George inherited 1,000 shares in OPCO Ltd. from his father. The FMV of the shares at the time of the inheritance was $500,000. His father had founded OPCO with an investment of $1,000 (i.e. $1 per share), and had grown it into a very successful business. In his final tax return after his death, George's father sheltered the full gain on these shares from taxes by claiming the capital gains exemption.
George transferred the inherited shares to a 100% owned holding corporation, HOLDCO Ltd. at their FMV of $500,000, receiving HOLDCO's promissory note for $500,000. Soon after this transaction, OPCO paid a dividend of $100,000 to HOLDCO, and HOLDCO redeemed $100,000 of the promissory notes held by George. The expectation was that over a period of years, dividends from OPCO would be used to pay down the remainder of the notes outstanding. Income tax reference: ITA 84.1
What are the tax consequences of this transaction?
[This question was contributed by Victor Waese, MBA, CPA, CGA, Instructor, Financial Management, British Columbia Institute of Technology.]