March 30 Update John Campbell, in a comment posted below, points out that paragraph 110.6(15)(b) likely provides an escape from the “trap” that I discuss below at least insofar that one is concerned about whether the shares of Holdco qualify for the exemption.
I was helping a fellow tax professional with a situation like the following where I think I almost stumbled into a trap relating to the $750,000 capital gain exemption.
Assume that Mr X owns all of the issued shares in the capital of Holdco, which owns all of the issued shares of Opco. Holdco’s only asset is the shares of Opco, and Holdco owes Mr X $300. The gross value of Opco’s assets is $1,000, $700 of which is attributable to assets primarily used in an active business carried on principally in Canada. The other $300 is attributable to cash not needed in Opco’s business. Opco’s retained earnings are $100; it doesn’t have any debt.
Mr X wants to sell his shares in the capital of Holdco. Until now, the Holdco shares have met the asset tests applicable during the 24-month holding period. If Mr X wants to claim the exemption for his sale of the Holdco shares, however, he will need to remove the cash from Opco. Fortunately, Holdco owes him money, and so he need only move cash from Opco to Holdco and then cause Holdco to repay the debt it owes to him to “purify” the corporations to ensure he can claim the exemption.
So far, so good. The difficulty arises because of the negative retained earnings. Purchasers and their accountants tend not to like seeing deficits on balance sheets, and so it might be tempting to have Opco loan cash to Holdco rather than have Opco pay a dividend of the cash. The problem with the loan is that it likely throws the Holdco shares offside the 24-month asset test.
Paragraph (d) of the definition of a qualified small business corporation share (QSBCS) in subsection 110.6(1) provides that, if for any period of time during the 24-month holding period 90% or more of the gross value of Holdco’s assets is not attributable to active business assets or shares of a corporation that meets the 50% test, then Opco must meet a 90% asset test during that period. If Opco loans funds to Holdco, however, then neither corporation will meet these tests. Holdco will have cash such that it does not meet the 90% test; Opco will have a receivable from Holdco that likely is not an active business asset so that it doesn’t meet the 90% test either. The shares of Holdco, then, will not meet the 24-month holding period asset test. Mr X will not be able to claim the exemption unless he holds the shares of Holdco for another 24 months throughout which the asset test is met.
Paying a dividend from Opco does not cause this problem. When the cash is paid as a dividend paid from Opco to Holdco, Holdco no longer meets the 90% test, and so, while Holdco holds the cash, Opco must meet the 90% test instead, which it will because all of the excess cash has been paid to Holdco. Once Holdco repays the debt owing to Mr X, both corporations will meet the 90% asset test, which means that the Holdco shares will likely be QSBCSs at the time of the sale.
Can Opco pay a dividend that creates a deficit? The legal test in the Business Corporations Act (Ontario) for paying a dividend says nothing about retained earnings. Rather, the Act simply requires that the board of directors of the corporation have no reasonable grounds for believing that the corporation is, or after the payment of the dividend, would be, unable to pay its liabilities as they become due or that the realizable value of the Corporation’s assets would be, by the declaration or payment of the dividend, less than the aggregate of (1) the Corporation’s liabilities, and (2) the Corporation’s stated capital of all classes of shares of the Corporation.
The foregoing argues against being casual about moving funds from Opco to Holdco at any time because of the effect on the 24-month holding period asset test. Advisers would also do well to keep in mind the CRA’s rather strict notions about what is required to ensure that an amount paid is treated as a dividend. If cash is moved, but no proper dividend resolutions are prepared, then the CRA might argue that the movement of cash created an inter-company receivable with the adverse consequences noted above.
In cases where up-stream debt has been part of the assets of subsidiary, we have looked to subsection 110.6(15)(b) to provide some comfort in determining that the upstream debt is valued at nil, when determining if the shares of the parent are a qualified small business corporation shares. The nil valuation only applies to determining if Holdco is a qualified small business corporation, and would not help if there were direct shareholders of Opco trying to claim the QSBC.