background Concepts: Stated Capital, Paid Up Capital (PUC), Deemed Dividend, and Adjusted Cost Base (ACB)

To understand the mechanics of section 84.1, you need a handle on three important tax concepts: stated capital, paid up capital (or PUC), deemed dividend, and adjusted cost base (or ACB).

Stated Capital

A corporation’s stated-capital account tracks the consideration that the corporation received in exchange for issuing its shares—in other words, the account tracks the amount paid by the shareholder to the corporation. The corporation should keep a separate stated-capital account for each class or series of shares. And proper accounting should allow you to discern the stated capital for each issued share. It is important that the corporation’s accountant coordinate with the corporation’s Canadian tax lawyer to ensure proper tax record keeping.

The corporation’s stated capital discloses the shareholders’ skin in the game. That is, the stated-capital account shows how much the shareholders have invested in the corporation. Because the stated capital represents the amount that the shareholders have invested in the corporation, it serves as a measure of shareholders’ limited liability. In other words, the stated-capital account shows exactly how much the shareholders have risked by investing in the corporation. As a result, it alerts potential future investors or lenders of risk when investing or lending to a corporation.

Generally, the stated-capital account tracks the fair market value of the consideration that the corporation received upon issuing a class or series of shares. But, in certain circumstances, corporate law allows the corporation to increase its stated capital by less than the full fair market value of the consideration received. The amount of the consideration that isn’t added to the stated capital is called a “contributed surplus,” and it can later be capitalized and added to the appropriate stated-capital account.

In addition, the stated-capital account for a class or series of shares must decrease if the corporation purchases, acquires, or redeems shares in that class or series.

Paid Up Capital (PUC)

Paid up capital (PUC) measures the contributed capital and capitalized surpluses that a corporation can return to its shareholders on a tax-free basis.

Paid up capital and stated capital are closely related concepts. The corporation’s stated capital serves as the basis for computing the paid up capital of its shares. And, like stated capital, PUC is an attribute of each issued corporate share.

But PUC may deviate from stated capital. Stated capital is a corporate-law concept; paid up capital is a tax-law concept. So, while PUC derives from stated capital, the two may diverge. For example, say you bought a property for $50,000 a few years ago. Now, the property is worth $100,000, and you transfer that property to a corporation in exchange for a single share, thereby incurring a capital gain. Your share’s stated capital and PUC will each be $100,000. In contrast, say you transferred the same property to the corporation at cost under section 85 of the Income Tax Act. (If the transaction qualifies, section 85 allows a taxpayer to avoid a taxable capital gain by transferring property to a corporation at the property’s tax cost.) In this case, your share’s PUC will be $50,000, yet its stated capital will be $100,000. (A section 85 rollover typically qualifies as a circumstance where corporate law allows a reduced stated capital. So, experienced Canadian tax-planning lawyers may sometimes adjust the stated capital to match the PUC. The default, however, is a mismatch.)

Deemed Dividend

Even in the absence of an explicit distribution from a corporation to its shareholder, Canada’s income-tax law forces the shareholder to recognize dividend income when certain transactions take place. To this end, section 84 (which is different from section 84.1) of Canada’s Income Tax Act contains several rules that deem a shareholder to have received a dividend in certain cases.

Why does the Income Tax Act contain deemed-dividend rules? Generally, these rules serve two purposes. First, Canada’s tax law allows a shareholder to withdraw a capital contribution from the corporation on a tax-free basis. The deemed-dividend rules preserve the integrity of this system by ensuring that corporate distributions exceeding contributed capital are taxed as dividends. Second, Canada generally taxes capital gains at a lower rate than that applied to dividends. The deemed-dividend rules hinder some transactions under which taxpayers could convert otherwise taxable dividends into capital gains.

The deemed-dividend rules all revolve around the notion of paid up capital (PUC). And for the purposes of this article, the main takeaway about the deemed-dividend rules is this: any alleged return of capital in excess of PUC results in a deemed dividend. In particular, if a shareholder holds shares with PUC of $100, yet draws $100,000 from the corporation as a purported return of capital, the shareholder is deemed to have received a dividend in the amount of $99,900 ($100,000 – $100)

As you’ll see below, section 84.1 counters a shareholder’s attempt to increase the shares’ PUC by using a non-arm’s-length transaction.

Adjusted Cost Base (ACB)

The adjusted cost base (ACB) is the shareholder’s tax cost for purchasing the shares. The ACB, when deducted from the proceeds of disposition, determines the amount of a capital gain or capital loss when the shareholder disposes of the shares.

The ACB is an attribute of the shareholder; stated capital and PUC are attributes of the shares. So, the shareholder’s ACB for a share need not accord with the share’s stated capital or PUC. The stated capital and PUC only capture a shareholder’s contribution to the corporation for a share; the ACB captures a shareholder’s contribution to any vendor for a share.

To illustrate, we continue with the example above: you transfer that property worth $100,000 to a corporation in exchange for a single share. Your share’s stated capital and PUC will each be $100,000. And your ACB will also be $100,000. You later sell your share to a buyer for $150,000. The corporation gets nothing out of this transaction. So, the share’s stated capital and PUC each remain at $100,000. But the buyer paid $150,000 for the share. So, the buyer’s ACB is $150,000.

When Does Section 84.1 Apply?

Section 84.1 applies only if all the following conditions are met:

A non-corporate taxpayer (i.e., a natural person or a trust) disposes of shares in a Canadian-resident corporation.
The shares constitute the taxpayer’s capital property.
The taxpayer disposes of the shares to a corporation with which the taxpayer doesn’t deal at arm’s length before the disposition.
Immediately after the disposition, the Canadian-resident corporation is “connected” with the purchaser corporation. The corporations are “connected” if (a) the purchaser corporation owns more than 10% of the target corporation’s voting shares, or (b) the purchaser corporation owns 10% or less, but the purchaser corporation and parties related to the purchaser corporation altogether own more than 50% of the target corporation’s voting shares.

These rules show how section 84.1 aims to target transactions involving the lifetime capital gains exemption (LCGE). For instance, section 84.1 doesn’t apply when a corporation disposes of shares because corporations don’t qualify for the LCGE. And section 84.1 doesn’t apply if the shares aren’t capital property because those shares won’t receive LCGE treatment.

When Do Parties Deal at “Arm’s Length”?

Section 84.1 applies only if an individual taxpayer disposes shares to a corporation with which that taxpayer doesn’t deal “at arm’s length.” So, when exactly does an individual and a corporation deal on non-arm’s-length terms?

Section 251 of the Income Tax Act defines when an individual and corporation deal on non-arm’s-length terms. Basically, the two don’t deal at arm’s length if the individual (a) controls the corporation, (b) is member of a related group that controls the corporation, or (c) is related to a person who either controls the corporation or is a member of a related group that controls the corporation.

Some examples:

• An individual and corporation don’t deal at arm’s length if the individual owns over 50% of the corporation’s voting shares: condition (a).
• An individual and a corporation don’t deal at arm’s length if the individual and the individual’s siblings altogether own over 50% of the corporation’s voting shares: condition (b).
• An individual and a corporation don’t deal at arm’s length if the individual controls another corporation that in turn owns over 50% of the voting shares in the target corporation: condition (c).
• An individual and a corporation don’t deal at arm’s length if the individual’s brother owns over 50% of the corporation’s voting shares (even if the individual owns no shares): condition (c).
• An individual and a corporation don’t deal at arm’s length if the individual’s siblings altogether own over 50% of the corporation’s voting shares (even if the individual owns no shares): condition (c).

The Income Tax Act expands the definition of a non-arm’s-length relationship for the purposes of section 84.1. The individual transferring the shares and the corporation acquiring the shares don’t deal at arm’s length if two conditions are met. First, immediately before the disposition, the individual is a member of a group of fewer than six people that control the target corporation (i.e., the corporation in which the individual sold shares). Second, immediately after the disposition, the individual is a member of a group of fewer than six people that control the purchasing corporation (i.e., the corporation that acquired the shares from the individual), and this same group controlled the target corporation before the disposition. Notably, these rules don’t require a non-arm’s-length relationship among the parties controlling the target corporation before the disposition or among the parties controlling the purchasing corporation after the disposition.

What Does Section 84.1 Do? Reduction of PUC & Deemed Dividend

At its core, section 84.1 targets transactions involving an individual who transfers shares (the “Subject Shares”) to a corporation (the “Purchasing Corporation”) and receives shares in the Purchasing Corporation (the “New Shares”).

If section 84.1 applies, it does two things. First, it prevents the individual from acquiring New Shares with PUC that exceeds the Subject Shares’ PUC (or ACB, if greater). Second, if, in exchange for the Subject Shares, the individual received non-share consideration—e.g., a promissory note or cash—from the Purchasing Corporation, section 84.1 deems the Purchasing Corporation to have paid the individual a dividend in the amount by which the value of the non-share consideration exceeds the PUC of the Subject Shares.

Tax Consequence 1: Reduction of New Shares’ PUC

Paragraph 84.1(1)(a) sets out a formula for reducing the paid up capital of New Shares that the individual received from the Purchasing Corporation. The PUC of the New Shares is reduced by the amount resulting from this formula:

• (A – B) x C/A, where
• A: the total increase (ignoring section 84.1) in PUC for all classes of shares of the Purchasing Corporation as a result of issuing the New Shares;
• B: the amount by which the greater of (i) the Subject Shares’ PUC, immediately before the disposition, and (ii) the individual’s ACB for the Subject Shares, immediately before the disposition, exceeds the value, immediately after the disposition, of any non-share consideration the individual received from the Purchasing Corporation for the Subject Shares;
• C: the increase (ignoring section 84.1) in PUC of any particular class of New Shares as a result of issuing the New Shares.

The result of this formula isn’t the amount of the New Shares’ PUC; the result is the amount by which the New Shares’ PUC is reduced. In particular, ignoring section 84.1, the New Shares’ PUC is the value of the Subject Shares. Section 84.1 reduces the New Shares’ PUC by the amount resulting from the above formula. Moreover, if, in consideration for the Subject Shares, the Purchasing Corporation issues multiple classes of New Shares, the PUC of each class of the New Shares is reduced in proportion to the amount by which it would have increased but for section 84.1.

For example, suppose that an individual owns OldCo shares with an adjusted cost base of $50 and paid up capital of $50. The value of the OldCo shares is $1,000. The individual transfers the OldCo shares to NewCo and receives shares in NewCo. Ignoring section 84.1, the PUC of the NewCo shares is $1,000. But paragraph 81.1(1)(a) reduces the PUC by $950—i.e., $1,000 (A) minus $50 (B). As a result, the individual receives NewCo shares with PUC equaling the PUC of the OldCo shares.

Tax Consequence 2: Deemed Dividend

If, in exchange for the Subject Shares, the individual received non-share consideration—e.g., a promissory note or cash—from the Purchasing Corporation, section 84.1 deems the Purchasing Corporation to have paid the individual a dividend. Paragraph 84.1(1)(b) gives a formula to determine the amount of the deemed dividend:

• (A + D) – (E + F), where
• A: the total increase (ignoring section 84.1) in PUC for all classes of shares of the Purchasing Corporation as a result of issuing the New Shares;
• D: the value of the non-share consideration that the individual received from the Purchasing Corporation for the Subject Shares;
• E: the greater of (i) the Subject Shares’ PUC, immediately before the disposition, and (ii) the individual’s ACB for the Subject Shares, immediately before the disposition;
• F: the total amount by which the Purchasing Corporation had to reduce its PUC as a result of paragraph 84.1(1)(a).

The formula basically means that the deemed dividend equals the amount by which the value of the non-share consideration exceeds the PUC of the Subject Shares. Also, by carving out the Subject Shares’ PUC (or ACB) from the deemed dividend, the formula effectively treats the non-share consideration as, to the extent of the Subject Shares’ PUC, a tax-free return of capital.

For example, suppose that an individual owns OldCo shares with a paid up capital of $50. The value of the OldCo shares is $1,000. The individual transfers the OldCo shares to NewCo and receives a $1,000 promissory note from NewCo. Since NewCo didn’t issue any shares, there’s no PUC reduction under paragraph 84.1(1)(a). But paragraph 84.1(1)(b) deems NewCo to have paid the individual a dividend in the amount of $900—i.e., $1,000 (D) minus $100 (E). In other words, the promissory note is treated as a return of capital to the extent of the PUC of the OldCo shares and as a dividend to the extent that it exceeds the PUC of the OldCo shares.

Here’s an example involving both the PUC reduction and the deemed dividend:

An individual owns OldCo shares with a PUC of $100 and a value of $1,000. The individual transfers the OldCo shares to NewCo. In consideration, NewCo issues to the individual (1) NewCo shares with PUC of $500 (before applying section 84.1) and (2) a $500 promissory note.

Paragraph 81.1(1)(a) reduces the NewCo shares’ PUC by $500—i.e., $500 NewCo PUC otherwise determined – ($100 OldCo PUC – $500 non-share consideration = nil). As a result, the individual receives NewCo shares with nil PUC.

Paragraph 81.1(1)(b) deems the individual to have received a dividend of $400—i.e., ($500 NewCo PUC otherwise determined + $500 non-share consideration = $1,000) – ($100 OldCo PUC + $500 PUC reduction under paragraph 81.1(1)(a) = $600).

In other words, the individual receives NewCo shares with nil PUC, and the $500 promissory note is treated as a $100 tax-free return of capital as a result of the $100 PUC of the OldCo shares and as $400 deemed dividend to the extent that it exceeds the PUC of the OldCo shares.

Another example:

An individual owns OldCo shares with a PUC of $100 and a value of $1,000. The individual transfers the OldCo shares to NewCo. In consideration, NewCo issues to the individual (1) NewCo shares with PUC of $925 (before applying section 84.1) and (2) a $75 promissory note.

Paragraph 81.1(1)(a) reduces the NewCo shares’ PUC by $900—i.e., $925 NewCo PUC otherwise determined – ($100 OldCo PUC – $75 non-share consideration). As a result, the individual receives NewCo shares with PUC of $25.

But the deemed dividend under paragraph 84.1(1)(b) is nil—i.e., ($925 NewCo PUC otherwise determined + $75 non-share consideration = $1,000) – ($100 OldCo PUC + $900 PUC reduction under paragraph 81.1(1)(a) = $1,000).

Because the $100 PUC of the OldCo shares exceeds the $75 promissory note, the full $75 promissory note is treated as a tax-free return of capital and the remaining $25 of OldCo PUC is preserved as the PUC of the NewCo shares.

Pro Tax Tips – Avoiding Section 84.1 Tax Trap

As mentioned above, section 84.1 targets surplus-stripping transactions. And because surplus-tripping transactions often rely on the lifetime capital gains exemption, section 84.1 catches some dispositions that qualify for LCGE treatment. As a result, when attempting to crystalize the lifetime capital gains exemption, unsuspecting taxpayers can trigger section 84.1 even when they aren’t attempting to surplus strip.

Most commonly, section 84.1 catches taxpayers attempting to crystalize the LCGE by transferring qualifying small business (QSBC) shares to a holding corporation. To avoid section 84.1, the taxpayer could crystalize the LCGE by transferring the QSBC shares not to a holding corporation but to a related individual or trust. By doing so, however, the taxpayer might lose out on advantages that come with using a holding corporation to crystalize the LCGE. For example, the disposition of the QSBC share might result in a capital gain that exceeds the taxpayer’s LCGE amount. By transferring the QSBC shares to a holding company instead of to an individual, the taxpayer can adjust the amount of the gain by electing under section 85. In other words, the holding company allows the taxpayer to crystalize the lifetime capital gains exemption without exceeding the LCGE limit and thereby realizing capital-gains tax.

But section 84.1 often goes unnoticed by inexperienced accountants and other tax advisers when structuring LCGE-crystallization transactions and other corporate reorganizations for their clients. To review pending transactions or for advice on reducing the risk of triggering section 84.1, consult one of our experienced Canadian tax lawyers.

The corporation’s stated capital need not accord with PUC. This inconsistency is a common trap for those relying solely on the corporation’s financial statements. Unaware that share capital exceeds PUC, inexperienced accountants and corporate lawyers often trigger deemed dividends for their clients by approving the issuance what appears to be a tax-free return of capital. This is especially the case when, thinking that he has increased the PUC of a client’s shares, the inexperienced adviser has in fact structured a transaction triggering section 84.1. Consult one of our experienced Canadian tax lawyers to review pending transactions or for advice on avoiding section 84.1 and reducing the risk of realizing a deemed dividend. For instance, one simple strategy is to reduce the corporation’s stated capital so that it reflects the PUC.

If you have already triggered a deemed dividend but failed to report the income on your return, speak with our Canadian tax lawyers about your options. For instance, you may qualify for relief under the Voluntary Disclosures Program, a rectification order, or a late-filed capital-dividend election.