CRA indicates that where Parent acquired the net tax equity in Subco at a bargain price (low share ACB), avoiding a s. 88(1)(b) gain on wind-up through reducing PUC is abusive
CRA provided two examples of when it would apply GAAR where paid up capital (“PUC”) is reduced to nil in order to avoid a s. 88(1)(b) gain on a wind up.
Example 1. Subco was formed by Xco with an injection of capital of $1,000 (being the PUC of Subco’s shares). Parentco acquired Subco for $1. On the winding-up of Subco into Parentco, Subco had assets with a cost amount of $1,000, and no liabilities or retained earnings (nor were retained earnings realized by it after its acquisition by Parentco).
CRA noted that if the Subco shares instead were redeemed for $1,000, the $999 excess of the redemption proceeds over the shares' ACB would produce a capital gain given that the shares had full PUC. In particular, since the cost amount of the Subco assets was not increased by income earned or realized by Subco after its acquisition of control by Parentco, this indicated that Parentco has made a bargain purchase in the form of the tax attributes in those assets, so that the scheme of s. 88(1)(b) dictated that a gain be realized by Parentco on the winding up in the amount of $999. Thus, CRA would apply GAAR to a reduction of PUC without payment prior to the winding up.
Example 3. Parentco owned all Subco shares which have a PUC and ACB of $1,000. Subco used $2,000 borrowed from a third party to acquire assets with a cost amount of $3,000 – which subsequently lost all their value. Parentco claimed a s. 50(1) loss $1,000 (thereby reducing the shares’ ACB to nil) prior to winding up Subco and assuming Subco's debt.
CRA indicated that the net cost amount of the assets of Subco is $1000, and consequently Parentco should realize a capital gain of $1000 on the winding up of Subco, under s. 88(1)(b). Parentco would essentially have taken two deductions for the same loss of $1000 – first the $1000 loss on the Subco shares under 50(1), and an additional loss of $1000 on the assets of Subco. Thus, a PUC reduction to avoid the s. 88(1)(b) gain would be GAARable.
Very briefly, Example 2 indicated that where the net tax equity in the Subco assets was matched by safe income, avoidance of s. 88(1)(b) would not be abusive.