An individual ("A") wholly-owning Holdco, held Holdco common shares with a nominal FMV, ACB and PUC, and Holdco preferred shares having an FMV of $1M and an ACB of $0.5 million (as a result of a previous capital gains crystallization transaction) and a nominal PUC. Holdco, which wholly-owned Opco, held Opco common shares having a nominal FMV, ACB and PUC, and Opco preferred shares having an FMV and ACB of $1M, and nominal PUC.
A first exchanged all his Holdco preferred shares for new preferred shares having a redemption value of $0.5M and (pursuant to s. 86(1)(g)) a deemed cost of $0.5M and for common shares having an FMV of $0.5M, and cost (pursuant to s. 85(1)(h)) of nil and a nominal PUC. After acquiring A’s Holdco common shares for FMV consideration ($0.5M in notes issued by them to A), A’s children then sold those shares to a Newco formed by them in exchange for a Newco promissory note for $0.5M. Holdco then redeemed its preferred shares held by A for $0.5M (paid with a $0.5M note of Holdco), so that Holdco received a deemed dividend of $0.5M and sustained a capital loss of $0.5M. Opco then redeemed its preferred shares held by Holdco for $0.5M, thereby enabling the repayment of the $0.5M note owing by Holdco to A. Holdco paid dividends to Newco, thereby permitting Newco to repay the notes issued to the children.
After indicating that on the disposition by the children to Newco for $0.5M of their common shares of Holdco acquired for $0.5M, the aggregate ACB to them of such shares would not have been reduced pursuant to s. 84.1(2)(a.1)(ii), so that s. 84.1 would not generate a deemed dividend, CRA stated:
[T]he crystallization of A's capital gains deduction would directly contribute to a capital loss of approximately $0.5 million being realized upon Holdco's redemption of the preferred shares of its capital stock. This capital loss could then be applied against the capital gain that would appear, on its face, to arise from A's disposition of the common shares of Holdco's capital stock to the children. These factors should be considered in light of the purpose of section 84.1, which is to prevent the withdrawal of corporate surpluses as a tax-free return of capital by way of a non-arm's length transfer of shares and through the use of the capital gains deduction. In addition … transactions of the type described above could … give rise to surplus stripping situations … which could also trigger the application of subsection 245(2).