Wednesday, August 6, 2008

Eintstein, Curved Time and Income Tax

Ever since Einstein advanced his general theory of relativity, we have been living with the concept of curved space-time. Eminent physicists tell us that a moving body affects the curvature of space and time - and that the modified curvature of space-time in turn alters the way that the body moves. Indeed, a clock located at the surface of the earth will run ever-so-slightly slower than a clock in a satellite far above the earth.

It is all beyond most of us, but - fortunately - intelligent people like Stephen Hawking understand it.

The Income Tax Act also has an inherent concept of curved time - or, at least, a concept of a space-time continuum that can throw a curve at the plans of many taxpayers.

For example, consider a Canadian controlled private corporation (a "CCPC", in scientific jargon). In order to be a CCPC, a corporation must not be controlled by any combination of publicly-traded corporations and non-residents (such as a US resident or, I suppose, one of Buckaroo Banzai's space aliens from the Ninth Dimension).

Suppose I am a Canadian resident and that I have been the sole owner of shares of a CCPC (let's call it "Canco") for at least two years. Suppose that Canco uses substantially all its assets in a Canadian active business. In this case, I would normally be able to claim the $750,000 capital gains exemption on a sale of the Canco shares. However, Canco has to continue to qualify as a CCPC up to the time of sale.

This is where curved time comes in. If I sell my Canco shares to a non-resident at 2 PM on the closing date, the sale of my shares will occur at 2 PM. The closing triggers a curved time provision, however, and the non-resident is deemed to have acquired control of Canco at the start of the day in question. Amazingly, the curved time provision applies only to the acquisition of control, which is considered to occur no matter who owns the shares. The curved time rule does not apply to the actual purchase of the shares, which still occurs at 2 PM. Consequently, at the time of (and indeed by virtue of) the 2 PM purchase, Canco is deemed to have been controlled by a non-resident since 12:01 AM and no longer qualifies as a CCPC. So I would not be able to claim my capital gains exemption on the sale proceeds.

Fortunately, there is a way around this curved-time quandary - as long as one knows enough to sprinkle the required interstellar dust. Canco can elect out of the curved time provisions. Regrettably, this requires action by Canco (the seller of the shares cannot file the election). After the 2 PM sale, the purchaser of the shares - not the seller -- will in fact control Canco. This means that the seller has to deal with the election well before the share sale and has to do this by inserting an appropriate provision in the share purchase agreement. If the share purchase agreement does not require that Canco elect out of the curved time provisions, the seller of the shares will have no way to force that result.

Remember curved time if you are ever selling shares of a CCPC to a publicly-traded corporation or to a non-resident. Otherwise, you might end up falling into a tax black hole.

-- Blair P. Dwyer

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.