The anti-surplus stripping rule in Section 84.1 of the Income Tax Act can apply where an individual taxpayer transfers shares of a corporation to another corporation with which the taxpayer does not deal at arm's length. If the rule applies, a dividend is deemed to be paid to the taxpayer by the transferee corporation equal to the amount by which the value of the non-share consideration received by the taxpayer on the transfer exceeds the greater of the paid-up capital and the 'hard' adjusted cost base of the transferred shares.
However, Section 84.1 does not apply where the taxpayer transfers the shares to an arm's-length party. The recent case of Poulin v The Queen(1) involved two taxpayers who attempted to use their capital gains exemptions to access corporate surplus by selling their shares to an arm's-length party. Interestingly, one of the two taxpayers succeeded in court, while the other did not.
Mr Poulin and Mr Turgeon were shareholders of a closely held private corporation (Opco). Poulin owned common shares and certain fixed-value non-voting preferred shares of Opco with a redemption amount of C$450,004. In 2007 Poulin sold the preferred shares to a corporation (Turgeon Holdco) controlled by Turgeon for a purchase price of C$450,004, which was paid with C$45,000 cash and a promissory note for the balance bearing interest at 5% per year to be paid over five years. The balance was in fact paid off in three years using funds primarily derived from the redemption of the preferred shares held by Turgeon Holdco. In 2012 Poulin sold his remaining shares of Opco to Turgeon Holdco and permanently left Opco. As a result of these transactions, Turgeon obtained control of Opco.
Poulin claimed his capital gains exemption in respect of the disposition of the preferred shares in 2007. The minister assessed the taxpayer dividend income of C$450,004 under Section 84.1 on the basis that Poulin had sold the shares to a person with whom he was not dealing at arm's length.
The court set aside the minister's assessment and found that Poulin and Turgeon Holdco were dealing at arm's length based on the following factors:
- Poulin wanted to leave Opco and the sale of his preferred shares was necessary for his departure;
- Turgeon wanted to obtain control of Opco, which was achieved through the purchase of Poulin's shares by Turgeon Holdco; and
- the balance from the sale of Poulin's preferred shares was repaid in accordance with the terms of the purchase and sale agreement.
Turgeon implemented his own transaction. In 2007 Turgeon sold certain fixed-value non-voting shares of Opco with a redemption amount of C$388,861 to a corporation (Helie Holdco) controlled by Mr Helie, who was a minority shareholder of Opco. Helie Holdco paid the purchase price of C$388,861 with a promissory note bearing interest at 4% per year without any specific repayment date. Between 2007 and 2014 Opco redeemed most of the preferred shares held by Helie Holdco and Helie Holdco used the redemption proceeds to repay the note owing to Turgeon. Helie acquired no voting shares of Opco as a result of these transactions.
Turgeon claimed his capital gains exemption in respect of the sale of his preferred shares of Opco to Helie Holdco in 2007. The minister similarly assessed Turgeon's dividend income of C$388,861 under Section 84.1 in respect of the 2007 tax year on the basis that Turgeon had sold the preferred shares to a person with whom he was not dealing at arm's length.
Unlike the case with Poulin, the court agreed with the minister that Turgeon and Helie Holdco were not dealing at arm's length because the preferred shares had no voting rights or cumulative entitlement to dividends, and it appeared that Helie Holdco never received any dividend on the preferred shares. In the court's view, Helie Holdco had no separate interest or benefit in purchasing the preferred shares from Turgeon.
The court's decisions are based on the premise that a sale between a buyer and seller dealing at arm's length should reflect ordinary commercial dealings between persons acting for their own respective benefits. Poulin demonstrates the importance of a commercial benefit in an arm's-length analysis.
With respect to the Poulin sale, Poulin's intention to retire coupled with Turgeon's desire to acquire control of Opco evidenced valid commercial motives. The existence of a reciprocal commercial benefit satisfied the court's scrutiny of the arm's-length relationship.
By contrast, the absence of a discernible commercial benefit in respect of Helie Holdco's decision to purchase the fixed-value non-voting preferred shares led to an unfortunate result for Turgeon.
This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.