Custeau – Court of Quebec finds that GAAR did not apply where individuals used PUC thrust upon them by an arm’s length investor (through PUC averaging) to subsequently strip surplus
When the taxpayers’ corporation (“Opco”), a small business corporation, was in financial difficulty, a Quebec regional development fund agreed to inject equity capital in Opco on terms dictated by the fund – which entailed the fund investing in the common shares of Opco, so that the paid-up capital of the taxpayers’ shares was boosted from a nominal amount to $1.45 million. About five years later, the taxpayers engaged in capital gains crystallization transactions in which they transferred most of their common shares of Opco to personal holding companies, realizing capital gains of $1 million, and took back preferred shares with a correlative adjusted cost base and also a paid-up capital that reflected the earlier step-up in the transferred shares’ PUC. Following the repurchase of all of the fund’s common shares of Opco, the taxpayers’ had their Holdcos distribute most of the PUC of their preferred shares in cash.
The ARQ considered there to have been abusive surplus-stripping, and applied the Quebec general anti-avoidance rule to treat most of the paid-up capital distributions as taxable dividends. 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), and that there was no abusive tax avoidance.
Respecting his first finding, he noted that the increase in the taxpayers’ PUC was not their doing but was a result of terms imposed by the fund, and that at that time it was “financially inconceivable” that Opco would be able to turn around within six years so as to both redeem out the fund at a large gain to it and fund the distribution of the taxpayers’ PUC.
Respecting his second finding, he accepted the taxpayers’ submission that Pomerleau and 1245989 were distinguishable on the basis that in those two decisions “the surpluses were stripped as part of ‘internal’ transactions between individuals and corporations not dealing at arm’s length, which is not the case here, as there is an arm’s length relationship between the plaintiffs and [the fund].”