3295940 Canada Inc v The King – Federal Court of Appeal overturns GAAR assessment based on the similar economic result of alternative transactions

Published by Morgan Watchorn

The Federal Court of Appeal (the “FCA”) recently released its decision in 3295940 Canada Inc v His Majesty The King, 2024 FCA 42. This decision is a welcome development in the jurisprudence regarding the application of the General Anti-Avoidance Rule (the “GAAR”) in subsection 245(2) of the Income Tax Act (the “Act”), particularly regarding the scope of the abuse analysis and relevance of alternative transactions.

Background

Gestion Micsau Inc. (“Micsau”) indirectly held a minority interest in a generic drug business (the “Business”). An American investment fund, RoundTable, indirectly held the majority interest in the Business. When Roundtable began negotiations to sell its interest in the Business to a third party, Micsau was forced to also sell its interest.

The FCA depicted the ownership structure of the Business, which existed prior to the sale, as follows:

As illustrated, Micsau’s shares of 3295940 Canada Inc. (“3295”) had an adjusted cost base (“ACB”), or tax cost, of approximately $48.1 million and fair market value (“FMV”) of approximately $101.8 million. Substantially all of that cost stemmed from a $47.46 million purchase of 3295 shares from a third party two years earlier.

As majority holder, Roundtable began negotiating the sale to the purchaser of all of the shares of Holdings. For Micsau, it would have preferred to simply sell the shares of 3295 to the purchaser given its high ACB in those shares. However, the purchaser was unwilling to purchase 3295.

Micsau submitted to Roundtable four alternative transactions (the “Alternative Transactions”). Each of the Alternative Transactions would have allowed Micsau to use its high ACB of the shares of 3295, resulting in an overall gain of $53.7 million (FMV of $101.8 million less ACB of $48.1 million).

Roundtable presented only one of the Alternative Transactions to the purchaser, which it rejected. Instead, the purchaser agreed to a further alternative transaction, which was ultimately carried out in this case, in exchange for a reduction of the ultimate purchase price by $1.5 million.

The series of transactions

The sale was carried out in seven steps (the “Series”), the result of which allowed Micsau to utilize its high ACB in the shares of 3295. The steps can be summarized as follows:

  1. Micsau exchanged its shares of 3295 for 100 common shares and newly-created Class D preferred shares of 3295 with a FMV (and fixed aggregate redemption amount) of $31.5 million. As a result, ACB of $31.5 million was isolated in the new Class D Shares.
  1. Micsau transferred the new Class D Shares of 3295 to a newly-created subsidiary company, 4244851 Canada Inc. (“4244”), in exchange for Class D shares of 4244 with an equivalent ACB and FMV. Micsau realized no capital gain on this step.

The FCA depicted the ownership structure at this stage of the Series as follows:

  1. 3295 transferred its shares of Holdings to 4244 in exchange for Class D shares of 4244 worth $57 million and common shares worth $31.5 million. 3295 elected to realize a capital gain of $53 million on the transfer.

The FCA depicted the ownership structure at this stage of the Series as follows:

  1. The cross-ownership between 4244 and 3295 was eliminated through a cross-redemption of shares for $31.5 million and a subsequent offset of the resultant promissory notes issued on the redemptions. As a result of the cross-redemption:
    • 4244 was deemed to have received a dividend of $31.5 million, which 3295 elected to be a capital dividend that was not taxable to 4244 and increased 4244’s capital dividend account (“CDA”) accordingly; and
    • thereafter, 3295 was deemed to have received a dividend of $31.5 million, which 4244 elected to be a capital dividend (also not taxable to 3295 and increasing 3295’s CDA accordingly).

The FCA depicted the ownership structure at this stage of the Series as follows:

  1. As a final step before the closing, Micsau transferred the Class D Shares of 4244 to 3295 in exchange for Class D shares of 3295. As a result, 3295 held all of the issued shares of 4244.

Immediately following this step, the ownership structure was depicted by the FCA as follows:

  1. 3295 sold all of the shares of 4244 to the purchaser. Given the transactions set out above, 3295 realized no capital gain on the sale.
  1. 3295 redeemed the Class D shares that it issued to Micsau in step 5 and paid cash of $31.5 million to Micsau. This step resulted in no tax liability.

As a result of the Series, the FCA noted that the overall result was that 3295 realized a gain of $53 million, which was the approximate amount of the gain that Micsau would have realized if it had sold its shares of 3295 directly to the purchaser.

The Minister of National Revenue (the “Minister”) reassessed 3295 pursuant to the GAAR to add a capital gain of $31.5 million to its income. The Minister’s position was that Micsau and 3295 carried out a series of avoidance transactions that resulted in a $31.5 million reduction of the capital gain 3295 would have realized if it had sold its shares of Holdings directly to the purchaser.

Decision

The Tax Court of Canada (the “TCC”) ruled that the Series abused subsection 55(2) of the Act and the scheme governing capital dividends. The TCC primarily found that the use of the capital dividends and cross-redemption of shares in step 4 were abusive because they circumvented subsection 55(2). The TCC thus upheld the Minister’s application of the GAAR.

3295 appealed to the FCA. On the appeal, the only issue was whether the TCC erred in holding that the Series was abusive.

The FCA ultimately sided with the taxpayer and allowed the appeal. As a core takeaway, the FCA held that the TCC erred in failing to consider the overall result of the entire Series. Further, the FCA found that error led the TCC to misconstrue the abuse analysis and improperly reject the Alternative Transactions, which demonstrated that the Series was not abusive.

The FCA held that the TCC improperly focused only on the capital dividends and cross-redemption of shares in step 4. The FCA found that the overall result of the Series “did not shortchange the Minister” because the ultimate gain taxed as a result of the Series ($53 million) was approximately the same as the gain that would have been taxed had Micsau sold its shares of 3295 directly to the purchaser ($53.7 million). Further, the FCA noted that Micsau could have also sold its shares of 4244 directly to the Purchaser, which would have also limited the overall gain to $53 million.

Of particular interest to tax practitioners, the FCA found that each of the Alternative Transactions was relevant to the analysis because each:

  1. was legitimately permitted by the Act;
  1. was not so remote as to be practically infeasible and could realistically have been carried out;
  1. had a high degree of commercial and economical similarity to the Series because all would have resulted in the indirect acquisition of the Business;
  1. would have generated tax consequences approximately as favourable as the Series; and
  1. was not abusive of the GAAR.

The FCA was satisfied that the overall result of the Series was consistent with the object, spirit and purpose of the capital gains regime set out in the Act because it taxed the real economic gain realized by Micsau. Thus, no abuse occurred.

Key takeaways

The FCA’s decision helpfully affirms that in considering whether a particular series of transactions violates the GAAR, the overall result of the series should be considered. Unduly focusing on any particular step or the consequence thereof, as the TCC was said to have done, is insufficient. Instead, the FCA recognized that the tax planning undertaken was designed to allow Micsau to utilize its “legitimately-obtained ACB” to ensure that only its “real economic gain” was taxed.

The FCA’s decision also resolutely confirms that legitimate, reasonable, and commercially-realistic alternative transactions are relevant in the GAAR analysis. The set of factors elucidated by the Court provide clear guidance that taxpayers and their advisors should readily analyze if faced with a GAAR assessment.