Atlantic Packaging – Tax Court of Canada finds that s. 54.2 did not apply to the drop-down of under 68% of the assets of a business division to a Newco for Newco shares

The taxpayer, a paper products manufacturer, engaged in a hybrid transaction in which it sold some of the assets of its “Tissue Division” directly to a third-party purchaser (“Cascades”) and rolled the balance of them down to a Newco under s. 85(1) for Newco shares and sold the Newco shares to Cascades. CRA assessed on the basis that the sale of the Newco shares was on income account. The only issue before Graham J was whether s. 54.2 deemed the Newco shares to be capital property, which required that the drop-down transaction be considered to be the transfer of substantially all the assets of an active business.

Graham J found that "the test in section 54.2 is intended to be a somewhat flexible test but … there is no reason not to consider the fair market value of the assets when applying the test.” From the FMV perspective, the transferred assets represented about 68% of the assets of the Tissue Division – and perhaps significantly less, given that some of the Tissue Division assets had not been valued. He also was receptive to arguments that, given the flexibility of the test, he should also consider whether the dropped-down assets represented “the heart of the business of the Tissue Division,” but did not find any such indication on the evidence. Accordingly, s. 54.2 did not apply, and it was unnecessary for him to go on to consider whether the Tissue Division was a separate business or merely a division of a larger business.

It is unclear why CRA considered that the gain on the taxpayer’s sale of the Newco shares was not a capital gain on general principles. In 2012-0438651E5, it recognized the Continental Bank and Loewen principle to the effect that a transaction is not an adventure in the nature of trade if it cannot generate an economic profit - irrespective of whether there is a deemed (fictitious) gain as a result of an ITA deeming provision. Here, assuming that the roll-down transactions occurred immediately before the sale (similarly to Continental Bank), there would have been no reason to expect the business to have appreciated in the intervening few minutes or days, so that there would have been no commercial profit generated on the sale of the Newco shares.

Neal Armstrong. Summary of Atlantic Packaging Products Ltd./Atlantic Produits d'Emballage Ltée v. The Queen, 2018 TCC 183 under s. 54.2.