saskatchewan cpled program corporate commercial section 9...

Saskatchewan CPLED Program Corporate Commercial Section 9

The Taxation of Corporations

Contents

Introduction ....................................................................Corporate-9-1

The Corporate Taxpayer................................................Corporate-9-1

The Taxation of Corporations: General Principles .......Corporate-9-2

Federal and Provincial Taxation ..............................Corporate-9-2

Basis for Saskatchewan Provincial Tax.....................Corporate-9-2

Basis for Federal Tax ................................................Corporate-9-2

The Calculation of Income .......................................Corporate-9-4

Calculation of Taxable Income ................................Corporate-9-5

Calculation of Tax ....................................................Corporate-9-6

Other Income................................................................Corporate-9-11

Personal Services Business ......................................Corporate-9-11

Investment Income Dividends and Other Sources .........................................................Corporate-9-12

The Decision to Incorporate .........................................Corporate-9-14

Introduction ............................................................Corporate-9-14

Advantages to Incorporation ..................................Corporate-9-14

Disadvantages to Incorporation..............................Corporate-9-18

Corporate Reorganizations .......................................... Corporate-9-20

General Background .............................................. Corporate-9-20

Non-Dispositions.................................................... Corporate-9-20

“Rollover” Provisions – General ............................Corporate-9-21

Transfer of Property to a Corporation: Section 85(1) ...........................................................Corporate-9-22

No part of this material may be reproduced, in whole or in part Corporate–9–i (in any manner), without the specific written permission of Saskatchewan Legal Education Society Inc. (2008 © SKLESI).

Corporate Commercial Section 9 The Taxation of Corporations 2008 © SKLESI

Corporate Reorganizations (continued)

Incorporation of a Partnership: Section 85(2), 3....................................................... Corporate-9-25

Share-for-share Exchange: Section 85.1 ............... Corporate-9-26

Share Capital Reorganization: Section 86............ Corporate-9-26

Corporate Distributions................................................ Corporate-9-27

Dividends and Paid-up Capital .............................. Corporate-9-27

Deemed Dividends ................................................. Corporate-9-28

Corporate–9–ii Saskatchewan CPLED Program

Corporate Commercial Section 9 2008 © SKLESI The Taxation of Corporations

Introduction

This chapter identifies some of the basic corporate tax issues you will likely encounter at the entry level of a business law practice and those that will require advice from a tax specialist.

Throughout this chapter you will see references to both federal and provincial legislation including the Income Tax Act, R.S.C. 1985 (5th Supp.), c. 1, as amended (“ITA”); The Income Tax Act (Saskatchewan), R.S.S. 1978, c.I-2, as amended; The Income Tax Act, 2000 (Saskatchewan), S.S. 2000, c.I-2.01, as amended; and The Saskatchewan Corporation Capital Tax Act.

The Corporate Taxpayer

A corporation is a separate taxpayer for income tax purposes and must calculate and pay its income tax based on its own taxable income.

The rate of tax payable by a corporation will depend on the type of income earned and the corporation’s status as a private corporation, public corporation, or Canadian-controlled private corporation (“CCPC”).

The ITA contains definitions of the different "types" of corporations. Never assume that a corporate client is a particular status or corporate type. The definitions are not always what one would imagine. For example, a wholly-owned subsidiary of Petro-Canada would not be a CCPC even though it is a private corporation with a Canadian parent. As well, a CCPC need not be "Canadian-controlled" to qualify (50 percent Canadian ownership / 50 percent foreign ownership will qualify).

The ITA contains many complex rules for determining who controls a particular corporation. The control of a corporation can affect its ability to claim the small business deduction (discussed below) as well as the special Part IV tax payable by a private corporation in respect of certain intercorporate dividends received by it.

Saskatchewan CPLED Program Corporate–9–1

http://www.canlii.org/ca/sta/i-3.3/





The Taxation of Corporations: General Principles

Federal and Provincial Taxation Taxes on income are considered to be direct taxes with the result that federal, provincial and territorial jurisdictions have the power to impose them.

Certain provinces have entered into collection agreements with the federal government, under which the federal government collects both federal and provincial income taxes. For Saskatchewan, both corporate and personal income tax is administered in such a manner. The Province of Saskatchewan has also established its own corporation capital tax structure, which it administers separately. However, the Saskatchewan corporation capital tax has started to be phased out in 2007 and should be fully phased out after June 30, 2008.

Basis for Saskatchewan Provincial Tax In general terms, a corporation that has a permanent establishment in Saskatchewan is liable for tax calculated on income it earns worldwide.

As indicated above, Saskatchewan has entered into an agreement with the federal government to collect and administer corporate and personal income tax on its behalf. Therefore, the computation of Saskatchewan tax follows the ITA.

Basis for Federal Taxation Residence Under the ITA, persons resident in Canada at any time in a particular taxation year must pay tax on their worldwide taxable income earned in that year. By definition, "persons" includes corporations.

Because of the artificial nature of a corporation, it does not reside anywhere as an individual does. However, at common law, a corporation is considered resident in the jurisdiction where its central "mind and management" is exercised, that is, where its directors meet and business decisions are made.

Corporate–9–2 Saskatchewan CPLED Program



A corporation can be deemed to be resident in Canada, even if its central mind and management are not exercised in Canada. Under section 250(4) of the ITA, a corporation is deemed to be a resident of Canada throughout a taxation year if, among other things:

• it was incorporated in Canada after April 26, 1965; or

• it was incorporated in Canada on or before April 26, 1965, and in any taxation year ending after April 26, 1965, it was resident in Canada (through the exercise of its central mind and management or it carried on business in Canada).

Non-Resident Corporations In limited circumstances, corporations not resident in Canada can be subject to tax in Canada, where Canada is considered to be the source of income earned. In general terms, non-resident corporations will be taxed on:

• business income earned in Canada; and

• gains realized on the disposition of taxable Canadian property (e.g., real estate).

In respect of business income, the non-resident:

• must be carrying on a business; and

• must do so in Canada. "Business" is defined in section 248(1) of the ITA as including a profession, trade, calling, manufacture or undertaking of any kind whatever and will generally include an adventure or concern in the nature of trade. Section 253 of the ITA deems a taxpayer to be carrying on business in Canada if it does certain things, including soliciting orders or offering anything for sale in Canada through an employee or an agent regardless of where the contract or transaction is completed.

“Taxable Canadian property" is defined in section 248(1) of the ITA as including real property situated in Canada, capital property used in carrying on a business in Canada, a share in the capital stock of a corporation resident in Canada that is not listed on a prescribed exchange, an interest in certain types of partnerships, and a capital interest in certain trusts. The ITA requires a seller to obtain a certificate from the Minister of National Revenue (the “Minister”) evidencing payment of tax or the provision of security for the tax. If no certificate is obtained, liability for the tax is on the buyer.








The ITA also imposes a tax on certain types of payments made to non-residents. In order to ensure collection of the tax levied, a payor is obliged to withhold a specified portion of each payment on account of tax and remit it to the Receiver General for Canada.

Further, certain non-resident corporations may be subject to a "branch tax" under Part XIV of the ITA in respect of a business carried on in Canada.

It is important to note that the legislation contained in a signed tax convention with another country may alter tax consequences of the above-mentioned legislation. Generally, such agreements are relieving in nature. However, further discussion on the tax conventions that are in place and how they are used is beyond the scope of this chapter.

The Calculation of Income Section 3 of the ITA provides the statutory framework for computing a corporation's income. In general terms, it provides that a corporation's income for a taxation year is determined by the following rules:

• determine its income for the year from business or properties from all sources inside or outside Canada;

• add the excess of

◊ taxable capital gains (except for "listed personal property") and taxable net gains from listed personal property; over

◊ allowable capital losses (except for listed personal property), excluding allowable business investment losses;

• deduct available deductions under the ITA; and

• deduct losses from business or property and allowable business investment losses.

A taxpayer's income from a business or property will be his or her profit. There is no definition of "profit" in the ITA. So, profit calculation is made in accordance with generally accepted commercial practice, subject to the express provisions of the ITA and applicable jurisprudence related to specific items of inclusion and deduction. In this regard, corporations will generally start with the financial statements that have been prepared under the generally accepted accounting principles and then make the required adjustments to get from accounting income to “income” for tax purposes.









Some of the more common adjustments that are made to get to ”income” for tax purposes include, but are not limited to:

• Additions to accounting income:

◊ non-deductible interest and penalties;

◊ amortization/Depreciation of tangible and intangible assets;

◊ recapture of capital cost allowance from the disposition of a capital asset;

◊ loss in equity of Subsidiaries and affiliates;

◊ loss on the disposal of assets;

◊ scientific expenditures deducted on the financial statements;

◊ non-deductible club dues and fees;

◊ non-deductible meals and entertainment expenses;

◊ non-deductible life insurance premiums; and

◊ non-deductible financial statement reserves, such as a general reserve for allowance for doubtful accounts receivable.

• Deductions from accounting income:

◊ gain on disposal of assets per financial statements;

◊ capital cost allowance and terminal losses from capital assets; and

◊ scientific research expenses as calculated and claimed under the ITA.

Other sections of the ITA require specific amounts to be included in “income”, for example, dividends and other amounts deemed to be income for tax purposes.

Calculation of Taxable Income Once a taxpayer's "income" for a taxation year has been determined, it is permitted to deduct certain other amounts within prescribed limits in order to arrive at "taxable income" including:

• taxable dividends from taxable Canadian corporations, resident corporations and certain foreign corporations;

• donations; and

• losses from other years.




Calculation of Tax Corporate taxes payable are calculated as a percentage of taxable income or, in the case of non-residents, taxable income earned in Canada. The calculation of tax will also depend on the type of corporation.

Types of Corporations Corporations are generally classified under the ITA as "public corporations" or "private corporations". Under section 89(1) of the ITA, a corporation will be a public corporation in any one of the following circumstances:

• it is a corporation that is resident in Canada and one or more classes of its shares are listed on one of the stock exchanges prescribed by the regulations made pursuant to the ITA;

• it is a corporation that is resident in Canada and at any time after June 18, 1971, it elected in the prescribed manner to be a public corporation, and at the time of the election complied with certain prescribed rules relating to the number of shareholders, the public trading of its shares and the dispersal of share ownership; or

• the Minister has designated the corporation as a public corporation for purposes of the ITA.

In limited cases, the status of a corporation can be changed so that it ceases to be a public corporation:

• if the corporation elects to do so and satisfies certain criteria relating to the number of shareholders, the public trading of its shares and the dispersal of share ownership; or

• the Minister designates it not to be a public corporation. A private corporation is defined in section 89(1) of the ITA as a corporation that is resident in Canada, is not a public corporation and is not directly or indirectly controlled by one or more public corporations or prescribed federal Crown corporations.

A third category of corporation is possible, given the wording of section 89(1). A resident corporation that is controlled by one or more other resident public corporations and that itself is not a public corporation, will fall into this unspecified third category.








A number of types of corporations are subject to special rules in the ITA. These rules are generally designed to accomplish a specific taxation treatment and are beyond the scope of this chapter.

Theory of Integration While a detailed analysis of the theory of integration is beyond this discussion, a conceptual understanding of it is necessary to appreciate the necessity for varying tax rates and to arrive at a form of business organization most appropriate to a particular taxpayer.

The theory of integration is that the form of business organization should not impact the total amount of tax payable. In other words, regardless of whether business is conducted by an individual taxpayer directly or through the use of a corporation, the total tax payable is the same and the individual taxpayer nets the same amount of income after tax.

One mechanism under the ITA that has attempted to achieve perfect integration is the dividend tax credit. Shareholders in receipt of dividend income from a corporation are required to increase or "gross up" that income to an amount that would theoretically equal the corporation's income before tax. Tax is then calculated on that total amount, as if the shareholder earned that income directly. A dividend tax credit is then applied to reduce the tax liability as calculated, to reflect the fact that some tax has already been paid by the corporation.

Additional legislation around dividends was introduced in 2007 which created another type of dividends, “eligible dividends”, subject to a different rate of tax. These dividends were introduced as a result of changing investment strategies, investment vehicles, and the taxation of investment trusts to try and maintain the theory of integration. Eligible dividends are discussed further under Investment Income: Dividends and Other Sources.

The theory of integration is apparent in a number of ITA provisions, most notably those relating to dividend income, active business income and certain types of investment income earned by particular types of private corporations.

It is unlikely that perfect integration will ever exist due to the numerous factors that impact the ITA, including the provinces that have self regulation over their provincial tax. Further to this, there is usually a time lag between federal changes and provincial






changes that may create opportunities/disadvantages to using certain structures and different types of entities, such as trusts, partnerships, and corporations with various yearends.

The following provides a numerical example of the theory of integration for Saskatchewan and demonstrates that perfect integration has not been achieved. Assume the following facts and assumptions are used in the example:

• Example: Sole proprietorship earns $100,000 vs. Corporation earning $100,000, paying corporate tax and then paying dividend to shareholder.

• Assumes top personal tax brackets of 44% on salary and 30.83% on dividends in Saskatchewan.

Proprietor CorporationIncome 100,000 100,000 Tax 44,000 15,500

84,500

Cash available in Corp 84,500 Tax on dividend to Individual 26,052

After tax cash to Individual 56,000 58,448

In this example, operating through a corporation yields an advantage of $2,448.

The Small Business Deduction An incentive for small businesses was introduced in 1971 to encourage their development in Canada. This deduction is only available to a corporation falling within the definition of a CCPC and only to a specified income threshold earned from an “active business”. The income threshold has and will continue to increase through the introduction of new incentives in the federal budget. Initially, the threshold was $200,000.00, meaning that the deduction was applicable only to the first $200,000.00 earned through active business. This was increased to $300,000 in 2003 (ITA, section 125), and further increased to $400,000 in 2007. Currently, for a corporation with a 2008 calendar year, active business income that is subject to the small business deduction is taxed at a federal rate of 11% as opposed to the regular rate of 19.5%.




The Saskatchewan legislation also contains a small business deduction on the first $450,000 of active business income up to June 30, 2008 and up to $500,000 after that, calculated on the lesser of:

• the income for the year from an active business carried on in Canada and any specified partnership income;

• the amount by which the corporation’s taxable income exceeds certain foreign tax deductions claimed (since no Canadian tax has been paid on this income); and

• the corporation's business limit for the year. Currently, for a corporation with a 2008 calendar year, active business income that is subject to the small business deduction is taxed at a Saskatchewan rate of 4.5% as opposed to the regular rate of 12.5%. As a result, the combined federal – Saskatchewan rate for active business income subject to the small business deduction is 15.5% and the general combined federal-Saskatchewan rate is 32% for calendar 2008. Note the differing small business deduction limits allowed under the federal and Saskatchewan legislation which then creates an intermediate tax rate on active business income in excess of the federal small business limit but less than the Saskatchewan limit: 24%.

A CCPC is defined under the ITA as a private corporation that is:

• a "Canadian corporation" (a corporation that is resident in Canada at the particular time and was either incorporated in Canada or resident in Canada throughout the period that began on June 18, 1971 and ending at the time of making the determination); and

• was not directly or indirectly controlled in any manner by one or more non-resident persons, by one or more public corporations (except certain prescribed venture capital corporations), by a corporation which has its shares listed on a prescribed stock exchange, or any combination thereof.

An "active business" is defined as any "business" carried on other than a specified investment business or a personal services business (both of which are discussed below). In general terms, an active business will not include an investment business or a business incorporated by an employee in an attempt to convert employment income into business income.




Corporations that are considered “associated” under the ITA must share the income threshold to which the small business deduction applies. See section 256 of the ITA for the complex rules outlining when two or more corporations will be considered associated.

Further, there are certain "anti-avoidance" provisions in the ITA that are designed to prevent abuse of the small business incentive. For instance, a corporation that is a member of a partnership is only entitled to a pro rata share of the income threshold, based on its entitlement to share in partnership income.

Refundable Dividend Tax on Hand The government discourages the earning of investment income in a corporation as opposed to personally. This is accomplished by taxing investment income and “portfolio” dividends initially at higher rates in the corporation than what would be paid if it was earned directly by an individual. The refundable dividend tax on hand (“RDTOH”) is one of the mechanisms the ITA uses to readjust the tax impact as between the corporation and individuals once the after-tax investment income has been distributed by the corporation as taxable dividends.

That is, once a taxable dividend is paid by a private corporation, it is then eligible for a tax refund equal to 1/3 of the taxable dividends it paid in that taxation year, up to the balance in its “refundable dividend tax on hand” account (ITA, section 129). The dividend refund is issued after the corporate tax return has been filed and assessed. Therefore, the corporation will receive the refund in the subsequent fiscal period from when the taxable dividends were paid.

Generally, the RDTOH is defined as:

• where the corporation is a CCPC, the least of:

◊ 26 2/3% of the aggregate investment income less the net of the foreign non-business tax credit claimed less 9 1/3% of the foreign investment income; or

◊ 26 2/3% of the amount, if any, that the taxable income for the year exceeds the total of o the income subject to the small business

deduction; o 25/9 of the foreign non-business income tax credit

claimed; and o 10/4 of the foreign business income tax credit

claimed.

◊ the corporations Part I taxes payable for the year without reference to section 123.2;








• total Part IV taxes payable for the year; and

• the prior year RDTOH balance less the dividend refund for the preceding year.

It is important to note that RDTOH is only available to private corporations. Therefore, if a private corporation is planning on going public, they should pay a dividend sufficient to recover the amount in the RDTOH account before going public.

Other Income

Personal Services Business The provisions of the ITA relating to income from a personal services business (“PSB”) represent an attempt by the Canada Revenue Agency (“CRA”) to discourage employees from converting employment income (taxed at personal marginal rates) into corporate income eligible for the small business deduction by interposing a corporation between the individual and his or her employer. Where income is found to be from a PSB, the ITA has penalizing provisions.

This is accomplished, in part, by excluding a PSB from the definition of an “active business” in section 125(7) of the ITA. As only income from an active business is eligible for the small business deduction, this exclusion results in any income generated by a personal services business corporation being taxed at the full corporate rate. (This may be considered GRIP income which may partially alleviate the penalizing impact of these other provisions). In addition, instead of being able to deduct any and all expenses incurred for the purpose of earning business income, the expenses that a PSB can deduct are limited to those that an employee could deduct against his or her employment income. Note, accrued and unpaid eligible expenses of a particular year are not allowed as deductions in computing PSB income for the year.

A "personal services business" is defined in section 125(7) of the ITA as a business of providing services of an "incorporated employee", or anyone related to the incorporated employee, to an entity of which the incorporated employee otherwise reasonably would be regarded as an officer or employee (the “But For” test). Consequently, in determining whether an individual taxpayer can “incorporate”, the taxpayer will first have to determine whether






he or she is currently employed by the payor (i.e., is engaged in a contract of service) or is simply being hired as an independent contractor (i.e., is engaged in a contract for services). Wiebe Door Services Ltd. v. Minister of National Revenue (1986), 46 Alta. L.R. (2d) 83 (F.C.A.) is the benchmark case that outlines the tests that a court will consider in making this determination.

In addition to the “But For” test, for a corporation to constitute a PSB, the incorporated employee or person related thereto must be a "specified shareholder" of the corporation providing the services. A “specified shareholder” is defined in section 248(1) as a person who directly or indirectly owns at least 10 percent of the issued shares of any class at any time in the year. It includes a person who owns at least 10 percent of the issued shares of a "related" corporation. Shares owned by someone who does not deal at arm’s length with a taxpayer (i.e., the taxpayer’s spouse) are deemed to be owned by the taxpayer.

Investment Income Dividends and Other Sources Dividends A corporation is required to include, in its computation of income in a taxation year, all amounts received in the year from corporations resident in Canada on account of taxable dividends (ITA, section 82(1)(a)). A taxable dividend is defined as a dividend other than certain capital dividends (being dividends from the capital dividend account representing the non-taxable portion of capital gains, or life insurance proceeds) and certain qualifying dividends paid by a public corporation to shareholders of a prescribed class of tax-deferred preferred shares.

However, section 112 provides that the recipient corporation can deduct the amount of the dividend in computing its taxable income if one of two conditions exist:

• the payor corporation is a “taxable Canadian corporation”, namely, a corporation that is “resident” in Canada that was either incorporated in Canada or has been resident in Canada continuously since June 18, 1971 and that is not exempt from Part I tax; and

• the payor corporation is resident in Canada and is controlled by the recipient corporation but is not a non-resident-owned investment corporation or a corporation exempt from tax under Part I.

The intent of the rules is to provide a mechanism to ensure that if the income of a corporation has been subject to taxation, it should




not be taxed again until distributed to a non-corporate shareholder of a corporation (that income should not be subject to tax when distributed to corporate shareholders).

With the introduction of eligible dividends (ITA, section 89(1)), corporations need to track its general rate income pool (“GRIP”) to determine what type of taxable dividends can be paid to the shareholders. In general, to the extent that a corporation has a GRIP balance, it can elect to pay an eligible dividend to the shareholders. In order for the dividend to be an eligible dividend, the corporation must, immediately upon payment of the dividend, notify the payee shareholder in writing that the dividend is an eligible dividend. The appropriate legal documentation will therefore not only include the designation of the dividend as out of GRIP in the corporate resolutions but also an appropriate written notice to the recipient of the nature of this dividend.

In some cases, there may be the opportunity to plan to pay eligible dividends to a high income earner and non-eligible dividends to a low income earner because of the difference in effective tax rates. Currently, eligible dividends in Saskatchewan are taxed at a top marginal rate of 20.34% compared to 30.83% for non-eligible dividends.

Specified Investment Business Income Similar to income from a personal services business, income from a “specified investment business” (“SIB”) is not eligible for the small business deduction. Consequently, it is subject to full corporate rates. To deter individuals from holding their investments in a corporation rather than personally, the ITA imposes various surtaxes on such income such that the overall corporate rate on investment income exceeds the income tax rate that would have applied had the investment income been earned and received personally.

Generally speaking, a SIB is defined by section 125(7) to be a business whose principal purpose is to derive income from property (i.e., interest, dividends, rents or royalties) unless:

• it employs throughout the taxation year more than five full-time employees; or

• it would have employed more than five full-time employees had certain services (i.e., managerial, administrative, etc.) not been provided to it by an associated corporation. Current jurisprudence suggests that 5.1 employees will meet this test, but the corporation will have to ensure that this minimum is met continuously throughout the year.




The Decision to Incorporate

Introduction The effect of incorporating a company is the creation of a legal person distinct from its shareholders. In law, "person" includes both a natural person and an artificial person (a corporation). Having established capacity, a corporation can enter into valid and enforceable legal relationships with its shareholders, employees or subsidiaries, and with third parties.

Despite the number of significant commercial advantages to be gained from owning assets through a separate corporate entity, it has historically been the tax-related advantages, for instance, absolute savings and the deferred taxes that have provided the most compelling reasons for incorporating. Tax implications are only one factor to address in deciding whether or not to incorporate. Others are limitation of liability, financing alternatives and the ability to carry on business in other jurisdictions. These can far outweigh any tax advantages connected with incorporation.

Though by no means exhaustive, the following are some of the tax-related factors that should be considered in deciding whether to incorporate a particular source of income.

Advantages to Incorporation • Deferral of Tax

The Small Business Deduction The small business deduction is available to corporations on a portion of the income they earn in a year from “active business”. See Calculation of Tax for a discussion of this deduction.

Investment Income There is no deferral advantage to incorporating investment income and portfolio dividend income (other than dividends which are deductible from corporate income). In Saskatchewan, the applicable combined corporate rate on that income is presently higher than the maximum individual marginal rate of tax in Saskatchewan.



• Tax Savings

Active Business Income Until recently, significant absolute tax savings could be realized through the incorporation of an active business. However, amendments to the ITA have reduced the absolute tax savings available through incorporation.

Investment Income Amendments have eliminated any absolute tax savings available from incorporating investment income. In fact, there can be a tax cost.

Income Splitting The term "income splitting" refers to the organization of income-producing property to reduce the aggregate tax burden on the income by having it earned by individuals with lower marginal tax rates (because of low income levels) than the taxpayer who initially owns the income-producing property. For example, rather than have income earned by a taxpayer with a personal marginal rate of tax of 39 percent, less tax would be paid on that income if it were earned in three equal shares by three other individuals, each with a lower personal marginal rate.

One common method of income splitting is for an individual to acquire and hold income-producing property through a corporation. The shareholders might include the individual and his or her family members. After-tax corporate income is distributed by way of dividends to the shareholders. Lower taxes on that income will result, in the aggregate, if the other family members have lower marginal rates of tax than the individual.

Another common method is for an owner manager to incorporate an active business into a corporation. Low rate family members are allowed to hold equity interests either directly (or indirectly through a family trust) such that on a dividend distribution, such income will be taxed at the lower rates thereby creating absolute tax savings.

Where a taxpayer acquires shares in a corporation for the purposes of receiving dividends on them, and there are family members holding shares in the corporation, refer to the numerous "attribution rules" in the ITA. These may require that the dividend income must be effectively taxed in the hands of the taxpayer, rather than his/her family members.





Minimization of Income Level Fluctuation

If the profits of a particular business are subject to annual fluctuations, incorporation can minimize the effects of that fluctuation on an individual’s personal income. This is because that individual can exercise some discretion in the distribution of after-tax corporate earnings.

Deductibility of Interest on Borrowed Funds Where an individual seeks to incorporate investment or business assets, interest on borrowed funds injected into a corporation can be deductible in computing income. Section 20(1)(c) of the ITA permits a taxpayer to deduct reasonable interest paid or payable in a year, provided the interest was incurred for the purpose of earning income from a business or property.

However, where an advance by a shareholder to a corporation is by way of a non-interest-bearing loan or a loan bearing a rate of interest less than the interest paid by the shareholder to acquire those funds, CRA may disallow the negative spread on the interest expense on the basis that the interest expense was not incurred for the purpose of earning income (though there is recent case law to the contrary).

Where a shareholder borrows funds to acquire additional common shares in a corporation, any amount of interest paid on the loan is generally deductible. Where the shareholder borrows to buy preferred shares, CRA may allow a deduction of the interest paid on the loan to the extent that the equivalent after-tax rate of return on the preferred shares is at least equal to the interest expense. However, there is case law to the effect that interest is deductible even if the interest expense exceeds the rate of return so long as the expectation of some income being earned is reasonable.

Capital Gains A capital gain is the amount by which the proceeds of disposition (less related expenses of disposition) exceed the adjusted cost base of the capital property.

The sale of certain investment or business property can give rise to fully taxable income (e.g., recapture of capital cost allowance or depreciation previously deducted) or a capital gain, one-half of which is taxable (subject to the lifetime capital gains exemption which can exempt the capital gain from tax).

If the property sold was held by a corporation and was sold through sale of the corporation’s shares, the taxable income can possibly be converted to a capital gain attracting preferred




tax treatment. However, it may also be that the sale of shares will be viewed as a sale of the underlying property, resulting in income treatment as opposed to capital gains treatment. Furthermore, the purchaser will often want to purchase the asset directly for various reasons including the ability to have more writeoffs against income.

Estate Freezing Immediately before his or her death, a taxpayer is deemed under section 70(5) of the ITA to have disposed of all of his or her depreciable and non-depreciable capital properties, resource properties and land inventories. The disposition is deemed to have been made at specified amounts based on the fair market value of the property at the time of death.

The deemed proceeds of disposition are directly related to the fair market value of the properties at that time. The potential tax liability can be reduced by minimizing the fair market value of the properties owned by the deceased at the time of death.

An estate freeze restricts future increases in an asset’s value by limiting its value to a certain amount at a particular point in time. Any increase in value after that point in time will accrue to the benefit of persons other than the taxpayer. At the time of the taxpayer’s death, therefore, it is only the value of the asset at the previous point in time that is relevant in determining his/her potential tax liability arising from the deemed disposition. In other words, the value of the asset is "frozen" at a particular time.

One means of implementing an estate freeze is through the use of a corporation. For example, assume an individual owns a business valued at $1,000,000.00, expected to appreciate in value in the future. He or she transfers the business to a corporation, the common shareholders of which include the members of his or her family. As consideration for the business transferred, the corporation issues to the individual proprietor, special preferred shares having a fixed value of $1,000,000.00. Those shares will not increase in value in the event the value of the business increases. Rather, any future appreciation accrues to the common shareholders.

Conversion of Capital Loss to Business Investment Loss On disposition of capital property, an individual realizes a capital loss to the extent that the proceeds of disposition are less than the adjusted cost base of the property. One-half of that loss can be deducted from the taxable one-half of capital gains realized in the current year, the three preceding years, or in any future year.




If the property is held by a qualifying corporation, and the individual disposes of the shares in that corporation to an arms’ length third party (rather than selling the property itself), any loss realized on the disposition of the shares can represent a "business investment loss", one-half of which (the "allowable business investment loss") is deductible against other sources of income without limitation.

Capital Gains Exemption Planning If an individual was to sell his proprietorship or partnership interests for a gain, the amounts would be subject to tax. If however his business was operated through a corporation, if it constituted a “qualified small business corporation” and met certain other requirements, the gain up to $750,000 could be exempt from tax. The prerequisites of the $750,000 lifetime capital gains exemption is beyond the scope of these materials.

Disadvantages to Incorporation • Complexity

Corporations involve additional time and expense in establishment, regular reporting and maintenance, including the preparation of separate and more complicated corporate T2 tax return and other tax filings.

In addition, it requires the individual to keep his affairs separate from those of the corporation. The failure to do this creates problems in reconciling records and can result in shareholder loans or shareholder appropriations which can be significantly penalized under the ITA.

• Increased Tax on Earnings Business income not eligible for the small business deduction is taxed higher when combined with the taxation of the individual shareholder receiving dividends from the corporation (representing after-tax corporate profits). As discussed earlier under the heading Investment Income: Dividends and other Sources, the introduction of “eligible dividends” reduces the level of increased taxes. Admittedly, the active business income in excess of the small business deduction will be taxed at the higher general rate of 32% in Saskatchewan (in calendar 2008); however a level of tax deferral is achieved in that the income that might otherwise be paid out to the individual shareholder could be taxed at the top marginal rates of 44% in Saskatchewan.




• Trapped Start-up Losses Corporate losses are trapped in the corporation, and are not deductible from an individual shareholder's other income. If the individual had carried on business through a proprietorship and suffered a loss, the individual would be able to reduce personal taxes for the year by offsetting this against other personal income earned. For this reason, it is generally advantageous to convert a business to corporate form when it begins to show a profit, allowing deduction of start-up losses from the individual proprietor's personal income in the meantime. This is generally done through a transfer of the business on a tax deferred basis.

• Transferring Assets Out of a Corporation Certain provisions of the ITA allow a taxpayer to transfer assets to a corporation without the immediate realization of gain (for example, under section 85 rollover). However, there is no equivalent provision enabling a transfer of assets from a corporation to an individual shareholder. Typically, these transfers are made at fair market value or will be deemed to be made at fair market value thereby triggering taxes within the corporation.

• Double Taxation Assets held by an individual are deemed disposed of on death and taxed at that time based on the fair value of the assets. Where a corporation holds the assets, on the other hand, two levels of taxation exist:

• on the deemed disposition of shares of the corporation at the time of death; and

• on the disposition of the underlying assets by the corporation itself.

Only in limited circumstances under the ITA can this double taxation be eliminated.





Corporate Reorganizations

General Background The focus of this part is tax-deferred or "rollover" transactions.

Our scheme of taxation imposes tax on any gains realized by those disposing of property. Ordinarily, where property is sold or transferred for a price in excess of its cost to the seller, the seller is required to include in his or her income for the year of sale all of the gain where that gain is an income gain or one-half of the gain where it is a capital gain.

In most instances, it is recognized that the sale or transfer of property from one person to another will be for fair market value on the basis that independent bargainers will each seek to obtain the best price possible for their respective interest. On the other hand, if the nature of the relationship between the parties to the sale is not at arm’s length, or if the parties are "related" to one another so that they are deemed not to deal with one another at arms’ length, then the property will generally be deemed to be sold for a fair market value price (ITA, section 69).

It is partly in relief of these deeming provisions that the corporate reorganization rules in the ITA were created. The rationale is that, where a taxpayer has not "cashed out" his/her interest in the property disposed of, and so there has been no true economic realization of the person's interest in the property, it is inequitable that the transaction should give rise to the immediate recognition of an income tax liability.

If a taxpayer is contemplating a rollover, the taxpayer and his or her advisors should carefully consider meeting the requirements to effect a tax deferred rollover. One key requirement is that they make a genuine estimate of the fair market value of the property being transferred. Another is to ensure the prescribed election is filed within the prescribed time limits.

Non-Dispositions One means of providing relief from the deemed sale at fair market value rules is to deem the transaction not to be a disposition of property at all. Accordingly, there will be no sale or transfer of





property recognized by the ITA in respect of which a gain may be realized. Some common situations where dispositions are deemed or considered not to have occurred are:

• stock splits and stock consolidations will generally not be considered to give rise to a disposition of shares by the holders thereof (Interpretation Bulletin IT-65 - Stock Splits and Consolidations);

• the exercise of a conversion right attached to a corporation’s debt obligation that represents capital property of a holder and which entitles him/her to convert the debt obligation into shares of the corporation is deemed not to be a disposition of that debt obligation (ITA, section 51); and

• the exchange of a share of a corporation that represents capital property of the holder for other shares of the corporation is deemed not to be a disposition of that share (ITA, section 51) (however, will still be considered to be a “transfer” for other purposes under the ITA such as section 74.4 and section 74.5).

Note that CRA can consider altered rights or restrictions attaching to shares or debt obligations to be a disposition of those shares or debt obligations, depending upon the overall economic effect of the changes (see Interpretation Bulletin IT-448 – Dispositions - Changes in Terms of Securities and IT-448SR).

"Rollover" Provisions - General Another means of providing relief from the deemed sale at fair market value rule is to have the ITA recognize the disposition of property as having taken place, for income tax purposes, for an amount equal to the tax cost of the property disposed of, rather than its fair market value. A sale at this price will not give rise to the immediate recognition of a gain. This is the method followed by most rollover provisions.

The primary rollover provisions pertaining to corporations are found in the following sections of the ITA:

• section 85(1) - Transfer of property to a taxable Canadian corporation;

• section 85(2) and (3) - Incorporation of a partnership;

• section 85.1 - "Share-for-share exchange" or corporate "takeover";

• section 86 - Share capital reorganization;



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• section 87 - Amalgamations of taxable Canadian corporations; and

• section 88 - Winding up of 90% or more owned subsidiary corporations.

Transfer of Property to a Corporation: Section 85(1) Overview The provisions of section 85(1) of the ITA are probably the most frequently used of the rollover provisions because of the breadth of their application. They are useful when considering the transfer to a corporation of a proprietorship or unincorporated business, a professional practice or an investment portfolio. They are also frequently used in the implementation of estate plans that might include the opportunity to split income with family members, when transferring assets within related corporate groups (perhaps to transfer income producing properties of one corporation to another corporation that is generating losses) or to divide assets of a corporation among its shareholders (a "butterfly" reorganization).

In general terms, the provisions of section 85(1) allow a seller to transfer property to a buyer corporation for an agreed-upon amount for income tax purposes, notwithstanding that the actual sale price may be some other amount. However, the provisions require that the consideration received for the transfer must include shares of the buyer corporation and that the agreed amount be within a specified range. If the sale is structured properly and the agreed amount is equal to the tax cost of the transferred property, the seller will not recognize a gain or profit for income tax purposes.

The sale agreement between the parties will usually include an undertaking by both parties to make a joint election under section 85(1) of the ITA in the prescribed form and within the time required by the ITA.

Transferor and Transferee For the purposes of a section 85 rollover, the only requirement on a seller is that he or she is a "taxpayer", which can include individuals, trusts and corporations, whether or not resident in Canada. If the seller is a partnership, section 85(2) provides similar rollover treatment for property transferred by a partnership to a corporation.

The buyer corporation must be a "taxable Canadian corporation" as defined in section 89(1) of the ITA.







Eligible Property For the purposes of a section 85 rollover, an election can be made in respect of most types of property, since this type of rollover is stated to apply to the transfer of capital property (both depreciable and non-depreciable property, which includes such items as shares, bonds, partnership interests, land held as an investment, buildings and equipment), eligible capital property (such as goodwill, perpetual licenses and trademarks), inventory and resource property. These categories also allow an election to be made relating to a transfer of accounts receivable (in the absence of a generally more beneficial election being made pursuant to section 22 of the ITA) and professional work-in-progress in respect of which an election pursuant to section 34(a) of the ITA has been made. The only items within these property categories in respect of which an election cannot be made are:

• interests in or options in respect of real property owned by a non-resident person, and

• real property owned by any person if it forms part of the person's business inventory.

Consideration Given for the Transferred Property The underlying premise of a section 85 rollover is that at least the difference between the agreed amount and the fair market value of the transferred property will be paid for by the issuance of shares of the buyer corporation. The provision presupposes that the gain deferred by an election will be represented by the value of shares received from the buyer corporation. The balance of the consideration for the transferred property can also be paid for with share consideration or, provided the transferred property is not shares of some other corporation, with other forms of consideration like cash, debt represented by a promissory note, or the assumption of liabilities of the seller.

As a general rule, provided the fair market value of non-share consideration received (commonly referred to as “boot”) for the transferred property does not exceed the tax cost of the transferred property, the parties will be entitled to agree to and elect an amount equal to the tax cost of the transferred property, and the transaction will not give rise to an immediate income tax liability.

In cases where the property transferred by the seller is shares in some other corporation, the receipt of non-share consideration can give rise to a deemed dividend to the seller (sections 84.1 and 212.1).





The Election Section 85(1) of the ITA requires that the seller and buyer corporation jointly execute an election and that it be filed in the prescribed form with CRA (Form T2057).

Range of Elected Amounts The ITA contains a number of restrictions to the amount that can be agreed to and elected in respect of the transfer of a property under a section 85 rollover.

The rule with overall priority requires that the elected amount must never exceed the fair market value of the property sold. A secondary rule sets the lower limit of the amount that can be elected at the tax cost of the property sold unless the fair market value of any non-share consideration received for the property is greater than that tax cost, in which case the lower amount is established at the fair market value of the non-share consideration.

EXAMPLE: A seller sells property that cost $100 and that has a fair market value of $150. If the seller receives $125 cash from the buyer corporation and shares in the buyer corporation, the elected amount cannot be less than $125. The seller will realize a gain of $25, based on the $125 elected amount less the tax cost of the transferred property, being $100. On the other hand, if only $50 cash is paid, the lowest amount that can be elected is $100, being the tax cost of the property to the seller. In that case, the seller realizes no gain as a result of the sale.

Anti-Benefit Provisions One of the most problematic areas in a section 85 rollover is where the property is transferred to a corporation with shareholders related to the transferor. In this case, section 85(1)(e.2), an "anti-benefit" provision, will penalize a seller if the sale of the property to the buyer corporation results in any benefit being conferred on those familial shareholders.

If the fair market value of the property transferred to the corporation is greater than the consideration paid for it (both share and non-share consideration) and if it is reasonable to regard the excess value as a gift made by the seller to or for the benefit of any other shareholders of the buyer corporation related to him or her (for example, by an increase in the value of their shares), then the amount of that benefit will be added to the



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amount otherwise elected to be proceeds of disposition of the transferred property. Typically, this will result in the seller recognizing immediate tax liability (because the agreed amount and, in turn, the seller's proceeds of disposition, will now exceed his or her tax cost of the transferred property).

To avoid the application of the anti-benefit rules, transactions will often be structured using redeemable, retractable, preferred shares as the share consideration issued to the seller. Because a seller must attempt to ensure that the actual fair market value of the consideration it receives from the purchasing corporation is exactly equal to the fair market value of the transferred property, a purchasing corporation will issue shares that have a fixed amount (the "redemption amount") which the seller is entitled to receive from the purchasing corporation if it purchases or redeems these shares. The redemption amount is set at an amount equal to the fair market value of the transferred property or, if non-share consideration is also being given to the seller, an amount equal to the difference between the fair market value of the transferred property and the fair market value of the non-share consideration paid to the seller.

Incorporation of a Partnership: Section 85(2), (3) The combination of sections 85(2) and (3) of the ITA allow for the "incorporation" of a partnership on a rollover basis. Section 85(2) of the ITA provides that if a partnership transfers assets to a taxable Canadian corporation for consideration that includes shares of the buyer corporation, the provisions of section 85(1) of the ITA will apply to an election by all the members of the partnership and the buyer corporation as if the partnership were a taxpayer referred to in section 85(1).

Section 85(3) then goes on to provide that if the partnership is wound up within 60 days after a disposition of property to which section 85(2) applies, and provided the only property owned by the partnership immediately before the winding up is money or property received from the buyer corporation, the disposition by partners of their partnership interests (by extinguishment on winding-up) in exchange for the distribution to them of property of the partnership may take place on a rollover basis. A complete rollover will be achieved where the aggregate of the fair market value of property, other than shares of the buyer corporation, and the tax cost to the partnership of shares of the buyer corporation that are distributed to the particular partner do not exceed the tax cost to that partner of his or her partnership interest.






Share-for-share Exchange: Section 85.1 Section 85.1 of the ITA is referred to as a "share-for-share exchange" or the "take-over" provision. It applies where a taxpayer transfers to a Canadian buyer corporation, with whom he/she deals at arms’ length, shares of a particular class that he or she owns in a “target” corporation. In return, if the taxpayer receives only shares of a particular class in the buyer corporation as consideration for the transferred shares, the transfer will automatically take place on a rollover basis (unless the shareholder chooses to report a gain, in which case he/she must report the full gain or make an election under section 85(1) of the ITA).

Analogous to the effect of an election under section 85(1), this provision deems the tax cost of the shares that are sold to be both the seller's proceeds of disposition of those shares and the tax cost of the share consideration received from the buyer corporation. A significant difference between the operation of this provision and section 85(1) is that the tax implications to the buyer do not depend on whether the seller has determined to have the rollover treatment apply. The cost to a buyer corporation of the shares in the target corporation is the lesser of the fair market value of the shares acquired and their paid up capital.

Share Capital Reorganization: Section 86 Section 86 of the ITA is referred to as the "share capital reorganization" provision. It applies where, in the course of a reorganization of the capital of a corporation, taxpayers dispose of capital property that includes all shares of a class of the corporation owned by them (the "old shares"), for consideration that includes shares of another class of the corporation (the "new shares"). “Reorganization of capital” is not defined in the ITA; however there is general consensus that it should at least include circumstances where Articles of Amendment are filed at the relevant corporations branch to change share characteristics or to add additional classes of shares.

Provided the fair market value of any non-share consideration given for the old shares does not exceed the tax cost of those old shares, taxpayers will be considered to have disposed of the old shares for their tax cost and no gain will be realized. However, the receipt of non-share consideration and paid-up capital of new shares in excess of the paid-up capital of the old shares disposed of could still give rise to a deemed dividend to the shareholder. As a general rule, where shares are being disposed of in the course of a section 86 reorganization of share capital, the fair market value of






non-share consideration received for the old shares should not exceed the tax cost of the old shares, and the aggregate of the fair market value of non-share consideration and the paid-up capital of new shares received by the shareholder should not exceed the paid-up capital of the old shares.

This is another "rollover" provision, so the tax cost of the old shares will also be relevant in determining the tax cost of the consideration received by the taxpayer from the corporation.

The “anti-benefit” provisions in section 86 of the ITA are applicable where a benefit is conferred on a person (not necessarily a shareholder) that is related to the taxpayer.

Section 86 is frequently relied on where, to implement an estate freeze or to enable a corporation to issue common shares to employees for nominal consideration, the existing shareholders of a corporation exchange their valuable common shares for redeemable, retractable preferred shares with a redemption amount equal to the then fair market value of their common shares. A new class of common shares is then created which can be issued for nominal consideration, since all of the value of the corporation will then be attributable to the preferred shares. The new common shares will gain value depending upon the prosperity of the corporation from that time on.

Summary Comparison Chart:

51 85 86Tax-deferred Yes Yes YesNon-share consideration allowed No Yes YesRequirement to transfer all shares of that class No No YesReorganization of capital required No No YesPUC reduction provision Yes Yes YesFiling requirement No Yes Yes

Corporate Distributions

Dividends and Paid-up Capital Distributions made by a corporation to a shareholder can have various income tax consequences to the shareholder, depending on the characterization of the distribution. Generally, distributions by a corporation to a shareholder can be in the form of salary or bonus, dividends (including deemed dividends), return of capital or benefits conferred.




There is no comprehensive definition of the word "dividend" in the ITA (it merely says that a dividend includes a stock dividend). However, the ITA does include as dividends most amounts received by a shareholder relating to his or her shares to the extent that those amounts represent any payment exceeding the paid-up capital in those shares.

Deemed Dividends The ITA seeks to treat as dividends all distributions of corporate surplus in excess of paid-up capital.

Increase of Paid-Up Capital If there is an increase in paid-up capital of a corporation resident in Canada without a corresponding increase in the net assets of the corporation, section 84(1) of the ITA deems a dividend to have been paid equal to the excess amount (with some exceptions). This deemed dividend is taxed on a pro rata basis in the hands of anyone who owned the shares that had the increase in paid-up capital. To the extent that a deemed dividend is included in income, the adjusted cost base of the shares will be increased under section 53 (1) (b).

Distribution on Winding-Up Under section 84(2) of the ITA, if a corporation distributes property to its shareholders on winding-up, discontinuance or reorganization of its business, it is deemed to have paid a dividend to its shareholders equal to the amount by which the fair market value of the property distributed to the shareholder exceeds the reduction in the paid-up capital of their shares. Again, the dividend is deemed to have been received by each shareholder who owns shares of that class on a pro rata basis.

Redemption of Shares Where a corporation resident in Canada redeems, acquires or cancels any of its shares, section 84(3) of the ITA deems the corporation to have paid a dividend equal to the excess of the amount paid by the corporation over the paid-up capital of the shares redeemed, acquired or cancelled.









The shareholder will also have disposed of the share redeemed, acquired or cancelled by a corporation, so he or she will also be required to make a determination of the gain or loss arising as a result of the disposition of the share. However, where the share was capital property of the shareholder, the proceeds of disposition of the share as otherwise determined (generally, the amount received on the sale or redemption of the share) are reduced by the amount that has been deemed to be a dividend received on the share: section 54(h)(x)). The shareholder's gain or loss in respect of the disposition of the share is then calculated as the difference between these reduced proceeds of disposition of the share and the adjusted cost base of the share to the shareholder.

Other Taxes When considering incorporation or reorganizations, other taxes such as the Goods & Services Tax or the Provincial Sales Tax can also come into play and should not be ignored.


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