LESSON 2 from CGA Tax Notes

1
LESSON 2 (from CGA Tax Notes)

• TWO MAJOR TOPICS
• Section 85 Asset transfers - more commonly
  referred to as asset rollovers
• -requires an election form T2057 to be
  filed
• 2) Affiliated Loss Rules these deny capital
  losses for certain transactions

2
WHAT DOES SECTION 85 DO?
Simply putit is a section in the ITA which
allows a taxpayer to transfer assets ( see the
list of eligible assets) to a taxable Canadian
corporation for consideration that includes at
least one share , and they may select a
disposition amount ( called the agreed amount)
ranging from the tax cost amount to the Fair
Market Value.
3
WHY UNDERTAKE A SECTION 85 ASSET TRANSFER ?

• Some reasons to do so are
• deferral of tax on disposition of property to a
  corporation
• taxfree consequences when incorporating a
  proprietorship
• implementing an Estate freeze
• to transfer (taxfree) assets between related
  corporations
• to crystallize your capital gain on qualified
  small business shares
• Are there any disadvantages? - there is the
  possibility of double taxation

4
TAX EFFECT ?
If you can choose to sell the asset for tax
purposes for any amount between the tax cost of
the asset and FMV then its possible to transfer
/sell it at your tax cost and thus defer all tax
consequences on the disposition. Not surprisingly
then there are a host of rules to make this
work and be fair. Discuss. -these rules
and others sections of the ITA which impact on
S.85 lead this to be a very complex area
5
S.85 ACB 50,000 FMV 100,000 Agreed
Amount 50,000
FMV 100,000
Share consideration
Land
Agreed Amount
Cost 50,000
50,000
Maximum Non-share consideration
Note that total FMV consideration (shares and
non share) must equal the FMV of the asset that
was sold.
6
S.85 same example continued
15(1) appropriation
FMV 100,000
Share consideration
Land
Agreed Amount
Cost 50,000
DPOD deemed cost to transferee
50,000
Maximum Non-share consideration
Note the agreed amount determines the deemed
proceeds to the transferor and the deemed cost to
the transferee. If your total consideration FMV
exceeds the FMV of the asset-then a section
15(1) appropriation is triggered.
7
ASSETS ELIGIBLE to TRANSFER

• capital propertythis includes both depreciable
  and non depreciable capital property (even
  shares) but does not include real property
  owned by a non resident
• Canadian foreign resource properties
• eligible capital property (like goodwill, milk
  quotas)
• inventory .other than an inventory of real
  property
• a security or debt obligation used in the
  business
• a non resident person can transfer real
  property if it is used in a active Canadian
  business or certain designated insurance property
  

8
Some of the DISPOSITION RULES

• 85(1)(a)
• 85(1)(b)
• 85(1)(c )
• 85(1)(c.1)

• Says the agreed amount becomes DPOD to transferor
  corps cost
• Says the agreed amount cannot be less than the
  Non- share consideration
• Says the agreed amount cannot exceed FMV
  (risking 15(1) application)
• Sets lower limit of Agreed Amount for inventory
  non-depreciable capital property t/p cannot
  elect at less than lower of cost amount or FMV

9
Disposition Rules continued

• 85(1)(c.2)
• 85(1)(d)
• 85(1)(e)
• 85(1)(e.2)
• 85(1)(e.3)
• 85(1)(e.4)

• Sets lower limit for AA for farm inventory (on a
  cash basis) no less than cost plus mandatory
  inventory adjustment
• Sets lower limit of AA for eligible capital
  property at cannot be less than the least of
  4/3 pool balance, historical cost or fmv
• Sets the lower limit of AA for depreciable
  property at no less than the least of u.c.c. of
  the class and historical cost or fmv (ordering
  rule in (e.1) ).
• Gifting ruleif FMV of property exceeds the
  total FMV of all consideration receivedpotential
  gifting application.which would bump proceeds
• Resolution of conflict between subsections
• Automobile rule..AA is at UCC figure
  

10
What is the COST of the Consideration received ??

• 85(1)(f)
• 85(1)(g)
• 85(1(h)

• Simple pecking order of ascribing cost is the
  Agreed Amount is allocated to
• 1st to any NSC received
• 2nd to any preference shares received (up to
  their respective FMVs )
• 3rd to any common shares received

11
PUC Rule for the Shares just Received as
Considerationthis rule is subject to 84.1and
212.1
This section contains a PUC reduction (a grind)
formula and a PUC increase (bump) formula. The
formula are adjustments to the legal puc of the
shares. For example the s.85(2.1)(a) is asking
you to deduct an amount from the legal puc to
arrive at a tax puc amount. Look at formula
(A-B) x C/A. The section is difficult to read but
what it is saying is that the TAX Puc can be no
higher than the Agreed Amount figure less any NSC
that was received.
12
Some additonal rules
Depreciable property concerns
85(5) if the transferors original capital cost
of a depreciable property is greater than the
Agreed Amount (which will likely be the UCC
figure) then the original capital cost is deemed
to flow through to the transferee (for s.13 20
only) and all previous CCA claims are deemed to
be the transferees - WHY?? To preserve the
ability to recapture prior CCA claims.
Partnerships can transfer Assets to a Corporation
s.85(2) allows partnerships to transfer assets to
a corporation and then wind up on a tax free basis
13
Example 2-1
14
What ex2-1 would look like on Form T2057
Note NO gain occurred because the Agreed Amount
did NOT exceed the ACB of the property
15
Example 2-2
16
Example 2-2 T2057 form presentation
This what the taxpayer thinks has occurred
The correct T2057 will reflect the deemed revised
Agreed Amount which will trigger a capital gain
to the transferor.
Question? can he amend the election?
17
Example 2-4 where NSC 160 Exceeds FMV of
the subject Property 150 -this leads to 15(1)
appropriation
18
Example 2-4 in T2057 form presentation
This shows that the 85(1)c, which states the
agreed amount cannot exceed the FMV of the asset,
over-rides 85(1)b for raising the agreed amount
up to the NSC.
15(1) Benefit this occurs because the the 160
cash received exceeds the 150 total FMV of the
assets ..so a 10 15(1) benefit occurs.
19
Example 2-5 New Twist FMV of Asset 50,
ACB 100, NSC of 100 and Agreed Amount of 70
20
Example 2-5 in T2057 form presentation
This what the taxpayer thinks has happened.
But remember that NCS cannot exceed the FMV of
the asset.
NOTE that 15(1) occurs for 50..but note a
capital loss is occurring here is it a
deductible loss ????
21
EX 2-6 shows per 85(1)(c.1) for inventory
non-depreciable capital ,..the lower limit for
AA is lesser of cost or FMV
Note this section says you could have a loss
but you cannot artificially trigger one.
22
Example 2-7 showing the lower limit rule for
the Agreed Amount for Eligible Capital Property
23
Example 2-8 shows the lower limit rule for the
Agreed Amount for Depreciable property
NOTE if FMV was the lower than UCC..a terminal
loss can occur..is it deductible ???
24
EX 2-9 IF AA is Less than the CC of a
DEPRECIABLE capital property then s.85(5)
preserves the ability for future recapture
25
Simple Gifting example s. 85(1)(e.2)
Before section 85 Bobs children owns 100 of
ABC Ltd and they own 100 common shares at a total
cost Fmv of 100

ABC Ltd
100 c.s. children ,fmv 100
New s.85 Bob sells asset to ABC Ltd for a
claimed FMV of 500,000 with an AA and ACB of
100,000 and takes back preference shares for
500,000 BUT asset was really worth 800,000.
ABC
100 cs Children FMV??
500,000 pref shares Bob
26
Gifting? The corporation acquired an asset with
a FMV of 800,000 yet it only issued total
consideration with a value of 500,000. WHO
benefits by this ?..the excess value falls to
the common s/hers and these are his children.
Gifting has occurred.
ABC
100 cs FMV 300,100 kids
500,000 fmv pref shares , Bob
Now what? Bob will have additional proceeds of
disposition equal to the value of the gift of
300,000. But his consideration (pref shares ) is
not bumped in any way. The Corp gets a bumped
asset.
27

• Tax Consequences of the gifting?
• - as it stands Bob will have an additional
  300,000 of proceeds to account for
• -was there a price adjustment clause in the
  agreement?
• -was there a valuation issue ?
• will Bob be allowed to fix the problem by
  amending the section 85 election?
• is there a CRA policy on valuation related
  issues and reimbursement or amending elections?

28
85(2.1) PUC Adjustments
As previously stated s.85 contains a PUC
reduction because without the rule legal puc
would prevail and this would often be greater
than the Agreed Amount. Since you could draw out
the PUC tax free it does not make sense that the
ITA would allow you to transfer at less than FMV
at the Agreed Amount and yet still Allow PUC to
rise to the FMV so you could draw out the full
FMV taxfree as a return of puc..
This section is one of several sections in the
ITA that will monitor PUC by reducing the
amount of TAX PUC that is recognized. Also
note that every puc reduction section is followed
by a puc increase section as well. Both sections
contain formula. In a moment we will look at some
examples from your notes.
29
PUC GRIND LAW -remember it produces an
amount to DEDUCT from legal puc
30
Example 2-20 PUC REDUCTION
Cost of the note pref shares
31
Example 2-20 continued
(always start with legal puc)
32
IF NO PUC REDUCTION HAD BEEN MADE THEN UPON
REDEMPTION there would be no deemed dividend but
a large capital gain would occur   1st Step of a
Redemption 84(3)   Proceeds of redemption
400,000 Less PUC
400,000 Deemed Dividend
NIL   2nd Step s.54 Proceeds of
disposition 400,000 Less 84(3)
dividend . NIL Revised
proceeds 400,000 Less
acb .
NIL Capital gain
400,000 And the gain may qualify for capital
gains exemption
33
IF A PUC REDUCTION OF 400,000 IS MADE Upon
redemption 1st Step of a Redemption
84(3)   Proceeds of redemption
400,000 Less PUC
. NIL Deemed Dividend
400,000   2nd Step s.54 Proceeds of
disposition 400,000 Less 84(3)
dividend 400,000 Revised
proceeds .
NIL Less acb
. NIL Capital gain
. NIL
34
PUC INCREASE the is a difficult section to read
..try to remember what its doing, why its
needed when you need it
35
Example 2-21
36
Example 2-21 continued .Remember you are adding
back to the class an amount equal to the
original puc reduction applicable for the 25
of the shares that were redeemed logically then
we should see an amount of 25 x 400,000
100,000
legal
(This is for the whole class)
37

• Example of a FREEZE with S.85
• Before Bob owns 100 of the 100 c.s. Of ABC
  Ltd., with an acb taxpuc of 100. Current FMV
  is 1,000,000.
• Bob wants to freeze his old common shares
  value into newly issued pref shares and bring
  in his children for the future growth of the
  company.
• Tax Planning Steps
• Holdco is set up issues 10 new common shares to
  the children for a nominal amount of 1 each
• Bob does a s.85 transferring his c.s. to a new
  Holdco at an AA amount of 100 and takes back as
  consideration 1,000,000 of pref shares.

38
Freeze example continued
S85 AA 100,
Before
After
ABC
ABC
Holdco
Bob 100 c.s.
1,000,000 pref Bob
10 c.s children
Bob has froze his c.s. value into the new pref
shares.
39
Freeze shown on a T2057 election form
Question? How was the FMV of the shares
determined? What is the acb of the new Pref
shares? What is the PUC of the new Pref shares?
40
Estate Freeze example an INTERNAL ROLL

• Bob owns 100 of the 100 c.s. Of ABC Ltd., with
  an acb taxpuc of 100. Current FMVis
  1,000,000.
• Bob wants to freeze his common shares into pref
  shares and bring in his children for the future
  growth of the co.
• Tax Planning Steps
• Bob does a s.85 transferring his c.s. right back
  to ABC LTD. (an internal rollover) at an AA
  amount of 100 and takes back as consideration
  1,000,000 of pref shares.
• ABC Ltd issues 10 new common shares to his
  children for a nominal amount of 1 each

41
Internal Roll using s.85(next week you will
encounter section 86 which looks very
similar.but has its own rules limitations.
Before
After
ABC
ABC
Bob 100 c.s.
10 new c.s to the children
1,000,000 pref Bob
Bob has froze his c.s. value into the new pref
shares.and again as long as the true FMV is not
less than the 1,000,000 he will have avoided
gifting. The T2057 form would look the same.just
transferee name changes.
42
CRYSTALLIZATION the other popular reason to
undertake a section 85 election. This is simply
taking advantage of the capital gains exemption ,
which is illustrated as 500,000 in your lesson
notes (but is now at 750,000) for QSBS. It
involves the disposition of your shares but not
having any real change in ownership. This is
often achieved by selling your share via section
85 to a new HOLDCO or doing an internal s.85. In
both cases the Agreed Amount you elect upon
triggers a 500,000 gain. Of course you use your
capital gains shield to offset the gain. The
share you receive back will have an ACB equal to
the agreed amount (less any NSC issued)..so in
theory you would have new shares with a an ACB
that was bumped up by 500,000 and yet you never
sold the shares to an outside 3rd party.
43
What the T2057 election form might look like
Again you could have sold them to a new Holdco
(or just back to the same corp that issued the
subject shares -internal roll).. In both cases a
gain is triggered to the vendor, which they
offset with their gain shield .
WHAT is the ACB of the Pref shares? .85(1)(g)
says its the AA less the NSC .so its 500,100 .
You have not really changed beneficial ownership
of the business yet you now possess shares with
an acb of 500,000. Crystallization freezing
are often done at the same time. It would seem
very tempting at this point to issue NSC for
500,000 to the vendor ..lesson 3 says watch
out, dont do it! Beware of 84.1
44

• Additional Items
• it is extremely important to value assets
  accurately real estate appraisals may be
  necessary plus business valuators may be needed
• this all takes time .when you consider
  too that new holdcos may have to be set up,
  Trusts created filed , new classes of shares
  set up, sale agreements, price adjustment
  clauses ..etc
• If a client is new to you , then you should
  contact CRA for copies of all previously filed
  section 85 ( any other ) elections. CRA
  maintains a Permanent Documents envelope. Get all
  contents!
• Filing requirements or deadlines are based on who
  ever has to file 1st for income tax , the
  transferor or transferee
• Mistakes do happen and you can file late or you
  can amend the election (up to 3 years after
  filing) , provided you pay the late/amending
  penaltynormally 100 per month its a good
  deal

45

• Section 85 What could possibly go wrong?
• You rely on B/S presentation for acb / cost of
  assets shares
• You are unaware of previous grinds to assets ie
  s.14(13), 13(7)(e)
• The assets were previously bumped under the 1994
  elective gains bump does not work well for
  depreciable properties
• 84.1 deemed dividends are triggered for NSC
• Gifting due to valuation problems
• Paid up capital errors legal vs tax puc bad
  B/S presentation
• FMV ACB issues- v-day, TPUS dividends,
  valuation techniques
• Inter-generational share flips or substituted
  shares
• Section 55(2) may impact on your reorganization
  plan
• Filing problems late penalty.amending
  penalties

46
Lets do a simple example Land cost 40,000
FMV 100,000 Transfer via s85, deferring all
gain and taking back a mixture of Pref shares and
non-share consideration (say a note for
20,000) Fill in the T2057 election form
47
What it should look like
What the ACB of the note ?
85(1)f Whats the ACB of the Pref shares?
85(1)g Whats the TAX PUC of the Pref
shares? 85(2.1)
48
Answers Acb of the note
30,000 Acb of the pref is (AA- NSC )
10,000 Tax Puc is (AA NSC )
10,000
What if we changed the disposal or agreed amount
to 60,000
49
This is what the T2057 election would look like
What the ACB of the note ?
85(1)f Whats the ACB of the Pref shares?
85(1)g Whats the TAX PUC of the Pref
shares? 85(2.1)
50
Answers Acb of the note
30,000 Acb of the pref is (AA- NSC )
30,000 Tax Puc is (AA NSC )
30,000
51
TRANSFER of PROPERTY to AFFILIATED PERSONS the
AFFILIATED LOSS RULES
These loss denial rules vary depending on the
nature of the property (dep., non-depr., ece.)
and on the type of taxpayer the transferor is.
Section 251.1(1) defines affiliated personsyou
are affiliated to yourself, your spouse and a
corporation you or your spouse control directly
or indirectly in any matter .(plus some
partnership rules as well).
The OLD loss denial rules in s.85 (which have
been struck) centered around transactions between
Non- Arms Length parties people related by
blood, marriage , adoption and their corps. This
had a wider scope it caught sales between
siblings, parent to child, even sales to in-laws.
Even though these old laws were in s.85 they
covered all NAL transactions.
52
Summary of the Loss Rules
Corporation as a Vendor of Non-depreciable
Capital property If a corporation sells a NON-
Depreciable Capital Property to an affiliated
person or affiliated corporation and incurs a
capital loss the loss is denied or suspended
per s.40(3.4). However the suspended loss may be
deducted by the transferor when any 1 of 5
events occur. The events are listed on p.2-3,
they are -if the property is subsequently sold
to a party who is not affiliated -the transferor
becomes a non resident or non taxable
entity -there is a acquisition of control of the
transferor -if the property becomes subject to
s.50(1) bad debt rules -the transferor winds
up, other than an 88(1) windup
53
Loss Rules Continued..
Individual as Vendor of a Non Depreciable Capital
Property When an individual sells a non
depreciable capital property to an affiliated
person or affiliated corp. an incurs a capital
loss S.40(2) (g)(ii) denies the loss as a
superficial loss (defined in s.54). The denied
loss is added to the ACB of the transferred
property s.53(1)(f). Example if you sell a
piece of land to your corp at a loss..then the
corporation acquires the land at that transfer
price but then adds the loss to the acb of the
property. Cost to you 10,000..sell for
6,000 fmv,loss of 4,000 Corp acquires it at
6,000 .but adds 4,000 to cost, total acb is
now 10,000 for the corp.
54
Share Losses on Redemption- ( in the Two step
redemption calculation , if you incur a capital
loss on the 2nd stepthen)

• If you suffer a capital loss on redemption then
• -the loss will be denied per s.40(3.6) if the
  corporation is affiliated with the s/her
  immediately after the redemption.
• - If you are not affiliated with corp. after the
  redemption you have a valid loss to claim.
• -This Loss is not viewed as a superficial loss
  because the shares are actually cancelled as
  opposed to held by the corp.
• However 40(3.6)(b) and 53(1)(f.2) will allow the
  s/her to add the denied loss to the ACB of any
  other shares he might own in the corp.
• However if you do not own any other shares- too
  bad, the loss is lost.

55
Loss on redemption continued
So we see these rules apply to individuals and
corporations. note there are even more loss
denial rules to be found in 112(3) for share
dispositions (and not just upon redemption there
are specific rules for individuals, corps, trusts
and partnerships they can be found in lessons
8,9, 10 of the CGA notes.these lessons do not
form part of the current tax law course.but if
you are curious please read ahead Question how
could you still be affiliated after you redeemed
all of your shareholdings in a corp.? Think
spouse
56
Losses on Depreciable Property sold to Affiliated
persons
Transferor /Vendor can be individuals or corps
( partnerships) and the transferees can be
individuals or corps (partnerships) s. 13(21.2)
applies if the FMV proceeds are LESS than the
tax cost of the asset ( UCC amount) . Normally
such a transaction produces a terminal loss. This
section will deny/suspend the terminal loss and
the amount that is the loss amount will be placed
in a separate c.c.a. class and continue to be
amortized by the vendor. The mechanism to do
this to deem proceeds to the class equal to the
UCC, and the difference between FMV ucc can be
the new separate class. But the purchaser still
only acquires the asset at FMV. Plus the old
original capital cost of the asset is deemed to
flow through to the new owner and they are
considered to have taken all cca claims on the
difference between original cost and the fmv.
WHY? To preserve the ability to recapture.-
57
Loss on depreciable property continued..
the loss may be finally recognized when any of 1
of 5 tests are met. These test are similar to the
5 tests when a corp sells an non depreciable
asset. But there are a few changes. Please read
them. Simple example of loss between affiliated
parties depreciable prop cost 100,000, ucc
is 50,000 fmv is 30,000
100,000
Cost
Transferor deemed proceeds
50,000
UCC
Loss
30,000
FMV
Transferee cost to amortize
Transferor sets up a new cca class with a 20,000
asset addition.
58
Sale of Eligible Capital Property to Affiliated
persons ex Goodwill, milk quota, egg quota,
customer list
If the vendor/ transferor is a Corporation, trust
or partnership then 14(12) will deny the loss on
the sale and allow the vendor to keep on
amortizing the loss amount as a separate cec
pool. This is similar to the depreciable property
rules but section 14 is an extremely complicated
section these days and it is enough to know for
this course that this affiliated loss rule
exists. The purchaser would amortize based on
the FMV purchase price. Again there are 5 rules
that will eventually allow you to recognize the
loss. Individuals who sell their ECP when going
out of business generally can deduct any losses
under 24(1). However 24(2) will deny a loss by
deeming a rollover to occur when?.. The
class rolls over at the c.e.c. balance if the
sale is to a spouse or a corporation controlled
by the vendor.