12 August 2003 Internal T.I. 2003-0029717 - Stock Dividends

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: (1) Whether series of transactions resulting in creation of non-capital loss subject to GAAR and (2) whether losses which arose from sale of shares could be characterized as capital loss in the alternative even though taxpayer carried on business as a securities trader.

Position: (1) Yes and (2) Yes.

Reasons: (1) Transactions are very similar to transactions that were successfully challenged under former s. 55(1), which was replaced by GAAR. Therefore, GAAR should be applied to the series of transactions in question. (2) The sale of shares in question can be distinguished from the taxpayer's trading activities and are therefore capital in nature.

		August 12, 2003

	XXXXXXXXXX  Tax Services Office	J. MacGillivray
(613) 948-5274
	Attention:  XXXXXXXXXX
		2003-002971

Stock Dividends

Reference is made to our telephone conversations of July 11 and 14, 2003 (XXXXXXXXXX/MacGillivray) and your e-mail correspondence of July 11, 2003 in which you requested our views with respect to the completed transactions described below, which are presently being reviewed by your office.

In XXXXXXXXXX, the taxpayer ("Gco"), a corporation resident in Canada for the purposes of the Income Tax Act (Canada) (the "Act"), entered into a series of transactions whereby it realized a loss from a sale of shares of a newly formed wholly-owned subsidiary ("Aco") to a trust (the "Trust").

The loss was deducted in computing Gco's income as a loss from its securities trading business, thereby creating a non-capital loss that was carried back to reduce income in Gco's prior taxation years.

Gco incorporated Aco on XXXXXXXXXX. By XXXXXXXXXX, Gco had subscribed for XXXXXXXXXX Common Shares of Aco for aggregate consideration of $XXXXXXXXXX. On XXXXXXXXXX, Aco declared and paid a stock dividend on the Common Shares by issuing XXXXXXXXXX Preferred Shares to Gco. The Preferred Shares were retractable by Aco and redeemable by Gco at a redemption/retraction price of $XXXXXXXXXX per share. As a result, the fair market value of the Preferred Shares of Aco was $XXXXXXXXXX and the fair market value of the Common Shares of Aco was $XXXXXXXXXX immediately after the payment of the stock dividend (i.e., the payment of the stock dividend shifted value from the Common Shares to the Preferred Shares in an aggregate amount equal to the redemption amount of the Preferred Shares). The declared amount of the stock dividend was $XXXXXXXXXX. This amount was added to the stated capital account maintained in respect of Aco's Preferred Shares.

Gco then sold all of the Common Shares of Aco to the Trust for $XXXXXXXXXX. In its XXXXXXXXXX income tax return, Gco reported a loss on this transaction of $XXXXXXXXXX, which is the subject of your inquiry. You have also advised us that the Trust is a shareholder of Gco.

You have asked us to consider whether the general anti-avoidance rule ("GAAR") in s. 245 of the Act should be applied to the above series of transactions in order to deny the loss and whether the loss realized by Gco on the disposition of the Common Shares of Aco should be treated as a capital loss as opposed to a loss from a business.

Our Comments

We believe that GAAR would apply to the above series of transactions and thereby disallow the deduction of the loss arising from the sale of the Common Shares to the Trust. It is clear that the above series of transactions would provide a significant tax benefit to Gco in the form of a non-capital loss were it not for the application of GAAR. The payment of the stock dividend to Gco, which shifted value away from the Common Shares, appears to have been carried out for the sole purpose of creating an inherent loss on the Common Shares that was to be realized on a contemplated disposition of the Common Shares to the Trust. Therefore, the stock dividend cannot reasonably be considered to have been undertaken for any purpose other than to obtain the tax benefit that results from the above series of transactions. Consequently, we believe that the payment of the stock dividend to Gco is an avoidance transaction.

In addition, we believe that this transaction results in an abuse having regard to the provisions of the Act read as a whole. It is our view that the decision of the Tax Court of Canada in 216663 Ontario Ltd. v. R., [1998] 3 C.T.C. 2425, supports the application of GAAR in these circumstances. In 216663 Ontario Ltd., the taxpayer's claim for an allowable business investment loss on a sale of a corporation's common shares was rejected in respect of a similar series of transactions whereby preferred shares of the corporation were issued in order to shift value away from the common shares, which were then sold by the taxpayer for a loss. The Court applied former s. 55(1) of the Act, which provided:

'55. (1) Avoidance - For the purposes of this subdivision, where the result of one or more sales, exchanges, declarations of trust, or other transactions of any kind whatever is that a taxpayer has disposed of property under circumstances such that he may reasonably be considered to have artificially or unduly

(a) reduced the amount of his gain from the disposition,
(b) created a loss from the disposition, or
(c) increased the amount of his loss from the disposition,

the taxpayer's gain or loss, as the case may be, from the disposition of the property shall be computed as if such reduction, creation or increase, as the case may be, had not occurred.'

This provision was repealed in conjunction with the introduction of GAAR in 1988. The 1988 Technical Notes to the Income Tax Act that discuss the repeal of the provision state the following:

"Subsection 55(1) is an anti-avoidance provision aimed at transactions designed to artificially or unduly reduce a capital gain or increase or create a capital loss on a disposition of property.

Subsection 55(1) is repealed as a consequence of the introduction of new section 245, which constitutes a general anti-avoidance rule. Because the scope of that general anti-avoidance rule is broad enough to cover the transactions to which subsection 55(1) was intended to apply, that subsection is no longer necessary. Subsection 55(1) is repealed."

Having regard to the foregoing, it is our view that GAAR was intended to apply to transactions designed to artificially create losses and should therefore apply to the series of transactions in question. The deduction of such artificial losses would result in an abuse having regard to the provisions of the Act read as a whole.

Alternatively, we agree that the loss on the disposition of the Common Shares to the Trust would be a capital loss as opposed to a loss from a business. While we understand that Gco is in the business of XXXXXXXXXX, the determination of whether losses from a sale of any XXXXXXXXXX are ordinary business losses or capital losses requires an examination of all relevant facts and circumstances. In our view, the circumstances surrounding the acquisition and sale of the Common Shares can be distinguished from Gco's normal trading activities and are therefore more appropriately characterized as the acquisition and disposition of a capital property for tax purposes.¹

In addition, Gco did not appear to acquire the Common Shares with any view to realizing a profit on a subsequent sale. Instead, the intent of the above series of transactions was to create a loss on the sale of those Common Shares. Given the absence of any profit element that could be tied to the acquisition and sale of Common Shares, it would be difficult for the taxpayer to successfully argue that the above transactions constituted an adventure or concern in the nature of a trade in order to characterize the losses on the sale of the Common Shares as non-capital losses.

Finally, we note that the series of transactions was carried out such that the amount of the dividend was less than the fair market value of the Preferred Shares issued in payment thereof. Presumably, one of the reasons to declare a nominal dividend was to avoid any potential s. 55(2) issues that could have arisen if the amount of the dividend was declared to be equal to the fair market value of the Preferred Shares.²

The validity of this type of stock dividend may provide a further alternative assessing position since it is unclear whether the payment of a "high-low" stock dividend complies with relevant corporate laws. In the past, we have stated that the amount of the stock dividend for tax purposes will be equal to the amount added to stated capital for corporate law purposes even if the amount added is less than the fair market value of the shares issued in payment of the stock dividend but only if the applicable corporate law statute allows the lesser amount to be added.³ However, even if this type of stock dividend was not permitted under applicable corporate laws, the issue of shares in payment of the dividend may still be valid, with the result that value would still have been shifted away from the shares upon which the dividend was paid. We therefore recommend that GAAR and the capital loss characterization be the primary grounds relied upon for disallowing the deduction of the non-capital losses that resulted from the sale of the Common Shares.

We trust that the foregoing comments are of assistance. As discussed previously, you have advised that the Tax Avoidance Section of the XXXXXXXXXX Tax Services Office will be contacted with respect to any further review of the transactions in the context of a GAAR reassessment.

Yours truly,

Mark Symes
for Division Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Legislation Branch

cc: Sharon Gulliver
Manager, GAAR and Technical Support Section I
Tax Avoidance and Special Audits Division
Compliance Programs Branch
112 Kent Street
Ottawa, Ontario K1A 0L5

ENDNOTES

¹ As stated above, it is our understanding the Trust is a shareholder of Gco. While we do not have sufficient information to provide any definitive comments on this point, we would add that the recognition of any capital loss by Gco that arises on the disposition of the Common Shares could be suspended pursuant to s. 40(3.4) of the Act if the Trust is affiliated with Gco.

² In addition, it appears that the addition to the stated capital account maintained in respect of the Preferred Shares would be restricted under corporate law since XXXXXXXXXX. If Aco's only asset after the stock dividend was the cash proceeds received from Gco for the subscriptions of Common Shares and there were no liabilities, the addition of any amount to the stated capital of the Preferred Shares in connection with the stock dividend would cause a breach of XXXXXXXXXX.

³ E 2001-0094305 and E9304837.

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