The latest chapter in the story of the 'half-loaf' plan has been penned by the Federal Court of Appeal in Gervais v the Queen.(1) The case concerned a plan by which the taxpayer, Guy Gervais, intended to split the capital gains on a share sale to an arm's-length purchaser between him and his wife, Lysanne Gendron, and thus benefit from both of their lifetime capital gains exemptions.
The case was originally heard by the Tax Court and decided without reliance on the general anti-avoidance rule (GAAR).(2) That decision was reversed by the Federal Court of Appeal and sent back to the Tax Court to be decided on the issue of the GAAR.(3) The Tax Court held that the GAAR applied and upheld the minister's reassessment.(4) The case was once again appealed to the Federal Court of Appeal and the appeal was dismissed.
The plan was simple. Gervais and his brother were the shareholders of Vulcain Alarme Inc. An arm's-length corporation, BW Technologies Ltd, made an offer to purchase the shares of Vulcain. Had Gervais sold his shares to BW Technologies without implementing the plan, he would have realised $2 million in capital gains. Instead, the following steps were taken:
- Vulcain's share capital was reorganised to convert Gervais's common shares into preferred shares.
- On the same day, Gervais sold one-half of his shares to Gendron at fair market value and elected not to have Section 73(1) of the Income Tax Act apply. Thus, he realised the full capital gain on one-half of his shares or $1 million.
- Four days later, Gervais gifted the remaining shares to Gendron – this time, allowing Section 73(1) to apply. Thus, he was deemed to have disposed of his shares for their adjusted cost base (ACB) and Gendron was deemed to acquire the shares for the same price.
- Approximately one week later, Gendron sold all of the shares to BW Technologies for fair market value. Section 47(1) of the Income Tax Act applied in determining the ACB and set this as the average between the two values (ie, fair market value for the half sold and original ACB for the half gifted). Therefore, on the sale, Gendron realised a capital gain of $1 million. One-half of this – the half related to the gift of shares – was attributed to Gervais under Section 74.1 of the act. The other half remained with Gendron, allowing her to use her lifetime capital gains exemption.
The overall result of the plan was that the capital gain was split between the sales to Gendron and BW Technologies. Further, one-half of the gain on the sale to BW Technologies was taxable to Gendron, allowing for the use of both spouses' lifetime capital gains exemptions.
The Tax Court performed a standard GAAR analysis, examining the following:
- Was there a tax benefit?
- Was the transaction giving rise to the tax benefit an avoidance transaction?
- Was the avoidance transaction giving rise to the tax benefit abusive?
The court answered 'yes' to all three questions and upheld the GAAR assessment.
On appeal, Gervais argued that none of the conditions of the GAAR had been met. The Federal Court of Appeal disagreed. It was clear that there was a tax benefit, as the plan allocated $500,000 in capital gains away from Gervais.
The court accepted that there was a bona fide purpose to the transaction (the gift of $1 million to Gendron for her contributions to the business), but found that it also had a tax purpose. In determining whether there was an avoidance transaction, the court emphasised the fact that certain steps (eg, the initial sale of shares to Gendron) were unnecessary for the fulfilment of the bona fide purpose. It stated that "the sale to [Gendron] cannot be explained otherwise than by a quest to obtain the tax benefit which [Gervais] derived. There was therefore an avoidance transaction".(5)
Lastly, Gervais was unable to persuade the court that the Tax Court had erred in finding the plan abusive. In particular, the court held that the steps of the plan were contrary to the object, spirit and purpose of Sections 73(1) and 74.2(1) of the Income Tax Act. These provisions allow a gain on transfer between spouses to be deferred, but are intended to attribute the gain back to the original transferor. Intelligent use of Section 47(1) of the act in order to reduce the impact of the attribution rules frustrated those rules; therefore, the GAAR applied.
Taxpayers seeking to multiply their capital gains exemption or split capital gains with their spouse should be aware of the GAAR. Careful consultation with a tax professional before implementation of any such plan is a must.
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(1) 2018 FCA 3.
(2) 2014 TCC 119.
(3) 2016 FCA 1.
(4) 2016 TCC 180.