Canada: Half-Loaf Fully Baked?

In the recent decision Gervais v. R.1, the Tax Court of Canada confirmed the application of the general anti-avoidance rule ("GAAR") to a taxpayer who attempted to benefit from his spouse's lifetime capital gain exemption.  The tax plan implemented is colloquially known as the "half-loaf plan".

The case was first heard by the Tax Court of Canada and then appealed to the Federal Court of Appeal, which returned the case to the Tax Court of Canada to analyse the GAAR issue.

The facts of Gervais are as follows.  Gervais and his brother were the only shareholders of Vulcain Alarm Inc. (the "Target").  In May or June 2002, an arm's length purchaser, BW Technologies Ltd. (the "Purchaser") made an offer to acquire all of the shares of the Target.  In September 2002, Gervais and his brother reorganized the share capital of the Target such that Gervais held (among other shares) 2,087,778 Class "E" Preferred shares in the share capital of the Target (the "Preferred Shares").  The redemption amount of the Preferred Shares is $1.00 per share, or $2,087,778 in aggregate.  After the deal with the Purchaser was approved by the shareholders of the Target, Gervais sold one-half of his Preferred Shares to his spouse Lysanne Gendron ("Disposition 1").  The consideration paid by Lysanne was a promissory note in the amount of $1,043,889 payable over five years, in five equal annual instalments and with interest at the annual rate of 4.5%.  Four days later, Gervais gifted the remaining half of the Preferred Shares to Lysanne ("Disposition 2").  On October 7, 2002, all of the shares of the Target were sold to the Purchaser.

In Disposition 1, Gervais elected out of the spousal rollover provision in subsection 73(1) of the Income Tax Act (Canada) (the "Act").  On his 2002 tax return, Gervais reported Disposition 1 as a capital gain of $1,000,000 (the adjusted cost base ("ACB") of the shares was $43,889).  On Disposition 2, the spousal rollover under subsection 73(1) of the Act was relied on and Gervais was deemed to have disposed of the Preferred Shares for an amount equal to the ACB of $43,889 and Lysanne was deemed to have acquired the shares for an amount equal to the ACB of $43,889.

Lysanne was fully aware of the impending sale to the Purchaser prior to acquiring the Preferred Shares.  In the purchase and sale agreement in respect of Disposition 1, Lysanne agreed to not sell the Preferred Shares to anyone other than the Purchaser without the consent of Gervais.

The sale to the Purchaser ensued and section 47 (identical property rules) of the Act was used to calculate the ACB of the Preferred Shares.  In his tax return for taxation year 2002, Gervais included the capital gain as a result of Disposition 1 and utilized his capital gain exemption.  Gervais also reported half of the capital gain generated on the sale to the Purchaser by Lysanne (as the capital gain resulting from the sale of the Preferred Shares acquired under Disposition 2 and subsequently sold to the Purchaser is attributed to Gervais).  In her tax return for taxation year 2002, Lysanne included half of the capital gain generated on the sale of the Preferred Shares acquired under Disposition 1 and sold to the Purchaser and also used her capital gain exemption (hence the name "half-loaf").  As a result, both spouses claimed their capital gain exemption (instead of only Gervais using his capital gain exemption if the foregoing transactions had not been undertaken).

The Tax Court of Canada found that, since Lysanne had the intention of selling the Preferred Shares to the Purchaser before she acquired them, the sale of the Preferred Shares acquired under Disposition 1 was on account of income and not capital in the hands of Lysanne.  Conversely, the Court found that the gifted shares which were subsequently sold to the Purchaser were on account of capital in the hands of Lysanne.  The Tax Court of Canada also held that section 47 is inoperative and no averaging of ACB is to occur in respect of the Preferred Shares acquired by Lysanne in Dispositions 1 and 2.  Therefore, Lysanne was not able to take advantage of the beneficial averaging of ACB pursuant to section 47.  Given that the attribution rules in section 74.2 applied to the gift, the resulting $1,000,000 capital gain was attributed back to Gervais.  The Court concluded that since the capital gain was attributed to Gervais as a result of section 74.2, there was no tax benefit for Gervais and therefore, the general anti-avoidance rule was not considered.

The decision was appealed to the Federal Court of Appeal which disagreed with the Tax Court of Canada and found that the sale to the Purchaser of the Preferred Shares acquired by gift or by sale by Lysanne were on account of capital.  The Federal Court of Appeal also held that the Tax Court judge erred in concluding that the general anti-avoidance rule was not applicable and returned that specific issue to the Tax Court of Canada for analysis.

In considering the application of the general anti-avoidance rule, the Tax Court of Canada noted that three conditions must be present in order to trigger the application of the general anti-avoidance rule.  First, the transaction must result in a tax benefit; second, the transaction must be an avoidance transaction; and third, the avoidance transaction must be a misuse of the provisions of the Act.  If these three conditions are met, the Court is required to determine the tax consequences that are reasonably necessary in the circumstances and deny the tax benefit.

In determining whether the first condition was met, the Court found that without the series of transactions made, Gervais would have been taxed on the entire capital gain generated by the disposition of the Preferred Shares to the Purchaser.  Consequently, there was a tax benefit for Gervais.

With regard to the second condition, the Court first held that, under the circumstances, there was a series of transactions determined in advance in order to produce a result.  The Court then had to determine whether the series of transactions was made for bona fide purposes or to obtain a tax benefit.  In this regard, the Tax Court concluded that the primary purpose of the transactions was to allocate the proceeds from the sale of the Preferred Shares from the Purchaser to Lysanne.  In the analysis, the Court found that where a transaction is made to obtain a tax benefit and for bona fide purposes, the primary purpose must be determined.  Moreover, where one of the transactions in the series of transactions is made for purposes other than bona fide purposes, there is an avoidance transaction.  In the case of Gervais, Disposition 1 was not necessary to make the gift to Lysanne (Disposition 2) and was hence made primarily to obtain a tax benefit.  For this reason, the Court found that it was an avoidance transaction.

The Court went on to analyse whether there was a misuse of the provisions of the Act.  In doing so, the Court stated that one of three conditions must be met to conclude that there is a misuse of the provisions of the Act.  First, the avoidance transaction achieves an outcome the statutory provision was intended to prevent.  Second, the transaction defeats the underlying rationale of the provision, or third, the transaction circumvents the provision in a manner that frustrates or defeats its object, spirit or purpose.  The Court then found that the object, spirit or purpose of subsections 73(1), 74.1(1), 74.5(1) and 47(1) of the Act is that where an individual transfers property to his spouse or common-law partner, there may be a deferral of tax, in which case, the capital gain generated once the property is sold by the spouse or common-law partner will be taxable in the individual's hands.  Since the transactions implemented by Gervais resulted in a partial allocation of the capital gain generated by the sale of the Preferred Shares to Lysanne, the Court held that the transactions implemented by Gervais achieved an outcome intended to be prevented by the provisions of the Act.  The Court did not accept Gervais' argument that there cannot be a misuse of the provisions of the Act where an election is made, and added that such an election must be considered in light of the general scheme of the Act.  Given that the election was made by Gervais to circumvent the application of the attribution rules, the Court found that there was a misuse of the provisions of the Act.

Consequently, the court ruled that the general anti-avoidance rule was applicable and that the capital gain generated by the sale of the Preferred Shares to the Purchaser was taxable in the hands of Gervais.  This decision essentially placed Gervais in the same tax position as if he had sold all of the shares directly to the Purchaser.

It may be that the half-loaf plan is now fully baked.  As at the time of writing, no appeal in respect of the most recent Tax Court decision has been filed.

There may be other legitimate tax planning opportunities to multiply the capital gain exemption. Early consultation with a tax expert is highly recommended.


1 Gervais, G. et al v. the Queen, 2014 CCI 119 (Tax Court of Canada); Gervais, G. et al v. the Queen, 2016 CAF 1 (Federal Court of Appeal) 1180; Gervais, G. et al v. the Queen, 2016 CCI 180 (Tax Court of Canada).

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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Bryant D. Frydberg
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