The Federal Court of Appeal (“FCA”) recently upheld the Tax Court of Canada (the “TCC”) decision in Groupe Honco Inc. v. R. (2012 TCC 305 and 2013 CAF 128), where capital dividends were re-characterized as taxable dividends by virtue of the application of the specific anti-avoidance rule in subsection 83(2.1) of the Income Tax Act (Canada) (the “Act”). This case is of significant importance since it is the first case where a Court expressed an opinion on this specific anti-avoidance rule.
Capital Dividends and Subsection 83(2.1) Anti-Avoidance Rule
Various tax-free surpluses accumulated by a Canadian private corporation such as the non-taxable portion of capital gains, certain life insurance proceeds received by the corporation and capital dividends received from other corporations are included in the capital dividend account. These surpluses may be distributed as capital dividends on a tax-free basis to the corporation's Canadian resident shareholders.
The payment of tax-free capital dividends is, however, subject to a specific anti-avoidance rule contained in subsection 83(2.1) of the Act which applies where a capital dividend is paid on a share of a corporation that “was acquired by its holder in a transaction or as part of a series of transactions one of the main purposes of which was to receive the dividend.” This provision, when applicable, has the effect of re-characterizing the tax-free capital dividend as a taxable dividend that is, consequently, included in computing the shareholder's income. Further, if the dividend is received by another corporation, it will not be included in computing the recipient corporation's capital dividend account.
Mr. Lacasse was the principal and controlling shareholder of Groupe Honco Inc. (“Honco”). In 1997, one of the companies in the Honco group constructed a $600,000 turn-key structure for Industries Supervac Inc. (“Old Supervac”), an unrelated corporation owned and controlled, directly or indirectly, by Mr. Bédard. As the structure neared completion, it became apparent that Old Supervac was in serious financial difficulty and would be unable to pay the purchase price for the building. After negotiation, it was agreed that Old Supervac would not purchase the structure but would rent it.
In late 1998, the financial situation of Old Supervac remained a problem and Mr. Bédard was diagnosed with terminal cancer. In an effort to save his investment in the turn-key structure, Mr. Lacasse formed a new corporation (“New Supervac”) to purchase all of Old Supervac’s inventory and lease all of its business assets with an option to purchase the business assets and shares of Old Supervac.
Under Mr. Lacasse’s management, New Supervac quickly returned the Supervac business to profitability. Mr. Bédard passed away in May 1999 and Old Supervac received life insurance proceeds from the life insurance policy it owned on the life of Mr. Bédard. In October 1999, New Supervac purchased all of the business assets of Old Supervac and in November 1999, it acquired all the shares of Old Supervac. Old Supervac and New Supervac were amalgamated on January 1, 2001. In 2004, the corporation resulting from the amalgamation of Old Supervac and New Supervac (“Amalco”) declared a capital dividend to its shareholder, Honco, which in turn declared a capital dividend to its shareholder, Gestion Paul Lacasse Inc. (“Gestion”).
The Minister of National Revenue reassessed each of Amalco, Honco and Gestion in 2007, on the basis that subsection 83(2.1) of the Act applied to treat the capital dividends as taxable dividends.
Arguments of the Taxpayers
The taxpayers argued that the principal purposes of the series of transactions at issue were to permit:
- Groupe Honco to recover its investment in the Supervac structure;
- New Supervac’s business to be carried on as part of Honco group without the need for new certification; and
- the amalgamation of New Supervac and Old Supervac in order to utilize Old Supervac’s carry forward losses against New Supervac’s business.
TCC Analysis and Decision
The TCC agreed that the aforementioned purposes should be considered principal purposes of the series of transactions under review in the context of subsection 83(2.1). The TCC confirmed that the test to be applied under subsection 83(2.1) was not entirely subjective and that a Court should look for objective manifestation of purpose. In the TCC’s view, this determination is ultimately a question of fact to be decided based on all of the particular circumstances.
The TCC considered whether, on a preponderance of the evidence, the acquisition of the capital dividend account and the payment of the capital dividends was also one of the principal purposes of the series of transactions. The TCC held that the taxpayers had not met their onus of proof in order to satisfy the TCC that such a purpose was not one of the principal purposes of the series of transactions. This finding appeared to be driven by the TCC’s belief that the parties must have had knowledge of the existence of the capital dividend account during the negotiations for the purchase of the shares of Old Supervac.
FCA Analysis and Decision
The judgment of the TCC was upheld by the FCA. The FCA accepted the evidence of the taxpayers to the effect that the transactions had several principal purposes having no connection with the capital dividend account of Old Supervac. However, the FCA was of the view that the expression "one of the main purposes" is without ambiguity and suggests that a taxpayer may have multiple main reasons to acquire the shares. The FCA did not find a determining error that would have justified modifying the conclusions of the TCC.
Interestingly, the FCA refused to consider the possible application of subsection 83(2.3) of the Act which provides an exception to the anti-avoidance rule in subsection 83(2.1) when the capital dividend account is increased by life insurance proceeds. As a result, the scope of subsection 83(2.1) remains to be determined. For instance, it is not clear whether this exception could apply where successive payments of capital dividends are made through a chain of corporations.
The decision reached in this case is somewhat surprising. The tax policy underlying this specific anti-avoidance rule is generally aimed at prohibiting the trading of capital dividend accounts. In the Honco case, genuine business considerations were driving the transactions and actual assets were purchased. The scope of subsection 83(2.1) was interpreted very broadly by both the TCC and FCA. Taxpayers should consider the implication of this broad interpretation in structuring their transactions.
The taxpayers have not sought leave to appeal the FCA decision to the Supreme Court of Canada