Purification Planning for Sole Proprietor - Case Study Example

Zhiying Yvonne Chen Dennis Gee TAXX 344 October 18, 2009 Recommendation of Purification Planning for Sole Proprietor Table of Contents1. Executive summary 1 1. Introduction 2 The example of Cell City: 10 A number of factors come into play, and the owners rely heavily on the rules and regulations to make this decision. They may have tax-related questions but will also want to know the advantages and disadvantages to the business. The report analyzed and discussed alternative tax planning for Cell City, and recommended some simple solutions and complex methods for purification for sole proprietor. 12 5. References 13 Executive summary This paper analyzes the prickly effects associated with maintaining a corporation "pure" so that its shares come under the purview of qualified small business corporation shares. This will entitle their owner to claim the $750,000 capital gains exemption with regard to any gain realized on a disposition of the shares. This way a company or a sole proprietor can reduce Paid-up Capital through a payment and the qualifying shares are subsequently sold to arm's length party. This paper tries to answer the question as to whether Mr. Edward Lau, a Canadian Resident, who is the sole shareholder of Cell City is qualified to avail the CGD when he sells his shares. Mr. Edward wants to sell his shares and thus the tax implications have been examined. An analysis of all the possible tax issues that will be raised, and how to overcome it is being discussed in this paper. It is vital to do this kind of planning by Cell City sooner rather than later. The planning becomes more complicated and risky, and probably, more expensive, if such planning is contemplated on the eve of a sale. 1. Introduction Mr. Edward Lau, a Canadian Resident, is the sole shareholder of Cell City and has been since its inception. Cell City owns 100% of common shares of Space, which consist of 100 shares with a Paid up Capital (PUC) and an Adjusted Cost Base (ACB) of $50,000. Edward has never claims a Capital Gain Deduction (CGD). Edward has received an offer for his shares in Cell City. Before making his decision, he requests our advice on all the tax consequences resulting from such a decision. He informs us that Cell City has exited since 1989 and that the balance sheet for both corporations has remained substantially the same for the last three years. The balance sheets as at August 31, 2009, are presented below: Cell City: FMV Cost Treasury Bills 150,000 150,000 Shares of public corporations 100,000 75,000 Shares-Space 1,000,000 50,000 1,250,000 275,000 Share Capital 100 Retained Earnings 1,249,900 1,250,000 Space: FMV Cost Loan to Broke Ltd. 300,000 300,000 Land 100,000 75,000 Building 700,000 425,000 Equipment 400,000 600,000 Goodwill 150,000 0 1,650,000 1,400,000 Liabilities 50,000 Mortgage 600,000 Share Capital 50,000 Retained Earnings 950,000 1,650,000 The value of goodwill is reflected in the Fair Market Value (FMV) of retained earnings. Broke Ltd. is not related to Space and the loan does not bear interest it is controlled by a friend of Edward Lau. Edward Lau has asked us to explore the rules applicable to purification planning, identify situations that may come under the provisions of the rules, and determine the tax consequences. Then the provisions of the ITA that allow the Capital Gains Deduction (CGD) to be claimed on disposal of shares in a Canadian-Controlled Private Corporation (CCPC) and qualified assets are also analyzed. This is a significant benefit, since using the CGD serves to reduce Edward Lau's tax bill. This paper will determine taxpayers' tax liability and regulatory requirements and exposure. Tax implications of proposed and completed transactions are evaluated and analyzed and tax-planning issues are discussed. Business decisions in their legal context, along with preparing and advising on contract structure and enforcement is discussed. The first section of this paper looks at the background of Cell City. The second section has the literature review. Brief overview of Cell City's expectation is presented in the third section. The fourth section provides details on the preliminary scale purification methodology and suggests alternatives for purification. 2. Related tax rules for purification Regarding Cell City's circumstances, we determine the range of the related rules. In this regard the important areas like Capital Gain Deduction, Paid up Capital, Section 85, 84, 112(1) and 55(2) related to small business corporation have to be taken up. Some companies remove disqualified assets in order to qualify as qualified small business corporation shares and therefore qualify for the Capital Gain Deduction. What is qualified small business corporation shares (QSBCS). Key points of QSBCS are: The percentages outlined in the above mentioned Sections are conditions referring to the FMV of the assets The FMV of assets not appearing in the balance sheet (assets not purchased) such as goodwill has to be considered. Liabilities are not relevant in the calculation of ineligible or eligible assets. What is Capital Gain Deduction (CGD) Capital gain realized on the disposition of QSBC shares may be eligible for the CGD as per Section 110.6(2). The capital gains deduction for the purposes of this course and examination purposes is $375,000 (Capital Gain of $750,000) for dispositions after March 18, 2007 Finally, what is purification and how is it related to the disposition of QSBCS At the time of disposal, the shares must be shares of a small business corporation (SBC); that is, shares of a corporation which is a CCPC or substantially all (90% or more) of the FMV are attributable to assets. Shares must not be owned by anyone other than the individual or a person/partnership related to the individual, throughout the 24 months period prior to the disposition. Throughout the 24 month period prior to disposition, the shares should have been of a Canadian Controlled Private Corporation (CCPC), of which more than 50% of the FMV are used in an active business carried on primarily in Canada by the corporation or a related corporation. Where all or substantially all of a corporation's assets cannot be attributed to eligible assets at a time during the 24 month period preceding the disposition, then all or substantially all of the assets of connected corporations must be assets used by the corporation principally in carrying on a business in Canada at that time. 3. Analysis of Cell City's expectation Edward Lau wants to reduce Cell City's PUC by a payment, by selling the shares to third party. If Edward Lau can successfully benefit the PUC payment and CGD, then all the tax rules are to be considered. Edward Lau wants to decide whether he could offer his shares, and he wants to know the advantages and disadvantages to the business. The tax bill on disposition of qualified small business shares and property can be smaller if certain conditions are met and appropriate actions taken in order to claim a CGD of up to $750,000. Planning for the transaction with the help of an accountant will enable him to make major tax savings either immediately or later. Under the tax rules, Cell City can through legal procedures opt for purification. Mr. Edward Lau can earn the benefits reduce his PUC and claim for CGD. The purification planning will include analysis of qualifying asset, QSBCS, and suggest the alternatives methods. 4. Alternatives for purification We need to indicate to Edward whether the shares of Cell City and Space qualify as QSBC shares, allowing him a capital gains deduction of $375,000. The three main criteria to be met for Edward Lau to be entitled to the $375,000 CGD under subsection 110.6(2.1). These criteria are contained in subsection 110.6(1) under the definition of "Qualified small business corporation shares", and provide ITA references. The three main criteria for the same are as under: 1) When the sale occurs, Cell City must be a Small Business Corporation within the meaning of subsection 248(1), which states that all or substantially all (90%) of the FMV of its assets must be comprised of qualifying assets, a criteria that is not met. 2) Throughout the 24 months preceding the sale, Edward, or a person related to Edward, must have owned the shares of Cell City. A criterion has been met. 3) Cell City is a CCPC and throughout the 24 months preceding the sale of shares, more than 50% of the FMV of Cell City's assets were composed of qualifying assets and more than 90% of the FMV of Space's assets were composed of qualifying assets, or more than 90% of the FMV of Cell City's assets were composed of qualifying assets and more than 50% of the FMV of Space's assets were composed of qualifying assets, a criteria that is not met under paragraphs 110.6(1)(c)&(d). Cell City: 80% qualifying assets Space shares / FMV of total assets 1,000,000 / 1,250,000 = 80% < 90% Space: 81.8% qualifying assets Total FMV of assets less loan to Broke Ltd. / Total FMV of assets 1,350,000 / 1,650,000 = 81.8% < 90% Neither Cell City nor Space has qualifying assets representing at least 90% of total assets. We suggest a solution to remove the ineligible assets from Cell City and Space. The ineligible assets could be removed from Cell City and Space by the following steps: 1) A new corporation (A) is formed by Edward Lau. He will own 100% of common shares. 2) Space declares a dividend of $300,000, which is paid to Cell City by transferring the loan granted to Broke Ltd. The dividend received by Cell City of taxable but is deductible under subsection 112(1), and is not subject to Part IV tax assuming Space has not received refund as a result of the payment of the dividend. 3) Edward Lau transfers 44 common shares of Cell City to A utilizing section 85 of the ITA (Income Tax Act) and receives as consideration preferred shares having a PUC of $44, which are redeemable for $550,000. The FMV of preferred shares represent the total value of the ineligible assets of Cell City. The number of common shares transferred to A is determined based on the FMV of Cell City's ineligible assets and is calculated as follows, Loan to Broke Ltd. 300,000 Treasury Bills 150,000 Shares of Public Corporations 100,000 550,000 FMV of Ineligible Assets 550,000 Total FMV of Cell City Shares 1,250,000 Equals 44% 100 common shares X 44% = 44 shares 4) Cell City transfers its ineligible assets to A under Section 85 in exchange for voting preferred shares redeemable for $550,000 and having a PUC equal to the cost (agreed amount) of the assets transferred. A combination of preferred shares and notes could also be used. 5) Cell City redeems the common shares held by A and A redeems the preferred shares held by Cell City using a simple exchange of cheques. The redemptions will give rise to taxable dividends under section 84(3), which are deductible under subsection 112(1). Keep in mind that section 55(2) might apply if the shares of either company are subsequently sold to an arm's length party. Following the above steps, Cell City and Space have only qualifying assets and therefore qualify as Small Business Corporations. However, if Edward sold his Cell City shares, he would not be entitled to the $375,000 CGD because both Cell City and Space would not have had a sufficient percentage of qualifying assets throughout the 24- month period. If Edward wishes to claim the CGD, he must wait for 24 months before selling the shares of Cell City. Of course there are other solutions to remove ineligible assets from both corporations but the above steps is the most common method of purifying or removing ineligible assets from a corporation when an amalgamation or wind-up doesn't work. Purification planning is not the only one method, but there are other methods that can be summarized as follows: 4.1. Simple method There are some simple solutions for internal purification measure. - The ineligible liquid assets that do not bring in business income can be used for repaying liabilities - Ineligible assets to be utilized to pay bonus or dividend to shareholders - Ineligible assets can be used to pay shareholder up to the PUC of their shares - Amalgamation of two subsidiaries. One with a high debt ratio and one with substantial liquid assets, then, the non-qualifying assets can be used to pay the debt. The debt can either be of qualifying assets with a large dollar value and non-qualifying assets with a small dollar value. Amalgamated company is purified because the high dollar valued qualifying assets make up more than 90% of total assets. - If similar characteristics between parent and non-qualifying subsidiary exist as described in the amalgamation examples above, winding-up subsidiary into parent can achieve purification. 4.2. Complex Purification Measures There are two complex methods for purification: Transfer of shares to company under Section 85 of the Income Tax Act, and redemption of shares under Section 86 of the Income Tax Act. 4.1.1 Section 85 to rid corporation The example of Cell City: - The FMV of the ineligible assets has to be calculated - PUC of common shares in the first corporation to be determined - The ineligible assets to be divided by the per share PUC to determine the number of shares required in order to equal the FMV of the ineligible assets - A new corporation to be formed with Edward owning 100% of the shares - Under Section 85 of Income Tax Act, transfer the shares of the first corporation corresponding to the value of the ineligible assets to the new corporation. Edward receives new corporation shares with an equal FMV and PUC as those transferred - First Corporation uses its ineligible assets to redeem its shares held by the new corporation - All the above transactions results in a deemed dividend under Section 84(3) which after the 112(1) deduction, is not taxable to the new corporation 4.1.2 Section 86 to rid corporation - Determine the Fair market Value of the ineligible assets using the above-related rules. - Reorganize the capital of the corporation with owner receiving common shares equal to the FMV of the eligible assets and preferred shares redeemable for the FMV of the ineligible assets. - A new corporation to be formed with owner owning 100% of the shares - Under Section 86, owner transfers his preferred shares to the new corporation, receiving new corporation shares with the same PUC and Fair Market Value. - First corporation uses its ineligible assets to redeem its preferred shares held by the new corporation. - Deemed dividend under section 84(3) not taxable as new corporation receives 112(1) deduction. Two methods have the disadvantages, such as accrued gain on the sale of non-qualifying assets may result in taxes payable by First Corporation and Section 55(2) may apply if first corporation shares are sold to a different third party. A number of factors come into play, and the owners rely heavily on the rules and regulations to make this decision. They may have tax-related questions but will also want to know the advantages and disadvantages to the business. The report analyzed and discussed alternative tax planning for Cell City, and recommended some simple solutions and complex methods for purification for sole proprietor. 5. References Canadian Income Tax Act with Regulation, Annotated 85th Edition 2008 Spring. Toronto, Ontario: CCH Canadian Limited, Consolidate to February 26, 2008.. Leduc, Johanne, and St-Onge, Francine.Advanced Personal & Corporate Taxation, Burnaby, BC: 2008. Print. $750,000 Lifetime Capital Gains Exemption (LCGE) / $375,000 Lifetime Capital Gains Deduction. Revised: September 6, 2009. . CALCULATION OF CAPITAL GAINS DEDUCTION FOR 2008. Canada Revenue Agency. 2008. Paul, Duarte. Is The Income Tax System Legal : A Guide to the Canadian Income Tax System. Bloomington: AuthorHouse, 2008. Read More