Sabex (a.k.a., 3295940) – Tax Court of Canada finds that a circular use of capital dividends abused s. 55(2) and the purpose of the CDA

The taxpayer (3295940) was a holding company holding a shareholding in a Target with a low ACB (even after using safe income on hand to step up such ACB), whereas the holding company (Micsau) holding shares in 3295940 had a high ACB for its shares. Unfortunately, the third-party purchaser (Novartis) was unwilling to acquire the shares in the capital of 3295940 (due to potential liabilities), and was only interested in acquiring shares from 3295940 itself.

Under the plan to try to address this:

1. Micsau created a sister company (4244) to 3295940 to which it transferred newly-created pref shares of 3295940 having full ACB in exchange for full-ACB shares of 4244.
2. 3295940 then transferred its Target shares to 4244 on a partial s. 85 rollover basis, so that it effectively realized a capital gain corresponding to high-ACB prefs received by it from 4244, and also took back common shares of 4244 with a high FMV and nominal ACB.
3. 3295940 redeemed the prefs held by 4244 for a $31.5M note, and elected for the resulting $31.5M deemed dividend to be a capital dividend paid to 4244.
4. 4244 redeemed $31.5M of the low-ACB common shares that it had issued to 3295940 in Step 2 for a $31.5M note, and elected for the resulting $31.5M deemed dividend to be a capital dividend paid to 3295940.
5. Then the two notes were set off, Micsau transferred its shares of 4244 to 3295940, and 3295940 sold the shares of 4244 to Novartis at no further capital gain.

Favreau J noted that the total capital gain realized by 3295940 (on Step 2) was $31.5M lower than if 3295940 had simply sold its shares of Target outright to Novartis. He considered that, normatively, 3295940 should have been caused by s. 55(2) to have realized a capital gain of $31.5M on Step 4. However, this result was avoided because the resulting deemed dividend paid to 3295940 was a capital dividend (representing a recycling of CDA that had originated with it) rather than a taxable dividend that would then have been converted by s. 55(2) to a capital gain. This represent a GAAR abuse of ss. 55(2) and the capital dividend system. He stated:

The capital dividend was used in a way that is not consistent with its purpose: instead of allowing tax-free amounts to flow upwards in the corporate group, the amount circulated back to its starting point, in the hands of 3295940.

This recycling of the capital dividend prevented subsection 55(2) from applying and converting the deemed dividend paid by 4244 to 3295940 into a capital gain. The application of subsection 55(2) would have allowed the entire appreciation in value of the Holdings shares to be taxed, thereby preserving the integrity of the capital gains tax regime.

Regarding the taxpayer’s submission that it was appropriate for it to effectively access the high ACB of Micsau in the shares of 3295940, Favreau J noted that, in light of s. 88(1)(d.2), Micsau could not have used s. 88(1)(d) to bump the low ACB of the shares of Holdings to 3295940, and stated that 3295940 “reached the same result as if there had been a bump of the shares held by it, but without having to satisfy the required conditions.”

Regarding the submission of the taxpayer that (but for commercial roadblocks) it could have achieved a similar result by more directly using the high ACB of Micsau in 3295940, he stated:

[I]t was demonstrated that the sale of [the Target] shares was paramount. That being the case, the alternative transactions involving the sale of 3295940 shares cannot be submitted for comparison … .

Neal Armstrong. Summary of 3295940 Canada Inc. (formerly, Sabex Inc.) v. The Queen, 2022 CCI 68 under s. 245(4).