The topic of income tax reorganization is broad and is often the subject of one or more papers on its own right. The focus of this paper is limited to reorganization likely to be encountered by the entrepreneur in the initial stages of the business.
As discussed above, an entrepreneur may decide to commence business in a partnership or sole proprietorship form in order to take advantage of start-up losses. Once the business becomes profitable it is often necessary to incorporate.
A transfer of a sole proprietorship or a partnership to a corporation takes place under section 85. Section 85 is the general rollover provision for capital assets and is used in many different types of reorganization.
Under section 85, the disposition of property may give rise to the recognition of gain or loss by the taxpayer. The resulting tax liability may however be deferred on a transfer by a taxpayer to a corporation for consideration that includes shares issued by the transferee.
Some of the most common applications of section 85 are listed below:
- The incorporation of a business by an individual or a partnership
- The creation of a holding company by an individual or a partnership
- The transfer of property to a corporation in the context of an estate freeze and/or income splitting reorganization
- The transfer of property within a group of corporations for business or tax reasons
- The division of a corporation under paragraph 55(3)(b)
- The purchase of property for consideration which consists in whole or in part of shares
Section 85 of the Act does not restrict the deferral of tax liability to a specific type of transaction nor to a transaction carried out for a specific purpose. It applies to any disposition of eligible property to a taxable Canadian corporation. Common control is not required and the transfer need not be reorganizational. However, most elections under section 85 involve related parties or pertain to reorganizations, because the deferral of tax liability on the transfer of property is conditional on shares of the transferee being received as consideration by the transferor.
Under section 85, a joint election by the transferor and the transferee has the effect of deeming the proceeds of disposition of the property to be equal to an elected amount. The same amount is deemed to be the cost of acquisition of the property. The election can thus be regarded as substituting a deemed amount for the figure determined under the income tax rules otherwise applicable to both the transferor and the transferee.
In the case of the entrepreneur section 85 would be applicable on the transfer if the assets of the proprietorship or the partnership into the corporation in exchange for shares of this corporation. The results would be that the business originally carried on in an unincorporated form has now been acquired by the corporation on a tax deferred basis. The corporation will then continue the business.
A formal written agreement will be entered into between the entrepreneur as vendor and the corporation as purchaser. It will have some of the normal provisions of an arm’s length agreement of purchase and sale including all necessary conveyances of title to assets.
A detailed analysis of section 85 is beyond the scope of this paper.
Many reorganizations will be initiated for tax reasons, often by the company’s accountant. Tax-based reasons for reorganization include the following:
- Accessing corporate losses
- Crystallizing the capital gains exemption
- Purifying the corporation to retain its eligibility as a qualifying small business corporation for capital gains exemption purposes
- Departure of one of several shareholders
- Break up of the corporation among several shareholders
The reorganization set out above will, for the most part, involve the utilization of one or more section 85 rollovers.
Estate planning in this context is merely a specialized form of tax motivated reorganization, usually involving either a section 85 rollover or a section 86 internal reorganization. This subject is discussed in detail below.
Reorganization of a corporate group may also be undertaken with a view to protecting assets from creditors.
It is, of course, important to ensure that all relevant statutes are complied with.
Reorganization for creditor proofing purposes will usually take one of the following forms:
- Rolling certain operating assets (such as a separate division) into a sister company
- Setting up a holding company, declaring and paying a dividend equal to all of the equity of the operating company
- And then lending these funds back to the operating company secured by a general security agreement registered under the PPSA
- Setting up a new corporation for a new division
This is another case where reorganization will typically be carried out utilizing rollovers under section 85. Accordingly such reorganization will normally have no immediate adverse tax consequences.
Equity to Employees
Employees who are being given minor amounts of equity will usually obtain it by way of stock options.
The income tax planning for the structure of a stock option plan requires the income tax law and corporate law expertise that our experienced Vancouver tax lawyers bring to all client tax issues. In a stock option plan, the employee is given or earns the right to acquire shares of the corporation, usually at some fixed period of time in the future. Sometimes the employee acquires certain shares at the inception of the stock option plan with rights to acquire additional shares in the future. The vesting of the stock option rights may be deferred for some period of time and will usually only vest if the individual is still employed by the corporation. Read more
The tax treatment of conventional financing are straight forward. Special forms of financing, such as term preferred shares, are beyond the scope of this paper.
Interest on debt incurred by an individual or corporation for the purposes of earning income will be deductible by the borrower. It will also be taxable in the hands of the recipient.
Often it will be necessary for the entrepreneur to personally guarantee the obligations of the corporation.
Deduction of Guarantee Payments
Generally speaking, a taxpayer who is required to honour a Guarantee is considered to have acquired a debt at the time that the Guarantee is honoured equal to the amount of payment made pursuant to the Guarantee.
Whether the debt so acquired is a bad debt is a question of fact. If the Guarantee had been given for adequate consideration it will generally be considered to have been given for the purpose of gaining or producing income. Therefore, if the acquisition of a debt in these circumstances gives rise to a bad debt, any loss arising from a payment required by the Guarantor under that Guarantee will be considered to be a deductible capital loss. In certain circumstances, discussed in Interpretation Bulletin 239R2, loan guarantees for inadequate consideration may also give rise to capital losses. This occurs where:
- The corporation (or partnership) which benefited from the Guarantee used the borrowed funds to earn income
- The corporation could not obtain financing at competitive rates without the Guarantee
- The corporation permanently ceased to carry on its business
- The loan from the shareholder to the corporation did not result in any undue tax advantage
An equity investment does not give rise to a deduction to the borrower on payments made. Dividend payments from a corporation are made out of after tax funds. Dividends received by a corporation or a shareholder have special rules as set out above. A Canadian resident individual who receives a dividend from a Canadian-controlled private corporation is entitled to a gross up and dividend tax credit. As mentioned above, this is part of the integration mechanism which ensures that income earned by an entrepreneur through a corporation or directly through an unincorporated business will, ultimately be taxed at the same rate.
A corporation which receives a dividend may be entitled to a deduction in respect of the dividend depending on the nature of the income in the paying corporation which gave rise to dividend. A more complete analysis is beyond the scope of this paper.