The PUC scheme established in Copthorne does not require that all surplus be realized as dividends

While Copthorne stated that the PUC scheme in the Act was intended to prevent “a return of tax-paid investment without inclusion in income,” the Court did not state whether such inclusion should be as a dividend rather than as a taxable capital gain, i.e., the Court apparently considered that the characterization of the income inclusion does not matter so long as the transactions at issue do not result in the creation or preservation of PUC contrary to the intention of the Act. In contrast, CRA appears to seek the characterization of the extraction of all corporate surplus as dividend income, regardless of the legal substance of the transactions giving rise to such extraction.

Where tax is paid at capital gains rates on transactions involving surplus stripping and the transactions fall outside the specific bright-line tests in ss. 84.1, s 212.1, and 84(2), the transactions (or series) should not be found to violate the PUC scheme and, therefore, GAAR. Three examples:

Example 1

Mr. A, exchanges some of his common shares of his operating company (A Co, which at all times continues to carry on its business) for preferred shares and pays capital gains tax pursuant to a s. 85(1) election. He subsequently transfers the preferred shares to a holding company (B Co) for a B Co promissory note. A Co redeems the preferred shares and B Co repays the principal of the note.

Example 2

Mr. X (in transactions similar to MacDonald) transfers some of the common shares of his operating company (X Co, which at all times continues with its business), to his uncle, in exchange for a promissory note equal to the FMV of the transferred shares, thereby triggering capital gains tax. The uncle subsequently transfers the X Co common shares to his holding company (Uncleco), in exchange for a promissory note. Funds of X Co then are used to redeem the common shares held by Uncleco, with Uncleco using those funds to repay the note owing to the uncle, so that he can repay the note owing to Mr. X.

Example 3

Ms. R owns all the common shares of R Co, which transfers capital assets with unrealized gains to a newly-formed subsidiary (S Co) in exchange for S Co common shares, thereby realizing a capital gain, with those assets being leased back to R Co. R Co pays a dividend to Ms. R equaling the resulting capital dividend account balance.

In Example 1, hard ACB is legitimately created on the preferred shares for the purposes of s. 84.1. Considering that this transaction engaged GAAR would disregard the Copthorne dictum that there is no anti-surplus-stripping scheme in the Act.

In Example 2, Mr. X pays capital gains tax on each share contributing to the subsequent PUC bump on the transfer by the uncle to his holding company. Because the same result could be achieved by other means (namely, as per Example 1), there is a strong argument that GAAR should not apply in the circumstances.

In Example 3, there is no s. 84.1 concern since the transferor is a corporation rather than individual, and the objective is to create additional CDA balance (which increases from a taxable disposition), not PUC.

(Leaving aside the further implications of the comments in Robillard subsequent to this article), s. 84(2) may not apply to Examples 1 and 2 provided that (per Perrault) the company continues to carry on its business for at least one year, or if the distributions are funded with third-party money. In Example 3, per “Geransky and Kennedy, the sale of the capital assets in and of itself should not constitute a reorganization for the purposes of subsection 84(2) provided that R Co continues to carry on the same business.”

Neal Armstrong. Summary of Eytan Dishy and Chris Anderson, “The Permissibility of Surplus Stripping: A Brief History and Recent Developments,” Canadian Tax Journal (2021) 69:1, 1 -33 under s. 245(4).