These rules where designed to cause a deemed taxable dividend to individuals who receive share consideration and/or a promissory note on a non-arm’s length transfer of shares of a corporation resident in Canada. This could occur where the share consideration has a paid-up capital greater than of the transferred shares and/or where a promissory note exceeds a notionally adjusted tax basis of the transferred shares.
For example, if father sold shares of Fatherco to Sonco at fair market value for a promissory note, section 84.1 would deem father to have received a taxable dividend equivalent to the promissory note. Whereas if father sold the shares first to son for a promissory note and then son would transfer those shares to Sonco at that fair market value (ie, his tax basis), there would not be a deemed dividend to father.
However, if father claimed his available capital gains exemption on the sale of the shares to son and son took a promissory note equivalent to that fair market value on a subsequent transfer to Sonco, Son would then have a deemed dividend because his notional tax basis for purposes of this tax provision would be nil.
The grind of the tax basis looks back to any prior non-arm’s length transfer of those shares or substituted shares where the capital gains exemption was claimed.
The July 18, 2017 proposed rules will now grind the tax basis for purposes of Section 84.1 on any individual share transfers where a capital gain was realized by a prior non-arms length transferor, regardless if the capital gains exemption was previously claimed by that prior transferor. The proposal is effective for transactions occurring after July 17th.
In the foregoing example, if father did not claim his available capital gains exemption on the sale of Fatherco shares to son, then 84.1 would not apply. Now it will apply on son’s transfer to Sonco.