Section 84.1 of the Income Tax Act converts what looks like a capital gain into a deemed taxable dividend whenever an individual sells shares to a corporation they do not deal with at arm's length — the anti-surplus-stripping rule that makes selling to a related holding company fundamentally different from selling to an outside buyer.
Under ITA s. 84.1(1), where an individual disposes of shares to a non-arm’s-length purchaser corporation connected with the target, a dividend is deemed paid to the vendor and the purchaser corporation’s paid-up capital is ground down — a surplus strip through a related holdco is recharacterized rather than taxed as a capital gain. Section 84.1(2)(b) deems non-arm’s-length dealing wherever the vendor was, immediately before the sale, “one of a group of fewer than 6 persons” controlling the target and a similar group controls the purchaser afterward — catching sibling or small-family ownership groups even without a parent-child relationship anywhere in sight.
The relief valve is narrow and Bill C-208’s intergenerational-transfer rules in (2.31) and (2.32) are the main route out, and they are literally a rule for children, not for any related purchaser. The expanded “child” definition in s. 84.1(2.3)(a) covers a taxpayer’s child under s. 70(10) and “also includes… a niece or nephew… a niece or nephew of the taxpayer’s spouse or common-law partner… a spouse or common-law partner of such a niece or nephew, and… a child of such a niece or nephew” — a list that does not reach a sibling, a cousin, or an unrelated co-founder. A sale to a holdco controlled by any of those relatives stays inside s. 84.1’s deemed-dividend treatment with no statutory escape hatch, which is exactly why QSBC-eligible proceeds a vendor expects to shelter with the lifetime exemption can evaporate into an unplanned dividend the moment the buyer turns out to be a related party.
Three siblings jointly control an operating company and sell its shares for $6M cash plus a $2M vendor note to a holding company the same three siblings jointly control. Because the sellers and the holdco are a group of fewer than six persons controlling both corporations, s. 84.1(2)(b) deems the transaction non-arm’s-length, and s. 84.1(1)’s deemed-dividend formula applies to part of what the siblings receive. Because siblings are not “children” under s. 84.1(2.3)(a)’s expanded definition — which reaches nieces, nephews and their spouses and children, but not brothers or sisters — the intergenerational-transfer relief in (2.31) is unavailable to them regardless of how the rest of the deal is structured.
See also: Qualified small business corporation share · Safe income on hand · Section 85 rollover.
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