The concept of paid-up capital is important for Canadian tax purposes in that, unlike certain of its treaty partners, Canada permits corporations to return capital to shareholders (even if they have accumulated earnings and profits for tax purposes), without payment of Canadian non-resident withholding tax. For this reason, non-resident acquirers generally use Canadian acquisition corporations to acquire Canadian target businesses to preserve their invested capital for later repatriation. While the use of such acquisition companies generally does not to offend the Canadian tax system, even though such planning may have no purpose other than to reduce Canadian non-resident withholding tax on repatriated profits, other planning to preserve or create paid-up capital in situations where a non-Canadian shareholder then benefits from this tax savings has been challenged by the government using Canada’s general anti-avoidance rule (“GAAR”).
In Copthorne Holdings v. The Queen, a multinational group’s Canadian operations were reorganized, resulting in a $67 million increase in the paid-up capital of shares in a Canadian corporation held by a non-resident corporation. The increase resulted from an amalgamation of a Canadian parent corporation with its Canadian subsidiary which was structured as a horizontal rather than a vertical amalgamation in order to avoid the application of rules which would otherwise have eliminated the subsidiary’s paid-up capital on amalgamation. The shares of the amalgamated corporation were subsequently redeemed for an amount equal to the aggregate paid-up capital of the two predecessor corporations, resulting in no Canadian tax. The Federal Court of Appeal upheld the Tax Court of Canada’s decision that the GAAR applied on the basis that the non-resident shareholder had double counted a portion of its actual invested capital in the paid-up capital of the amalgamated corporation. This, said the Court, was abusive of the statutory provision in the Canadian taxing legislation pertaining to share redemptions, the computation of paid-up capital and the effect of an amalgamation on that computation. On January 28, 2010, the Supreme Court of Canada agreed to hear the taxpayer’s appeal of that decision.
The GAAR was held not to apply in Collins & Aikman Products Co. v. The Queen. A U.S. multinational reorganized its Canadian business operations so that it held directly a Canadian affiliate, Holdings, which in turn wholly owned another Canadian affiliate. The reorganization steps resulted in the creation of both paid-up capital and adjusted cost base in the shares of Holdings held by the taxpayer of $167 million (a significant increase over the $425,000 which the taxpayer had in the non-resident holding company for its Canadian operations before the reorganization). It was admitted that the reorganization was carried out to permit tax-free returns of capital in the future. The Tax Court of Canada, however, was unable to find that any of the steps in the reorganization were inappropriate or abusive of the Canadian tax legislation, and it cautioned that the GAAR should not be used to fill in what the CRA perceives to be a possible gap left by the legislators. The government has appealed this decision to the Federal Court of Appeal.
The three-pronged test for the application of the GAAR enunciated by the Supreme Court of Canada in Canada Trustco Mortgage Co. v. The Queen has resulted in a focus by the Courts on whether the transactions under scrutiny have resulted in abusive tax avoidance. The Supreme Court’s decision in Copthorne will be of significant interest to those who follow the evolution of the Canadian Courts’ interpretation of the GAAR, particularly in respect of the abusive tax avoidance test and the effect of the incorporation by reference of provincial statutes outside the tax domain into the relevant Canadian tax provisions on future reorganizations affecting paid-up capital of Canadian subsidiaries of foreign corporations.