General Anti-Avoidance Rule - Section 245 of the Income Tax Act
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General Anti-Avoidance Rule - Section 245 of the I.T
GENERAL ANTI-AVOIDANCE RULE SECTION 245 OF THE INCOME TAX ACT
IC88-2 October 21, 1988
1. The purpose of this circular is to provide guidance with respect to the application of the general anti-avoidance rule, section 245 of the Income Tax Act (the Act). This rule applies with respect to transactions entered into after Royal Assent is given to Bill C-139 except for:
(a) transactions that are part of a series of transactions, commencing before the day of Royal Assent and completed before 1989 (and for this purpose a series of transactions does not include any related transactions or events completed in contemplation of the series), or (b) any one or more transactions, one of which was entered into before April 13, 1988, that were entered into by a taxpayer in the course of an arrangement and in respect of which the taxpayer received from the Department of National Revenue, before April 13, 1988 a confirmation or opinion in writing with respect to the tax consequences thereof.
2. Revenue Canada, Taxation will issue advance rulings with respect to the application of the general anti-avoidance rule to proposed transactions and will publish summaries of the facts and rulings in those cases that will provide further guidance where the rulings themselves are not published.
In order to ensure that the rule is applied in a consistent manner, proposed assessments involving the rule will be reviewed by Revenue Canada, Taxation Head Office.
3. Subsection 245(2) states that where a transaction is an avoidance transaction, the tax consequences to a person shall be determined as is reasonable in the circumstances in order to deny a tax benefit that would result from that transaction or from a series of transactions that includes that transaction.
An avoidance transaction is defined in subsection 245(3) as a single transaction or one that is a part of a series of transactions where the single transaction or the series results directly or indirectly in a tax benefit, unless the transaction is carried out primarily for bona fide purposes other than to obtain the tax benefit.
"Tax benefit" is defined to mean a reduction, avoidance or deferral of tax or other amount payable or an increase in a refund of tax or other amount under the Act.
Subsection 245(4) provides that the rule in subsection (2) does not apply to a transaction where it may reasonably be considered that the transaction would not result directly or indirectly in a misuse of the provisions of the Act or an abuse having regard to the provisions of the Act read as a whole.
4. An avoidance transaction is a single transaction carried out primarily to obtain a tax benefit. Where a transaction, which is primarily tax-motivated, forms part of a series of transactions that is carried out primarily for non-tax purposes, the single transaction will nevertheless be an avoidance transaction. The fact that the series of transactions has bona fide non-tax purposes does not preclude a tax-motivated transaction that forms part of the series from being an avoidance transaction.
An avoidance transaction does not include a transaction that "may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit". The purposes of a transaction are determined not only from the taxpayer's statement of intention but also from all the circumstances of the transaction or transactions. If it can be inferred from all the circumstances that the primary or principal purpose in undertaking the transaction is other than to obtain a tax benefit, then the transaction is not an avoidance transaction.
A transaction will not be an avoidance transaction if the taxpayer establishes that it is undertaken primarily for a bona fide business, investment or family purpose. In making this determination it is important to distinguish those transactions which may have a business, investment or family effect from those which have a business, investment or family purpose. There are many transactions that have a business, investment or family effect, which may nevertheless be avoidance transactions because the primary purpose of the transaction is to obtain a tax benefit. (See, for example, paragraph 22 where the partnership has a business effect but the primary purpose of the partnership is to obtain a tax benefit.)
Misuse or abuse
5. Subsection 245(4) states that the rule does not apply to an avoidance transaction if it may reasonably be considered that the transaction would not result in a misuse of the provisions of the Act or an abuse having regard to the provisions of the Act read as a whole.
Transactions that rely on specific provisions, whether incentive provisions or otherwise, for their tax consequences, or on general rules of the Act can be negated if these consequences are so inconsistent with the general scheme of the Act that they cannot have been within the contemplation of Parliament. On the other hand, a transaction that is consistent with the object and spirit of provisions of the Act is not to be affected. Revenue Canada will follow this principle in interpreting section 245 of the Act.
6. The examples that follow illustrate the approach that Revenue Canada will take in certain situations. The transaction or transactions described are assumed to comply with the relevant provisions of the Act and not to be subject to any other anti-avoidance rule. They are also assumed for the purposes of this circular to have been undertaken primarily to obtain a tax benefit and they are, for that reason, avoidance transactions. Therefore, the issue to be determined is whether they would be regarded as a misuse of a provision of the Act or an abuse having regard to the Act as a whole. The examples are general in nature, and, for this reason, care should be exercised in extending the interpretative comments to specific situations.
7. Divisive Reorganizations (Butterflies)
At the commencement of a series of transactions that will be carried out to divide the assets of a particular corporation pursuant to paragraph 55(3)(b), 50% of the shares of the particular corporation are owned by A and 50% are owned by B, an individual with whom A deals at arm's length. The corporation carries on two businesses. The shares of the particular corporation owned by B are transferred to Bco, B's wholly-owned corporation. Bco incorporates a subsidiary, Subco, the particular corporation transfers all the property of one business to Subco, and the particular corporation and the Subco elect under subsection 85(1) in respect of the properties transferred to defer the recognition of the gain that would otherwise be realized on the transfer. Subco assumes liabilities of the particular corporation and issues to the particular corporation retractable preferred shares having a paid-up capital equal to the elected amount and a redemption amount equal to the amount by which the fair market value of the property transferred exceeds the non-share consideration. Subco redeems the preferred shares. The particular corporation purchases the common shares owned by Bco and Subco winds up into Bco. At the conclusion of the series of transactions Bco has received assets of the particular corporation in exchange for its shares of the particular corporation.
If each transaction in the series of transactions is consistent with the object and spirit of paragraph 55(3)(b), then subsection 245(2) would not apply. On the other hand if a transaction in the series of transactions results in a distribution of property that fails to comply with the object and spirit of paragraph 55(3)(b), then the particular corporation and Bco would be taxed in accordance with the provisions of subsection 55(2). This might occur, for example, if a transferee does not receive its proportionate share of each type of property of the particular corporation. However, subsection 245(2) would be applied to a transaction that is part of a series of transactions that has been structured to avoid the effects of the application of subsection 55(2).
8. Consolidation of Profits and Losses in a Corporate Group
A corporation transfers property used in its business to a related corporation to permit the deduction of non-capital losses of the related corporation. All of the shares of the two corporations have been owned by the same taxpayer during the period in which the losses were incurred.
The absence in the Act of restrictions against transferring property between related corporations, the existence of specific provisions permitting the payment of income and the transfer of losses between related corporations and references in the Explanatory Notes Relating to Income Tax Reform indicate that a transfer of the type in question is consistent with the scheme of the Act and, therefore, subsection 245(2) would not be applied.
However, if a transfer of a property or other transaction is undertaken to avoid a specific rule, such as a rule designed to preclude the deduction of losses after the acquisition of control of a corporation by an arm's length person, such a transfer would be a misuse of the provisions of the Act and be subject to section 245.
A person has property with an unrealized capital gain that it wishes to sell to a third party. A related corporation has a net capital loss. Instead of selling the property directly to the third party and realizing a capital gain, the person transfers the property to the related corporation and elects under subsection 85(1) to defer the recognition of the gain. The related corporation sells the property to the third party and reduces the resulting taxable capital gain by the amount of its net capital loss.
Subsection 69(11) does not permit a person to transfer property to an unrelated corporation on a tax-deferred basis where it is intended that the unrelated corporation will sell the property and reduce the amount of the gain by amounts of losses or similar deductions which it may claim. By implication, the subsection does permit a transfer to a related corporation on a tax-deferred basis. In these circumstances such a transfer would be acceptable as it is within the object and spirit of the Act.
10. Estate Freezes
Under a typical estate freeze arrangement a parent transfers to a newly-formed corporation all of the shares of an operating company and elects under subsection 85(1) in order to defer recognition of the gain on the transfer. The consideration for the transfer is preferred shares retractable at the option of the parent for an amount equal to the fair market value of the shares of the operating company transferred. The preference shares carry voting control. A trust for minor children of the parent subscribes for common shares of the new company for a nominal amount.
The Explanatory Notes state that estate freezes would not ordinarily result in misuse or abuse given the scheme of the Act including the recently enacted Subsection 74.4(4). Section 74.4 was enacted to deal with income splitting and could have application to certain estate freeze arrangements.
Subsection 74.4(2) may apply to deem an amount to be received as interest by an individual who loans or transfers property to the corporation and one of the main purposes of the loan or transfer may reasonably be considered to be to reduce the income of the individual and to benefit a designated person. A designated person is the individuals' spouse, or a person under 18 who does not deal with the individual at arm's length or who is the individual's niece or nephew.
Subsection 74.4(2) will not apply to "attribute" income to the individual throughout a period throughout which the corporation is a small business corporation as defined in subsection 248(1). In addition, as provided in subsection 74.4(4), the rule will not apply where the only interest which the designated person has in the corporation is a beneficial interest in the shares of the corporation which are held through a trust and the terms of the trust provide that the person may not obtain the use of any income or capital of the trust while the person is a designated person.
Subsection 245(2) will not apply to the transfer of the shares to the corporation where subsection 74.4(2) applies to deem the parent to receive an amount as interest. Similarly, subsection 245(2) would not apply where, for the reasons stated above, subsection 74.4(2) does not apply to deem the parent to receive an amount as interest.
Similar considerations would apply to other types of estate freezes involving a transfer of property by a parent to a corporation. For example, in an estate freeze carried out pursuant to section 86 of the Act, the parent would dispose of the shares of the operating company and receive preferred shares of the company having a redemption amount equal to the fair market value of the shares disposed of. The disposition of shares by the parent would constitute a transfer of property to the operating company for the purposes of subsection 74.4(2) of the Act and the application of subsection 245(2) to the transfer would be determined in the manner described above.
11. Incorporation of a Proprietorship
An individual taxpayer transfers his or her business to a corporation primarily to obtain the benefit of the small business deduction.
There is nothing in section 125 (that provides for the small business deduction) or elsewhere in the Act that prohibits an individual from incorporating his or her business. The incorporation is consistent with the Act read as a whole and, therefore, subsection 245(2) would not apply to the transfer of the business to the corporation.
12. Disposition of property
A taxpayer owns property that, if disposed of in a straightforward manner, would result in the immediate realization of income or a capital gain. The taxpayer and another taxpayer that wants to buy the property (the purchaser) form a partnership and the taxpayer transfers the property into the partnership and elects under subsection 97(2) to defer the recognition of gain which otherwise would arise. The purchaser contributes cash to the partnership in an amount equal to the fair market value of the property. The taxpayer withdraws all the cash from the partnership and, because of such withdrawal, the taxpayer's share of the income and loss of the partnership is reduced. The partnership continues to carry on business.
The use of the partnership is an attempt to circumvent the provisions that provide that proceeds of disposition of property are to be accounted for at the time of receipt and would be contrary to the scheme of the Act read as a whole. Subsection 245(2) would accordingly apply.
A corporation resident in Canada owns property, the proceeds of disposition of which would result in the immediate realization of income, a capital gain, or both. The taxpayer sells this property to an arm's length taxable Canadian corporation in consideration for redeemable shares having a redemption amount equal to the fair market value of the property sold. The taxpayer and purchaser elect under subsection 85(1) in respect of the property to defer recognition of the profit that would be realized on a straightforward sale of the property. The shares have paid-up capital equal to the amount elected so that on the redemption of the shares the taxpayer receives the profit on the sale as a taxable dividend deductible under subsection 112(1) of the Act.
If the property transferred is non-depreciable capital property, subsection 55(2) applies and the taxpayer would realize a capital gain equal to the difference between the redemption amount and the adjusted cost base of the redeemable preferred shares. Subsection 245(2) would, therefore, not apply. On the other hand, if the property transferred is depreciable property or property the proceeds of disposition of which would result in the realization of income, subsection 245(2) would apply on the basis that the issue of the preferred shares is undertaken to avoid the consequences of a straightforward disposition of the property.
14. Part IV tax on Taxable Dividends Received
Each of two private corporations owns less than 10% of the common shares of a payer corporation that is to pay a substantial taxable dividend. The payer corporation will not be entitled to a dividend refund on the payment of the dividend. None of the corporations is related to any of the others. The private corporations form a corporation, Newco, transfer their shares of the payer corporation to Newco in exchange for common shares of Newco and elect under subsection 85(1) in respect to the transfer. Following the transfer of the payer corporation's shares to Newco, Newco will be connected with the payer corporation. The payer corporation pays the dividend to Newco, free of Part IV tax. Newco pays the same amount to the private corporations as a dividend, free of Part IV tax. The primary purpose for the transfer of the shares is to avoid the Part IV tax which would be payable if the dividend were received directly by the private corporations.
As the transfer of shares to the Newco is part of an arrangement undertaken to avoid the tax required by Part IV of the Act to be paid in respect of dividends received on portfolio shares, the transfer of the shares would be a misuse of a provision of the Act or an abuse of the Act as a whole and subsection 245(2) would be applied.
15. Capital gains exemption
The common shares of a corporation would be "qualified small business corporation shares" as defined in subsection 110.6(1) except that at the time in question all or substantially all of the assets of the corporation are not used in an active business carried on primarily in Canada. The shareholders wish to sell their shares and to have the gains qualify for the special increased capital gains exemption provided by subsection 110.6(2.1) of the Act. To achieve this result, the shareholders incorporate a corporation and transfer to this corporation shares of the operating corporation that have a fair market value equal to the fair market value of the assets that are not used in the active business of the operating corporation. The operating corporation purchases these common shares from the new corporation and pays the purchase price of the shares by transferring the non-business assets to the new corporation. The operating corporation may have a tax liability arising from the disposition of the non-business assets. The new corporation may be subject to subsection 55(2) of the Act if the gain on the purchased shares is attributable to something other than income earned or realized by the operating corporation.
The formation of the new corporation and the transfer of the shares to the new corporation is not an abuse of the Act. The transfer of the non-business assets is governed by subsection 55(2) of the Act. Since the definition of a qualified small business corporation share does not require that all or substantially all of the assets be used in carrying on an active business in Canada for a particular period of time prior to the sale of the shares, the distribution of the non-business assets prior to the sale is acceptable. Therefore, in this case, the transactions undertaken to "purify" the corporation are in accordance with the scheme of the Act.
16. Services rendered to a Corporation
A corporation owes an amount for services rendered by a person who does not deal at arm's length with the corporation. The amount arises from a bona fide transaction and is deductible to the corporation. However the amount is not paid before the end of the second taxation year following the year in which the expense was incurred so as to maximize the deferral of its taxation in the hands of the person.
Section 78 (which deals with unpaid amounts) does not deny the deduction of a bona fide expense to a taxpayer in the year that it is incurred. It does, however, provide that either the taxpayer or the non-arm's length person will include the amount in income in the third taxation year following the year in which the expense is incurred. The deferral in such circumstances is contemplated by subsection 78(1) of the Act and subsection 245(2) would not apply.
An individual provides services to a corporation with which he or she does not deal at arm's length. The company does not pay a salary to the individual because payment of a salary would increase the amount of a loss that the company will incur in the year.
There is no provision in the Act requiring a salary to be paid in these or any circumstances and the failure to pay a salary is therefore not contrary to the scheme of the Act read as a whole. Subsection 245(2) would not apply to deem a salary to be paid by the corporation or received by the individual.
A Canadian-controlled private corporation pays its shareholder/manager an amount as salary that will reduce the corporation's income to its business limit for the taxation year. The amount of the salary is, however, not in excess of a reasonable amount.
Subsection 245(2) would not apply to the payment as the Act recognizes the deductibility of reasonable business expenses.
19. Deductibility of Interest Expense
A taxable Canadian corporation, which is profitable, has a wholly-owned taxable Canadian corporation that is sustaining losses and needs additional capital to carry on its business. The subsidiary could borrow the monies from its bank but the subsidiary could not obtain any tax saving in the current year by deducting the interest expense. Therefore, the parent corporation borrows the money from its bank and subscribes for additional common shares of the subsidiary and reduces its net income by deducting the interest expense. The subsidiary uses the money to gain or produce income from its business.
The borrowing by the parent corporation is for the purpose of gaining or producing income as required by paragraph 20(1)(c) of the Act and subsection 245(2) would, therefore, not apply.
A taxable Canadian corporation has agreed to purchase all of the shares of an operating corporation, which is also a taxable Canadian corporation. The purchaser incorporates a holding corporation which borrows the purchase price and pays the vendor for the shares. The holding corporation and the operating corporation amalgamate so that the interest payable on the monies borrowed to acquire the shares can be deducted in computing the income from the business of the amalgamated corporation.
The borrowing by the holding corporation and the amalgamation are not abusive and subsection 245(2) would not apply to the borrowing by the holding corporation.
21. Change of Fiscal Periods
An operating corporation merges with a shell corporation in an amalgamation described in subsection 87(1) of the Act. This merger is undertaken solely for the purpose of having the rules in paragraph 87(2)(a) deem the taxation year of the operating company to end immediately before the amalgamation, which year end will produce a tax benefit.
The definition of "fiscal period" in subsection 248(1) of the Act states that no change in the usual and accepted fiscal period may be made without the concurrence of the Minister. The use of the rules of subsection 87(2) to circumvent this requirement would be a misuse of subsection 87(1) and consequently subsection 245(2) would apply.
22. Transfer of Land Inventory
The taxpayer, a Canadian resident who holds land inventory that has appreciated in value wants to transfer the inventory on a rollover basis to a taxable Canadian corporation (the purchaser). Land inventory cannot be transferred on a tax-deferred basis under subsection 85(1). Since there is no prohibition in subsection 97(2) against transferring land inventory on a tax-deferred basis to a Canadian partnership, the taxpayer forms a partnership with the purchaser. The taxpayer transfers the land to the partnership and elects under subsection 97(2) to defer the gain on the transfer. The purchaser contributes a nominal amount of cash for its partnership interest. The vendor transfers the partnership interest to the purchaser in consideration for shares having a fair market value equal to the value of the partnership interest and the parties elect under subsection 85(1) in respect of the transfer. On the acquisition by the purchaser of the taxpayer's partnership interest the partnership ceases to exist and subsection 98(5) applies to deem the purchaser to acquire the land at the amount of the taxpayer's cost amount of the land.
The result of this series of transactions is that the taxpayer has avoided the recognition of the gain that the words of section 85 imply should be recognized in such circumstances. Although the partnership may carry on business and have a business effect, the formation of the partnership and the transfer of the land are undertaken to circumvent the prohibition in section 85. Subsection 245(2) would apply as the transfer of the land to
the partnership is contrary to the scheme of the Act read as a whole taking into account the section 85 prohibition.
23. Debtor's Gain on Settlement of Debts (Section 80)
A person who has purchased the debt and shares of a company in financial difficulty (the taxpayer) intends to reorganize the capital of the taxpayer to convert debt into shares. The debt of the taxpayer has a cost to the person that is less than its principal amount. The fair market value of the assets of the taxpayer is less than its principal amount with the result that payment of the debt by the issuance of shares will result in the application of section 80. To avoid this result the taxpayer transfers all of its property to a wholly-owned subsidiary ensuring that the amounts elected under subsection 85(1) result in the recognition of income from which the losses of the taxpayer may be deducted. The person then forgives the debt. The taxpayer amalgamates with its wholly-owned subsidiary with the result that all of the property of the subsidiary (which was formerly property of the taxpayer) becomes property of the amalgamated company. Section 80 would apply on the forgiveness of debt but only to reduce the adjusted cost base of the shares of the subsidiary. Since these shares are cancelled on the amalgamation, the application of the section is of no effect.
In this situation the transfer of the assets of the taxpayer to the wholly-owned subsidiary that is undertaken solely to avoid the results of a straightforward forgiveness of the debt would be subject to subsection 245(2).
24. Reserves for an Amount not due until a Later Year
The owner of real property has agreed to sell the property to an arm's length purchaser. The purchaser wants to buy the property for cash, but the owner does not want to recognize the sale proceeds in the year of sale. The owner sells the real property to an intermediary company deferring receipt of the proceeds of disposition of the property for more than two years after the date of sale. The intermediary immediately sells the property to the third party for cash. The owner receives interest from the intermediary in respect of the monies received by the intermediary from the third party.
As the interposition of the intermediary is made solely to enable the owner of the property to defer recognition of the gain the sale of the real property to the intermediary would be subject to subsection 245(2).
25. Dividend Stripping (Subsection 247(1))
As a consequence of the introduction of section 245, subsection 247(1) is repealed. Subsection 247(1) is directed at a transaction or series of transactions one of the purposes of which is to effect a significant reduction of, or disappearance of, assets of a corporation in order to avoid the whole or part of the tax that would have been payable on the distribution of property of a corporation.
In 1986, Revenue Canada, Taxation confirmed that subsection 247(1) could apply to a transaction or series of transactions that were undertaken to circumvent specific provisions that provided that a shareholder who disposes of shares to the issuing corporation account for an amount received on the disposition as a dividend rather than as proceeds of disposition. The specific rules mentioned at that time were sections 84.1 and 212.1 and subsections 66.3(2), 85(2.1), 192(4.1) and 194(4.1). The latter two subsections have since been repealed and subsection 85.1(2.1) has been enacted to restrict the increase in paid-up capital on a share for share exchange.
Also, Part II.1 imposes a tax on certain corporations that pay an amount to a taxpayer as a substitute for normal dividends if they pay such amount in a manner that allows the recipient to account for the amount received as proceeds of disposition of property.
Provisions, such as those mentioned above, indicate the circumstances in which amounts received by a shareholder of a corporation from the corporation on a disposition of shares or other property are to be accounted for as a dividend. 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 the provision in question.
26. Issue of stock dividend
A private corporation wishes to provide an annual dividend payment to its individual shareholders as tax-free capital gains. The corporation as part of an arrangement pays a stock dividend to its shareholders where the stock dividend shares received have a low paid-up capital and a high fair market value. As part of the same arrangement the shares are purchased by a corporation related to the issuing corporation or a third party broker or dealer where the purchase price of the shares is funded by the issuing corporation.
As the payment and repurchase of the stock dividend shares is part of an arrangement to avoid the shareholder tax required to be paid on dividends from the corporation, the payment and repurchase would be a misuse of a provision of the Act or an abuse of the Act as a whole and subsection 245(2) would apply.
Subsection 245(2) may also apply in other situations involving a reduction of assets of a corporation.
27. Conversion of Salary into Capital Gain
An employee of a private corporation wishes to receive a bonus, salary or a portion of the employer's profit as a capital gain in order to claim the capital gains exemption. The employee subscribes for preferred shares of the employer, which are redeemable at a premium that reflects a portion of the employees annual salary or the employer's book profit. Prior to their redemption, the preferred shares are purchased by a company related to the employer corporation, thereby allowing the employee to receive a distribution of surplus as a capital gain.
The acquisition of the preferred shares is part of an arrangement designed to avoid the tax that would have been required to be paid on salary. The acquisition therefore results in an abuse of the Act as a whole and subsection 245(2) would apply.
28. Redemption of Preferred Shares following an Amalgamation
A taxable Canadian corporation merges with another taxable Canadian corporation that is a shell company. On the merger the shareholders who controlled the predecessor receive common shares of the merged company and the minority shareholders of the predecessor receive redeemable preferred shares that are immediately redeemed. The sole reason that the minority shareholders receive shares instead of cash is to cause the merger to comply with the requirements of paragraph 87(1)(c) of the Act.
Subsection 245(2) would not apply to the issue of the preferred shares as such issue is not regarded a misuse of a provision of the Act or an abuse of the Act read as a whole.
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