If a business is successful, it will eventually have excess cash retained in the company that is not necessary for the operations of the business.  Two options for this cash is to distribute the excess to the shareholder(s) as a dividend, but that would result in personal tax being paid by the shareholder on the dividend or the company can simply retain the excess cash and invest it in non-business-related assets. Unfortunately this mixture of business (active) and non-business (passive) assets held by the company will potentially disqualify the shareholder(s) from gaining access to the capital gains exemption.

Purification strategy

To avoid this negative tax impact, it is common practice for tax professionals to recommend that companies undertake a purification strategy to remove this excess cash.  Purification sounds very invasive, like an exorcism of a demonic presence, but I can assure you it is not like that.

The concept of a purification is simple enough, but a properly executed purification strategy requires specific well-executed steps to avoid unintended tax consequences. These steps are sometimes overlooked when there is too much focus on the end result.

Purification is when a company (ACo) undertakes a series of transactions to transfer non-business-related (passive) assets to a separate corporate entity (BCo) on a tax-deferred basis. The result is the split-up of the assets of the original company into two companies with ACo holding the business (active) assets and BCo holding the passive assets. Since there is no increase in overall corporate value to both ACo and BCo, this purification is normally accomplished on a tax-deferred basis.

Best to provide an illustration of a typical purification strategy. Let’s assume the following facts:

• Clean Company Limited (CCL) operates a “hand-sanitizer” manufacturing business;
• Clean owns 100 per cent of the common shares of CCL (no other shares authorized or issued);
• Fair market value (FMV) of CCL is equal to $1,200,000;
• The FMV of CCL’s business assets is $800,000 with the remaining $400,000 in value representing excess cash (non-business assets); and
• Clean would like to purify the company and implement a family trust with a corporate beneficiary (Newco).

Common strategy steps[1]

A common first step in the purification process is to change Mr. Clean’s share ownership of CCL from one class of common shares into two separate classes of preferred shares with one class representing the FMV of the business and the other class representing the value of the excess cash. This step is commonly referred to as a “freeze” because the value of the company is frozen into the newly issued classes of preferred shares. This freeze should be accomplished on a tax-deferred basis under section 51, 85 or 86 of the Income Tax Act (ITA).

Immediately following the freeze, new common shares would be issued to the newly created family trust. Without getting into too much detail, the next few steps in the purification process would be as follows

1. Clean would transfer his preferred shares under section 85 of the ITA, representing the value of the excess cash, to Newco in exchange for preferred shares of Newco;
2. CCL would transfer its non-business assets under section 85 of the ITA to Newco in exchange for preferred shares of Newco; and
3. These preferred shares, now owned by the respective companies, would be redeemed and the resulting promissory notes created on the redemption would be equally offset.

In the end, Mr. Clean would have two companies, CCL holding the business assets, and Newco holding the excess cash.

The dangers of taking a short-cut

It is very easy to overlook the detailed purification steps and simply focus on the result. A short-cut approach would result in the freezing of CCL’s $1.2 million value into preferred shares allowing the issuance of new common shares to a family trust. This would then be followed by a dividend of $400,000 paid on CCL’s common shares to the family trust and allocated to the corporate beneficiary, Newco.

The result of this short-cut approach is the same.  CCL holds the business assets and Newco holds the excess cash.

The problem with this short-cut approach is the impairment of the $1.2 million preferred share value created on the freeze of CCL. The $400,000 dividend paid on the common shares reduces the FMV of CCL to $800,000, but the preferred share value remains fixed at $1.2 million. Without the proper steps of transferring, redeeming and cancelling the preferred shares representing the value of the extracted excess cash, the value of the preferred shares and the value of CCL are no longer aligned.

This misalignment of the values could result in the dividend being invalid resulting in no actual purification, or CRA may consider the initial freeze value to be inaccurate resulting in the freeze becoming a taxable event.

Be mindful of the steps

With every purification strategy, it is very important to properly design and execute the detailed steps. Just remember, most horror movies begin with someone taking the short-cut!

 

[1] These steps are a summarization of a typical purification strategy and are not meant to be a substitute for professional advice needed to develop a customized detailed purification strategy.