Surplus-Stripping Transaction Violates GAAR

In Pomerleau c. La Reine (2016 CCI 228; under appeal), the court held that GAAR applied to a redemption of shares undertaken as a series of transactions that had the effect of circumventing section 84.1. In holding that GAAR trumps specific anti-avoidance rules, this decision appears consistent with Lipson (2009 SCC 1) but not with Oxford Properties Group Inc. v. The Queen (2016 TCC 204; appeal filed).

In Pomerleau, the taxpayer engaged in a series of transactions in 2004 and 2005 that resulted in the holding of class C shares of Gestion Pierre Pomerleau Inc. with an ACB and PUC of $2 million. The ACB consisted, in part, of a capital loss of $1 million realized on a redemption of shares and deferred by adding it to the ACB of the remaining shares (paragraph 40(3.6)(a)). The class C shares were then redeemed for the amount of their ACB and PUC ($2 million), so the redemption occurred on a tax-free basis.

The minister reassessed the taxpayer on the basis of GAAR. The minister argued that absent the series of transactions undertaken by the taxpayer to circumvent section 84.1—the purpose of which is to prevent surplus stripping—$1 million would have been received as a taxable dividend. Counsel for the taxpayer argued that there was no abuse, because the series of transactions was undertaken as part of a valid non-tax purpose—an intergenerational business transfer. Further, counsel for the taxpayer argued that by adding the $1 million capital loss on the redemption to the ACB of the remaining shares, the "soft" ACB was converted into "hard" ACB. (Essentially, hard ACB is basis on which the taxpayer has paid tax, such as the purchase price of an asset, and soft ACB is basis on which no tax has yet been paid—for example, because of value accumulated before V-day value or the capital gains exemption.)

The court found in favour of the minister. Although the series of transactions did not fall within the literal wording of section 84.1, that section is an anti-avoidance provision designed to prevent taxpayers from undertaking transactions whose purpose is to strip surplus on a tax-free basis through the use of a tax-exempt margin (for example, the capital gains exemption). The fact that the taxpayer's ACB included amounts carried over from previous shares on which the capital gains exemption had been claimed (by the taxpayer, his mother, and his sister) put the series of transactions squarely within the scope of section 84.1.

Favreau J referred to Hogan J's decision in Descarries v. The Queen (2014 TCC 75; informal procedure) (see "V-Day Surplus Stripping an Abuse of Section 84.1," Canadian Tax Focus, August 2014), where a taxpayer had engaged in a similar series of transactions in order to extract surplus from a corporation on a tax-free basis. Both courts argued that the series of transactions converted soft ACB to a capital loss on share redemption, which made it possible to distribute surplus in a tax-free manner without triggering section 84.1. The transactions therefore violated the object, spirit, or purpose of section 84.1, and were found to be abusive.

Following the decision in Descarries, the CRA indicated that it would recommend that GAAR apply to similar series of transactions (2015-0610711C6, November 24, 2015)—a position that the CRA confirmed (2016-0633351E5, May 2, 2016) (rejecting the argument that such a position jeopardizes legitimate intergenerational business transfers). The CRA's position now has greater legal support, since Pomerleau is a general procedure TCC decision (unlike Descarries, which was decided under the informal procedure and has no official precedential value).

Jin Wen and Killy He
Grant Thornton LLP, Toronto

Canadian Tax Focus
Volume 7, Number 1, February 2017
©2017, Canadian Tax Foundation