Ms. Knight owns all of the common shares of Knight Manufacturing Limited (KML) that she acquired 20 years ago from an arm's length person. These shares have a paid-up capital of $100,000 and their adjusted cost base is $400,000. Their current fair market value is $1,800,000 and it is anticipated that this value will continue to grow rapidly. Ms. Knight is considering freezing the value of KML at $1,800,000 by holding non-growth debt and preferred shares and having her adult children own the common shares. Ms. Knight would like to use up her remaining (QSBC share) capital gains exemption of $400,000.
REQUIRED
(A) One method of freezing the future growth of her KML common shares is to transfer her present common shares to a newly-formed holding company, Knight Holdings Ltd. (KHL). She would take from the holding company as consideration for the shares, debt in the amount of $800,000 and voting preferred shares with a legal stated capital and fair market value of $1,000,000. What are the tax consequences of this plan and how can the adverse tax consequences be avoided? Show all calculations.
(B) What are the tax consequences if the preferred shares in KHL received in (A) are:
(i) sold in an arm's length transaction for their fair market value?
(ii) redeemed by the corporation for their fair market value?
(C) As an alternative, Ms. Knight is considering a capital reorganization of KML under section 86 in which she would receive $800,000 in debt and $1,000,000 in voting preferred shares in return for her common shares. The $1,000,000 amount of preferred shares represents their legal stated capital, fair market value and retractable value. What are the tax consequences to Ms. Knight on the reorganization? How can the adverse tax consequences be avoided?
(D) What are the consequences if the shares received by Ms. Knight on the reorganization in (C) are:
(i) Sold in an arm's length transaction for their fair market value?
(ii) Redeemed by the corporation for their fair market value?
(E) Compare the alternatives in (B) and (D) in terms of their total "net economic effects":
(i) With the adverse tax consequences of the plan as outlined, and
(ii) With the tax consequences of the plan that avoids these adverse tax consequences.