Canada: Section 84.1 Abused
25 August 2014
Posted by: Author: Jack Bernstein
Author: Jack Bernstein (Aird & Berlis LLP)
The tax plan in Descarries (2014 TCC 75) converted a deemed dividend into a capital gain that was ultimately offset. A capital gain was triggered, bumping the ACB and PUC of shares received from a holdco, and the subsequent share redemption generated a capital loss that offset the original capital gain. The TCC concluded that the transactions abused section 84.1, and therefore it recharacterized the transactions under GAAR to allow the minister’s assessment of the receipt as a deemed dividend (subject to a minor adjustment in the amount).
The individual taxpayer shareholders wanted to sell the assets of Oka Inc. and then liquidate the corporation; the resulting deemed dividend of $592,366 and capital loss did not offset one another. The chosen tax plan triggered a capital gain of $255,808 on the Oka shares via an internal section 85 reorganization; the taxpayers did not claim a capital gains exemption. The taxpayers transferred the new Oka shares to a newly incorporated Holdco for class A shares with high PUC and a high ACB ($347,848 each) and class B shares with nil PUC and a high ACB ($269,618): the class B shares’ PUC was limited by virtue of section 84.1. No tax arose on the class A shares’ redemption. The first class B share redemption resulted in a deemed dividend of $196,505 and a capital loss of $196,505, which significantly reduced the capital gain of $255,808 that had been triggered on the section 85 internal reorganization. The redemption of the balance of the class B shares—after the merger of Oka and Holdco—resulted in a deemed dividend of $69,000 and a capital loss of $73,112. At the time of the first two redemptions (of class A shares and the first tranche of class B shares), Oka still had four real estate lots in its inventory (the lots were sold later in the year) and held a loan receivable from Holdco. That loan was extended to Holdco before the first two redemptions in an amount equal to the sum of those two redemption amounts.
The CRA challenged the transaction on two alternative grounds: (1) there was an indirect winding up of Oka’s business under subsection 84(2) that resulted in a deemed dividend, or (2) the series of transactions was designed to convert dividends into capital gains contrary to GAAR.
n analyzing subsection 84(2), the court in Descarries referred to MacDonald (2013 FCA 110), which made a textual, contextual, and purposive analysis of the provision. MacDonald said that subsection 84(2) requires (1) a Canadian-resident corporation; (2) a winding up, discontinuance, or reorganization; and (3) a distribution in any manner whatever (4) to or for the benefit of the corporation’s shareholders. The FCA concluded that a court should examine (1) who initiated the winding up, discontinuation, or reorganization; (2) who received the funds at the end, and (3) the circumstances in which the purported distribution took place.
The TCC in Descarries also reviewed the Exchequer Court decision in Merritt ( Ex. Ct. 175) for guidance on indirect distributions. On the facts in Descarries, the TCC said that at the time of the first two redemptions, Oka was a subsidiary of Holdco and still held assets. The TCC said that the term "distribution” requires both a gain for the shareholders and a loss for the company. In MacDonald, the corporation’s assets were reduced by the amount appropriated to the shareholder. In McNichol (97 DTC 111 (TCC)), subsection 84(2) did not apply because the corporation’s assets remained unchanged at the time of the alleged distribution. There was no distribution when Oka loaned funds to Holdco, and there was no stripping of assets on the merger after the first two redemptions: Oka still owned inventory when those redemptions occurred, and its business continued to operate. For subsection 84(2) to apply, the distribution must be concurrent with a winding up; but on the facts, the business of Oka continued until almost two years after the first two redemptions, when it completed legal proceedings to legalize certain title deeds. Subsection 84(2) did not apply at the time of the initial redemptions. There was only one transaction (one distribution), and the court said that subsections 84(2) and (3) could not both apply to the same distribution.
The Crown also argued that GAAR applied, which required it to prove that the relevant transaction was abusive. Although the point was not raised by the CRA, which focused its GAAR arguments on subsection 84(2), the TCC addressed the question of whether the transactions abused section 84.1. The court concluded that on the basis of Lipson (2009 SCC 1), a court deciding a question of law is not bound by the parties’ agreement to any particular interpretation. The court gave both the CRA and the taxpayers the opportunity to make submissions so that they were not prejudiced by the court’s consideration of the issue.
Section 84.1 deems a dividend to occur if shares are transferred not at arm’s length to a Canadian-resident corporation for non-share consideration whose value exceeds the greater of the shares’ PUC and their ACB. If share consideration is received, the PUC of the shares received is deemed to be the PUC of the transferred shares. Because the corporation engaged in an internal rollover and triggered a capital gain, the PUC of the class A shares received was increased. The ACB of the class B shares was higher than their PUC, and thus their redemption generated a capital loss sufficient to eliminate the capital gain on the transfer of the Oka shares to Holdco. As a result of the transaction, part of Oka’s surplus was distributed tax-free in a manner contrary to the object and spirit of section 84.1. Because section 84.1 was abused, GAAR applied. Although the court agreed that section 84.1 was abused because the shares’ PUC would have been more limited without the internal reorganization, the court said that the assessed deemed dividend should be reduced to $525,422 from $592,362 in order to reflect a capital gain assessed on the death of the taxpayers’ father.
This article first appeared on ctf.ca.