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					                                             CHAPTER 8
                                       TAXATION ISSUES

                                      I.    PERSONAL TAX

a.    KEY QUESTIONS


      i.      WHAT IS THE DIFFERENCE BETWEEN PAYING TAX AS AN EMPLOYEE AND PAYING
              TAX AS A BUSINESS OWNER?

      ii.     WHAT DEDUCTIONS CAN A SOLE PROPRIETOR CLAIM?

      iii.    WHAT IS DEPRECIATION? HOW CAN AN ENTREPRENEUR DEDUCT THE COST OF
              CAPITAL ASSETS?

      iv.     ARE PARTNERSHIPS TAXED DIFFERENTLY FROM SOLE PROPRIETORSHIPS?

      v.      WHAT IS A "FISCAL YEAR"? CAN A SOLE PROPRIETOR SELECT A YEAR-END OTHER
              THAN DECEMBER 31 FOR TAX PURPOSES?

      vi.     WHAT IS A CAPITAL GAIN AND HOW ARE CAPITAL GAINS TAXED?

      vii.    IF AN ENTREPRENEUR'S BUSINESS LOSES MONEY IN ONE TAX YEAR, CAN THE
              ENTREPRENEUR USE THAT LOSS TO REDUCE HIS TAX PAYABLE IN ANOTHER
              YEAR?

      viii.   IF AN ENTREPRENEUR HAS EMPLOYEES, MUST HE DEDUCT TAX, C.P.P., U.I.C., AND
              WORKMEN'S COMPENSATION?

      ix.     IS THERE A DIFFERENCE BETWEEN "TAX EVASION" AND "TAX AVOIDANCE"?


INTRODUCTION

Income tax impacts upon the profitability of nearly all entrepreneurial ventures. It is, therefore, imperative
that the entrepreneur have a personal understanding of this area, or that he/she hire an accountant
possessing such knowledge. The following are answers to some of the more relevant and common
questions asked by entrepreneurs in the personal tax area.

i.    WHAT IS THE DIFFERENCE BETWEEN PAYING TAX AS AN EMPLOYEE AND PAYING TAX
      AS A BUSINESS OWNER?

The distinction between an employee and an independent contractor is important because an independent
contractor is entitled to claim more expenses as deductions, and as a result may pay less tax, than an
employee.

Independent contractors are allowed to deduct all reasonable expenses incurred for the purpose of
gaining and producing income (Income Tax Act (ITA) section 9). This general rule is subject to the list of
expenses specifically included in or excluded from income under Subdivision b of Division B, ITA. The net
                                                  8-2
profit is then taxed in the hands of the independent contractor at his personal rate along with all other
personal income for the calendar year.

Employees are strictly limited to the deductions listed in section 9 (ITA, subsection 8(2)). These are
restrictive and would include, for example, Canadian Pension Plan, UIC, and pension plan contributions.

The courts have invoked several tests in differentiating between employees and independent contractors.
                                                          See Appendix 1 for the various tests the Courts
                                                          have relied upon. The trend has been to move
                                                          away from single criterion tests and towards an
                                                          examination of the entire scheme of operations.
                                                          Because no single test is determinative, the facts
                                                          of each case are crucial.
                                                                                   1
The following are the 1999 combined Federal/Provincial personal income tax rates :

          Taxable Income                                         Alberta 44%
                                                                                 Marginal Rate on
                                                   2                                                       4
    Lower Limit      Upper Limit       Basic Tax           Rate on          Dividend       Capital Gains
                                                                                   3
                                                           Excess           Income




1
        The tax rates include the federal surtax and provincial flat tax of 0.5% of taxable
              income, surtax or reduction and reflect budget proposals to June 15,
              1999. Where the tax is determined undre the minimum tax (AMT)
              provisions, the above table is not applicable. AMT may be applicable
              where the tax otherwise payable is less than the tax determined by
              applying the relevant AMT rate (26.18% including federal and Alberta
              surtaxes) to the individual’s taxable income adjusted for certain
              preference items. All individuals are also entitled to a basic AMT
              exemption of $40,000.
2
        The tax determined by the table should be reduced by the provincial tax value of
              all applicable tax credits (see Chart below) other than the basic and
              supplementary personal tax credits, which have been reflected in the
              calculations.
3
        The rates apply to the actual amount of taxable dividends received by individuals
              from taxable Canadian corporations.
4
        The rates apply to the actual amount of the capital gain. The capital gains
              exemption on qualified farm property and small business corporation
              shares may apply to eliminate tax on those specific properties.
                                                   8-3
         $    0 to          $ 7,044         $     0           0.00%      0.00%            0.00%
          7,045 to            7,294               0            17.00       4.58            12.75
          7,295 to          10,141               43            17.34       5.01            13.01
         10,142 to          17,194              536            29.53       9.25            22.15
         17,195 to          19,794            2,619            25.47       7.84            19.10
         19,795 to          29,590            3,281            24.98       7.23            18.74
         29,591 to          45,279            5,728            37.94      23.43            28.46
         45,280 to          46,735           11,681            38.86      23.98            29.14
         46,736 to          59,180           12,247            40.03      24.69            30.02
         59,181 to          62,391           17,228            44.59      30.40            33.44
         62,392 to          and up           18,660            45.17      30.79            33.87

                                                          5
1999 Federal Personal Tax Credits and Related Tax Value in Alberta

                                                                       Federal      Alberta Tax
                                                                        Credit         Value
    Amount of Credit:
        Basic personal credit (see not 2 above)                           $1,155         $1,779
        Spousal credit (reduced by 17% of spouse’s income of $572)           972          1,497
        Equivalent-to-spouse credit (reduced by 17% of dependant’s
             income over $572)                                               972          1,497
        Infirm dependant aged 18 or over (reduced by 17% of
             dependant’s income over $4,103)                                 400            616
                                 6
        Age credit (65 and over)                                             592            852
        Disability credit                                                    720          1,108
        Pension income (maximum)                                             170            262
        Education - per month                                                 34             52
    Credits as a percentage of:
        Tuition fees                                                      17.00%        26.18%
                          7                                                 17.00         26.18
        Medical expenses
        Charitable donations
        • first $200                                                       17.00          26.18
        • remainder                                                        29.00          44.67
                          8                                                17.00          26.18
        CPP contributions                                                  17.00          26.18
        EI premiums


5
             The tax value of each tax credit is the sum of the federal tax credit, the related
                   reduction in Alberta tax (44% of credit) and the reduction in federal and
                   Alberta surtaxes as it would apply to taxpayers in the highest tax bracket.
6
             The maximum age credit of $852 occurs at $25,921 of net income and declines
                  to nil as net income rises to $49,134.
7
             The credit is computed as 17% of the amount by which eligible medical
                  expenses exceed the lesser of $1,614 and 3% of net income.
8
             All CPP paid by both employees and self-employed individuals will give rise to a
                   tax credit.
8-4
                                                      8-5
Minimum Tax

The minimum tax rules are set out in ITA sections 127.5 to 127.55. The minimum tax establishes a
separate tax calculation to parallel the regular tax calculation. Only taxpayers with incomes in excess of
$40,000 need concern themselves with the minimum tax.

ii. WHAT DEDUCTIONS CAN A SOLE PROPRIETOR CLAIM?

The general rule is that a sole proprietor is allowed to deduct all reasonable expenses incurred for the
purpose of gaining or producing income (ITA section 9). This equates to the notion of generally accepted
accounting principles (G.A.A.P.). The words "subject to this Part" in section 9 indicate that this general rule
may be overridden by other sections of Part 1 of the Act. The most important sections for consideration in
this Part are sections 18 and 20 (although all sections should be canvassed).

The Act prohibits businesses, including sole proprietorships, from deducting certain expenses. In order to
be deductible, the expense must be made or incurred by the taxpayer for the purpose of gaining or
producing income from the business or property (paragraph 18(1)(a)). Appendix I offers some assistance
in interpreting paragraph 18(1)(a). It should also be borne in mind that deductions will only be allowed to
the extent they are reasonable (see ITA section 67).

No deduction of an outlay of a capital nature is allowed unless deduction is specifically authorized
elsewhere in Part 1 of ITA (for example, see section 20 and the discussion of depreciation in question 4 of
this chapter). This simply means that if the asset will last more than one year, it cannot be fully expended
in the year. Instead it must be written off, or depreciated over time. For example, a building or major piece
of equipment will last for more than one year. Therefore, the cost is not currently deductible. The following
offer some insight into what constitutes an outlay of a capital nature:

   (i) An expense incurred for the purpose of procuring for the company the advantage of an enduring
       benefit is not deductible (i.e., it is a capital outlay).

   (ii) An expense incurred to protect a company's right to market a product under a certain name is not
        a capital outlay where no permanent advantage is brought into existence.

   (iii) The advantage of an enduring benefit must be a direct result of the expenditure in order for a court
         to find the outlay to be capital in nature.

The Act also prohibits the deduction of personal or living expenses of the taxpayer, other than traveling
expenses (including meals and lodging) incurred by the taxpayer while away from home in the course of
carrying on his business. For example, the cost of travel between home and office are personal expenses
and are not deductible.

Other important restrictions on deductions include:

   (i) expenses related to a personal service business (18(1)(p)).
   (ii) allowances for the use of an automobile (18(1)(r)), and
   (iii) home office expenses (18(12)).

iii. WHAT IS "DEPRECIATION"? HOW CAN AN ENTREPRENEUR DEDUCT THE COST OF CAPITAL
     ASSETS?

Generally, where an expense is at issue the taxpayer will prefer the expense to be characterized as a
current expense - in which case the entire amount would be deductible in the current taxation year. See
the earlier discussion regarding ITA paragraph 18(1)(b) for tests used to differentiate between capital and
non-capital expenditures. Notwithstanding paragraph 18(1)(b), where an expenditure is of a capital nature
the taxpayer may be allowed to claim a depreciation deduction (paragraph 20(1)(a)).
                                                     8-6

Paragraph 20(1)(a) provides for this deduction and refers you to the regulations. Part XI of the Income Tax
Regulations (ITR) sets out the details of the capital cost allowance (CCA) system. In general terms it
provides a depreciation rate for different types of property. Paragraph 100(1)(a) of the Regulations
requires that assets be pooled by class and depreciated using a declining balance method (except for
classes 13, 14, 15, 19, 20,21, 24, 27, 29 and 34 which use a straight-line method). CCA may be claimed
in respect of the property in each pool in an amount not exceeding the designated rate for that class.

The regulations limit CCA deductions of an asset to 50% of the prescribed rate for the year in which that
asset was acquired. This rule applies regardless of whether the depreciable asset was acquired near the
beginning of or near the end of the tax year. The Regulations also impose a business purpose limitation -
the asset must have been acquired for the purpose of gaining or producing income otherwise no CCA
deduction is allowed.

When a taxpayer claims CCA, the amount claimed is deducted from the capital cost of the class, leaving a
balance known as undepreciated capital cost (UCC). UCC is defined in paragraph 13(21)(f). The amount
of CCA that a taxpayer can claim in any tax year is based upon the UCC of the class.

Appendix 2 provides information regarding some areas of the CCA system.

The various classes of depreciable property are detailed in Schedule II of the ITR.

iv. WHAT HAPPENS WHEN YOU DISPOSE OF DEPRECIABLE ASSETS?

The purpose of depreciation, as previously discussed, is to allow a "write-off" for the declining value of the
assets. That being the case, when an asset is sold, its value or the POD should be equal to the asset's
UCC. Of course, this rarely is the case. The asset may be sold for:

   1. less than its UCC, meaning the POD are less than the UCC of the asset;

   2. more than its UCC, meaning the POD are more than the UCC of the asset but less than the ACB
      of the asset; or

   3. more than both its UCC and ACB.

The income tax consequences arising from the disposition of depreciable property can be summarized as
follows:

   1. Depreciable property sold for POD greater than the ACB (and, therefore, greater than the UCC) of
      the asset.

        a.   As in the case of capital property, POD exceeding the ACB of the property results in a capital
             gain equal to the amount of the excess.

        b.   The amount by which the ACB of the asset exceeds the UCC of the asset is recaptured
             income which means that too much CCA was claimed in respect of the asset and must be
             added back into income. Recapture is pure income added to the income of the taxpayer in the
             year of disposition [subsection 13(1)]. If the ACB and UCC is the same (meaning no CCA has
             been claimed), there will be no recapture, simply a capital gain.
                                                 8-7
The following diagram may be of some help:


                              15
                                          POD
                                                        Capital Gain
                              10
                                          ACB
                                                        Recapture
                               5
                                          UCC


In this case, where POD = $15, ACB = $10 and UCC = $5, there will be $5 of recaptured income and a
$5 capital gain.

2. Depreciable property sold for POD less than the ACB but greater than the UCC of the asset.

    a.   Since POD do not exceed the ACB of the property there is no resulting capital gain. However,
         unlike capital property, no capital loss arises notwithstanding that the POD are less than the
         ACB of the asset sold.

    b.   The amount by which the POD of the asset exceeds the UCC of the asset is recaptured
         income since again too much CCA was claimed in respect of the asset and must be added
         back into income.

The following diagram illustrates the above:

                              15
                                           ACB
                              10
                                           POD
                                                          Recapture
                               5
                                           UCC


In this case, where POD = $10, ACB = $15 and UCC = $5, there will be $5 of recaptured income.

3. Depreciable property sold for POD less than both the ACB and the UCC of the asset.

    a.   Again, since POD do not exceed the ACB of the property there is no resulting capital gain.

    b.   The amount by which the lesser of the ACB and UCC of the asset exceeds the POD becomes
         a terminal loss which is deductible in computing the income of the taxpayer for the year of
         disposition [subsection 20(16)].
                                                       8-8
   The following diagram illustrates the above:

                                   15
                                                 ACB
                                   10
                                                UCC
                                                                Recapture
                                    5
                                                 POD


   In this case, where POD = $5, ACB = $15 and UCC = $10, there will be a $5 terminal loss.

iv. ARE PARTNERSHIPS TAXED DIFFERENTLY FROM SOLE PROPRIETORSHIPS?

Partnerships are governed by special provisions in subdivision j of Division B of Part 1 of the ITA. For
assistance in determining whether or not a partnership exists see Appendix 3. See also the information
contained in Chapter 2 regarding the partnership as a business format.

It is important to note that net income is computed at the partnership level and the income is then taxed in
the individual hands of the partners on a pro rata basis at each partner's personal tax rate. The
partnership itself does not file a tax return but must file an information return. In contrast, where the format
is that of a joint venture each co-venturer computes net income separately. Therefore, it is crucial to
determine whether the business is a partnership or a joint venture.

v. WHAT IS A "FISCAL YEAR"? CAN A SOLE PROPRIETOR SELECT A YEAR END OTHER THAN
   DECEMBER 31 FOR TAX PURPOSES?

A fiscal year is a period of 12 consecutive months chosen by a business as the accounting period for
annual periods. Until 1995 a taxpayer could use any fiscal period for the businesses provided that period
conformed with the limitations in subsection 248(1). For example, income of a sole proprietorship for the
12 month fiscal period ending January 31, 1994 would be reported with any other income of the individual
for the 1994 taxation year ending December 31, 1995. The deferral benefit is now gone for sole
proprietors and partnerships that include individuals or professional corporations and both must report
business income based on the calendar year. Corporations, however, may still file based on a fiscal
period.

vi. WHAT IS A CAPITAL GAIN AND HOW ARE CAPITAL GAINS TAXED?

Generally, a taxpayer will want to characterize income as being from a capital source because income
from such a source is taxed at only 3/4 of the rate at which income from a non-capital source is taxed.
Also, the taxpayer may be able to take advantage of the $500,000 capital gains exemption for shares of a
small business corporation and certain farming property.

There is a capital gain where the proceeds of disposition exceed disposition costs plus the original cost (or
"adjusted cost base") of the property. A capital loss exists where the original cost (adjusted cost base)
plus disposition costs exceed the proceeds of disposition. The taxable capital gain or allowable capital
loss is equal to 3/4 of the capital gain or capital loss, respectively (section 38).
                                       8-9
vii. IF AN ENTREPRENEUR'S BUSINESS LOSES MONEY IN ONE TAX YEAR, CAN THE
        ENTREPRENEUR USE THAT LOSS TO REDUCE HIS TAX PAYABLE IN ANOTHER YEAR?

There are two basic types of restrictions on losses available for carry-over. First there is a restriction on
the type of income against which the loss carry-over can be deducted, second there is a restriction on the
number of years a loss can be carried over.

    (i) Deductible capital losses on capital property (other than listed personal property or personal use
        property) may be offset against:

        a.   Any taxable capital gain in the year.
        b.   Any taxable net capital gain in the 3 preceding years.
        c.   Any taxable net capital gain in any following year(s).

An entrepreneur may choose to operate through a sole proprietorship rather than through a corporation
because of the loss carry-back and carry-forward provisions. A sole proprietor may use losses of the
business (which often occur in the early years) to reduce personal taxes arising from other sources of
income. On the other hand, a corporation, being a separate entity, can only offset loses against corporate
profits and not against personal income of the entrepreneur.

    (ii) Allowable non-capital losses may be offset against:

        a.   Any income in the year.
        b.   Any income of the preceding years.
        c.   Any income of the following 7 years.

An entrepreneur may choose to operate through a sole proprietorship rather than through a corporation
because of the loss carry-back and carry-forward provisions. A sole proprietor may use losses of the
business (which often occur in the early years) to reduce personal taxes arising from other sources of
income. On the other hand, a corporation, being a separate entity, can only offset loses against corporate
profits and not against personal income of the entrepreneur.

viii.   WHAT IS A TAX AUDIT? WHEN CAN Canada Customs & Revenue Agency REQUIRE AN
        ENTREPRENEUR TO PERMIT THEM TO AUDIT HIS TAX RETURNS?

An audit is an inspection and verification, performed by Canada Customs & Revenue Agency, of a
taxpayer's return or other transactions possessing tax consequences. The sections of the ITA pertaining
to audits are sections 230 to 237.1. Taxpayers are required to keep books and records so as to enable
taxes to be determined (section 230 and Regulation 5800). Generally, books and records must be kept for
a period of 6 years but section 230 and Regulation 5800 should be consulted to determine exact
requirements. Sections 231 and 231.6 set out the broad authority of Canada Customs & Revenue Agency
officials to inspect such books and records, as well as other property. Generally, officials may enter
business premises at any reasonable time, but require a search warrant issued by a judge to enter
premises that are a "dwelling house" ("dwelling house" is defined in section 231). For further information
regarding audits and bookkeeping requirements consult Appendix 3 and Chapter 3.

ix. IF AN ENTREPRENEUR HAS EMPLOYEES, MUST HE DEDUCT TAX, CPP, UIC AND WC FROM
    THEIR PAY?

TAX: Subsection 153(1) stipulates that "every person paying at any time in a taxation year salary or
wages ... shall deduct or withhold therefrom such amount as may be determined in accordance with
prescribed rules and shall, at such time as may be prescribed, remit that amount to the Receiver General
on account of the payee's tax for the year under this Part". Employers must remit the withheld amount to
Canada Customs & Revenue Agency by prescribed dates. These dates may vary with the amount of the
remittance - consult the various legislation for further details.
                                                   8-10

An employer who fails to withhold any amount as required by subsection 153(1) is liable to civil penalty
(subsection 227(8)) and criminal penalty (section 238).

The Income Tax Regulations Part 1 and Schedule 1 to the regulations establish the amounts to be
withheld. Every year, employees receive withholding tables to assist in this regard. Regulation 200 lists
persons who are required to make information returns in the prescribed form.

Amounts withheld by the payor under section 153 constitute trust funds held in trust for Her Majesty and
all such amounts must be kept separate and apart from the payor's own moneys: section 227(4) and (5).
Failure to comply with section 227(5) is an offence. In the event of any liquidation, assignment or
bankruptcy such amounts shall remain apart from and form no part of the estate in liquidation, assignment
or bankruptcy.

WC: An employer whose industry is not designated in the General Regulations as exempt is required to
establish an account when regular, casual, or contract workers are employed. The employer is required to
notify the Workers' Compensation Board within 15 days of the commencement of employment and to
provide specific information about his operations, together with an estimate of assessable earnings of his
workers for the year. An account is then established in the name of the employer, and an assessment
statement is issued. Items that employers are required by Canada Customs & Revenue Agency Taxation
to report as taxable benefits are to be included in their report of workers' earnings for assessment
purposes.

UIC:   Subsection 53(1) of the Act (UIA) states:

   "Every employer paying remuneration to a person employed by him in insurable employment shall
   deduct from that remuneration an amount equal to the employee's premium payable ... and remit it
   together with the employer's premium payable ..."

Employees employed in insurable employment are required to pay, by deduction, a certain amount
(subsection 51(1)). Similarly, employers are required to pay a certain amount.

Section 3, UIA, is important because it differentiates between insurable employment (for which deductions
must be made) and excepted employment (for which deductions are not required).

Section 3, 51, and 53 of the UIA can be found in Appendix 19.

CPP: CPP payments must also be deducted by the employer in most circumstances. The relevant
sections of the Canada Pension Plan Act (sections 6, 8 and 10) are similar to the above mentioned
sections of the UIZ.

x. IS THERE A DIFFERENCE BETWEEN "TAX EVASION" AND "TAX AVOIDANCE"?

Tax evasion involves knowingly reporting tax that is less than the tax payable under the law with an
attempt to deceive by omitting revenue, fraudulently claiming deductions, or failing to use all of the true
facts of a situation. Tax evasion is illegal and can be prosecuted as such (see the ITA sections 238 and
239).

Tax avoidance arises in situations in which taxpayers attempt to eliminate or minimize their tax obligations
either through openly arranging their affairs in such a manner as to take advantage of the most beneficial
provisions of the income tax legislation, or to rely on reasonable differences in interpreting provisions of
that legislation. Although tax avoidance is not illegal, Canada Customs & Revenue Agency may challenge
attempts at tax avoidance by various means available to it including the general anti-avoidance rule found
in ITA section 245.
                                                 8-11
The following are some of the ITA provisions commonly used to curtail tax avoidance:

   i.    Arm's Length - related persons are deemed not to deal at arm's length and it is a question of fact
         whether non-related persons deal at arm's length (section 251). Where anything was acquired for
         consideration in excess of fair market value then it is deemed to have been acquired at fair market
         value (paragraph 69(1)(a)). Where a taxpayer sells anything at a price below fair market value or
         disposes of anything by way of gift inter vivos, the taxpayer is deemed to have received fair market
         value (subparagraphs 69(2)(b)(i) and (ii)).

   ii.   By virtue of the attribution rules in sections 73 to 75.1, in certain situations income or capital gains
         from property will be attributed back to the transferor and will be taxable to him. In general,
         property cannot be gifted or transferred for less than fair market value to a spouse or a related
         minor child without attribution.

   iii. Subsection 56(2) prevents the redirection of payments or transfers. Subsection 56(2) applies
        when the following conditions are satisfied:

         a.   there has been a payment or transfer of property made to a person other than the taxpayer;

         b.   the payment or transfer was made pursuant to the direction of the taxpayer or with his
              concurrence [Interpretation Bulletin IT-335, dated August 9, 1976, Canada Customs &
              Revenue Agency states that the direction or concurrence of the taxpayer "may be implicit"];

         c.   the payment or transfer is for the taxpayer's own benefit or for the benefit of some other
              person on whom the taxpayer wished to confer it; and

         d.   the payment or transfer, if made to the taxpayer, would have been included in his income.

         The amount to be included in the taxpayer's income with respect to the payment or transfer made
         to the third party, is the amount that would have been included in his income had he received the
         payment directly. In Interpretation Bulletin IT-335, the point is made that if the payment or transfer
         would have been considered to be income or capital if it had been received by the taxpayer, it will
         be taxed in the same way under subsection 56(2).

   iv. Subsection 56(4) prevents the transfer or assignment of rights to an amount and may be
       redundant in light of subsection 56(2).

   v.    Sections 127.5 to 127.55 require the taxpayer to pay a minimum tax.

   vi. There is now a general anti-avoidance rule in section 245.
                                                    8-12
                          II. TAXATION OF PARTNERSHIPS

a. KEY QUESTIONS


     i.   HOW ARE PARTNERSHIPS TAXED?

     ii. ARE THERE SPECIFIC TAX PROVISIONS THAT SHOULD BE CONSIDERED WHEN
         DRAFTING A PARTNERSHIP AGREEMENT?

     iii. ARE THERE SPECIAL TAX CONSIDERATIONS IN ADMITTING A PARTNER?

     iv. WHAT ARE THE TAX ADVANTAGES AND DISADVANTAGES OF INCORPORATION VS.
         PARTNERSHIP?

     v. WHAT ARE THE TAX ADVANTAGES OR SETTING UP A PROFESSIONAL CORPORATION?


i.   HOW ARE PARTNERSHIPS TAXED?

Partnerships are governed by special provisions in Subdivision j of Division B of Part I of the ITA.

Income of a partner is computed as if the partnership was a separate person resident in Canada. The tax
year is the fiscal period of the partnership. Elections in relation to tax treatment in the computation of
income with respect to a number of matters must be made at the partnership level and, therefore, be
treated in the same manner by all partners. This election must be made on behalf of all members of the
partnership by one who has the authority to make that election. These matters include: the role of
accounts receivable; exclusion of "work in progress" from the computation of income from a professional
business; the transfer of property from partner to partnership; capital gains computation; and the amount
of CCA to be claimed, Appendix 11 gives an accurate description of which revenues and expenses are
calculated at the partnership level and which revenues and expenses are calculated at the partner's level.

Each taxable capital gain and allowable capital loss from the disposition of property owned by the
partnership and the amount of any income or loss of the partnership from such sources as business or
property will be calculated for each fiscal period of the partnership. However, this income is not taxed at
the partnership level but is allocated to the partners according to the terms of the partnership agreement.

The income that flows through to each partner retains its original character, thereby enabling the partners
to benefit, for example, from the dividend tax credit, the foreign tax credit and the capital gains deduction.
(See Appendices 4 and 5).
                                       8-13
ii. ARE THERE SPECIAL TAX PROVISIONS THAT SHOULD BE CONSIDERED WHEN DRAFTING A
    PARTNERSHIP AGREEMENT?

PART I
                             *********
1. Statement of Intention

The tax provisions, particularly division of profits or assets will apply only if a partnership exists. The
existence of a partnership has been in dispute, particularly in husband and wife situations. Therefore a
clear statement of intention is desirable, i.e., ―Whereas Dana C. and Bill C. are barristers and solicitors
duly qualified in and for the Province of Alberta and are desirous of carrying on the practice of law in
partnership upon the terms and subject to the conditions hereinafter provided‖.

2. Continuation of the Partnership

Under most provincial partnership Acts, the notice of a partner of his intention to dissolve the partnership,
the death or insolvency of a partner, or the admission of a new partner will have effect of a dissolution of a
partnership. The tax implications of a dissolution are far reaching and result in the disposition for tax
purposes of the partnership assets at their fair market value.

In order to avoid such unintended tax consequences, therefore, it is generally advisable that the
partnership agreement provide that, to the extent possible, one of these events will not affect the
continued existence of the partnership. A clause such as the following might serve this purpose:

     The Partnership hereby constituted and this agreement shall not terminate on the retirement,
     death, expulsion, incapacity or withdrawal of a Partner or on the admission of a new Partner or
     Partners. In the event of the retirement, death, expulsion, incapacity or withdrawal of a Partner, the
     Partnership shall terminate only as to such Partner and shall continue as to the remaining Partners
     and in such event the Partnership shall not be required to close its accounts. Each Partner hereby
     renounces any right which he may otherwise have under the law to dissolve the Partnership at will
     and acknowledges that the Partnership may only be dissolved by the vote of the Partners as
     provided elsewhere in this agreement.

A clause of this kind will not be effective in the event of the death, retirement, or withdrawal of one
member of a two-partners firm. In this situation, the agreement should provide an option which gives the
ongoing party the right to acquire the interest of the partner who died, retired, or withdrew at an
appropriate amount, in lieu of the realization of distribution of the property of the firm. Such an option, if
exercised, would permit the application of the rules in subsection 98(5) of the Income Tax Act, which
would have the effect of deferring some portion of the gains accrued with respect to the property of the
firm. Wording such as the following might have this effect:

     Where a member of the firm dies or otherwise ceases to be a partner, the surviving or continuing
     member shall have the right to continue the business of the firm and, further, shall have an
     irrevocable option to acquire the interest of the former member who has died, or otherwise ceased
     to be a partner, for an amount determined in accordance with other provisions of this agreement.
     This option, to be effective, must be exercised within thirty days after the day on which the first
     named former member ceased to be a member of the partnership.



*********
     The answer to this question is adapted in large part from: K.McNair, Partnership
Tax Considerations and the Partnership Agreement 33rd Tax Conference, Canadian
Tax Foundation at 282.
                                                   8-14

3. Elections by Members of Partnership

The Income Tax Act, subsection 96(3), provides that certain elections relevant to the computation of a
partner’s income from a partnership may be made only by one partner acting with authority on his own
behalf and on behalf of every other person who was a partner during the relevant fiscal period. Each other
partner, in the event such an election is properly made by the authorized partner, is deemed to have made
a valid election. The elections which are covered by subsection 96(3) are those made under:

   1. section 22-43 the purchase or sale of accounts receivable;

   2. subsection 13(4) - re the deferral of recapture of capital cost allowance where replacement
      property acquired;

   3. subsection 13(5) - re optional treatment of proceeds of disposition of a vessel owned before 1966
      and disposed of before 1974;

   4. subsection 13(16) - election in respect of proceeds of disposition of a vessel, to which subsection
      13(15) does not apply;

   5. subsection 14(6) - election re amount payable with respect to disposition of eligible capital property
      that may be applied in respect of replacement property;

   6. subsection 20(9) - election to deduct one-tenth of expenses of representations for purpose of
      obtaining a licence, permit, franchise, or trademark, in lieu of immediate deduction;

   7. subsections 21(1) to (4) - elections to treat interest expense as part of capital cost of property or
      as part of exploration and development expense;

   8. subsection 29(1) - election to deduct in computing income a portion of the taxpayer’s basic herd;

   9. subsection 97(2) - election with respect to the proceeds of disposition and cost to the partnership
      of property transferred to the partnership by a person who, immediately thereafter, is a member of
      the partnership;

   10. paragraph 34(1)(d) - election to exclude work in progress in the computation of income from a
       profession;

   11. subsection 50(1) - election to have Canadian securities deemed to be capital properties;

   12. subsection 44(1) - election to defer capital gain where a replacement property is required;

   13. subsection 44(6) - election where land and building constituting a form of business property is
       disposed of to deem proceeds of one part to be proceeds of the other part.

In order to ensure that these elections are made as required by the Income Tax Act, the agreement should
contain a clause assigning the authority and responsibility for the completion of this task. Such a clause
could be worded in the following manner:

   Where an election is required under the Income Tax Act to be made by one partner acting on his
   own behalf and on behalf of all other partners, or such other partner as she may in writing
   designate, is authorized to make such election. The partners hereby acknowledge that such an
   election, made by partners such person as is designated by her is made with the authority of the
   partners and will be binding on each one of them.
                                                    8-15

4. Method of Accounting

Partners may elect under paragraph 34(1)(d) to exclude work in progress from the calculation of income
for tax purposes. In this case the agreement might provide for the accounting method to be used to
determine profits for internal purposes in the following manner:

   All financial transactions of the business affairs and operations of the Partnership shall be
   recorded and accounted for using the accrual method in accordance with generally accepted
   accounting principles consistently applied. For this purpose the work in progress of the firm will be
   valued at its cost, except to the extent that the partner responsible for a particular client determines
   that the cost of the work in progress for that client is not likely to be recovered.

Some description or definition of the cost of work in progress, in particular as it relates to partners’ time,
might be desirable.

The partner’s intention to elect under paragraph 34(1)(d) of the Income Tax Act might also be reflected in
the agreement as follows:

   The Partners agree that an election will be made under paragraph 34(1)(d) of the Income Tax Act
   by such other partner as she may designate, on behalf of the Partner electing and all other
   Partners, that in calculating the income of the Partnership for tax purposes, work in progress will
   be excluded.

Since the determination of income for internal purposes may be different from the determination of that
amount for tax purposes, an additional clause to the following effect might be desirable:

   Information necessary for each Partner to determine his income from the Partnership for tax
   purposes will be maintained by the Partnership and will be furnished to each Partner with his copy
   of the annual financial statement of the firm. The information will include the Partner’s share of the
   work in progress at the beginning and end of each fiscal period.

5. Capital Cost Allowance (CCA)

CCA must be claimed at the partnership level. Consequently, each partner will indirectly receive the same
deduction, proportionate to his interest, as every other partner. Obviously, the differing tax considerations
of the partners cannot all be reflected in the decision as to the capital cost allowance claim to be made by
the partnership. To prevent disagreement among the partners, in the event that a partner may wish to
increase his income from the partnership in a future period to offset other losses, the agreement should
provide that the partnership will claim the maximum capital cost allowance for tax purposes each year in
the absence of an unanimous agreement to a contrary effect. A clause such as the following might be
appropriate:

   In connection with the determination of the income of the Partnership for each fiscal period, the
   maximum capital cost allowance and other deductions that may be available to the Partnership
   under applicable income tax legislation shall be claimed, unless by unanimous vote of the partners
   a lesser deduction is approved.

6. Property Transferred by a Partner

The normal rule on the transfer of property to a partnership by a person who, immediately after the
transfer, is a partner, is contained in subsection 97(1), which provides that the transferor will be deemed to
have received proceeds equal to the fair market value of the transferred property, and the partnership will
be deemed to have acquired it at a cost of the same amount. Subsection 97(2), however, provides that an
election may be made jointly by the transferor and all the other partners and the amount elected, subject
                                                     8-16
to certain limitations, will be deemed to the proceeds of disposition to the transferor and the cost to the
partnership. The amount elected may not be less than the amount of the consideration received for the
transfer, other than an interest in the partnership, and may not be more than the fair market value of the
property transferred.

The amount elected under subsection 97(2) may, and probably will, differ from the amount credited to the
capital account of the transferor partner. That is, the transferor will probably receive consideration,
including a credit to his capital account equal to the fair market value of the property contributed to the
partnership, while the amount elected under subsection 97(2) will be a somewhat small amount.

Where the credit to the capital account is, in fact, greater than the elected amount, on the subsequent
disposition of the property by the partnership that gain is distributed among the partners in the normal
profit-sharing percentages. In other words, the other partners will be bearing a part of the tax burden
properly that of the transferor partner.

To illustrate, assume that a partner transfers a property having a fair market value of $200 to the
partnership and that amount is credited to his capital account, electing under subsection 97(2) an amount
of $100. The partnership subsequently disposes of the property for $250. For tax purposes, the gain will
amount to $150, measured from the elected amount of $100. The appropriate distribution of this gain
would be to allocate the first $100 to the transferor partner, since this measures the deferred gain,
accrued while he owned the property. The remainder of the gain, $50, that part of the total that arose while
the property was owned by the partnership, should be allocated to all the partners, including the transferor
partner, in their normal profit-sharing percentages.

Since the effect of the election is to enable the transferor partner to defer all or part of the gain accrued on
the property prior to its transfer, it seems reasonable to assume that he should be taxable on the ultimate
realization of that gain. To ensure that this is the case, it would seem appropriate to provide in the
partnership agreement a clause having this effect. The following might serve this purpose:

   Where a partner has contributed or transferred property to the partnership, and an election has
   been made under subsection 97(2) with respect to the contribution or transfer, the cost of the
   property, for purposes of partnership accounting, will be the aggregate of

        (i)   the fair market value of any consideration received by the partner, other than by way of a
              credit to his capital account; and

        (ii) the amount credited to his capital account with respect to the transfer or contribution of the
             property.

The profit, income, gain or loss on the disposition of this property will be determined for partnership
accounting purposes by comparing the proceeds of disposition of the property with the cost as determined
above, and will be allocated to the partners in the same proportions as apply in the case of other amounts
of income gain or loss. The amount by which the cost of the property for accounting purposes exceeds the
amount elected for tax purposes under subsection 97(2) of the Income Tax Act will be treated as part of
the income, gain, or loss for tax purposes of the partner by whom the contribution or transfer was made.
(See Appendix 6).
                                              8-17
7. Death, Retirement, or Withdrawal of a Partner

i)   Death

1. Where a two-man partnership ceases to exist, the ongoing former partner should have the option to
   acquire the interest of the other party and the right to carry on the business of the firm. The purpose of
   this provision is to ensure that the ongoing party can take advantage of the rules in subsection 98(5)
   and avoid the tax consequences of the realization of the partnership property.

2. Subsection 98(3) will also have the effect of avoiding this realization. In order to take advantage of this
   deferral, a number of conditions must be satisfied, including the joint election by all persons receiving
   a distribution of property and a distribution of property in such a way that each person has the same
   undivided percentage interest in each property. To ensure this treatment the agreement should
   contain a provision to ensure that all partners agree to that form of distribution and an undertaking that
   they will enter into the required election. Such a clause might read as follows:

         In the event that the partnership is dissolved by the vote of the partners, as provided
         elsewhere in this agreement, the partnership property will be disposed of and the proceeds
         distributed among the partners as their interests may appear, unless a majority of the parties
         to this agreement vote in favour of a method of distribution to which subsection 98(3) of the
         Income Tax Act will apply. Where such a vote takes place, each party to this agreement
         agrees to accept an undivided interest in each property of the partnership equal to his
         percentage interest in the partnership, in lieu of realization of the partnership property and
         distribution of the proceeds. Each party undertakes, furthermore, to enter into a joint election
         with the other parties in the form prescribed by the Income Tax Act, and within the time
         referred to in the Act, for the purposes of subsection 98(3).

Both subsection 98(3) and 98(5) are only available if the partnership in question is a Canadian partnership
as defined in section 102, that is, a partnership all the members of which at the relevant time are resident
in Canada. Since the availability of these rollover provisions may be extremely significant, the preservation
of this status may be a matter that should be addressed in the agreement. Although it is difficult to know
how effective it would be, a clause such as the following might have some positive effect:

     In the event that a partner ceases to be resident in Canada, for purposes of the Income Tax Act,
     he shall be deemed to have withdrawn from the firm and to have ceased to be a partner
     immediately before the time at which he ceased to be so resident.

ii) Retirement or Withdrawal

If a partner withdraws or retires from the firm, the agreement should have provisions that establish the
amount to which he will be entitled to receive for his interest, and the terms that will apply to the payment
of this amount. In the alternative, the agreement may provide for a purchase of the interest of the former
partner by the continuing partners rather than for a payment from the firm. Similarly, in the event of the
death of a partner the agreement may provide for the payments to be made to his estate or beneficiaries
by the firm, or for the purchase of his interest from the estate or the beneficiaries. From a tax standpoint,
perhaps the most important matters to deal with in the agreement are the amounts to be treated as
income in the hands of the retired or deceased partner or his beneficiaries. These amounts will include
amounts of work in progress previously excluded from income as well as the income for the part year
immediately preceding death, retirement , or withdrawal. One way in which they could be handled
appropriately would be to provide that such amounts would be treated as an allocation of income subject
to subsection 96(1.1) of the Act. It seems possible to accomplish this in the agreement by providing a
formula for establishing the amount of the allocation and further indicating an agreement by all partners
that the amount is to be so allocated. Such a clause could be worded in the following manner:

     In the event of the death, retirement, or withdrawal of a partner an allocation of income will be
                                             8-18
   made to him for the year in which his death, retirement, or withdrawal occurs equal to the
   aggregate of:

        (i)   the amount of work in progress excluded from his income at the end of the immediately
              preceding fiscal year-end of the partnership, and

        (ii) the partner’s share of income as determined under other provisions of this agreement for
             the period commencing with the beginning of the fiscal period in which his death,
             retirement, or withdrawal occurred and ending with the date of his death, retirement, or
             withdrawal.

   This clause is drafted on the presumption that the clause of the agreement setting out the amount
   to be paid to the former partner or his representative will include in that amount the amounts
   described. Amounts allocated to a former partner under subsection 96(1.1) of the Act are included
   in the income of that partner. In contrast a sale of the partnership interest to the remaining partners
   would result in a capital gain to which the capital gains exemption would apply.

In the absence of an express agreement, payment will be viewed as capital in nature, with the result that
the remaining partners would bear the full tax burden. See DeLesalle v. The Queen, [1986] 1 CTC FCTD,
59.

iii) Are there special tax considerations in admitting a partner?

Jane Armstrong has been invited to become a partner on February 1, of the law firm that now employs
her. The two current partners, Brenda E. and Dana C., began the partnership two years ago and have built
up the business to the point where they believe its value is $90,000. Their capital account balance and
ACB of their partnership interest will be nil at January 31. Neither Jane nor her partners are tax lawyers
and therefore have approached you to advise them on any tax issues which may be important when
admitting a new partner to their firm.

There are a number of methods available to admit Jane to the partnership. The tax implications of each
method will vary. Consider the following three alternatives:

   I.   Jane purchases a 1/3 interest from Brenda and Dana directly for $30,000 ($15,000 to each).

   II. Jane contributes $30,000 cash to the partnership and Brenda and Dana withdraw $15,000 each.

   III. Jane earns her way in by giving her first $60,000 of future earnings to Brenda and Dana and they
        withdraw $30,000 each over time.
                                                         8-19
I.   Sale of 1/3 Interest to Jane

     1. Capital Accounts                            Brenda Dana                   Jane
        (Accounting)

         Balance Jan. 31                      -                   -                -
         Admission of Jane                            -                     -                 -
                                                    _____                 _____             ______

         Balance Feb. 1                                  -                 -                 -

                                                    _____                 _____             ______

         ACB at Feb. 1 (Tax)                             -                 -                 -

                                                    _____                 _____             $30,000


     2. Results

         (a) Brenda and Dana (Vendors)

         The sale triggers a capital gains as follows:

                                                                Brenda Dana

         Proceeds                                               $15,000           $15,000
         ACB                                                       -                 -
                                                                _______           _______

         Capital Gain                                           $15,000           $15,000

         3/4 Taxable                                            $11,375           $11,375


         (b) Jane (Purchaser)

         Jane will have a ACB for her partnership interest of $30,000. She will also receive a full share of
         future partnership income taxed at her marginal tax rate.
                                                     8-20
II. Contribution of $30,000

   1. Capital Accounts (Accounting) Dana                    Brenda Jane

       Balance Jan. 31                15,000        15,000        (30,000)
       *Adjustment re admission of Jane      15,000        15,000         (30,000)

       (Drawings) Contribution                     ($15,000)        $15,000)         30,000(A)

       Balance Feb. 1                                 Nil             Nil               Nil

       ACB at Feb. 1 (Tax)                         ($15,000)        ($15,000)        $30,000 (B)

   *   This adjustment reflects goodwill prior to admitting Dana and then the writing off of goodwill after
       her admission for partnership accounting purposes.

   2. Results

       (a) Brenda and Dana (Vendors)

            There is no immediate capital gain.

       (b) Jane (Purchaser)

       Jane will have an ACB for her partnership interest and she will receive a full share of future
       partnership income taxed at her marginal tax rate.

   NOTES:

   A. If Jane contributes property rather than cash, she can elect to transfer it to the partnership at its
      ACB (s. 97(2)) and thus avoid immediate tax consequences. The partnership agreement should
      state that on a subsequent disposition of that property by the partnership any gain or loss will, to
      the extent it accrued prior to the date of transfer into the partnership, be allocated entirely to her. In
      this way, the partnership has the use of her property but the gain accrued to the date of transfer
      remains with her.

   B. The ACB’s of Brenda’s and Dana’s partners’ capital accounts would not be adjusted at the time of
      Jane’s capital contribution for tax purposes notwithstanding that their capital accounts for
      accounting purposes may be adjusted to reflect their new proportionate value of the partnership
      (i.e. the goodwill element not previously reflected in the accounting records). Their ACB’s would,
      however, be reduced if they withdraw Jane’s capital contribution. This would not result in any
      immediate tax consequences to them even though it reduced their ACB’s to a negative amount (s.
      40(3)).

III. Jane Earns Her Way In

   (1) Capital Accounts

   If Jane earns her way in by permitting Brenda and Dan to receive the first $60,000 ($30,000 each) of
   what would otherwise be her share of the partnership income, this amount would be included in their
   income and not hers. $30,000 each is required rather than $15,000 in order to permit them the same
   amount after tax as they would receive if one of the other alternatives was followed. This alternative is
                                                   8-21
   really no different than (a) or (b) above since in those alternatives Jane required $60,000 of pre-tax
   income in order to have $30,000 after tax to fund her admission to the partnership.

   After the first $60,000 of Jane’s earnings are paid to Brenda and Dana, Jane will share equally in
   future partnership earnings.

   (2) Results

   (a) Brenda and Dana (Vendors)

       The payment is ordinary income which is taxed at their marginal tax rates. The ACB of their
       partnership interest does not change.

   (b) Jane (Purchaser)

       (i)   Jane will have no ACB in her partnership interest. However, she does not have to commit
             funds and incur related financing costs. (If she earns her way in over several years instead of
             one year as illustrated, she might not suffer the same degree of financial hardship.)

Most partnership agreements contain a continuation clause. However, whichever alternative is chosen,
the existing partnership agreement and the applicable provincial law should be reviewed to determine
whether either will cause the cessation of the old partnership and the creation of a new partnership when
Jane is admitted. If a new partnership is created, s. 98(1) does not apply to prevent, for tax purposes, the
dissolution of the old partnership and formation of the new one and therefore, the two existing partners
would be deemed to have disposed of their old partnership interest and acquired their new partnership
interest at FMV. In these circumstances, provided this was a Canadian partnership, the old partners could
file elections under subsections 98(3) and 97(2), which may enable the dissolution of the old partnership
and formation of the new one to take place with no immediate tax consequences.

iv. WHAT ARE THE TAX ADVANTAGES AND DISADVANTAGES OF INCORPORATION VS.
    PARTNERSHIP?

   1. Advantages of Partnership over Corporation

       a.    The ability to flow through losses and claim them against personal income.
       b.    No double taxation of income.
       c.    Distribution of Capital (can exceed amount contributed).
       d.    Ability to borrow funds without tax consequences.

   2. Disadvantages

       a.    No access to small business deduction on the first $200,000 of active business income.

       b.    The $500,000 capital gains exemption is not available.

       c.    May affect income splitting.
                                     8-22
v. WHAT ARE THE TAX ADVANTAGES OF SETTING UP A PROFESSIONAL CORPORATION?

  The following lists some advantages of setting up a Professional Corporation. You should also consult
  Appendix 7.

  1. Tax Rate = 19% on the first $200,000 of corporate income. Additional tax is payable when funds
     are distributed as dividends. $200,000 limit is prorated if the PC is a partner.

  2. Tax Deferral - to the extent that income taxed at the low rate is not distributed to the shareholder,
     a substantial tax savings may result, i.e. 19% vs. 46%.

  3. Capital Gains Exemption - Up to $500,000 on disposition of shares may be available.

  4. Transfer of Assets - Assets may be transferred on a tax free basis to the corporation by electing
     under s. 85.
                                                    8-28
                                    III. CORPORATE TAX

a. KEY QUESTIONS


   i.       HOW DOES THE ITA DIFFERENTIATE BETWEEN INDIVIDUAL AND CORPORATE TAX
            PAYERS?

   ii.      WHAT IS THE          DIFFERENCE        BETWEEN       A   RESIDENT      AND     NON-RESIDENT
            CORPORATION?

   iii.     WHAT ARE THE BASIC INCOME TAX RATES OF CORPORATIONS?

   iv.      WHAT ARE THE CLASSIFICATIONS OF CORPORATIONS FOR TAX PURPOSES?

   v.       WHO CAN CLAIM THE SMALL BUSINESS DEDUCTION?

   vi.      HOW DO CORPORATIONS DISTRIBUTE PROFITS TO SHAREHOLDERS?

   vii.     DOES THE ITA ACHIEVE PERFECT INTEGRATION?

   viii. WHAT ARE THE TAX ADVANTAGES AND DISADVANTAGES OF INCORPORATION?

   ix.      HOW CAN INCORPORATION RESULT IN TAX DEFERRAL?

   x.       HOW ARE CORPORATIONS TAXED IN RESPECT OF CAPITAL GAINS?

   xi.      ARE THERE ANY DIFFERENCES BETWEEN INDIVIDUAL AND                                  CORPORATE
            DEDUCTIONS FOR CAPITAL COST ALLOWANCE CALCULATION?

   xii.     CAN A CORPORATION CLAIM ANY TAX CREDITS OR DEDUCTIONS NOT AVAILABLE
            TO INDIVIDUAL TAXPAYERS?

   xiii. HOW CAN AN ENTREPRENEUR INCORPORATE A COMPANY TO RUN HIS EXISTING
           BUSINESS?

            APPENDICES



THE CORPORATE TAXPAYER

This portion of the chapter will introduce you to the concept of a corporation as a taxpayer. It will discuss
the different kinds of corporations, the computation of a corporation's taxable income and the rates at
which they are taxed. It's purpose is to assist in deciding whether or not to incorporate and to outline the
basic tax rules and rates applicable to corporations.
                                                       8-29

OUTLINE OF TOPICS COVERED:

     1.   Part I Tax
     2.   Basic Corporate Tax Rates
     3.   Special Tax rates for Certain Corporations
     4.   Classification of Corporations
     5.   Part IV Tax

i.   HOW DOES THE INCOME TAX ACT DIFFERENTIATE BETWEEN INDIVIDUAL AND CORPORATE
     TAXPAYERS?

Under Part I of the Act (section 2), income tax is payable each year on the taxable income of every person
resident in Canada at any time in the year. Under subsection 248(1), "person" includes a corporation,
therefor, a corporation, if resident in Canada, must pay Part I tax on its taxable income. The taxable
income for a taxation year is the taxpayer's income plus any additions and minus any deductions
permissible under Division C of the Act. All corporations are subject to the prescribed rules and rates
applicable to corporations. These rules and rates are discussed in this chapter.

ii. WHAT IS THE DIFFERENCE BETWEEN A RESIDENT AND NON-RESIDENT CORPORATION?

Non-resident persons are only subject to income tax on taxable income earned in Canada.

A corporation is deemed to be resident in Canada under subsection 250(4) in the following situations:

     1. If it was incorporated in Canada after April 26, 1965, or

     2. If it was incorporated in Canada before April 27, 1965, if at any time in the taxation year or
        at any time in the preceding taxation year of the corporation ending after April 26, 1965, it
        was resident in Canada or carried on business in Canada.

In the latter case, it is still necessary to determine whether the corporation is resident in Canada or if it
carries on business in Canada. "Carrying on business" is defined in section 253 of the Act, however, there
is no definition for "resident". The rules developed at common law will determine whether a corporation is
resident in Canada. Additionally, corporations incorporated elsewhere may also be considered to be
resident in Canada, based on the common law rules.

Under common law, a corporation is considered to be resident where its central management and control
is located. In general, this is where the directors reside or meet and exercise control, however, it is also
possible to find management and control other than where the directors meet, where control in fact is
exercised elsewhere by persons other than the directors.

iii. WHAT ARE THE BASIC CORPORATE INCOME TAX RATES?

Section 123 imposes a 38% tax payable by every resident Canadian corporation on its taxable income, or
if it is a non-resident, on its taxable income earned in Canada.

In addition, under section 123.2, a federal corporate surtax of 3% is imposed on the federal tax payable.
This 3% surtax will be increased to 4% for taxation years ending after February 28, 1995.

By virtue of subsection 124(1), the corporation is entitled to a 10% reduction of its taxable income earned
in the year in a province. This is essentially a credit for the provincial tax levied against the corporation's
                                                  8-30
taxable income earned in a province. This credit does not entirely offset the provincial tax payable as the
tax levied in most provinces exceeds 10%. Currently, in Alberta, the provincial corporate income tax rate,
is 15.5%.

The basic combined federal and provincial corporate income tax rate is therefore 44.62%. It is calculated
as follows:

       basic federal rate                          38 %
       less federal abatement                     (10) %
       surtax (4%) on federal
       tax payable                                  1 .12 %
                                                  ------------

       effective basic federal rate                29.12 %
       basic provincial rate                       15.50 %
                                                  ------------
       basic combined federal and
       provincial corporate rate          44.62%

The combined rate varies from province to province due to the amount of provincial tax levied, for the
purposes of the discussion we will assume the highest combined corporate tax rate is 45%. (See
Appendix 8).

Depending on the type of corporation, it may further be entitled to certain deductions (or abatements from
tax). Examples of some of these are:

   s.125          -     the small business deduction
   s.123.1        -     the Manufacturing and Processing Profits deduction
   s.126          -     the Foreign Tax Credit
   subs.127(5)    -     the Investment Tax Credit

We will only briefly look at the Small Business deduction and the Manufacturing and Processing Profits
deduction.

   A. The Small Business Deduction

   The small business deduction is contained in subsection 125(7) of the Act. It is available to Canadian-
   controlled private corporations (discussed further on). Such a corporation may deduct from tax an
   amount equal to 16% of its income from an active business carried on in Canada (up to a certain
   amount of income). The small business corporation is the subject of another lesson. For the purposes
   of this lesson, where a corporation is entitled to the deduction, the effective federal tax rate is 13.12%.
   A corporation entitled to this deduction is also entitled to a reduced tax rate at the provincial level as
   well. In Alberta, such corporations are taxed at 6%, therefor, the effective combined federal and
   provincial corporate tax rate in Alberta is 19.12 calculated as follows:
                                                      8-31
  SMALL BUSINESS DEDUCTION:

      basic federal rate                             38 %
      less federal abatement                        (10) %
      surtax (4%) on federal
      tax payable                                     1.12%
                                                    ----------

      effective basic federal rate                   29.12%
      less small business deduction 16%
                                                    ----------
                                                     13.12%

      basic provincial rate (15.5%)                     6 %
      minus small business                          ----------
      deduction of 9.5%)

      basic combined federal and
      provincial corporate rate          19.12%*

  B. Manufacturing and Processing Profits Deduction

  Section 125.1 allows for a 7% deduction from tax otherwise payable by a corporation on its Canadian
  manufacturing and processing profits as defined in paragraph 125.1(3)(a). The deduction, however,
  does not apply to business income that qualifies for the small business deduction. These corporations
  are subject to the basic provincial rate of tax.

  A table of rates for each province is contained in the Appendix. Following is a summary of the rates in
  Alberta based on the increased surtax.

                                        Federal               Combined Federal and
                                                                 Provincial (Alberta)
                               --------------------------------------------------------------

      Basic rate                         29.12%                44.62%

      Manufacturing
      and Processing
      Corporations                                  22.12%               36.62%
      Small Business
      Corporations                                  13.12%               19.12%

iv. WHAT ARE THE CLASSIFICATIONS OF CORPORATIONS FOR TAX PURPOSES?

  The type of corporation is important in determining the amount of tax payable. There are definitions
  contained in the Act for Canadian corporation, private corporation, public corporation and a Canadian-
  controlled private corporation.

  A. Canadian Corporation

  Paragraph 89(1)(a) defines a "Canadian corporation" to be one that is resident in Canada and was
  either incorporated in Canada, or was resident in Canada throughout the period commencing June 18,
  1971 until the time in consideration.
                                                8-32

B. Private Corporation

The requirements for a "private corporation" are set out in paragraph 89(1)(f). It must:

(i) be resident in Canada;
(ii) not be a public corporation; and
(iii) not be controlled by one or more public corporations.

C. Public Corporation

A "public corporation" is subject to the highest corporate tax rate. Pursuant to paragraph 89(1)(g) it is
one that is resident in Canada and is listed on a prescribed stock exchange. Alternatively, a
corporation can elect to be one or it can be designated as one by the Minister. In this regard, see IT-
391R and Regulation 4800.

D. Canadian-Controlled Private Corporation ("CCPC")

A CCPC is subject to the lowest corporate tax rate. The requirements as set out in subsection 125(7)
are as follows:

(i) It must be a Canadian corporation;
(ii) It must be a private corporation; and
(iii) It must not be controlled, directly or indirectly in any manner whatever, by 1 or more non-resident
      persons or 1 or more public corporations.

E. Meaning of "Controlled" and "Controlled, Directly or Indirectly in any Manner Whatever"

"Control" is not defined in the Act. The courts have found it to mean "the right of control that rests in
ownership of such a number of shares as carries with it the right to a majority of votes in the election
of the board of directors." (Buckerfield's Limited et. al. v. MNR, [1964] C.T.C. 504). Further, where A
controls B within the meaning of Buckerfield's and B controls C, then A controls C (Vineland Quarries
and Crushed Stone Ltd. v. MNR, [1966] C.T.C. 69).

Where the Act refers to "controlled, directly or indirectly in any manner whatever," control not only has
the meanings described above, but also an extended meaning pursuant to subsection 256(5.1). This,
in simple terms, will find control where a person who although may not have sufficient voting control,
does have control in fact (i.e. "defacto" control). For example, an individual who only has 5% of the
shares of a corporation may have a management contract with the corporation which effectively gives
him control.

With respect to CCPCs, also see IT-458R and subsection 251(5). For the purposes of determining
control of a CCPC, paragraph 251(5)(b) deems persons to be in the same position as if they owned
the shares where such person has the right to acquire the shares in some manner. Further, where a
person has a right to cause a corporation to redeem, cancel or acquire its own shares, that person is
deemed to be in the same position in relation to control of the corporation as if such shares were
redeemed, acquired or cancelled. Paragraph 251(5)(b) does not, however, apply where the rights
above are only exercisable on death, bankruptcy or permanent disability.

Keep in mind when determining control, directly or indirectly in any manner whatever, once control is
found in non-residents or public corporations or a combination of both, whether direct or indirect, it
matters not whether control is also found in residents.
                                                  8-33

Part IV Tax

By virtue of paragraph 12(1)(j), dividends received from a corporation resident in Canada are to be
included in computing the taxpayer's income. This is applicable to both corporate and individual
taxpayers.

Section 82 sets out the amount of income from dividends to be included. Generally, the full amount of
the taxable dividend is to be included into income if received by a corporate shareholder. If received by
an individual, the full amount of the dividend PLUS one-quarter of the full amount must be included in
computing the income of the individual. This is the "gross-up of dividends" received by individuals. The
individual is then entitled to a dividend tax credit under section 121. We will return to the treatment of
dividends received by an individual in a later lesson. For this module, we will just look at how dividends
are treated when received by a corporate shareholder.

As mentioned, a corporate shareholder includes all "taxable dividends" received by it from a
corporation resident in Canada. Under section 112 the full amount of any "taxable dividends" received
from "taxable Canadian corporations" may be deducted from the income of the recipient corporation
for the year for the purpose of computing its taxable income. "Taxable Canadian corporation" and
"taxable dividends" are defined in paragraphs 89(1)(i) and (j). This is the ―theory of tax-free flow of
incorporate dividends‖. However, to prevent an individual shareholder from incorporating simply to
defer tax, Part IV tax was introduced. Part IV tax is payable by certain corporations and is equal to
33.3% of the taxable dividends received. It is refundable to the corporation when dividends are paid
out to its shareholders. Under section 129, the corporation is refunded the tax paid under this part at a
rate of $1 for every $3 it pays out in taxable dividends. So, it is basically a temporary tax to offset any
deferral where holding companies are used to hold portfolio investments.

Under subsection 186(1), all private corporations must pay tax in the amount of one-third (33.33%) of
the aggregate of:

(i) all taxable dividends received by it that were deductible under subsection 112(1), unless the
    dividends are received from a payor corporation that was "connected" with it [within the meaning of
    subsection 186(4)];

(ii) if received from a payor corporation connected with it, the private corporation (recipient) pays one-
     third (33.3%) of its share of the refund received by the payor corporation, if any.

In the latter case, the calculation looks as follows:

    tax        =      33.33% (3 x refund x dividend received by recipient)
    payable                   received by
                              payor           total dividends paid out by
                              corporation            payor corporation)

If the payor corporation does not receive a refund, no Part IV tax is payable by the recipient.

Subsection 186(4) describes when the payor corporation and the recipient corporation are connected.
They are connected if the payor corporation is controlled by the receiving corporation or if the receiving
corporation owned at that time more than 10% of the issued share capital (having full voting rights
under all circumstances) of the payor corporation and such shares have a fair market value of more
than 10% of all of the issued shares of the payor corporation.

To determine "control", in addition to the common law tests, subsection 186(2) defines control for the
purposes of this part. The recipient corporation controls the payor corporation if it owns alone, or in
concert with persons with whom it does not deal at arm's length, more than 50% of the issued capital
                                                  8-34
of the payor corporation (having full voting rights in all circumstances).

Subsection 251(1) deems "related persons" not to deal at arm's length. Subsections 251(2) through
(6) set out when persons are related to each other. Section 252 deals with extensions of related
persons. Also see It-64R3 which discusses the departments's views on control of a corporation and
IT-419 on the meaning of arm's length.
Under paragraph 251(2)(b) persons related to each other are:

(i) a corporation and a person who controls the corporation, if it is controlled by one person.

(ii) a corporation and a person who is a member of a related group that controls the corporation.
     Related group is defined in paragraph 251(4)(a) to be a group of persons each member of which
     is related to every other member of the group.

(iii) a corporation and any person related to a person described in the first two instances above.

Under paragraph 251(2)(c) two corporations are related in the following situations:

1. If both corporations are controlled by the same person or group of persons.




                      A                                             A




2. If                X Corp.               each                   Y Corp.        corporation         is
                                      controlled  by                             one person and the
                                      person     who                             controls          one
                                      corporation is                             related to the person
     who controls the other corporation.


                      A                                         A’s Brother




                    X Corp.                                        Y Corp.

In      this                         case, individuals                            connected by blood
                                       relationship,                              marriage or adoption
are related to each other [251(2)(a)]. Blood relationship is defined in subsection 251(6).

3. If one of the corporations is controlled by one person and that person is related to any member of
   a related group that controls the other corporation. Related group is defined in paragraph
   251(4)(a) to be a group of persons each member of which is related to every other member of the
   group.
                                               8-35

                                                           Mary’s Brother
                     A                                      Mary’s Sister
                                                           A’s wife (Mary)




                    X Corp.
                                                                Y Corp.


4. If one of the corporations is controlled by one person and that person is related to each member of
   an unrelated group that controls the other corporation.

                         A                                  B, C and D




                      X Corp.                                    Y Corp.

    In this                           case  A   is                               related to B, C and D
    but B,                            C and D are                                not related to each
    other.

5. If any member of a related group that controls one of the corporations is related to each member
   of an unrelated group that controls the other corporation.

                 A, B and C                                    D, E and F




                     X Corp.                                      Y Corp.


    In this                           case A, B and C                               are related to each
    other. D, E and F are not related to each other but A is related to each of D, E and F.
                                               8-36
   6. If each member of an unrelated group that controls one of the corporations is related to at least
      one member of an unrelated group that controls the other corporation.
                       A, B and C                                    D, E and F




                          X Corp.                                       Y Corp.



       So, in this case A, B and C are not related to each other and D,E and F are not related to each
       other but, for example, A is related to D, B is related to E and C is related to F.

   7. Also, pursuant to subsection 251(3), if two corporations are related to the same corporation in any
      manner as described above, then those two corporations are deemed to be related to each other.

   Confused? When given a fact situation, it also helps to draw a picture.


v. WHO CAN CLAIM THE SMALL BUSINESS DEDUCTION?

The small business deduction is only available to CCPCs. The combined federal and provincial tax rate in
Alberta is 19.12% (in B.C., 20.12% and Ontario it is 21.62%, in Nova Scotia 18.12% and in Saskatchewan
12%). This rate is only available in respect of the first $200,000" of active business income" ("ABI") of
thecorporation.

Subs. 125(1) provides that a CCPC, which was a CCPC throughout the year, may deduct from the 38%
tax rate otherwise payable, 16% of the least of the following:

   (i) its net income from an active business carried on in Canada and its net specified partnership
       income, if the corporation was a membership of a partnership,

   (ii) its taxable income (subject to adjustments for foreign tax credits), and

   (iii) its business limit, which is $200,000 unless the corp. is associated with one or more CCPCs in
         which case it is nil. Associated corporations can allocate the $200,000 limit amongst themselves
         or failing that the Minister may do so.

An "Active business" is any business carried on by the corp. other than a "specified investment business"
("SIB") or a "personal services business" ("PSB") [para. 125(7)(a)].

The "Income of the corporation" is income from an active business carried on by the corporation including
any income pertaining to or incident to that business but excluding income from a source in Canada that is
property [para. 125(7)(c)]. Investment income received from an associated corporation is deemed to be
ABI, and not property income [see subparagraph 129(4)(a)(ii)] if it was deductible in computing the payor
corporation's income.

   "Property income" includes income from a SIB but does not include income:

   (i) from any other business,

   (ii) from any property that is incident or pertains to an active business carried on by it, or
                                                   8-37

   (iii) from any property used or held principally for the purpose of gaining or producing income from an
         active business [subs. 129(4.1)].

Property is also defined in subsection 248(1). These definitions are somewhat circular and in practice the
distinction between income from property and income from a business is not always clear and has been
the subject of much litigation. (See Appendix 9).

If income is derived from a source that is separable from the active business, it is not considered active
business income. Also, see the definition of "specified investment business" in paragraph 125(7)(e). We
will return to specified investment businesses further on.

The courts have also set some guidelines to be used in distinguishing between business and property
income with respect to corporations. ABI has been identified using the following questions: "Was the fund
employed or risked in the business. Was it committed to the carrying on of the business in order to meet
the company's obligations?" Were the invested funds linked to some definite obligation or liability of the
business?

There is also a general (rebuttable) presumption that where a corporation was incorporated to earn
income by doing business, the profits arising from its activities should be considered as prima facie
income from a business [Canadian Marconi v. The Queen, [1986] 2 C.T.C. 465 (S.C.C.)] business.

ASSOCIATED CORPORATIONS

Where 2 or more Canadian-controlled private corporations are "associated" at any time in the year, they
must share the $200,000 business limit. This rule is designed to prevent corporations with substantially
common ownership from gaining multiple access to the small business deduction (see IT-64R3). When
are corporations associated?

Section 256 contains detailed rules prescribing when corporations are associated. A corporation is
associated with another in a taxation year if at any time in the year one of the following situations exist:

1. Paragraph 256(1)(a): one corporation controlled, directly or indirectly in any manner whatever, the
   other.

                  A


                                     51%



                  B
                                                    8-38
   Recall that where "controlled, directly or indirectly in any manner whatever" is used, control not only
   has the meaning prescribed by common law i.e. "dejure" control, but also that in subsection 256(5.1)
   i.e. "de facto" control. Additionally, subsection 256(1.2) deems control in certain situations for the
   purposes of subsections 256(1) to (5) only.

2. Paragraph 256(1)(b): if both corporations were controlled, directly or indirectly in any manner
   whatever, by the same persons or group of persons.


                 A                                                            B




      99%                   1%                                1%
      Ms A                 Mr. B                                                             99%
                                                             Ms A
                                                                                             Mr. B




3. Paragraph 256(1)(c): if each corporation is controlled directly or indirectly in any manner whatever by
   a person, and a person who controlled one of the corporations was related to the person who
   controlled the other, and either of them owned in respect of the other corporation not less than 25% of
   the issued shares of any class of the capital stock thereof, other than a "specified class". ("Specified
   class" is defined in subsection 256(1.1). It simply exempts out, for example, loan or strictly financing
   shares).

        Mr. A.                                                                      Mr. A.
        100%                                                                        75%

                                              25%


            A                                                                            B
                                                  8-39




4. Paragraph 256(1)(d): if one of the corporations was controlled directly or indirectly in any manner
   whatever, by a person and that person was related to each member of a group of persons that
   controlled the other corporation and that person owned, in respect of the other corporation, not less
   than 25% of the issued shares of any class of the capital stock thereof, other than a specified class.

       Mr. A.                             Mrs. A.         Mrs. A’s Grandmother
       100%                                30%            30%

                             40%

          A                                           B
                                                    8-40
   Recall the "related" rules previously discussed. Mr. A is related to Mrs. A [paragraph 251(2)(a)] and he
   is also related to his wife's grandmother by virtue of subsection 252(2). Mrs. A and her grandmother
   make up a control group and Mr. A owns not less than 25% of the stock of Corporation B.

5. Paragraph 256(1)(e): each of the corporations was controlled directly or indirectly in any manner
   whatever by a related group and each of the members of one of the related groups was related to all
   of the members of the other related group and 1 or more persons who were members of both related
   groups, either alone or together, owned in respect of each corporation, not less than 25% of the issued
   shares of the capital stock thereof, other than a specified class.


   Mr. A.       Son                            Mrs. A.       Mrs. A’s Grandmother
   50%         50%                              30%          30%

                                  40%

                 A                                       B

   As mentioned, subsection 256(1.2) also deems control to exist for the purposes of associated
   corporations in the following situations:

1. Paragraphs 256(1.2)(a) and (b): together, these two paragraphs say that a group of persons means
   any 2 or more persons who own shares of the same corporation.


               A                                                        B




 X                           A                            X                           B
33%            Y            33%                          1%              Y           49%
              33%                                                       50%

   X and Y control Corporation A and Corporation B, although neither by themselves control either
   corporation. In this case, because a control group controls both corporations, they are associated.

2. Paragraph 256(1.2)(c): FAIR MARKET VALUE TEST - if a person has more than 50%
    Ms A has                                                            Ms B has
    1% worth                                                           99% worth
    $100,000                                                            $40,000



                                             A
                                                                                              of the fair
market value of all outstanding shares issued, she is deemed to have control.
                                                  8-41




Ms. A is deemed to have control. Note that Ms. B also has control. Under paragraph 256(1.2)(b)(ii), 2 or
more persons may be deemed to independently have control.
3. Paragraph 256(1.2)(d): PROPORTIONATE SHARE RULE - Assume corporation A has shares of
   Corporation B. A shareholder of Corporation A is deemed to have his/her proportionate share of the
   shares Corporation A holds in Corporation B.

  A               B              C                                                     A
 10%             80%            10%                                                   50%


                                                   50%
                   A                                                                     B




   A normally would not control Corporation B. However, A is also deemed to own her proportionate
   share (10%) of the shares that Corporation A holds in Corporation B (50%) or an additional 5%. By
   virtue of this paragraph, A owns 55% of Corporation B and therefore has control.

   Subsections 256(1.3), (1.4), (2) and (2.1) are additional provisions to take note of. Subsection 256(1.3
   provides that for the purposes of determining association, parents are deemed to own the shares of
   their children under the age of 18. Subsection 256(1.4) deems a person to own shares which he/she
   may acquire by some agreement other than an agreement which operates on death, bankruptcy or
   permanent disability. Under subsection 256(2), if Corporation A is associated with Corporation C and
   Corporation B is also associated with Corporation C, then Corporation A and B are deemed to be
   associated. Finally, under subsection 256(2.1), the Minister may deem association to exist even if
   none of the above rules apply.

   Confused yet? It is useful to draw a diagram or diagrams next to each of the above rules to visualize
   what exactly each particular provision is trying to catch.

   PERSONAL SERVICES BUSINESS ("PSB")

   An employee who incorporates and provides services on behalf of the corp. is not entitled to the SBD.
   A PSB is a business of providing services where an individual (the "incorporated employee") who
   performs the services on behalf of the corp., or any person related to such person, is a specified
   shareholder of the corp. and would reasonably be regarded as an officer or employee of the person or
   partnership to whom the services are provided but for the existence of the corp. [para. 125(7)(d)]. An
   exception is made if the corp. employs throughout the year more than 5 full time employees or the
   amount paid to the corp. for the services is received from a corp. with which it was associated in the
   year. In either case it will not be considered to be a PSB.
                                                    8-42

   A "specified shareholder" is a taxpayer or any person related to him who owns, directly or indirectly,
   not less than 10% of the issued shares of any class of the capital stock of the corp. or of any other
   corp. that is related to the corp.

   The consequences of being classified as a PSB are two-fold. First, the business is not entitled to the
   SBD. Second, no deductions under paragraph 18(1)(a) (business expenses) are allowed in calculating
   corporate income.


   SPECIFIED INVESTMENT BUSINESS ("SIB")

   Income from a SIB is also denied the SBD. Instead, income from property qualifies for special tax
   treatment through the refundable dividend tax on hand (RDTOH) account.

   Income from a SIB includes income from any business the principal purpose of which is to derive
   income from property such as interest, dividends, rents and royalties. As we saw earlier, the distinction
   between income from property and income from a business is not always clear [para. 125(7)(e)].

   In certain circumstances, a SIB may be considered to be an active business and entitled to the SBD.
   These exceptions are set out in subparagraphs 125(7)(e)(i) and (ii). As in the case of a personal
   services business, if an SIB employs more than 5 full-time employees throughout the year, it will
   qualify as an active business. Alternatively, if a corporation associated with the SIB provides the
   employment services and it is reasonable that the SIB would have required the services of more than
   five full- time employees had those services not been provided, it will qualify as an active business.

vi. HOW DO CORPORATIONS DISTRIBUTE PROFITS TO SHAREHOLDERS?

Distributions of profit to shareholders can take the form of dividends (including "deemed dividends"),
capital reductions or benefits or appropriations. Tax liability may also arise where a payment or transfer of
property is made at the direction of or with the concurrence of a taxpayer to some other person for the
benefit of the taxpayer or as a benefit to that person (subs. 56(2)).

A. DIVIDENDS

For corporate law purposes,dividends are declared by the directors and may be paid in money or other
property. For tax purposes, dividend includes the receipt of any property from a corp. that is not a return of
capital, a repayment of debt, or otherwise included in the shareholder's income. IT-67R3 states that any
distribution by a corp. of its income or capital gains made pro rata among its shareholders may properly be
described as a dividend.

Dividends must be included in income (para. 12(1)(j) and (k)); for individuals, the gross-up and credit
applies, for corporate shareholders, para. 82(a), section 112 and, in the case of a private corp., section
186 apply (Part IV tax).

   1. Dividends-in-Kind

   Distributions made in a form other than cash or stock of the payor (e.g. property) are generally referred
   to as "dividends-in-kind". Where a dividend-in-kind is received, subsection 248(1) provides that the
   amount of the dividend will equal the money value of the property received. The corporation is deemed
   to have disposed of the property for its fair market value (FMV)(subsection 52(2)). The taxpayer also
   acquires the property at its FMV. This amount will be important when he/she subsequently disposes
   of it in determining any capital gain or loss.

   2. Stock Dividends
                                                8-43

By virtue of subsection 248(1), a dividend includes a stock dividend which is a dividend paid in the
stock of the issuer, not in money, but in a proportional number of shares. Where a stock dividend is
declared, additional shares are issued pro rata to the shareholders accompanied by a capitalization of
retained earnings or surplus accounts otherwise available for distribution. As a result, the total PUC of
the class of shares will be increased. The amount of the stock dividend will equal the amount of the
increase in the PUC of the corporation by virtue of the payment of the dividend. The cost to the
shareholder is the same amount. Subsection 15(1.1) may also deem a shareholder benefit where one
of the purposes of the payment of the stock dividend was to significantly alter the value of the interest
of any specified shareholder of the corporation. In this case, the FMV of the stock dividend will be
included in computing the income of the shareholder, except to the extent it was otherwise included in
income under paragraph 82(1)(a).

3. Stock Splits

In a stock split, the total number of shares are divided so that one share may be split into two or more
shares. Since there is no increase in the PUC of the outstanding shares, a stock split will normally not
give rise to any immediate tax liability. Instead, the cost base and PUC of the already issued shares
will be reallocated and averaged among the newly issued shares.

4. Deemed Dividends

The Act contains rules to deem certain payments which otherwise might not be considered to be
dividends to be dividends for tax purposes. These rules apply to amounts paid to shareholders as a
return of capital on a winding-up, discontinuance or reorganization of its business, on a redemption,
acquisition or cancellation of its shares or on a reduction of its capital.

Deemed dividends are treated for all purposes of the Act as ordinary dividends; i.e. subject to the
gross-up and credit if received by an individual, or deductible in computing taxable income if received
by a corp. The deemed dividend provisions are contained in section 84. A deemed dividend is
determined by comparing the amount of any distribution or acquisition by the corp. to the PUC. The
deemed dividend rules are used, among other things, to prevent a conversion of retained earnings to
capital. Without section 84 a corporation could, for example, convert its retained earnings to capital by
simply increasing the PUC of its shares. The corporation would then be able to return a larger amount
to its shareholders as a tax-free return of capital.

(i) Subsection 84(1)

    A deemed dividend will occur where a corp. has increased its PUC otherwise than by

    1.   payment of a stock dividend;

    2.   a transaction by which the value of the corp.'s assets less its liabilities has been increased by
         an amount not less than the increase in PUC;

    3.   a transaction by which the value of its liabilities less its assets has been decreased by an
         amount not less than the increase in PUC;

    4.   a transaction by which the PUC of shares of the corporation of other classes is reduced by an
         amount not less than the increase in question.

    In other words, if a corp. increases the PUC of its shares without receiving corresponding
    consideration either in cash or other property, or by converting a debt owed to the shareholders
    into shares, a deemed dividend will result.
                                               8-44
      When subsection 84(1) applies, the corporation is deemed to have paid a dividend in the amount
      by which the increase in PUC exceeds:

      1.   the amount by which the value of the corporation's assets less its liabilities has been
           increased, or

      2.   the amount by which the value of its liabilities less its assets has been reduced, and

      3.   the amount by which the PUC of other classes of shares has been reduced.

      Any amount treated as a deemed dividend is added to the ACB of the shares pursuant to
      paragraph 53(1)(b).

  (ii) Subsection 84(2)

      Where corp. assets are distributed the winding-up, discontinuance or reorganization, a deemed
      dividend may result. It will equal the amount of funds or property distributed, minus the amount by
      which the PUC of the class of shares on which the distribution is made is reduced on the
      distribution or appropriation.

      If the distribution includes property other than cash, the dividend equals the value of the property.
      The winding-up shares on which the distribution is made are also deemed to have been disposed
      of. However, the deemed dividend is excluded from the POD of the shares (para. 54(h)(x)).
      Consider the following example:

      On a winding-up, property with a FMV of $100 is distributed. The shares have a PUC of $10 and
      an ACB of $10. The deemed dividend will equal $90 ($100 - $10). The shares will also be
      disposed of for $100. Subparagraph 54(h)(x) will reduce the POD by $90 to $10. Since this is also
      the ACB of the shares, no capital gain or loss will result.

  (iii) Subsection 84(3)

      Subs. 84(3) applies where a corp. has "redeemed, acquired or cancelled in any manner whatever"
      shares of any class (and the transaction is not covered by subs. 84(1) or (2)). Where such a
      transaction occurs, the corp. is deemed to have paid a dividend equal to the amount paid on the
      redemption in excess of the PUC of the shares. Again the shares are deemed disposed of,
      however, subpara. 54(h)(x) excludes the amount of the dividend from the POD.

  (iv) Subsection 84(4)

      On a reduction of capital a deemed dividend may result if the amount paid to the shareholders
      exceeds the reduction in PUC. Any amount distributed that is not deemed to be a dividend, will
      result in a reduction in the ACB of the shares (subpara. 53(2)(a)(ii)). In other words, if the PUC is
      reduced by the exact amount distributed, the ACB of the shares will also be reduced by that
      amount. If the reduction in PUC is less than the amount distributed, there will be a deemed
      dividend but no reduction in the ACB of the shares. Note: if a public corporation reduces PUC the
      shareholders are deemed to have received a dividend but there is no reduction in the ACB of their
      shares.

B. SECTION 15

      1.   Subsection 15(1)

      Where a corporation confers a benefit upon a shareholder or on a person in contemplation of his
      becoming a shareholder, the amount of the benefit must be included in the shareholder's income.
                                              8-45
A section 15 benefit, among other things, does not include dividends or deemed dividends and
therefore the dividend tax credit will not be available. This means the full amount of the benefit is
                                                   8-46
        included in income with no relief for the corporate tax already paid on the amount. Any amount
        which has been deemed to be a dividend by section 84, is not included in calculating the amount
        of the benefit conferred.

        2.   Subsection 15(2)

        Certain persons who receive loans from a corp. may be required to include the amount in income
        unless either:

        (a) the loan was made for certain specified purposes and bona fide arrangements have been
            made for repayment within a reasonable time, or

        (b) the loan was repaid within 1 year from the end of the taxation year in which it was made.

        Loans are treated as ordinary income. On repayment of the loan, para. 20(1)(j) allows for a
        deduction in respect of any income included under subs. 15(2).

        3.   Subsection 56(2) - Indirect Benefits

        A payment or transfer of property made pursuant to the direction of, or with the concurrence of, a
        taxpayer to some other person for the benefit of the taxpayer or as a benefit the taxpayer desires
        to have conferred on the other person, must be included in computing the taxpayer's income.

vii. DOES THE ITA ACHIEVE PERFECT INTEGRATION?

As a taxpayer, a corporation is a person which is taxed separately from the natural persons (individuals)
who are its shareholders. Hence, this could give rise to double taxation, with the same income being
taxed, first, at the corporate level and then, again, at the individual shareholder level. Conceptually, a
corporation should really be treated as a non-taxable conduit through which income flows to the individual
shareholders, in the same way that a proprietorship business or a partnership business is a conduit
through which income flows to the individual proprietorship or partners.

Ideally, integration should cause the total tax paid by a corporation and its shareholders to be equal to the
total tax paid by an individual who carries on the same economic activity directly and not through the
corporation. By integrating the corporate and personal tax systems, the double taxation of corporation
income can be avoided.

The mainstay of the integration system as it applies to individual shareholders of all taxable Canadian
corporations is the gross-up and tax credit procedure. The gross-up is intended to add to the dividend
received by the individual shareholder an amount equal to the total income tax (including provincial tax)
paid by the corporation on the income that gave rise to the dividend. Thus, the grossed-up dividend is
intended to represent the corporation's pre-tax income. The shareholder will pay tax on the grossed-up
dividend at his personal rate. The federal dividend tax credit, including its effect in reducing personal
provincial taxes by reducing basic federal tax, is intended to give the individual shareholder credit for the
tax paid by the corporation on the corporation's taxable income. This procedure is intended to equate to
the tax that would have been paid on the same income if earned directly by the individual. The potential
double taxation on income earned through a private corporation is thereby avoided.

Where the corporate rate of tax is 20%, integration is potentially perfect. (Remember that in Alberta
CCPC's are taxed at approximately 19%). Where the corporate tax rate is less than 20% it is more
advantageous to the taxpayer to earn income through the corporation. The reverse is true where the
corporate tax rate is greater than 20%.

Under perfect integration, the corporate tax is like a withholding tax on the shareholder's income which the
corporation earns on behalf of the shareholder. In a sense, it is similar to the withholding tax on the salary
                                                     8-47
or wages of an employee. The corporate tax prevents tax on income earned by a corporation from being
deferred until a dividend is paid and taxed in the hands of the shareholder. When the shareholder receives
a dividend, notionally the pre-tax income earned by the corporation is reported by the shareholder, just as
an employee reports gross salary or wages. Then tax is computed at the shareholder's personal rate. In
the same way that taxes withheld from salary or wages are used to reduce the employee's final tax
payable, so the dividend tax credit (representing the tax paid by the corporation) reduces the shareholder's
tax payable on the dividend income.

viii.    WHAT ARE THE TAX ADVANTAGES AND DISADVANTAGES OF INCORPORATION?

From the foregoing analysis, it should be possible to draw some conclusions of both a tax and non-tax
nature regarding the incorporating of business operations. The advantages of incorporation include the
following:

    a. limited liability, although it should be recognized that to the extent creditors of an incorporated
       business demand personal guarantees from shareholders, limited liability is negated;

    b. tax savings if the combined corporate tax rate is under 20%;

    c.   tax deferral at higher personal income levels on business income not eligible for the small
         business deduction or the manufacturing and processing profits deduction and at all personal
         income levels on business income eligible for the small business deduction;

    d. income splitting potential with family members as employees or shareholders in carefully planned
       and very restrictive situations;

    e. estate planning advantages on the transfer of future growth in the corporation's shares to children;

    f.   separation of business and personal activities;

    g. stabilization of income of the individual through salary payments or greater flexibility in the timing
       of the receipt of income subject to personal tax;

    h. continuity of the separate legal entity; and

    i.   deferral of accrued capital gains on transfer of shares to a spouse.

    The disadvantages of incorporating business operations appear to include:

    a. a tax cost if the combined corporate tax rate is over 20%;

    b. a prepayment of tax at lower levels of personal income on business income not eligible for the
       small business deduction (i.e. if the corporation does not qualify as a CCPC).

    c.   the additional costs of maintaining a corporation including payment of provincial and federal capital
         taxes; and

    d. a loss of the availability of business and capital losses to offset personal income. While this
       disadvantage may be offset, to some extent, by the availability of allowable business investment
       loss treatment for shares of a small business corporation, the loss is only partially deductible only
       on sale of the shares of bankruptcy of the corporation.

Often the tax saving, if any, or deferral will, in many cases, outweigh the disadvantages of incorporating
such income, at least for rates of corporate tax in existence at less than 20%. This is particularly so where
business income eligible for the small business deduction is earned through a corporation. The optimum
                                                 8-48
salary/dividend mix can only be computed after considering all the relevant factors for each case. This
would normally require:
    (i) a review of the current and projected future income levels of the corporation and its
        shareholder(s), and how much of the corporate income represents active business income;

   (ii) a determination of the effect of the current and anticipated future income levels on the
        corporation’s cumulative deduction account;

   (iii) whether the company is a CCPC and whether it is associated with other corporations; if so, this
         will require a review of the income earned by each member of the group and the amount of the
         annual business limit to be allocated to each corporation.

   (iv) an examination of the company's share structure to determine whether minority shareholders
        would benefit from large dividend payments that would otherwise be used to remunerate the
        owner/manager; and

   (v) consideration of income splitting opportunities available by paying salaries and/or dividends to
       family members, bearing in mind that family members employed in the business would normally
       expect a greater share of the profits than others who are passive shareholders.

Where an individual has no other income, he may receive up to approximately $22,300 in dividends
without paying any income tax on those dividends.

ix. HOW CAN INCORPORATION RESULT IN TAX DEFERRAL?

On active business income eligible for the small business deduction, a small tax cost results from the
incorporation of such income compared to receiving it directly if the total corporate tax rate is higher than
the theoretical 20% where integration is perfect. There is, however, the possibility of deferring tax on
dividends ultimately distributed to the shareholders by delaying that distribution. Deferral of tax allows an
Alberta CCPC to pay tax of approximately 19% and then reinvest or utilize all remaining funds, whereas if
the income was to immediately flow through to the shareholder, the funds would be taxed at the
shareholder’s personal tax rate (likely in excess of 19%). The result is that where the shareholder desires
to reinvest the funds in the business he will probably benefit by having the CCPC pay tax at a rate of
approximately 19%, and deferring personal taxes.

When a taxpayer starts to carry on business in a given year, a fiscal period ending at the beginning of the
following calendar year can be chosen to defer income taxes as long as possible. (This option may be
eliminated if the 1995 Budget Proposal, which will require all businesses to report on a calendar year
basis, is passed).

Deferral of taxes is also possible where a corporation’s profits are increasing from one year to the next (a
likely scenario in the early years of a business). A corporation is required to make income tax instalments
unless federal income tax paid for the preceding year is $1,000 or less. In all other situations, a
corporation must make income tax instalments according to one of the following methods:

1. on or before the last day of each month of the year, an amount equal to 1/12 of income tax payable for
   the preceding year. (There is a third method contained in section 157, but that method will not be
   discussed here).

2. on or before the last day of each month of the year, an amount equal to 1.12 of income tax payable for
   the preceding year. (There is a third method contained in section 157, but that method will not be
   discussed here).

Any remaining Part I tax, based on actual income, shall be paid before the end of the third month following
the end of the taxation year in the case of a CCPC and in all other cases before the end of the second
                                                    8-49
month following the end of the taxation year.

Method ―2" above allows corporations to base the present year’s instalments on taxes payable the
previous year. If income is greater in the present year than in the previous year, taxes can be deferred by
utilizing method ―2" and then paying the remaining tax nearly 3 months (2 months if the corporation is not
a CCPC) after the end of the taxation year.

x. HOW ARE CORPORATIONS TAXED IN RESPECT OF CAPITAL GAINS?

Corporations are taxed at a rate of 3/4 with respect to capital gains. This is the same rate at which
individuals are taxed and in most respects, corporate capital gains are taxed in the same manner as are
capital gains of an individual. One notable exception is the capital gains deduction. Under subsection
110.6(3) and (5), the deduction is permitted to an individual who was resident in Canada throughout the
year, or who was resident at any time in the year, as well as throughout the immediately preceding year or
the immediately following year. The deduction is also available to spousal trusts, but is not available to
corporations.

xi. ARE THERE ANY DIFFERENCES BETWEEN INDIVIDUAL AND CORPORATE DEDUCTIONS FOR
    CAPITAL COST ALLOWANCE CALCULATION?

There is no difference between individual and corporate deductions for CCA. Paragraph 20(1)(a) of the
ITA permits a ―taxpayer‖ to deduct CCA as allowed by regulation. Regulation 1100(1) also uses the word
―taxpayer‖. Under subsection 248(1) ―taxpayer‖ includes any ―person‖ and ―person‖ includes any body
corporate. Therefore, the CCA provisions apply to both corporations and individuals.

xii. CAN A CORPORATION CLAIM ANY TAX CREDITS OR DEDUCTIONS NOT AVAILABLE TO
        INDIVIDUAL TAXPAYERS?

The most common tax credits and deductions claimed by corporations (income earned in Canada, small
business deduction, manufacturing and processing profits, foreign tax credit, political contribution tax
credit, and the investment tax credit) were covered above in the discussions of the basic tax treatment of
various types of corporations.

Corporations and individuals are, in some instances involving credits and deductions, treated alike (for
example, political contributions are treated in the exact same manner regardless of whether made by a
corporation or an individual). However, charitable donations made and dividends received are subject to
different treatment depending on whether a corporation or individual is involved.

Charitable Donations

Under section 118.1, an individual may claim a tax credit in respect of gifts made to registered charities (or
other organizations listed in section 118.1). The first $200 of a donation are credited at a rate of 17%,
which is the lowest personal tax rate. Any donations above $200 for the year are credited at 29%. The
maximum credit allowed is 20% of the taxpayer's net income.

For corporations, a charitable gift is treated as a deduction as opposed to a tax credit. The result of
treating the gift as a deduction is that the corporation's taxable income is reduced and the after tax value
of the deduction depends upon the corporation's tax rate. Again, the amounts claimed must be supported
by official receipts and the deduction may not exceed 20% of net income. However, as with the
individuals, amounts in excess of 20% of net income may be carried forward up to 5 years.

Dividends

A dividend is a distribution of after-tax income. It would be unfair and inequitable to tax a recipient
corporation on dividends received when the dividends have come from another taxable corporation. To
                                                      8-50
avoid taxing this income twice, the gross amount of the dividend included in the recipient corporation's net
income may be deducted in the computation of taxable income under subsections 112(1), 112(2) and
113(1). Subsections 112(2.1) to 112(2.9) disallow the deduction for dividends on certain types of shares,
however, this area is too complex to discuss in this chapter. If the shares held represent less than 10% of
the total outstanding shares a special Part IV tax equal to 33.3% of the amount of the dividend may be
payable. This tax is refundable at the rate of $1 for every $3 distributed to individual shareholders.

ix. SALARY-DIVIDEND MIX

The optimum salary/dividend mix can only be computed after considering all the relevant factors including
the amount of income not taxed at the small business rate. This would normally require:

x. HOW CAN INCORPORATION RESULT IN TAX DEFERRAL?

If all of the income eligible for the small business deduction is taxed at the corporate level and distributed
in that year to shareholders, a small tax cost results from incorporation compared to receiving the income
directly. There is, however, the possibility of deferring tax on dividends ultimately distributed to the
shareholders by delaying that distribution. Incorporation allows an Alberta CCPC to pay tax of
approximately 19% and then reinvest all remaining funds . In contrast, if the income was to immediately
flow through to the shareholder as salary the funds would be taxed at the shareholder's personal tax rate
(likely in excess of 19%). The result is that where funds are reinvested the CCPC pays tax at a rate of
19%, and personal taxes are deferred.

When a taxpayer starts to carry on business in a given year, a fiscal period ending at the beginning of the
following calendar year can be chosen to defer taxes as long as possible.

xi. CAN A CORPORATION CLAIM TAX CREDITS OR DEDUCTIONS NOT AVAILABLE TO
    INDIVIDUAL TAXPAYERS?

   Charitable Donations

Under section 118.1, an individual may claim a tax credit in respect of gifts made to registered charities (or
other organizations listed in section 118.1). The first $250 of a donation are credited at a rate of 17%,
which is the lowest personal tax rate. Any donations above $250 for the year are credited at 29%. The
maximum credit allowed is 20% of the taxpayer's net income.

For corporations, a charitable gift is treated as a deduction as opposed to a tax credit. The result of
treating the gift as a deduction is that the corporation's taxable income is reduced and the after tax value
of the deduction depends upon the corporation's tax rate. Again, the amounts claimed must be supported
by official receipts and the deduction may not exceed 20% of net income. However, as with the
individuals, amounts in excess of 20% of net income may be carried forward up to 5 years.
                                                        8-51
Dividends

A dividend is a distribution of after-tax income. It would be unfair and inequitable to tax a recipient
corporation on dividends received when the dividends have come from another taxable corporation. To
avoid taxing this income twice, the gross amount of the dividend included in the recipient corporation's net
income may be deducted in the computation of taxable income under subsections 112(1), 112(2) and
113(1). If the shares held represent less than 10% of the total outstanding shares a special Part IV tax
equal to 331/3% of the amount of the dividend may be payable. This tax is refundable at the rate of $1 for
every $3 distributed to individual shareholders.

xiii.       HOW CAN AN ENTREPRENEUR INCORPORATE A COMPANY TO RUN HIS EXISTING
            BUSINESS?

                                            SECTION 85 ROLLOVERS

1. Section 85 Overview

Section 85 allows a taxpayer to transfer the assets and in exchange receive shares of the corporation on a
tax deferred basis. The election permits a rollover of the cost base of the assets to the shares and a
deferral of the recognition of any income, capital gains, or recapture that would otherwise be realized on a
disposition of those assets.

                                         PARAMETERS OF SECTION 85

2. Minimum Statutory Requirements

Subsection 85(1) will not operate unless the taxpayer receives consideration from the corporation which
includes shares of that corporation. The section also permits the receipt of non-share consideration,
however, the amount of that consideration may trigger tax consequences.

3. Eligible Assets

Not all assets can be ―rolled over‖ under section 85. Section 85 applies where ―eligible property‖, defined
in subsection 85(1.1), is transferred to a taxable Canadian corporation (TCC). The following are
specifically excepted from the rollover treatment:

        •   real property which is inventory (e.g., land owned by a dealer in real estate), or any interests in or
            options in respect of real property where they form part of a taxpayer's inventory;

        •   real property including interests and options owned by a non-resident (unless the property is used
            in the year in a business carried on in Canada).

4. Mechanics of Filing

Section 85 requires the taxpayer transferring the assets (who might be an individual, partnership or a
corporation) and the corporation receiving the assets to jointly elect and file the section 85 election. To
avoid penalties, the filing date is on or before the day that is the earliest day in which either taxpayer
making the election is required to file a return of income for the taxation year in which the transaction to
which the election relates occurred. There are provisions for late filing with penalty and special cases.

The election allows the transferor and the corporation to specify an amount (within the parameters of
section 85) which will be deemed to be the "proceeds of disposition" ("POD") of the property to the
taxpayer and its cost of acquisition to the corporation [85(1)(a)]. For example, a taxpayer with land with an
ACB of $50 and a FMV of $100, would elect $50 if he does not wish to realize any part of the capital gain
on the transfer. He could also elect, for example, $75 in which case a $25 capital gain would be realized.
                                                    8-52

5. Elected Amount ("EA")

For each type of property transferred there is a range within which the election may be made. The
maximum election is always the FMV of the asset [85(1)(c)]. Para. 85(1)(b), (c), (c.1), (c.2), (d) and (e) set
limits on the minimum value that may be elected. The minimum elected amount is the greater of the
following:

   1. the FMV of any non-share consideration ("boot") received [85(1)(b)], and

   2. the lesser of the FMV of the property and the ACB of the property, if it is capital property
      [85(1)(c.1), or the lesser of the FMV of the property, the ACB of the property and the UCC of the
      property, if it is depreciable property [85(1)(d)], or the lesser of the FMV of the property, the ACB
      of the property and 4/3 of the cumulative eligible capital ("CEC") of the property, if it is eligible
      capital property [85(1)(e).

If the EA is lower than the minimum, it is deemed to equal the minimum. If the EA exceeds the maximum,
it is deemed to equal the maximum. These are often referred to as the "floor" and "ceiling" rules or the
range within which an election may be made.

6. The "Boot" Rule

The taxpayer must receive consideration that includes shares of the transferee corporation. He may also
receive non-share consideration, for example cash or a promissory note. In this event, under paragraph
85(1)(b), the elected amount cannot be less than the FMV of the non-share consideration received.

7. Maximum Elected Amount

The elected amount is limited to a maximum amount equal to the fair market value of the assets being
transferred to the corporation [85(1)(c)- the "ceiling" rule]. If a higher amount is elected, the elected
amount will be deemed to be the FMV of the transferred asset.

8. The Consideration Received and Valuation Issues

To use section 85 the taxpayer must receive shares. If there are other related shareholders, these shares
must be carefully structured to ensure they will avoid any gift problems. This will commonly be required,
for example, when the taxpayer is using section 85 to freeze his estate so that subsequent appreciation of
it accrues to the common shareholders (i.e. the taxpayer's children). Preference shares redeemable and
retractable for a fixed amount provide an acceptable solution.

The taxpayer may also receive non-share consideration ("boot"). However, total consideration received
must equal the FMV of the transferred assets. The value of the preference shares must therefore be equal
to the FMV of the assets transferred less any boot. Insufficient consideration may trigger the gift provisions
[para. 85(1)(e.2)]. Excess consideration may result in a subs. 15(1) shareholder benefit. Since improper
valuation can result in immediate tax liability, price adjustment clauses are often filed with the s. 85
election (see IT-169). Note: s. 84 may apply if PUC exceeds the EA less any boot received or where
shares are transferred see also section 84.1].

9. The Indirect Gift Rule - paragraph 85(1)(e.2)

Paragraph 85(1)(e.2) operates as a penalty provision where one of the results of a section 85 rollover is
that a benefit has been conferred on a person related to the taxpayer. Where this paragraph applies, the
elected amount is deemed to be increased by the value of the benefit. The provision requires a calculation
of the difference between the fair market value of the transferred property at the time of the disposition
and the greater of the fair market value of all consideration received by the transferor and the elected
                                                     8-53
amount. If it is reasonable to regard any portion of this difference as a benefit that the transferor desired to
have conferred on a person related to the taxpayer, the elected amount is deemed to be increased by the
benefit portion, except for purposes of calculating the cost base of the shares received on the transfer.

10. Consideration, Deemed Dividends and Paid-Up Capital

Generally, the EA becomes the taxpayer's POD and the corp.'s cost of the acquired asset. Some further
adjustments are required where depreciable property is being transferred (subs 85(5).) The cost of any
boot received by the taxpayer is its FMV (85(1)(f)). The cost of preferred shares is the lesser of: the EA
minus boot and their FMV (85(1)(g)) Any amount remaining becomes the cost base of any common
shares received by the taxpayer (85(1)(h)).

Upon the redemption of his shares, a deemed dividend may arise to the extent that the redemption value
exceeds the paid-up capital (PUC) of the shares [sub. 84(3)]. The amount of the deemed dividend will
reduce the taxpayer's POD [54(h)(x)] and the potential capital gain on the disposition. With the capital
gains exemption, it would be more attractive to maintain a high PUC for the shares, to ensure capital gains
treatment on redemption. Unfortunately, sub.85(2.1) will limit the PUC of the shares issued to the elected
amount. PUC will be further reduced by the FMV of non-share consideration received.

Where the elected amount for depreciable property is less than its ACB, the corporation will still acquire
the property at its ACB ($100,000) and the difference between the elected amount and the ACB for the
property becomes the corporation's CCA claimed or in other words, the property will still have a UCC of
$80,000 in the hands of the corporation. This is to prevent recaptured income, which is fully taxable, from
being converted into capital gains on a subsequent disposition of the property.
                                                  8-54
                                            Appendices

1. Interpretation of s.18(1)(a) ITA. (IT-487)

2. Capital Cost Allowance (IT-128R)

3. Books and Records (IC-7810R3)

4. Determination of partnership for tax purposes (IT-90)

5. Tax rules for computing income of partnerships (IT-138R)

6. Elections by partnerships (IT-413R)

7. Corporations Used by Practicing Members of Professions (IT-189R2)

8. Corporate Tax Rates (year 2000)

9. The Small Business Deduction (IT-73R5)

10. Transfers of Property to a Corporation (IT-291R2 and IC 76-19R3)
                                                    8-55
Interpretation Bulletin IT-487 — General Limitation on Deduction of Outlays or
Expenses
Date:     April 26, 1982
Reference:     Paragraph 18(1)(a)

1. Paragraph 18(1)(a) provides a general restraint on the deductions permitted in the computation of
income of a taxpayer from a business or property by prohibiting the deduction of an outlay or expense
except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing
income from the business or property.

2. The Department’s views may be helpful in the interpretation of certain phrases used in the opening
words of subsection 18(1) and in paragraph 18(1)(a), but it should be remembered that these phrases
must also be considered in relation to the wording of the paragraph as a whole.

   (a) ―... of a taxpayer... ‖. The business or property referred to in the paragraph must be that of the
   taxpayer himself and not that of some other person. If a son, for example, paid the realty taxes on an
   apartment building owned and operated by his retired father, those taxes would not be deductible as
   an expense of the son, because the property is that of the father.

   (b) ―... for the purpose... ‖. It is not necessary to show that income actually resulted from the particular
   outlay or expenditure itself. It is sufficient that the outlay or expense was a part of the income-earning
   process.

   (c) ―... gaining or producing income... ‖. The word ―income‖ refers to income after deductions as
   computed under Division B [of Part I] of the Income Tax Act. An expense would not be disallowed
   simply because the income-earning process produced a loss as long as the intention in making the
   expenditure was to produce income. Outlays or expenses made or incurred to maintain income or to
   reduce other expenses are also deductible as their purpose would be to increase income, whether or
   not such an increase resulted.

   (d) ―... from the business... ‖. The taxpayer must have been carrying on the business during the fiscal
   period in which the amount was expended. For comments on when the carrying on of a business may
   be considered to have commenced see IT-364 — Commencement of Business Operations.

3. Even when an outlay or expense is brought within the wording of paragraph 18(1)(a), it does not
necessarily follow that it is deductible. Deduction may still be denied by one of the more specific
prohibitions contained in sections 18, 19 or 19.1. For example, the deduction of a capital outlay or loss is
denied by paragraph 18(1)(b), reserves by 18(1)(e) and personal or living expenses by 18(1)(h). In
addition, section 67 denies a deduction of expenses to the extent that they are unreasonable. In contrast,
section 20 specifies a number of items to be deductible in the determination of business or property
income notwithstanding paragraphs 18(1)(a), (b) and (h).

4. The Department has issued several Interpretation Bulletins dealing with specific types of expenditures
which meet the general requirements of paragraph 18(1)(a) (See Sectional Index).
                                                       8-56
Interpretation Bulletin IT-128R — Capital Cost Allowance — Depreciable
Property
Date:     May 21, 1985
Reference:    Paragraphs 20(1)(a) and 13(21)(b)(also Regulations 1102(1))

This Bulletin replaces and cancels Interpretation Bulletin IT-128 issued on October 29, 1973.

1. The classes of property described in Part XI of the Regulations and in Schedule II in respect of which
capital cost allowances are deductible under paragraph 20(1)(a) in computing income do not include
property that was not in fact acquired by the taxpayer or property listed in Regulation 1102(1), a partial list
of which includes
    (a) property the cost of which is deductible in computing the taxpayer’s income.
    (b) property that is described in the taxpayer’s inventory.
    (c) property that was not acquired for the purpose of gaining or producing income.
    (d) property that was acquired by an expenditure in respect of which the taxpayer is allowed a
    deduction under section 37.
    (e) property that was acquired after November 12, 1981 that is
         (i) a print, etching, drawing, painting, sculpture, or other similar work of art, the cost of which to the
         taxpayer was not less than $200,
         (ii) a hand-woven tapestry or carpet or a handmade appliqué, the cost of which to the taxpayer
         was not less than $215 per square metre,
         (iii) an engraving, etching, lithograph, woodcut, map or chart, made before 1900, or
         (iv) antique furniture, or any other antique object, produced more than 100 years before the date it
         was acquired, the cost of which to the taxpayer was not less than $1,000,
other than property that was acquired from a person with whom the taxpayer was not dealing at arm’s
length (otherwise than by virtue of a right referred to in paragraph 251(5)(b)) at the time the property was
acquired if the property was acquired in the circumstances where the provisions of Regulation 1102(14)
were applicable, and other than property described in (i) or (ii) above that was created by an individual who
was a Canadian, as defined by Regulation 1104(10)(a), at the time the property was created.
    (f) property that was a camp, yacht, lodge or golf course or facility acquired after December 31, 1974
    (subject to the transitional rules in Regulation 1102(17)) if any outlay or expense for the use or
    maintenance of that property is not deductible by virtue of paragraph 18(1)(l) (also see IT-148R2).
    (g) property in respect of which a capital cost allowance for the purposes of paragraph 20(1)(a) is
    claimed and permitted under Part XVII of the Regulations by a farmer or fisherman.

Ownership

2. Capital cost allowance may only be claimed in respect of capital expenditures made in respect of
property owned by the taxpayer or in which the taxpayer has a leasehold interest. In this connection it is
important to note that in computing the income of a partnership, subsection 96(1) and Regulation
1102(1a) require that partnership property (including depreciable property) be accounted for as if it were
owned at the partnership level.

3. In most instances, where a taxpayer incurs a cost in respect of a capital asset he will obtain ownership
of or a lease to that asset will be obtained either at the time the cost was incurred or at a later date.
However, there may be circumstances in which neither a freehold nor a leasehold interest in the property
is acquired. If a taxpayer constructs and incurs the cost of a structure on land owned by another person,
or otherwise incorporates an asset into property owned by another as an integral part thereof, and does
not have a leasehold interest in or ownership of the asset, capital cost allowance may not be claimed in
respect of such property. This will be the case where a road providing access to a taxpayer’s plant is built
at the taxpayer’s expense on land owned by a municipality. Also, capital expenditures for architectural and
engineering services in preparing plans and estimates for new plants, or for additions to existing plants or
other construction work of a capital nature, are not subject to capital cost allowance if the work for which
the plans and estimates were prepared is not carried out. However, an expenditure of this nature may be
                                                    8-57
an eligible capital expenditure (defined in paragraph 14(5)(b)) for which an allowance is permitted by virtue
of paragraph 20(1)(b) of the Act (see IT-143R2).

Capital Expenditures on Depreciable Property versus Current Expenditures on Repairs and
Maintenance

4. The following guidelines may be used in determining whether an expenditure is capital in nature
because depreciable property was acquired or improved, or whether it is currently deductible because it is
in respect of the maintenance or repair of a property:

   (a) Enduring Benefit — Decisions of the courts indicate that when an expenditure on a tangible
   depreciable property is made ―with a view to bringing into existence an asset or advantage for the
   enduring benefit of a trade‖, then that expenditure normally is looked upon as being of a capital nature.
   Where, however, it is likely that there will be recurring expenditures for replacement or renewal of a
   specific item because its useful life will not exceed a relatively short time, this fact is one indication that
   the expenditures are of a current nature.

   (b) Maintenance or Betterment — Where an expenditure made in respect of a property serves only to
   restore it to its original condition, that fact is one indication that the expenditure is of a current nature.
   This is often the case where a floor or a roof is replaced. Where, however, the result of the
   expenditure is to materially improve the property beyond its original condition, such as when a new
   floor or a new roof clearly is of better quality and greater durability than the replaced one, then the
   expenditure is regarded as capital in nature. Whether or not the market value of the property is
   increased as a result of the expenditure is not a major factor in reaching a decision. In the event that
   the expenditure includes both current and capital elements and these can be identified, an appropriate
   allocation of the expenditure is necessary. Where only a minor part of the expenditure is of a capital
   nature, the Department is prepared to treat the whole as being of a current nature.

   (c) Integral Part or Separate Asset — Another point that may have to be considered is whether the
   expenditure is to repair a part of a property or whether it is to acquire a property that is itself a separate
   asset. In the former case the expenditure is likely to be a current expense and in the latter case it is
   likely to be a capital outlay. For example, the cost of replacing the rudder or propeller of a ship is
   regarded as a current expense because it is an integral part of the ship and there is no betterment; but
   the cost of replacing a lathe in a factory is regarded as a capital expenditure, because the lathe is not
   an integral part of the factory but is a separate marketable asset. Between such clear-cut cases there
   are others where a replaced item may be an essential part of a whole property yet not an integral part
   of it. Where this is so, other factors such as relative values must be taken into account.

   (d) Relative Value — The amount of the expenditure in relation to the value of the whole property or in
   relation to previous average maintenance and repair costs often may have to be weighed. This is
   particularly so when the replacement itself could be regarded as a separate, marketable asset. While
   a spark plug in an engine may be such an asset, one would never regard the cost of replacing it as
   anything but an expense; but where the engine itself is replaced, the expenditure not only is for a
   separate marketable asset but also is apt to be very substantial in relation to the total value of the
   property of which the engine forms a part, and if so, the expenditure likely would be regarded as
   capital in nature. On the other hand, the relationship of the amount of the expenditure to the value of
   the whole property is not, in itself, necessarily decisive in other circumstances, particularly where a
   major repair job is done which is an accumulation of lesser jobs that would have been classified as
   current expense if each had been done at the time the need for it first arose; the fact that they were
   not done earlier does not change the nature of the work when it is done, regardless of its total cost.

   (e) Acquisition of Used Property — Where used property is acquired by a taxpayer and at the time of
   acquisition it requires repairs or replacements to put it in suitable condition for use, the cost of such
   work is regarded as capital in nature even though, in other circumstances, it would be treated as
   current expense.
                                                   8-58

   (f) Anticipation of Sale — Repairs made in anticipation of the sale of a property or as a condition of the
   sale are regarded as capital in nature. On the other hand, where the repairs would have been made in
   any event and the sale was negotiated during the course of the repairs, or after their completion, the
   cost should be classified as though no sale was contemplated.

Depreciable Assets versus Inventory Assets

5. The Department’s practice with respect to a taxpayer who deals in a particular kind of property and who
also uses that kind of property for some other purpose is discussed in IT-102R2.
Buildings Incidentally Acquired on Obtaining a Site

6. Where a taxpayer purchases real estate including a building and the building is torn down within a
relatively short time after purchase, the question arises as to whether the building should be classed as
depreciable property. If the building is demolished by the purchaser without having been used to earn
income, the building cannot be regarded as depreciable property. Also, where the building is used to earn
income for only a short time prior to demolition, it is not regarded as depreciable property unless the
taxpayer can clearly establish that the prime intention on acquiring the building was for the purpose of
gaining or producing income. The Department’s practice with respect to the costs of demolishing a
building incidentally acquired on obtaining a site is discussed in IT-485.
                                                    8-59
Information Circular 78-10R3 * — Books and Records Retention/Destruction
Date: October 5, 1998
This circular cancels and replaces Information Circular 78-10R2 dated July 14, 1989, and Information
Circular 78-10R2(SR) dated February 10, 1995. This update adds information about new legislation that
requires computer records to be kept in an electronically readable format even when a paper copy of the
record(s) has been kept.
1. The circular gives information and guidance to persons who are required by law to keep records and
books of account according to sections 230 and 230.1 of the Income Tax Act, section 87 of the
Employment Insurance Act, and section 24 of the Canada Pension Plan. It does not reflect the
requirements imposed by other statutes, whether federal, provincial, or municipal, to maintain adequate
records and books of account.
2. The sections and subsections referred to in this circular are from the Income Tax Act. Parallel
provisions for most of these matters exist in the Employment Insurance Act and Canada Pension Plan.
Where significant differences do exist, they are indicated.
Who has to keep books and records?
3. For the purpose of this circular, person has the meaning assigned by subsection 248(1) of the Income
Tax Act (the Act). Therefore, a person in this context includes a corporation, a trust, and any exempt entity
listed in subsection 149(1) of the Act such as a registered charity, a registered Canadian amateur athletic
association, and a non-profit organization.For the purpose of this circular, person has the meaning
assigned by subsection 248(1) of the Income Tax Act (the Act). Therefore, a person in this context
includes a corporation, a trust, and any exempt entity listed in subsection 149(1) of the Act such as a
registered charity, a registered Canadian amateur athletic association, and a non-profit organization.
4. Books and records must be kept by every:
• person carrying on a business;
• person who is required to pay or collect taxes or other amounts according to the Acts mentioned in 1
above;
• registered charity or registered Canadian amateur athletic association; and
• registered agent of a registered political party or an official agent for a candidate in a federal election.
Records to be kept
5. For the purpose of this circular, a record has the meaning assigned by subsection 248(1) of the Act. A
―record‖ includes an account, an agreement, a book, a chart or table, a diagram, a form, an image, an
invoice, a letter, a map, a memorandum, a plan, a return, a statement, a telegram, a voucher, and any
other thing containing information, whether in writing or in any other form.‖
6. As a general rule, the Department does not specify the records and books to be kept. However, records
and books of account have to:
• permit the taxes payable or the taxes or other amounts to be collected, withheld, or deducted by a
person to be determined;
• substantiate the qualification of registered charities or registered Canadian amateur athletic
association for registration under the Act;
• permit the verification of all charitable, athletic, and political donations received for which a deduction
or tax credit is available; and
• be supported by source documents that verify the information in the records and books of account.
7. A source document includes items such as sales invoices, purchase invoices, cash register receipts,
formal written contracts, credit card receipts, delivery slips, deposit slips, work orders, dockets, cheques,
bank statements, tax returns, and general correspondence.
Location of records
8. The records and books of account have to be kept at the person's place of business or residence in
Canada or another place designated by the Minister and have to, upon request, be made available to
officers of Canada Customs & Revenue Agency for audit purposes at all reasonable times. Records and
books of account kept outside Canada and accessed electronically from Canada are not records and
books of account in Canada. Access to electronic records means direct, physical contact to the medium
on which the record is stored (e.g., tape, disc, CD-ROM).
Methods of keeping records
9. Keeping records and books of account pertains to a system of recording financial and other information.
                                                       8-60
For example, records are considered to be kept electronically when information is directly entered into any
device for electronic processing, manipulation, and/or storage on electronic or optical media and
reproduction to paper.
10. Canada Customs & Revenue Agency recognizes as records and books of account:
• the traditional records and books of account (including supporting source documents) produced and
retained in paper format; and
• records and books produced and retained in an electronically readable format that can be related back
to the supporting source documents and which are supported by a system capable of producing
accessible and readable copy.
Ways of keeping records
11. A person who is required to keep records and books is responsible for keeping the records and books
in a way that will ensure the trustworthiness and readability of the information recorded.
12. All records and books of account (including source documents) that originate in paper format have to
be kept except where an acceptable imaging or microfilming program, as discussed in the following
section, is in place. Paper format includes paper source documents from which data is entered into an
electronic record-keeping system.
13. A person who is required to keep records and who records them electronically has to keep the records
in an electronically readable format. This means that a person who uses computerized systems to
generate records and/or books of account must keep the electronic records, even when a hard copy is
kept.
14. This person should ensure that proper back-up records are maintained at all times. If any electronic
records required to be maintained are lost, destroyed, or damaged, the person must report this situation to
the Director of the local tax services office and recreate the files within a reasonable period of time.
Imaging
15. Source documents and records that are in an electronically readable format must be kept in addition to
the microfilm and/or electronic image.
16. Electronic image means the representation of a source record that can be used to generate an
intelligible reproduction of that record, or the reproduction itself, where:
• the reproduction is made with the intention of standing in place of the source record;
• the interpretation of the reproduction, for the purposes for which it is being used, gives the same
information as the source record; and
• the limitations of the reproduction (e.g., resolution, tonal, or hues) are well defined and do not obscure
significant details.
Paper source documents may be disposed and their images kept as permanent records.
17. Imaging and microfilm (including microfiche) reproductions of books of original entry and source
documents have to be produced, controlled, and maintained according to the national standard of
Canada, as outlined in the publication called Microfilm and Electronic Images as Documentary Evidence.
This publication, identified as CAN/CGSB-72.11-93, is available from:
Canadian General Standards Board
Sales Centre
Phase 3, 6B1
Place du Portage
11 Laurier St.
Hull QC K1A 0S5
Telephone number for calls from the Ottawa area:
(819) 956-0425
Toll-free telephone number for calls from other parts of Canada:
Fax number: (819) 956-5644
18. An acceptable imaging program requires that:
(a) someone in the organization has confirmed in writing that the program will be part of the usual and
ordinary activity of the organization's business;
(b) systems and procedures are established and documented;
(c) a logbook is kept showing:
• the date of imaging;
• the signatures of the persons authorizing and performing the imaging;
                                                      8-61
• a description of the records imaged; and
• whether source documents are destroyed or disposed of after imaging, and the date a source
document was destroyed or disposed of;
(d) the imaging software maintains an index to permit the immediate location of any record, and the
software inscribes the imaging date and the name of the person who does the imaging;
(e) the images are of commercial quality and are legible and readable when displayed on a computer
screen or reproduced on paper;
(f) a system of inspection and quality control is established to ensure that c), d), and e) above are
maintained; and
(g) after reasonable notification, equipment in good working order is available to view, or where feasible, to
reproduce a hard copy of the image.
Electronic records
19. Documentation describing physical, environmental, and system controls that exist or existed to prevent
unauthorized alteration or loss of the records have to be maintained. This would also include flow charts
and policy/procedure manuals or instructions to document the flow and treatment of transactions through
the accounting system from initiation to closure and storage.
20. The electronic records must show an audit trail from the source document(s), whether paper or
electronic, to the financial accounts. Where no paper source document(s) exist, as in a transaction
covered by a trading partner agreement of electronic data interchange (EDI), the electronic record(s)
including functional acknowledgments have to be kept. It is the record keeper's responsibility to ensure the
trustworthiness and readability of EDI transaction records.
21. Retained records should be stored in a way that is appropriate to the media on which the information is
recorded. Information recorded on rewritable media such as computer hard disks should be backed up on
tape or other suitable medium to avoid accidental deletion or erasure of the recorded information. The
media containing the recorded information should be stored in an environment free from magnetic fields,
direct light, and excessive heat.
23. A person who keeps records electronically is not relieved of any of the record keeping, readability,
retention, and access responsibilities because he or she contracts out the record keeping function to a
third party such as through a time share, service bureau, or other such arrangements. Therefore, the
person must ensure that these requirements are met in the event of system changes by the third party,
bankruptcy of the third party, or a change from one third party to another third party or from a third party to
an in-house record keeping system. The record keeper is also responsible for keeping electronic records
and providing access to authorized persons when a value added network (VAN) is used as an
intermediary/mailbox, regardless of where the VAN is located.
23. A person who uses turnkey or packaged software to keep books and records electronically is not
relieved of the responsibility to keep adequate electronic records because of deficiencies in the software.
In cases where the software backup procedures are deficient, additional specific backup procedures may
be required to retain adequate electronic records. Documentation must be kept at a level of detail that will
describe the data entry procedures, reports produced, and any features that alter standard reports or
create new reports.
24. Where electronically kept records are converted from one format to another, it is the record keeper's
responsibility to ensure that the converted records are trustworthy and readable. The conversion must not
result in a loss, destruction, or alteration of information and data relevant to the determination of taxes
payable, collected, or withheld.
25. The Department is prepared to offer advice on keeping, maintaining, retaining, and storing electronic
records. You can get this advice from your tax services office. This advice should not be considered or
viewed as an audit, inspection, or a ruling issued by the Department. The record keeper is responsible for
keeping, maintaining, retaining, and safeguarding records.
26. Subsection 230(4.2) of the Income Tax Act provides that the Minister may exempt a person or a class
of persons from the requirement to keep electronic records under terms and conditions that are
acceptable to the Minister.
27. The Department occasionally enters into agreements to keep specific files of electronic records to be
used during subsequent audits. These agreements are referred to as record retention agreements. The
files under these agreements should be kept for the statutory period referred to in paragraph 30 below.
Retention period
                                                       8-62
28. Records and books of account have to be kept for the period or periods provided by subsections
230(4) to (7) and Part 5800 of the Income Tax Regulations or until the Minister gives written permission
for their disposal. Failure to comply with this requirement could result in prosecution by the Department.
29. Subsection 230(4.1) requires every person who keeps records electronically to retain them in an
electronically readable format for the retention period outlined in subsection 230(4).
30. Under the Act, books, records, and their related accounts and source documents, other than those
referred to in paragraphs 31 and 32 below, have to be kept for a minimum of six years from the end of the
last tax year to which they relate. The tax year is the fiscal period for corporations and the calendar year
for all other taxpayers. Under the Employment Insurance Act and Canada Pension Plan, the retention
period begins at the end of the calendar year to which the books and records relate.
31. The prescribed retention periods for certain books, records, and their related accounts and source
documents are specified in Regulation 5800 (see Appendix). The required retention periods can be
summarized as follows:
• for a corporation, two years from the date of the dissolution of the corporation (in the case of
corporations that amalgamate or merge, books and records have to be retained on the basis that the new
corporation is a continuation of each amalgamating corporation);
• for any non-incorporated business, six years from the end of the tax year in which the business
ceased;
• for the duplicate donation receipts of a registered charity or registered Canadian amateur athletic
association, other than receipts for donations of property to be held for a period of not less than ten years,
two years from the end of the calendar year in which the donations were made;
• for other specified records of registered charities and registered Canadian amateur athletic
associations, two years from the date the registration is revoked; and
• for records relating to political contributions, two years from the end of the calendar year to which they
relate.
There are no similar provisions in the Employment Insurance Act or Canada Pension Plan.
32. Exceptions to the rules outlined in paragraphs 28 and 29 above are:
• The Minister may exempt a person or class of persons from the requirement to keep records
electronically according to subsection 230(4.2.)
• Books of account and records may be destroyed at an earlier time than outlined elsewhere in this
circular if the Minister gives written permission for their disposal. To get such permission, a person can
use Form T137, Request for Destruction of Books and Records, or can apply in writing to the Director of
his or her tax services office. A written request, signed by the person or an authorized representative,
should provide the following information:
• a clear identification of books, records, or other documents to be destroyed;
• the tax years for which the request applies;
• details of any special circumstances which would justify destroying the books and records at an earlier
time than that normally permitted;
• and any other pertinent information.
• The Minister may, by registered letter or by a demand served personally by a representative of the
Department, require specific records to be kept for an additional period of time stipulated in the letter or
demand.
• If a return required by section 150 of the Act is filed late, the books and records referred to in
paragraph 30 above must be kept for six years from the day the return is filed.
• Every book and record necessary for dealing with a notice of objection or appeal must be kept until the
notice of objection or appeal is disposed of and the time for filing any further appeal has expired.
• In the case of paragraph 31 above, only the books and records of a deceased taxpayer or a trust can
be destroyed upon receipt of a clearance certificate issued according to subsection 159(2) concerning the
distribution of all property.
When Canada Customs & Revenue Agency gives permission to destroy records and books, this
permission applies only to information required to be kept under the legislation administered by Canada
Customs & Revenue Agency, and does not imply permission to destroy any books and records required to
be kept under any other legislation, or by any other department or government agency.
33. The minimum retention period for the records referred to in paragraph 30 above is generally
determined by the last tax year when a record may be required for purposes of the Act, and not the year
                                                      8-63
when the transaction occurred and the record was created. For example, records supporting the
acquisition and capital cost of investments and other capital property held by a person (including
registered charities and registered Canadian amateur athletic associations) should be maintained until the
day that is six years from the end of the last tax year in which such an acquisition could enter into any
calculation for income tax purposes.
Inadequate records
34. If a person has failed to keep adequate records and books of account, subsection 230(3) provides that
the Minister can specify what records or books of account shall be kept.
35. If Canada Customs & Revenue Agency finds that records and books of account are inadequate, the
Department will ordinarily request a written agreement that books and records be maintained as required.
Within a reasonable period of time, usually not less than a month, the Department will follow up the
request by letter or visit to ensure compliance.
36. If there has been no compliance within the time allowed, the Department will issue a formal
requirement letter. The letter describes the information to be recorded in the books and describes the
legal consequences and penalties for failing to comply. Failure to comply with the letter within a specified
period of time may result in prosecution by the Department. On summary conviction, and in addition to any
penalty otherwise payable, a taxpayer is liable to a fine of not less than $1,000, or both the fine and
imprisonment. No such minimum is required under the Employment Insurance Act or the Canada Pension
Plan.
37. A person who destroys or otherwise disposes of records or books of account to evade the payment of
tax is subject to prosecution according to section 239. Information Circular 73-10, Tax evasion, discusses
Department policies on tax evasion.
Appendix — Part LVIII — Keeping books and records
5800. (1) For the purposes of paragraph 230(4)(a) of the Act, the required retention periods for records
and books of account of a person are prescribed as follows:
a) in respect of
(i) any record of the minutes of meetings of the directors of a corporation,
(ii) any record or the minutes of meetings of the shareholders of a corporation,
(iii) any record of a corporation containing details with respect to the ownership of the shares of the capital
stock of the corporation and any transfers thereof,
(iv) the general ledger or other book of final entry containing the summaries of the year-to-year
transactions of a corporation, and
(v) any special contracts or agreements necessary to an understanding of the entries in the general ledger
or other book of final entry referred to in subparagraph (iv),
the period ending on the day that is two years after the day that the corporation is dissolved;
b) in respect of all records and books of account that are not described in paragraph (a) of a corporation
that is dissolved and in respect of the vouchers and accounts necessary to verify the information in such
records and books of account, the period ending on the day that is two years after the day that the
corporation is dissolved;
in respect of
(i) the general ledger or other book of final entry containing the summaries of the year-to-year transactions
of a business of a person (other than a corporation), and
(ii) any special contracts or agreements necessary to an understanding of the entries in the general ledger
or other book of final entry referred to in subparagraph (i),
the period ending on the day that is six years after the last day of the taxation year of the person in which
the business ceased;
d) in respect of
(i) any record of the minutes of meetings of the executive of a registered charity or registered Canadian
amateur athletic association,
(ii) any record of the minutes of meetings of the members of a registered charity or registered Canadian
amateur athletic association,
(iii) all documents and by-laws governing a registered charity or registered Canadian amateur athletic
association, and
(iv) all records of any donations received by a registered charity that were subject to a direction by the
donor that the property given be held by the charity for a period of not less than 10 years,
                                                      8-64
the period ending on the day that is two years after the date on which the registration of the registered
charity or the registered Canadian amateur athletic association under the Act is revoked;
e) in respect of all records and books of account that are not described in paragraph (d) and that relate to
a registered charity or registered Canadian amateur athletic association whose registration under the Act
is revoked, and in respect of the vouchers and accounts necessary to verify the information in such
records and books of account, the period ending on the day that is two years after the date on which the
registration of the registered charity or the registered Canadian amateur athletic association under the Act
is revoked;
f) in respect of duplicates of receipts for donations (other than donations referred to in subparagraph
(d)(iv)) that are received by a registered charity or registered Canadian amateur athletic association and
are required to be kept by that charity or association pursuant to subsection 230(2) of the Act, the period
ending on the day that is two years from the end of the last calendar year to which the receipts relate; and
g) notwithstanding paragraphs (c) to (f), in respect of all records, books of account, vouchers and
accounts of a deceased taxpayer or a trust in respect of which a clearance certificate is issued pursuant to
subsection 159(2) of the Act with respect to the distribution of all the property of such deceased taxpayer
or trust, the period ending on the day that the clearance certificate is issued.
(2) For the purposes of subsection 230.1(3) of the Act, with respect to the application of paragraph
230(4)(a) of the Act, the required retention period for records and books of account that are required to be
kept pursuant to section 230.1 of the Act is prescribed to be the period ending on the day that is two years
after the end of the last calendar year to which the records or books of account relate.
                                                    8-65
Interpretation Bulletin IT-90 — What is a Partnership?
Date:     February 9, 1973
Reference:     Section 96

1. The Income Tax Act does not define a ―partnership‖, but outlines the tax consequences if one exists.
Section 102 defines what is meant by a ―Canadian partnership‖, but presupposes that there is a
partnership. A partnership is not a person, nor is it deemed to be within the meaning of the Act,
notwithstanding that section 96 provides that the income of a member of a partnership is computed is if
the partnership were a separate person resident in Canada.

2. Generally speaking, a partnership is the relation that subsists between persons carrying on business in
common with a view to profit. However, co-ownership of one or more properties not associated with a
business, (which under Common Law might be a joint tenancy or a tenancy in common), does not of itself
create a partnership, and this is so regardless of an arrangement to share profits and losses. For
guidance on whether a particular arrangement at a particular time constitutes a partnership, reference
should be made to the relevant provincial law on the subject, and such law will be viewed as persuasive by
the Department of National Revenue.

3. A characteristic of a partnership is a sharing of profits of a business as opposed to a sharing of gross
returns. Where the share of profits represents the payment of an obligation as opposed to a partnership
right to so share, any presumption of partnership relating to the share of profits is rebutted.

4. A joint venture agreement, whereby two or more persons agree that each provides his own property to
perform a specific task and receives a specific division of profits from such a task, may be considered a
partnership as regards such profits; but as long as the property is not held under joint tenancy or tenancy
in common, it is not considered to be partnership property. Thus the capital cost allowance provisions
relating to partnership property do not apply.

5. Where several persons form an association for the purpose of carrying out particular business
transactions in which they are mutually interested, the association has the characteristic of partnership.
However, such persons may associate without each accepting total liability for the association’s debts. In
these circumstances, contracts may indicate that the associated persons will be liable only for their
respective agreed portions of the debts. The existence of such an arrangement is viewed as an indication
that a partnership does not exist. One of the original examples of this type of association which does not
constitute a partnership is a syndicate of insurance underwriters. Associations or syndicates in connection
with natural resource industries often are in the same category.

6. Since a partnership is a relationship between persons carrying on business for profit, the type and
extent of a person’s involvement in the business is relevant in determining whether he is in reality a
partner.

7. Formal registration of a partnership or limited partnership is not in itself decisive because a declaration
of this type does not prevail in partnership law over the actual facts of a situation.

8. Any of the factors mentioned in this Bulletin are not necessarily decisive in themselves, but merely
serve as objective criteria on which to base a decision on the existence or non-existence of a partnership.
                                                     8-66
Interpretation Bulletin IT-138R — Computation and Flow-through of Partnership
Income
Date:     January 29, 1979
Reference:     Section 96(also section 99, paragraphs 89(1)(b), (k) and (l), and
               subparagraphs 53(1)(e)(i), 53(2)(c)(i) and 3(e)(ii) of the Act, and
               section 41 of the Income Tax Application Rules, 1971 (ITAR))
This bulletin replaces and cancels Interpretation Bulletin IT-138 dated December 18, 1973.

1. For purposes of the Income Tax Act, a partnership is not a person and is not deemed to be a person.
However, in determining a member’s share of the income or loss of the partnership from a source or from
sources in a particular place, the partnership first computes its income as if it were a person. A member’s
share of the income or loss of the partnership from each source then flows through to him pursuant to
paragraph 96(1)(f) or (g), retaining its characteristics in respect of its source and nature. This bulletin
discusses some of the results of this procedure.

Capital Cost Allowances and Reserves

2. In determining income or loss at the partnership level, capital cost allowance on property owned by the
partnership and the various reserves permitted by the Act are claimed by the partnership and not by the
partners individually.

Farming

3. Where a partnership operates a farming business, paragraphs 96(1)(f) and (g) provide for the
allocation to the partner of only his share of the income whether or not the provisions of section 31 relating
to ―chief source of income‖ are applicable to him. Thus the deduction for the net farming losses of each
partner whose chief source of income is neither farming nor a combination of farming and some other
sources of income is restricted to the amount (up to $5,000) determined under section 31.

Dividends

4. Paragraphs 96(1)(f) and (g) provide that the income or loss allocated to each partner is his share of the
net income or net loss (after applicable expenses) from any source or from sources in a particular place.
However, when a partnership receives dividends from a taxable Canadian corporation, and there are
expenses applicable thereto, it is considered that the partnership may allocate to each member his share
of the gross dividend and his share of the expenses. The effect is that the gross-up of the dividend and
the dividend tax credit are calculated on the gross dividend rather than on the net dividend income.

5. Where a partnership which includes corporate members receives a dividend paid out of tax-paid
undistributed surplus on hand or 1971 capital surplus on hand pursuant to subsection 83(1), as it applied
to dividends becoming payable before 1979, for the purposes of computing a corporate partner’s tax-paid
undistributed surplus on hand or 1971 capital surplus on hand under paragraph 89(1)(k) or 89(1)(l) as they
applied prior to 1979, the corporate partner is considered to have received the dividend to the extent of its
share thereof.

Disposition of Capital Property

6. Subparagraph 96(1)(c)(i) states that, when a partnership disposes of capital property, the taxable
capital gain or allowable capital loss (half the capital gain or loss) is allocated to the partners. On
dispositions of listed personal property, however, it is considered that the capital gain or loss (not half the
gain or loss) must be allocated to the partners. A partner then includes such gains or losses with any other
capital gains or losses on disposition of listed personal property held by him in computing his taxable net
gain under section 41.
                                                    8-67

7. For the purposes of computing the adjusted cost base on dispositions of capital property held by the
partnership on December 31, 1971, the median rule under subsection 26(3) of the ITAR, and the
provisions of subsection 20(1) of the ITAR in respect of depreciable property apply at the partnership level.

Averaging

8. Partnership income from a particular source retains its identity in the hands of a partner. Therefore, to
the extent that the income from a particular source qualifies, the partner is entitled to take advantage of
the transitional averaging provisions in sections 39, 42, 45, 46 and 48 of the ITAR.

Option — End of Fiscal Period

9. The option provided in subsection 99(2) of the Act to move back the date on which a fiscal period ends
is available only to an individual. Accordingly, where a partnership (the first partnership) is a member of
another partnership (the second partnership) which ceases to exist before the end of its normal fiscal
period, the first partnership cannot use that option. For example, suppose that the fiscal period of the first
partnership ended on December 31, 1972. The fiscal period of the second partnership ended on June 30,
1972. If the second partnership ceased to exist on October 31, 1972, the first partnership includes in
income for the 1972 taxation year its share of the income of the second partnership for the periods ending
June 30, 1972 and October 31, 1972. The first partnership cannot use subsection 99(2) to move back the
end of the second period from October 31, 1972 to June 30, 1973. Moreover, subsection 41(3) of the
ITAR does not apply, in respect of the two fiscal periods of the second partnership, to an individual who is
a member of the first partnership.
Salaries

10. Salaries paid by a partnership to its members do not constitute a business expense, but are a method
of distributing partnership income among members. The income of a partnership in a taxation year may
be less than the salaries which the partnership agreement requires to be paid to the partners. In this
event, the excess of the salaries over such income appears as a deduction in the partners’ capital
accounts. Such a reduction of the capital of each partner is allowed as a deduction in determining the
allocation to him of the income or loss of the partnership.

11. For example, suppose that A and B are members of AB partnership. Under the partnership
agreement, A is to receive an annual salary of $2,500, after which A and B divide the income or loss
equally. The income of the partnership before deduction of the $2,500 salary paid to A is $1,000. The loss
after the salary is deducted is $1,500 and $750 is charged to each of the capital accounts. In such a case,
A’s income is $1,750 ($2,500 – $750) and B’s loss is $750. Thus A’s income of $1,750 minus B’s loss of
$750 equals the income of the partnership.

Rent Paid to Partner

12. Where a partnership leases property owned by a partner, the rent is an expense of the partnership
and income of the member, and not an allocation of partnership income.

Expenses of Partner

13. A partnership agreement may require that certain expenses incurred by a member of the partnership,
such as automobile expenses and advertising expenses, are to be paid by each member personally. The
member may deduct such expenses to the extent that they are incurred in earning the partnership income.

14. * If the partnership’s fiscal period does not coincide with the calendar year, a partner who is an
individual may deduct, in computing his income for a calendar year, those expenses otherwise allowable
that were incurred in the calendar year. Alternatively, he may deduct those expenses incurred during the
fiscal period to the partnership that ends in the calendar year.
                                                     8-68

15. The alternative mentioned in paragraph 14 above does not apply to interest expense that is deductible
under paragraph 20(1)(c) of the Act on money borrowed by a partner to acquire an interest in a
partnership.

Adjusted Cost Base of Partnership Interest

16. For the purposes of the additions to and deductions from the adjusted cost base of a partnership
interest under subparagraphs 53(1)(e)(i) and 53 (2)(c)(i), the share of income or loss allocated to a partner
is computed before any deduction for expenses mentioned in paragraphs 13, 14 and 15 above.

Debtor’s Gain on Settlement of Debts

17. Since a partnership has no non-capital losses, net capital losses, or restricted farm losses, its gain on
settlement of debts within the meaning of section 80 is applied to reduce as prescribed the capital cost to
the partnership of any depreciable property and the adjusted cost base to it of any capital property.

Individual Capital Loss Deduction

18. Paragraph 96(1)(c) requires in part a computation of each taxable capital gain, each allowable capital
loss and each income and loss of the partnership from each other source as if the partnership were a
separate person. The amounts so computed flow-through to each partner by paragraphs 96(1)(f) and (g)
to the extent of his share thereof. Therefore, the $2,000 ($1,000 prior to the 1977 taxation year) deduction
in respect of allowable capital losses from other income for the taxation year as provided for in
subparagraph 3(e)(ii) does not apply at the partnership level but applies to an individual who is a member
of the partnership or who is a member of a second partnership who is a member of the partnership.

Corporate Partner’s Capital Dividend Account

19. For the purposes of paragraph 89(1)(b) it is considered that each of the items in subparagraphs
89(1)(b)(i), (ii), (iii) and (iv) is to be included in the corporate partner’s capital dividend account to the
extent of its share thereof.

Limited Partner’s Share of Limited Partnership’s Loss

20. The Department considers that a limited partner’s share of a partnership’s loss pursuant to paragraph
96(1)(g) cannot exceed the lesser of his share of the partnership’s loss as determined by the provisions of
the relevant Partnership Act or the agreement between all members of the partnership, and his ―equity‖ in
the partnership determined as the aggregate of the capital he has contributed and any amount he has
agreed to pay to the partnership as an additional capital contribution plus or minus the net adjustments to
the adjusted cost base of his interest in the partnership pursuant to paragraphs 53(1)(e) and 53(2)(c). Any
loans or advances made to the partnership by a limited partner and any obligations of the partnership
guaranteed by a limited partner are not considered to be an addition to partnership ―equity‖.

General

21. The following is a list of Interpretation Bulletins which discuss the flow-through of other items:

   IT-73R2 Meaning of Active Business Income
   IT-81R       Partnership-Income of Non-Resident Partners
   IT-125R Disposition of Resource Properties
   IT-183       Foreign Tax Credit -- Member of a Partnership
   IT-245       Income-Averaging Annuity Contracts for Partners
                and Beneficiaries of Trusts
   IT-333       Interest and Dividend Deduction
                                          8-69
IT-346R Commodity Futures and Certain Commodities
                                                     8-70
Interpretation Bulletin IT-413R — Election by Members of a Partnership Under
Subsection 97(2)
Date:     July 7, 1989
Reference:     Subsections 96(3) and 97(2)(also subsections 96(4), (5), (5.1) and
               (6) and paragraph 102(b))
Application

This bulletin cancels and replaces IT-413 dated May 15, 1978. Current revisions are indicated by vertical
lines.

Summary

Pursuant to subsection 97(2) a taxpayer may dispose of certain property to a partnership on a rollover
basis provided that a joint election is executed by the taxpayer and all the other members of the
partnership and that the other requirements of that subsection are satisfied. To be valid, such an election
on behalf of the members of a partnership must comply with the rules in subsection 96(3). This bulletin
explains the implications of subsection 96(3) to a subsection 97(2) election where the property is disposed
of by a Canadian partnership or where a member of the Canadian partnership that acquires the property is
itself a Canadian partnership.

Discussion and Interpretation

1. Paragraph 102(b) clarifies that the rules in subdivision j (sections 96 to 103) apply to a partnership
which is a member of another partnership. Although paragraph 102(b) applies after February 25, 1986 its
enactment merely recognizes the Department’s previous position in respect of subdivision j and does not
involve a change in that position.

2. Paragraph 96(3)(a) provides that where a person who is a member of a partnership has made an
election under subsection 97(2), the election is not valid unless it was made or executed on behalf of that
person and each other person who was a member of the partnership and that person had authority to act
for the partnership. Where a partnership disposes of property which is the subject of an election under
subsection 97(2), the manner in which the requirements of paragraph 96(3)(a) apply to the part of the joint
election to be made on behalf of the members of the disposing partnership is discussed in 3 below. Where
a partnership is a member of another partnership which acquires property that is the subject of an election
under subsection 97(2), the manner in which the requirements of paragraph 96(3)(a) apply to the part of
the joint election to be made on behalf of the members of the acquiring partnership is discussed in 4
below.

3. Where the ―taxpayer‖ referred to in subsection 97(2) that disposes of property to a partnership is itself
a partnership (the first partnership), that part of the joint election required by subsection 97(2) to be made
by the ―taxpayer‖ must be made or executed by a member of that first partnership on behalf of all
members of that first partnership, including the member making or executing the election and the member
who makes or executes the election must have authority to act on behalf of the members of that
partnership.

4. Generally, that part of the joint election in respect of all other members of the partnership that is
acquiring the property must be made by a member of that partnership on behalf of that member and of
each other person who was a member of the partnership and that member must have the authority to act
for the partnership. In a situation where a partnership (the first partnership) is a member of the partnership
(the second partnership) that is acquiring the property, that part of the joint election required by subsection
97(2) to be made by ―all other members of the partnership‖ must be made or executed by a member of
the second partnership on behalf of each member of the first partnership and each member of the second
partnership, including the member making or executing the election and the member making or executing
                                                   8-71
the election must have the authority to act on behalf of the members of the first partnership as well as on
behalf of the members of the second partnership.

5. Paragraph 96(3)(b) provides that unless the subsection 97(2) election is invalid by virtue of paragraph
96(3)(a), each other person who was a member of the partnership during the relevant fiscal period shall
be deemed to have made or executed the election. Where one member of the partnership (the ―second
partnership‖) is itself a partnership (the ―first partnership‖), each person who is a member of the first
partnership is also deemed to have made or executed the election in addition to each other person who is
a member of the second partnership.

6. Subsection 96(4) provides that any election under subsection 97(2) shall be made on or before the day
that is the earliest of the days on or before which any taxpayer making the election is required to file a
return of income pursuant to section 150 for the taxpayer’s taxation year in which the transaction to which
the election relates occurred. The words ―any taxpayer‖ in the foregoing sentence includes

   (a) the taxpayer who disposed of the property to the partnership and, where it was a partnership that
   disposed of the property, each member of that partnership, and
   (b) each member of the partnership that acquired the property and, where a member of the
   partnership that acquired the property was itself a partnership (the first partnership), each member of
   the first partnership as well.

7. Where it is a partnership that disposes of the property, the late filing penalty, if any, provided for in
subsections 96(5), (5.1) and (6) is considered to be payable by that partnership on behalf of its members
and the notice of assessment referred to in subsection 96(7) will be sent to the address of the partnership.

8. Elections for the purposes of subsection 97(2) must be made on prescribed Form T2059 and require
the signatures of the transferor or an authorized signing officer and of the authorized officer of the
transferee.
                                                      8-72
Interpretation Bulletin IT-189R2 — Corporations Used by Practising Members of
Professions
Date:     May 24, 1991
Reference:     Sections 9 and 125(also sections 10 and 34 and paragraph 18(1)(p))

Application

This bulletin cancels and replaces Interpretation Bulletin IT-189R dated February 27, 1984. Current
revisions are indicated by vertical lines.

Summary

This bulletin deals with corporations used by practising members of professions, such as law, medicine,
engineering, architecture or accounting. These practitioners may be employees of a corporation which
they or their relatives own or control and which carries on the business of the professional practice. While
the tax treatment of situations of this nature can only be determined after ascertaining all of the relevant
facts of a given case, this bulletin discusses some of the applicable provisions of the Act and other
general guidelines.

Discussion and Interpretation

Incorporated Professional Practices

1. A corporation may be recognized as carrying on a professional practice unless provincial law or the
regulatory body for the particular profession provides that only individuals may practice the profession. If
this first condition is met, a corporation is recognized as carrying on a professional practice if the activities
of the corporation and its relationship to its employees and clients are similar to those ordinarily associated
with a corporation carrying on a business. Such activities include:

    (a) owning or renting the premises of the business,
    (b) owning or renting the furniture, fixtures and major equipment of the business,
    (c) operating a bank account in its own name through properly authorized signing officers,
    (d) purchasing necessary supplies,
    (e) providing clerical services,
    (f) billing clients for professional services in its own name,
    (g) depositing the collections in its bank,
    (h) paying salaries to individuals performing the professional services offered by a corporation,
    (i) making the clients aware that they are dealing with the corporation, and
    (j) maintaining an employer-employee relationship between the corporation and the individual, with the
    services to be performed clearly set out in a dated, written agreement wherein specific provisions
    determine a reasonable salary for the services performed.

2. If provincial law or the regulatory body for the profession precludes the practice of the profession by a
corporation, income derived from the profession will normally be considered to be earned by the individual
who rendered such professional services and not by a corporation.

Work in Progress

3. A corporation that is carrying on the practice of a profession within the parameters of 2 above is
required to determine its income on the accrual basis, except that it may qualify to make an election under
section 34 not to include in its income any amount in respect of work in progress at the end of the year
(see the current version of IT-457, Election by Professionals to Exclude Work in Progress from Income).
This election may be made only in respect of a business that is the professional practice of an accountant,
dentist, lawyer (including a notary in the province of Quebec), medical doctor, veterinarian or chiropractor.
                                                    8-73
Except where a valid election has been made under section 34, work in progress is required to be valued
at the year end and must be included in computing the income from the professional business (see the
current version of IT-473, Inventory Valuation). Subsection 10(4) provides that for 1983 and subsequent
taxation years, the fair market value of property that is work in progress of a business that is a profession
means the amount that can reasonably be expected to become receivable for that work in progress after
the end of the year.

Limits on Deductions by Professional Corporations

4. A Canadian-controlled private corporation (see the current version of IT-458) which carries on a
professional practice may be entitled to the small business deduction pursuant to subsection 125(1),
provided certain conditions are met. However, to the extent that such a corporation derives its income for
the year from carrying on a ―personal services business‖ or a ―specified investment business‖, the small
business deduction is not available. Furthermore, the deduction of expenses by a personal services
business of a corporation is restricted to the narrow range of items described in paragraph 18(1)(p). Refer
to the current version of IT-73 for a discussion of these topics in greater detail.

Ineffective Arrangements and Shams

5. In some cases, a corporation (or certain of its transactions and business arrangements) might not be
constituted in a legally effective way. Furthermore, various acts and transactions (shams) might be
engaged in with the intention of misleading outside parties, the Department or the courts as to the nature
of the rights and obligations (if any) which the parties themselves actually intend to create. For example,
the corporation might not in fact carry on the business operation, it might perform few or no services, its
activities might consist of little more than a series of accounting entries in its books of account or its
management agreement with the practitioner might not be complied with or might lack substance. In
appropriate cases of this nature, the income purported to be that of the corporation can be taxed as
income of the individual practitioners who have, in fact, carried on the business operation.
                                                 8-74
Corporations: Federal Rates

                               2000 Corporate Tax Rates

                          Standard %               M&P%                    Active Business
                                                                              CCPC%

   Basic rate                          38.00                     38.00                    38.00
Less: Provincial abatement          (10.00)                      (10.00)                  (10.00)

                               28.00                    28.00                     28.00

Plus: Surtax at 4%                     1.12                     1.12            1.12
   [Note]
   Less: M&P deduction                  -                        (7.00)                     -

Less:   Small business deduction       _____                ______                        (16.00)

    Total federal tax                   29.12                    22.128                   13.12


Corporations: Provincial Rates

Ontario, Quebec and Alberta collect their own corporation income tax in separate tax returns. All other
provinces (the ―agreeing provinces‖) express their tax rate as a stated percentage of taxable income as
determined under the federal Act and Regulations, and their taxes are collected for them by the federal
government. Following are the provincial income tax rates effective January 1, 1995:

Nfld.   5-14%           P.E.I. 7.5-16%          Que. 9.15-15.5%            Man. 7-17%
Alta.   6-15.5%         N.W.T. 5-14%            N.S.    5-16%              N.B.   6-15.5%
Ont.    8-15.5%         Sask. 10-17% B.C.       5.5-16.5%     Y.T.         2.5-15%
                                                      8-75
Interpretation Bulletin [Cancelled] IT-73R5 * — The Small Business Deduction — Income From an
Active Business, a Specified Investment Business and a Personal Services Business
Date: February 5, 1997
Reference: Section 125(also subsections 14(1), 129(4), 129(4.1), 129(6), the definitions ―active business‖
and ―specified shareholder‖ in subsection 248(1), paragraph 18(1)(p), subparagraph 12(1)(e)(ii) of the
Income Tax Act and section 6700 of the Income Tax Regulations)
Application
This bulletin cancels and replaces IT-73R4 dated February 13, 1989.
Summary
This bulletin deals with the rules concerning the small business deduction that may be claimed by a
Canadian-controlled private corporation (CCPC) in respect of its income from carrying on an active
business in Canada. Active business carried on by a CCPC in Canada does not include a ―specified
investment business‖ or a ―personal services business.‖ These two types of businesses are defined and
discussed in this bulletin. In addition, details of the components of the calculation of the small business
deduction are provided.
Section 125 of the Income Tax Act provides for a corporate tax reduction (commonly referred to as ―the
small business deduction‖) in respect of income of a CCPC from an active business carried on by it in
Canada. The small business deduction is provided by way of an annual tax credit which is calculated as
16 percent of the least of the corporation's:
(a) active business income for the year;
(b) taxable income for the year (subject to certain adjustments); and
(c) business limit for the year (which is generally $200,000).
The corporation must be a CCPC throughout the year to qualify for the small business deduction for that
year.
The special low rate of tax provided by the small business deduction recognizes the special financing
difficulties and higher cost of capital faced by small businesses and is intended to provide these
corporations with more after-tax income for reinvestment and expansion. As the small business deduction
is intended to benefit only small corporations, a large corporation's access to the deduction is restricted on
the basis of its taxable capital employed in Canada.
The subject matter of this bulletin is arranged under the following headings
                     Table of Contents

Subject                                  Paragraphs
General Comments                                   1-2
Income From an Active Business Carried
on in Canada -- Paragraph 125(1)(a)
 Active Business                                 3
 Income from an Active Business                         4-8
 Cessation of a Business                             9
 Meaning of "Carried on in Canada"                       10
 Specified Investment Business                       11-17
 Personal Services Business                         18-19
 Specified Partnership Income                          20
 Specified Partnership Loss                          21
Taxable Income Limit -- Paragraph 125(1)(b)                   22
Business Limit -- Paragraph 125(1)(c)                     23
 Agreement Filed by Associated CCPCs                       24-25
 Where Effective Agreement Not Filed                       26
 Taxation Year Less than 51 Weeks                          27
 Multiple Taxation Years in the Same Calendar Year               28
 Reduction of the Business Limit for Large Corporations          29
Discussion and Interpretation
General Comments
1. Subsection 125(1) provides a reduction (the ―small business deduction‖) from Part I tax otherwise
payable for a taxation year by a corporation that was, throughout the taxation year, a CCPC. ―Canadian-
                                                       8-76
controlled private corporation‖ is defined in subsection 125(7) as a private corporation that is a Canadian
corporation other than a corporation which is controlled, directly or indirectly, in any manner whatever, by:
(a) one or more non-resident persons;
(b) one or more public corporations (other than a prescribed venture capital corporation, as defined in
section 6700 of the Regulations); or
(c) any combination of (a) or (b) above.
The terms ―Canadian corporation,‖ ―public corporation‖ and ―private corporation‖ are defined in subsection
89(1). See the current version of IT-458, Canadian-Controlled Private Corporation, for a more detailed
discussion of the definition of a CCPC.
Note: Bill C-69 proposes to amend the definition of ―Canadian-controlled private corporation‖ in subsection
125(7) to clarify that the following types of corporations are not CCPCs:
• corporations that are not actually controlled by non-residents or public corporations because their
shares are widely held but would otherwise be controlled by non-residents or public corporations if all of
their shareholdings were notionally attributed to one particular person; and
• corporations whose shares are listed on a foreign stock exchange prescribed by section 3201 of the
Income Tax Regulations.
This amendment, if enacted as proposed, will apply after 1995.
2. The small business deduction, for a particular taxation year, is equal to 16 percent of the least of (a),
(b), and (c):
(a) the total of the corporation's income for the year from each active business carried on by it in Canada
(see 3 - 10 below); and
• the corporation's ―specified partnership income‖ for the year (see 20 below);
Minus:
• the total of the corporation's losses for the year from each active business carried on by it in Canada;
and
• the corporation's ―specified partnership loss‖ for the year (see 21 below);
(b) the corporation's taxable income for the year minus the total of any amounts of its taxable income for
the year that is exempt from tax under Part I because of an Act of Parliament and a specified portion of
any foreign tax deductible under subsection 126(1) and deducted under subsection 126(2) for the year
(see 22 below); and
(c) the corporation's business limit for the year (see 23 below).
Income From an Active Business Carried on in Canada — Paragraph 125(1)(a)
Active Business
3. The term ―active business carried on by a corporation‖ is defined in subsection 125(7) as any business
carried on by a corporation other than a ―specified investment business‖ (see 11 below) and a ―personal
services business‖ (see 18 below) and includes an adventure or concern in the nature of trade (see the
current version of IT-459,Adventure or Concern in the Nature of Trade).
Income from an Active Business
4. ―Income of the corporation for the year from an active business,‖ as defined in subsection 125(7),
means the corporation's income for the year from an active business carried on by it, including any income
for the year pertaining to or incident to that business, as well as amounts received from a ―NISA Fund No.
2,‖ that are included under subsection 12(10.2) in computing the corporation's income for the year. ―NISA
Fund No. 2,‖ as defined in subsection 248(1), means the part of a taxpayer's net income stabilization
account described in paragraph 8(2)(b) of the Farm Income Protection Act. However, it does not include
any income from a source in Canada that is property, as set out in subsection 129(4.1) and for taxation
years that end after June 1995, as set out in subsection 129(4). The income or loss of a corporation from
a source in Canada that is property includes the income or loss from a specified investment business
carried on by a corporation in Canada but excludes any income or loss from:
• any other business;
• property that is incident to or pertains to (see 5 below) an active business carried on by the
corporation; and
• property used or held principally for the purpose of gaining or producing income from an active
business carried on by the corporation.
If the original gain on the sale of real property was categorized in a previous year as income from an
active business, amounts included in income in subsequent years in respect of the realization of the
                                                      8-77
mortgage reserve pursuant to subparagraph 12(1)(e)(ii), are considered to be income from an active
business. This also applies to any mortgage interest received pertaining to such mortgage. As discussed
in 7 below, subsection 129(6) provides an exception to these general rules with respect to certain amounts
received or receivable from associated corporations.
5. Income of a corporation that ―pertains to‖ or is ―incident to‖ the income of the corporation from an active
business is referred to in the definition of ―income of the corporation for the year from an active business‖
in subsection 125(7) but those terms are not defined in the Act.
In examining the ordinary dictionary meaning of these words, ―incident to‖ generally includes anything that
is connected with or related to another thing, though not inseparably, or something that is dependent on or
subordinate to another more important thing. ―Pertain to‖ generally includes anything that forms part of,
belongs to or relates to another thing.
The courts have found that, in interpreting the meaning of ―pertains to‖ or ―incident to‖ in context, there has
to be a financial relationship of dependence of some substance between the property in question and the
active business before the property is considered to be incident to or pertain to the active business carried
on by the corporation. In addition, the operations of the business have to have some reliance on the
property such that the property is a back-up asset that could support the business operations either on a
regular basis or from time to time.
If, for example, a corporation which carries on an active business holds term deposits that are not used or
connected to its business operations, the term deposits are not property that is incident to or pertains to an
active business carried on by the corporation, nor are the term deposits used or held principally for the
purpose of gaining or producing income from an active business by the corporation. Accordingly, a
determination is required of whether the source of income (e.g., term deposits) is a separable activity,
apart from the corporation's main business activities.
The courts have held that when a corporation derived income from an activity that was inseparable from
its normal active business, such income was properly classified as active business income. If the income
is part of the normal business activity of the corporation, and it is inextricably linked with an active
business, it is considered active business income. For example, in the 1981 case of Supreme Theatres
Ltd. v. The Queen, [1981] C.T.C. 190, 81 DTC 5136, it was held by the Federal Court — Trial Division
that rental income from hiring out the part of a building that was a motion picture theatre auditorium
constituted active business income derived from the company's normal business activity of operating
motion picture theatres, while the rental income from hiring out a portion of a parking lot was not.
6. As indicated in 4 above, for the purpose of the small business deduction, income from property does
not include income ―from any property that is incident to or pertains to an active business‖ or ―from any
property that is used or held principally for the purpose of gaining or producing income from an active
business.‖ Income from property that is employed or risked in a corporation's business operations is
considered to be active business income. This must be distinguished from income from property, which is
not connected to or is necessary to sustain a corporation's business operations. It is a question of fact
whether a property is used principally in an active business. Factors to be considered in determining
whether a property is used in an active business include the actual use to which the asset is put in the
course of the business, the nature of the business involved and the practice in the particular industry. The
issue of whether property was used or held by a corporation in the course of carrying on a business was
considered by the Supreme Court in Ensite Limited v. Her Majesty the Queen, [1986] 2 C.T.C. 459, 86
DTC 6521. The court held that the holding or using of property must be linked to some definite obligation
or liability of the business and that a business purpose test for the use of the property was not sufficient.
The property had to be employed and risked in the business used to fulfil a requirement which had to be
met in order to do business. In this context, risk means more than a remote risk. If the withdrawal of the
property would have a decidedly destabilizing effect on the corporate operations, the property would
generally be considered to be used in the course of carrying on a business. In other words, the property
has to be an integral part of the financing of the business or necessary to the overall business operations
in order for the property to fall within the meaning of paragraph 129(4.1)(b).
For example, although a mortgage receivable is an asset whose existence may be relevant to the equity
of a corporation, it is not generally an asset used in an active business because the funds tied up in the
mortgage are not available for the active business use of a corporation. However, if the corporation could
establish that the mortgages are employed and risked in the business such that the mortgages are
inextricably tied to or vitally connected with the business, they could be considered to be used in an active
                                                       8-78
business carried on by the corporation.
7. A corporation may derive income from holding property in Canada (e.g., income in the form of real
estate rentals, interest, or royalties). If such income is received or receivable from an associated company
and the amount is or may be deductible in determining the associated company's income from an active
business carried on by it in Canada, then paragraph 129(6)(b) deems the income in the recipient's hands
to be income from an active business carried on by it in Canada.
If subsection 129(6) deems rental income to be active business income and capital cost allowance on the
rented building was deducted in calculating active business income, any recapture of capital cost
allowance on the disposition of the building would also be considered to be active business income.
8. If a corporation is incorporated to earn income by doing business, there is a general presumption that
profits arising from its activities are derived from a business (or from separate businesses as discussed in
the current version of IT-206, Separate Businesses). Thus, from the time that the activities contemplated
commence (see the current version of IT-364, Commencement of Business Operations) until they
permanently cease, most corporations carry on or will have carried on one or more businesses. However,
in some circumstances, a corporation's entire profits can be characterized as income from property, as
might be the case where the corporation is formed for the sole purpose of holding shares of a second
corporation or holding a property to be rented with limited landlord responsibilities. It is, of course, quite
possible that a corporation will earn income from property as well as income from a business carried on, if
such property income is not income from another separate business.
Cessation of a Business
9. Income related to a business that arises after cessation of that business cannot qualify as income from
a business except when it arises from:
(a) bad debt recoveries;
(b) the recapture of various reserves;
(c) the sale of the inventory of the business;
(d) the disposition of eligible capital property of the business and the income is the amount of the excess
described in subsection 14(1);
(e) the recapture of capital cost allowance; or
(f) a similar item to those described in any of (a) to (e) above.
Income that does qualify as income from a business because it arises from a source described in (a) to (f)
above will be considered to be income from the same category of business as that to which the source
originally related. However, with respect to (e) above, this does not apply to situations in which the
depreciable property is subsequently treated as a rental property and capital cost allowance is claimed
against the rental income since the rental property would give rise to income from property that is not
income from an active business. If the property was only rented or leased for a short time during which it
was listed for sale and no capital cost allowance was claimed against the rental or lease income, the
income would still be considered to be income from the same category of business before the rental or
lease. It is a question of fact whether or not a corporation has ceased to carry on a business.
A temporary period of inactivity does not necessarily mean that a corporation has ceased (and
subsequently recommenced) to carry on a business. For example, the nature of a real estate development
business is such that no real estate may be held at certain times or real estate that is held may not be
actively developed for a significant period of time. Unless it is evident that the corporation does not intend
to recommence its development activities, it is considered to be carrying on business throughout the
dormant period. In any event, a corporation ceases to carry on a business before (but not necessarily
immediately before) the time when it:
• commences to distribute its assets to its shareholders in the course of winding up the corporation; or
• sells or otherwise disposes of the business.
Meaning of ―Carried On in Canada‖
10. Whether or not a particular business is carried on in whole or in part in Canada is a question of fact.
However, as a general rule, a business that involves the sale or leasing of goods is usually carried on in
the country where the corporation is resident, unless the business (or a part of it) is conducted by a
virtually autonomous branch operation outside Canada. When a corporation's business involves the
rendering of services, that business is carried on in Canada only to the extent that services are rendered
in Canada, necessitating an apportionment of net business income on a reasonable basis. Income derived
from property, ancillary to the activities involved in carrying on a business, that is categorized as income
                                                      8-79
from an active business may also have to be apportioned on a reasonable basis having regard to the
place where the related business is carried on.
Specified Investment Business
11. A ―specified investment business‖ carried on by a corporation in a taxation year is defined in
subsection 125(7) to be a business the principal purpose (see 12 to 14 below) of which is to derive income
from property. Such income includes interest, dividends, rentals from real estate (including subrentals)
and royalties. Specifically excluded from the definition is any business carried on by a credit union or a
business of leasing property other than real property. However, the business of the corporation will
generally be considered to be an active business rather than a specified investment business when either:
(a) the corporation employs in the business throughout the taxation year more than five full-time
employees (see 15 to 17 below); or
(b) an associated corporation, in the course of carrying on an active business, provides managerial,
administrative, financial, maintenance or other similar services to the corporation in the year and it is
reasonable to assume that the corporation would have required more than five full-time employees in its
business if those services had not been provided.
These comments apply only if the investment activities are carried on as the main business of the
corporation or as a separate business (see the current version of IT-206, Separate Businesses). If this is
not the case, refer to the comments in 3 and 7 above for the status of investment income.
Note: Bill C-69 proposes to amend the definition of ―specified investment business‖ in subsection 125(7),
applicable to 1995 and subsequent taxation years, so that the exceptions in (a) and (b) above do not apply
to a business carried on by a prescribed labour-sponsored venture capital corporation where the main
purpose of the business is to derive income from property. Section 6701 of the Regulations contains the
meaning of ―prescribed labour-sponsored venture capital corporation‖; however, at the time of printing,
section 6701 had not yet been amended to prescribe that definition for the purposes of the definition of
―specified investment business‖ in subsection 125(7). As indicated in the June 20, 1996 Notice of Ways
and Means Motion and Explanatory Notes, it is the intention of the Department of Finance that section
6701 be so amended.
12. ―Principal purpose‖ is not a defined term in the Act for the purposes of the definition of ―specified
investment business‖ in subsection 125(7), but it is considered to be the main or chief objective for which
the business is carried on.
13. A corporation which operates a business may buy real property for the purpose of using the site in the
future as a business premise. In the interim, if rental income is derived, such income would probably be
considered to be active business income rather than income from a specified investment business. In
such cases, there is a presumption that the principal purpose test referred to in the definition of ―specified
investment business‖ in subsection 125(7) would not be met for as long as the corporation's principal
purpose in owning the site is not to derive rental income from it. A corporation which operates a hotel is
generally considered to be in the business of providing services and not in the business of renting real
property. Accordingly, the business is normally considered to be an active business rather than a specified
investment business.
14. The principal purpose of a corporation's business must be determined annually after all the facts
relating to that business carried on by that corporation in that year have been considered and analyzed.
Included in this evaluation should be such things as:
(a) the purpose for which the business was originally commenced;
(b) the history and evolution of its operations, including changes in its mode of operation and purpose of
existence; and
(c) the manner in which the business is conducted.
15. The phrase ―...the corporation employs in the business throughout the (taxation) year more than five
full-time employees...‖ is considered to mean that an employer has six or more employees working a full
business day (or a full shift) on each working day of the year, subject to normal absences due to illness or
vacation. Employees working part-time cannot qualify as full-time employees. A part-time employee is
generally a person employed for irregular hours of duty or specific intermittent periods, or both, during a
day, week, month, or year and whose services are not required for the normal work day, week, month, or
year. Vacancies caused by terminations that temporarily reduce the staff to less than six employees will
normally not disqualify the corporation provided immediate action is taken to restore the staff to normal
strength and there is no undue delay in filling the vacant positions.
                                                       8-80
16. If, for example, two corporations carry on a business in partnership as equal partners with the
partnership business employing more than five full-time employees, each partner would, for the purpose
of paragraph (a) of the definition of ―specified investment business‖ in subsection 125(7), be considered to
employ more than five full-time employees. However, if the business is carried out by corporations in a
joint venture or other form of co-ownership, the total number of full-time employees who work jointly for all
the co-owners must be allocated to each co-owner in accordance with the co-owner's percentage interest
in the property.
17. In the following situations, employees of a corporation would not be considered to be full-time
employees throughout a taxation year:
(a) Mr. A is employed two days a week, does all the bookkeeping, but is available whenever his services
are required;
(b) Mr. B's only activity is to attend board of directors meetings, although he is always available whenever
his services are required; and
(c) a corporation employs ten employees full-time for six months in a taxation year and for the remaining
six months employs no one as it is inactive.
Personal Services Business
18. Pursuant to the definition of ―personal services business‖ in subsection 125(7), a corporation is
carrying on a ―personal services business‖ in a taxation year if it is in the business of providing services
and:
(a) an individual who performs the services provided to another person or partnership (the entity) on
behalf of the corporation (referred to as an incorporated employee) would, if it were not for the existence
of the corporation, reasonably be regarded as an officer or employee of the entity to which the services
were provided;
(b) the incorporated employee or any person related to the incorporated employee is a ―specified
shareholder‖ of the corporation (see below);
(c) the corporation employs in the business throughout the year fewer than six full-time employees (see 15
to 17 above) including incorporated employees and other employees; and
(d) the fee for the services is not received or receivable by the corporation from a corporation with which it
was associated in the year.
A personal services business does not qualify for the small business deduction and is therefore subject to
tax at full corporate rates. In addition, paragraph 18(1)(p) limits the deductions permitted in computing a
corporation's income for a taxation year from a personal services business.
Subject to various deeming provisions in the definition of ―specified shareholder‖ in subsection 248(1), a
―specified shareholder‖ of a corporation in a taxation year is a taxpayer who owns directly or indirectly at
any time in the year not less than 10% of the issued shares of any class of the capital stock of the
corporation or of any other corporation that is related to the corporation.
19. The condition stipulated in 18(a) above is not met if, in the absence of the corporation, there would be
no common law master-servant relationship and the individual who undertakes to perform the services
would be viewed as a self-employed individual carrying on a business. The determination of whether an
incorporated employee would otherwise be regarded as self-employed or as an officer or employee of the
entity to which the services were provided is a question of fact. The following list of factors, although not
exhaustive, are indications of employee status:
(a) the entity to which the services are provided has the right to control the amount, the nature and the
direction of the work to be done and the manner of doing it;
(b) the payment for work is by the hour, week or month;
(c) payment by the entity of the worker's travelling and other expenses incidental to the payor's business;
(d) a requirement that a worker must work specified hours;
(e) the worker provides services for only one payor; and
(f) the entity to which the services are provided furnishes the tools, materials and facilities to the worker.
Specified Partnership Income
20. As noted in 2 above, one of the components in the calculation of the small business deduction is the
corporation's ―specified partnership income.‖ The specified partnership income of a corporation for a year,
as defined in subsection 125(7), is calculated as the amount determined by the formula below:
A+B
Where
                                                    8-81
A = The lesser of:
• the corporation's share of all income from partnerships for fiscal periods ending in the year, or for
taxation years that end after 1994, amounts included in income for the year from the partnership because
of subsection 34.2(5), that were derived from active businesses carried on in Canada by the corporation
as a member, minus the amount deducted (at the partner level) in computing the corporate partner's
income for the year from the businesses (excluding amounts deducted in computing the income of the
partnership from the businesses) and;
• the quotient obtained by dividing the corporation's share of all income from partnerships for fiscal
periods ending in the year, that was derived from active businesses carried on in Canada by the
corporation as a member, by the total partnership income for fiscal periods ending in the year that was
derived from active businesses carried on in Canada. The quotient is then multiplied by $200,000 (or a
proportionately smaller amount when the number of days in the fiscal period(s) involved is less than 365);
B = The lesser of:
• the corporation's loss for the year from active businesses carried on in Canada plus the corporation's
specified partnership loss for the year; and
• the corporation's share of all income from partnerships for fiscal periods ending in the year or for
taxation years that end after 1994, amounts included in income for the year from the partnership because
of subsection 34.2(5), that were derived from active businesses carried on in Canada by the corporation
as a member, minus the amount deducted (at the partner level) in computing the corporate partner's
income for the year from the businesses (excluding amounts deducted in computing the income of the
partnership from the businesses) minus the corporation's share of income of the partnership for a fiscal
period ending in the year from an active business carried on in Canada subject to an annual maximum of
that proportion of $200,000 (or a proportionately smaller amount when the number of days in the fiscal
period(s) involved is less than 365) that the corporation's share is to the total amount of such income of
the partnership.
The second component (―B‖) ensures that any losses of the corporation for the year from active
businesses carried on by it in Canada are offset first against business income that is not eligible for the
small business deduction before reducing the income that would otherwise qualify for the small business
deduction. This is relevant only if the corporation has both losses in the year from an active business
carried on by it in Canada (whether as a member of a partnership or otherwise) and income for the year
from an active business carried on by it in Canada as a member of a partnership.
Specified Partnership Loss
21. The ―specified partnership loss‖ of a corporation for a taxation year, as defined in subsection 125(7), is
one of the components in calculating the small business deduction. The specified partnership loss of a
corporation for a year, as defined in subsection 125(7), is calculated as the amount determined by the
formula below:
A+B
Where
A = The corporation's share of all losses from partnerships for fiscal periods ending in the year that was
derived from active businesses carried on in Canada by the corporation as a member; and
B = The amount deducted (at the partner level) in computing the corporate partner's income for the year
from the businesses (excluding amounts deducted in computing the income of the partnership from the
businesses) minus the corporation's share of all income from partnerships for fiscal periods ending in the
year or for taxation years that end after 1994, amounts included in income for the year from the
partnership because of subsection 34.2(5), that were derived from active businesses carried on in Canada
by the corporation as a member.
Taxable Income Limit — Paragraph 125(1)(b)
22. In computing the small business deduction of a CCPC, paragraph 125(1)(b) requires the determination
of the corporation's taxable income for the taxation year in excess of the total of:
• 10/3 of the corporation's foreign tax credit on investment income deducted under subsection 126(1) for
the year or for taxation years ending after June 1995, 10/3 of the corporation's foreign tax credit on
investment income deductible under subsection 126(1) for the year without reference to section 123.3;
• 10/4 of the corporation's foreign tax credit on foreign business income deducted under subsection
126(2) for the year; and
• any portion of the corporation's taxable income for the year that is exempt from tax under Part 1
                                                      8-82
because of an Act of Parliament.
The amounts deducted from the corporation's taxable income represent income on which no Canadian
income tax was paid because the income is exempt from tax or because of the foreign tax credit.
Business Limit — Paragraph 125(1)(c)
23. Generally, the business limit for a CCPC is $200,000 unless the corporation is associated in the year
with one or more other CCPCs and its taxation year is not less than 51 weeks. If two or more CCPCs are
associated with one another in a taxation year, the small business deduction must be shared, by allocating
the annual business limit of $200,000 amongst the corporations for the taxation year. Corporations may
file an agreement (Form T2013, Agreement Among Associated Corporations) annually making this
allocation (see 24 below). If the taxation year of the CCPC is shorter than 51 weeks in duration, see 27
and 28 below. In addition, if a CCPC has a Part I.3 large corporations tax liability for the preceding year,
the corporation's business limit for the year may be reduced or eliminated (see 29 below).
In calculating a CCPC's business limit, the provisions of section 125 should be applied in the following
order:
• subsections 125(2) to (4) (see 24 to 26 below);
• subsection 125(5) (see 27 and 28 below); and
• subsection 125(5.1) (see 29 below).
Agreement Filed by Associated CCPCs
24. All CCPCs that, under section 256, are associated with each other in a taxation year, may in
accordance with subsection 125(3) allocate amongst themselves, the annual business limit amount. If this
allocation is made in accordance with the requirements described in 25 below, and the total of the
amounts allocated is $200,000, the business limit for the taxation year of each corporation is the amount
allocated to it, as indicated on the agreement filed in prescribed form.
25. In order to allocate the $200,000 business limit for a taxation year amongst the corporations referred
to in subsection 125(3), the following must be done:
(a) an agreement in prescribed form (Form T2013) must be filed by each corporation in the group of
associated corporations; and
(b) the duly completed Form T2013 must be signed on behalf of each corporation in that group.
A new agreement on Form T2013 must be filed for each taxation year. If another corporation that is not an
initial signatory to the Form T2013 is considered to be associated with the corporations that did sign the
agreement, that corporation must also sign the Form T2013. If an agreement has not been signed by all
the corporations that originally filed as being associated, or if it is not signed (upon request) by another
corporation that is considered to be associated, subsection 125(4) may be applied. Normally, an
assessment will not be made based on an incomplete agreement.
Where Effective Agreement Not Filed
26. If any one of the CCPCs that are associated with each other in a taxation year fail to file or refuse to be
a signatory to a Form T2013 within 30 days after written notice has been issued to any of them of such a
requirement, the Minister shall, under subsection 125(4), allocate $200,000 in total to one or more of them
and the amount so allocated shall be the corporation's business limit for the year.
Taxation Year Less than 51 Weeks
27. The business limit for a CCPC for a taxation year of less than 51 weeks duration is, under paragraph
125(5)(b), that proportion of the corporation's business limit as otherwise determined that the number of
days in the taxation year is of 365.
Multiple Taxation Years in the Same Calendar Year
28. A CCPC may have two or more taxation years ending in a calendar year in which it is associated with
another CCPC. When there is more than one taxation year ending in the calendar year, a CCPC's
business limit under paragraph 125(1)(c), for each second or subsequent taxation year that ends in the
calendar year, subject to the rule in 27 above, is the lesser of:
(a) the amount allocated to the corporation under subsection 125(3) or (4), as its business limit for its first
taxation year that ended in that calendar year; and
(b) the amount allocated to the corporation under subsection 125(3) or (4), for that particular taxation year
ending in that calendar year.
The intent of (b) above is to ensure that the total determined for the business limit for a group of
associated CCPCs does not exceed $200,000 for any second or subsequent taxation year.
Example:
                                                         8-83
Why Co. and Zed Co. are associated CCPCs and both have taxation years ending September 30, 1995.
Of the business limit of $200,000, Why Co. and Zed Co. have chosen to allocate to themselves $50,000
and $150,000, respectively, pursuant to subsection 125(3), for their first taxation year.
On October 1, 1995, X Co. becomes associated with Why Co. and Zed Co. The fiscal year end of X Co. is
November 30, 1995, and this was not a short taxation year. Why Co. and Zed Co. change their fiscal year
end to November 30, 1995. The associated group of companies allocate the $200,000 business limit
(before any proration required for a short taxation year for Why Co. and Zed Co. pursuant to paragraph
125(5)(b)) for the second taxation year as follows:
• $25,000 to Why Co.,
• $25,000 to Zed Co., and
• $150,000 to X Co.
Pursuant to subsection 125(5), the business limit for Why Co. for the second taxation year is $4,178,
which is the lesser of:
(a) The lesser of:
• $50,000 (clause 125(5)(a)(i)); and
• $25,000 (clause 125(5)(a)(ii)); and
(b) The amount from (a) above prorated by the ratio of the number of days in the short taxation year to
365 days ($25,000 × 61/365 = $4,178, paragraph 125(5)(b)).
The business limit for Zed Co. for the second taxation year is also $4,178. The business limit, pursuant to
subsection 125(5), for X Co. for the year ended November 30, 1995, is $150,000 (no proration is required
pursuant to paragraph 125(5)(b) because the year ended November 30, 1995, for X Co. was not a short
taxation year).
Reduction of the Business Limit for Large Corporations
29. A CCPC's access to the small business deduction is restricted by subsection 125(5.1) through the
reduction of its annual business limit for taxation years that end after June 30, 1994. The reduction of a
CCPC's business limit is an amount, if any, equal to:
                          its Part I.3 tax liability
the corporation's business              for the preceding year
limit for the year         X ---------------------------
                               $11,250
The corporation's Part I.3 tax liability referred to above excludes any deduction provided under
subsections 181.1(2) and (4) from Part I.3 tax otherwise payable.
Generally, Part I.3 tax is calculated as the current rate of tax payable (.225 percent) multiplied by the total
of a corporation's taxable capital employed in Canada for the year minus its capital deduction for the year.
For this purpose, ―capital‖ is defined in subsection 181.2(3). In general, the capital deduction available
under subsection 181.5(1) is $10,000,000 so that corporations with taxable capital of $10,000,000 or less
for the year would not be subject to Part I.3 tax for that year. Any reduction in the business limit would
increase proportionately with any increase in tax payable under Part I.3.
If the corporation is associated with one or more corporations, whether CCPCs or not, in the year, it is
required to take into account the Part I.3 tax liability of the associated corporations for their last taxation
year ending in the prior taxation year as well as its own such liability for the preceding taxation year.
Example:
XYZ Co. is a CCPC throughout 1996, and its business limit is $125,000, before any proration required by
subsection 125(5) for a short taxation year. XYZ Co.'s taxation year end is December 31, 1996, but it had
a short taxation year in 1996 of 130 days. It is not associated with any other CCPC. The corporation's
taxable capital employed in Canada is $12,000,000 and its Part I.3 tax liability for 1995 is $4,000.
Step 1
Application of paragraph 125(5)(b): The proration of XYZ Co.'s business limit, based on its short taxation
year ended December 31, 1996, is calculated as follows:
$125,000 × 130/365 = $ 44,520
Step 2
Application of subsection 125(5.1): The reduction of XYZ Co.'s business limit for 1996 is calculated as
follows:
$44,520 × $4,000/$11,250 = $15,829
XYZ Co.'s 1996 business limit is therefore $28,691 ($44,520 – $15,829).
                                                   8-84
If you have any comments about matters discussed in this bulletin, please send them to:
Director, Business and Publications Division
Income Tax Rulings and Interpretations Directorate
Policy and Legislation Branch
Canada Customs & Revenue Agency
25 Nicholas Street
Ottawa ON K1A 0L5
Interpretation bulletins can be found on the Canada Customs & Revenue Agency internet site at:
http://www.rc.gc.ca
                                                    8-85
Interpretation Bulletin IT-291R2 — Transfer of Property to a Corporation under
Subsection 85(1)
Date:     September 16, 1994
Reference:     Subsection 85(1)(also sections 22 and 85.1, subsections 15(1),
               28(1), 66(5), 85(1.1), (2.1), (4), (5) and (5.1), 89(1), 138(12) and
               256(5.1), and paragraphs 20(1)(l) and (p), 24(1)(a), 53(1)(c) and
               66(15)(c))

Application

This bulletin cancels and replaces IT-291R dated June 6, 1980 and generally applies to dispositions of
property occurring after 1986. Where it is necessary to determine the application of subsection 85(1)
before that date, please refer to the law itself.

Note:

The comments in this bulletin do not reflect any changes which may be required as a result of S.C. 1994,
c. 8 (formerly Bill C-9) given Royal Assent on May 12, 1994, S.C. 1994, c. 21 (formerly Bill C-27), given
Royal Assent on June 15, 1994 or the Notice of Ways and Means Motion to Amend the Income Tax Act of
February 22, 1994.

Summary

This bulletin discusses the rollover provisions of the Act whereby a taxpayer may elect to transfer ―eligible
property‖ to a taxable Canadian corporation in exchange for consideration including at least one share of
the corporation. ―Eligible property‖ includes capital property of a resident of Canada, Canadian or foreign
resource property, eligible capital property and inventory, other than inventory that is real property. Where
the taxpayer and the corporation agree upon an amount that does not exceed the fair market value of the
property disposed of and is not less than the fair market value of the consideration (other than shares of
the corporation or a right to receive such shares) that is received, the agreed upon amount becomes,
subject to certain specific limitations, the taxpayer’s proceeds of disposition and the corporation’s cost of
the property. By choosing an appropriate amount within those limits the property can be transferred on a
tax-deferred basis, that is, the corporation assumes the taxpayer’s potential income tax liabilities for the
property.

Discussion and Interpretation

Definitions:

For the purposes of this bulletin:

All or substantially all — when the level of 90% of whatever is being measured is reached, the ―all or
substantially all‖ requirement is considered to have been met.

Non-share consideration means all the consideration received by the vendor other than shares of the
transferee corporation or a right to receive such shares.

Share means a share or a fraction of a share of the capital stock of a corporation.

1. The rules in subsection 85(1) enable a taxpayer (the transferor) to dispose of ―eligible property‖ (see 4
below) to a taxable Canadian corporation (the transferee), as explained in 3 below, so that most, if not all,
of the tax consequences which usually arise on such a disposition are shifted to the corporation from the
taxpayer. The transferor is permitted to dispose of the property to the transferee for an ―agreed amount‖
                                                    8-86
which may be other than the fair market value of either such property or the consideration received for it.
This ―agreed amount‖, which is subject to the limitations explained in 9 through 13 and 19 below, generally
becomes the proceeds of disposition of the property to the transferor and the cost to the transferee. It also
establishes the cost of the consideration receivable by the transferor from the transferee in return for the
property transferred to the transferee (see 21 below). Subsection 85(1) will apply in any case where

   (a) the property disposed of is ―eligible property‖ described in subsection 85(1.1) (see 4 below),

   (b) the transferor and the transferee make a valid joint election in the form authorized by the Minister
   (T2057) to invoke the provisions of subsection 85(1) (see 31 below),

   (c) the consideration received by the transferor for the property disposed of to the transferee includes
   at least one share of the capital stock of the transferee, and

   (d) subsection 85(5.1) is not applicable (see 22 below).

Transferor

2. Subsection 85(1) applies to a transferor that is a ―taxpayer‖. ―Taxpayer‖ is defined in subsection 248(1)
to include any person whether or not liable to pay tax and, accordingly, includes individuals, corporations,
and trusts. (Comments on the transfer of property to a corporation by a partnership under subsection
85(2) are contained in the current version of IT-378, Winding-up of a Partnership).

Transferee

3. For subsection 85(1) to apply to a disposition of property the transferee must, at the time of the
disposition, be a ―taxable Canadian corporation‖ as defined in subsection 89(1). Basically this is a
corporation that is a ―Canadian corporation‖ not exempt from Part I tax. A ―Canadian corporation‖ is
defined in subsection 89(1) as being a corporation that at the relevant time is resident in Canada and was
either incorporated in Canada or resident in Canada throughout the period commencing June 18, 1971
and ending at that time.

Eligible Property

4. Pursuant to subsection 85(1.1), ―eligible property‖ for the purposes of subsection 85(1) means:

   (a) a capital property (other than real property, an interest in real property or an option on real property,
   owned by a non-resident person), including

        (i) depreciable property, whether or not of a prescribed class, (however subsection 85(5.1) will
        preclude the application of subsection 85(1) to dispositions of depreciable property of a prescribed
        class in certain instances see 22 below), and

        (ii) accounts receivable (other than those on which an election under section 22 has been made —
        see 7 below) where they are being transferred along with all or substantially all of the other assets
        relating to a taxpayer’s business,

   (b) a capital property that is real property, an interest in real property or an option on real property
   owned by a non-resident insurer where that property and the property received as consideration for it
   are property us ed by it in the year in, or held by it in the year in the course of (within the meaning
   assigned by subsection 138(12)), carrying on an insurance business in Canada,

   (c) a Canadian resource property (see 6 below),

   (d) a foreign resource property,
                                                    8-87

   (e) an eligible capital property,

   (f) an inventory including work in progress of a professional who has elected under paragraph 34(a),
   but excluding an inventory of real property and, for dispositions after December 20, 1991, an inventory
   of interests in and options on real property,

   (g) a property (other than a capital property or an inventory) that is a security or debt obligation used or
   held by a taxpayer in the year in an insurance or money lending business,

   (h) a capital property that is real property, an interest or an option concerning such capital property,
   owned by a non-resident person (other than a non-resident insurer) and used in the year in a business
   carried on by the non-resident person in Canada, (see 8 below) or

   (i) a net income stabilization account (NISA) Fund No. 2, as defined in subsection 248(1), for
   dispositions occurring after 1990.

5. For fiscal periods commencing after 1988, inventory of a taxpayer who follows the cash method of
reporting income as provided in subsection 28(1) is defined to include the cost or value of the property that
would have been relevant in computing the taxpayer’s income if the income from the business had not
been computed in accordance with the cash method, and for a farming business, includes all of the
livestock held in the course of carrying on the business. For dispositions occurring after July 13, 1990,
paragraph 85(1)(c.2) provides a calculation for determining the proceeds of disposition of inventory
transferred to a corporation by a taxpayer who calculates income from a farming business according to
the cash method. The amount determined by the calculation is deemed to have been received by the
taxpayer as proceeds of disposition at the time of the transfer and to have been received by the taxpayer
in the course of carrying on the farming business so that the agreed amount must be included in
computing the taxpayer’s income for the year which includes the date of the transfer under subparagraph
28(1)(a)(i). Similarly, where the inventory is owned by the corporation in connection with a farming
business and the corporation calculates its income using the cash method, the amount is deemed to be
an amount paid by the corporation at the time of the transfer and to have been paid in the course of its
farming business.

The calculation under paragraph 85(1)(c.2) is generally as follows:

(A × B/C) + D
where
• A is the amount that would be included in the taxpayer’s income by virtue of paragraph 28(1)(c) if the
taxpayer’s taxation year had ended immediately before the transfer,
• B is the value (determined in accordance with subsection 28(1.2)) to the taxpayer of purchased
inventory for which an election under subsection 85(1) is being made,
• C is the value (determined in accordance with subsection 28(1.2)) to the taxpayer of all the purchased
inventory that was owned by the taxpayer, and
• D is such additional amount as the taxpayer and the corporation designate for the inventory
transferred to the corporation.

In effect D is the amount that the taxpayer could have elected to include in income for the year under
paragraph 28(1)(b) for the transferred inventory if the year had ended immediately before the transfer. See
the current version of IT-526, Farming — Cash Method Inventory Adjustments, for a discussion of the
inventory adjustments under paragraphs 28(1)(b) and (c).
For fiscal periods commencing before 1989, property of a farming or fishing business that would ordinarily
qualify as inventory, except for the fact that income from the business was computed on the cash method
pursuant to section 28, was nevertheless eligible for a subsection 85(1) election. In that case, however,
the cost amount, for the purposes of subsection 85(1) of all such property, including fuel, bait, livestock,
seed and general supplies, was considered to be nil. If the corporation that received such property elected
                                                  8-88
to compute its income from a farming or fishing business pursuant to section 28, it could, where the
inventory is paid for after 1988, deduct under paragraph 28(1)(e), the amount agreed upon in the
subsection 85(1) election. [For taxation years commencing before 1988 the deduction is made under
paragraph 28(1)(c) as it read before 1989.] Further information is contained in the current versions of IT-
427, Livestock of Farmers and IT-433, Farming or Fishing — Use of Cash Method.

6. The reference in paragraph 85(1.1)(c) to a Canadian resource property may, by virtue of its definition in
subsection 66(15), include real property. However, real property so included will not be subject to the
exclusion in paragraph 85(1.1)(f) concerning real property that is inventory. Accordingly, a taxpayer,
including a dealer in Canadian resource property to which subsection 66(5) applies, may transfer real
property that is Canadian resource property to a taxable Canadian corporation under subsection 85(1).

7. If accounts receivable of a taxpayer are being transferred to a corporation under subsection 85(1) as
part of the transfer of all or substantially all of the taxpayer’s business to the corporation, any loss on the
sale will generally be a capital loss to the taxpayer. Where the purchase is on capital account and an
election is filed under subsection 85(1), the transferee is not entitled to claim deductions under paragraph
20(1)(l) or (p) for a reserve for doubtful debts or bad debts on the accounts acquired and any gain or loss
on realization of the accounts is a capital gain or loss. The use of the rollover provisions of subsection
85(1) precludes the use of a section 22 election but the accounts receivable may be sold using section 22,
before the other assets of a business are ―rolled‖ under subsection 85(1). See the current version of IT-
188, Sale of Accounts Receivable, for a discussion of the election under section 22.

8. An election under subsection 85(1) for property described in 4(h) above may be made only if
    (a) immediately after the disposition the transferee was controlled by
         (i) the transferor,
         (ii) a person or persons related (otherwise than by reason of a right referred to in paragraph
         251(5)(b)) to the transferor, or
         (iii) persons described in (i) and (ii);
    (b) all or substantially all of the property used in the business described in 4(h) above is disposed of by
    the transferor to the transferee; and
    (c) the disposition was not part of a series of transactions that resulted in control of the transferee
    being acquired after the time that is immediately after the disposition.

Where the relevant conditions are met, 4(h) above will apply to dispositions occurring after 1989.

Limits for Agreed Amount

9. General Limits — Subsection 85(1) generally provides that the agreed amount can neither exceed the
fair market value of the property disposed of (the upper limit — paragraph 85(1)(c)) nor be less than the
fair market value of the non-share consideration received for it (the lower limit — paragraph 85(1)(b)). If
the fair market value of the property disposed of is less than the fair market value of the non-share
consideration received, the lesser amount must be the agreed amount (see 10 below for an example).
The agreed amount otherwise determined or explained under this paragraph and 10 to 14 below is subject
to the overriding provisions of subsection 69(11) where the circumstances set out in that subsection exist.

Additional Limits — The agreed amount determined under the general limits is further subject to specific
limits in paragraphs 85(1)(c.1), (d) and (e). These specific limits, which are in turn subject to paragraph
85(1)(e.3) (see 19 below), provide that the agreed amount is compared with the fair market value of the
property disposed of. As a result, a loss on disposition of the property can only be recognized where the
property’s fair market value at the time of disposition is less than the other specified limits in paragraphs
85(1)(c.1), (d) and (e) at the time of disposition. However, such loss may be denied as a result of the
application of subsection 85(4) or (5.1) as described in 22 and 23 below.

I Interaction of paragraphs 85(1)(b), (c.1) and (e.3)
                                                     8-89
Paragraph 85(1)(c.1) applies in the calculation of the agreed amount on the disposition of
• inventory
• capital property (other than depreciable property of a prescribed class — see the comments on
   paragraph 85(1)(e) below)
• a security or debt obligation used or held in an insurance or money lending business
• a NISA Fund No. 2.

General Limits — paragraph 85(1)(b)

Lower limit — fair market value of the non-share consideration received

Additional Lower Limits — paragraph 85(1)(c.1)

Lesser of

•   fair market value of the property disposed of
•   cost amount of that property

See 11 below for an example of the application of paragraph 85(1)(c.1).
Paragraph 85(1)(e.3) provides (in part) that the greater of

• the amount determined under paragraph 85(1)(c.1), and
• the amount determined under paragraph 85(1)(b)
is the agreed amount.

II Interaction of paragraphs 85(1)(b), (d) and (e.3)

Paragraph 85(1)(d) applies in the calculation of the agreed amount on the disposition of eligible capital
property of a business.

General Limits — paragraph 85(1)(b)
Lower limit — fair market value of the non-share consideration received
Additional Lower Limits — paragraph 85(1)(d)
Least of
• 4/3* of the cumulative eligible capital of the business
• fair market value of the property disposed of
• cost of that property
See 12 below for an example of the application of paragraph 85(1)(d).
The interaction of paragraphs 85(1)(d) and (e.3) is as described above concerning the interaction of
paragraphs 85(1)(c.1) and (e.3).
III Interaction of paragraphs 85(1)(b), (e) and (e.3)
Paragraph 85(1)(e) applies in the calculation of the agreed amount on the disposition of depreciable
property of a prescribed class.
General Limits — paragraph 85(1)(b)
Lower limit — fair market value of the non-share consideration received
Additional Lower Limits — paragraph 85(1)(e)
Least of
• the undepreciated capital cost of all the property of the class
• fair market value of the property disposed of
• cost of that property
See 13 below for an example of the application of paragraph 85(1)(e).
The interaction of paragraphs 85(1)(e) and (e.3) is as described above concerning the interaction of
paragraphs 85(1)(c.1) and (e.3).

Example of General Limits
                                                                         8-90

10. This example demonstrates the tax affect where:
    (a) the original agreed amount and
    (b) the fair market value of the consideration
exceed

(c) the fair market value of the property transferred.

Assumptions

The type of eligible property is not relevant.
Original Agreed Amount ..................................................................................................................... $100 (a)
Fair market value of property transferred .............................................................................................. 80 (c)

Consideration:

   Fair market value of non-share consideration received ........................................................................ 149
   Fair market value of share consideration received ................................................................................... 1
   Total Consideration ........................................................................................................................ $150 (b)

The agreed amount would be deemed by paragraph 85(1)(b) to be $149 except that paragraph 85(1)(c)
(which deems the agreed amount to be $80) takes precedence over paragraph 85(1)(b). The excess of
the fair market value of the total consideration received over the fair market value of the property
transferred, $70, is taxable in the hands of the transferor as a benefit pursuant to subsection 15(1) less
any portion which may be deemed by subsection 84(1) to be a dividend. See the current version of IT-432,
Appropriation of Property to Shareholders.
Example of the application of paragraph 85(1)(c.1)

11. This example demonstrates the tax affect where:

     (a) the original agreed amount
     is less than the lesser of
     (b) the fair market value of the property and
     (c) its cost amount.

Assumptions

The property is inventory or capital property other than depreciable property of a
prescribed class.

Original Agreed Amount .................................................................................................................... $ 100 (a)
Fair market value of the property at the time of disposition ................................................................. 150 (b)
Cost amount to the transferor at the time of disposition ...................................................................... 120 (c)

Consideration:

  Fair market value of non-share consideration received ...................................................................... $ 90
  Fair market value of share consideration received ................................................................................ 60
Total Consideration ................................................................................................................................ $ 150

The agreed amount is deemed by paragraph 85(1)(c.1) to be $120, the lesser of the fair market value of
the property and its cost amount to the transferor at the time of disposition. The transferor is thereby
prevented from creating a loss on the disposition. The term ―;cost amount‖ of capital property or inventory,
as discussed in this example, is defined in subsection 248(1) as being respectively the adjusted cost base
or its value at the time of disposition as determined for the purpose of computing the transferor’s income.
                                                                          8-91

Example of the application of paragraph 85(1)(d)

12. This example demonstrates the tax affect where:
    (a) the original agreed amount
    is less than the least of
    (b) the fair market value of the property,
    (c) its cost and
    (d) four-thirds of the cumulative eligible capital of the relevant business.

Assumptions

The taxpayer has only one business.
The property is eligible capital property.
Original Agreed Amount ..................................................................................................................... $100 (a)
Fair market value of the property at the time of disposition ................................................................. 180 (b)
Cost of the property to the taxpayer .................................................................................................... 200 (c)
4/3* of the cumulative eligible capital immediately before the disposition ............................................ 160 (d)

Consideration:

  Fair market value of non-share consideration received ...................................................................... $100
  Fair market value of share consideration received ................................................................................ 80
Total Consideration ................................................................................................................................. $180

The agreed amount is deemed by paragraph 85(1)(d) to be $160, that is, the least of four-thirds of the
cumulative eligible capital, the cost of the property and the fair market value of the property at the time of
disposition. There is therefore no amount deductible pursuant to paragraph 24(1)(a) because three-
quarters of the deemed proceeds of disposition of $160 equals the balance of the cumulative eligible
capital immediately before the disposition. See also 23 below.
* See the footnote in 9 II which describes when the fraction 4/3 is applicable.
Example of the application of paragraph 85(1)(e)

13. This example demonstrates the tax affect where:

     (a) the original agreed amount
     is less than the least of
     (b) the fair market value of the property,
     (c) its cost and
     (d) the undepreciated capital cost (UCC) of all the property of the relevant class.

Assumptions

The property is the remaining depreciable property of a prescribed class.
The transaction is not subject to subsection 85(5.1) (see 22 below)
Original Agreed Amount ....................................................................................................................... $40 (a)
Fair market value of the property at the time of disposition .................................................................. 65 (b)
Cost of the property to the transferor .................................................................................................... 90 (c)
UCC of all property of that class immediately before the disposition .................................................... 80 (d)

Consideration

  Fair market value of non-share consideration received ........................................................................ $40
  Fair market value of share consideration received ................................................................................ 25
Total Consideration ..................................................................................................................................... 65
                                                                          8-92

The agreed amount is deemed by paragraph 85(1)(e) to be $65. A terminal loss of $40 otherwise arising
is reduced to $15. The $25 difference is the excess of the fair market value of the property ($65) over the
amount originally agreed upon by the taxpayer and the corporation ($40).

14. Where more than one depreciable property of a prescribed class, or more than one eligible capital
property are transferred simultaneously to a corporation under subsection 85(1), paragraph 85(1)(e.1)
provides that each such property is transferred separately, in the order designated by the taxpayer. If the
taxpayer does not designate any such order, the order is designated by the Minister. The purpose of
paragraph 85(1)(e.1), in providing that each property is transferred separately in a designated order, is to
allow a reduction in the UCC of the class, or the cumulative eligible capital, as each property is
transferred. The order in which properties are transferred will only become significant where consideration
other than shares is received on the transfer, e.g., where cash and shares are included in the
consideration.

The following is an example of the application of paragraph 85(1)(e.1) to the transfer of two depreciable
properties of the same prescribed class:

Assumptions

Cost of Property A ................................................................................................................................... $100
Fair market value of Property A................................................................................................................... 80
Fair market value of non-share received for Property A ............................................................................. 80

Cost of Property B ..................................................................................................................................... 500
Fair market value of Property B................................................................................................................. 400
Fair market value of non-share received for Property B ............................................................................NIL

UCC of the class ....................................................................................................................................... 300

The taxpayer stipulates that the properties are to be transferred at the minimum allowable amounts and
designates the order to be Property A followed by Property B. To achieve the best result, the taxpayer
should elect $80 for Property A which, when deducted from the UCC of the class, leaves a balance of
$220. Property B would then be transferred at an agreed amount of $220 and no recapture of capital cost
allowance results. If the order of transfer was Property B followed by Property A, Property B would have to
be transferred at an amount of $300 and the UCC of the class would be reduced to nil. Property A cannot
be transferred at an agreed amount of nil because of the non-share consideration of $80 received for it.
Property A must therefore be transferred at an amount of $80 pursuant to paragraphs 85(1)(b) and
85(1)(e.3) and recapture of capital cost allowance of $80 results.

15. It may be desirable to have a corporation, which is owned by two or more taxable Canadian
corporations, transfer an undivided interest in its properties to these owner corporations. Provided that the
conditions described in subsection 85(1) are met (see 1, 3 and 4 above) and provided that the transaction
is not one to which subsection 85(5.1) is applicable (see 22 below), a property may be transferred
pursuant to subsection 85(1) to the owner corporations in such a manner that the percentage interest in
the property of each owner corporation is the same as its percentage of the ownership of the transferor.
An example of the application of subsection 85(1) to such a transaction follows:

Assumptions:

A Co and B Co have owned the shares of C Co in the ratio of 60:40 for a number of years. C Co’s sole
asset is land having a cost of $1,000 and a fair market value of $2,000. The land, which is eligible
property, is to be transferred at its cost and in such a manner that A Co and B Co will have a 60% and
40% undivided interest in it respectively.
                                                    8-93
A Co will give consideration to C Co having a fair market value of $1,200 — ($600 in each of share
consideration and non-share consideration). B Co will give consideration to C Co having a fair market
value of $800 — ($40 0 in each of share consideration and non-share consideration).

For the purposes of subsection 85(1), elections may be made by C Co and A Co at an agreed amount of
$600and by C Co and B Co at an agreed amount of $400. In this way interests in a particular property may
be transferred to more than one corporation pursuant to subsection 85(1).
In like manner, an undivided interest in a depreciable property or an eligible capital property can be
transferred from a corporation to the taxable Can adian corporations that own the corporation at
respectively the undepreciated capital cost or the cumulative eligible capital.

16. Where, after June 30, 1988, a taxpayer transfers property to a corporation under subsection 85(1) and
the fair market value of the property that is transferred to the corporation exceeds the greater of:

     (a) the fair market value of the consideration received by the taxpayer and
     (b) the amount agreed upon by the taxpayer and the corporation<
[gt]the provisions of paragraph 85(1)(e.2) will operate to increase the amount otherwise agreed upon if it is
reasonable to regard any part of the excess as a benefit that the taxpayer desired to confer on a person
related to the taxpayer.

17. For dispositions occurring after June 1988, paragraph 85(1)(e.2) does not apply where a taxpayer
transfers property to a wholly owned corporation of the taxpayer for consideration and at an agreed
amount that is less than the fair market value of the property. ―Wholly owned corporation‖ is defined in
subsection 85(1.3).

18. The fair market value of the consideration received by the taxpayer in subparagraph 85(1)(e.2)(i)
refers to all consideration, including the value of consideration received in the form of shares of the
corporation.

19. Paragraph 85(1)(e.3) provides that where the amount deemed to be the agreed amount pursuant to
paragraph 85(1)(c.1), (d) or (e) is greater or less than the amount deemed to be t he agreed amount
pursuant to paragraph 85(1)(b), subject to paragraph 85(1)(c), the agreed amount is deemed to be the
greater of the two amounts. For example, the agreed amount in 11 above is deemed by paragraph
85(1)(c.1) to be $120. However, if the non-share consideration received for the property is $150, this latter
amount is deemed by paragraphs 85(1)(b) and (e.3) to be the agreed amount. Paragraph 85(1)(c) has no
application because the amount deemed by paragraph 85(1)(e.3) to be the agreed amount i s not greater
than the fair market value of the property at the time of disposition.

20. *For taxation years and fiscal periods commencing after June 17, 1987 that end after 1987, paragraph
85(1)(e.4) provides that where, in non-arm’s length transactions, the transferor disposes of a passenger
vehicle (as defined in subsection 248(1)) which had an actual cost to the transferor of more than $20,000,
or such other amount as may be prescribed in subsection 7307(1) of the Regulations, the agreed a mount,
except for the purposes of subsection 6(2), shall be deemed to be equal to the UCC of the vehicle to the
transferor immediately before the disposition. This rule supersedes the more general rule in paragraph
85(1)(e) for depreciable property of a prescribed class (see 9 and 13 above). The current version of IT-
419, Meaning of Arm’s Length contains comments on whether a taxpayer is dealing at arm’s length with a
corporation.

Subsection 7307(1) of the Regulations prescribes the following amounts:

   (a) for an automobile acquired after August 1989 and before 1991, $24,000 and
   (b) for an automobile acquired after 1990, $24,000 plus the Goods and Services Tax and Provincial
   Sales Tax payable had the automobile been acquired for $24,000.

Cost to Transferor of Consideration Received from the Corporation
                                                    8-94

21. For purposes of determining the cost of any property received as consideration by the transferor, the
agreed amount a s determined by subsection 85(1) is allocated by paragraphs 85(1)(f), (g) and (h) as
follows (assuming that only one type of non-share consideration, and one class of either preferred or
common shares, or one class of both, are received):
     (a) non-share consideration — the cost is deemed to be the lesser of the fair market value of non-
     share consideration received and the fair market value of the transferred property,
     (b) preferred shares — the cost is deemed to be the lesser of the excess of the agreed amount over
     the fair market value of non-share consideration and the fair market value of all preferred shares
     receivable by the transferor as consideration for the disposition, and
     (c) common shares — the cost is deemed to be the balance of the agreed amount after deducting the
     portions attributed to the non-share consideration and the preferred shares.
Paragraphs 85(1)(f), (g) and (h) also provide rules for allocating costs amongst the various properties
received as consideration where more than one type of non-share consideration, or more than one class
of either preferred or common shares, or both, are received.

Loss From Disposition of Property

22. The provisions of subsection 85(5.1) will apply to the transfer of depreciable property of a prescribed
class to a corporation where control is exercised in the manner described in paragraph 85(5.1)(a) or (b).
Where the provisions of subsection 85(5.1) are applicable, subsection 85(1) is not applicable and the
proceeds of disposition are basically deemed to be such that the transferor is denied any terminal loss
which might otherwise arise.

Paragraph 85(5.1)(a) describes a transferee that was a corporation that was ―controlled, directly or
indirectly in any manner whatever‖. See 24 below for comments on those words as used in paragraph
85(5.1)(a).

23. Where capital property or eligible capital property is transferred and immediately after the transfer the
transferee was controlled, directly or indirectly in any manner whatever, by taxpayers described in
subsection 85(4), paragraph 85(4)(a) deems any capital loss or deduction pursuant to paragraph 24(1)(a)
in computing the transferor’s income for the taxation year in which the transferor ceased to carry on the
business, as otherwise determined, to be nil. In such a case, paragraph 85(4)(b) provides for an addition
to the adjusted cost base of all the shares of any particular class of the capital stock of the corporation
owned by the transferor immediately after the disposition referred to therein.

See 24 below for comments on ―controlled, directly or indirectly in any manner whatever‖.

24. Pursuant to subsection 256(5.1), for taxation years commencing after December 31, 1988, the use of
the expression ―controlled, directly or indirectly in any manner whatever‖, expands the concept of control
to include what is often considered to be de facto control. See the current version of IT-64, Corporations:
Association and Control After 1988, for a discussion of subsection 256(5.1).
Taxable Canadian Property

25. Where a taxpayer transfers taxable Canadian property to a corporation under subsection 85(1), all the
shares of the corporation received by the taxpayer as consideration for the transfer are deemed to be
taxable Canadian property pursuant to paragraph 85(1)(i).

Contribution of Capital

26. Where subsection 85(1) applies to a transfer of property which results in a contribution of capital to the
transferee corporation, no adjustment to the adjusted cost base of any shares of that corporation is
permitted under paragraph 53(1)(c). For example, where eligible property which has a fair market value
equal to $100 is transferred at an agreed amount of $100 in exchange for one preferred share with a paid-
up capital and a redemption amount of $10, the $90 difference is not a contribution of capital which can be
                                                   8-95
added to the adjusted cost base of the preferred share.

Reduction of Paid-up Capital

27. Subsection 85(2.1) is an anti-avoidance rule that is intended to prevent the removal of taxable
corporate surpluses as a tax-free return of capital in circumstances where sections 84.1 and 212.1 do not
apply. (See the current version of IT-489, Non-Arm’s Length Sale of Shares to a Corporation for a
discussion of sections 84.1 and 212.1.) Subsection 85(2.1) applies where property is transferred to a
corporation pursuant to subsection 85(1) or (2) and the paid-up capital of the share consideration exceeds
the cost to the corporation of the property less the fair market value of any non-share consideration. In any
such case, paragraph 85(2.1)(a) requires the paid-up capital of the shares of the corporation to be
reduced by the amount of the excess. The paid-up capital reduction is allocated among the classes of
shares of the corporation based upon the increase to their respective stated capitals under the relevant
corporate law as a result of the transfer.

An example of the application of paragraph 85(2.1)(a) is as follows:

Assumptions

The property is other than shares described in section 84.1 or 212.1.

Fair market value of the property transferred .......................................................................................... $125
Cost of property to the transferor .............................................................................................................. 100
Agreed Amount ......................................................................................................................................... 100
Stated capital for corporate purposes of the shares issued ....................................................................... 60

Consideration

 Fair market value of non-share consideration received ........................................................................ $ 65
 Fair market value of share consideration issued...................................................................................... 60
Total Consideration ................................................................................................................................. $125

Pursuant to paragraph 85(2.1)(a) the decrease in the paid-up capital arising from the transaction is $25
being the amount by which the increase in the s tated capital exceeds the excess of the agreed amount
over the fair market value of the non-share consideration received.

Deemed Capital Cost Allowance

28. Where the rules in subsection 85(1), (2) or (5.1) have applied to a disposition of depreciable property
and the capital cost to the transferor exceeds the transferor’s proceeds of disposition, subsection 85(5)
applies for the purposes of sections 13 and 20 and any regulations made under paragraph 20(1)(a) to
deem
    (a) that the capital cost of the property to the transferee is the amount that was the capital cost to the
    transferor, and
    (b) that the excess has previously been allowed to the transferee as capital cost allowance.

Subsequent Dispositions of Eligible Capital Property

29. Paragraph 85(1)(d.1) applies where a taxpayer has disposed of eligible capital property to a
corporation and subsequently the corporation disposes of eligible capital propert y. The paragraph applies
to add an amount to that otherwise determined for Q in the definition ―cumulative eligible capital‖ in
subsection 14(5) to determine the amount to be included under paragraph 14(1)(b) in computing the
corporation’s income. The amount to be added is determined by the formula
A × B/C
where
                                                    8-96
A is the amount, if any, determined for Q in the definition ―cumulative eligible capital‖ in subsection 14(5)
for the taxpayer’s business immediately before the time of the disposition,
B is the fair market value immediately before the time of disposition of the eligible capital property
disposed of to the corporation by the taxpayer, and
C is the fair market value immediately before the time of disposition of all eligible capital property of the
taxpayer for the business.
Paragraph 85(1)(d.1) applies to dispositions of property to a corporation occurring after the
commencement of the corporation’s firs t taxation year after June 1988.

General Anti-Avoidance Rule

30. The current version of Information Circular 88-2, General Anti-Avoidance Rule, discusses a number of
examples which illustrate the use of subsection 85(1) and comments on the application of subsection
245(2) thereto. These examples include Divisive Reorganizations (Butterflies), Consolidation of Profits and
Losses in a Corporate Group, Estate Freezes, Incorporation of a Proprietorship , Part IV Tax on Taxable
Dividends Received, and Transfer of Land Inventory.

Administrative Information

31. See the current version of Information Circular 76-19, Transfer of Property to a Corporation under
Section 85, for information and guidance in making a valid election.

Share for Share Transfer

32. Pursuant to paragraph 85.1(2)(c), the rules provided in section 85.1 (regarding a share for share
exchange) do not apply where an election under subsection 85(1) has been made.
                                                       8-97
Information Circular 76-19R3 — Transfer of Property to a Corporation Under
Section 85

Date: June 17, 1996
This Circular cancels and replaces Information Circular 76-19R2 dated June 15, 1990. It provides
information and guidance to help you make elections under subsections 85(1) and (2) of the Income Tax
Act for certain types of property transferred to a corporation. You should read this circular in conjunction
with Forms T2057 and T2058, and Interpretation Bulletins IT-169 and IT-291. Any reference to an
Interpretation Bulletin or Information Circular in this circular refers to the current version of that bulletin or
circular.

This Information Circular incorporates the 1991 to 1994 amendments to the Income Tax Act and clarifies
the departmental policies. It does not include any comment on 1995 draft legislation.
Where applicable, Canada Customs & Revenue Agency has extended its position on section 85 elections
to elections under subsection 93(1), Election re disposition of share in foreign affiliate, subsection 97(2),
Rules where election by partners, and subsection 98(3), Rules applicable where partnership ceases to
exist. You should use Form T2107, Election in Respect of a Disposition of Shares in a Foreign Affiliate,
Form T2059, Election on Disposition of Property by a Taxpayer to a Canadian Partnership, and Form
T2060, Disposition of Property Upon Cessation of Partnership respectively to make these elections. The
Department’s views on the merger or amalgamation of Canadian partnerships are set out in IT-471,
Merger of Partnerships

Property Transferred

1. Subsection 85(1) permits a taxpayer, and subsection 85(2) permits all members of a partnership to
elect to defer all or part of the income which would otherwise arise on the transfer of certain types of
property to a taxable Canadian corporation. This section provides that you, as the taxpayer, can make the
transfer at an agreed amount on which the Act imposes various limitations. You have to elect a dollar
amount, as opposed to making a descriptive election, in setting the agreed amount for the purposes of
subsection 85(1). You may amend (see paragraph 15) but you cannot revoke an election filed under
section 85.

2. The rules in section 85 apply to each property transferred. Accordingly, if the parties intended but failed
to include a particular property transferred when filing an original election form, we will consider that the
transferor disposed of the omitted property for proceeds equal to the fair market value. However,
according to subsection 85(7) or 85(7.1), the parties may file an additional election for that property after
the date the election was otherwise due (see paragraph 15).

3. Although Form T2057, Election on Disposition of Property by a Taxpayer to a Taxable Canadian
Corporation, and Form T2058, Election on Disposition of Property by a Partnership to a Taxable Canadian
Corporation, require a specific and adequate description of each property transferred, the parties to the
election can exercise some discretion when transferring many properties. For example, if you are
transferring all the depreciable properties of a prescribed class, it is not necessary to list each property, or
show the consideration for each on the election form. Instead, you have to indicate on the form only the
total fair market value of the properties, the lesser of the undepreciated capital cost and the cost of the
properties, the fair market value of the consideration received, and the agreed amount for the whole class.
However, you must retain supporting schedules. They are particularly important to determine the
designated order of disposition of each depreciable property, as described in IT-291, Transfer of Property
to a Corporation under Subsection 85(1).

4. The Department will accept elections reporting a nominal amount as the agreed amount for the transfer
of property, provided that the amount is within the limitations imposed in the relevant paragraphs e.g.,
85(1)(c), (c.1), (c.2), (d), and (e).
                                                      8-98

5. Paragraph 85(1)(d) ensures that the agreed amount for eligible capital property for a business cannot
be less than the least of 4/3 of the cumulative eligible capital of that business, the cost, and the fair market
value. When the lowest of these amounts is zero (e.g., earned goodwill for which there is no cost) and the
parties intended to transfer the property on a tax-deferred basis, the parties still have to list the property on
Form T2057 and state a nominal amount. If the parties transfer goodwill and do not include it on the
prescribed form, we will consider it to be disposed of at its fair market value. It may be possible to avoid
this tax consequence by filing a late election (see paragraphs 2 and 15 to 18). For more information, refer
to IT-143, Meaning of Eligible Capital Expenditure, and IT-123, Transactions Involving Eligible Capital
Property.

6. Forms T2057 and T2058 require you to disclose the fair market value of both the property disposed of
and of the non-share consideration received. You should keep the working papers used to arrive at these
values.

7. Even though you may list several properties on a single election form, section 85 requires a separate
agreed amount for each property transferred. The Department will adjust an election form to disregard all
references to a transfer of an ineligible property, without affecting the validity of the other transfers. There
may be tax consequences in transferring ineligible properties. Therefore, it is important to ensure that you
include only eligible properties in any election filed under section 85.

Consideration Received

8. Under section 85, the consideration that the transferor receives for the property transferred to the
corporation has to include at least one share (or fraction of a share) of the capital stock of that corporation
for the election to be valid.

Filing Requirements

9. Form T2057 applies to elections made under subsection 85(1). Transferors must file this form
separately from any income tax return at the tax centre where they file their tax returns. The transferor, or
a person authorized in writing on the transferor’s behalf, and the authorized officer of the transferee have
to sign the election form.

10. Two or more transferors may elect to transfer the same property, or a number of partners may transfer
their partnership interests. In these situations, one designated person should file all the completed T2057
forms and a list of all the electing transferors simultaneously at the tax centre serving the transferee
corporation. We will accept the signature of the person that the transferors authorized to act on their
behalf if that person has provided proof of authority. The designated person has to provide the address
and social insurance number, or the corporation account or business number for each transferor resident
in Canada.

11. For a transferor that is a partnership, one partner designated by the partnership should file Form
T2058. All partners, or a person authorized in writing by the partners to sign for them, has to sign the
election form, along with an authorized officer of the transferee. We will accept the signature of the
designated partner only if the partnership provides proof of authority. The partnership has to file the
election form separately from any income tax return, at the tax centre where the transferee usually files its
income tax return. [See comments on the transfer of property to a corporation by a partnership under
subsection 85(2) in IT-378, Winding-up of a Partnership.]

12. The deadline to file forms T2057 and T2058 is the earliest date on which any of the parties to the
election has to file an income tax return for the taxation year in which the transfer occurred. Under
subsection 150(1), an individual has to file an income tax return for the calendar year in which the
individual disposed of a capital property, or has a taxable capital gain. For property other than capital
property, we have to consider any election under subsection 25(1) or 99(2) that extends the fiscal period
                                                      8-99
of either an individual proprietor who disposed of a business, or an individual member of a terminated
partnership.
13. The parties to an election have to provide all the information required by the forms, obtain the
appropriate signatures, and pay any late-filing penalties when filing the forms. All parties should ensure
that they file their election on the most recent version of the prescribed form (available from their tax
services office).

14. The relevant forms provide more details on filing requirements.

Late and Amended Elections

15. Under subsection 85(7), you can make an election up to three years after the filing deadline referred to
in paragraph 12. Subsection 85(7.1) provides that you can file an election more than three years after the
original due date, or amend an election at any time if, in the opinion of the Minister, the circumstances
giving rise to the late or amended election are just and equitable. The Minister delegates the authority to
accept these late and amended elections to the directors of tax services offices. You or your
representative should file a late or amended election, provided under subsection 85(7.1), at the
transferor’s tax services office, together with a written request to the Minister to accept the election. The
request should provide the reasons why you consider that it is just and equitable to accept the election. If
you do not include these reasons, the Department will not process the election. You also have to pay an
estimate of the applicable penalty when making the election (refer to paragraph 21).

16. We will generally accept an amended election under subsection 85(7.1) if its purpose is to revise an
agreed amount, and without this revision, there would be unintended tax consequences for the taxpayers
involved. We will permit revisions to correct an error, omission, or oversight made at the time of the
original election. However, we will not permit revisions when, in the Department’s view, the main purpose
of the amended election is:
(a) retroactive tax planning, such as taking advantage of losses or tax credits not considered when the
election was originally filed. In situations where the changes are partly retroactive tax planning and partly
to correct errors, we will advise you that we will only accept an amended election for the latter;
(b) to take advantage of amendments in the law enacted after the election was filed, e.g., an increase in
the agreed amount of an election made in April 1985 to create a capital gain that may be offset by a
capital gains deduction under Section 110.6;
(c) to improperly avoid or evade tax; or
(d) to change the agreed amount in a statute-barred year.

17. The Department will accept an amended election only if you or your representative originally filed a
valid election under subsection 85(1) or (2). For example, if, in the original election, consideration received
by the transferor does not include at least one (or a fraction of one) share, it will not be a valid election.

18. Canada Customs & Revenue Agency will generally accept an amended election when:
(a) it corrects an inaccurate property valuation that gave rise to unintended tax consequences;
(b) it reduces the agreed amount of transferred shares to the correct cost amount when a transfer at cost
was the intention, e.g., subsection 83(1) dividends were omitted when calculating their adjusted cost base;
(c) it corrects situations where it is clear that an amount was inserted in error, such as the transfer of
depreciable property at its net book value instead of its undepreciated capital cost; and
(d) it corrects other situations which resulted in unintended tax consequences, e.g., the application of
section 84.1, subsections 15(1), 84(1), and 85(2.1), or paragraph 85(1)(e.2), when it is clear the parties
wanted the rollover without any immediate tax consequences.

Amended Election Not Required

19. The Department will correct clerical errors without requiring an amended election. We will consider
transposition or typographical errors as clerical errors only if they are obvious upon our initial review of the
election form. We will not consider as a clerical error a situation where the agreed amount equals the fair
                                                    8-100
market value of the property at the time of transfer.

20. Paragraphs 85(1)(b), (c), (c.1), (c.2), (d), (e), (e.2), (e.3), and (e.4) automatically adjust the agreed
amount of the transferred property. In such cases, you do not have to file an amended election. However,
we will need an amended election if you want to avoid the tax consequences resulting from the automatic
adjustment to the agreed amount, subject to the comments in paragraphs 15 to 18 above.

Penalty for Late and Amended Elections

21. The Department does not accept an amended or late-filed election made under subsection 85(7) or
(7.1), unless the transferor calculates and pays the estimated penalty when filing the election. We will
subsequently determine and assess the balance of the penalty the transferor has to pay without delay. If
we accept a late or amended election, the penalty, calculated pursuant to subsection 85(8), is the lesser
of:
(a) one-quarter of 1% of the excess of the property’s fair market value at the time of the disposition over
the agreed amount for each month or part of a month after the election’s original due date and before the
filing of the late or amended election; and
(b) $100 for each month or part of a month referred to above, to a maximum of $8,000.

22. The penalty described in paragraph 21 is subject to the provisions of subsection 220(3.1). For details
on the cancellation or waiver of any penalty, see Information Circular 92-2, Guidelines for the Cancellation
And Waiver Of Interest And Penalties.

Benefit Conferred on Related Person

23. Paragraph 85(1)(e.2) prevents you as the taxpayer from using subsection 85(1) to confer a benefit on
a person related to you. If the fair market value of the transferred property immediately before the
disposition exceeds the fair market value of all the consideration taken back, the agreed amount will be
increased by the portion of this excess that can reasonably be regarded as a benefit conferred on a
person related to you. This rule applies except for the purpose of determining the cost to you of the shares
of the transferee corporation you received as consideration for the transferred property. Transfers to a
corporation that was a wholly owned corporation of the taxpayer immediately after the disposition will not
be subject to paragraph 85(1)(e.2) ―benefit conferred to a related person. ‖ In these circumstances no
benefit will be considered to have been conferred even though the fair market value of the transferred
property exceeds the fair market value of the consideration received. Subsection 85(1.3) defines the term
― wholly owned corporation.‖

24. The potential deferred tax liability in the hands of the transferee does not reduce the fair market value
of the transferred property. You should consider this when you determine the amount of consideration that
has to be taken back to ensure that paragraph 85(1)(e.2) does not apply. Generally, we will not apply
paragraph 85(1)(e.2) when you satisfy all the following conditions:
• the transferor takes back retractable preference shares having a retraction amount equal to the fair
    market value of the transferred property less any other consideration taken back;
• the net fair market value of the transferee corporation is not less than the retraction amount of the
    retractable shares immediately after the transfer; and
• the rights, conditions, and characteristics of the shares are such that they maintain their value until
    they are redeemed.
For clarification purposes, ―retractable shares‖ are shares that are redeemable at the option of the holder.

Deemed Dividends and Appropriations

25. A person transferring property to a corporation shall receive consideration which includes shares, or a
fraction of a share, of a class of the capital stock of that corporation. This transfer may result in an
increase in paid-up capital that is more than the increase in the value of the corporation’s net assets. In
such a situation, for property disposed of before November 22, 1985, all the shareholders of that class of
                                                     8-101
shares are deemed to have received a dividend according to subsection 84(1). After November 21, 1985,
when the taxpayer transfers property to a corporation under subsection 85(1) or (2), and the paid-up
capital of the share consideration is greater than the cost to the corporation of the property (less the fair
market value of any non-share consideration), subsection 85(2.1) will apply to reduce the paid-up capital
of the shares by the amount of the excess. As a result, we will take into account the reduction in paid-up
capital under subsection 85(2.1) in determining the amount of any deemed dividend under subsection
84(1) for the same transaction. In such situations, where the total fair market value of the consideration is
more than the fair market value of all the properties transferred, subsection 15(1) applies, except for any
amount that was already included in income under subsection 84(1). For more details and examples, see
IT-432, Benefits Conferred on Shareholders, and IT-291, Transfer of Property to a Corporation under
Subsection 85(1). For information concerning paid-up capital, refer to IT-463, Paid-up Capital.

Price Adjustment Clauses

26. IT-169, Price Adjustment Clauses, states the conditions under which the Department will recognize a
price adjustment clause for property transferred in a non-arm’s-length transaction. However, a price
adjustment clause does not automatically amend a section 85 election. In order to give effect to a price
adjustment clause, you have to file an amended election under subsection 85(7.1). An acceptable price
adjustment clause has to adjust the price of the property transferred and the consideration received, not
the quantity of the property transferred. The terms ―amount‖ and ―fair market value‖ in section 85 must be
interpreted as fixed and specific dollar figures at the date of transfer, not formulas that can determine or
adjust an amount later. A price adjustment clause cannot change these figures retroactively.

Losses from disposition of property to a controlled corporation

27. Generally, you cannot claim an allowable capital loss or a terminal allowance (i.e., the deduction of
your cumulative eligible capital) if it arises on a transfer to a corporation and, immediately after the
transfer, the corporation was controlled directly or indirectly by the taxpayers described in subsection 85(4)
- see IT-291, Transfer of Property to a Corporation under Subsection 85(1). This restriction on losses
applies on a property-by-property basis. Consequently, losses and gains on properties transferred at the
same time may not be offset.

Pre-1972 Appreciation

28. In certain cases, you will be unable to obtain a tax-free distribution of a pre-1972 gain as a result of a
transfer under section 85. For example, if the fair market value of depreciable property at December 31,
1971, is more than the actual cost of the property, and an individual transfers the property to a corporation
under section 85 at less than the fair market value at December 31, 1971, no 1971 capital surplus (or,
after 1978, pre-1972 capital surplus) will arise if the corporation later disposes of the property at more than
its actual cost. For more details, see IT-132, Capital Property Owned on December 31, 1971 - Non-Arm’s
Length Transactions.

Facsimile Election Forms

29. The Department may permit facsimile forms if you obtained prior written consent from the:
Director
Publishing Directorate
Canada Customs & Revenue Agency
17th floor
Albion Tower
25 Nicholas Street
Ottawa ON K1A 0L5
You should send a copy of the proposed facsimile form with your submission to the Department at least
60 days before the electors have to sign the forms. For more comments on facsimile forms, see
Information Circular 92-5, T1, T2 and T3 Customs Returns.
                                                                   8-102




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