In 1245989 Alberta Ltd. v. The Queen, 2017 TCC 51, a private company (Opco) and its shareholder (Mr. A) carried out an internal reorganization to separate ownership of Opco’s business assets from the ongoing business operations. Simplified for sake of explanation, the transactions involved the following steps:
1) Holdco: Mr. A formed a new holding company (Holdco).
2) Share transfer to Holdco and PUC grind: Mr. A transferred his shares of Opco to Holdco in exchange for a class of preferred shares of Holdco. Mr. A and Holdco filed a joint tax election under s. 85(1) at an amount that triggered a capital gain to Mr. A, which gain was sheltered by Mr. A’s capital gain exemption. The paid-up capital (PUC) of Mr. A’s preferred shares of Holdco was reduced (ground down) to a nominal amount under s. 84.1.
3) Asset transfer to Holdco and PUC increase: Opco transferred its business assets to Holdco in exchange for preferred shares of Holdco. The latter shares were of the same class of preferred shares issued to Mr. A in step 2 above. Opco and Holdco filed a joint tax election under s. 85(1) at an amount equal to the tax cost of the business assets transferred. This tax cost reflected undistributed surplus in Opco, and was substantially higher than the PUC of Mr. A’s preferred shares of Holdco issued in step 2 above. This same tax cost was also added to the PUC of the preferred shares of Holdco issued on the transfer. Immediately thereafter, the total PUC of the preferred shares of Holdco was automatically averaged across all the preferred shares of that class under s. 89(1). This averaging resulted in a substantial “shift” (increase) in PUC on the preferred shares of Holdco held by Mr. A (and a corresponding decrease in the PUC on the preferred shares of Holdco held by Opco).
4) Elimination of cross shareholdings: The preferred shares of Holdco held by Opco were redeemed at fair market value ($X) for a promissory note. Substantially all of the Opco shares held by Holdco, also having a fair market value of $X, were repurchased for a promissory note. The resulting deemed dividends to Opco and Holdco, respectively, were tax-free under s. 112. The two promissory notes were set off against one another and cancelled.
5) Lease of assets to Opco: The business assets (now) held by Holdco were leased back to Opco for continued use in Opco’s business.
The CRA applied the general anti-avoidance rule (the GAAR) in s. 245 to deny the PUC increase on Mr. A’s preferred shares of Holdco described in step 3 above. The Tax Court of Canada agreed. First, the PUC increase constituted a tax benefit (see paragraph 25). Second, the key features of reorganization – in particular the use of only one class of preferred shares of Holdco – were carried out solely to achieve this tax benefit (see paragraphs 94 to 96). Third, the entire series of transactions: (1) achieved a result that s. 84.1 was intended to prevent, i.e., the extraction by Mr. A of underlying corporate surplus (in the form of increased PUC) under cover of his capital gain exemption; and (2) defeated the underlying rationale of s. 84.1 and s. 89(1), by misusing the PUC averaging rule and thereby artificially inflating the PUC on Mr. A’s preferred shares of Holdco without any new capital being invested by Mr. A (see paragraph 104). The resulting PUC increase on Mr. A’s preferred shares of Holdco thus constituted abusive tax avoidance under s. 245(4).