Federal Income Taxation---Problem 7 (Basic)

[ITA: 84.1, 85(1)]

Mrs. Andrews, a Canadian resident, has just told you about a proposed transaction she is planning to undertake shortly. She would like your advise on her plan.

She recently set up VonTrapp Holdings Limited (VHL) with 100 common shares, which she owns and are worth $1 each. The plan is for her to sell her shares in Plummer Enterprise Inc. (Plummer) to Holdings in order to crystallize her capital gains exemption and for her to have a holding company to accumulate capital away from the risks of the business. She has never claimed the capital gains exemption in the past.

Mrs. Andrews owns 100% of the outstanding common shares of Plummer. Plummer is a small business corporation and meets all the tests for the shares to be qualified small business corporation shares. Plummer and Holdings are both Canadian resident corporations. She purchased the Plummer shares in 1996 from an unrelated third party for their then fair market value of $200,000.

The fair market value of the Plummer shares today is $4,000,000. The paid-up capital of these shares is $1,000.

Mrs. Andrews plans to transfer her shares of Plummer to Holdings on December 3rd and has been advised by someone else to jointly elect under section 85 with Holdings and take back the following consideration:

Mrs. Andrews will jointly elect under section 85 with VHL and will take back the following consideration:

(a) non-interest bearing note for $200,000, and

(b) voting preference shares which are retractable for $3.84 million and have a dividend rate of 6%.

REQUIRED

Advise Mrs. Andrews on the tax implications of the proposed transaction, supported by your computations.