chap15 sol 2

CHAPTER 15

268 Introduction to Federal Income Taxation in Canada

Solutions to Chapter 15 Assignment Problems267

CHAPTER 15

Corporate Distributions, Windings-Up, and Sales

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)

14,00041,500

Income effect

$154,350

Capital Dividend Account

Balance: January 1, 2011

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 ( $41,25027,500

Balance: December 31, 2011

$107,750

The above can be summarized in tabular form as follows:

AssetIncome effectCapital dividend account

Untaxed fraction of net cap. gainsCapital dividend receivedUntaxed fraction of net gain on ECPUntaxed life ins. proceedsCapital dividend paidBalance

ABIAII

Investments

$(19,250)$(19,250)$(19,250)

Land

75,00075,00075,000

Building

$25,00024,50024,50024,500

Equipment.

7,600

ECP

41,500

$27,500

27,500

$74,100$80,250$80,250Nil$27,500NilNil$107,750

Solution 2 (Advanced)Capital dividend account

1988Disposal of bonds: $10,000 capital gain ( 1/2

$5,000

1990Received capital dividend

5,000

1992Disposal of shares: $4,000 capital loss ( 1/4

(1,000)

1994Disposal of equipment: $6,000 capital gain ( 1/4

1,500

2002Sale of shares: $20,000 capital gain ( 1/2

10,000

2004Life insurance: $100,000 $20,000

80,000

2006Capital dividends paid

(50,000)

2009Sale of customer list: ($100,000 $40,000)* ( 1/2

30,000

2011Sale of shares: $37,500 capital gain ( 1/2

18,750

Account balance

$99,250

* CEC balance$25,000

Proceeds ( 3/475,000

(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:

YearAssetCapital dividend account

Untaxed fraction of net cap. gainsCapital dividend receivedUntaxed fraction of net gain on ECPUntaxed life ins. proceedsCapital dividend paidBalance

1988bonds

$5,000$5,000

1990$5,0005,000

1992shares

(1,000)(1,000)

1994equip

1,5001,500

1998land

NilNil

2002shares

10,00010,000

2004life ins

$80,00080,000

2006dividend paid

$(50,000)(50,000)

2009cust. list

$30,00030,000

2011shares

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 1998 gain on the vacant land was reassessed as income, it is not included in the capital dividend account.

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)).

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

Solution 5 (Basic)(A)

Actual or deemed proceedsIncome generatedCapital dividend accountRDTOH

ABIAII

Opening balance

NilNil$4,000Nil

Cash

$2,500NilNil

Accounts receivable(1)

7,500$(1,250)Nil

Inventory(2)

15,500(6,750)Nil

Land(3)

45,000Nil$17,00017,000

Building(4)

95,00027,50030,00030,000

Equipment(5)

10,000(12,000)Nil

Marketable securities(6)

32,000Nil8,8758,875

Goodwill(7)

47,50023,750Nil23,750

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)


$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 section22 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


Proceeds

$95,000

Capital cost (adjusted cost base)

35,000

Gain

$60,000


$30,000(A)


$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


Proceeds

$32,000

Adjusted cost base

14,250

Gain

$17,750


$8,875


$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

Solution 6 (Advanced)(A)


ABIAII

Opening balance

NilNil$8,000$5,000

Cash

$10,000NilNil


18,000$5,000$(6,000)(6,000)

Land(2)

150,000Nil47,50047,500

Building(3)

320,00075,00075,00075,000

Equipment(4)

3,000(9,000)Nil

Shares(5)

26,000Nil5,5005,500

Goodwill(6)

120,00054,500Nil35,000

Liabilities

(35,000)

Income taxes(7)

(82,033)$125,500$122,00032,533

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 HST 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 years reserve (active business income)$5,000


$18,000

Cost

(30,000)

Capital loss

$(12,000)*

Allowable capital loss ( ( $12,000) (investment income offset)

$(6,000)

Income effect (assuming taxable capital gain to offset allowable capital loss)

$(1,000)

Capital dividend account ( ( $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 ( ( ($150K $55K)) (investment income)

$47,500

Capital dividend account ( ( ($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:


$320,000

Cost

(170,000)

Capital gain

$150,000

Taxable capital gain ( ( $150,000) (investment income)

(B)$75,000

Capital dividend account ( ( $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 ( ( ($26K $15K)) (investment income)

$ 5,500

Capital dividend account ( ( ($26K $15K))

$5,500

(6)CEC balance$18,000

Proceeds (

(90,000)

(72,000)

Previous CECA ( ( $50,000 $18,000)

19,500

Balance

$52,500

Income: ( $52,500

$35,000

Recapture (above)

19,500$54,500

CDA: ( $52,500

$35,000*

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

(7)Tax @ 20% on active business income (20% of $125,500)

$25,100

Tax @ 46% on investment income (46% of $122,000)

56,933

Total tax

$82,033

RDTOH (26% 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.


ProceedsABIAIICapital

dividend acct.RDTOH

Opening balance

NilNil$12,000$6,000

Cash

$15,000


52,000$5,000(4,000)(4,000)

Inventory(2)

127,00017,000Nil

Land(3)

150,000Nil32,50032,500

Building(4)

97,00043,00015,50015,500

Equipment(5)

6,000(4,000)


26,000NilNil

Eligible capital property(7)

130,00055,013Nil43,773

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)


$18,000

Cost

(18,000)

Capital gain

Nil

Taxable capital gain

Nil

NOTES TO SOLUTION

(1)Accounts receivable:

Inclusion of last years 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:


$150,000

Cost

(85,000)

Capital gain

$65,000


$32,500


$32,500

(4)Building:

Proceeds on sale of building

$97,000

UCC

(23,000)

Gain

$74,000

Recapture ($23,000 $66,000)

$43,000


$97,000

Less: capital cost

(66,000)

Capital gain

$31,000


$15,500


$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


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

Solution 8 (Advanced)(A)Corporations position

Proceeds for land and building ($700,000 $170,000)

$530,000

Cost

(400,000)

Capital gain

$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)Shareholders 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

26,00046,000

Net retained by shareholder

$654,000



ABIAII

Income during year/opening balances

$ 50,000

$48,000

Cash

$23,000Nil


54,000Nil$(2,000)(2,000)

Inventory

50,0009,000

Land(2)

210,000Nil28,00028,000

Building(3)

440,000215,00015,00015,000

Goodwill(4)

85,00042,500

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)


$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


$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


Nil

$620,000

Combined taxes @ 46%

$ 285,200

Less:Combined dividend tax credit (13% + 6% ( $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 [ (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 [ (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 [ (P $120,000)]= $586,300

Solving for P,P= $663,247

(E)Maximum share price acceptable to Lets-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 vendors 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 purchasers 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:

=

= $31,500If 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:

=

= $11,143The 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

$43,00043,000

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

1,8001,800

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:

Purchasers after-tax cost:

Pre-taxAfter-tax

Asset purchase

$862,000 $825,250

Share purchase

$781,593 $825,250

Vendors after-tax proceeds:

Pre-taxAfter-tax

Asset sale

$862,000 $586,300

Share sale

$725,584 $586,300

This table can be further summarized as follows:

AssetsShares

The maximum the purchaser will pay

$862,000$781,593

The minimum the vendor will accept

862,000725,584

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)


$(2,000)


$210,000

ACB

(154,000)

Capital gain

$56,000

Taxable capital gain ( ( $56,000)

$28,000


$28,000


$440,000

Capital cost

(410,000)

Capital gain

$30,000


$15,000


$15,000

Recapture ($195,000 $410,000)

$215,000

(4)3/4 of proceeds = 3/4 ( $85,000

$63,750


$42,500

Income (2/3 ( $63,750)

$42,500

(5)The $500,000 business limit for the small business deduction ($300,000 of which was allocated to Shining Limited) 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 31% 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.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 Glendas 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.

ADVISORY CASE DISCUSSION NOTESThe 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 $550,000, 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 29.5% (16.5% federal and 13% provincial) leaving about 70.5%, or $35,250, after tax.

The tax deferral is (46% 29.5%) $50,000 = $8,250. If the funds are kept in the corporation, then the $35,250 could be paid out later as a dividend from GRIP with personal tax of approximately 24% (after the 41% gross-up and tax credit) on this dividend, leaving about $26,790 after tax.

If a bonus is not paid, then:

corporate tax instalment options will be based on this higher tax liability; 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; some tax is deferred with a little double tax on payment of the dividend. If a bonus is declared, then:

Was there a valid liability at December 31?

Is it reasonable?

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

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.(c) Salaries to children

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 cause 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.

(c) Company Loan for the Cottage [IT-119R3]

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.

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chap15 sol 2

Documents

capital gain

capital loss

capital dividends

immediate deemed dividend

eligible capital property

disposal of shares

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