Assets dropped into the corporation below fair value to clear the active-asset test

The situation

An Ontario manufacturer had, over several years, accumulated a passive investment portfolio that left its active-business assets at 43% of the corporation’s total fair market value — short of the threshold a qualified small business corporation share requires. Eight months before an agreed sale, the sole shareholder’s advisors identified the shortfall and looked for a way to raise the active-asset ratio before closing rather than sell the portfolio down, which would have crystallised an unrelated tax cost inside the corporation.

The shareholder personally owned a warehouse, unrelated to the business being sold, worth $900,000 on an independent appraisal obtained for the transaction. Four months before closing, he contributed the warehouse to the corporation in exchange for a small block of new shares with a stated value of $60,000 — a fraction of the warehouse’s appraised worth.

The problem

Because the warehouse was an asset used in an active business once inside the corporation, the contribution mechanically raised the active-asset ratio from 43% to 91% — comfortably over the “all or substantially all” line. But s.110.6(7)(b) exists for precisely this manoeuvre. It denies the exemption where the disposition giving rise to the capital gain is part of a series that includes “any property is acquired by a corporation or partnership for consideration that is significantly less than the fair market value of the property at the time of acquisition”, with a narrow carve-out for amalgamations, wind-ups and certain trust distributions that did not apply here.

The gap between the $900,000 appraisal and the $60,000 of share consideration issued was not a rounding difference or a valuation dispute — it was the entire mechanism by which the ratio moved. Diligence for the buyer’s tax counsel reconstructed the contribution and the appraisal side by side within a day of receiving the corporate minute book.

The numbers

Sale price $5,100,000. Warehouse fair market value $900,000; share consideration issued for it, $60,000 — a shortfall of $840,000. Had the corporation instead purchased the warehouse at its full $900,000 fair value, or had the shareholder simply sold it to an unrelated party and left the corporation’s asset mix untouched, s.110.6(7)(b) would not have been engaged at all: the trigger is the below-value gap, not the acquisition itself.

The rule that decided it

Read the unit carefully, because it is narrower than a general rule against buying assets to pass the test. s.110.6(7) denies the deduction “no amount may be deducted under this section in computing an individual’s taxable income for a taxation year in respect of a capital gain of the individual for the taxation year” where the disposition is part of a series that includes, under paragraph (b), an acquisition “for consideration that is significantly less than the fair market value of the property at the time of acquisition”. A corporation that purchases active-business assets at full fair value shortly before a sale — even purely to clear the asset test — does not fall within paragraph (b) on its own facts. The provision is not a general timing rule against last-minute purification; it is targeted specifically at value being dropped into the corporation without matching consideration flowing back out to whoever contributed it.

s.110.6(8) is the neighbouring, separate hook, and it is aimed at a different manoeuvre: it denies the deduction where a significant part of the gain is attributable to the fact that “dividends were not paid on a share” or were paid below “90% of the average annual rate of return on that share” — a rule about withheld dividends inflating a share’s value, not about assets contributed below value. The two provisions sit side by side in the same subsection numbering and are easy to conflate, but they catch different mechanics: paragraph (7)(b) looks at what came into the corporation; subsection (8) looks at what did not come out of a particular class of share.

The outcome

The exemption claim on the shortfall attributable to the warehouse contribution was withdrawn before filing, once the advisors confirmed the below-value gap could not be cured after the fact. The shareholder instead sold the warehouse to the corporation for its full $900,000 appraised value in a corrected transaction, funded by a note payable back to him, which raised the active-asset ratio on the same facts without engaging paragraph (7)(b) at all — because the corporation now held a matching liability rather than value contributed for nothing.

What it would have cost otherwise

Filing on the original below-value contribution and having it identified on audit rather than corrected before filing would have meant a full denial of the exemption on the entire gain attributable to the series that included the contribution — not merely the $840,000 shortfall — since paragraph (7)(b) denies the deduction on the capital gain from the disposition, not a pro-rated portion of it.

The tell

The tell was the mismatch between the independent appraisal commissioned for the sale itself and the share consideration recorded for the same asset four months earlier — two numbers, produced within the same file, that were never reconciled until diligence put them side by side.

Takeaways

• • s.110.6(7)(b) is triggered by a below-fair-value acquisition, not by timing alone — a fair-value purchase of active assets before closing does not fall within it.
• • s.110.6(8) is a separate, narrower rule about withheld dividends inflating a share’s value — distinct from the asset-contribution problem in (7)(b), despite sitting in the same subsection numbering.
• • If the active-asset ratio needs to move before a sale, match the consideration to the value contributed — a note payable back to the contributor, not a nominal share issuance.
• • A denial under s.110.6(7)(b) applies to the capital gain from the disposition, not merely the portion attributable to the below-value contribution — the exposure is the whole gain, not a slice of it.

Sources

• • Income Tax Act s.110.6(7)(b) — denial of the exemption where property is acquired by the corporation for consideration significantly less than fair market value, as part of the same series as the disposition.
• • Income Tax Act s.110.6(8) — the separate withheld-dividend anti-avoidance rule, referenced for the structural distinction.
• • Treadstone Law — LCGE and deal structure in an Ontario business sale — general background on structuring a deal around the exemption. It does not address the below-value acquisition rule in s.110.6(7)(b) specifically; the statutory text above is the operative rule.