In 3295940 (2024 FCA 42; rev’g 2022 TCC 68) (“3295”), the FCA provides welcome guidance on the court’s application of the General Anti-Avoidance Rule (the “GAAR”) in section 245 of the Income Tax Act (Canada) (the “Act”). 3295 is one of the few GAAR cases that has been decided in favour of the taxpayer after a long string of decisions following the Supreme Court of Canada’s decision in Deans Knight (2023 SCC 16).
Analysis
3295 involved a series of transactions to utilize the high adjusted cost base (“ACB”) of Micsau’s shares in 3295. 3295 was a minority shareholder in the target company (“Holdings”). The shares of Holdings had a low ACB. The majority shareholder of Holdings (“RoundTable”) negotiated the terms of the sale of Holdings without input from Micsau or 3295 and did not involve the purchase of 3295’s shares in Holdings.
Micsau intended to simply sell the shares of 3295 outright to the purchaser, however, due to business considerations, the purchaser was unwilling to directly or indirectly own the shares of 3295. Micsau wanted to utilize the high ACB of 3295’s shares and therefore, proposed four alternative transactions to RoundTable that would replicate the tax consequences of selling the shares of 3295 directly to the purchaser. RoundTable only presented one of the alternative transactions to the purchaser, which was further altered and ultimately accepted for a purchase price reduction of $1.5 million.
The series of transactions entered into involved seven steps. First, a new class of shares of 3295 was created and exchanged for Micsau’s existing shares in 3295. This step effectively transferred a portion of Micsau’s high ACB in the existing shares of 3295 to the new class of shares. Micsau then transferred the new shares to a newly created subsidiary 4244851 Canada Inc. (“4244”). This transfer was done on a tax-efficient basis and did not create a capital gain. Subsequently, 3295 sold its shares in Holdings to 4244 which resulted in a gain roughly equal to the gain that would have been realized if it had sold its shares directly to the purchaser. Once the transfer of shares occurred, the cross-ownership between 3295 and 4244 was eliminated through a cross-redemption since the purchaser did not want to own any shares of 3295. This step was simply to provide comfort to the purchaser prior to the eventual sale. The elimination of the cross-ownership did not change the value of the shares of 3295 or Holdings. As a final step prior to selling the shares, Micsau transferred its shares of 4244 to 3295, resulting in 3295 holding all the shares of 4244. 3295 then sold the shares of 4244 to the purchaser on a tax-efficient basis producing no capital gain as the sale price and ACB of the shares were equal. Lastly, 3295 redeemed the new class of shares issued in previous steps, which did not produce any tax liability.
As a result of the transactions undertaken to sell the shares to the purchaser, the only step that resulted in tax liability was the sale of the Holdings shares to 4244. This gain is approximately the same amount of gain that would have been realized if 3295 had sold its shares directly to the purchaser, without undertaking the series of transactions. It is worth noting that as a result of the transactions, the Minister was not prejudiced and collected the appropriate amount of tax on the sale of shares.
The Minister reassessed 3295, by applying the principles of the GAAR to add a capital gain of $31.5 million to its income, arguing that Micsau and 3295 carried out a series of avoidance transactions that resulted in a tax benefit, which was a reduction of capital gain by $31.5 million that should have been realized if 3295 had directly sold its shares in Holdings to the purchaser.
The TCC ruled that the series of transactions entered into by 3295 was an abuse of subsection 55(2) and the capital dividend scheme in the Act, since the object, spirit and purpose (“OSP”) of the provisions is to “prevent a taxpayer from using a tax-free dividend to avoid the capita gain inherent in the shares of a corporation that is attributable to an unrealized appreciation”.
The FCA was tasked with determining whether the TCC erred in its holding that the series of transactions was abusive. As stated by the FCA, the TCC failed to consider the entire series of transactions or the overall result of the transaction. The reality of the transaction is that the Minister was not “shortchanged” as a result of the transaction because the ultimate gain taxed ($53 million) as a result of the series of transactions was approximately the same as if the shares were sold directly to the purchaser ($53.7 million). The sole purpose of entering into the alternative transactions was to simply placate the purchaser who, for business purposes, did not want to own the shares of 3295 directly or indirectly. The TCC incorrectly focused on one step of the transaction, specifically the capital dividends and cross-redemption of shares, in determining that the series of transactions was abusive. The FCA ruled that if the TCC had analyzed the cross-redemption step in conjunction with the other steps undertaken in the series, it would not have resulted in an abuse of the provisions of the Act, and is in fact, consistent with the OSP of the capital dividend regime because it taxed real economic gain.
The FCA further disagreed with the TCC’s failure to consider alternative transactions in the course of its GAAR analysis. The FCA found that, in certain cases, “the existence of a tax benefit can only be established by comparing the tax consequences of the transaction or series actually carried out with the tax consequences of an alternative transaction that might have been carried out”. 3295 requested that the TCC consider the four alternatives proposed to RoundTable to effectuate the share sale, however, the TCC refused to consider the alternatives because they were related to the sale of 3295’s shares instead of the sale of Holdings’ shares, which the TCC determined was an essential factor of the sale. In concluding that the TCC had made a palpable and overriding error in their interpretation, the FCA considered the evidence and record and found there was nothing that suggested the sale of Holdings’ shares was essential. In fact, the shares of Holdings were not sold through the series of transactions, rather the shares of 4244 were ultimately sold to give effect to the transactions.
The FCA’s final comments are of particular note with respect to determining when alternative transactions are relevant. The alternatives were relevant in this case since (i) they were permitted pursuant to the Act, (ii) they were practicable and feasible to enter into, (iii) there was a high degree of commercial and economic similarity of the alternatives to the series of transactions actually undertaken because the overall result was the same, (iv) the tax consequences were approximately the same as the series of transactions, and (v) they were not abusive of the GAAR (i.e., a transaction that does not attract the application of the GAAR).
In my opinion, the conclusion reached by the FCA is a welcome respite from the overreaching application of the GAAR in recent cases. If the courts were to uphold the Minister’s application of the GAAR in cases where transactions are simply meant to utilize tax attributes and which do not result in shortchanging tax, this could create havoc and cause tax uncertainty among taxpayers entering into transactions simply to apply their legitimate tax attributes.
Conclusion
The FCA’s decision is particularly useful, such that it affirms the overall series of transactions should be considered collectively to determine whether a transaction is abusive of the OSP of the Act. Simply determining that one step of a series is abusive is insufficient in determining whether the Act has been abused and may lead to an incorrect application of the GAAR. The FCA also affirms that legitimate, feasible and commercially available alternative transactions should be considered in a GAAR analysis. The analysis provided by the FCA in respect of determining when alternatives are relevant is a useful guide for taxpayers and advisors to consider when structuring transactions where alternatives are available or when encountered with a GAAR assessment.
About the author
Danielle is an associate in the Tax practice at MicMillan LLP, Toronto.
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