Reference no: EM132902826

Question - Mr. Doug Johnston is the sole shareholder of Johnston Home Furnishings, a Canadian controlled private corporation involved in the sale of retail products for the home. He has operated this Company for the last 20 years, in most years earning a satisfactory rate of return on the invested assets.

As of December 31, 2020, relevant information as to the values associated with his Company is as follows:

Initial Investment (Paid Up Capital) $478,000

Fair Market Value - December 31, 2020 $3,985,000

Mr. Johnston is nearing retirement and wishes to gradually dispose of his business. In preparation for retirement, he has enrolled in a variety of courses at a local college. One of these courses, Taxation 405, has introduced him to the concept of transferring property to a corporation under Section 85 of the Income Tax Act. In reviewing this provision, it has occurred to him that, by transferring the shares of Johnston Home Furnishings to a new company, he could effectively escape taxation on part of the difference between his initial investment of $478,000 and the $3,985,000 fair market value of his business. This reflects the fact that, while he has made some use of his lifetime capital gains deduction in previous years, the balance that is available for 2020 is $500,000.

In view of his analysis of this situation, he has planned to transfer all of the shares of Johnston Home Furnishings to a new company, Johnston Investments during January, 2020. The transfer will be made under the provisions of ITA 85(1) and an elected value of $978,000 will be used for the transfer. In return for the shares of Johnston Home Furnishings, Mr. Johnston will receive a non-interest bearing note for $978,000 and ten shares of the new company's no par common shares. These shares have a legal stated capital and a redemption value of $3,007,000.

The note will be due in one year and Mr. Johnston anticipates that, as a result of dividends received from Johnston Home Furnishings, Johnston Investments will have sufficient cash to pay the entire amount at that time.

Neither of the Companies have a balance in their General Rate Income Pool (GRIP) account in any of the years under consideration.

Required -

A. In the absence of ITA 84.1, indicate the tax consequences of the transfer of the shares of Johnston Home Furnishings to Johnston Investments.

B. Determine whether ITA 84.1 would be applicable in this case. Assuming that ITA 84.1 is applicable, calculate the deemed dividend that would arise on this transfer. In addition, indicate the net economic effect that would result from this transfer combined with a redemption of the Johnston Investments shares at their fair market value of $3,007,000 ($3,985,000 - $978,000).