25 March 2002 External T.I. 2002-0120945 - ELIGIBLE SMALL BUSINESS INVESTMENT

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: 1.Taxpayer enquiry on whether existing shares & proposed replacement shares will qualify for the "small business investment deferral" where original shares are shares of farming corporation and replacement shares are a "XXXXXXXXXX " corporation.

Position: Question of fact-but farming corporations do not likely qualify for such deferral. Will provide general comments

Reasons: 44.1(10) excludes corporation where >50% of FMV of assets is real property (net of debts)-unless farm is heavily leveraged it would not likely qualify.

2002-012094
XXXXXXXXXX Lena Holloway
613-957-2104
March 25, 2002

Dear XXXXXXXXXX:

Re: Technical Interpretation Request - Section 44.1

This is in reply to your undated letter received January 30, 2002, regarding the application of section 44.1 of the Income Tax Act to your specific situation. Your letter stated that you owned one-third of the issued shares of a farm corporation (your sisters own the remaining two-thirds shares) and that you were considering selling your interest in this farm and reinvesting the sale proceeds in another corporation. The corporation whose shares you wish to purchase carries on a XXXXXXXXXX business and is currently wholly owned by your husband. You had asked whether such an undertaking would qualify for capital gains deferral under section 44.1.

The particular circumstances in your letter on which you have asked for our views is a factual situation. As explained in Information Circular 70-6R4 issued by Canada Customs and Revenue Agency ("CCRA") on January 29, 2001, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling. If you wish to obtain a binding commitment with respect to an actual case similar to that outlined in your letter, an advance income tax ruling application should be submitted. We note further that your request appears to be in the nature of a tax consultation. We cannot respond to your request as such, as the CCRA does not provide tax-planning advice. We are willing, however, to provide you with some general comments on the subject of the capital gain deferral for investments in small businesses. Considering the complexity of the issues involved with respect to this subject matter, we suggest that you may wish to consult with a tax professional that specializes in the area of small business tax incentives. However, if you require additional information regarding your specific tax situation, we invite you to contact your local tax services office.

All references herein are to the Income Tax Act (Canada) (the "Act") unless otherwise indicated.

Our Comments

The technical notes accompanying the introduction of the capital gains deferral for eligible small business investments offered the following explanation of this tax incentive:

New subsection 44.1(2) of the Act permits an individual that has a capital gain, determined without reference to section 44.1, from a qualifying disposition in a taxation year to claim the permitted deferral of the individual in determining the individual's capital gain for the year from the disposition. Where the individual has a permitted deferral in respect of a qualifying disposition, the capital gain from the disposition is deemed to be the amount by which the individual's capital gain (determined without reference to section 44.1) exceeds the permitted deferral. The individual can establish a permitted deferral less than the maximum amount available by designating a lesser amount of replacement shares.

Under the subsection, the adjusted cost base to the individual, determined without reference to section 44.1, of the replacement shares of the individual in respect of the disposition is reduced by the amount of the individual's ACB reduction in respect of such replacement shares.

There are many restrictions and conditions to be met before one can avail themselves of the deferral of all or a portion of a gain from a qualifying disposition under subsection 44.1(2). A "qualifying disposition", defined in subsection 44.1(1) and explained below, refers to the disposition of a share that was an "eligible small business corporation share"("ESBC share") of an individual, and a common share of an "active business corporation". Subsection 44.1(10) provides a special rule for corporations that will not qualify as an eligible small business corporation or as an active business corporation and hence the owners of such shares cannot avail themselves of this tax deferral. The exclusions set out by subsection 44.1(10) are:

(a) a professional corporation;

(b) a specified financial institution;

(c) a corporation the principal business of which is the leasing, rental, development or sale, or any combination of those activities, of real property owned by it; or

(d) a corporation more than 50 per cent of the fair market value ("FMV") of the property of which (net of debts incurred to acquire the property) is attributable to real property.

Generally a farming corporation would have more than 50 per cent of the net FMV of its property attributable to real property (land and buildings) hence could not qualify as an eligible small business corporation or as an active business corporation by virtue of the exclusion cited above. The following statement made in the October 2000 Economic Statement and Budget Update speech clearly reflects the legislation's targeted economic sector: "Given that this measure is intended to improve access to capital for small businesses with high growth potential, especially in the fast-growing high-tech industries, specified financial institutions, professional corporations and corporations with significant real estate holdings will not qualify as eligible small businesses." As previously stated, generally a corporation with significant real property holdings (such as a farm) would not qualify for this deferral unless such real property held by the corporation was heavily financed, as the 50 per cent real property test is net of debts incurred to acquire the property. Should the 50 per cent real property test not present a problem there are several other conditions to be met before this deferral can be utilized.

A "qualifying disposition" of an individual is a disposition of shares that were ESBC shares and throughout the period of ownership by the individual, common shares of an active business corporation. The shares must have been owned by the individual throughout the 185-day period that ended immediately before the disposition.

ESBC shares are common shares issued by a corporation to the individual, if at the time of the issue the corporation was an eligible small business corporation, and the total carrying value of the assets (valued as per generally accepted accounting principles) of the corporation and corporations related to it did not exceed $50 million either immediately before or after the issuance. An eligible small business corporation must be a Canadian-Controlled Private Corporation as defined in subsection 125(7) where all or substantially all of the FMV of the assets is attributable to assets that are:

-used principally in an active business carried on primarily in Canada by the corporation or a related eligible small business corporation;

-shares or debt of other related eligible small business corporations; or

-a combination thereof.

The "active business corporation" condition mentioned above would require that the corporation be a taxable Canadian corporation as defined in subsection 89(1) and that all or substantially all of the FMV of the corporation's assets is attributable to assets that are:

-used principally in an active business carried on by the corporation or a related active business corporation;

-shares or debt of other related active business corporations; or

-a combination thereof.

In addition the business must be carried on primarily in Canada for at least 730 days (or throughout the ownership period if less than 730 days).

Note that where the phrase "all or substantially all" is used the CCRA has interpreted this to mean 90 percent or greater and where the word "principally" is used the reference is to greater than 50 percent.

Subsection 44.1(1) describes the type of share that qualifies as a "replacement share" as an ESBC share that is:

-acquired by the individual in the year or within 60 days after the year-end but not later than 120 days after the qualifying disposition; and

-designated by the individual to be a replacement share in the individual's tax return for the year.

Once more, if greater than 50 percent of the net FMV of the replacement corporation's assets is attributable to real property it cannot qualify as a "replacement share" (such may be the case with a XXXXXXXXXX corporation).

The foregoing comments represent our general views with respect to the subject matter and are not an exhaustive explanation of the many details of the small business investment capital gains deferral. After reading the above summary if you still believe your farming corporation shares and the proposed replacement shares may qualify for this deferral treatment, we again suggest that you consider consulting with a tax professional.

As indicated in paragraph 22 of Information Circular 70-6R4, the above comments do not constitute an income tax ruling and accordingly are not binding on the CCRA.

We trust the above comments are of assistance to you.

Yours truly,

Milled Azzi, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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