In Auto Parts Inc. Lecavalier v. The Queen, 2013 CCI 310 (English version not yet available), the Tax Court of Canada (TCC) applied the general anti-avoidance rule (GAAR) to effectively re-characterize a cash share subscription followed by cash debt repayment as a direct equity-for-debt exchange – resulting in debt forgiveness. Very briefly:
- A US parent company (US Parent) had capitalized its Canadian subsidiary (Canco) with both equity and debt.
- The value of Canco’s assets subsequently declined well below the debt: the asset value was approximately $10m; the debt (held by US Parent) was approximately $24m.
- Prior to the sale of Canco’s shares to a Canadian buyer (Buyer), US Parent injected the approximate $14m shortfall in value as a further cash subscription for additional shares of Canco. Canco immediately thereafter used this cash to pay down $14m of the debt owed to US Parent. (The newly issued shares effectively had no value after this $14m debt repayment.)
- US Parent then sold to Buyer both its shares of Canco (for $1) and its $10m debt of Canco (for approximately $10m).
The CRA reassessed Canco on the basis that the $14m share subscription and $14m debt repayment prior to the sale to Buyer were avoidance transactions under the GAAR (s. 245). Furthermore, these avoidance transactions abusively circumvented both the “debt parking” rule (in s. 80.01(7)) and the “shares-for-debt” rule (in s. 80(2)(g)). The TCC agreed. Accordingly, the $14m share subscription and $14m debt repayment were effectively ignored – giving rise to $14m of debt forgiveness in Canco under s. 80. This forgiven debt reduced Canco’s available tax attributes to zero and resulted in a 50% income inclusion for the balance (under s. 80(13)).
Two quick additional observations:
- Canco argued (in part) that the transactions were structured by US Parent primarily for US tax purposes, and as such, were not avoidance transactions from a Canadian tax perspective. However, Canco failed to introduce direct evidence from either US Parent or a US tax expert in support of this contention.
- The avoidance transactions did not involve the stop-loss rule in s. 40(2)(e.1) from the creditor’s perspective. In that context, an important question arises: Are pre-sale debt restructure transactions that rely on the CRA’s Advance Income Tax Ruling ATR-66 (and similar transactions) affected by this decision? Such transactions generally involve a transfer of debt internally within the existing group before the share sale to an arm’s length buyer. No debt forgiveness arises and the CRA sees no abuse as a policy matter. Arguably such transactions should not be affected by the decision inAuto Parts Inc. Lecavalier as a policy matter. That is, the CRA has previously accepted such transactions because the creditor does not access the inherent loss in the system (directly or indirectly). In Auto Parts Inc. Lecavalier, the creditor (i.e., US Parent) appears to have accessed the inherent loss in the system – albeit on the shares of Canco sold to Buyer. Accordingly, the decision in Auto Parts Inc. Lecavalier may well be distinguishable on that basis.