Print Edition
      October 2002

Rollover provisions made simple

By Alexander M. G. Gelardi

There is a simple way to calculate the deferred tax on some rollovers

Many CAs deal with small business owners. Imagine a client tells you he has decided to sell the shares of his business, Old Ltd., and invest in a new venture, New Ltd. Both companies are Canadian controlled private corporations (CCPCs). Since his investment in Old Ltd. has gained a great deal in value, he will suffer tax on the large capital gain. He fears he will not be able to invest as much as he would like into New Ltd. You realize the new rollover provisions for eligible small business investments may apply, but the provisions as set out in the Income Tax Act can be quite complex.

Fortunately, in most cases, a simple formula can be used to calculate the deferred tax. First, let's look at what dispositions are eligible for the rollover provision.

Eligible corporations
The new rollover provisions for eligible small business investments were enacted in June 2001 for dispositions made after February 27, 2000. To qualify for the rollover, a "qualifying disposition" must take place. The shares must be of an eligible small business corporation (ESBC). This is a CCPC that has all or substantially all (usually at least 90%) of its assets in an active business carried on primarily in Canada. Alternatively, all or substantially all the corporation's assets can be shares or debt of a related ESBC, or a combination of active business and such shares or debt. Certain companies are excluded from the definition of an ESBC: professional corporations, specified financial institutions, corporations where the principal business is leasing, renting, developing or selling real estates owned by it and real estate corporations (more than 50% of the fair market value of the property of the corporation is from real property).

As mentioned, the active business of the company must be mainly in Canada. There is an exception, however, if the company had carried on business primarily in Canada for at least two years (730 days) after the individual acquired the shares being disposed of. Let's say the client bought the shares in January 1995, while the company was carrying on its business in Canada. In June 1998, the company expanded abroad, and most of its business was conducted there. The disposition of the shares could still qualify for the rollover, since the business had been primarily in Canada for more than two years after the taxpayer had purchased the shares.

The shares of the ESBC have to be common shares issued by the company. The total carrying value of the assets of the corporation, plus any related corporation, both before and after the share issue, should not greater than $50 million.1 The carrying value is to be determined as the value of the assets on the balance sheet if valued under the provisions of GAAP, with the proviso that the value of shares or debt issued by a related corporation is nil. To be eligible for the rollover, these shares would have had to be owned by an individual. This provision indicates that the rollover is not available to trusts or corporations. Also, the individual must have owned the shares at least 185 days before the sale. Special rules allow the individual's spouse, common law partner or parent, who have inherited the shares because of the individual's death, to count the time the individual had owned the share as part of their ownership period. Similarly, if the spouse (or common law partner) of an individual receives the ESBC shares as part of a divorce settlement, the holding period is deemed to include that of the individual. Furthermore, in certain corporate reorganizations, the holding periods of old ESBC shares and new ESBC shares can be combined.2

Rollover provisions
For rollover purposes, two critical factors should be kept in mind: the adjusted cost base (ACB) in the shares being disposed; and the percentage of the proceeds that are reinvested. The ACB of the shares disposed of must not be more than $2 million3. If it is, the maximum amount that can be deferred is the portion that $2 million is of the total ACB of the shares. Thus, if the ACB of the shares is $5 million, the deferral would not exceed two-fifths of the gain. This $2-million limitation seems to be a lifetime maximum for a particular ESBC. This would prevent a taxpayer from disposing of shares with an ACB of $2 million and gaining the rollover and then later disposing of more shares of the company.

The rollover is restricted if the full proceeds are not reinvested in a new ESBC. The amount of the qualified gain that can be deferred is multiplied by the ratio of the replacement cost (qualified cost) to the qualified proceeds (but the ratio cannot exceed one). Thus, if the taxpayer sells the old ESBC for proceeds of $2 million and reinvests $1.2 million in a new ESBC, the proportion of the maximum gain that can be deferred would be 60% ($1.2 million/$2 million).

Qualifying cost is the lesser of the actual cost of the new shares and $2 million4. The costs of the particular company and all related companies are to be treated together. Thus, the $2 million limitation is for the related group. Again, the $2 million seems to be a lifetime maximum for the cost of any particular replacement company or group. However, it seems the taxpayer could invest in several unrelated companies and thus roll over more than $2 million of gains. The restriction of the proceeds can be seen in the examples that follow.

There is a timing consideration for the replacement of the investment. The new shares have to be purchased within 120 days after disposition. There is in fact a further restriction, where the shares are bought toward the end of the year. The new shares must be bought within 60 days of the new year. Thus, if the shares are sold on July 1, the taxpayer has until October 29 (120 days later) to buy the new shares. If, however, the old shares were sold on December 10, the taxpayer has only until March 1 of the following year to buy the new shares. Therefore, you must be careful if the sale occurs after the beginning of November in any year.

Rollover calculations
As a result of these definitions, the act requires a taxpayer to perform a number of calculations to arrive at the amount that may be deferred. At first sight, these seem quite complex. Since they are interconnected, however, they can be reduced to a simple calculation. The deferred gain can be calculated, in most instances, as the lower of:

  a) actual capital gain  *  $2,000,000 (or ACB, if lower) 
                ACB
    
 and   b) actual capital gain *sum of cost of each replacement ESBC
          proceeds of disposition

The cost of each replacement ESBC is limited to a maximum of $2 million, as indicated above.

This simplifying formula will work only for the first of a series of dispositions of the same ESBC. After that, the formal calculations from the Income Tax Act should be used (see example 6). The examples will use the simple calculations in the text, with the formal calculation in the endnotes.

The rollover is effected by reducing the ACB of the new company's shares by the deferred gain. If the taxpayer invests in more than one new company, the deferred gain is apportioned among all the new investments in the proportions of their qualifying costs.

Example 1 [See endnote 5 for the formal calculation]5
Aabed sells his shares in Trupp Ltd., an ESBC, for $2 million. His cost was $500,000. He buys shares in Udavic Ltd., another ESBC, for $1.2 million, within the time limit.

His gain is:   
 Proceeds 

2,000,000 

 ACB 

  (500,000)

 Gain

1,500,000 

Aabed has to consider two restrictions on the rollover. The first is related to the ACB of the Trupp Ltd. shares. Since his ACB is less than $2 million, his gain is not restricted by this criterion. The second restriction is the proportion reinvested in the new ESBC as it relates to the proceeds of disposition of the old ESBC. Since Aabed reinvests $1.2 million after receiving proceeds of $2 million, his capital gain available for deferral will be restricted.

The gain eligible for deferral is: lower of

  a) $1,500,000 * $500,000/500,000 = $1,500,000 
   
      andb) $1,500,000 * $1,200,000/$2,000,000 = $ 900,000
  

The ACB of the Udavic Ltd. shares would be: Cost of purchase

 $1,200,000 

Less: deferred gain

 (900,000)

ACB

 $   300,000 


Example 2
6
Maria sells her shares in Dubito Ltd , an ESBC, for $9 million. Her ACB is $3 million. She reinvests the full proceed of $9 million into Supero Ltd., another ESBC.

Her gain is:   
 Proceeds 

$ 9,000,000 

 Cost 

  (3,000,000)

 Gain

$ 6,000,000 

Since Maria's ACB in Dubito Ltd. is more than $2 million and her reinvestment is more than $2 million, she will be affected by both restrictions. The simple case calculation can still be used, however.

The gain eligible for deferral is: lower of

  a) $6,000,000 * $2,000,000/3,000,000 = $4,000,000 
   
      andb) $6,000,000 * $2,000,000/$9,000,000 = $1,333,333

(The cost of the new investment is restricted to $2 million.)

The ACB of the Supero Ltd. shares would be: Cost of purchase

 $9,000,000 

Less: deferred gain

 (1,333,333)

ACB

 $  7,667,667 


Example 3 [See endnote 7 for the formal calculation]7
The facts are the same as in Example 2, except that Maria invests $4.5 million in Supero Ltd. and $4.5 million in Ubique Ltd.

Her gain is the same as before:       
                   Proceeds 

9,000,000 

 ACB 

  (3,000,000)

 Gain

6,000,000 


The gain eligible for deferral is: lower of

  a) $6,000,000 * $2,000,000/3,000,000 = $4,000,000 
   
      andb) $6,000,000 * $4,000,000/$9,000,000 = $2,666,667


(The cost of each new investment is restricted to $2,000,000 giving $4,000,000.)
As can be seen, by investing $4.5 million in two ESBCs, Maria can increase the deferred gain.

The ACB of the Supero Ltd. shares would be: 

Cost of purchase

 $4,500,000 

Less deferred gain 2,666,666 * 4,500,000/9,000,000

 (1,333,333)

ACB

 $  3,166,667 


The ACB of the Ubique Ltd. shares would be:

Cost of purchase

 $4,500,000 

Less deferred gain 2,666,666 * 4,500,000/9,000,000

 (1,333,333)

ACB

 $  3,166,667 


Example 4
8
The facts are the same as in Example 2, except that Maria invests $2 million in each of four ESBCs and $1 million in a fifth.

Her gain is:       
                   Proceeds 

9,000,000 

 Cost 

  (3,000,000)

 Gain

6,000,000 


The gain eligible for deferral is: lower of

  a) $6,000,000 * $2,000,000/3,000,000 = $4,000,000 
   
      andb) $6,000,000 * $9,000,000/$9,000,000 = $6,000,000

(The cost of each new investment is restricted to $2,000,000 giving $9,000,000 in total.)


In this case, Maria can defer $4 million of her capital gain. Here her gain is only limited by the restriction because she has an ACB of more than $2 million in Dubito Ltd. shares. Thus, by investing $2 million or less in a number of ESBCs, she can defer her capital gain up to the ACB restriction. If her ACB in the Dubito Ltd. shares had been $2 million or less, she would have been able to defer her entire capital gain.

The ACBs of the new shares will be reduced by a portion of the deferred gain. The ACBs in the four ESBCs in which Maria invested $2 million will be reduced by $888,889 ($4 million * 2, million/9 million), and her ACB in the fifth ESBC will be reduced by $444,444 ($4 million * 1 million/9 million).

Example 59
The facts are the same as in Example 2, except that Maria invests $1.5 million in Tenebrae Ltd.

Her gain would still be:       
                   Proceeds 

9,000,000 

 Cost 

  (3,000,000)

 Gain

6,000,000 


The gain eligible for deferral is: lower of

  a) $6,000,000 * $2,000,000/3,000,000 = $4,000,000 
   
      andb) $6,000,000 * $1,500,000/$9,000,000 = $1,000,000

(The cost of the investment is the actual amount of $1.5 million, being less than $2 million.)

Here the restriction is the percentage of the proceeds that is reinvested.

The ACB of the Tenebrae Ltd. shares would be:          
                            Cost of purchase 

$1,500,000 

 Less deferred gain 

  (1,000,000)

 ACB

  500,000 


Example 6
Sandro wants to sell his shares in Comes Ltd., an ESBC. The shares have a value of $10.5 million and an ACB of $3 million. He wishes to invest his full proceeds in shares of Rex Ltd., another ESBC. He has heard that his rollover would be restricted if the ACB of the shares disposed of is greater than $2 million. He therefore comes up with the following strategy:

Sandro sells some shares in Comes Ltd. for $7 million. These shares have an ACB of $2 million. He invests the proceeds of $7 million in shares of Rex Ltd. Later, he sells the remaining Comes Ltd. shares, which have an ACB of $1 million, for $3.5 million. He buys more shares of Rex Ltd. for $3.5 million.
 
For the first disposition:10

His gain would be:
                   Proceeds 

$ 7,000,000 

 Cost 

  (2,000,000)

 Gain

$ 5,000,000 


The gain eligible for deferral is: lower of
  a) $5,000,000 * $2,000,000/2,000,000 = $ 5,000,000 
   
      andb) $5,000,000 * $2,000,000/$7,000,000 = $1,428,571

Here the restriction is the percentage of the proceeds that is reinvested.

The ACB of the Rex Ltd. shares would be:            
                            Cost of purchase 

$7,000,000 

 Less deferred gain 

  (1,428,571)

 ACB

5,571,429 


For the second disposition, you need to use the formal calculation, using the notation in the act:
Qualifying proportion of capital gain:- J*(1-(K/L).
    J = 2,500,000
    K = 1,000,000 + 2,000,000a - 2,000,000
    L = 1,000,000
$2,500,000*(1-(1,000,000/1,000,000)) = 0.
a) ACB of the shares in the first disposition.
Qualifying proportion of proceeds: - M*(N/O). $3,500,000*(0/2,500,000) = $0.
Permitted deferral:- (G/H)*I. ($2,000,000/0)*0 = $0.
Thus, the second disposal will not be give rise to any deferred amount, which is the desired aim.

The ACB of the new Rex Ltd. shares would be the actual cost of $3.5 million. Thus, the total ACB in the Rex Ltd. shares would be $9,071,429.

If Sandro had made only one sale of all his Comes Ltd. shares for $10.5 million (ACB $3 million) and bought the Rex Ltd. shares for $10.5 million, his deferred amount would be :

His gain would be:
                   Proceeds 

$ 10,500,000 

 Cost 

  (3,000,000)

 Gain

7,500,000 


The gain eligible for deferral is: lower of
  a) $7,500,000 * $2,000,000/3,000,000 = $ 5,000,000 
   
      andb) $7,500,000 * $2,000,000/$10,500,000 = $1,428,571

Here the restriction is the percentage of the proceeds that is reinvested.

The ACB of the Rex Ltd. shares would be:            
                            Cost of purchase 

$10,500,000 

 Less deferred gain 

  (1,428,571)

 ACB

$ 9,071,429 


So, Sandro is no better off making two dispositions than he would be if he had made only one.

These examples show that simple calculations can be used in all cases except where there is a second (or greater) disposition of the same ESBC. These simple calculations should allow you to serve your clients quickly and efficiently.


Alexander M. Gelardi, PhD, CA, is an associate professor in the faculty of business administration at Simon Fraser University in BC. He can be reached at gelardi@sfu.ca.



ENDNOTES


  1. For disposition after February 27, 2000 and before October 18, 2000, the carrying cost of the assets, prior to the issuance of the shares, was not to be greater than $2.5 million; and after the issuance of the shares, not greater than $10 million.
  2. These reorganizations would include: transfer of property to a corporation [Section 85], share for share exchanges [Section 85.1] and amalgamations [Section 87].
  3. For disposition after February 27, 2000 and before October 18, 2000, the limit of the ACB was $500,000.
  4. For disposition after February 27, 2000 and before October 18, 2000, the limit of the cost was $500,000.
  5. Following the notation in the Income Tax Act.
    Qualifying proportion of capital gain:
    - J*(1-(K/L). $1,500,000*(1-0/500,000) = $1,500,000.
    Qualifying proportion of proceeds:
    - M*(N/O). $2,000,000*(500,000/500,000) = $2,000,000.
    Permitted deferral:
    - (G/H)*I. ($1,200,000/2,000,000)*1,500,000 = $900,000.
  6. Following the notation in the Income Tax Act.
    Qualifying proportion of capital gain:
    - J*(1-(K/L). $6,000,000*(1-(1,000,000/3,000,000)) = $4,000,000.
    Qualifying proportion of proceeds:
    - M*(N/O). $9,000,000*(4,000,000/6,000,000) = $6,000,000.
    Permitted deferral:
    - (G/H)*I. ($2,000,000/6,000,000)*4,000,000 = $1,333,333.
  7. Following the notation in the Income Tax Act.
    Qualifying proportion of capital gain:
    - J*(1-(K/L). $6,000,000*(1-(1,000,000/3,000,000)) = $4,000,000.
    Qualifying proportion of proceeds:
    - M*(N/O). $9,000,000*(4,000,000/6,000,000) = $6,000,000.
    Permitted deferral:
    - (G/H)*I. ($4,000,000/6,000,000)*4,000,000 = $2,666,666.
    Note that the calculation of qualifying proportion of capital gain and qualifying proportion of proceeds remains the same as in Example 2, since they are not dependent on the cost of the new ESBC.
  8. Following the notation in the Income Tax Act.
    Qualifying proportion of capital gain:
    - J*(1-(K/L). $6,000,000*(1-(1,000,000/3,000,000)) = $4,000,000.
    Qualifying proportion of proceeds:
    - M*(N/O). $9,000,000*(4,000,000/6,000,000) = $6,000,000.
    Permitted deferral:
    - (G/H)*I. ($6,000,000/6,000,000)*4,000,000 = $4,000,000.
    In this case G will be equal to H, since total of the qualifying costs is greater than the qualifying proportion of proceeds of disposition.
    Again, the calculation of qualifying proportion of capital gain and qualifying proportion of proceeds remains the same as in example 2, since they are not dependent on the cost of the new ESBC.
  9. Following the notation in the Income Tax Act.
    Qualifying proportion of capital gain:
    - J*(1-(K/L). $6,000,000*(1-(1,000,000/3,000,000)) = $4,000,000.
    Qualifying proportion of proceeds:
    - M*(N/O). $9,000,000*(4,000,000/6,000,000) = $6,000,000.
    Permitted deferral:
    - (G/H)*I. ($1,500,000/6,000,000)*4,000,000 = $1,000,000.
  10. Following the notation in the Income Tax Act.
    Qualifying proportion of capital gain:
    - J*(1-(K/L). $5,000,000*(1-(0/2,000,000)) = $5,000,000.
    Qualifying proportion of proceeds:
    - M*(N/O). $7,000,000*(5,000,000/5,000,000) = $7,000,000.
    Permitted deferral:
    - (G/H)*I. ($2,000,000/7,000,000)*5,000,000 = $1,428,571.
  11. Following the notation in the Income Tax Act
    Qualifying proportion of capital gain:
    - J*(1-(K/L). $7,500,000*(1-(1,000,000/3,000,000)) = $5,000,000.
    Qualifying proportion of proceeds:
    - M*(N/O). $10,5000,000*(5,000,000/7,500,000) = $7,000,000.
    Permitted deferral:
    - (G/H)*I. ($2,000,000/7,000,000)*5,000,000 = $1,428,571.



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