Sale of Projectco before allocation to it by sub LP of condo sale profits (pp. 12:2-3)
Developers often undertake projects in a single-purpose entity ("Projectco") for commercial reasons.…A further level of liability protection can be provided if the project is held in a limited partnership…
[T]he developer will sell the shares of Projectco to another party that has the ability to reduce or shelter the income that will be allocated at the end of the fiscal period of the limited partnership following the sale of the Projectco shares. The sale will take place after the project has been completed and sold, but before profit has been allocated or distributed by the partnership. Typically, the profit will be held by the partnership in the form of cash or a loan to the developer or a related party….
[T]he purchase price for the Projectco shares will exceed the amount by which the value of the assets exceeds the liabilities and the full amount of the latent tax liability of Projectco….
Use of stock dividends to minimize gain to developer (p.12:3-4)
Whether this gain [on the sale of Projectco] is on income or capital account…the developer will seek to minimize [it]…by payment of one or more stock dividends by Projectco in an aggregate amount that will be equal to the purchase price of the Projectco shares less the adjusted cost base (ACB) of the shares, which is assumed to be minimal.
[T]he developer will take the position that the capital gain that would otherwise be realized on the sale of the shares of Projectco at fair market value is attributable to income earned prior to the "safe-income determination time"…
CRA s. 160 challenges to Projectco transactions (p. 12:13)
[T]he manner in which the purchase price is funded could affect the developer's exposure to a challenge to the transaction under section 160 on the basis that property of Projectco has been transferred to the developer for consideration that is less than its fair market value. This is an indirect basis upon which the CRA, has challenged similar transactions. [fn 18: See the Amended Notice of Appeal (filed on February 18, 2014) and the Reply to Amended Notice of Appeal (filed on February 28,2014) in 594710 British Columbia Ltd. v. The Queen, docket no. 2013-4033(IT)G (TCC).]… the discussion considers the developer's position on the basis that Projectco is liable to pay tax on the income allocated from the partnership, and it is this liability that underlies a derivative assessment against the developer under section 160.
Hurdles to a successful s. 160 challenge (pp. 12:13-14)
[H]urdles include the following determinations:
- whether the payment of the stock dividend constitutes a transfer of property;
- whether the developer and the acquiror deal at arm's length;
- whether the sale of the Projectco shares constitutes a direct or indirect transfer of property by Projectco to the developer for consideration that is less than fair market value; and
- depending upon the timing of the taxation year-ends of Projectco following its acquisition of control by the acquiror, whether Projectco has a tax liability in a taxation year in which property may be considered to be transferred to the developer.
It is clear that the payment of a stock dividend does not constitute a transfer of property…[a]s… stated in Algoa Trust… .
Indirect transfer of property (p. 12:15)
[A]s stated by the Federal Court of Appeal in Medland, "[the words 'indirectly...by...any other means' in subsection 160(1) of the Act refer to any circuitous way in which property of any kind passes from one person to another." [fn 22: … 98 DTC 6358, at paragraph 20…] Applying such a broad interpretation, a court could find that property of Projectco has been transferred indirectly to the developer. In fact, Medland also stands for the proposition that a reduction of a liability of a non-arm's-length person owed to a taxpayer is a transfer of property. So a reduction of a liability of the developer to Projectco (for example, by way of a loan from Projectco to the developer) as a consequence of the proposed transactions could be considered to be a transfer of property….
Double application of GAAR in 594710 case (p. 12:16)
[I]n a case currently before the Tax Court, [fn 23: 594710 British Columbia Ltd. supra note 18] the CRA has taken the position that section 160 applies to the developer by virtue of the application of GAAR. In fact, the CRA is arguing for a double application of GAAR: in the first instance, to create a tax liability in Projectco; and then to create a derivative liability in the developer based on an abuse of the provisions of the Act having regard to section 160. The CRA's basis for the application of GAAR is that the policy behind section 160 is to "prevent a taxpayer from avoiding a liability under the Act by transferring property to a non-arm's-length person for inadequate consideration." The problem with this characterization of the policy is that it does not reflect the manner in which subsection 160(1) applies. The provision actually looks not at the consideration received by the transferor, but at the consideration paid by the transferee….
Sale of Projectco before allocation to it by sub LP of condo sale profits (pp. 12:2-3)
Developers often undertake projects in a single-purpose entity ("Projectco") for commercial reasons.…A further level of liability protection can be provided if the project is held in a limited partnership…
[T]he developer will sell the shares of Projectco to another party that has the ability to reduce or shelter the income that will be allocated at the end of the fiscal period of the limited partnership following the sale of the Projectco shares. The sale will take place after the project has been completed and sold, but before profit has been allocated or distributed by the partnership. Typically, the profit will be held by the partnership in the form of cash or a loan to the developer or a related party….
[T]he purchase price for the Projectco shares will exceed the amount by which the value of the assets exceeds the liabilities and the full amount of the latent tax liability of Projectco….
Use of stock dividends to minimize gain to developer (p.12:3-4)
Whether this gain [on the sale of Projectco] is on income or capital account…the developer will seek to minimize [it]…by payment of one or more stock dividends by Projectco in an aggregate amount that will be equal to the purchase price of the Projectco shares less the adjusted cost base (ACB) of the shares, which is assumed to be minimal.
[T]he developer will take the position that the capital gain that would otherwise be realized on the sale of the shares of Projectco at fair market value is attributable to income earned prior to the "safe-income determination time"…
Sale of Projectco on capital account (p. 12:5)
[T]he principle established in the Fraser case [fn 5: Fraser v. Minister of National Revenue, 11964] SCR 657.] should not apply since the sale of the Projectco shares will not be a method of selling the underlying real property—which will already have been substantially or fully sold when the shares are sold under the transaction. For the shares to be considered to be held on income account, it would be necessary to find that the developer was trading or dealing in shares or that the acquisition of the Projectco shares was an adventure in the nature of trade….
VIH indicates Projectco shares are sold for more than FMV (p. 12:6)
[I]n the VIH Logging decision…the Federal Court of Appeal found as a fact based on expert evidence that the fair market value of the shares of the corporation was the fair market value of the assets of the corporation, principally cash, reduced by its liabilities—including the full liability for tax on income arising on the sale of the former assets of the corporation….
Projectco capital gain is attributable to Projectco pre-tax income (p. 12:7)
[W]hile the administrative position of the CRA is clear that the safe income should be reduced by the latent tax, there seems to be little doubt that no portion of the actual capital gain that would have been realized on the sale of the Projectco shares can be attributable to anything other than the pre-tax income of Projectco….
Dubious relevance of stub period accrual (pp. 12:7-8)
[A] typical partnership in which Projectco has an interest will not have reported any income in a prior fiscal period, so Projectco is not required to include a stub period accrual in its income for the taxation year ending on the acquisition of control of Projectco by the purchaser….
[T]he CRA stated in a technical interpretation issued in March 2014 [fn 10: … 2012-0471021E5…] that the amount of partnership safe income attributable to shares of a corporate partner to which the rules in section 34.2 apply should be the adjusted stub period accrual for the year. This is a substantial change from the CRA's former position that the safe income of a corporate partner should include the partner's share of the income of the partnership for the period ending at the safe-income determination time. [fn 11: … 2007-0243151C6…] While some may question whether this former position is supported by case law, [fn 12: See, for example, Canada v. Kruco Inc., 2003 FCA 284] it makes sense to the extent that the income of a partnership contributes to a gain arising on the sale of the shares of a corporate partner….
The CRA's March 2014 technical interpretation takes the position that the stub period accrual rules, where applicable, in effect constitute a code for the determination of income attributable to a corporate partner's interest in a partnership. The method for determining the adjusted stub period accrual is not based on income earned by the partnership for the portion of the fiscal period up to the safe-income determination time. Instead, it is based on income earned in a preceding fiscal period. While the rules in section 55 are somewhat artificial, it seems that an interpretation that achieves a result more in keeping with the economic situation of Projectco—that is, the accrual of income actually earned during the stub period—should be preferred….
[I]n VIH Logging… Woods J recognized that permitting the inclusion of stub period income is an unusual interpretation of paragraph 55(3)(c), which deems income earned and realized for a period to be the taxpayer's income as determined under the Act for the period; however, it was seen as "the only reasonable interpretation." It is equally reasonable to include stub period income earned or realized by a partnership of which a corporation is a partner in the corporate partner's safe income. One may reasonably ask whether this interpretation is in accordance with the provisions of paragraph 55(5)(a). That paragraph deems the portion of a capital gain attributable to income expected to be earned or realized to be a capital gain attributable to anything other than income, and consequently, deemed to be a capital gain under subsection 55(2)….[I]n a seminal 1981 paper, John Robertson noted that at least one of the purposes of the provision was to preclude an argument that a valuation based on a multiple of current income is based on income earned or realized.15 Such future earnings will not have been "earned or realized" in any normal sense. In the case of stub period income of a partnership, the income has been "earned or realized" but has not yet been allocated to a corporate partner.
[t]he amount of sale income of Projectco will include any income arising from the sale of units occurring before the payment of the stock dividend—which dividend will trigger the safe income determination time in respect of the transaction…the result of the application of subsection 52(3)—that is, the creation of" cost in the stock dividend shares—is not confined to subdivision c and will apply for all purposes of the Act…
Effect of latent tax liability on safe income and cost of stock dividends (pp. 12:10-11)
[T]he cost of the stock dividend shares is effectively limited to Projectco's safe income on hand. As discussed previously, the amount of safe income will be based on the taxable income of Projectco either with or without a reduction for the latent tax obligation.
If safe income is based on deducting the fall amount of the latent tax liability, the developer's tax basis in the stock dividend shares will depend on the fair market value of the Projectco shares. If, in turn, the determination of fair market value is based on the reasoning in VIH Logging, the portion of the dividend in excess of safe income will not be subject to the provisions of subsection 55(2), but the stock dividend shares will have no basis to the extent of the excess. If the fair market value is found to be the selling price, then the excess will be deemed to be a capital gain under subsection 55(2) and not a dividend. In this case, the excess will form part of the cost of the stock dividend shares. So in either case the developer will realize a capital gain on the amount of the excess, either as a result of the direct application of subsection 55(2) to the stock dividend or as a result of a reduction in ACB on the sale of the shares. However, there is a difference in circumstances in these two cases. In the former case, where the fair market value of the Projectco shares is based on VIH Logging, no capital dividend will arise on the sale of the stock dividend shares. Clause (a)(i)(A) of the definition of "capital dividend account" in subsection 89(1) provides that the amount of a capital gain for the purposes of computing the capital dividend account is to be determined without reference to subparagraph 52(3)(a)(ii), with the result that there is no increase in capital gain in computing the capital dividend account for tax-deductible stock dividends that are not attributed to safe income and would otherwise reduce ACB. In the latter case, the amount of the excess is deemed to be a capital gain under subsection 55(2) (and does not reduce ACB) because it is not deductible under subsection 112(1) and creates an addition to the capital dividend account.
…[I]f safe income is not based on the deduction of the full amount of the latent tax liability…the cost of the stock dividend shares will be different. If the fair market value of the Projectco shares is not based on VIH Logging, the developer should have full basis in the stock dividend shares because the full fair market value of the shares will be attributable to safe income . If the VIH Logging reasoning applies, the result is not clear. However, it might still be argued that the full amount of the dividend, including the excess over fair market value, is not subject to subsection 55(2) because it is attributable to safe income. The excess may not be subject to subsection 55(2) because it does not reduce the capital gain on a disposition at fair market value, but that does not mean that the excess is also not subject to subsection 55(2) because it is attributable to safe income….
Non-application of hypothetical income test where mother ship is subsidiary management LP (p. 12:21)
[C]lause (B)…does not have to be met where the income is income of the "directly related" affiliate, or a partnership of which it is a member, whose income is to be recharacterized.
No need for 5 full time employees where subsidiary management lP services sister development LPs (pp. 12:21-22)
[I]t is not uncommon that Services LP may employ more than five employees. However, Development LP may have no employees if work is given to contractors. As a result, when several development projects are undertaken at once, each separate development entity may not meet the "more than five employees" test in the definition of "investment business" in subsection 95(1) (based on the use of employees of Service LP being shared among a number of projects), and so the separate entity's activity may be an investment business. The business of providing services is an active business… . Thus…the treatment of the income of the development partnership as active business income under amended subparagraph 95(2)(a)(i) does not depend on meeting the "more than five employees" test in paragraph (c)….
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