Tax Blog

TCC Shuts Down Strategy To Multiply Lifetime Capital Gains Exemption

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.

 

*     Note: this article was first published by the Canadian Tax Foundation in Tax for the Owner-Manager, vol. 14, no. 3, July 2014.

Murphy’s Law of Tax

Murphy’s Law is, as everyone knows, the proposition that “Anything that can possibly go wrong, does.” There are many variants of this. Among tax practitioners, a well known one is the proposition “There is no equity in a tax statute.” Roughly translated, this means that as a taxpayer, you may not rely on the fairness of your position when contesting a tax assessment – fairness has nothing whatever to do with the correctness of the assessment, and Tax Court judges will be quick to remind you of this. Almost always this version of Murphy’s Law is applied against the taxpayer, so it is refreshing to be reminded that from time to time it will be applied against the tax department, too. The recent Tax Court Decision in Henco Industries Limited is a very recent example of this. (See the July 2 blog post “Tax Court finds settlement payment was a non-taxable capital receipt” by my colleague Ian Gamble for a discussion of some of the technical issues in the case.)

The Henco case evolved out of a very difficult set of circumstances at the Town of Caledonia in Ontario. Henco was in the course of building a residential subdivision on lands to which it held legal title, but which a local Aboriginal Band claimed as sacred territory. Certain Band members embarked on a course of conduct designed to halt the development. Initially, this involved acts of civil disobediance, but these quickly escalated into acts of violence against individuals and serious property damage. Acting on orders from the provincial government of the day, the provincial police force declined to take action against the lawbreakers. This was done in full recognition of the consequences for the developer and other property owners in the community. Rightly or wrongly, they were regarded as collateral damage in the larger issue involved, namely, the government’s desire to avoid an all out confrontation with the Band. (The sad circumstances are outlined in detail in a book on the subject by Christie Blatchford, titled Helpless: Caledonia’s Nightmare of Fear and Anarchy, and How the Law Failed All of Us).

The government decided to buy out Henco’s interest in the development and made the company a payment of some $15.8 million. In a short agreement evidencing the settlement, it was stated that the payment was compensation for Henco’s interest in the land and for its release of all its claims of whatever kind in respect of the circumstances leading up to the settlement. Not surprisingly, I suppose, the CRA took the position that the payment should be taxed as net profit from the real estate development. This is what tax departments do when business taxpayers receive substantial sums of money. However, the Tax Court disagreed and decided that not only was the payment of a capital nature (notwithstanding that it was paid to a developer in respect of an interest in its land), but it was not taxable at all under the tax provisions in force at the time. (Those provisions have since been amended.) The decision is of interest to tax practitioners for the judge’s extensive analysis of the distinction between income and capital receipts, and for why he decided that the payment was not subject to tax on any basis. But I like the decision for a different reason.

The circumstances in Caledonia at the time were, to put it mildly, egregious. The government’s decision not to enforce the law in favour of Henco and the citizens of Caledonia was questionable – see the Blatchford book noted above. A direct fallout from the decision as far as Henco was concerned was that it was out of business. The $15.8 million was far less than what it expected to earn from the subdivision. Certainly when looked at from Henco’s perspective, the result was grossly unfair. One level of government chooses not to enforce the law and decides to buy peace by paying off the developer. Then another level of government tries to tax away a significant portion of the payment as if it were income from doing business as usual when whatever business there was had been destroyed as a direct consequence of the first government’s non-action! There’s nothing fair about that, but from the CRA’s perspective I suppose that fairness had nothing to do with the case. While the judge didn’t frame his decision in the context of what’s fair, I can’t help wondering if Murphy, wherever he is, is smiling at this twist on Murphy’s Law of Tax. I know I am.

Tax Court finds settlement payment was a non-taxable capital receipt

In Henco Industries Limited v. The Queen, 2014 TCC 192, a company carried on the business of developing land for sale in Caledonia, Ontario.  In 2006, certain members of local Aboriginal groups occupied the area, which made continuation of the company’s business physically impossible.  Ontario subsequently refused to enforce injunctions against the occupiers and rezoned the company’s property; this made continuation of the company’s business legally impossible.  These actions essentially put the company out of business (paragraph 166).  Ontario ultimately agreed to pay the company $15.8 million in exchange for land, chattels, certain covenants, and a final release of any claims against Ontario.  In a wide-ranging judgment, the Tax Court of Canada (TCC) held as follows:

  1. In substance the $15.8 million payment was not for the sale of the company’s land inventory (paragraph 156).
  2. Rather, the payment was to make the company “go away”: to enable Ontario to acquire control of a volatile situation and restore peace in the area (paragraph 162).
  3. In addition, the payment was to compensate the company “…for the whole loss of its business” or “…for certain rights, or more accurately the extinction of certain rights: the right to sue Ontario and the right to takes steps to enforce the injunction it obtained” (paragraph 170).
  4. The payment was not caught by s. 14 as it then read (paragraph 200).
  5. At the time the payment was made, the company had no source of income; the payment represented a non-taxable capital receipt (paragraph 203).

Strangely the TCC did not consider the Supreme Court of Canada’s decision in Tsiaprailis v. The Queen, 2005 SCC 8 (dealing with the tax character of settlement payments).  On an unrelated valuation issue, the TCC helpfully said that where a taxpayer chooses a value which falls within a range of reasonable fair market value, that choice should not be disturbed (paragraph 131).

Supreme Court of Canada considers existence and nature of Aboriginal title

In Tsilhqot’in Nation v. British Columbia, 2014 SCC 44, the Supreme Court of Canada reaffirmed that the doctrine of terra nullius – no one owned the land prior to European assertion of sovereignty – never applied in Canada: the Royal Proclamation (1763), R.S.C. 1985, App. II, No. 1 (paragraph 69).  Where Aboriginal title can be established, such title confers overriding legal and beneficial ownership rights analogous to those associated with fee simple: essentially the right to use and control the land and to reap the benefits flowing from it (paragraphs 2 and 73).  However, this right represents a collective title held not only for the present Aboriginal generation but for all succeeding generations; this means the title cannot be alienated (except to the Crown) or encumbered in ways that would prevent future generations of the Aboriginal group from using and enjoying it (paragraph 74).  The Crown can only infringe on Aboriginal title with the consent of the Aboriginal group or where the encumbrance is justified by a compelling and substantial public purpose that is not inconsistent with the Crown’s fiduciary duty to the Aboriginal group (paragraphs 2 and 88).  As a practical matter, in any proposed resource development where Aboriginal title is claimed, the Crown and project proponents will likely gain certainty only “…by obtaining the consent of the interested Aboriginal group” (see paragraph 97).  Short of such consent, any project rights secured might be reversed retroactively if they are later shown to unjustifiably infringe on Aboriginal title (paragraph 92).  This case will likely have important implications on the tax characterization of certain project costs in many resource industries.

CRA confirms trap on rollover of foreign affiliate shares held through a partnership

When a Canadian company (Canco) receives a pre-acquisition surplus dividend (Pre-Acq Dividend) from a foreign affiliate (FA), s. 92(2) reduces Canco’s tax basis (ACB) in the FA shares.  However, this ACB adjustment does not apply if Canco holds FA through a partnership and the Pre-Acq Dividend is received by the partnership.  Rather, the Pre-Acq dividend is accounted for: (1) under s. 92(5) and s. 92(6) as a deemed gain to Canco when the partnership sells the shares of FA; or (2) under s. 92(4) as additional proceeds to Canco when Canco sells its partnership interest.  In 2014-0526751C6, the CRA confirmed that these rules are automatically engaged even where the disposition (sale) of the FA shares (or the partnership interest) occurs under a rollover provision in an internal restructuring – such as under s. 85(1) or s. 85.1.

Tax Court Agrees with Itself that Trips to Thailand, Indonesia, Cambodia, Vietnam, Malaysia, Philippines, Burma, Ecuador, Venezuela, Honduras, Mexico, Costa Rica and India Qualify for Medical Expense Tax Credits.

In the recent Tax Court case of Trudy Tallon v. the Queen, Woods, J. was asked to rule on travel and transportation medical expenses tax credits claimed under paragraphs 118.2(2)(g) and (h) by the taxpayer in her 2009 taxation year.  While this may sound routine, the facts upon which the tax credits were claimed were rather unusual.

Trudy Tallon was in the unfortunate position of suffering from chronic pain, the treatment for which was, upon legitimate recommendation by her doctor, absconding from her normal home in Thunder Bay during the winter months for warmer climates.  Additionally, her doctor had certified that, for the taxpayer, “travel without a companion would be ‘extremely difficult… if not impossible.’”  Through what must have been a heroic gesture of solidarity and sacrifice, her husband accompanied her over the years for her various medically-deductible trips to Thailand, Indonesia, Cambodia, Vietnam, Malaysia, Philippines, Burma, Ecuador, Venezuela, Honduras, Mexico, Costa Rica and India.   The taxpayer had chosen not to visit the United States due to the medical costs being too high and the climate not being warm enough.

For the taxpayer’s 2008 tax year, the Minister had disallowed similar expenses to those under appeal. These assessments had been overturned by the Tax Court, which ruled for the 2008 year that these expenses were allowable.  The Minister, nevertheless, reassessed the taxpayer’s 2009 taxation year in exactly the same fashion as was overturned by the Tax Court for the 2008 taxation year.  Before the Court, the Minister argued the reasons in Goodwin v. the Queen, where the Tax Court denied the tax credits for short trips to the United States to alleviate the taxpayer’s psoriasis.  Ms. Tallon, not surprisingly, directed the Court to its decision of her case in the immediately preceding year.

Woods, J.  was not entirely unsympathetic to the Ministers cause, but simply found the Minister’s counsel’s presentation lacking.  The court noted that the Minister was asking it to overturn a previous decision without actually providing a copy of that previous decision, and instead attempting to “communicateJjustice Lamarre’s reasons in a general way at the hearing, which [the Court] did not find very illuminating.”  This lack of a previous transcript seems to have overshadowed any other legitimate arguments the Minister could have made.

The Minister offered to have the transcripts sent to the court after the hearing, but ultimately the court determined that that would result in unwarranted delay, especially considering the taxpayer had already driven to Toronto to expedite the proceeding, and ruled against the Minister.

In a final note, Woods J. noted that she was troubled with the number and location of countries that Ms. Tallon had visited, as this would suggest that these locations were not chosen for medical reasons but, as the Crown had not argued the reasonableness requirement in subparagraph 118.2(2)(g)(v) was not satisfied, she was limited in her ability to rule against the taxpayer.

CETA Promises Lower Trade Costs for Canadians and Europeans, Eventually.

On October 23, 2013, Prime Minister Stephen Harper and European Commission President José Manual Barroso signed an agreement-in-principle relating to the Comprehensive Economic and Trade Agreement (“CETA”).  This agreement provides for the removal of nearly all customs duties and tariffs charged on goods and services traded between Canada and the European Union.

This agreement is a further step in the slow but steady march towards more open economies.  Since the Second World War, most world governments have recognized the failure of general protectionist attitudes and welcomed a more open approach to trade.  Canada is no exception.  As well as entering into larger multi-party agreements such as the GATT and the WTO, Canada has entered into many specific free trade agreements, beginning with the Canada-US Free Trade Agreement in 1989.  The CUSFTA was replaced in 1994 by NAFTA, and since then, Canada has also entered into agreements with Israel, Chile, Costa Rica, Iceland, Liechtenstein, Norway, Switzerland, Peru, Columbia, Jordan, Panama, South Korea and Honduras.  But, the European Union – Canada’s second largest trading partner – was still noticeably absent from this preferential trade list before CETA.

The technical summary of the agreement-in-principle released by the Government of Canada contains a substantial amount of information as to which goods and services will have their duties reduced, to what level, and over what timeframe.  Spoiler alert – almost all of the tariffs drop to zero eventually (which is what one would expect from a free trade agreement).   The summary divides trade into three segments:  non-agricultural goods, agricultural goods, and services.

After transition periods of various lengths for various goods (the longest of which are seven years), 100% of Canada’s non-agricultural tariff lines will be duty-free.  The exceptions itemized in the technical summary are ships (3 or 7 years), automobiles (3, 5, or 7 years) and various agricultural goods (3, 5, or 7 years).  Many rules-of-origin  are also changing – for example, automobiles now have a 70% transaction value or 80% net cost test for non-originating materials, and there are hints that U.S.-manufactured auto parts could count as Canadian origin.  There are other exceptions which the technical summary does not itemize which will presumably be released once the agreement is fully negotiated – the Government has been very tight-lipped about the actual text of the agreement, leading various parties to create petitions and public pressure for its release.

The tariff elimination of agricultural goods is somewhat more restrictive, whereby only 92% of Canadian tariff lines will be immediately eliminated.  The only tariff rate quotas (TRQs) that will permanently remain will be for cheese.  Specifically, Canada will still have a TRQ for 16,800 tonnes of cheese and 1,700 tonnes of industrial-use cheese.  It’s not immediately obvious whether the consumption of imported “industrial-use cheese” is something that should be encouraged domestically, though as long as it is only 10% of our import quota, it should be relatively benign to our gastronomic sensibilities.  In any case, cheese is the only industry (so far) whereby the Government has pledged to provide compensation “should a negative impact be observed.”

With respect to services, the agreement-in-principal contains numerous bulwarks, in that it specifically excludes services relating to various social services, culture, and allows preferential treatment of Aboriginals and minority groups.  Beyond these measures, the agreement-in-principal is entirely lacking in details regarding tariffs on services, which will presumably be released when the text of either the agreement-in-principle or the signed final agreement is released.  As the trade in services between Canada and the EU is roughly half the dollar value of the trade in goods and Canada is a much higher net-importer on a percentage basis in services, this should result in a substantial benefit to those Canadian service-importers at the expense of their Canadian substitutes.

Additionally, the agreement and its surrounding literature are vague as to when the agreement comes into force.  Presumably, this is because the agreement must be ratified by Canada, the European Union, and each of its 28 member states.  As with attempting to foster any European-wide consensus, this may prove to be difficult, but only time will tell.

Tax Court Finds Abusive Indirect Strip of V-Day Value

In Lucie Descarries v. The Queen, 2014 TCC 75, the Tax Court of Canada (TCC) held that one result of the taxpayer’s share transactions was to indirectly extract from her company, on a tax-free basis, value that had accumulated before 1971 (V-Day Value) (see paragraphs 56 and 57).  This result defeated the underlying rationale of s. 84.1, and could therefore be set aside as abusive tax planning under the general anti-avoidance rule in s. 245(1).  Although the amounts in the judgment are difficult to follow, it appears the abusive result was achieved as follows:

    1. creating a capital gain in respect of post-V-Day Value, and generating stepped-up tax cost (including hard ACB), on an internal share-for-share exchange with the existing operating company (Opco) under s. 85(1);
    2. transferring the new Opco shares to a new holding company (Holdco) in exchange for Holdco Shares, allowing for the operation of s. 84.1 to eliminate any V-Day Value from the PUC of the Holdco Shares – but preserving all the ACB and the PUC created in respect of the hard ACB;
    3. redeeming the Holdco shares, resulting in a deemed dividend and a capital loss in respect of V-Day Value; and
    4. using the capital loss in respect of V-Day Value in 3 above to offset the capital gain in respect of post-V-Day Value in 1 above.

Also of interest is the Court’s decision that s. 84(2) could not apply on the redemption of the Holdco shares because: (A) none of Opco’s assets were actually distributed at the time the Holdco shares were redeemed (paragraph 27), (B) the redemption of Holdco shares did not coincide with a winding-up, discontinuance or reorganization of Opco’s business (paragraphs 29 and 34), and (C) s. 84(2) and s. 84(3) cannot be applied at the same time to the same distributions (paragraph 37).

Tax Court considers implied waiver of solicitor-client privilege

In Gerbro Inc. v. The Queen, 2014 TCC 179, the Tax Court of Canada (TCC) examined two tests for an implied waiver of solicitor-client privilege: (1) when a communication between solicitor and client is legitimately “brought into issue in an action” and (2) “where the interests of fairness and consistency so dictate”.  The TCC held that neither test was met on the facts before it.  First, a statement of fact in the relevant pleading – which referred to the company’s knowledge of a proposed change in law – was not sufficient to “bring legal advice into issue” because the particular statement did not imply that the company intended to rely on legal advice to establish this knowledge (paragraph 54).  Second, “the bar is set high” for a court to require disclosure of legal advice based on the “fairness and consistency” test; the disclosure must be “vital” to the opposing party’s ability to answer an allegation made by the party seeking to preserve the privilege (paragraphs 58-60).  (See paragraph 50 for a general summary of all principles that may be applicable to an implied waiver of privilege.)

Federal Court of Appeal upholds Tax Court decision on GAAR

In The Queen v. Spruce Credit Union, 2014 FCA 143, the Federal Court of Appeal (FCA) upheld the trial judge’s key findings of fact (a) that certain dividends were paid by a deposit insurance corporation (DIC) to credit unions in proportion to their respective shareholdings rather than in proportion to assessments the DIC had previously received from the credit unions (paragraph 50), and (b) that these dividends were paid primarily for bona fide non-tax purposes (paragraph 64).  The finding in (a) meant that s. 137.1(10)(a) did not apply to include the dividends in the credit unions’ income; the finding in (b) meant that the receipt of the dividends – and the resulting deduction under s. 112 – was not an “avoidance transaction” under the general anti-avoidance rule in s. 245(3) (GAAR).  Of interest are the FCA’s statements that underscore important principles previously set out by the Supreme Court of Canada in relation to an avoidance transaction under the GAAR, namely:

  1. The fact that a tax benefit plays an important role in the choice of a transaction does not automatically mean that the primary purpose of the transaction is to obtain the tax benefit (paragraph 61).
  2. The mere existence of an alternate transaction which could result in greater tax is not sufficient to establish an avoidance transaction; to the contrary, taxpayers are permitted to order their affairs to minimize their tax liability (paragraph 63).