Transcript Chapter 14 & 15

Problem 9
FMV of assets – step 1
Julie Inc. (Julie) assets:
Shares of Opco Inc. at FMV
$850,000
49.3
%
Shares of RE Inc. at FMV
800,000
46.4
%
Portfolio investments at FMV
75,000
4.3 %
Active business assets at FMV
$900,000
94.7
Term deposits
50,000
5.3 %
Liabilities
(100,000)
Opco Inc. (Opco) assets and liabilities:
RE Inc. (RE) assets and liabilities:
Land and building at FMV
$800,000
80 %
Portfolio investments at FMV
200,000
20 %
Mortgage
(200,000)
%
SBC test
SBC test
• (1) SBC Test
• At the determination time, Julie must be a small business
corporation, which means that all or substantially all (generally 90%)
of the fair market value of its assets must be used in an active
business carried on primarily in Canada by the corporation or a
related corporation, or invested in shares or debt of a connected
SBC. In this case, Julie has 4.3% of the fair market value of its
assets held in portfolio investments which are not used in an active
business. While Julie has 95.7% of its assets invested in Opco and
RE, it still needs to be determined whether these two subsidiaries
are connected SBCs. Since both are owned 100% by Julie, they are
both connected corporations to Julie. In this case, Opco is a SBC,
since 94.7% of its assets are used principally in an active business
carried on primarily in Canada by the corporation or a related
corporation. RE, on the other hand, is not a SBC, but the real estate
is used “principally” in the active business of Opco, a related
corporation. As a result, RE meets the 50% test. Then, since only
49.3% of the assets of Julie are invested in connected SBCs, Julie is
not a SBC.
Holding period test
Holding period test
• To meet this test, Rogo or a related party
must have owned the shares of Julie
throughout the 24 months preceding their
disposition. This test is met by the facts
given in the question.
Basic asset test
Basic asset test
• In order to meet this test, Julie needs to
have more than 50% of its assets used in
an active business carried on primarily in
Canada for the previous 24 months. In this
particular case, Julie does not have any of
its assets used directly in an active
business, but it does have shares of
connected corporations. Therefore, the
modified asset test must be used.
Modified asset test
Modified asset test
• If Julie meets the 90% test with a combination of its
own active business assets (it has none) and shares
or debt of connected corporations that meet the 50%
test, the modified asset test is met.
• This test requires, in this particular case, both of the
connected corporations meet the 50% test throughout
the 24 months preceding the determination time and
that Julie meets the 90% test throughout the 24
months preceding the determination time.
• If RE is reviewed, it can be seen that the real estate is
used principally in an active business carried on by RE
or by a related company, Opco. Therefore, its main or
principal use is in the active business of Opco.
However, the land and building only represent 80% of
RE’s assets. Thus, RE only meets the 50% test.
Analysis
•
•
•
On reviewing Opco, it can be seen that more than 50% of its assets are used principally in
an active business carried on primarily in Canada, i.e., 94.7% of its assets are used in this
way.
Finally, on reviewing Julie, it can be determined that since both Opco and RE meet the
50% test, Julie must meet the 90% test with the shares of both RE and Opco considered.
Julie has 95.7% of its assets invested in the shares of Opco.
As a result, Julie will meet the modified basic asset test with the shares of Opco
considered.
•
•
•
If the facts were somewhat different, such that Julie did not meet the 90% test, but Julie did
not need to include the shares of either Opco or RE to meet the more than 50% asset test,
then the following interpretation would apply. According to a private CRA technical
interpretation, only the assets of the corporation whose shares help Julie meet the 50%
test must meet the 90% test. According to this interpretation, the assets of both
corporations must meet the 90% test only if the shares of both corporations are needed to
help Julie meet the 50% test. In the case at hand, this is not necessary, because the assets
of Julie meet the 90% test.
Conclusion:
Julie meets both the holding period test and the modified basic asset test, but fails the SBC
test. Therefore, the shares of Julie are not QSBC shares at this time.
How to purify the company?
• What can you do to purify the company so
it is a QSBC?
Possibilities
• In order for Julie to become a SBC it can look at a number of
different options. It can dispose of the shares of RE. Another option
is to cause RE to decrease the proportion of portfolio investments to
less than 10%.
• By disposing of the shares of RE, Julie will possibly create a
significant tax liability on any capital gain realized. The net proceeds
would first be used to pay any tax liability on the sale and then could
be used to pay off the liabilities in Opco. After that, the excess funds
will have to be paid as a dividend with the resulting tax liability to
Rogo. If this option is chosen, then the shares of RE should be sold
to someone who would continue to rent the property to Opco.
• If RE were to dispose of $112,000 of its portfolio investments, then it
would have 90% of its assets ($800,000 out of $888,000) used in
the active business of a related corporation but only if the $112,000
of cash proceeds is used to pay off part of the mortgage to reduce it
to $88,000. In this way, a non-qualified asset is eliminated by
reducing a liability.
Chapter 15: Corporate
distributions, windings-up and
sales
Today’s topics
• The tax-free or tax-paid components of
corporate surplus
• Tax effects of distributing corporate
surplus
• How to analyze the two options of selling
• Applying the distribution of a variety of
dividends
• Options available on the sale of a
corporation
Corporate surplus balances
• Need to analyze the
shareholders equity
section of the balance
sheet in order to
create the tax-basis
balance sheet
Tax basis balance
sheet
LIABILITIES
ASSETS
CAPITAL
STOCK
(PUC)
RETAINED
EARNINGS
(CDA &
Undistributed
surplus)
PUC of shares
• PUC is an important concept as it is the
amount which the corporation can return
to the shareholder without being reported
as a dividend
• Otherwise known as the ACB
• PUC is aftertax funds of the shareholder
Terms
• Legal stated capital
• Paid-up capital
• Share capital
– Normally all equal
– Can be different on sec transfer
Effect of PUC
• Computed at corporate level and not
shareholder level
• ACB is computed at shareholder level
• Can lead to deemed dividend when a
portion of the shares are disposed of
background
• Joe incorporated Smithco 5 years ago and
paid $1,000 for 1,000 common shares. His
ACB is $1,000 and the PUC is $1,000
• Joe needed additional capital and Bill
bought 1,000 shares for $100,000.
• Joe’s ACB is $1,000 and Bill’s ACB is
$100,000
• PUC is $101,000 and is equally allocated
• PUC for Joe and Bill is $50,500 each
Illustration
# sh
ACB
PUC
FMV
Joe
1,000
1,000
50,500
100,000
Deemed dividend
Bill
1,000
100,000
50,500
100,000
Proceeds
100,000
100,000
PUC
(50,500)
(50,500)
49,500
49,500
Proceeds
100,000
100,000
Deemed
dividend
(49,500)
(49,500)
Adjusted
proceeds
50,500
50,500
ACB
(1,000)
(100,000)
Gain/loss
49,500
(49,500)
A+B
99,000
NIL
Joe
Deemed
dividend
Bill
Capital gain (loss)
Summary
• PUC
– Calculated at
corporate level
– Based on capital
contributed to the
corporation
– Averaged among all
shareholders of that
class
– Can be withdrawn free
of deemed dividend
• ACB
– Calculated at
shareholder level
– Based on amount paid
for the shares
– Unique to each
shareholder
– Considered on
disposition of shares
Capital dividend account
• Completes the integration of corporate and
personal tax on capital gains and similar
receipts
• Only in private corporations
• Starts from date of incorporation
The components
• Portion of net capital gains (gains in
excess of losses) not recognized in
computing income for tax plus
• Capital dividends from other corporations
plus
• Portion of net gain not recognized in CEC
plus
• Proceeds arising from death on life
insurance minus
• Capital dividends paid
CEC
• CEC is normally at ¾
• To include correct amount in capital gain,
multiply by 2/3
Example
CEC account
Cost of ECC on
November 30, 2006
12,000 ECE x ¾ (12,000 x ¾)
PoD January 15, 2008
20,000
Economic gain
8,000
9,000
CECA – 2006 (7%)
(630)
Balance 12/31/06
8,370
CECA – 2007 (7%)
(586)
Balance 12/31/07
7,784
ECA x ¾ (20,000 x ¾)
Negative balance
Previous CECA
Final balance
(15,000)
(7,216)
1,216
(6,000)
Income inclusion on December 31, 2008
Recapture of prior
CECA
1,216
2/3 x final balance
(6,000)
4,000
Income
5,216
Capital dividend account
2/3 x final balance
4,000
Discussion
•
•
•
•
•
•
Surplus Accumulation Ltd has the following dispositions during FY
December 31, 2008
Capital dividends received: $10,000
Capital dividends paid: $5,000
Purchased goodwill for $6,000 in 1998 and has CECA of $2,325 to date
Sold an indefinite life franchise for $19,000 in 2008
Land
– Cost $20,000
– Selling cost $1,500
– PoD $35,000
•
Equipment
– Cost $5,000
– Selling cost $100
– PoD $500
•
Securities
– Cost $3,000
– Selling cost $200
– PoD $2,000
•
What is the CDA balance?
Untaxed fraction of NCG/L
Discussion
•
•
•
•
•
•
Surplus Accumulation Ltd has the
following dispositions during FY
December 31, 2008
Capital dividends received: $10,000
Capital dividends paid: $5,000
Purchased goodwill for $6,000 in
1998 and has CECA of $2,325 to
date
Sold an indefinite life franchise for
$19,000 in 2008
Land
–
–
–
•
Equipment
–
–
–
•
Cost $5,000
Selling cost $100
PoD $500
Securities
–
–
–
•
Cost $20,000
Selling cost $1,500
PoD $35,000
Cost $3,000
Selling cost $200
PoD $2,000
What is the CDA balance?
Land
PoD
35,000
ACB
20,000
Sell $
1,500
CG
21,500
13,500
Net ½
6,750
Equipment
No capital loss on depreciable property
Securities
PoD
ACB
Costs
CL
NIL
2,000
3,000
200
3,200
(1,200)
Net ½
(600)
Excess
6,150
Capital dividends received
10,000
Untaxed fraction of gain on ECP
CEC bal (6,000 x ¾ - 2,325)
2,175
PoD x ¾ (19,000 x ¾)
(14,250)
Negative balance
(12,075)
Recaptured CECA
2,325
(9,750)
Income (2/3 x RCECA + net)
Addition @ 2/3 x 9,750
8,825
6,500
Less capital dividends paid
(5,000)
CDA balance 12/31/08
17,650
Alternative format
Year
Asset
1998
Goodwill
2008
Land
Equip
Securities
Untaxed
CG
CD rec
Untaxed
ECP
Untaxed
life ins.
CD paid
Balance
(3,000)
6,750
NIL
(600)
Franchise
9,500
CD rec
10,000
CD paid
(5,000)
6,150
10,000
6,500
0
(5,000)
17,650
Use of surplus balances
• Cash, stock, inkind or deemed dividends
are treated by a shareholder as having
been received in cash
• Gross up rules apply if individual is
receiving the dividend
Source of dividends
• CCPC may have high rate income (GRIP)
– Composed of:
•
•
•
•
CCPC GRIP balance at end of PY
After-tax earnings assuming a 32% tax rate
Eligible dividends received by the corporation
Reduced by eligible dividends paid
• LRIP (low rate tax)
– If a non-CCPC receives dividend from CCPC,
then must pay it first
Cash or stock dividends
• Amount of dividend deemed equal to
increase in PUC regardless of market
value
• Deemed to be the shareholders ACB
Dividends in kind
• Possible to pay dividends in assets of
company
– Deemed at FMV
– Acquisition deemed at FMV
– Dividend deemed to have been paid equal to
FMV of assets
• Losses to corporation on transfer of assets
to a controlling shareholder are denied
Deemed dividends
• Anything in equity that
is not PUC or capital
dividend balance is
taxable retained
Simple equity
earnings
PUC
Distribution
$XXXXX Not taxable
as a
dividend
CDA
XXXXX Not taxable
by election
Retained
earnings
XXXXX Taxable
dividend
Deemed dividend on increase
in PUC
• May occur when a corporation increases
PUC without an increase in net assets (ie
sale of property)
• Exceptions:
– Increase is from payment of stock dividend
– Increased as a result of change in FV of assets
on issue of shares for cash or conversion
– PUC of one class is transferred to another
– Conversion of contributed surplus on issuance of
shares into PUC
Illustration
A
Facts
Increase
in FMV
Increase
in PUC
100
100
B
C
90
100
A
B
C
110
Results
Deemed dividend
100
100
100
100
Increase
in PUC
Net
assets
increase
(100)
(90)
(110)
Excess
NIL
10
NIL
Contrib
surplus
NIL
NIL
10
Denied capital loss
• Capital loss on redemption will be denied if
the company and the shareholder are
affiliated after the transaction
– Sale of shares to a spouse for a loss
Summary of differences
• PUC
– Used to determine the
deemed dividend
resulting from a
redemption or
cancellation of shares
– Calculated at
corporate level on a
class of shares
– Changes affect all
shareholders equally
• ACB
– Used to calculate
capital gains or losses
– Calculated at
shareholder level and
relates to a particular
class of shares and
can be unique for each
shareholder
– PUC is always the
same for each
shareholder
Deemed dividend on reduction
of PUC
• Sale of part of company and proceeds are
given to shareholders without redeeming
the shares
• For example a distribution of capital of $8
per share on shares with PUC of $10 and
there is a reduction of PUC of $7, then
there is a deemed dividend of $1
Now we get into some good
stuff
• Problem 1
• Problem 5
Winding up of a Canadian
corporation
• Disposition of net assets
• Deemed dividend on windup
• Components:
– Capital dividend to the extent of the balance
in the company’s capital dividend account if
the corporation elects on that amount AND
– A taxable dividend to the extent of the
balance of the deemed dividend
Two steps
Step 1 – deemed dividend
Step 2 – capital gain or
loss
Funds or property
available for
distribution
Funds or property
available for
distribution
Less PUC
Deemed dividend
Less elected CD
Deemed dividend
taxable
XXX
(XXX)
Less deemed dividend
XXX
(XXX)
XXX
Adjusted PoD
XXX
(XXX)
ACB of shares
XXX
Capital gain
XXX
XXX
Application
Winditup Limited
Balance sheet
December 31, 2008
Assets
Liabilities
Cash
5,000 Liabilities
RDTOH
5,000
NIL
Land at
cost (FMV
$210,000)
150,000 PUC of
shares
1,000
Building
at UCC
(cost
$200,000
FMV
$250,000)
125,000 Surplus
284,000
285,000
285,000
CDA balance is $50,000
• Compute amount
available for
distribution assuming
tax rate of 20%/40%
before ART of 6%
• Determine
components of
distribution
• Compute the taxable
capital gain or
allowable capital loss
Solution - available
Winditup Limited
Income generated
Actual/ Business Invest.
deemed
Opening
NIL
NIL
Balance sheet
CDA
50,000
Cash
5,000
NIL
NIL
Land
210,000
NIL
30,000
30,000
Bldg
250,000
75,000
25,000
25,000
Tax
(40,667)
75,000
55,000
RDTOH
19,667
444,000
RDTOH
Assets
5,000
Liabilities
Cash
5,000 Liabilities
RDTOH
5,000
NIL
Land at
cost (FMV
14,667 $210,000)
150,000 PUC of
shares
1,000
Building at
UCC (cost
$200,000
FMV
$250,000)
125,000 Surplus
284,000
285,000
285,000
19,667
105,000
December 31, 2008
CDA balance is $50,000
Solution - components
Actual/ CDA
deemed
Opening
50,000
RDTOH
Winditup Limited
5,000
December 31, 2008
Cash
5,000
Land
210,000
30,000
Funds available for distribution
Bldg
250,000
25,000
Less PUC
Tax
(40,667)
14,667
Deemed dividend on windup
19,667
19,667
Less capital dividend
RDTOH
444,000 105,000
PUC
1,000
Deemed taxable dividend
444,000
(1,000)
443,000
(105,000)
338,000
Solution – taxable capital gain
Actual/ CDA
deemed
Opening
50,000
RDTOH
Winditup Limited
5,000
December 31, 2008
Cash
5,000
Land
210,000
30,000
Actual proceeds
Bldg
250,000
25,000
Less deemed dividend
Tax
(40,667)
14,667
Proceeds of disposition
19,667
19,667
ACB
RDTOH
444,000 105,000
PUC
1,000
Taxable capital gain
444,000
(443,000)
1,000
(1,000)
NIL
Summary
• Winding up is as follows
– Dispose of all assets at FMV and determine any
resulting income or loss and adjustments to the
CDA
– Pay liabilities including tax
– Calculate RDTOH and assume fully refunded
– Distribute net proceeds to shareholder, determine
a deemed dividend as the excess
– Elect on an amount not in excess of the CDA
– Check to see if taxable dividend is sufficient to
generate the full dividend refund
– Compute shareholders gain or loss on disposition
of shares
Sale of assets vs shares
• Sale of an incorporated business in two
ways
– Sale of assets
• Does not assume liabilities
– Sale of shares
• Assumes control of assets
• Assumes responsibilities for liabilities
Discussion
Option – sale of shares for
$130,000
Proceeds
ACB
Capital gain
130,000
10,000
120,000
Taxable capital gain
60,000
Tax at 46%
27,600
Net proceeds (120,000 – 27,600)
102,400
Option – sale of assets and
windup
Actual or
deemed
proceeds
Opening
balance
Business
income
Investment
income
NIL
NIL
Capital
dividend
account
20,000
Cash
4,000
NIL
NIL
A/R
7,000
(1,000)
NIL
Inventory
37,000
7,000
NIL
Land
20,000
NIL
5,000
5,000
Bldgs
39,000
25,000
2,000
2,000
Equipment
12,000
(6,000)
NIL
Goodwill
47,000
23,500
NIL
48,500 x
20%
7,000 x
46.67%
Cur liab
(20,000)
Income taxes
(12,967)
RDTOH
1,867
134,900
RDTOH
NIL
23,500
1,867
7,000 x 26
2/3%
50,500
1,867
Option – sale of assets and
windup
Actual or Capital
deemed
dividend
proceeds account
Opening
balance
20,000
Cash
4,000
A/R
7,000
Inventory
37,000
Land
20,000
5,000
Bldgs
39,000
2,000
Equipment
12,000
Goodwill
47,000
Cur liab
(20,000)
Income
taxes
(12,967)
RDTOH
1,867
134,900
RDTOH
Calculation of deemed dividend
Funds available
134,900
Less PUC
(10,000)
Deemed dividend
124,900
Less capital dividend
(50,500)
NIL
Deemed taxable dividend
Calculation of taxable capital gain
Actual proceeds
Less deemed dividend
23,500
PoD = PUC
1,867
50,500
74,400
1,867
Cost
134,900
(124,900)
10,000
(10,000)
Capital gain
NIL
Taxable capital gain
NIL
Option – sale of assets and
windup
Net cash retained
Calculation of deemed dividend
134,900
Funds available
Funds distributed
Tax on incremental income
Deemed
dividend
74,400
Gross up
(25%)
18,600
GUD
93,000
TCG
NIL
Incremental
income
93,000
46% tax
42,780
DTC (20%)
Net cash
Less PUC
(10,000)
Deemed dividend
124,900
Less capital dividend
(50,500)
Deemed taxable dividend
74,400
Calculation of taxable capital gain
Actual proceeds
Less deemed dividend
(18,600)
134,900
PoD = PUC
(24,180)Cost
110,720Capital gain
Taxable capital gain
134,900
(124,900)
10,000
(10,000)
NIL
NIL
Factors to consider
• By purchaser
• By CCPC as purchaser
• By Canadian public company as
purchaser
• By non-resident corporation as purchaser
Factors to consider by
purchaser
•
•
•
•
Interest on funds borrowed is deductible
Cash flow
Tax costs
Deductibility of loss carryovers
Factors for a CCPC
• Tax advantages will continue (ie SBD)
– Must be allocated among associated group
Factors for public company
•
•
•
•
Loss of SBD
Loss of capital dividend account
Loss of refundable taxes
Impact on cash flows
Factors for non resident
• Loss of SBD
• Application of withholding taxes
• Rollovers not available (discussed next
week)
• Acquisition subject to government review
• Higher expenses for acquisition and lower
share value
• Problem 4
Next week
• Read chapter 16
• Chapter 15 problems 6 and 7 for
discussion