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When purchasing shares of a private operating company, it can be advantageous to purchase those shares through a holding company. This allows the purchaser to pay for the shares using dollars generated from the business that have not been subject to personal tax.
In British Columbia, for example, income earned in an operating company is subject to a 13.5% corporate tax rate (assuming the income is subject to the small business limit rate). The after-tax income can be funneled tax-free, assuming the two companies are connected pursuant to Section 186 of the Income Tax Act (the “Act”), to a holding company to pay for the purchase price. If a holding company is not used, in British Columbia that income will be taxed at the individual’s marginal tax rate, which could be as high as 43.7%. Due to the difference in corporate and personal tax rates, a holding company allows for the purchase price to be paid off substantially faster.
When using this structure, one must be careful to ensure that the vendor and the purchaser are not related. Related party purchases may be subject to an anti-avoidance rule in Section 84.1 of the Act which applies to non-arm’s length transactions. Related individuals are considered to be non-arm’s length pursuant to paragraph 251(1)(a) of the Act. A particular individual is considered to be related with his or her parents, grandparents, great-grandparents, children, grandchildren, great-grandchildren, siblings, spouse, his or her spouse’s family (the spouse’s parents, grandparents, great-grandparents, children, grandchildren, great-grandchildren, siblings) and anyone married to any of the individuals mentioned above.
If an individual utilizes a holding company to purchase shares from a related individual, assuming other conditions are met, Section 84.1 of the Act will deem the vendor to have received a taxable dividend instead of a capital gain.
For example, assume Mr. A holds shares that qualify for the Capital Gains Exemption with a fair market value of $750,001 and a cost base of $1. On the sale of those shares to an unrelated party, a capital gain of $750,000 will be realized which will be sheltered by Mr. A’s Capital Gains Exemption. As a result, no income taxes will be payable (ignoring Alternative Minimum Tax) on the transaction. Now assume that Mr. A sells those same shares to a holding company owned by Mr. A’s son. Because Mr. A and his son are related and therefore non-arm’s length and assuming other conditions are met, Section 84.1 of the Act will deem Mr. A to receive a dividend of $750,000. This results in approximately $250,000 of personal tax, assuming British Columbia’s highest marginal tax rate on dividends. Even if Mr. A’s shares don’t qualify for the Capital Gains Exemption and the son’s holding company purchases the shares directly from Mr. A, Section 84.1 will deem a dividend of $750,000 to be received by Mr. A.
If structured properly, and assuming that the Capital Gains Exemption has not been claimed on the sale of the shares, the detrimental consequences of Section 84.1 can be avoided. However, if the Capital Gains Exemption has been claimed on the sale of shares, the provisions of Section 84.1 of the Act will apply to ensure that the funds used to pay for the sheltered gain will be subject to personal tax.
Great care must be taken when dealing with non-arm’s length transactions and the sale of shares to ensure the provisions of Section 84.1 of the Act do not apply.
Section 84.1 is a complex section of the Act that applies to a far greater range of transactions than just the one mentioned above.
Related Topics:Shareholders; Capital Gains
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