The recent decision of Gervais c. La Reine (2014 CCI 119; available only in French) gave the TCC an opportunity to review a common planning technique that spouses use to multiply the use of their lifetime capital gains exemption (CGE) on a sale of qualified small business corporation (QSBC) shares to a third party. Unfortunately for the taxpayers, the TCC decided in favour of the CRA and cast serious doubt on the validity of the technique.
The planning in Gervais relied on the technical application of the spousal rollover in subsection 73(1), the attribution rules in section 74.2, and the averaging rule for identical properties in subsection 47(1). Prior to Gervais, it was accepted that the rules could allow spouses to share their respective CGEs before selling QSBC shares to a third party (subject to the potential application of GAAR).
The general idea behind this type of planning was as follows. Assume that a husband owns 1.6 million QSBC shares with a nominal ACB and an FMV of $1.6 million. His wife owns no shares. The husband wants to sell his QSBC shares to an arm’s-length third party. Instead of selling the shares directly to the third party and realizing a capital gain of $1.6 million ($800,000 of which would be sheltered by the husband’s CGE), the husband first transferred all of his shares to his wife by way of two separate transactions: (1) a sale of 800,000 shares for FMV proceeds payable by a promissory note bearing interest at the prescribed rates (the purchased shares) and (2) a gift of the remaining 800,000 shares (the gifted shares). The husband elected out of the spousal rollover in subsection 73(1) in respect of the purchased shares but not in respect of the gifted shares.
The sale of the purchased shares to the wife was treated as a taxable disposition to the husband; it triggered a capital gain of $800,000 in his hands for which he claimed the CGE. The cost of the purchased shares to the wife became $800,000. In contrast, the transfer of the gifted shares took place on a tax-deferred basis under subsection 73(1) and gave rise to no gain or loss to the husband. The cost of the gifted shares to the wife was nil. Under the averaging rule in subsection 47(1), the wife’s ACB of her 1.6 million QSBC shares was averaged among all of the shares such that she had an aggregate ACB of $800,000. The wife then sold all of her QSBC shares to the third-party purchaser for FMV consideration of $1.6 million and repaid the note owed to her husband. The wife realized a capital gain of $800,000, half of which was attributed to her husband under section 74.2; the other half was included in her income and was offset by her CGE. Overall, this planning strategy technically allowed both spouses to claim the CGE and shelter $1.2 million of capital gain (instead of only $800,000).
The taxpayers in Gervais, a husband and wife, implemented a strategy similar to that in the example before they sold their QSBC shares to an unrelated third party. The CRA reassessed the taxpayers on the basis that the gain realized by the wife on the sale of her QSBC shares to the third party was on income account (and not a capital gain) or, alternatively, that GAAR applied to include the gain in the husband’s income as a capital gain.
The TCC ruled against the taxpayers on the first issue, so there was no need to consider the application of GAAR. The TCC’s findings, however, are surprising: even though the sale of the QSBC shares to the third party was one single transaction, the shares were treated in two separate blocks. In effect, the TCC held that the purchased shares acquired by the wife were not capital property but were held on income account. This conclusion was largely based on the following facts: (1) the wife acquired the shares from her husband with the intention of reselling them shortly thereafter; (2) the shares did not generate any income while she held them; (3) she sold the shares less than two weeks after she acquired them; and (4) she did not pay any money to her husband to acquire the shares (rather, she gave him a promissory note repayable over five years). In contrast, the gifted shares were held to be capital property to the wife.
Despite finding that the purchased shares were on income account, the TCC acknowledged that the wife did not realize any gain on the sale thereof to the third party because her cost in the shares (being the purchase price she paid to acquire them from her husband) was equal to the sale price she received. However, since the gifted shares were held to be capital property and therefore had a nil ACB under subsection 73(1), the sale of the gifted shares to the third party gave rise to a capital gain to the wife, all of which was required to be attributed back to the husband under section 74.2. Note that the averaging rule in subsection 47(1) did not apply because the purchased shares were not capital property. Therefore, the end result is that the entire gain, not just half of it, was recognized by the husband as a capital gain and thus was eligible for the husband’s CGE only. On the other hand, the wife was treated as if she had realized no gain on the sale to the third party, and her CGE remained unused.
By attributing two different characterizations to the same sale of shares, the TCC effectively prevented the spouses from using their respective CGEs to shelter a portion of the gain realized on the sale of their QSBC shares to the third-party purchaser. Some tax practitioners have questioned the correctness of the TCC’s finding that the purchased shares were on income account in light of the fact that the wife had no intention of reselling the shares at a profit, a factor often considered crucial to such a conclusion. That said, although the Gervais decision seems to put a brake on strategies designed to multiply the use of the CGE between spouses, one could argue that this type of planning should nevertheless remain available when the facts support a determination that the purchased shares are on capital account.
This article was first published by the Canadian Tax Foundation inTax for the Owner-Manager, vol. 14, no. 3, July 2014.