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, 2018 FCA 3. The case dealt with a plan by which the taxpayer, Mr. Gervais, intended to split the capital gains on a share sale to an arm’s-length purchaser between himself and his wife, Ms. Gendron, thus benefitting 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”): 2014 TCC 119. That decision was reversed by the Federal Court of Appeal and sent back to the Tax Court to be decided on the issue of GAAR: 2016 FCA 1. The Tax Court held that GAAR applied and upheld the Minister’s reassessment: 2016 TCC 180. The case was once again appealed to the Federal Court of Appeal. The appeal was dismissed.
The plan itself was simple. Mr. Gervais and his brother were the shareholders of Vulcain Alarme Inc. (“Vulcain”). An arm’s-length corporation, BW Technologies Ltd. (“BW Technologies”) made an offer to purchase the shares of Vulcain. Had Mr. Gervais sold his shares to BW Technologies without implementing the plan he would have realized $2,000,000 in capital gains. Instead, the following steps were taken:
- Vulcain’s share capital was reorganized to convert Mr. Gervais’s common shares into preferred shares.
- On the same day, Mr. Gervais sold half his shares to Ms. Gendron at fair market value and elected not to have subsection 73(1) of the Income Tax Act (Canada) (the “Act”) apply. Thus, he realized the full capital gain on half of his shares, or $1,000,000.
- Four days later, Mr. Gervais gifted the remaining shares to Ms. Gendron, this time allowing subsection 73(1) to apply. Thus, he was deemed to have disposed of his shares for their ACB, and Ms. Gendron was deemed to acquire the shares for the same price.
- Approximately one week later, Ms. Gendron sold all the shares to BW Technologies for fair market value. Subsection 47(1) of the Act applied in determining ACB and set it as the average between the two values—fair market value for the half sold, and original ACB for the half gifted. Thus, on the sale, Ms. Gendron realized a capital gain equal to $1,000,000. Half of this, the half related to the gift of shares, was attributed to Mr. Gervais under section 74.1 of the Act. The other half remained with Ms. Gendron, allowing her to use her lifetime capital gains exemption.
The overall result of the plan is that the capital gain was split between the sale to Ms. Gendron and the sale to BW Technologies. Further, half of the gain on the sale to BW Technologies was taxable to Ms. Gendron, allowing for the use of both spouses’ lifetime capital gains exemptions.
The Tax Court performed a standard GAAR analysis, examining the following three issues: (1) was there a tax benefit; (2) was the transaction giving rise to the tax benefit an avoidance transaction; and (3) 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 to the Federal Court of Appeal, Mr. Gervais argued that none of the conditions of GAAR had been met. The court disagreed. It was clear that there was a tax benefit, as the plan allocated $500,000 in capital gains away from Mr. Gervais.
The court accepted that there was a bona fide purpose to the transaction (the gift of $1,000,000 to Ms. Gendron for her contributions to the business), but found there was also a tax purpose. In determining whether there was an avoidance transaction, the court emphasized the fact that certain steps, such as the initial sale of shares to Ms. Gendron, were not necessary for the fulfillment of the bona fide purpose. As the court put it at para. 41, “the sale to his spouse cannot be explained otherwise than by a quest to obtain the tax benefit which he derived. There was therefore an avoidance transaction”.
Lastly, Mr. 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 subsection 73(1) and 74.2(1). Those 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 subsection 47(1) to reduce the impact of the attribution rules frustrated those rules, so GAAR applied.
It’s clear that taxpayers seeking to multiply their capital gains exemption or split capital gains with their spouse must always be aware of the GAAR. Careful consultation with a tax professional before implementation of any such plan is a must.