The two taxpayers (Charles and Philippe, who were brothers) subscribed nominal amounts each subscribed nominal amounts for Class A common shares of the family operating company (the “Corporation”) in January 1997 while they were still young (age 17 in the case of Charles). In May 1997, while the Corporation was having cash flow difficulties, the Fonds régional de solidarité Estrie (“FRSE”), a regional fund of the Fonds de solidarité (“FSTQ”) (which was a Québec development capital organization with a mission to invest in local businesses to further economic development) subscribed a significant amount for Class B shares of the Corporation. The financial difficulties of the Corporation continued, and in December 1998, FRSE subscribed a further amount for Class A shares, converted the rest of its shares into Class A shares and FSTQ itself subscribed a larger amount for Class A shares. As a result of the above subscriptions and conversion, and a Class A share subdivision, on December 17, 1998 the issued and outstanding share capital of the Corporation was as follows: each of Charles and Philippe: 5,156 Class A shares with a paid-up capital of $723,026; FRSE – 2,412 Class A shares with a paid-up capital of $338,235; and FSTQ - 3,181 Class A shares with a paid-up capital of $446,072.
In January 2003 and January 2004, Charles and Philippe engaged in capital gains crystallization transactions. In each year, Charles transferred 2,578 Class A shares (i.e., close to half) to a wholly-owned personal holding company (a “Holdco”) in consideration for preferred shares which, after giving effect to the joint election made under the Quebec equivalent of s.85(1) so a as to realize a taxable capital gain by him in each year of $250,000, had a paid-up capital equal to their deemed cost. The Corporation had been restored to financial health, and following a repurchase by the Corporation in September 2005 of all the Class A shares of FRSE and FSTQ for $1.85 million and $2.18 million, respectively, the Holdco of Charles made a paid-up capital distribution to him (in February 2006) of $555,000 (being virtually all of the shares’ paid-up capital). Philippe and his Holdco implemented essentially the same transactions.
The ARQ considered there to have been abusive surplus-stripping, and applied the Quebec general anti-avoidance rule to treat $499,950 of the paid-up capital distribution made to each of Charles and Philippe to be a deemed dividend.
Dortélus JCQ found both that there had been no avoidance transaction (with his focus being on the boosting of the paid-up capital of the taxpayers’ shares in 1998), and that there was no abusive tax avoidance. Respecting his first finding, he stated (at paras. 64-65, 72-73, TaxInterpretations translation):
[T]he evidence … demonstrates that the investment made by the FSTQ in 1998 in Class A common shares as well as the exchange by the FRSE Fund of its share in the Corporation for common shares, were imposed on the Custeau Group by the FSTQ.
These transactions did not form part of a tax plan or a long term plan with an objective or goal of crystallizing the capital gains exemption in 2003 and 2004 and reducing capital in 2006. …
[T]he capital dilution had already occurred in 1998, at the time of the investment by FSTQ, and is not to be linked to the 2006 capital reduction that produced a tax benefit. …
[I]t was financially inconceivable in 1998 for the plaintiffs to one day to be in the position to redeem the investment of FSTQ and FRSE and have enough liquidity to effect a reduction in capital in the neighbourhood of $555,000 each in 2006.