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Stranger Than Fiction:
The Bizarre New World of Share Sales

by David Louis, B. Com., J.D., C.A., Tax Partner
Minden Gross LLP, a member of MERITAS Law Firms Worldwide. 

(*This release is based on an article published in Tax Notes #543, April 2008, CCH Canadian Limited)   

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Once upon a time, the tax effects resulting from a sale of a company’s shares were relatively straightforward.  In the last few years, though, there have been a growing number of tax issues turning on this transaction, some of which are downright bewildering.

As many readers may be aware, perhaps the most bizarre of these became widely known last month, when the CRA released a Technical Interpretation[1] which confirmed the impact of a recent case on the availability of the capital gains exemption[2].  In a nutshell, it states that the capital gains exemption will not be available to an individual, where non-resident and/or public corporations acquire control of an otherwise-qualifying small business corporation. 

Parallel Universe

This seemingly-incongruous conclusion is based on the effect of a recent case, La Survivance v. The Queen[3].  The case itself dealt with the effect of subsection 256(9) of the Act, which indicates that, in the absence of an election to the contrary (more on this later), the acquisition of control of a corporation is deemed to occur at the beginning of the day in which the sale actually occurs. 

In effect, the case says that subsection 256(9) creates a fiction – a parallel tax universe where, by the time the sale of shares actually takes place, the target corporation is no longer a Canadian-controlled private corporation – because the acquisition of control is deemed to have occurred earlier in the day.[4]  So if the purchaser is a public corporation and/or non-resident, the capital gains exemption is no longer available, because in the parallel universe, the “targetco” has ceased to be a CCPC at the beginning of the day.

The antidote to this unhappy result is for the targetco to elect out of the deeming rule in subsection 256(9).  But if the deal has closed, a threshold issue could be whether the vendor could cause the targetco to file an election to begin with.  The co-operation of the purchaser would normally be needed, unless there is a provision in the purchase and sale agreement where the vendor could force the election to be made (in most cases, this is unlikely).  Also, making the election could jeopardize other tax planning.[5] 

Subsection 256(9) itself requires that the target corporation must make the election on filing its tax return for the year ending immediately before the acquisition of control.  If the filing deadline for the return has already passed, the election can be late-filed under subsection 220(3.2), but this is at the discretion of the CRA – i.e., as part of the “fairness package”[6].  While the CRA’s normal policy is that accepting a late-filed election under the fairness package is assessed on a case-by-case basis, a CRA Ottawa official I talked to led me to believe that it would be sympathetic to accepting a late-filed election.[7]

In the absence of the election, the CRA believes that its hands are tied: the law requires the denial of the capital gains exemption in the circumstances I have described[8].  However, the official I spoke with indicated that, because the CRA does not like the result of the case, it will not be going out of its way to find and reassess these claims, e.g., by “reviewing” capital gains exemption claims.  The CRA has also brought the matter to the attention of the Department of Finance, which is considering remedial legislation, possibly with retrospective effect.  We will keep you posted. 

Strangers in a Strange Land

The effect of La Survivance is just the latest in a series of new and often bewildering tax effects centered around the sale of shares of a corporation.  Besides the capital gains exemption issue, an acquisition of control will result in a year-end for tax purposes, and will also trigger a variety of other provisions resultant from an acquisition of control[9].  Some of these are fairly well known, such as the “loss streaming” rules, which require that, for non-capital losses to be carried forward after the acquisition, the pre-existing business must continue to be carried on with a reasonable expectation of profit, with the carry forward restricted to profits from the particular and “similar” businesses.  Several other provisions require the writedown of tax accounts to fair market value of the particular assets, with the resulting loss thereby affected by the loss streaming rules.[10]  An acquisition of control will also result in a complete loss of carry forwards for pre-existing charitable donations and capital losses[11].

Yet another set of rules may be triggered at the time an agreement of purchase and sale (and even some forms of letters of intent) is entered into, e.g., with a public company and/or non-resident.  Due to the application of paragraph 251(5)(b) of the Act (which deems future rights to control to be treated as if they had been exercised), this may trigger a change of status of the corporation, so that it is no longer a CCPC.  This change of status triggers a year-end – yes, another year end[12].  One saving provision, paragraph 110.6(14)(b), usually preserves the capital gains exemption[13] which would otherwise be destroyed as a result of the change of status stemming from the sale agreement itself.  Alas, it has no effect the denial of the capital gains exemption on the actual sale, as previously discussed.  The agreement of purchase and sale could also trigger a number of other untoward tax effects, such as unintended “association” between the buyer and the seller[14].

So pervasive are the tax issues stemming from purchase and sale agreements that a “sign and close” approach has developed - where the purchase agreement is signed only on closing, and the parties hold their breath on the deal in the meantime.  But it doesn’t help on the capital gains exemption issue.

Sale of CCPC Shares to Public Company and/or Non-Resident
– Change of Control*

	Agreement of Purchase and Sale	Completion of Sale
CCPC status	Lost	No effect (status already lost)
Year-end	Deemed year-end	Another deemed year-end
Capital Gains Exemption	Shares usually continue to qualify**	Lost unless subsection 256(9) election

*Assumes that a binding agreement of Purchase and Sale is entered into prior to closing.
** paragraph 110.6(14)(b)

Many thanks to Joan Jung and Michael Goldberg of Minden Gross, who pointed out the significance of La Survivance a year and a half ago.