CRA would seriously consider applying GAAR where excluded share status is achieved through shifting a professional services business
A professional corporation (PC1) whose non-voting equity was held equally by a physician (Dr. A) and Spouse A (who had no involvement in the practice) applied earnings to build up a large investment portfolio, which CRA noted very well might be an investment business (notwithstanding that a brokerage did all the investing work) given that the “courts have generally held that the level of activity required to conclude that a corporation has a business is low.” However, on December 30 of Year 1, PC1 ceased carrying on its medical services business, on December 31, Spouse A acquired 50% of Dr. A’s voting shares, and on January 1 of Year 2, Dr. A commenced carrying on the medical services business in a newly- incorporated professional corporation (PC2) with the same ownership as prior to December 30.
After finding that (i) the medical services business of PC1 constituted a related business in respect of Spouse A as regards any dividends paid on December 31 of Year 1 notwithstanding that such business had been previously discontinued and (ii) that such dividends paid by PC1 likely were “derived directly or indirectly” from such related business “given that the capital invested in the Portfolio was wholly-derived from either after-tax earnings of PC1’s medical services business or reinvested investment income,” CRA turned to the question of whether, if PC1 had an investment business the shares of Spouse A qualified as “excluded shares” in Year 2 - and found that this technically appeared to be the case. In particular, the test under para. (c) of the excluded share definition was by its terms to be applied to the results of the previous year (Year 1) and “all or substantially all of the income of PC1 is derived directly or indirectly from one or more related businesses (i.e., the medical services business and the investment business) in Year 1, and PC1 is still carrying on these businesses in Year 1” so that “any dividends paid from PC1 to Spouse A in Year 2 would be an ‘excluded amount’ and not subject to TOSI.”
However, CRA stated:
[T]he facts in the above scenario strongly suggest that these transactions were undertaken primarily to ensure that the shares of PC1 could meet the definition of “excluded shares” such that the “excluded amount” exemption would be available to Spouse A. If it is determined that any transaction, either alone or as part of a series, has been undertaken primarily to obtain the “excluded amount” exemption under paragraph 120.4(1) in a manner that would frustrate the object, spirit and purpose of section 120.4, the CRA would seek to apply the GAAR.
The condition in para. (c) of “excluded shares” would not be satisfied in Year 3 or subsequently, so that the shares of Spouse A would not be excluded shares in those years. Furthermore, "any dividend paid by PC1 to Spouse A would be considered to be derived directly or indirectly from a 'related business' carried on by PC2 (and not PC1) in Year 2 and subsequent years," given that the "derived directly or indirectly" phrase was to be construed broadly.