12 October 1995 Internal T.I. 9525030 - SURPLUS STRIPS

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.

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

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

Principal Issues:

Application of Section 84.1 to factual non-arm's length situations

Position:

it applies

Reasons:

1995 Ontario Tax Conference
October 12, 1995

Dealing at Arm's Length and Acting in Concert: Section 84.1 and Subsection 245(2)

QUESTION 1

In view of the fact that Revenue Canada would not normally consider a capital gains exemption crystallization transaction an abuse of the Act read as a whole, and if there is a sustainable argument that each of Mr. X and Mr. Y are, as a question of fact, dealing with each of Yco and Xco at arm's length, why would GAAR apply to this transaction? Section 84.1 sets out specific circumstances in which an individual's proceeds from the sale of shares to a non-arm's length company are subject to deemed dividend treatment, so how can it be said that the purpose of section 84.1 has been thwarted?

Department's Position

Although the Department accepts that the crystallization of a capital gain to take advantage of the taxpayer's capital gains deduction may not be abusive, in and by itself, it is the Department's view that in a closely-held situation the steps taken to crystallize the gain must comply with the provisions of section 84.1. Section 84.1 is an avoidance provision which is intended to prevent the conversion of taxable corporate surplus into proceeds of disposition of the corporation's shares which may result in an exempt capital gain in the hands of the individual shareholder.

Section 84.1 applies when an individual who resides in Canada disposes of capital property consisting of shares in a Canadian corporation (the subject corporation) to another corporation in a non-arm's length transaction following which the subject corporation is connected with the purchaser corporation within the meaning of subsection 186(4) (i.e. where no Part IV tax would be payable on a dividend paid by the subject corporation to the purchaser). The basic rule under subsection 84.1(1) is that the maximum amount that can be received by the individual transferor from the purchaser corporation as proceeds in the form of any non-share consideration and the paid-up capital of any share consideration is restricted to the greater of the paid-up capital of the transferred shares and what is generally referred to as the individual's arm's length actual adjusted cost base of the shares. Consequently, an acceptable capital gains crystallization should not involve any actual or potential surplus strip.

In the situation described, if each of Mr. X and Mr. Y had transferred his shares of Aco to a company owned by him for consideration consisting of an interest bearing note, the provisions of paragraph 84.1(1)(b) would have applied as intended to deem each of them to have received a dividend to the extent that the amount of the note exceeded the greater of the paid-up capital of the Aco shares which were transferred or the arm's length actual adjusted cost base of such shares. In our view, the result of Mr. X transferring his Aco shares to Mr. Y's company and Mr. Y transferring his Aco shares to Mr. X's company is no different than if they had each transferred the shares to their own holding company. Since it is difficult to imagine any bona fide reason for structuring the transactions in this manner other than an attempt to avoid the application of paragraph 84.1(1)(b) to a situation to which it was intended to apply, it is the Department's view that these transfers would constitute avoidance transactions within the meaning of subsection 245(3) of the Act. We believe that the situation described is one contemplated in paragraph 25 of Information Circular 88-2 where it is stated: "If as a result of a series of transactions a shareholder realizes a capital gain on the disposition of property and a transaction in the series is an avoidance transaction, subsection 245(2) will be applied to the transaction if it is determined that the series of transactions was carried out to thwart the purpose" of a specific provision such as section 84.1.

Consequently, while we believe that there is a good argument that paragraph 84.1(1)(b) will apply since Mr. X, Mr. Y, Xco and Yco are acting in concert without separate interests in respect of these transactions, the Department would also rely on subsection 245(2) to challenge this and similar arrangements.

QUESTION 2

If Xco was wholly-owned by Mrs. X and Yco was wholly-owned by Mrs. Y, would a sale by Mr. X of a 45% interest in Aco to Yco and a sale by Mr. Y of his 45% interest in Aco to Xco result in a different answer? Would the Department's answer be influenced by how the repayment of the promissory note issued by each of Xco and Yco was funded? For example, if Mrs. X and Mrs. Y borrowed the funds from a financial institution and used the money to subscribe for shares in their respective companies which in turn used the funds to repay the promissory notes?

Department's Position

In the situation described, if each of Mr. X and Mr. Y had transferred his shares of Aco to a company owned by his respective wife for consideration consisting of an interest bearing note, the provisions of paragraph 84.1(1)(b) would have applied as intended to deem each of them to have received a dividend to the extent that the amount of the note exceeded the greater of the paid-up capital of the Aco shares which were transferred or the arm's length actual adjusted cost base of such shares. In our view, the result of Mr. X transferring his Aco shares to Mrs. Y's company and Mr. Y transferring his Aco shares to Mrs. X's company is no different than if each had transferred his Aco shares to his own wife's holding company. Although there may be legitimate non-tax reasons for each of Mr. X and Mr. Y transferring his Aco shares to his own wife's holding company, it is difficult to imagine any bona fide reason for structuring the transactions in the manner described other than an attempt to avoid the application of paragraph 84.1(1)(b) to a situation to which it was intended to apply. It is, therefore, the Department's view that these transfers would constitute avoidance transactions within the meaning of subsection 245(3) of the Act. Since the series of transactions would again appear to be carried out to circumvent the provisions of section 84.1, the Department would also rely on subsection 245(2) to challenge this arrangement. However, since these transfers seem to be interdependent, we believe that a good case can be made that the parties are acting in concert such that section 84.1 will apply.

The manner in which the repayment of the promissory note issued by each of Xco and Yco was funded would not influence our view.

QUESTION 3

If Mr. X's shares of Aco consisted of a separate class of voting common shares of which 55 were issued and outstanding and held by Mr. X and the only other class of shares of Aco consisted of non-voting common shares of which 45 were issued and outstanding and held by Mr. Y, would Revenue Canada's position on the application of section 84.1 and GAAR be any different if the transactions outlined in the Access Letter were completed in the manner described therein?

Department's Position

As mentioned in our response to question 1, section 84.1 applies only where the Canadian corporation whose shares are transferred is connected with the purchaser corporation for purposes of Part IV of the Act immediately following the transfer.

Since Xco will not own any voting common shares of Aco, Aco will not be connected with Xco unless Mr X transferred his remaining 10 voting common shares of Aco to it. Consequently, section 84.1 would not be applicable to Mr. Y's transfer of his non-voting shares of Aco to Xco, even if it is determined that Mr. Y and Xco are not dealing at arm's length with respect to these transactions.

Whether section 84.1 would apply to Mr. X's transfer of the 45 voting common shares of Aco to Yco would depend on a consideration of all of the relevant facts of the particular situation. Although Yco will be acquiring de jure control of Aco, if it is determined that the operation and management of Aco have not been affected by the transactions and that they have been undertaken in an attempt to circumvent the provisions of section 84.1, then the Department would likely argue that Mr. X and Yco are, as a question of fact, dealing at non arm's length such that section 84.1 will apply to deem Mr. X to have received a dividend. For the reasons explained previously, GAAR would likely also be applied to challenge this arrangement.

In addition, if as part of the series of transactions, Mr. X transferred all or some of his remaining voting common shares of Aco to Xco such that Aco would become connected to Xco, the Department would consider applying GAAR to Mr. Y's transfer of his shares of Aco to Xco.

QUESTION 4

If Mr. X sold 45% of the shares of Aco to Mrs. Y for a promissory note and Mr. Y sold his shares of Aco to Mrs. X, section 84.1 would not apply to these transfers as the respective purchasers are not corporations. Assume that each of Mr. X and Mr. Y claim their capital gains exemption in respect of the capital gain arising on these share transactions. If, independently and at a subsequent date, either or both of Mrs. X and Mrs. Y decide to transfer their shares of Aco to their own corporations, would the adjusted cost base of the Aco shares for purposes of applying section 84.1 be reduced by the capital gains exemptions that were claimed by Mr. Y and Mr. X, respectively.

Department's Position

It is difficult to imagine any bona fide reason for structuring the transactions in this manner other than an attempt to avoid the application of paragraph 84.1(2)(a.1) to a situation to which it was intended to apply. If each of Mr. X and Mr. Y had transferred his shares of Aco to his own wife for consideration consisting of a promisory note, the provisions of paragraph 84.1(2)(a.1) would have applied to reduce the wives' adjusted cost base of such shares for purposes of section 84.1 by an amount equal to the capital gains exemption claimed by her husband in respect of such transfer. In our view, the result of Mr. X transferring his Aco shares to Mrs. Y and Mr. Y transferring his Aco shares to Mrs. X is no different than if each had transferred his Aco shares to his own wife.

We believe that there is a good argument that paragraph 84.1(2)(a.1) will apply on the basis that Mr. X, Mr. Y, Mrs. X and Mrs. Y are acting in concert without separate intersts in respect of these transactions. However, the Department would also rely on subsection 245(2) to challenge this arrangement.

QUESTION 5

Assume that all of the shares of Aco are owned by Mr. X and that all of Aco's assets are used in carrying on an active business in Canada. The shares have been owned by Mr. X for over 2 years and the company has been a small business corporation throughout that period. The shares have nominal paid-up capital and adjusted cost base. An unrelated third party, Buyco, has approached Mr. X and Aco about purchasing all of the assets of Aco for cash. Mr. X has never used any of his lifetime capital gains exemption and he does not have a cumulative net investment loss.

Mr. X, Aco and Buyco structure the transaction so that as a first step, Buyco purchases from Mr. X shares of Aco which have a fair market value of approximately $500,000. Aco then purchases for cancellation the shares that were purchased by Buyco from Mr. X. Following these transactions, Buyco purchases the remaining net assets of Aco from Aco.

In case (a), Aco is connected with Buyco immediately after it purchases shares of Aco from Mr. X.

In case (b), Aco is not connected with Buyco immediately following the share purchase from Mr. X.

Would the Department seek to apply either section 84.1 in case (a) or subsection 245(2) in case (b) and on what basis?

Department's Position

Case (a)

In the situation where Aco is connected with Buyco immediately after Buyco's acquisition of the Aco shares, the Department would seek to apply paragraph 84.1(1)(b) to the sale. In our view, Buyco is merely accommodating Mr. X by structuring the transactions in this manner, since it has no independent interest in acquiring the Aco shares and its acquisition of the shares appears to be on the condition that they be immediately repurchased for cancellation. Consequently we believe that Mr. X and Buyco are not, in fact, dealing at arm's length in respect of this aspect of the transaction. For the reasons explained in our response regarding case (b) we would argue that if section 84.1 is not applicable GAAR is applicable to the transactions.

Case (b)

In our view, the economic substance of the transactions is that Buyco is buying the assets, rather than the shares, of Aco. We would consider the attempt by Mr. X to receive a portion of the proceeds as a tax-free capital gain would constitute a series of transactions one of the purposes of which is to effect a significant reduction of, or disappearance of, assets of Aco in order to avoid the whole or any part of the tax that would have been payable on the distribution of the property by Aco to which former subsection 247(1) would have been applicable. Since GAAR is intended to apply to those arrangements to which former subsection 247(1) would have applied, GAAR would apply unless the series of transactions does not include an avoidance transaction. In our view, the sale of the shares of Aco by Mr. X to Buyco is an avoidance transaction since there is no apparent bona fide non-tax purpose for the sale. This is evidenced by the fact that the shares are to be immediately purchased for cancellation by Aco. Since the series of transactions includes an avoidance transaction and subsection 245(4) is not applicable, subsection 245(2) would be applied to deny the tax benefit (i.e. the receipt of the proceeds as a tax-free capital gain) and to recharacterize the proceeds as a dividend.

In addition, on the basis of the decision in Smythe et al. v. M.N.R. 69 DTC 5361, the Department would also argue that the $500,000 received by Mr. X represented funds or property of Aco which have been distributed or otherwise appropriated in any manner whatever to or for the benefit of Mr. X on the winding-up, discontinuance or reorganization of its business such that subsection 84(2) would apply to deem the amount to be a dividend received by him.

Author: T. Harris
File: 952503
Date: September 21, 1995