Canada: Surplus Stripping Limits Clarified

Although the taxpayers were largely unsuccessful in the case of Descarries v. R., 2014 TCC 75, the decision of Tax Court Judge Hogan J. provides a useful analysis of the limits to be applied to "surplus stripping" and contains much that is positive for taxpayers.

The facts are quite complicated but for present purposes can be simplified and summarized as follows.

The shareholders of La société l'immobilière d'Oka Inc. ("Oka") held shares of Oka that had a low paid-up capital ("PUC") and an aggregate adjusted cost base ("ACB") that resulted in large part from the value of the shares on December 31, 1971 when capital gains were first introduced (the "V-day ACB") and also from transactions unrelated to the value on December 31, 1971 or the capital gains deduction.

The Appellants, being the shareholders of Oka, carried out a complicated series of transactions involving an increase of the ACB of the Oka shares by way of an internal reorganization, the rollover of the Oka shares to a holding company ("Holdco") for preferred shares of Holdco and, finally, the redemption of the preferred shares of Holdco.  One of the results of this series of transactions was that the Appellants received the V-day ACB of the Oka shares on a tax-free basis.

The Minister reassessed the Appellants on the basis that all of the proceeds of redemption in excess of the PUC of the shares should be deemed to be a dividend under subsection 84(2) of the Income Tax Act (Canada) ("ITA") or, alternatively, that subsection 84(2) had been abused and the general anti-avoidance rule ("GAAR") should apply.

For reasons not discussed here, Hogan J. concluded that subsection 84(2) did not apply to the series of transactions, nor did the transactions constitute an abuse of subsection 84(2) for purposes of the GAAR.

Instead, although the issue was not pled by the parties, Hogan J. concluded that section 84.1 ITA had been abused and applied the GAAR to treat all the proceeds in excess of the good ACB (the portion unrelated to the V-day ACB or to the capital gains deduction) as a dividend.

Despite the fact that Hogan J. found against the taxpayers in this case, his comments on the applicability of the GAAR to treat all corporate distributions in excess of PUC as dividends were very interesting and may prove helpful in future cases.

In paragraph 43 of the judgment, Hogan J. reiterated his comments in Gwartz v. The Queen, 2013 TCC 86:

... I noted in Gwartz v. The Queen that the Act does not contain any general prohibition stating that any distribution by a company must be done in the form of a dividend.  However, I also specified in that case that, although the taxpayers may arrange to distribute surpluses in the form of dividends or of capital gains, that option is not limitless.  Any tax planning done for that purpose must comply with the specific anti-avoidance provisions found in sections 84.1 and 212.1 of the Act.

Having stated that taxpayers may arrange to distribute corporate surplus as dividends or as capital gains subject only to section 84.1 (or section 212.1 in the case of non-residents), Hogan J. went on to analyze section 84.1 and concluded at paragraph 53 of the judgment that:

Paragraphs 84.1(2)(a) and (a.1) and subsection 84.1(2.01) change how the adjusted cost base of the subject shares is calculated for the purposes mentioned above.  Under the rules established in these provisions, the part of the adjusted cost base of the subject shares that is attributable to the value accumulated as of 1971 is not recognized in order to prevent shareholders from using the tax-exempt margin to strip a corporation of its surpluses.  This adjustment also applies when the shareholders purchased the subject shares after 1971 from a person with whom they were not dealing at arm's length.  A similar rule applies to prevent the capital gain exemption from being used to strip a corporation of its surpluses in similar cases.  In summary, the specific rules show that the object, spirit or purpose of section 84.1 of the Act is to prevent taxpayers from performing transactions whose goal is to strip a corporation of its surpluses tax-free through the use of a tax-exempt margin or a capital gain exemption.

Hogan J.'s analysis clearly demonstrates that, to the extent that neither the value accumulated as of December 31, 1971, nor related party capital gains deductions have been used to result in tax-free distributions, GAAR should not apply to prevent taxpayers from arranging to distribute corporate surpluses in the form of dividends or capital gains.  Since dividends are taxed at top marginal rates that may be as much as 15 percentage points higher than capital gains, taxpayers contemplating a significant corporate distribution should consider structuring the distribution so that it will be taxed as a capital gain rather than a dividend.  This will generally be possible by way of an internal reorganization or other transaction to create a capital gain with respect to the shares and the subsequent transfer of the shares to a holding corporation.

The Decarries case is confirmation that, to the extent that neither the tax-free margin resulting from the value of the shares on December 31, 1971, nor the capital gains deduction is involved, corporate distributions can be structured as capital gains without the GAAR applying to change the capital gain into a dividend.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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