The so-called “anti-surplus stripping rule” in section 84.1 of the Income Tax Act (Canada) 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 (PUC) and the “hard” adjusted cost base (ACB) of the transferred shares.
Section 84.1 will not apply, however, where the taxpayer transfers the shares to an arm’s length party. The recent case of Poulin v. The Queen, 2016 TCC 154 involves 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 was successful in Court – the other was not.
The Poulin Sale
Mr. Poulin and Mr. Turgeon were shareholders of a closely-held private corporation (“Opco”). Mr. Poulin owned common shares and certain fixed-value non-voting preferred shares of Opco with redemption amount of $450,004. In 2007, Mr. Poulin sold the preferred shares to a corporation (“Turgeon Holdco”) controlled by Mr. Turgeon for a purchase price of $450,004, which was paid with $45,000 cash and a promissory note for the balance bearing interest at 5% per year to be paid over 5 years. The balance was in fact paid off in 3 years using funds primarily derived from the redemption of the preferred shares held by Turgeon Holdco. In 2012, Mr. Poulin sold his remaining shares of Opco to Turgeon Holdco and left Opco for good. As a result of these transactions, Mr. Turgeon obtained control of Opco.
Mr. 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 $450,004 under section 84.1 on the basis Mr. 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 Mr. 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 Mr. Poulin’s shares by Turgeon Holdco; and
- The balance from the sale of Mr. Poulin’s preferred shares was repaid in accordance with the terms of the purchase and sale agreement.
The Turgeon Sale
Mr. Turgeon implemented his own transaction. In 2007, Mr. Turgeon sold certain fixed-value non-voting shares of Opco with redemption amount of $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 $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 Mr. Turgeon. Mr. Helie did not acquire any voting shares of Opco as a result of these transactions.
Mr. 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 Mr. Turgeon dividend income of $388,861 under section 84.1 in respect of the 2007 tax year on the basis that Mr. Turgeon had sold the preferred shares to a person with whom he was not dealing at arm’s length.
Unlike the case with Mr. Poulin, the Court agreed with the Minister that Mr. Turgeon and Helie Holdco were not dealing at arm’s length because the preferred shares did not have any 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 did not have any separate interest or benefit in purchasing the preferred shares from Mr. Turgeon.
Comparing the Two Sales
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. The Poulin case demonstrates the importance of a commercial benefit in an arm’s length analysis.
With respect to the Poulin sale, Mr. Poulin’s intention to retire coupled with Mr. Turgeon’s desire to acquire control of Opco evidenced valid commercial motives. The existence of a commercial benefit going both ways satisfied the Court’s scrutiny of the arm’s length relationship.
By contrast, the absence of a discernable commercial benefit in respect of Helie Holdco’s decision to purchase the fixed-value non-voting preferred shares led to an unfortunate result for Mr. Turgeon.