In the recent decision Gervais v. R., the Tax Court of Canada denied a taxpayer's attempt to multiply the capital gains exemption with his spouse.

Mr. Gervais owned shares, worth approximately $2,000,000, of a family owned business. In contemplation of a sale, Mr. Gervais carried out a series of transactions seeking to use his own capital gains exemption and his spouse's capital gains exemption. His strategy involved three steps:

Step 1: Mr. Gervais sold shares worth $1,000,000 to his spouse, electing out of the rollover provisions under subsection 73(1) of the Income Tax Act and creating a disposition at fair market value and a capital gain of $1,000,000. He used his capital gains exemption on this sale.

Step 2: Mr. Gervais gifted his remaining shares worth $1,000,000 to his spouse, using the rollover provisions of subsection 73(1) and creating a disposition at cost so that no capital gain was triggered on the transfer.

Step 3: The spouse sold shares worth $2,000,000 to a third-party purchaser.

The intended result of the transactions was for the spouse to own shares with a fair market value of $2,000,000, an adjusted cost base of $1,000,000 due to the averaging rules in the Act, and an inherent capital gain of $1,000,000. On the sale of shares to the third party purchaser, one half of the capital gain would be attributed back to Mr. Gervais and the spouse would use $500,000 of her capital gains exemption on the remaining portion of the gain. The Canada Revenue Agency disputed this result.

The Tax Court of Canada ruled that the sale of shares to the spouse under step 1 was on account of income and not a capital transaction. The spouse held the shares for a short time, earned no investment income and formed the intention of selling the shares before actually purchasing them. In addition, the purchase was financed with a five-year promissory note. The proceeds from the sale of shares provided a cash flow benefit to the spouse, as the promissory note did not have to be repaid at the time of the sale.

In contrast, the transfer of shares by way of gift in step 2 resulted in a capital gain on the disposition. The Tax Court ruled that there was a difference in the intention of the spouse between purchasing shares and accepting shares as a gift.

In essence, the spouse held shares of a corporation in a manner that resulted in her owning half of the shares on account of income and the other half as capital property. Since the averaging rule under subsection 47(1) of the Act applies only to capital property, the adjusted cost base of the shares acquired in step 1 could not be averaged with the adjusted cost base of the shares in step 2. As a result, the tax consequences on the sale of shares to the purchaser were as follows:

Step 1: There was no income gain or loss. The proceeds of $1,000,000 equaled the spouse's cost of $1,000,000.

Step 2: There was a capital gain of $1,000,000; all of which was attributed back to Mr. Gervais.

The Tax Court of Canada essentially placed Mr. Gervais in the same tax position as if he had sold the shares directly to the third-party purchaser.

The case will leave tax practitioners with some concern as to how the CRA will assess future transactions. Hybrid transactions are commonly undertaken prior to a share sale or when shares of an operating company are transferred to a holding company. If the outcome in Gervais is applied in these types of transactions, the entire gain could be taxed as income. Perhaps additional steps could be performed to help mitigate this concern, such as paying small dividends and extending the time period that the shares are held.

Tax practitioners may also take comfort from the outcomes in Irrigation Industries Ltd. vs MNR and Continental Bank of Canada v. R., where somewhat similar transactions were determined to be on account of capital and not income.

The decision in Gervais has been appealed to the Federal Court of Appeal but has not yet been heard. Contact your Collins Barrow advisor for more information.

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