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
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
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
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.
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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