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Introduction – GAAR, Surplus Stripping and the Use of PUC Averaging
The general anti-avoidance rule (GAAR) in section 245 of the Income Tax Act is designed to prevent taxpayers from obtaining tax benefits through transactions that, while compliant with the literal wording of the Act, frustrate its object, spirit, and purpose.
The decision in D'Arcy v. The King demonstrates how GAAR can be applied to complex corporate reorganizations that use paid-up capital (PUC) averaging to facilitate the tax-free extraction of corporate surplus (retained earnings).
Peter and Linda D'Arcy reorganized their operating company, Tech/Pro Heavy Industrial Inc., through a series of rollover transactions that transferred assets into a newly formed holding company, Tiffany Holdings Ltd. By issuing shares of the same class both to themselves and to Tech/Pro, and then relying on the PUC averaging rules in subsection 89(1), the taxpayers increased the PUC allocated to their shares without injecting new capital. This allowed them to withdraw hundreds of thousands of dollars tax-free, sidestepping section 84.1's PUC 'grind.'
The Canada Revenue Agency (CRA) reassessed, concluding that the arrangement constituted abusive tax avoidance under GAAR. The Tax Court agreed, holding that the inflated PUC frustrated the purpose of section 84.1 in conjunction with subsection 89(1) and that the reductions in PUC were characterized adequately as taxable dividends.
This case underscores the limits of planning strategies that rely on technical share structuring and highlights the importance of consulting an expert Canadian tax lawyer before implementing transactions that may be viewed as surplus-stripping
Surplus Stripping and the Use of PUC Averaging
The dispute in D'Arcy v. The King arose from a surplus-stripping arrangement involving the use of paid-up capital (PUC) averaging. Peter and Linda D'Arcy each held one common share of Tech/Pro Heavy Industrial Inc., an operating company with a combined fair market value of $10 million but with only $2 of total PUC. Seeking to reorganize their holdings, the appellants incorporated Tiffany Holdings Ltd. in 2011 and undertook a series of rollover transactions under Section 85 of the Income Tax Act.
As part of the plan, Tech/Pro transferred its Quebec and Ontario real estate properties to Tiffany in exchange for preferred shares and the assumption of existing mortgages. On the same day, the D'Arcys transferred their Tech/Pro shares to Tiffany in exchange for 10 million preferred shares of Tiffany. Notably, Tiffany also issued shares of that same class to Tech/Pro, a step that later triggered subsection 89(1)'s PUC averaging mechanism.
By combining shares held by both Tech/Pro and the appellants in a single class, the PUC that otherwise would have been ground down under section 84.1 was reallocated, leaving the appellants with more than $928,000 PUC despite no new capital having been contributed.
In subsequent years, Tiffany carried out PUC reductions: $250,000 in 2013 and $107,239 in 2014. These amounts were credited against shareholder loan balances owed by the appellants, effectively extinguishing the loans without generating taxable income. The appellants did not report the loan repayments or PUC reductions as income, treating them as tax-free returns of capital.
The CRA reassessed, arguing that the PUC averaging strategy had been implemented in a way that avoided the application of section 84.1's PUC grind and facilitated the extraction of corporate surplus on a tax-free basis.
The reassessments added $125,000 and $53,620 in deemed dividends for the 2013 and 2014 taxation years, respectively. The D'Arcys challenged the tax reassessments, contending that the purpose of the reorganization was creditor-proofing Tech/Pro's assets and that any tax benefits were incidental.
At trial, however, the Tax Court emphasized that the issuance of same-class shares to both the appellants and Tech/Pro had no bona fide commercial justification apart from inflating PUC.
The Court concluded that the transactions were pre-planned, executed with precision, and intended to facilitate surplus stripping under the guise of creditor protection. In rejecting the appeals, the Court held that the series of steps constituted abusive tax avoidance, falling squarely within the scope of the GAAR.
GAAR in Action: Lessons from the D'Arcy Case
At trial, the Tax Court of Canada held that the transactions gave rise to a tax benefit because the D'Arcys used subsection 89(1)'s PUC averaging to sidestep the PUC "grind" in section 84.1. The Court emphasized that the issuance of the same class of preferred shares to both the appellants and their operating company, Tech/Pro, was not commercially necessary and served only to inflate the PUC allocated to the appellants' holdings. Without any new capital injected, the appellants were able to generate more than $928,000 of PUC, which was later drawn out through tax-free PUC reductions.
The Court rejected the taxpayers' claim that the overarching purpose of the transactions was creditor-proofing. Citing Mackay v. Canada and Lipson v. Canada, the judge noted that even if a series of transactions includes bona fide non-tax objectives, the GAAR can still apply where at least one step is primarily tax motivated.
Here, the use of same-class shares to trigger PUC averaging had no genuine creditor-protection rationale and was clearly aimed at extracting surplus on a tax-free basis. The taxpayers themselves admitted that Tiffany's primary purpose in issuing the shares was to obtain tax benefits.
The Court further relied on Deans Knight Income Corp. v. R. to frame the GAAR analysis, applying its three-step test: (1) there was a tax benefit, admitted by the appellants; (2) the issuance of same-class shares constituted an avoidance transaction; and (3) the transaction was abusive.
On the third step, the Court traced the object, spirit, and purpose of section 84.1—preventing surplus stripping through non-arm's length share transfers—and found that PUC averaging was misused to defeat this rationale. He highlighted that section 84.1 and subsection 89(1) operate in tandem to ensure that only capital contributed from after-tax funds can be withdrawn tax-free, while any excess must be taxed as dividends. The inflated PUC in Tiffany contravened this legislative intent.
The Tax Court concluded that the D'Arcys' series of transactions frustrated the purpose of sections 84.1 and 89(1) and therefore constituted abusive tax avoidance under subsection 245(4). The "reasonable tax consequence" was to disregard the PUC averaging and to recharacterize the 2013 and 2014 PUC reductions as deemed dividends under subsection 84(4). Accordingly, the reassessments adding $125,000 and $53,620 to the appellants' income were upheld.
This reasoning illustrates how Canadian courts analyze surplus-stripping strategies under GAAR. The case confirms that sophisticated structuring—such as manipulating PUC allocations across the same class of shares—will not shield taxpayers when the result frustrates the anti-avoidance purpose of the Act.
For practitioners, the lesson is clear: even technically compliant reorganizations can fall within GAAR when their substance is tax-free extraction of corporate surplus, underscoring the importance of consulting a top Canadian tax lawyer before implementing such transactions.
Pro Tax Tips – Beware of Surplus Stripping Through PUC Averaging
The D'Arcy decision highlights how Canadian courts scrutinize surplus-stripping arrangements that rely on technical share structuring. Section 84.1 prevents shareholders from using non-arm's length transfers and the lifetime capital gains exemption to extract corporate surplus tax-free, while subsection 89(1) governs the calculation and averaging of paid-up capital. When combined with the GAAR in section 245, these provisions give the CRA powerful tools to recharacterize transactions that artificially inflate PUC.
Taxpayers contemplating reorganizations should carefully evaluate whether each step of their plan has a genuine commercial purpose beyond tax savings. Relying on same-class share issuances to shift PUC without injecting new capital is a clear red flag.
Maintaining contemporaneous documentation of creditor protection or other bona fide business objectives can help demonstrate that a transaction was not primarily designed to achieve a tax benefit.
Most importantly, consulting an expert Canadian tax lawyer at the planning stage is essential to reduce the risk of reassessment and ensure that legitimate reorganizations are not recharacterized as abusive tax avoidance.
FAQ – Surplus Stripping, PUC Averaging, and GAAR
What is "surplus stripping" in Canadian tax law?
Surplus stripping occurs when shareholders extract retained earnings in a manner that avoids dividend taxation, often by recharacterizing the distribution as a tax-free return of capital.
How does section 84.1 of the Income Tax Act operate?
Section 84.1 prevents individuals from transferring shares of a corporation to a non-arm's length corporation in a way that would allow them to convert taxable surplus into tax-free capital. It does this by "grinding" (reducing) the paid-up capital of shares received on the transfer so that it cannot exceed the contributed capital or adjusted cost base of the shares disposed of.
Why was PUC averaging under subsection 89(1) central in the D'Arcy case?
By issuing the same class of shares to both the taxpayers and their operating company, the taxpayers triggered the subsection 89(1) PUC averaging rules, which artificially reallocated paid-up capital to their shares without new capital being invested. This allowed them to withdraw amounts tax-free, which the Court found to be an abuse of section 84.1.
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.
