Section 84.1

The following article on section 84.1 of the Income Tax Act (Canada) appeared in the latest edition of the Hamilton Law Association Law Journal.

1 Accountants will tell you that mistakes involving section 84.1 of the Income Tax Act (Canada) (the “Act”)[1] are at or near the top of the list of reasons why members of that profession must report themselves to their insurers. Of course, clients typically look to their accountants for tax advice, and a lawyer who implements a reorganization further to instructions received from an accountant, and in reliance upon his or her tax expertise, should not be liable for any tax mistakes. But the key word in that last sentence is “should”. A deemed dividend under section 84.1 will be a nasty surprise for a client, and he or she might not be so willing to recognize the division of labour between the lawyer and the accountant after the CRA hands out a reassessment. In any case, if you can recognize some of the section 84.1 danger signs and prevent an error by asking questions, you might earn the undying gratitude of the referring accountant.

What is Section 84.1?

2 Section 84.1 is an anti-avoidance rule: it is meant to prevent taxpayers from removing corporate surpluses by triggering capital gains, in particular capital gains that might be eligible for the $750,000 capital gains exemption. The section is unlike some anti-avoidance rules in the Act: it does not contain a purpose test. Rather, section 84.1 achieves its goal by re-characterizing a capital gain as a deemed dividend in certain circumstances. If the conditions of the section are met, then the re-characterization follows, even if the parties did not intend to avoid taxes. This is what makes the section pernicious.

3 What are the conditions for the application of section 84.1? What are the warning signs you need to watch for to ensure that the section won’t trip you up? This article does not discuss all of the intricacies of section 84.1; such a discussion would be much longer than space permits. Rather, this article highlights some of the more obvious problems.

Who are the Parties?

4 Section 84.1 can apply to a taxpayer resident in Canada other than a corporation who sells shares of a corporation resident in Canada (the “subject shares”) to another corporation. Section 84.1, then, can apply if the vendor of shares is an individual or a trust. The section does not apply if a corporation sells shares.[2] The section is an anti-surplus-stripping rule, but in general corporate surpluses can pass between corporations tax free, and so section 84.1 does not apply to a corporate vendor.

5 The purchaser of the shares must be a corporation, but it need not be a corporation resident in Canada. Any old corporate purchaser will do for the purposes of section 84.1.[3]

6 The subject shares must be issued by a corporation resident in Canada. Whether a corporation is a resident of Canada for the purposes of the Act can be a complex question, but in general a corporation incorporated under the laws of Canada or a province is deemed to be resident here.

Dealing at Arm’s Length

7 Section 84.1 only applies if the vendor of the subject shares does not deal at arm’s length with the corporate purchaser. Whole articles have been written about the meaning of “arm’s length” for the purposes of the Act. Very generally, persons will be considered not to deal at arm’s length in four sets of circumstances. First, a taxpayer and a trust are deemed not to deal at arm’s length if the taxpayer, or a person not dealing at arm’s length with the taxpayer, is beneficially interested in the trust. Next, related individuals are deemed not to deal at arm’s length. Third, persons can be considered to deal with each other not at arm’s length in certain factual circumstances. Finally, section 84.1 itself contains special rules deeming persons not to deal at arm’s length. The latter three situations require further discussion.

8 The Act contains detailed rules on the meaning of “related”, and while the application of these rules can be complicated, the results are usually clear. For example, a person is related to herself. Some other obvious cases involve family members: they are generally deemed to be related to each other: a parent and child are related, as are sisters and brothers. A husband is related to his mother-in-law; a wife is related to her father-in-law. In addition, an individual is related to a corporation that is controlled by a person to whom the individual is related.

9 Related person are deemed to be dealing not at arm’s length with each other, even if they communicate only via their lawyers. This rule and section 84.1 give fits to family members who are in business together but who wish to go their separate ways. Why? Assume that Michael and Robert are brothers, and each of them owns 50% of the issued shares of Opco. Unfortunately, they are not getting along, and so Rob wants to buy Mike’s shares. Mike is willing to sell, but he wants to claim the capital gains exemption. He can claim the exemption, however, only if he sells the shares personally (the exemption is not available to a corporate vendor). On the other hand, Rob will prefer to buy Mike’s shares using a corporation (“Buyco”) because, if Rob must borrow to buy Mike’s shares, he will prefer to do so through Buyco. Buyco will be able to repay its debt using dollars that have been subject to tax at lower corporate rates rather than the rates applicable to Rob. That is, the after-tax cost of borrowing will be higher for Rob than for his corporation. Rob, then, will insist on purchasing Mike’s shares using Buyco. Because they are related, however, section 84.1 will apply if Mike sells his shares of Opco to Buyco. As a result, Mike will not realize a capital gain: the gain will be re-characterized as a dividend, and Mike cannot claim the capital gains exemption in respect of a dividend.[4] The parties must now engage in some hard bargaining about who will bear the costs imposed by section 84.1.

10 Section 84.1 could apply to Mike and Rob even if they were unrelated because they could be dealing not at arm’s length as a matter of fact. The CRA has published Interpretation Bulletin IT-419R2 (“Meaning of Arm’s Length”) to outline its position on when parties deal not at arm’s length as a matter of fact. The CRA asks three questions to help it determine whether parties are not dealing with each other at arm’s length:

(1) Is there a common mind which directs the bargaining for both parties to a transaction?

(2) Is there “de facto” control?

(3) Are the parties to a transaction acting in concert without separate interests?

11 Questions 1 and 2 are really the same question: is one side of the transaction controlling the other in some way? If so, then the parties are likely not dealing at arm’s length. The last question—the “acting in concert” doctrine—is quite problematic. It has been roundly criticized for its vagueness, and even experienced tax professionals have difficulty predicting when the CRA will choose to apply it. The best indicator of trouble appears to be whether the transaction in question has some odour about it from a tax perspective. The problem, of course, is that taxpayers and the CRA tend to have very different senses of smell.

12 Finally, even if the parties to a transaction deal at arm’s length in light of the foregoing tests, they might be deemed not to deal at arm’s length because of the application of rules in section 84.1 itself. These detailed rules, however, are beyond the scope of this article.

“Connected”

13 Section 84.1 will apply to a sale of shares only if, immediately after the sale, the corporation that issued the shares is connected with the purchaser corporation.

14 The Act contains detailed rules on the meaning of “connected” for this purpose, but an issuer will generally be connected with a shareholder corporation where

(1) the shareholder controls the issuer; or

(2) the shareholder holds shares that have more than 10% of the votes and value inhering in all issued shares of the corporation.

15 In the example above, Opco will be connected with Buyco after Buyco buys Mike’s shares because Buyco will control Opco.

Non-Share Consideration

16 The good news is that, even if section 84.1 applies to a sale of shares, a dividend can be deemed to be paid only where the vendor receives non-share consideration (“boot” in tax jargon). If an individual sells shares in the capital of one corporation to another corporation, and the other corporation only issues shares as consideration, then section 84.1, even if it applies, will only reduce the amount otherwise added to the stated capital account of the newly issued shares.[5] This can give rise to adverse tax consequences in the future, but it has no immediate effect on the vendor.

17 The position is different if, as payment for the subject shares, the vendor receives a note or cash from the purchasing corporation or the purchasing corporation assumes liabilities of the vendor. In such circumstances, the purchaser is deemed to pay, and the vendor is deemed to receive, a dividend if the fair market value of this “boot” exceeds the greater of the paid-up capital of the subject shares and their adjusted cost base. “Paid-up capital” means tax paid-up capital, which is the stated capital of a class of shares as adjusted by various provisions of the Act. The adjusted cost base of the subject shares is their cost otherwise computed less certain adjustments. The adjustments, among other things, reduce the cost of a vendor’s shares for the purposes of section 84.1 by the amount of the capital gains exemption claimed in respect of the shares by the vendor or any person not dealing at arm’s length with the vendor. The purpose of the rule is to prevent a taxpayer, or any person not dealing at arm’s length with the taxpayer, from using the capital gains exemption to extract corporate surplus from a corporation.

18 Note that section 84.1 can apply even if (or particularly if) the vendor receives nothing but boot as consideration. Sometimes the analysis under section 84.1 is confused with the analysis of section 85 rollovers (section 85 only applies where shares have been issued). Section 84.1 can apply even if no shares are issued and no section 85 election is contemplated.

Summary

19 This article does not purport to be a complete summary of section 84.1, but it does provide the reader with a list of questions he or she can ask about a sale of shares to a corporation that will help to identify whether the section might pose problems for a client. Based on the foregoing, the reader can now ask the following questions about a transaction to help assess the section 84.1 risk:

(1) Is the vendor a taxpayer resident in Canada other than a corporation? Is the vendor an individual or a trust?

(2) Is the purchaser a corporation?

(3) Is the issuer of the shares a corporation resident in Canada for the purposes of the Act? If the issuer was incorporated in this country, then it probably is.

(4) Do the vendor and the purchaser deal not at arm’s length? For example, are the vendor and the purchaser related for tax purposes? If they are, then they are deemed to deal not at arm’s length.

(5) Will the purchaser be connected with the corporation that issued the subject shares immediately after the completion of their transfer to the purchaser? For example, will the purchaser control the issuer corporation immediately after the transaction is completed? If so, then the purchaser and the issuer will be connected.

(6) Will the vendor receive “boot” (non-share consideration) for his or her shares?

20 If the answer to each of these questions is “yes”, then section 84.1 might deem a dividend to be paid to your client when the client expects to complete the transaction in question free of tax. It is probably worth asking the instructing accountant, very politely of course, whether the issues under section 84.1 have been addressed. This might help to ensure that the client will not receive any nasty surprises in the mail from the CRA in respect of the sale of shares. At the very least, it will clear up any possible confusion about who was responsible for performing the 84.1 analysis.