1245989 Alberta Ltd. v. The Queen[1] is a recent decision of the Tax Court of Canada. The case concerned the denial by the Minister of National Revenue (the “Minister”) of an increase to the paid-up capital (“PUC”)[2] of certain shares owned by Perry Wild (“Mr. Wild”). The Minister’s basis was that the general anti-avoidance rule (the “GAAR”) in section 245 of the Income Tax Act (Canada)[3] (the “ITA”) applied to deny the tax benefit of the increased PUC that Mr. Wild would have otherwise obtained. Mr. Wild and his corporations (collectively, the “Taxpayers”) appealed.
The key elements of the transaction for the purposes of the GAAR are in steps 8 and 15 below. Pursuant to subsection 89(1), PUC is calculated by dividing the cumulative PUC of a class of shares by the number of shares in the class. As will be more fully outlined below, when P.W. Rentals Ltd. (“PWR”), Mr Wild’s corporation, transferred property to Mr. Wild’s other corporations in a manner which increased the PUC of the shares they received as consideration, half of the value of that increase accrued to the shares of an identical class which were already held by Mr. Wild. There was a corresponding decrease to the PUC of the shares held by PWR.
Background
The relevant transactions which led to the increased PUC are as follows:
1. 1245989 Alberta Ltd. (“1245”) was incorporated, and Mr. Wild subscribed for 100 common shares.
2. 1251237 Alberta Ltd. (“1251”) was incorporated, and Mr. Wild’s spouse subscribed for 100 common shares.
3. At the time of the transaction, Mr. Wild owned 110 Class A common shares of PWR.
The 1251 Transactions
4. On June 1, 2007, Mr. Wild transferred 16.4 Class A common shares of PWR, which had a cumulative fair market value (“FMV”) of $348,500, to 1251 for 348.5 Class C preferred shares of 1251, pursuant to section 85. The Class C Preferred shares had a cumulative FMV and redemption amount of $348,500.
5. Mr. Wild and 1251 elected proceeds of disposition to Mr. Wild, adjusted cost base (“ACB”) in his shares of 1251 and ACB in the 16.4 Class A common shares of PWR to 1251, at $129,000. As a result, Mr. Wild incurred a capital gain of $128,984, which he sheltered using his lifetime capital gains exemption (“LCGE”).
6. As a result of the application of subsection 84.1, the PUC of the Class C preferred shares Mr. Wild received was $16.40, being the PUC of the transferred Class A common shares.
7. On June 2, 2007, PWR transferred certain equipment to 1251, pursuant to section 85. The equipment’s FMV was $348,500 and its undepreciated capital cost (“UCC”) was $256,279. PWR and 1251 elected proceeds of disposition of $256,279. In consideration, PWR received Class C preferred shares (i.e. the same class of shares Mr. Wild had previously received) of 1251 with a FMV of $348,500 and ACB and PUC of $256,279.
8. Following this transfer, and pursuant to the PUC calculation rules in subsection 89(1), the cumulative PUC of the Class C preferred shares of 1251 was averaged among all shares of that class. The result was an increase in the PUC of Mr. Wild’s Class C preferred shares to $128,148.
9. PWR and 1251 then cross-redeemed the shares they held in one another as a result of the above transactions, and received off-setting promissory notes. The resulting deemed dividends arising under subsection 84(3) were deducted from taxable income pursuant to section 112.
The 1245 Transactions
10. On June 6, 2007, Mr. Wild transferred his remaining 93.6 Class A common shares of PWR, which had a cumulative FMV of $1,989,000 to 1245 for 1,989 Class E preferred shares of 1245, pursuant to section 85. These Class E preferred shares had a cumulative FMV and redemption amount of $1,989,000.
11. Proceeds of disposition and ACB were elected at $621,000. Mr. Wild incurred a capital gain of $620,906 on the transfer, which he sheltered using his LCGE.
12. As a result of the application of subsection 84.1, the PUC of Mr. Wild’s Class E preferred shares was reduced to $93.60.
13. On June 7, 2007, PWR transferred land and depreciable property to 1245 for the assumption of $613,738 of PWR’s debt and 1,826.242 Class E preferred shares of 1245. The cumulative redemption amount of these Class E preferred shares was $1,826,242.
14. PWR and 1245 elected at the land and depreciable property’s cumulative cost amount of $1,509,652. By operation of subsections 85(1) and 85(2.1), the PUC of PWR’s Class E preferred shares received on the transfer was reduced by the value of the non-share consideration (the assumption of PWR’s debt) received on the transfer to $895,914.
15. Following this transfer, and pursuant to the PUC calculation rules in subsection 89(1), the cumulative PUC of the Class E preferred shares of 1245 was averaged among all shares of that class. The result was an increase in the PUC of Mr. Wild’s Class E preferred shares to $467,115.62.
16. PWR then redeemed 86 of its 93.6 Class A common shares which 1245 then held. 1245 redeemed all of the 1,826.242 Class E preferred shares which PWR held. They received largely off-setting promissory notes, with $1,258 still payable by PWR to 1245. The resulting deemed dividends arising under subsection 84(3) were deducted from taxable income pursuant to section 112.
The Clean-up Transactions
17. On June 11, 2007, Mr. Wild transferred his 348.5 Class C preferred shares of 1251 to 1245 for 348.5 Class E preferred shares of 1245, pursuant to section 85. The transfer occurred at cost, such that the Class E shares Mr. Wild received had an ACB of $129,000 and PUC of $128,148.
18. On June 12, 2007, 1251 redeemed the 348.5 Class E preferred shares then held by 1245 for their FMV and redemption price of $348,500. Payment was satisfied by promissory note, and the resulting deemed dividend was deducted from income pursuant to section 112.
19. On June 13, 2007, PWR split the 7.6 Class A common shares still owned by 1245 after step 16 into 100 Class A common shares.
The end result of these transactions was that the PUC of Mr. Wild’s Class E preferred Shares of 1245 was $595,264, almost none of which reflected capital contributions, but all of which could be taken out of 1245 as a tax-free return of capital. As a result of the parties’ reliance on section 85 to transfer the properties, the LCGE to shelter capital gains tax and section 112 to deduct any deemed dividends, no tax had been paid in order create this PUC.
Proceedings Before the Court
Section 245 provides that three conditions must be met before the GAAR will apply. There must be:
(a) a tax benefit;
(b) an avoidance transaction; and
(c) misuse or abuse of a provision of the ITA in a manner which frustrates its object, spirit or purpose.
The Minister argued that the Taxpayers had misused subsection 89(1) in a manner which circumvented section 84.1, a specific anti-avoidance surplus stripping provision. Alternatively, the Minister contended that the transactions were abusive because they achieved an outcome that the relevant provisions were meant to prevent and/or defeated their underlying rationale.
The Taxpayers conceded that there was a tax benefit to the transactions and that elements of the transaction constituted avoidance transactions.
The Taxpayers argued that the reorganization was primarily undertaken for asset-protection purposes, and that subsection 89(1) was a formulaic provision of the ITA which is not susceptible to abuse. They suggested that the Minister’s position was misguided as it ignored the corresponding decreases in the PUC of the Class C and Class E shares held by PWR (as a result of the averaging), was silent on section 112 and generally advanced a pre-Canada Trustco Mortgage Co. v. Canada[4] position.
The Court’s Decision
The Court determined that the taxpayer had enjoyed a tax benefit as a result of avoidance transactions.
In determining whether a provision was misused or abused, Justice Lyons reviewed the applicable case law at length, and determined that the object, spirit or purpose of the relevant provisions were as follows:
(a) subsection 89(1) is designed to compute PUC equally of shares within a class with reference to corporate law principles, subject to applicable adjustments listed in paragraph 89(1)(b)(iii), that represents the amount invested in the company shares by its shareholders; and (b) section 84.1, an anti-avoidance rule, is to prevent the removal of taxable corporate surplus as a tax-free return of capital through the use of the capital gains exemption (or tax-exempt margin), where there is a non‑arm’s length transfer of shares by an individual resident in Canada from one corporation to another and PUC in excess of the amount invested cannot be withdrawn tax free.[5]
In determining that the object, spirit or purpose of subsection 89(1) and section 84.1 had been defeated, the Court stated the following:
[97] The avoidance transactions achieved an outcome, and in the context of the series of which those were part, that section 84.1 was intended to prevent (individual shareholders in a non-arm’s length share for share exchange convert corporate distributions, that would otherwise be taxed as dividends, into exempt returns of capital by utilizing the capital gains exemption) and defeated its underlying rationale - and the underlying rationale of subsection 89(1) - by misusing the PUC calculation that triggered the share averaging effect.
[98] It is clear from the key features of the plan the appellants took deliberate steps, in the context of the series, to defeat the application of section 84.1 and what it was intended to prevent by misusing subsection 89(1), and did so in a manner that defeats the object, spirit and purpose of section 84.1 and subsection 89(1). I am of the opinion that the avoidance transactions were applied in an abusive fashion.
Having determined that the conditions for the application of the GAAR had been satisfied, Justice Lyons concluded that the Minister has properly applied the GAAR to deny the tax benefit to Mr. Wild. Accordingly, the PUC of Mr. Wild’s 2,337.5 Class E Preferred shares of 1245 was reduced to $110.
Concluding Remarks
This case is another reminder of the Tax Court of Canada’s willingness to apply the GAAR to surplus stripping transactions which circumvent section 84.1. Taxpayers should be careful to obtain competent tax-planning advice before entering into these transactions. Equally, tax professionals should be careful to make their clients aware of the potential risk of reassessment following these types of transactions.
About the author
Benjamin Mann is an associate in the tax group at the Toronto office of Miller Thomson.
[2] Generally, PUC represents taxpayers’ capital contributions to corporations, and may be withdrawn tax-free.
[3] R.S.C. 1985, c.1 (5th Supp.). Unless stated otherwise, all references to statutory provisions in this article are references to provisions of the ITA.
[5] supra note 1 at para 68.