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The Subsection 69(11) Trap

12/11/2012


Subsection 69(11) has generally been interpreted by tax practitioners as a provision which applies when, as part of a series of transactions or events, a taxpayer disposes of property for less than fair market value and one of the main purposes is for a non-affiliated person (as defined in subsection 251.1(1)) to obtain a benefit of any deduction, including the capital gains deduction. For example, it eliminates the ability of a child to use his/her capital gain exemption on assets gifted (i.e. farmland, shares of a family farm corporation, etc.) at its adjusted cost base to the child from a parent and subsequently sold within three years. As subsection 69(11) is currently enacted, the transaction described above could result in a deemed disposition by the parent at fair market value, assuming the main purpose of the transaction was to allow the child to use his/her capital gain exemption on the sale.

Upon further review, it would appear that the subsection could be interpreted by the tax authorities to encompass a broader scope of transactions.

For Example

Any time a family farm partnership involves a non-affiliated person (as that term is defined in subsection 251.1), for example a parent and a child, or two siblings, it may not be possible to avoid subsection 69(11) on a transfer of the partnership interests to a single company, as one of the parties will always be non-affiliated with the company, and the company will make use of the small business limit on the subsequent disposition of the substitute property (say the farm grain inventory). This would then leave the transaction open to the Canada Revenue Agency (“CRA”) concluding that “the main purpose” of the initial creation of the partnership (via the transfer of inventory/equipment, etc to the partnership) was to avail the taxpayer of either the capital gain exemption on the sale of the partnership interest, or to allow the taxpayer access to the small business limit inside the company on the subsequent sale of the inventory/equipment (the property substituted for the partnership interest).

Being Prudent

It may be prudent to always wait at least three years from the date of the transfer of assets to the partnership, prior to the incorporation of a partnership interest when the transaction involves non-affiliated taxpayers, and that each non-affiliated group of partners transfer their respective interests into a separate company they are affiliated with. You should consider waiting at least three years prior to amalgamating the corporate partners and collapsing the partnership. One would need to be aware of the provision of subsection 69(13) on the subsequent amalgamation, which deems all property of the predecessor corporations to have been disposed of at its cost amount, which is likely less than fair market value, and which may again place you back into the provisions of subsection 69(11).

As subsection 69(11) invokes a “main purpose” test, one could always take the position that this test has not been met, and therefore argue that the provision does not apply, and proceed with the transactions inside the three year period. However the burden of proof would rest with the taxpayer, and therefore one would need to be very confident with this position, or risk being offside.

We are not aware of the CRA applying the provision extensively. The subsection has limited court precedent. As the discussion of the case below identifies, the precedent is not directly related to the issues discussed above.

Within the interpretation it states that subsection 69(11) does not permit a person to transfer property to an unrelated corporation on a tax-deferred basis where it is intended that the unrelated corporation will sell the property and reduce the amount of the gain by amounts of losses or similar deductions which it may claim. By implication, the subsection does permit a transfer to a related corporation on a tax-deferred basis. In these circumstances such a transfer would be acceptable as it is within the object and spirit of the Income Tax Act ('ITA').

Despite the most common examples encountered being those of gifting farming assets such as farm land from parents to children and of transferring farming operations from proprietor to partnership and eventually to corporations, a third and equally important example can be found in our clients wishing to use shares in their corporations to fund post secondary education of a child. This scenario focuses on the interpretation within subsection 69(11)(a)(i) of obtaining a benefit of “any deduction in computing income”. It appears as though “the benefit of any deduction” could be interpreted in a number of ways to encompass not only capital gain exemption deductions, but also deductions such as the dividend tax credit. Consider the case where a child is just starting university and requires money to fund her education. If the parent were to use subsection 73(4.1) to gift shares in his family farm corporation to the child and have the corporation immediately (or shortly thereafter) redeem a portion of her shares we may inadvertently fall under subsection 69(11). The redemption of the shares by the corporation will result in a deemed dividend received by the child. As the child likely has little or no other income, the deemed dividend would likely result in little or no tax payable, however, it could be interpreted that the dividend tax credit claimed by the child was obtained as a part of a series of transactions or events. If the dividend tax credit is determined to fall under “any deduction in computing income”, the parent will be deemed to have disposed of the shares for proceeds equal to fair market value, and will likely trigger unanticipated taxes payable by the parent, while at the same time continuing to tax the dividend income on the child’s return, resulting in double taxation.

When considering the implications of subsection 69(11), there are a number of additional items that must also be given important consideration to ensure any potential risks on a transaction are identified, discussed with our clients and mitigated if at all possible. As currently worded, the affiliated test is “immediately before the series of transactions began”. However, subsection 69(14) deems a taxpayer (i.e. a company established later in the series to be used in an incorporation) to have existed at the start of the series of transactions. It is important that we not only consider current potential reorganizations, but also things done in the recent past and projected future that could potentially impact our engagement.

What Does the Income Tax Act Say?

As previously discussed above, the ITA is currently worded, “any deduction…in computing income, taxable income…. or tax payable under the Act” can result in the provisions of the subsection applying. We generally consider the capital gain exemption (“CGE”) as being the “deduction” that can result in the subsection 69(11) application, however any deduction (i.e. small business deduction included), not simply the CGE, on a disposition of the property or substituted property can result in the application of the provision.

We generally conclude that a holding period of greater than three years removes you from the application of the provision. The actual wording in the provision is “where the subsequent disposition occurs, or arrangements for the subsequent disposition are made, before the day that is 3 years after the particular time”. One should keep in mind that the CRA could interpret a creation of a family farm partnership on say January 1, 2012, with the “main purpose” of the series of transactions to allow the taxpayer to use their CGE on the subsequent disposal of the partnership interest to the company (something we always advise our clients of when we create the partnership), to be offside of subsection 69(11) (assuming non-affiliated persons were involved) even after a three year holding period.

Are You Ready? 
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