Section 84.1 of the Income Tax Act is intended to prevent the creation of paid-up capital or the tax-free removal of corporate surplus on a non-arm's length transfer of property to a corporation by an individual.
The general consequences of section 84.1 are a reduction in paid-up capital (to the extent there was an increase from the transaction) and/or a deemed dividend to the extent non-share consideration, such as cash or promissory notes, received on the transfer exceeds the tax cost of the property.
While the reduction in paid-up capital does not create an immediate tax bill, the receipt of non-share consideration in excess of tax cost creates immediate tax on a deemed dividend. Tax cost, for section 84.1 purposes, differs from the usual definition in the Act. For section 84.1, tax cost is generally cost less any cost base related to capital gains exemption claimed by a related party and/or a V-day (1971 value increment) increment in the shares.
A simple transfer by an individual, of an operating company to a holding company, can cause unexpected tax consequences due to section 84.1.
Consider the following example:
X transfers shares of Opco, with a fair market value of $750,000, a tax cost of $750,000 from a capital gains crystallization (see Tax Tip 10-15) and nominal paid-up capital, to a holding company. X receives a $750,000 note from the holding company, given that the tax cost of the Opco shares is $750,000. In this case, the shares of Opco had a tax cost of $750,000 for all other sections of the Act, but the tax cost for section 84.1 was actually nominal. As a result, section 84.1 will apply to create a deemed dividend of $750,000 to X.
This adjustment would not apply if X had purchased the Opco shares from a third party and the third party had used the capital gains exemption.
The above is a simple example but section 84.1 can apply in less obvious situations.† For that very reason, it is no surprise that section 84.1 assessments are a major cause of litigation against tax advisors.
This †provision can have dire consequences and should not be overlooked when considering a transfer to a non-armís length party.
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