Anonymised, illustrative composite. The advisor called it a sale. The Income Tax Act, once it looked closely, called it a dividend.
At a glance
The founder of a profitable management-consulting corporation, FMV $3,000,000 and a nominal $100 adjusted cost base, wanted liquidity without selling to a third party. His general practice accountant proposed incorporating a new wholly-owned holding company and having the founder sell his operating-company shares to it for a $3,000,000 promissory note, to be repaid over time from the operating company’s own future dividends flowing up tax-free to the new holdco.
The plan, as drafted, expected the transaction to be taxed as a straightforward capital disposition: a $2,999,900 gain ($3,000,000 less the $100 ACB), taxable half $1,499,950 under ITA s.38(a), sheltered to the extent of the founder’s own $625,000 lifetime capital gains exemption — the figure in the formula in s.110.6(2)(a), indexed for taxation years beginning after 2025 under s.117.1(2)(c) — leaving $874,950 taxable as a capital gain. It is exactly the transaction ITA s.84.1 exists to catch.
The founder controlled both the operating company (the “subject corporation”) and the new holdco (the “purchaser corporation”) — the plainest possible case of the two being connected and the sale not being at arm’s length. ITA s.84.1(1) applies precisely here: where a Canadian-resident individual disposes of shares to a non-arm’s-length purchaser corporation connected with the subject corporation immediately after, “a dividend shall be deemed to be paid to the taxpayer by the purchaser corporation,” and the purchaser corporation’s paid-up capital is ground down accordingly. Under the LCGE route the founder expected, $874,950 would have remained taxable, at capital-gains rates. Recharacterized as a deemed dividend, the transaction loses both the one-half inclusion and the exemption in one step. Section 110.6(2.1) — marginal note Capital gains deduction — qualified small business corporation shares — allows a deduction to an individual “who disposed of a share…that, at the time of disposition, was a qualified small business corporation share,” measured against the individual’s annual and cumulative gains limits. Those limits are built out of capital gains. A deemed dividend is not a capital gain, so there is nothing for the deduction to be measured against. The taxable base at stake swings from $874,950 to as much as $2,999,900 — roughly 3.4 times larger — for what the founder had been advised to think of as a routine internal reorganization.
The relieving switch in s.84.1(2)(e) only revives arm’s-length treatment “if this paragraph applies because of subsection (2.31) or (2.32)” — and paragraph (b)(ii) of each of those subsections requires the purchaser corporation to be “controlled by one or more children…of the taxpayer, each of whom is 18 years of age or older.” Not by the taxpayer himself. No version of the intergenerational relief could have saved this transaction, because it was never a transfer to the next generation; it was a sale from the founder to himself.
Caught before implementation, the plan was rebuilt around ITA s.85(1) instead of a sale: the founder transferred his operating-company shares into the new holdco for share consideration, with a joint election setting the elected amount at his $100 cost base. Under s.85(1)(a) the elected amount “shall be deemed to be the taxpayer’s proceeds of disposition of the property and the corporation’s cost of the property”; paragraph (c) caps it at the property’s fair market value, and paragraph (c.1) floors it, for capital property, at the lesser of fair market value and cost amount — here, the same $100. Elect at $100 and no gain is triggered on the transfer at all. Two details decide whether that survives contact with the filing calendar. The election is joint and must be made, under s.85(6), “on or before the day that is the earliest of the days on or before which any taxpayer making the election is required to file a return of income…for the taxation year in which the transaction…occurred” — s.85(7) allows a late filing for three years after that, with a penalty. And s.84.1 does not switch off merely because s.85 is used: it still applies to the disposition, and s.84.1(1)(a) still grinds the purchaser corporation’s paid-up capital. What saves the founder is that the consideration is all shares, so the formula in s.84.1(1)(b) — which measures the deemed dividend by reference to non-share consideration — produces nothing. The note was the problem, not the holdco. The founder achieved the corporate structure he wanted, with the tax on the underlying value deferred, not manufactured into a bigger bill on the way in.
Had the original sale-for-a-note structure gone ahead as drafted, the swing described above — a taxable base of up to $2,999,900, recharacterized as a dividend with no exemption available, against the $874,950 the founder had planned for as a sheltered capital gain — is exactly what would have landed on his return for the year of the “sale.” The rollover instead produced no income inclusion in the year of the transfer at all, preserving the LCGE for a genuine future arm’s-length sale rather than trying to crystallize it early through an internal transaction that was never going to qualify.
The tell was in the engagement letter’s own language: it used the word “sell” throughout, describing a related-party share movement as a sale for a note. The machinery Parliament built for exactly this kind of internal reorganization — ss.85 and 86 — is described in terms of rollovers, elections and exchanges, specifically because those mechanics are what keep s.84.1 from applying. Any internal document describing a related-party transfer as a “sale” or “purchase” is worth a second look before it is implemented, not after.
A 30-minute call can tell you whether an internal reorganization on your books is a rollover or an accidental dividend.
