Section 85 Rollover

[Griet van Vliet]

As much as Griet seemed to be struggling jo juggle the personal image she wished to project by now, keeping up the appearance of Griet being primarily an accountant was necessary to make her bounty hunting life manageable. A Talz client came to her office on Orto Plutonia feeling that she can no longer, but she needs some help prior to filing the T2057 form (i.e. the election of a Section 85 rollover), or getting her Articles of Incorporation for that alternative medicine pharmacy. The pharmacist estimated the cost of the Articles of Incoporation to fit within the 3,000 limit that is CCA-exempt and can be expensed in full the year it occurs. Lumusel's manifest of tangible assets (which are not the same as the values on the balance sheet) indicate that, at fair market value, the tangible assets are worth 850,000 and their current tax values are 275,000 (be it UCCs or ACBs). Even though she has no right to record internally-generated goodwill on the balance sheet, Lumusel estimated the goodwill to be 300,000 if an arm's length party was to buy the pharmacy from her, for a total value of 1.15 million. Liabilities are worth 83,000, with the remaining values on the right-hand balance sheet being various equity accounts: retained earnings and contributed capital (no AOCI since Lumusel follows ASPE).

 

[Griet van Vliet]

"Just because the ceiling is 1.15 million, doesn't mean that you have to elect this much: in fact, it is best not to. Can the pharmacy afford just enough in non-share consideration to cover the tax values of the assets rolled over?"

"<What happens if it doesn't?>"

"It will affect the ACB of the share consideration if you have too much tied in share consideration. Also, if you take too much non-share consideration, it will constrain the values you can elect under Section 85"

"<I'll assume the liabilities of the pharmacy personally, and have the pharmacy issue a note payable to me for 17,000, but that's all I can afford>"

The perfect rollover: no immediate tax consequences, and maximum amount of cash received tax-free. It occurs only when the total NSC = sum of UCCs/ACBs. Here it was obvious that such was not the case: the NSC is just 100,000, so there is a need to allocate the remaining 175,000 to the two classes of shares. 125,000 of it is in redeemable preferred shares, and the ACB of the 925,000 in common shares is therefore just a measly 50,000. The increase in legal stated capital is 1.05 million, but the TPUC is 175,000 because of the following calculation:

Increase in legal stated capital 1,050,000
Less the excess of:
Elected value 275,000
Over NSC (100,000) | 175,000
PUC reduction 875,000

Allocating said 875,000 is a proration of the total share consideration, so the PUC reduction for the preferred shares is 125,000*875,000/1,050,000 = 104,167 and 925,000*875,000/1,050,000 = 770,833 for the common shares, with the resulting PUCs being 20,833 and 154,167 respectively.

 

[Griet van Vliet]

"<I knew a capital structure with redeemable preferred shares would allow me to get the money back from the pharmacy, but what if I wanted to redeem them before the dividend declaration date?>"

"Selling and redeeming it aren't the same for tax even though, before tax, you'll still be getting the same amount of money. Here's the breakdown of the tax consequences in either case"

Redemption: Proceeds of redemption 125,000
Less: PUC 20,833
Deemed dividend 104,167 (ineligible since it has no GRIP balance)

Deemed proceeds of disposition 20,833
Less: ACB 125,000
Disallowed capital loss (52,083)

Sale: Proceeds of sale 125,000
Less: ACB 125,000
Capital gain Nil

 

[Griet van Vliet]

"<Thank you for help me fill out the T2057 form and also understand the consequences of doing so>"

"You're welcome"

"There seems to be another client coming in at the door, a... capital gains stripper that needs some guidance as to the tax consequences of selling a 100% owned subsidiary. Doldem I believe is the name"

"Welcome, Doldem. Please explain your case and introduce any document you feel is relevant"

Capital gains stripping: of all tax evasion problems Talz commonly encounter, CGS is the one that requires an arm's length party for it to be an issue, rather than a non-arm's length one, she thought, while Doldem exposed his case. He intends to sell the wholly-owned subsidiary, Darco, whose shares were originally purchased for 1.65 million. Laraz, an arm's length company dealing in the same line of business as Darco, made an offer for 4.7 million cum-dividend. Its Safe Income is 893,000, while its ASPE-basis retained earnings is 3.05 million, probably because of CCA regularly being much higher than ASPE-basis depreciation expense. Here are the two options for implementing the sale: have Darco take out a loan of 3.05 million, then wipe out the entire Retained Earnings balance by giving out a dividend for that amount, and then Laraz would only need to pay the ex-dividend price of 1.65 million. Or, alternatively, Laraz could just elect 1.65 million as the transfer price of these shares under Section 85 and take back redeemable preferred shares for that value and a redemption value of 4.7 million.

 

[Griet van Vliet]

"To the extent it is made from Safe Income, any attempt at artificially reducing the equity will remain a deemed dividend. The first scenario, doing it from wiping out the retained earnings balance of 3.05 million, would result in a dividend of 893,000 and a capital gain of 2.157 million, of which one-half is taxable with the ART and whatnot at 38-2/3%, with the CDA balance increasing by 1,078,500, the NRDTOH increasing by 330,740, and that's assuming the least of the three values considered for refundable Part I tax is, in fact, borne from AII after the fact"

"What about the second scenario, redeeming the shares soon after the sale?"

The loan made for the payment of dividends was a much more straightforward example than the use of Section 85. Using S85 here at the elected value of 1.65 million would mean the following tax consequences:

Proceeds of redemption 4.7 million
Less: PUC of shares 1.65 million
ITA 84(3) deemed dividend in absence of ITA 55(2) 3.05 million

Proceeds of disposition 4.7 million
Less: Deemed dividend 3.05 million
Adjusted POD 1.65 million

Deemed POD under ITA 55(2)(b ) 2.157 million = 3.05 million - 893,000
Adjusted POD 1.65 million
Total POD 3.807 million
Less: ACB 1.65 million
Capital gain 2.157 million

"In short, the tax consequences are exactly the same: the purchaser won't have to think about repaying an additional 3.05 million in debt if you just take the Section 85 election at the PUC/ACB"

 

[Griet van Vliet]

"Now, there is also the consideration of having Doldem selling the land to Darco, the ACB is 120k, the FMV is 100k, I'm prepared to have Darco pay 90k in non-share consideration and issue shares for the remaining 10k, or personally do the same on a second plot of land with the same tax characteristics since it's a neighboring one"

"You can't incur the capital loss on this rollover, nor can you use Section 85 for this, but in the first situation Doldem keeps the capital loss until either Doldem is bought, wound up under Section 88(2) or Darco sells the plot, in the second situation, Darco gets the old ACB even though you sold at FMV"

"And now I'm contemplating to redeem a block of Doldem shares, whose FMV is 100,000, ACB is 90,000 and PUC is 80,000"

The deemed dividend on this transaction is 100,000-80,000 = 20,000, and then the capital gain/loss calculation is as follows: 100,000-20,000 = 80,000 as the DPOD. And then a capital loss of 10,000 is disallowed. Now came another issue related to Section 85: terminal losses. There was a building on the plot under consideration, and it had the following tax characteristics: FMV of 1M, ACB of 1.5M, UCC of 1.2M, and the NSC Doldem is prepared to pay is 900k, but because the price is lower than the UCC, and Doldem still controls Darco, he cannot use S85 for this. Also, there are no remaining assets in that CCA class (a 4% Class 1 asset, all other real estate owned by Darco is either Class 1.1 or Class 1.2): there are no capital losses here, but 200,000 as a terminal loss. Yet, what's happening with the terminal loss is the following: it's becoming a depreciable asset in its own right on the tax books of Doldem, in the same class, and when one of those events occur: essentially the same as for non-depreciable property.

 

[Griet van Vliet]

Poodoo: today is the day where all my clients seem to come strictly for Section 85 issues, she thought. Two Talz belonging to the Dime clan, with the husband being a proprietor of a small harpoon manufacturing business. He is meeting with Griet today, with a blank T2057 at the ready, and the following balance sheet information, prior to filing Articles of Incorporation:

Dime Harpoons​

Balance sheet​

As at...​

Assets:
Cash 20,000
A/R 90,000 (FMV: 85,000)
Inventories 86,000 (FMV: 92,000)
Shares of Mirai Confectionery 50,000 (FMV: 20,000)
Land 200,000 (FMV: 339,000)
Building 25,000 (FMV: 75,000)
Equipment 40,000 (FMV: 5,000)
Goodwill Nil (FMV: 60,000 because internally-generated)

Total assets 511,000

Liabilities:

Current liabilities:
Accounts payable 23,000

Non-current liabilities:
Bank loan 69,000
Mortgage on building 18,000

Total non-current liabilities 87,000

Total liabilities 110,000

Retained earnings 401,000

Total liabilities and equity 511,000

 

[Griet van Vliet]

"The UCC of the depreciable equipment please..."

"Building: Cost is 60,000, UCC is 15,000, and is the Class 1.2 UCC balance, while the equipment has an original cost of 80,000, with total UCCs across classes of 35,000"

"Cash cannot be rolled over, for A/Rs, you should elect Section 22 rather than Section 85. You'd then be able to have the loss as an active business loss for the year"

The A/Rs is 90,000 net of a 6,000 AFDA (even though most businesses these days don't even have AFDAs at all) so it's 96,000 of A/Rs, but then, for tax purposes, they are deemed to be bad debt expenses under S22, so it can claim 11,000 in tax writeoffs. With Section 85, it's only 5,500 as a capital loss, and, because the wife subscribes a controlling interest in Dime Harpoons, and hence are affiliated for S85 purposes, the company gets an ACB of 50,000, thereby rolling over the capital loss. If the husband wanted to roll it over. But he should not. Because the FMV is 30,000 lower and keep it due to disallowed capital loss if it does. And equipment can't be rolled over because UCC is higher than FMV and they are affiliated. The terminal loss of 30,000 will be denied and otherwise the husband will recognize an asset for this amount, in the same classes, and take CCA on it, which can be recognized as a terminal loss once Dime Harpoons sell the equipment, is subject to a S88(2) windup, or is bought by an arm's length party.

 

[Griet van Vliet]

"For the non-share consideration, I'll personally assume all the liabilities, A/Ps and loans, and defer all possible capital gains on the remaining assets that can be rolled over, issue a note payable for the remaining amount of possible NSC, and issue preferred shares to me for the balance"

"For internally-generated goodwill, you can't elect nil, so you have to elect one credit"

For the four assets on the T2057 form:
Inventory | Cost: 86,000 | FMV: 92,000 | AA: 86,000 | NSC: 86,000 | P/S: 6,000
Land | ACB: 200,000 | FMV: 339,000 | AA: 200,000 | NSC: 200,000 (24,000 in assumed debt, 176,000 in the note) | P/S: 139,000
Building | UCC: 15,000 | FMV: 75,000 | AA: 15,000 | NSC: 15,000 | P/S: 60,000
Goodwill | UCC: Nil | FMV: 60,000 | AA: 1 | NSC: 1 | P/S: 59,999

Total value for the note: 191,001, total preferred shares: 264,999

The PUC and ACB: ACB of the NSC is taking up the entire agreed amount of 301,001, so the ACB of the preferred shares is nil. As for the PUC: also nil since the full agreed amount has been used in non-share consideration.

"ACB matters for sale, PUC for redemption, so you would declare a 50,000 capital gain on sale, or a 100,000 deemed dividend respectively, subject to the usual gross-up and tax credit procedures. Any other tax issues you want to cover?"

"I own a 15% NCI of a QPC that carries 100% active business, I paid 150,000 for that, their PUC, as stated on the share certificate, is 1,000, and I was given an offer for 325,000. I didn't use the LGCD"

 

[Griet van Vliet]

"Don't roll these over to the company, even at the PUC of 1,000: you won't be able to use the LGCD. Now you'd be using up 175,000 of your LGCD allowance but at your salary level, saving tax on 87,500 would mean saving about 40,000 in taxes or so"

The only way someone would even have a 15% stake in a company that isn't a NCI would be a company with widely distributed NCIs. From the looks of it, they are having some profits from their unincorporated business, so the AMT is not a consideration, unlike an otherwise low-income person that sold shares from a QSBC. (Which is pretty much the only reason why someone would be liable for the alternative minimum tax, except maybe a dividend stripper that is somehow unable to accrue enough capital gains to offset the losses incurred while stripping dividends, and exclusively uses stocks of companies paying eligible dividends). In fact, the Talz she killed on Yuuzhan'tar on the first shot used dividend stripping to launder money. Sure, that Talz gangster's testamentary executor hired VPN for their accounting needs, but for his last year, the gangster's only legal income was, net of unused capital losses accrued in vivo that, post-mortem, were used against any type of income, was just 160,000 in eligible diviends prior to any gross-ups. Which meant the gross up was 60,800 and the total dividend tax credit was this much, too. His tribe charging a surtax of 48% (i.e. for every credit in federal tax one was liable to pay, one had to pay an additional 48 cents in tribal tax), this amounted to a marginal tax rate of 48.84% for every credit in taxable income past 205,842. 14,958*0.4884 + 47,970*1.48 = 78,301.09, less 60,800 in DTC, less 2,621.08 in personal tax credits = 14,880.01 being his total tax bill the estate had to pay. Or, if the AMT were paid on the year of death, his estate's tax bill would still come out to about 20,000.

 

[Griet van Vliet]

"<Welcome. Legally speaking, my late settlor's assets only comprise stocks. No real estate, since his mailing address on Orto Plutonia was a rental property, and also the beneficiaries'>" the notary told Griet.

"Most people don't elect out of ITA 70(6) on a will. Those that do, typically accrued a lot of capital losses when they lived. In fact, did the settlor elect out of ITA 70(6)?"

"<No. Actually very few people even mention it when they come to me to get their wills made>"

"This means all of the assets will flow through to the beneficiaries at the deceased's ACB, if you're quick enough not to receive any dividends, and the beneficiaries will get capital gains or losses based on the price the deceased paid for it"

Finally, somebody that doesn't come to me for Section 85 stuff today! she thought, upon seeing the testamentary executor of the gangster she offed on Yuuzhan'tar alongside a Vong kingpin of the Scourge. Kind of ironic that I am the person doing his estate's taxes. She can kind of feel where it was going: although Section 70(6)'s aims, from a tax planning perspective, were similar to those of Section 85, that is, deferral of taxes, the mechanism differs. She can also feel that the trustee wants the trust to be a GRE, or graduated rate estate. Yet, a GRE can only last three standard years from the day of the deceased's death, in this case, the day she even went on Yuuzhan'tar to kill the Vong kingpin. The main benefit of designating a trust as a GRE is to be able to have the income generated by the estate's assets, and retained in it, be taxed at the same rates (and AMT considerations also) as individuals and to have a non-calendar year. Ancillary is the exemption from installment payments. She could tell the gangster was willing to risk tax and legal complications to allow its remaining family to enjoy the fruits of his in-vivo hard work.

"You want to designate this estate as a GRE? There are two more questions, since the third is already answered by virtue of you asking me these questions only a few days after his death. Technically a GRE can be designated at any time during the three years following an individual's death. First, are there any other testamentary trusts with that individual as the settlor? Second, do you accept to provide the deceased's SIN for producing the trust's tax returns? If you do this, make sure you can distribute all the assets to the people in the will within three standard years, and hopefully within one"

 

[Griet van Vliet]

"<It's well before the first, and hopefully, only tax return is due for the estate, so I will put the deceased's SIN if it's required to designate it as a GRE. As for the existence of other testamentary trusts, no, the will didn't provide for another>"

Without a testamentary trust, deemed dispositions at death can generate a huge tax bill for the estate, since deemed dispositions at death are deemed to be made at fair market value, and that's also what happens when one's estate elects out of Section 70(6) but nevertheless has a testamentary trust. GREs make sense if 1) the deceased's assets can reasonably be distributed within three years of death and 2) the more illiquid assets of the estate aren't expected to earn revenues that are large enough for the top bracket, but non-GRE testamentary trusts are subject to the top bracket regardless of how much revenue its assets generate to the extent the revenues aren't redistributed or the trust doesn't cost that much to operate. Technically someone has to ask about whether there are even other testamentary trusts in the first place, but she knew that people with assets so illiquid that it would take more than three years to sell or transfer to the beneficiaries would be the only ones that may need more than one testamentary trust. With that said, capital property being donated to registered charities from a GRE can be exempt of capital gains taxation.

"A dividend stripper typically relies on a market's liquidity to operate as a dividend stripper. Even though all the assets should be liquid enough, there is another precaution I feel is necessary and that people often forget about GREs: tainting"

"<Tainting of a testamentary trust? How? What happens if the prospective GRE is tainted?>"

"The trust loses all of the advantages of a GRE and is treated as an inter-vivos trust for taxation, but taint the trust only if the assets proves to be too illiquid for three years' lead time to sale. As for tainting the trust: a beneficiary could contribute to it outside of a consequence of the settlor's death, a failure to distribute the assets, a beneficiary paying part or all of the trust's expenses, extending a loan to the trust, paying the settlor's tax liability arising from its final tax return(s), and finally, altering the composition of the assets significantly enough by means other than by distribution"

 

[Griet van Vliet]

In the most extreme cases of illiquidity (in a testamentary context at least), one was deemed to have sold and re-acquired the property 21 years after the trust as established, with the tax consequences of doing it at the fair market value of the time, but the 21-year rule is typically more of a concern to inter-vivos trusts. For some reason, the gangster couldn't trust his wife for managing millions in a varied portfolio of equity securities, at least not immediately, and especially not when the portfolio contains hundreds of different stock blocks, none of which were bought for over 10,000. Plus there is only one reason left to even have the testamentary trust over a direct distribution to her spouse: avoiding both the tax on split income and the attribution rules. If the spouse was to give chunks of the portfolio to their kids directly after the husband's death, the resulting dividends would be attributed back to her, on the other hand, since these chunks of the portfolio are an inheritance from their late father, flowing those through the trust would allow the kids to earn the dividends without having to worry about the TOSI, nor attribution rules.

"One more thing: just because the trust can get the portfolio at the price the late husband paid for it for tax purposes, does not mean the distribution of such assets will be made at that price. So watch out for the capital gains upon distribution: try to distribute the blocks of shares when they are trading at prices low enough to minimize the capital gains. If you don't think you can distribute all at once, that is; if you can distribute the portfolio all at once, wind up the trust then"

 

[Griet van Vliet]

And now an elderly Talz operating a sole proprietorship (in the Talz sense), Scrum, and wanted to sell its business for retiring from it. Any discussion starts with the balance sheet. Typically RDTOH, differentiated or not, and CDA, are not recognized on balance sheets, but somehow these two items appear on Scrum's balance sheets. According to his tribe's tax records, the tax rates are the following: 15% for ABI eligible for the SBD, 28% on all other ABI, and 46-2/3% on its investment income, which includes the ART. Because it has no GRIP balance, its entire balance of RDTOH will be considered NRDTOH. Having bought it some thirty years ago, for 100,000 and with a PUC of 150,000, his last three balance sheets are very similar to each other, similar enough for it to be usable as-is for the purposes of the LGCD, of which he has a balance of 400,000 left. Without further ado, here was the most recent pro-forma balance sheet:

Scrum​

Balance sheet​

As at...​

​

Assets:

Current assets
Cash 47,000
Marketable securities at cost (FMV: 35,000) 65,000
NRDTOH 10,000
Inventory at cost (FMV: 82,000) 114,000

Total current assets 236,000

Non-current assets
Land at cost (FMV: 460,000) 220,000
Building at UCC (FMV: 1.6 million, Cost: 1.3 million) 1,120,000

Total assets: 1,576,000

Liabilities (100% current) 134,000

Equity:
PUC 150,000
CDA 85,000
Retained earnings 1,207,000

Total liabilities and equity 1,576,000

 

[Griet van Vliet]

"Let's start with the sale of shares"

"<I received an offer for 1.7 million: I came here because it was either buying the shares or buying assets and liabilities>"

"You may as well file a T2057 form, i.e. a Section 85 election in the latter case"

Clearly the FMV of the marketable securites is less than 10% of 2.142 million (the sum of the FMVs of inventory, land and building) so the LGCD can be used against it. But the AMT applicable to him is 27% (15% federal and 12% tribal) subject to a 40,000 exemption.

POD 1,700,000
ACB 100,000
Capital gain 1,600,000

TCG 800,000
CGD (400,000)
Taxable income 400,000

Without AMT: 400,000*45% = 180,000 balance owing => 1.52 million in net cash

With AMT: 840,000*27% = 226,800 => 1,473,200 in net cash

 

[Griet van Vliet]

"That's assuming there was no additional income from other sources, probably because you took a paycut to get the company to even... break even. Are there other associated companies for SBD purposes?"

"<No one else in my family owns businesses, nor am I controlling, or am controlled by someone else>"

"So no associated businesses"

Sale of assets:

Asset | POD | ABI | AII | CDA
O/B | Nil | Nil | Nil | 85,000
Cash | 47,000 | Nil | Nil | Nil
Marketable securities | 35,000 | Nil | (15,000) | (15,000)
Inventory (under S22) | 82,000 | (32,000) | Nil | Nil
Land | 460,000 | Nil | 120,000 | 120,000
Building (both recapture of CCA and capital gain) | 1,600,000 | 180,000 | 150,000 | 150,000

Closing balance | 2,224,000 | 148,000 | 255,000 | 340,000

Corporate taxes:

ABI: 148,000*15% = 22,200
AII: 255,000*46-2/3% = 119,000

Part I tax 141,200

NRDTOH O/B: 10,000
30-2/3% of AII: 78,200
Dividend refund: 88,200

Balance owing 53,000

Cash from assets 2,224,000
Less: Liabilities (134,000)
Less: Current tax expense (53,000)
Cash left: 2,037,000 (to be allocated between the CDA and the ineligible dividend)

 

[Griet van Vliet]

The liquidating, ineligible dividend:

POD 2,037,000
Less: PUC 150,000
84(2) dividend 1,887,000
Less: CDA 340,000
Taxable ineligible dividend 1,547,000

As for the capital gain: still the same 2.037 million. But one needs to remove the deemed dividend from the POD (or alternatively, add it to the ACB, same result) so one has

POD 2,037,000
Less: 84(2) dividend: 1,887,000
RPOD 150,000
ACB 100,000
Capital gain 50,000
TCG 25,000 (the shares are no longer eligible for the LGCD when a 88(2) wind-up happens)

 

[Griet van Vliet]

Personal tax bill:

TCG 25,000
Ineligible dividend 1,547,000
Gross up of 16%: 247,520

Taxable income 1,819,520

Gross tax payable 818,784
Less: Dividend tax credit 247,520

Balance owing (without AMT) 571,264

Balance owing (with AMT) 1,547,000*27% = 417,690

Net cash: 2,037,000 - 571,264 = 1,465,736

"Bottom line: I'd recommend selling the shares, even though the advantage of doing it is only 7,464"

 

[Griet van Vliet]

"<Thank you>" the last client told her before leaving.

It seemed that the next client wanted to perform an "estate-freeze", using Section 86, the fair-market value of the shares of that small business was 200,000, with the ACB and PUC being the same, 1,000. But he asked Griet for advice as to whether giving up the entire class of shares was worth the implementation of the estate freeze. He was contemplating doing it for 150,000 in preferred shares and 50,000 in NSC, which will also be the NSC's ACB. But the preferred shares' ACB is the following:

ACB of common shares 1,000
Less: NSC of the (50,000)
ACB of preferred shares Nil

POD of old C/S:
ACB of NSC 50,000
ACB of P/S Nil
POD C/S 50,000

TPUC of new P/S:
LPUC 150,000
Less: (A-B)*C/A = [150,000-0]*150,000/150,000 = 150,000
TPUC Nil

 

[Griet van Vliet]

"That's not all: deemed dividends are also part of the game here, so do you have a GRIP balance? What about the RDTOH, eligible or not?"

"<Why a GRIP balance? Why eligible or ineligible RDTOH?>"

"The RDTOH rules have changed, with each RDTOH account requiring to designate a non-eligible and eligible dividend respectively. You can designate the deemed dividend as eligible only to the extent you have a GRIP balance, and your existing RDTOH balance can be an ERDTOH only up to 38 1/3% of the GRIP"

POD 50,000
Less: PUC C/S 1,000
Deemed diviend 49,000 (ineligible)

POD 50,000
Less: DD 49,000
RPOD 1,000
ACB C/S 1,000
TCG Nil

"You may want to adjust the NSC if you want the estate freeze to be done with no immediate tax consequences. Take the lesser of PUC or ACB of the old shares in NSC"