Learning Center: Accounting : Taxation

Corporate Distributions, Windings-Up, and Sales

Problem 1 (Basic)

Surplus Accounts Limited, a Canadian-controlled private corporation, whose fiscal year-end is December 31, provides you with the following data concerning its tax accounts and capital transactions for 2008. The balance in its capital dividend account was nil on January 1, 2008. Ms. Tsakiris, a Canadian resident, is the sole shareholder.

Surplus Accounts Limited is considering winding up the corporation and wishes to determine the impact of the sale of all its capital assets on its tax surplus accounts. The following capital assets are recorded in the books of account:

Assets	Cost	UCC/CEC	Estimated proceeds	Estimated selling costs
Investments...........	$ 60,000		$ 22,000	$ 500
Land......................	40,000		200,000	10,000
Building.................	70,000	$ 45,000	125,000	6,000
Equipment.............	35,000	Nil	8,000	400
Customer lists (Note 1).................	40,000	16,000	60,000	—

Additional Information

(1) The balance in the cumulative eligible capital account reflects the purchase of the customer lists in 1998 for $40,000 less the tax write-offs for 1998 to 2007, inclusive.

(2) In addition to the above assets, there is $35,000 of goodwill which will also be sold.

—REQUIRED

Compute the effect on income and the capital dividend account balance immediately after the above transactions.

Solution 1 (Basic)

Effect on Income
Investments: ACL ¹/₂ ´ ($22,000 – ($60,000 + $500)).........................................................................		$ (19,250)
Land: TCG ¹/₂ ´ ($200,000 – ($40,000 + $10,000)).............................................................................		75,000
Building: TCG ¹/₂ ´ ($125,000 – ($70,000 + $6,000)).........................................................................		24,500
Building: recapture ($45,000 – $70,000)...............................................................................................		25,000
Equipment: recapture (($8,000 – $400) – nil)........................................................................................		7,600
Eligible capital property: goodwill and customer lists:
Proceeds (³/₄ ´ (60K + 35K))................................................................................	$ 71,250
Less: CEC balance.................................................................................................	16,000
	$ 55,250
Previous CECA claims ((³/₄ ´ $40,000) – $16,000)..............................................	14,000
	$ 41,250
Income (²/₃ ´ $41,250)..........................................................................................	27,500
Income (recapture of CECA).................................................................................	14,000	41,500
Income effect.........................................................................................................................................		$ 154,350
Capital Dividend Account
Balance: January 1, 2008.......................................................................................................................		Nil
Investments: ¹/₂ ´ ($22,000 – ($60,000 + $500))..................................................................................		$ (19,250)
Land: ¹/₂ ´ ($200,000 – ($40,000 + $10,000).......................................................................................		75,000
Building: ¹/₂ ´ ($125,000 – ($70,000 + $6,000))..................................................................................		24,500
Eligible capital property: goodwill and customer lists:
²/₃ ´ $41,250		27,500
Balance: December 31, 2008.................................................................................................................		$ 107,750

The above can be summarized in tabular form as follows:

Asset	Income effect		Capital dividend account
			Untaxed fraction of net cap. gains	Capital dividend received	Untaxed fraction of net gain on ECP	Untaxed life ins. proceeds	Capital dividend paid	Balance

	ABI	AII
Investments....		$ (19,250)	$ (19,250)					$ (19,250)
Land...............		75,000	75,000					75,000
Building..........	$ 25,000	24,500	24,500					24,500
Equipment......	7,600
ECP................	41,500				$ 27,500			27,500
	$ 74,100	$ 80,250	$ 80,250	Nil	$ 27,500	Nil	Nil	$ 107,750

Problem 2 (Advanced)

[ITA: 89(1)]

You have been asked to compute the capital dividend account of Granatstein Ltd., a Canadian-controlled private corporation incorporated in 1986. You have reviewed the tax returns of the corporation for the period January 1, 1986 to December 31, 2008 and made the following notes:

1987 Disposed of bonds resulting in a capital gain of $10,000.

1989 Received taxable dividend of $2,000 and capital dividend of $5,000.

1990 Disposed of shares resulting in a capital loss of $4,000.

1992 Disposed of equipment resulting in a capital gain of $6,000 and recapture of $3,000.

1994 Eligible capital property was purchased for $40,000.

1995 Sold vacant land and reported capital gain of $100,000.

1998 1995 capital gain of sale of vacant land was reassessed by the CRA as income. Granatstein Limited did not fight the reassessment.

2001 Sold shares resulting in a capital gain of $20,000.

2003 Received life insurance proceeds of $100,000 on a life insurance policy on the life of the company president purchased in 1995. As at January 1, 2003, the policy had an adjusted cost basis of $20,000.

2004 Paid capital dividends of $50,000.

2007 Sold a customer list for $100,000. The company’s cumulative eligible capital balance at the time of the sale was $25,000.

2008 Sold shares resulting in a capital gain of $37,500.

—REQUIRED

Compute the balance in Granatstein Ltd.’s capital dividend account at the end of the 2008 taxation year. Show all calculations and explain why you omitted any of the above amounts in your answer.

Solution 2 (Advanced)

		Capital dividend account
1987	Disposal of bonds: $10,000 capital gain ´ ¹/₂......................................................................	$ 5,000
1989	Received capital dividend....................................................................................................	5,000
1990	Disposal of shares: $4,000 capital loss ´ ¹/₄........................................................................	(1,000)
1992	Disposal of equipment: $6,000 capital gain ´ ¹/₄.................................................................	1,500
2001	Sale of shares: $20,000 capital gain ´ ¹/₂.............................................................................	10,000
2003	Life insurance: $100,000 – $20,000....................................................................................	80,000
2004	Capital dividends paid.........................................................................................................	(50,000)
2007	Sale of customer list: ($100,000 – $40,000)* ´ ¹/₂..............................................................	30,000
2008	Sale of shares: $37,500 capital gain ´ ¹/₂.............................................................................	18,750
	Account balance...........................................................................................................	$ 99,250

	* CEC balance	$ 25,000
	Proceeds ´ ³/₄	75,000
		(50,000)
	Previous CECA claims ((³/₄ ´ $40,000) – $25,000)	5,000
		$ 45,000
	CDA (²/₃ ´ $45,000)	$ 30,000

The above can be summarized in tabular form as follows:

Year	Asset	Capital dividend account
Year	Asset	Untaxed fraction of net cap. gains	Capital dividend received	Untaxed fraction of net gain on ECP	Untaxed life ins. proceeds	Capital dividend paid	Balance
1987	bonds.................	$ 5,000					$ 5,000
1989			$ 5,000				5,000
1990	shares................	(1,000)					(1,000)
1992	equip..................	1,500					1,500
1995	land....................	Nil					Nil
2001	shares................	10,000					10,000
2003	life ins................				$ 80,000		80,000
2004	dividend paid.....					$ (50,000)	(50,000)
2007	cust. list.............			$ 30,000			30,000
2008	shares................	18,750					18,750
		$ 34,250	$ 5,000	$ 30,000	$ 80,000	$ (50,000)	$ 99,250

The following amounts are not included in the capital dividend account:

(1) Recapture is not included in the capital dividend account.

(2) Since the 1995 gain on the vacant land was reassessed as income, it is not included in the capital dividend account.

Problem 3 (Advanced)

[ITA: 53(1)(b), 84]

The following situations deal with a Canadian-controlled private corporation and its shareholders. Each transaction described below is separate and distinct from the other transactions.

(a) Capital Inc. issued 135 preferred shares with PUC equal to $110 each for $11,050 cash and assets with a FMV of $2,800.

(b) Paid Ltd. has shares with a FMV of $35,000 and a PUC of $5,500. Paid Ltd. is considering making the following paid-up capital reductions on these shares. Their shareholders have an ACB of $16,000 for their shares:

(i) payment of $3,750; and

(ii) payment of $8,750.

(c) Up Ltd. has 4,500 common shares with a PUC of $22,500. In March of this year the corporation declared and distributed a 15% stock dividend in common shares with a PUC of $3,375.

(d) (i) The sole shareholder of Baker Corp. Ltd. contributed assets worth $38,400 to the corporation in return for cash of $15,400 and preferred shares with a PUC of $23,000 (redemption value of $23,000).

(ii) A year later, the sole shareholder redeemed the preferred shares.

—REQUIRED

Discuss the tax consequences for deemed dividends [sec. 84] for each of the above transactions.

Solution 3 (Advanced)

(a) The transaction results in an immediate deemed dividend of $1,000 due to the fact that the PUC of the preferred shares increased by $14,850 (135 shares ´ $110), but the increase in the FMV of the assets was only $13,850 (cash $11,050 and assets $2,800) [ssec. 84(1)]. Also, the ACB increases by $1,000 to $14,850.

(b) (i) The payment of $3,750 will not result in an immediate deemed dividend, as the payment is less than the PUC of the shares ($5,500) [ssec. 84(4)]. This payment would be considered to be return of the original capital injected by the shareholders. This payment will, however, reduce the adjusted cost base to $12,250 ($16,000 – $3,750) [spar. 53(2)(a)(ii)]. This reduction would result in a higher capital gain upon ultimate disposition of the shares because $3,750 of the cost in the shares has been recovered tax-free by this payment.

(ii) The payment of $8,750 will result in an immediate deemed dividend of $3,250 because the payment of $8,750 is in excess of the PUC of $5,500. The ACB of the shares will be reduced by the non-taxed portion of the payment of $5,500 ($8,750 – $3,250).

(c) The payment of the stock dividend of $3,375 increased the PUC by $3,375 but it does not result in a deemed dividend, because paragraph 84(1)(a) excludes a stock dividend from deemed dividend treatment under section 84. However, subsection 82(1) and the definition of an “amount” [ssec. 248(1)] require that a dividend equal to the increase in PUC be included in income. In addition, the ACB increases by $3,375.

(d) (i) The contribution of the assets will not result in a deemed dividend as the increase in the PUC of the preferred shares of $23,000 does not exceed the increase in net assets of $23,000 ($38,400 – $15,400).

(ii) The shareholder of Baker Corp. Ltd. will not receive a deemed dividend, since there is no difference between redemption value and PUC [ssec. 84(3)]. Since the ACB of the shares is $23,000 (i.e., $38,400 − $15,400), there will also be no capital gain or loss on the redemption (i.e., proceeds ($23,000) – ssec. 84(3) dividend (nil) – ACB ($23,000)).

Problem 4 (Basic)

[ITA: 54, 84(3), 84(6)]

Ms. Chiu owns all of the 100 Class B shares issued by Chiu Ltd., a small business corporation, which was formed by Ms. Chiu about 15 years ago. Her son owns all the Class A shares. The current fair market value of the Class B shares is $100 per share. The paid-up capital value of the shares and their adjusted cost base to Ms. Chiu is presently $5 each. Ms. Chiu would like to know the tax consequences if (a) her shares are redeemed by Chiu Ltd. for their fair market value or, alternatively, (b) she sells her shares to her son for their fair market value.

Ms. Chiu has also sold 100 common shares of Bellco Limited, a company whose shares are listed on a designated stock exchange. She has found out Bellco Limited, itself, had purchased her shares through the exchange for $4.10 each. The paid-up capital value of the shares was $1 each and their cost to Ms. Chiu three years ago was $1.25 each.

—REQUIRED

Comment on the tax implication of the above transactions.

Solution 4 (Basic)

Redemption Versus Sale of Chiu Ltd. Class B Shares

(a) Redemption

Redemption proceeds (100 shares ´ $100).................................................	$ 10,000
Less: PUC (100 shares ´ $5)......................................................................	500
Deemed dividend [ssec. 84(3)]....................................................................	$ 9,500
Redemption proceeds..................................................................................	$ 10,000
Deemed Dividend [ssec. 84(3)]...................................................................	9,500
Proceeds of disposition [sec. 54].................................................................	500
Less adjusted cost base (100 shares ´ $5)...................................................	500
Capital gain (loss)........................................................................................	Nil

(b) Sale

Proceeds of disposition (100 shares ´ $100)..............................................	$ 10,000
Less adjusted cost base (100 shares ´ $5)...................................................	500
Capital gain (loss)........................................................................................	$ 9,500
Taxable capital gain (¹/₂ ´ $9,500)...............................................................	$ 4,750

Note the in both cases, the economic gain is $9,500. In the case of the redemption, it is taxed as a dividend, and in the case of the sale, it is taxed as a capital gain.

Open Market Purchase of Bellco Ltd. Shares

Subsection 84(3), which is applicable on a redemption, acquisition or cancellation of shares by a corporation, does not apply if the shares were acquired by the corporation in the open market in the manner in which shares would normally be purchased by any member of the public [par. 84(6)(b)]. Therefore, the following tax consequences would result:

Proceeds if disposition (100 shares ´ $4.10)..........................................................	$ 410
Less adjusted cost base (100 shares ´ $1.25)..........................................................	125
Capital gain (loss)....................................................................................................	$ 285

Problem 5 (Basic)

[ITA: 54, 83(2), 84(2), 84(2.1), 89(1)]

Ms. Batt owns all the common shares of Batterup Ltd., a Canadian-controlled private corporation, which started operations in 1987. Batterup Ltd. has been quite profitable since the early 1990s. As a result, Three-Strikes Ltd., a Canadian public corporation, has offered Ms. Batt $252,500 for the assets, excluding cash, as at December 31, 2008. The offer price reflects unrecorded goodwill of $47,500. Ms. Batt wants to wind up the company after the sale of the assets.

The pro forma balance sheet of Batterup Ltd. as at December 31, 2008, is as follows:

Assets	Cost	UCC	FMV
Cash............................................	$ 2,500
Accounts receivable (net)............	8,750		$ 7,500
Inventory.....................................	22,250		15,500
Land............................................	11,000	—	45,000
Building.......................................	35,000	$ 7,500	95,000
Equipment...................................	45,000	22,000	10,000
Marketable securities...................	14,250	—	32,000
	$ 138,750		$ 205,000
Liabilities
Current liabilities.........................	$ 54,000
Future income taxes.....................	5,000
Shareholder’s Equity
Paid-up capital.............................	10,000
Capital dividend account..............	4,000
Retained earnings........................	65,750
Total liabilities and equity............	$ 138,750

Additional Information:

(1) Batterup Ltd. pays corporate tax at the overall rate of 20% on active business income eligible for the small business deduction and an initial 40% rate for investment income, plus the 6²/₃% additional refundable tax on investment income. The corporation has a GRIP balance of nil.

(2) The reserve for doubtful accounts at December 31, 2008, was $1,500.

(3) Batterup Ltd. and Three-Strikes Ltd. elected under section 22.

—REQUIRED

(A) Compute the amount available for distribution to the shareholder.

(B) Determine the components of the distribution to the shareholder.

(C) Compute the taxable capital gain or allowable capital loss on the disposition of Ms. Batt’s shares on the winding-up. (Assume the adjusted cost base of Ms. Batt’s common shares is $10,000.)

(D) Explain the conditions for and advantages of using a section 22 election.

Solution 5 (Basic)

(A)

	Actual or deemed proceeds	Income generated		Capital dividend account	RDTOH
		Income generated
		ABI	AII
Opening balance..................................		Nil	Nil	$ 4,000	Nil
Cash.....................................................	$ 2,500	Nil	Nil
Accounts receivable⁽¹⁾..........................	7,500	$ (1,250)	Nil
Inventory⁽²⁾..........................................	15,500	(6,750)	Nil
Land⁽³⁾.................................................	45,000	Nil	$ 17,000	17,000
Building⁽⁴⁾............................................	95,000	27,500	30,000	30,000
Equipment⁽⁵⁾........................................	10,000	(12,000)	Nil
Marketable securities⁽⁶⁾........................	32,000	Nil	8,875	8,875
Goodwill⁽⁷⁾..........................................	47,500	23,750	Nil	23,750
Liabilities.............................................	(54,000)
Income taxes⁽⁸⁾.....................................	(32,325)	$ 31,250	$ 55,875		$ 14,900
RDTOH⁽⁹⁾...........................................	14,900				$ 14,900
	$ 183,575			$ 83,625
(B) Funds available for distribution.............................................................................................................					$ 183,575
Less: Paid-up capital..............................................................................................................................					(10,000)
Deemed dividend [ssec. 84(2)]..............................................................................................................					$ 173,575
Less: Capital dividend [ssec. 83(2)].......................................................................................................					(83,625)
Deemed taxable dividend.......................................................................................................................					$ 89,950
(C) Proceeds................................................................................................................................................					$ 183,575
Less: Deemed dividend [sec. 54: def. of proceeds of disposition].........................................................					(173,575)
Adjusted proceeds of disposition...........................................................................................................					$ 10,000
Less: Adjusted cost base........................................................................................................................					(10,000)
Capital gain (loss)..................................................................................................................................					$ Nil

(D)

In order to deduct a reserve for doubtful debt or write off a bad debt, an amount in respect of the debt must have been included previously in income. This is not the case, if accounts receivable had been purchased from someone else. Where a person has sold all or substantially all of the property used in a business to a purchaser who will continue the business, section 22 provides for a joint election by the vendor and purchaser which results in permitting the purchaser to take the reserve or write-off with respect to the accounts receivable.

Under section 22, the purchaser must include in income the difference between the face amount and amounts paid. This inclusion will allow the purchaser to deduct a reasonable reserve for doubtful debts on the accounts receivable purchased and to deduct any bad debts as they occur.

The vendor, regardless of whether section 22 is used, must add to income the reserve for doubtful accounts. Under section 22, the vendor would have a business loss with respect to the disposition of the accounts receivable.

If section 22 is not used, any loss on the disposition of the accounts receivable would be considered a capital loss, and any loss realized by the purchaser on the collection of accounts receivable will be a capital loss with no reserve or write-off permitted to the purchaser.

—NOTES TO SOLUTION

(1) The reserve for doubtful accounts of $1,500 must be added to income regardless of whether a section 22 election is used.

If a section 22 election is used, the excess of face amount over proceeds of $2,750 would be a business loss such that the net effect on income would be a $1,250 business loss.

(2) Income/loss from business is the difference between the fair market value and the cost of inventory. In this case such a loss results due to:

Fair market value (proceeds)......................................................................................................	$ 15,500
Cost of inventory.......................................................................................................................	22,250
	$ (6,750)

(3) Land
Taxable capital gain:
Proceeds............................................................................................................................	$ 45,000
Adjusted cost base.............................................................................................................	11,000
Gain...................................................................................................................................	$ 34,000
Taxable capital gain (¹/₂ of gain)........................................................................................	$ 17,000 (A)
Capital dividend account (¹/₂ of gain).........................................................................................	$ 17,000 (B)
(4) Building
Taxable capital gain:
Proceeds............................................................................................................................	$ 95,000
Capital cost (adjusted cost base)........................................................................................	35,000
Gain...................................................................................................................................	$ 60,000
Taxable capital gain (¹/₂ of gain)........................................................................................	$ 30,000 (A)
Capital dividend account (¹/₂ of gain).........................................................................................	$ 30,000 (B)
Active business income
Cost...................................................................................................................................	$ 35,000
UCC..................................................................................................................................	7,500
Recapture...........................................................................................................................	$ 27,500 (C)
Increase in value
P of D................................................................................................................................	$ 95,000
UCC..................................................................................................................................	7,500
(A) + (B) + (C)..........................................................................................................................	$ 87,500
(5) Equipment
Proceeds....................................................................................................................................	$ 10,000
UCC..........................................................................................................................................	22,000
Terminal loss.............................................................................................................................	$ 12,000
(6) Marketable securities
Taxable capital gain:
Proceeds............................................................................................................................	$ 32,000
Adjusted cost base.............................................................................................................	14,250
Gain...................................................................................................................................	$ 17,750
Taxable capital gain (¹/₂ of gain)........................................................................................	$ 8,875
Capital dividend account (¹/₂ of gain).........................................................................................	$ 8,875
(7)
(a) Unrecorded goodwill (given).............................................................................................	$ 47,500
(b) Business income ²/₃ ´ ³/₄ of $47,500.................................................................................	$ 23,750
(c) Capital dividend account (²/₃ ´ ³/₄) ´ $47,500...................................................................	$ 23,750
(8) Income taxes
Investment income:
46²/₃% ´ $55,875..............................................................................................................	$ 26,075
Business income:
20% ´ $31,250..................................................................................................................	6,250
Tax payable................................................................................................................................	$ 32,325
(9) RDTOH
26²/₃% ´ $55,875......................................................................................................................	$ 14,900

Problem 6 (Advanced)

[ITA: 54, 83(2), 84(2), 88(2), 89(1)]

You have been approached by one of your clients, Mr. Sidney Chow, for help in determining what will be the tax consequences if he sells all his assets in his corporation (at their fair market value) in 2008 to someone who will continue the business. However, Mr. Chow is not sure if he should wind up his corporation at this time. The following tax balance sheet for Chow Enterprises Ltd. has been prepared as at December 31, 2008.

Chow Enterprises Ltd. BALANCE SHEET as at December 31, 2008
Cash............................................................................................		$ 10,000
RDTOH......................................................................................		5,000
Accounts receivable ................................................	$ 30,000
Less: reserve for doubtful debts .............................	5,000	25,000
Land............................................................................................		55,000
Building (Class 1) — UCC.........................................................		95,000
Equipment (Class 8) — UCC......................................................		12,000
Shares in Bell Canada — cost.....................................................		15,000
Goodwill — cumulative eligible capital balance..........................		18,000
		$ 235,000
Liabilities.....................................................................................		$ 35,000
Future income taxes.....................................................................		12,000
Common shares — PUC.............................................................		20,000
Capital dividend account..............................................................		8,000
Other surplus...............................................................................		160,000
		$ 235,000

Additional Information

(1) Mr. Chow owns all the common shares of the corporation, which he acquired in 1995 for $20,000 when the business was incorporated.

(2)

Assets	Cost	FMV
Accounts receivable...............................................	$ 30,000	$ 18,000
Land......................................................................	55,000	150,000
Building — Class 1...............................................	170,000	320,000
Equipment — Class 8............................................	30,000	3,000
Shares in Bell Canada............................................	15,000	26,000
Goodwill...............................................................	50,000	120,000

Goodwill was acquired in 1998 in connection with a similar business which was purchased that year. The fair market value reflects the goodwill for the combined businesses. The maximum amortization has been deducted for tax purposes.

(3) The corporation is taxable at a total 20% corporate tax rate for the first $300,000 of active business income and a 40% rate for any other income, plus the 6²/₃% additional refundable tax on investment income. The corporation has a GRIP balance of nil.

(4) The accounts receivable are to be sold to a factoring company.

—REQUIRED

(A) Compute the effect of the sale of the above assets on the various tax accounts in 2008, ignoring any potential normal business transactions.

(B) If Mr. Chow should decide to wind up beginning in 2009, ignoring any subsequent business transactions,

(i) determine the components of the distribution to him; and

(ii) compute the taxable capital gain or allowable capital loss on the disposition of Mr. Chow’s shares.

(C) Indicate briefly the tax consequences of leaving the proceeds in the corporation and investing the money in high-yielding securities.

(D) Discuss the GST implications on the sale of assets and the subsequent winding-up.

Solution 6 (Advanced)

(A)

	Actual or deemed proceeds	Income generated		Capital dividend account		RDTOH
		ABI	AII
Opening balance........................................		Nil	Nil	$ 8,000		$ 5,000
Cash...........................................................	$ 10,000	Nil	Nil
Accounts receivable⁽¹⁾................................	18,000	$ 5,000	$ (6,000)	(6,000)
Land⁽²⁾.......................................................	150,000	Nil	47,500	47,500
Building⁽³⁾..................................................	320,000	75,000	75,000	75,000
Equipment⁽⁴⁾..............................................	3,000	(9,000)	Nil
Shares⁽⁵⁾.....................................................	26,000	Nil	5,500	5,500
Goodwill⁽⁶⁾................................................	120,000	54,500	Nil	35,000
Liabilities...................................................	(35,000)
Income taxes⁽⁷⁾...........................................	(82,033)	$ 125,500	$ 122,000			32,533
RDTOH⁽⁸⁾.................................................	37,533					$ 37,533
	$ 567,500			$ 165,000
(B) Funds available for distribution to shareholders....................................................................................					$ 567,500
Less: paid-up capital..............................................................................................................................					(20,000)
Deemed dividend on winding up [ssec. 84(2)]......................................................................................					$ 547,500
Less: capital dividend elected [ssec. 83(2)]............................................................................................					(165,000)
Deemed taxable dividend (sufficient to clear RDTOH).........................................................................					$ 382,500
Taxable capital gain to shareholder:
Proceeds on winding-up................................................................................................................					$ 567,500
Less: deemed dividend...................................................................................................................					(547,500)
Proceeds of disposition..................................................................................................................					$ 20,000
Cost...............................................................................................................................................					(20,000)
Capital gain....................................................................................................................................					Nil⁽⁹⁾

(C) If the winding-up is not implemented immediately, the shareholder can defer the tax on the deemed taxable dividend and the taxable capital gain that arise on the winding-up. The corporation could declare a dividend and elect that it be paid from the capital dividend account of $165,000. This dividend would be tax-free to the recipient shareholder. The corporation could also pay a taxable dividend sufficient to clear its RDTOH, but that dividend would attract tax in the hands of the shareholders. It would also be possible for the corporation to reduce and distribute its PUC to be received tax-free by the shareholders. None of these transactions require a winding-up distribution.

The corporation would have income from a specified investment business. As such its total tax rate would be about 20% after the dividend refund. If the shareholder had no other source of income, it would be possible to distribute substantial amounts of dividends without attracting further tax in the hands of the shareholder. (See Chapter 13.) However, the corporation would no longer be a small business corporation and the availability of the QSBC capital gains deduction would be lost.

(D) The sale of assets of Chow Enterprises Ltd. would be subject to the general GST rules. An election may be available [ETA: ssec. 167(1)]. Subsection 167(1) deals with the situation where a registrant sells or transfers all or substantially all of the assets used in a commercial activity. If Chow Enterprises Ltd. engages in a commercial activity, it would appear an election under subsection 167(1) can be made when the assets are sold.

Subsection 167(1) also applies when a corporation is wound up and the rules of subsection 88(2) of the Income Tax Act apply.

—NOTES TO SOLUTION

(1) Inclusion of last year’s reserve (active business income)		$ 5,000
Proceeds of disposition..........................................................................................	$ 18,000
Cost.......................................................................................................................	(30,000)
Capital loss............................................................................................................	$ (12,000)*
Allowable capital loss (½ ´ $12,000) (investment income offset).........................		$ (6,000)
Income effect (assuming taxable capital gain to offset allowable capital loss)........		$ (1,000)
Capital dividend account (½ ´ $12,000)................................................................		$ (6,000)

* The disposition does not qualify for section 22 election, since the accounts receivable were sold to a factoring company and, hence, the disposition does not meet the “all or substantially all” and “carrying on the business” tests.

(2) Taxable capital gain (½ ´ ($150K – $55K)) (investment income)..................................................		$ 47,500
Capital dividend account (½ ´ ($150K – $55K))...........................................................................		$ 47,500
(3) Proceeds on sale of building..........................................................................................................		$ 320,000
UCC..............................................................................................................................................		(95,000)
Gain: Sum of (A), (B), and (C) calculated below..........................................................................		$ 225,000
Recapture ($95K – $170K) (active business income)............................................	(A)	$ 75,000
Capital gain:
Proceeds of disposition..................................................................................	$ 320,000
Cost...............................................................................................................	(170,000)
Capital gain....................................................................................................	$ 150,000
Taxable capital gain (½ ´ $150,000) (investment income).....................................	(B)	$ 75,000
Capital dividend account (½ ´ $150,000)..............................................................	(C)	$ 75,000
(4) Proceeds on sale of equipment.......................................................................................................		$ 3,000
UCC..............................................................................................................................................		(12,000)
Terminal loss (active business income offset)................................................................................		$ (9,000)
(5) Proceeds on sale of shares.............................................................................................................		$ 26,000
Adjusted cost base.........................................................................................................................		(15,000)
Full increase in value.....................................................................................................................		$ 11,000
Taxable capital gain (½ ´ ($26K – $15K)) (investment income)....................................................		$ 5,500
Capital dividend account (½ ´ ($26K – $15K)).............................................................................		$ 5,500
(6) CEC balance	$ 18,000
Proceeds ´ ⅓.........................................................................................................	(90,000)
	(72,000)
Previous CECA (¾ ´ $50,000 – $18,000)............................................................	19,500
Balance..................................................................................................................	$ 52,500
Income: ⅔ ´ $52,500..........................................................................................	$ 35,000
Recapture (above)..................................................................................	19,500	$ 54,500
CDA: ⅔ ´ $52,500................................................................................................		$ 35,000*

* Check: ½ ´ ($120,000 – $50,000) = $35,000

(7) Tax @ 20% on active business income (20% of $125,500)..........................................................	$ 25,100
Tax @ 46⅔% on investment income (46⅔% of $122,000)...........................................................	56,933
Total tax.........................................................................................................................................	$ 82,033
RDTOH (26⅔% of $122,000)......................................................................................................	$ 32,533

(8) Assumes a minimum $112,599 (i.e., 3 ´ $37,533) is to be distributed as a taxable dividend to produce a refund to clear the RDTOH.

(9) The capital gains deduction on qualified small business corporation shares would not apply, because the shares would not meet the small business corporation test after the assets have been sold for cash.

Problem 7 (Advanced)

[ITA: 54, 83(2), 84(2), 88(2)]

J. Tilkenhurst Limited (JTL) is a Canadian-controlled private corporation which was started in 1988 by Mr. Santosh Prasad with an initial investment in common shares of $18,000. Mr. Prasad has decided that it’s time to retire and move to his retirement home in Saskatoon, Saskatchewan. Therefore, Mr. Prasad wishes to wind up JTL.

The following is a projected tax balance sheet prior to the sale and distribution of the assets as at the intended date of the winding-up:

J. Tilkenhurst Limited BALANCE SHEET as at December 31, 2008
Cash............................................................................................		$ 15,000
RDTOH......................................................................................		6,000
Accounts receivable ..............................................	$ 60,000
Less: reserve for doubtful accounts ......................	5,000	55,000
Inventory.....................................................................................		110,000
Marketable securities...................................................................		26,000
Land............................................................................................		85,000
Building — UCC........................................................................		23,000
Equipment — UCC.....................................................................		10,000
Customer list — CEC account balance........................................		20,600
		$ 350,600
Liabilities.....................................................................................		$ 45,000
Future income taxes.....................................................................		41,000
Common shares (PUC)...............................................................		18,000
Capital dividend account (no unabsorbed negative amounts)......		12,000
Other surplus...............................................................................		234,600
		$ 350,600

Additional Information

(1) The corporation is taxable at a total 20% corporate tax rate for the first $400,000 of active business income and an initial 40% rate for all other income, plus the 6²/₃% additional refundable tax on investment income. The corporation has a GRIP balance of nil.

(2)

Assets	Cost	FMV
Accounts receivable.....................	$ 60,000	$ 52,000
Inventory.....................................	110,000	127,000
Marketable securities...................	26,000	26,000
Land............................................	85,000	150,000
Building.......................................	66,000	97,000
Equipment...................................	30,000	6,000
Customer lists*............................	42,453	70,000

* The customer lists were acquired in 2002 from a similar business which was acquired that year. The balance in the CEC account includes the maximum cumulative eligible capital amounts in each year.

(3) The books of account do not reflect unrecorded goodwill with an estimated fair market value of $60,000. This is in addition to the customer lists.

(4) The accounts receivable are to be sold to a factoring company.

—REQUIRED

Prepare an analysis of the income tax implications of the winding-up.

Solution 7 (Advanced)

(A)

	Proceeds	ABI	AII	Capital dividend acct.	RDTOH
Opening balance............................		Nil	Nil	$ 12,000	$ 6,000
Cash...............................................	$ 15,000
Accounts receivable⁽¹⁾....................	52,000	$ 5,000	(4,000)	(4,000)
Inventory⁽²⁾....................................	127,000	17,000	Nil
Land⁽³⁾...........................................	150,000	Nil	32,500	32,500
Building⁽⁴⁾......................................	97,000	43,000	15,500	15,500
Equipment⁽⁵⁾..................................	6,000	(4,000)
Marketable securities⁽⁶⁾..................	26,000	Nil	Nil
Eligible capital property⁽⁷⁾..............	130,000	55,013	Nil	43,773
Liabilities.......................................	(45,000)
Income taxes⁽⁸⁾...............................	(43,736)	$ 116,013	$ 44,000		11,733⁽⁹⁾
RDTOH.........................................	17,733				$ 17,733
	$ 531,997			$ 99,773
(B) Funds available for distribution to shareholder......................................................................................					$ 531,997
Less: paid-up capital..............................................................................................................................					(18,000)
Deemed dividend on winding up [ssec. 84(2)]......................................................................................					$ 513,997
Less: capital dividend elected [ssec. 83(2)]............................................................................................					(99,773)
Deemed taxable dividend (sufficient to clear RDTOH).........................................................................					$ 414,224
(C) Taxable capital gain to shareholder:
Proceeds on winding-up........................................................................................................................					$ 531,997
Less: Deemed dividend..........................................................................................................................					(513,997)
Proceeds of disposition..........................................................................................................................					$ 18,000
Cost.......................................................................................................................................................					(18,000)
Capital gain............................................................................................................................................					Nil
Taxable capital gain................................................................................................................................					Nil

—NOTES TO SOLUTION

(1) Accounts receivable:
Inclusion of last year’s reserve (active business income).......................................................................	$ 5,000
Proceeds of disposition*........................................................................................................................	52,000
Cost.......................................................................................................................................................	(60,000)
Capital loss............................................................................................................................................	(8,000)
Allowable capital loss (¹/₂ ´ $8,000).....................................................................................................	(4,000)
Capital dividend account (¹/₂ ´ $8,000).................................................................................................	$ (4,000)

* The disposition does not qualify for the section 22 election, since the accounts receivable were sold to a factoring company and, hence, the disposition does not meet the “all or substantially all” and “carrying on the business” tests.

(2) Inventory:
Proceeds................................................................................................................................................		$ 127,000
Cost.......................................................................................................................................................		(110,000)
		$ 17,000
(3) Land:
Proceeds of disposition..........................................................................................................................		$ 150,000
Cost.......................................................................................................................................................		(85,000)
Capital gain............................................................................................................................................		$ 65,000
Taxable capital gain................................................................................................................................		$ 32,500
Capital dividend account (¹/₂ ´ $65,000)...............................................................................................		$ 32,500
(4) Building:
Proceeds on sale of building..................................................................................................................		$ 97,000
UCC......................................................................................................................................................		(23,000)
Gain.......................................................................................................................................................		$ 74,000
Recapture ($23K – $66K)......................................................................................................................		$ 43,000
Proceeds of disposition..................................................................................................................		$ 97,000
Less: capital cost............................................................................................................................		(66,000)
Capital gain....................................................................................................................................		$ 31,000
Taxable capital gain (¹/₂ ´ $31,000).......................................................................................................		$ 15,500
Capital dividend account (¹/₂ ´ $31,000)...............................................................................................		$ 15,500
(5) Equipment:
UCC......................................................................................................................................................		$ 10,000
Less: lower of cost or proceeds.............................................................................................................		6,000
Terminal loss.........................................................................................................................................		$ (4,000)
(6) Marketable securities:
Proceeds................................................................................................................................................		$ 26,000
Adjusted cost base.................................................................................................................................		(26,000)
Increase in value....................................................................................................................................		Nil
Taxable capital gain................................................................................................................................		Nil
Capital dividend account........................................................................................................................		Nil
(7) CEC balance .................................................................................................................	$ 20,600
Proceeds ´ ³/₄................................................................................................................	(97,500)
	(76,900)
Previous CECA ((³/₄ ´ $42,453) – $20,600) ................................................................	11,240
Balance .........................................................................................................................	$ 65,660
Income: ²/₃ ´ $65,660 .................................................................................................	$ 43,773
Recapture (above) .........................................................................................	11,240	$ 55,013
CDA: ²/₃ ´ $65,660.......................................................................................................		$ 43,773*

* Check: ¹/₂ ´ ($130,000 – $42,453) = $43,773

(8) Tax @ 20% on active business income (20% of $116,013)......................................................	$ 23,203
Tax @ 46²/₃% on investment income (46²/₃% of $44,000).......................................................	20,533
Total tax..............................................................................................................................................	$ 43,736
(9) RDTOH (26²/₃% of $44,000)...........................................................................................................	$ 11,733

Problem 8 (Advanced)

[ITA: 14, 38, 82, 83(2), 117, 121, 123, 124, 129]

Mr. Lotsaluck incorporated a company in 2008 in a province with a 20% corporate tax rate on active business income, a 40% total corporate tax rate on other income, before the 6 ²/₃% additional refundable tax, and a 46% combined personal tax rate (including a 17% personal provincial tax on income rate), taking one share with a paid-up capital value of $1 and a note representing a loan to the company of $499,999. The company, Luck Unlimited Limited, a private corporation, purchased the assets of a business in the same year for $500,000. The purchase price was allocated to the land and building of the business in the amount of $400,000 and to goodwill in the amount of $100,000. However, before the business had commenced, the company sold the assets of the business for $700,000, including $170,000 for goodwill.

—REQUIRED

Assume that the sale of land and building was considered to result in a capital gain. How much of the $700,000 received in the corporation would Mr. Lotsaluck retain, if he removed all of this amount from the corporation.

Solution 8 (Advanced)

(A) Corporation’s position
Proceeds for land and building ($700,000 – $170,000) ................................................	$ 530,000
Cost ..............................................................................................................................	(400,000)
Capital gain ...................................................................................................................	$ 130,000
Taxable capital gain (¹/₂ ´ $130,000).............................................................................		$ 65,000
Proceeds for goodwill ´ ³/₄ ($170,000 ´ ³/₄) ................................................................	$ 127,500
Cumulative eligible capital balance ($100,000 ´ ³/₄) .....................................................	(75,000)
Balance .........................................................................................................................	$ 52,500
Income ²/₃ ´ $52,500.............................................................................................................................		35,000
Division B income and taxable income..................................................................................................		$ 100,000
Tax (20% ´ $35,000) + (46²/₃% ´ $65,000).........................................................................................		$ 37,333
Refundable portion of Part I tax on TCG...............................................................................................
(26²/₃% of $65,000)		$ 17,333
Capital dividend account:
Untaxed one-half of capital gain....................................................................................................		$ 65,000
Untaxed CEC (¹/₂ ´ ($170,000 – $100,000))................................................................................		35,000
Balance..........................................................................................................................................		$ 100,000
Funds available for distribution:
Proceeds of sale of business..........................................................................................................		$ 700,000
Tax.................................................................................................................................................		(37,333)
Dividend refund (requires taxable dividend of $51,999)...............................................................		17,333
Funds available..............................................................................................................................		$ 680,000
Distribution by corporation:
Repay loan (no tax consequences).................................................................................................		$ 499,999
Redeem share (tax-free).................................................................................................................		1
Elect capital dividend (tax-free) [ssec. 83(2)].................................................................................		100,000
Taxable dividend (sufficient for dividend refund)..........................................................................		80,000
Total distribution............................................................................................................................		$ 680,000
(B) Shareholder’s position
Taxable dividend....................................................................................................................................		$ 80,000
Gross-up (¹/₄ ´ $80,000).......................................................................................................................		20,000
Increase in taxable income.....................................................................................................................		$ 100,000
Tax on taxable income increase:.............................................................................................................
Combined federal and provincial tax @ 46%.................................................................................		$ 46,000
Less: combined dividend tax credit (²/₃ ´ $20,000 + ¹/₃ ´ $20,000)..............................................		(20,000)
Net tax on distribution from corporation		$ 26,000
(C) Summary
Proceeds to corporation.........................................................................................................................		$ 700,000
Net tax paid by corporation ($37,333 – $17,333) .........................................................	$ 20,000
Net tax paid by shareholder ..........................................................................................	26,000	46,000
Net retained by shareholder...................................................................................................................		$ 654,000

Problem 9 (Advanced)

[ITA: 54, 83(2), 84(2), 84(2.1), 89(1)]

Ms. Debbie, the sole shareholder of Shining Limited, a CCPC, has been considering selling her common shares to Let’s-Make-a-Deal Ltd., a CCPC. However, Ms. Debbie recalls reading somewhere that one should compare a share sale with an asset sale to determine which would result in higher after-tax cash flow.

Ms. Debbie provides you with the following information:

(1) The cost of Ms. Debbie’s common shares in Shining Limited was $120,000.

(2) Shining Limited pays tax at the overall rate of 20% on the first $300,000 (assuming that the other $100,000 is allocated to an associated corporation) of active business income, 33% on the additional active business income, and 40% on all other income, plus the 6²/₃% additional refundable tax on investment income. The corporation has a GRIP balance of nil.

(3) Ms. Debbie’s combined federal and provincial personal tax rate is 46%, including a personal provincial tax on income rate of 17%. The provincial tax dividend tax credit is 6²/₃% of the grossed-up dividend from the LRIP and 12.1% of the grossed up dividend from the GRIP.

(4) Financial information concerning Shining Limited on December 31, 2008 is as follows:

Assets	Book cost	UCC	FMV
Cash (required as working capital)............................................	$ 23,000
Marketable securities (required as working capital)...................	58,000		$ 54,000
Inventory...................................................................................	41,000		50,000
Land..........................................................................................	154,000		210,000
Building (Note).........................................................................	213,700	$ 195,000	440,000
Goodwill...................................................................................	Nil		85,000
	$ 489,700		$ 839,000
Liabilities
Current liabilities.......................................................................	$ 43,000
Future income taxes...................................................................	4,800
Paid-up capital...........................................................................	120,000
Capital dividend account............................................................	48,000
Retained earnings......................................................................	273,900
	$ 489,700

(5) Shining Limited earned active business income of $50,000 during the year.

NOTE: The original cost of the building in Class 1 was $410,000. Book cost of $213,700 is net book value after accumulated amortization.

—REQUIRED

(A) If Ms. Debbie sells all of the assets, except cash, to Let’s-Make-a-Deal Ltd., pays the outstanding liabilities, and then winds up Shining Limited, what would be the net amount available for distribution to her? Show all computations.

(B) Determine the components of the distribution to Ms. Debbie.

(D) Determine a selling price for the Shining Limited shares that results in the same after-tax net cash retained as the net cash from sale of assets followed by a wind-up, as determined in Part (C).

(E) Based on the indicated fair market value of the net assets, what is the maximum price a Canadian-controlled private corporation should be willing to pay for the shares of Shining Limited? Assume that the CCPC pays tax at the low rate of 20% on all of its business income, that it uses an after-tax discount rate of 10%, and that it does not expect to sell the fixed assets of Shining Limited for a very long time. Also, assume that if the purchaser bought the assets, it would have to invest $23,000 in cash to meet working capital requirements.

Solution 9 (Advanced)

(A)

	Actual or deemed proceeds	Income generated			Capital dividend account		RDTOH

		ABI	AII
Income during year/opening balances..............		$ 50,000			$ 48,000
Cash.................................................................	$ 23,000	Nil
Marketable securities⁽¹⁾....................................	54,000	Nil	$ (2,000)		(2,000)
Inventory.........................................................	50,000	9,000
Land⁽²⁾.............................................................	210,000	Nil	28,000		28,000
Building⁽³⁾........................................................	440,000	215,000	15,000		15,000
Goodwill⁽⁴⁾......................................................	85,000	42,500			42,500
Bonus⁽⁵⁾...........................................................	(16,500)	(16,500)
Liabilities.........................................................	(43,000)
Income taxes⁽⁶⁾.................................................	(79,133)	$ 300,000	$ 41,000				$ 10,933
RDTOH⁽⁷⁾.......................................................	10,933						$ 10,933
	$ 734,300				$ 131,500
(B) Calculation of deemed taxable dividend on the winding-up:
Funds available for distribution...........................................................................................................						$ 734,300
Less: Paid-up capital.................................................................................................................						(120,000)
Deemed dividend [ssec. 84(2)]............................................................................................................						$ 614,300
Less: Capital dividend elected [ssec. 83(2)]..............................................................................						(131,500)
Deemed taxable dividend						$ 482,800
(C) Calculation of taxable capital gain on winding-up:
Actual proceeds...................................................................................................................................						$ 734,300
Less: Deemed dividend [sec. 54 def. of proceeds of disposition].............................................						(614,300)
Deemed proceeds of disposition..........................................................................................................						$ 120,000
ACB....................................................................................................................................................						(120,000)
Capital gain..........................................................................................................................................						$ Nil
Taxable capital gain..............................................................................................................................						$ Nil
Net cash retained after sale of assets and winding-up:
Funds distributed.................................................................................................................................						$ 734,300
Bonus..................................................................................................................................................						16,500
Tax on incremental income:
Deemed taxable dividend.....................................................................................				$ 482,800
Gross-up..............................................................................................................				120,700
				$ 603,500
Bonus..................................................................................................................				16,500
Taxable capital gain..............................................................................................				Nil
				$ 620,000
Combined taxes @ 46%......................................................................................				$ 285,200
Less: Combined dividend tax credit (13⅓% + 6⅔% ´ $603,500)....................				120,700		(164,500)
Net cash retained..................................................................................................................................						$ 586,300

(D) Minimum share price acceptable:

The calculation of net retention can be represented algebraically as:

P – .46 [½ (P – $120,000)], where P = proceeds of disposition

To equate the above expression with the net cash retained of $586,300 derived in Part (C), above, from the sale of assets and the wind-up of the corporation, the following equation in one unknown results:

P – .46 [½ (P – $120,000)] = $586,300

Solving for P, P = $725,584

Therefore, Ms. Debbie should require an offer of $725,584 for the shares, given the indicated fair market value of the net assets.

Note that if the capital dividend account is paid to Ms. Debbie, before the sale of the shares, the $48,000 would be received tax free, instead of as proceeds for the shares. Although the value of the shares would fall, tax on $48,000 of capital gain would be saved. In that case, the minimum share price would be determined from the following:

$48,000 + P – .46 [½ (P – $120,000)] = $586,300

Solving for P, P = $663,247

(E) Maximum share price acceptable to Let’s-Make-A-Deal:

On the purchase of marketable securities, which are part of the working capital requirements of the business, the ACB is established at fair market value of $54,000. If shares of Shining Ltd. are purchased, the resultant acquisition of control will require a realization of the accrued capital loss [par. 111(4)(c)] at the deemed taxation year-end with a new ACB established at $54,000, the fair market value. Therefore, there is no difference in the tax consequences between a purchase of assets and a purchase of shares on the marketable securities.

On the purchase of inventory, the cost is established at fair market value of $50,000. If shares are purchased, the purchaser steps into the vendor’s tax position for the inventory which has a cost of $41,000. A gain of $9,000 will be realized on the ultimate disposition of the inventory by the purchaser corporation. Therefore, on the purchase of the shares there is an inherent tax liability of $1,800 (i.e., $9,000 ´ .20) on the sale of inventory within the year. This inherent tax liability should lower the value (i.e., increase the cost) of the shares by $1,800 from the purchaser’s perspective.

On the purchase of the land, the ACB is established at fair market value of $210,000. If the shares are purchased, the purchaser assumes the inherent tax liability for the $56,000 of capital gain accrued on the land. However, this tax is only incurred on the sale of the land by the purchaser. In this case, since the purchaser does not anticipate a sale in the foreseeable future, the present value of this future tax can be assumed to be negligible.

On the purchase of the building, the UCC and the ACB are established at fair market value of $440,000. If shares are purchased, the purchaser assumes the tax liability for the recapture of $215,000 and the capital gain of $30,000 if they are ultimately realized on the disposition of the building. Again, since the purchaser does not anticipate a sale of the building in the foreseeable future, the present value of this future tax can be assumed to be negligible.

However, on the purchase of the building, the purchaser can benefit from an increase in CCA, relative to a purchase of shares, which will shield future income from tax. The present value of the tax shield for the purchase of a building in Class 1-NRB in this case is given by:

= $31,500

If shares are purchased, the corporation continues to deduct CCA in Class 1 on a UCC base of $195,000, providing a tax shield with a present value given by:

= $11,143

The incremental tax saved from CCA on the purchase of assets in present value terms is $20,357 (i.e., $31,500 – $11,143).

On the purchase of goodwill at a fair market value of $85,000, the purchaser can add $63,750 (i.e., ³/₄ ´ $85,000) to its cumulative eligible capital account and it can amortize that amount at 7% on a declining balance basis. The present value of the write-off is given by:

= $5,250

To summarize these effects, the following is a calculation of the cost of a purchase of assets net of the cost reduction discussed above:

Cost of assets at FMV ($839,000 + $23,000*)...................................................................................		$ 862,000
Tax savings:
PV of future CCA/CECA:
Building.......................................................................................................	$ 31,500
Goodwill......................................................................................................	5,250	(36,750)
After-tax cost of assets........................................................................................................................		$ 825,250

* While the purchaser would not buy cash, if the corporation requires the $23,000 for working capital, the purchaser will have to invest that amount in the business being acquired.

Next, we need to determine what the purchaser would pay for the shares to have an after-tax cost of $825,250. This calculation would be as follows:

Price of shares.............................................................................................................	x =	$ 781,593
Liabilities assumed......................................................................................................	$ 43,000	43,000
Tax on income of $50,000	10,000	10,000
Tax savings:
PV of future CCA:
Building.......................................................................................................	(11,143)	(11,143)
Tax costs:
PV of tax on accrued gains:
Inventory.....................................................................................................	1,800	1,800
After-tax cost of shares...............................................................................................	$ 825,250	$ 825,250

This net cost of $781,593 is the maximum amount that the purchaser should be willing to pay for the shares of Shining Ltd.

The results of the analysis of Parts (E) and (F) can be summarized, in terms of pre-tax costs and equivalent values, as follows:

Purchaser’s after-tax cost:
	Pre-tax	After-tax
Asset purchase.............................................	$ 862,000	$ 825,250
Share purchase.............................................	$ 781,593	$ 825,250
Vendor’s after-tax proceeds:
	Pre-tax	After-tax
Asset sale.....................................................	$ 862,000	$ 586,300
Share sale.....................................................	$ 725,584	$ 586,300

This table can be further summarized as follows:

	Assets	Shares
The maximum the purchaser will pay..................................................................	$ 862,000	$ 781,593
The minimum the vendor will accept...................................................................	862,000	725,584

In this case, given that the value of the assets is established to be $862,000, a transaction in shares can be negotiated to the benefit of both vendor and purchaser. To be better off on the sale of shares, Ms. Debbie, the vendor, must receive more than $725,584. To be better off on the purchase of the shares, the purchaser must pay less than $781,593. In this case, therefore, there is a negotiation range for a transaction in shares between $725,584 and $781,593.

If the $48,000 balance in the capital dividend account is paid to Ms. Debbie as a tax-free dividend, then she requires a minimum of only $663,247 for the shares, to be indifferent between a sale of shares and a sale of assets. In this case, the range for negotiation of a share price changes from a low of $663,247 to a high of $733,593 (i.e., $781,593 – $48,000, since the value of the shares and the net assets will decrease by the $48,000 distributed as a capital dividend).

However, it should be noted that there may be a bigger benefit to the vendor in selling the assets and holding the net proceeds in the corporation to defer the tax on the distribution dividend. That tax amounts to about $156,910 (i.e., $164,500 – .46 ´ $16,500).

—NOTES TO SOLUTION

(1) Proceeds of disposition................................................................................................................	$ 54,000
ACB............................................................................................................................................	(58,000)
Capital loss..................................................................................................................................	$ (4,000)
Allowable capital loss..................................................................................................................	$ (2,000)
Capital dividend account..............................................................................................................	$ (2,000)
(2) Proceeds of disposition................................................................................................................	$ 210,000
ACB............................................................................................................................................	(154,000)
Capital gain..................................................................................................................................	$ 56,000
Taxable capital gain (½ ´ $56,000)..............................................................................................	$ 28,000
Capital dividend account..............................................................................................................	$ 28,000
(3) Proceeds of disposition................................................................................................................	$ 440,000
Capital cost..................................................................................................................................	(410,000)
Capital gain..................................................................................................................................	$ 30,000
Taxable capital gain......................................................................................................................	$ 15,000
Capital dividend account..............................................................................................................	$ 15,000
Recapture ($195K – $410K)........................................................................................................	$ 215,000

(4) ³/₄ of proceeds = ³/₄ ´ $85,000....................................................................................................	$ 63,750
Capital dividend account (²/₃ ´ $63,750).....................................................................................	$ 42,500
Income (²/₃ ´ $63,750)................................................................................................................	$ 42,500
(5).. The $400,000 business limit for the small business deduction must be prorated for the number of days in the taxation year. Since the winding-up may take some time to complete, this solution assumes that the corporation maintains its eligibility for the small business deduction in the year in which the sale of assets occurs [IT-73R6 pa. 9]. In this case, $16,500 of business income would be taxed at the corporate rate given as 33% for this problem. Therefore, it is probably advisable to declare and pay a bonus equal to $16,500 to avoid the double taxation that occurs when integration is not perfect, particularly, if the winding-up will take place fairly soon, such that there is little deferral advantage. Imperfect integration will continue if the corporate rate of tax on high-rate business income exceeds 31%. The bonus will be taxable, directly, in the hands of Ms. Debbie.
Note that as part of the payment of liabilities, the bonus will be paid to Ms. Debbie who will pay personal tax on that bonus.
(6) Tax @ 20% of $300,000.............................................................................................................	$ 60,000
Tax @ 46²/₃% (i.e., 40% + 6²/₃%) of $41,000.............................................................................	19,133
Total Part I tax.............................................................................................................................	$ 79,133
(7) Refundable portion of Part I tax for RDTOH (26²/₃% of $41,000).............................................	$ 10,933

Advisory Case

Case 1: Palace Catering Ltd.

Glenda is considering the purchase of a family-run catering business, called Palace Catering Ltd. The corporation specializes in the planning, preparation, and hosting of professional dinners, parties, and activities. Although Glenda is qualified for operating and managing the business, there is a high probability that profits from operating this business will not begin for a couple of years. She is wondering if she should purchase the net assets from the corporation or 100% of the shares presently held by the vendor family. The corporation had a proven record of profits until two years ago, when the death of the chef, along with the retirement of two employees resulted in a loss of business. The accumulated non-capital loss carryforward is $84,000.

Glenda's plan for the new business is to carry on catering. She is also toying with the idea of producing dessert cakes for sale to hotels and restaurants. Over the next two years she expects she could make profits on the sale of cakes of $4,000 and then $18,000. Thereafter, she estimates profit from the cakes of about $25,000 annually.

Glenda plans to use an 8% small business loan to purchase the business. If there are any further operating losses she will use the proceeds from her bond investment to finance the business over the next few years. From January 1 to August 31 of the current year, Glenda earned $38,000 as senior hostess at the Professional Club in Saskatoon, and $12,000 in interest income.

Glenda would like your advice on what should be considered in deciding on a share purchase or an asset purchase.

—ADVISORY CASE DISCUSSION NOTES

· Main issues:

· Should Glenda purchase the shares or assets of the corporation?

· If she were to purchase the assets, should she incorporate a new company (presently or in the future)?

· Factors to be considered:

(1) If Glenda purchases the shares of the corporation, the non-capital loss carryforwards will continue to be available to the corporation (against future profits) as the loss business is continuing to operate. However, as she is forecasting continuing losses, there is a low risk that the carryforward losses could expire before they are used.

(2) If Glenda acquires assets and operates the company as a proprietorship, the accumulated non-capital loss carryover is lost. However, as she has not paid anything for the “value” of those losses, she has not really lost anything in this respect.

(3) If Glenda acquires assets, the continuing operating losses (as projected) would be deductible from her other sources of income. This way, there would at least be some tax recovery from the losses, whereas inside the corporation, there is no income to deduct them from. Should the business prove to be profitable in the future, she can always incorporate at that time.

(4) If Glenda acquires the shares, she could write off her share purchase price as an ABIL (against any type of income), should the business fail. In an asset purchase scenario, the same would be true, only it would be terminal losses on equipment and on eligible capital property (goodwill), if any.

(5) Although a corporation provides “limited liability^” in the event of a business failure, banks advancing loans often require that shareholders sign personal guarantees. Considering Glenda’s lack of business experience, she will most likely have to sign such a guarantee in order to obtain her 8% small business loan. The corporate form of organization does not provide Glenda with limited liability in regard to the bank loan.

(6) No information is provided about the purchase price of either the assets or the shares. If shares are being acquired, the purchase price is (presumably) less as liabilities are also being assumed. The two different prices must be considered in any decision.

(7) If the shares are acquired, what protection does she have from undisclosed liabilities or potential future tax reassessments for potential wrongful past tax filings?

The more conservative approach would be to acquire assets and, then, if the business ultimately proves profitable, incorporate.

Case 2: Ottawa Associates Inc.

Ottawa Associates Inc. is a business that was set up 25 years ago by Grant Carter to provide consulting services to the federal government. When the economy was good, the company was able to generate substantial profits and, even now, with a slow economy, the profits are approximately $450,000 before tax. Grant now feels that the company is worth $1,200,000 based on the income it is generating.

Grant is 50 years old this year. When he started the business, another shareholder, John Price, owned the other 50% of the shares. Each had put $10,000 of cash into the corporation as share capital. Initially, their working relationship had been excellent, but John had wanted to branch out into other areas of consulting, while Grant wanted to concentrate on government consulting. Fifteen years ago, they had agreed to go their own separate ways and Grant had bought John's shares from him for $30,000.

Grant's wife, Betty, does not work in the business directly. However, she does receive a salary for her work as secretary-treasurer of the corporation and for the time she spends on charitable activities, which is sometimes of benefit to Grant in his business. Grant would like to involve Betty in the ownership of the business, unless there are any problems with this.

Grant and Betty's two children, Scott and Kelly, are 21 and 16 years old, respectively. Scott is in university at Queen's and Kelly is in high school in Ottawa. At this point, it is not certain whether Scott and Kelly will join Grant in the business, but both are open to the possibility. Both work in the business during the summer holidays and are paid enough to cover their schooling costs.

Grant and Betty are now planning to build the cottage they have always wanted. They feel they need a place to unwind on the weekends and, also, they want a place for the children to come back to once they have left home. They see the cottage as a family gathering place. The land and construction costs are going to be approximately $200,000. Although they have that much extra cash in the corporation, they do not want to pay tax on the dividends to get the cash out. As a result, they plan to take out a mortgage to finance the cottage and pay it off over 10 years from Grant's bonus cheques.

Please provide your recommendations.

—ADVISORY CASE DISCUSSION NOTES

The main issues in this case relate to:

· compensation, and

· how to get cash out of a corporation.

1. Compensation

(a) Bonus

· The pre-tax profit in the corporation is $450,000, so he could pay himself a bonus of $50,000 on which he would pay about 46% tax, leaving $27,000 after tax.

· Alternatively, the corporation could retain the income and pay tax at 36% (22.1% federal and 14% provincial) leaving about 64%, or $32,000, after tax.

· The tax deferral is (46% − 36%) × $50,000 = $5,000.

· If the funds are kept in the corporation, then the $32,000 could be paid out later as a dividend from GRIP with personal tax of approximately 22% (after the 45% gross-up and tax credit) on this dividend, leaving about $25,000 after tax.

· If a bonus is not paid, then:

o corporate tax instalment options will be based on this higher tax liability;

o the final tax instalment will be due at the end of the second month instead of at the end of the third month following year end;

o some tax is deferred with a little double tax on payment of the dividend until corporate rates are closer to 31% in 2011.

· If a bonus is declared, then:

o Was there a valid liability at December 31?

o Is it reasonable?

o Will it be paid before 180 days after the year end?

o Some double tax will be avoided; in fact, a slight tax savings will be realized.

(b) Salary to Betty

· Is the salary reasonable in relation to the work performed?

· Especially important since she is not dealing at arm's length.

· What is reasonable to pay a secretary-treasurer for the activities she performs?

· Was this expense incurred to earn income, since her activity was to be involved with local charities?

· If disallowed, then double tax; no deduction in the company but income to the recipient.

· What is a reasonable amount to pay Scott and Kelly?

· Was this expense incurred to earn income ?

· If disallowed, then double tax; no deduction in the company but income to the recipient.

(d) Reorganization to involve Betty in share ownership and provide her with dividend income

· Given the excess cash it is holding, the corporation may not be a small business corporation (SBC) (may not meet the 90% test).

· Grant cannot crystallize to use up his capital gain exemption if the company does not qualify as an SBC.

· He might consider purifying the company by paying out the PUC, paying off liabilities, or paying a dividend, etc.

· The corporate attribution rules in subsection 74.4(2) may apply to deem an interest benefit on the full value of the shares received as consideration less any interest received and ⁵/₄ times any dividend received.

2. Methods of Receiving Cash from the Company

(a) Paid-up capital reduction

· The paid-up capital of the corporation appears to be $20,000.

· Now that Grant owns all the shares, he can reduce the paid-up capital of the company by $20,000 and there will be no deemed dividend under subsection 84(4).

· A PUC reduction will causes a corresponding reduction in his ACB, but since his ACB is $40,000 before the reduction this will only reduce his ACB to $20,000.

(b) Arm's length ACB

· Grant can transfer his shares to a holding company under subsection 85(1), elect at whatever value he chooses between his ACB and FMV, and take back cash equal to his arm's length ACB without triggering a subsection 84.1 deemed dividend.

· This is one way of getting some extra cash out of the corporation tax free, i.e., the $20,000 by which his ACB exceeds the PUC.

· Interest paid on a mortgage taken out to buy a cottage personally will not be deductible.

· They can borrow from the company but need to assess subsections 15(2), 80.4(1), and 80.4(2).

· Who should borrow the money, Grant or Betty?

· This withdrawal of cash will probably not cause the corporation to become a SBC, since the cash has been replaced with an investment.

3. Other Issues

(a) Valuation

· Is the company really worth $1,200,000, or is most of that value personal goodwill of Grant?

(b) Holding company

· Consider setting up a holding company to separate the excess cash from the business liabilities.

· After the holding company has been established, pay a dividend.

· On the transfer to the holding company, the capital gain exemption can be crystallized by electing under subsection 85(1).

· Betty could be included in the ownership, but corporate attribution [ssec. 74.4(2)] needs to be considered

· He can receive cash on the transfer equal to the ACB without triggering a deemed dividend under section 84.1.

Monday, January 7, 2013

Accounting : Taxation