Rogo Dan owns all of the common shares of Julie Inc. which in turn owns all of the shares of two other companies, Opco Inc. and RE Inc. Opco Inc. carries on an active business in Sudbury. RE Inc. owns real estate, of which 100% is used by Opco Inc. in its business. All three corporations are CCPCs. The following are further details:
Julie Inc. assets:
Shares of Opco Inc. at FMV …………………………………………………. $850,000
Shares of RE Inc. at FMV …………………………………………………….. 800,000
Portfolio investments at FMV ………………………………………………….. 75,000
Opco Inc. assets and liabilities:
Active business assets at FMV ………………………………………………. $900,000
Term deposits …………………………………………………………………... 50,000
Liabilities ……………………………………………………………………… 100,000
RE Inc. assets and liabilities:
Land and building at FMV ………………………………………………….. $800,000
Portfolio investments at FMV ………………………………………………... 200,000
Mortgage ……………………………………………………………………… 200,000
The proportion of assets in each of the companies has been constant over the past three years. Rogo has owned the shares of Julie Inc. for the past five years.
REQUIRED
(A) Determine whether Julie Inc. meets each of the three tests necessary for its shares to be qualifying small business corporation shares.
(B) If the shares of Julie Inc. are not QSBC shares, then suggest ways of purifying Julie Inc. and indicate the tax consequences of your recommendations.
SOLUTION
Part (A)
The first step is to analyze the fair market value of the assets of each of the companies. The analysis would be as follows:
| Julie Inc. (Julie) assets: | | |
|---|
| Shares of Opco Inc. at FMV..................................................................... | $ 850,000 | 49.3 % |
| Shares of RE Inc. at FMV........................................................................ | 800,000 | 46.4 % |
| Portfolio investments at FMV.................................................................. | 75,000 | 4.3 % |
| Opco Inc. (Opco) assets and liabilities: | | |
| Active business assets at FMV................................................................. | $ 900,000 | 94.7 % |
| Term deposits........................................................................................... | 50,000 | 5.3 % |
| Liabilities................................................................................................. | (100,000) | |
| RE Inc. (RE) assets and liabilities: | | |
| Land and building at FMV....................................................................... | $ 800,000 | 80 % |
| Portfolio investments at FMV.................................................................. | 200,000 | 20 % |
| Mortgage.................................................................................................. | (200,000) | |
In order for the shares of Julie to qualify as QSBC shares, the following tests must be met:
(1) SBC Test
At the determination time, Julie must be a small business corporation, which means that all or substantially all (generally 90%) of the fair market value of its assets must be used in an active business carried on primarily in Canada by the corporation or a related corporation, or invested in shares or debt of a connected SBC. In this case, Julie has 4.3% of the fair market value of its assets held in portfolio investments which are not used in an active business. While Julie has 95.7% of its assets invested in Opco and RE, it still needs to be determined whether these two subsidiaries are connected SBCs. Since both are owned 100% by Julie, they are both connected corporations to Julie. In this case, Opco is a SBC, since 94.7% of its assets are used principally in an active business carried on primarily in Canada by the corporation or a related corporation. RE, on the other hand, is not a SBC, but the real estate is used “principally” in the active business of Opco, a related corporation. As a result, RE meets the 50% test. Then, since only 49.3% of the assets of Julie are invested in connected SBCs, Julie is not a SBC.
(2) Holding Period Test
To meet this test, Rogo or a related party must have owned the shares of Julie throughout the 24 months preceding their disposition. This test is met by the facts given in the question.
(3) Basic Asset Test
In order to meet this test, Julie needs to have more than 50% of its assets used in an active business carried on primarily in Canada for the previous 24 months. In this particular case, Julie does not have any of its assets used directly in an active business, but it does have shares of connected corporations. Therefore, the modified asset test must be used.
(4) Modified Asset Test
If Julie meets the 90% test with a combination of its own active business assets (it has none) and shares or debt of connected corporations that meet the 50% test, the modified asset test is met.
This test requires, in this particular case, both of the connected corporations meet the 50% test throughout the 24 months preceding the determination time and that Julie meets the 90% test throughout the 24 months preceding the determination time.
If RE is reviewed, it can be seen that the real estate is used principally in an active business carried on by RE or by a related company, Opco. Therefore, its main or principal use is in the active business of Opco. However, the land and building only represent 80% of RE’s assets. Thus, RE only meets the 50% test.
On reviewing Opco, it can be seen that more than 50% of its assets are used principally in an active business carried on primarily in Canada, i.e., 94.7% of its assets are used in this way.
Finally, on reviewing Julie, it can be determined that since both Opco and RE meet the 50% test, Julie must meet the 90% test with the shares of both RE and Opco considered. Julie has 95.7% of its assets invested in the shares of Opco.
As a result, Julie will meet the modified basic asset test with the shares of Opco considered.
If the facts were somewhat different, such that Julie did not meet the 90% test, but Julie did not need to include the shares of either Opco or RE to meet the more than 50% asset test, then the following interpretation would apply. According to a private CRA technical interpretation, only the assets of the corporation whose shares help Julie meet the 50% test must meet the 90% test. According to this interpretation, the assets of both corporations must meet the 90% test only if the shares of both corporations are needed to help Julie meet the 50% test. In the case at hand, this is not necessary, because the assets of Julie meet the 90% test.
Conclusion:
Julie meets both the holding period test and the modified basic asset test, but fails the SBC test. Therefore, the shares of Julie are not QSBC shares at this time.
Part (B)
In order for Julie to become a SBC it can look at a number of different options. It can dispose of the shares of RE. Another option is to cause RE to decrease the proportion of portfolio investments to less than 10%.
By disposing of the shares of RE, Julie will possibly create a significant tax liability on any capital gain realized. The net proceeds would first be used to pay any tax liability on the sale and then could be used to pay off the liabilities in Opco. After that, the excess funds will have to be paid as a dividend with the resulting tax liability to Rogo. If this option is chosen, then the shares of RE should be sold to someone who would continue to rent the property to Opco.
If RE were to dispose of $112,000 of its portfolio investments, then it would have 90% of its assets ($800,000 out of $888,000) used in the active business of a related corporation but only if the $112,000 of cash proceeds is used to pay off part of the mortgage to reduce it to $88,000. In this way, a non-qualified asset is eliminated by reducing a liability.