A CRA policy goal has driven it to warp the proper interpretation of s. 40(3.5)(c)(i)
It is suggested that CRA’s interpretation of s. 40(3.5(c)(i) (which can prevent the release of a suspended loss):
appears to be driven by a policy goal that suspended losses should not be released as a result of a winding up that is not subject to Canadian tax (either because the winding up qualifies for Canadian tax deferral or because the parties to the winding up are outside the reach of the Canadian tax system).
CRA's expansive interpretation of s. 40(3.5)(c)(i) (in, e.g., 2017-073715117) interprets "merger or combination" as including a winding-up, and the reference to "the corporation formed" on a merger combination as including a shareholder of a wound-up corporation. It is suggested that this interpretation renders ss 40(3.5)(c)(ii) and (iii) redundant. Based on this and other considerations, including the French version - which effectively refers to an “amalgamation” rather than the somewhat broader term “merger” (which nonetheless is not cognate with a winding-up) – it is suggested that s. 40(3.5)(c)(i) applies to Canadian amalgamations and similar foreign reorganizations, in which two or more companies merge to form a single corporate entity (such as foreign mergers described in subsection 87(8.1).).
Even if a winding up could be considered a "merger" or "combination," it would not result in the “formation” of a corporation.
Furthermore, CRA considers that a s. 40(3.5)(c)(i) merger or combination can include the winding-up of a corporation into multiple shareholders. In addition to being linguistically untenable, this interpretation effectively forces CRA to apply the stop-loss rule in ways not contemplated by its language.
For example, Canco, which owns FA3 directly and (as to the other 50% shareholding) through FA1, has a suspended loss when it drops its directly-held 50% shareholding of FA3 into FA2. CRA considers that s. 40(3.5)(c)(i) prevents the release of this suspended loss when FA3 is wound-up into (i.e., “merged” with) FA2 and FA1.
But what if Canco then sells FA1 to a third party? CRA apparently would consider FA1 to continue to own 50% of the FA3 shares, suggesting that the sale of FA1 could release 50% of the suspended loss. However, there is no support for such an approach in the words of the provision.
Neal Armstrong. Summaries of Ian Bradley and Jonathan Bright, “The Stop-Loss Rules and Corporate Reorganizations – Interpretive Challenges,” Canadian Tax Journal, (2019) 67:2, 383-410 under s. 40(3.5)(c)(i) and Statutory Interpretation - Interpretation Act, s. 33(2).