Asset Removal Under Subsection 55(2) Gone Wrong

Former subsection 55(2) deemed an intercorporate dividend to be a capital gain if one of the purposes of the dividend (or one of the results of a dividend under subsection 84(3)) was to effect a significant reduction in the capital gain that, but for the dividend, would have been realized on a disposition of any shares immediately before the dividend. The TCC's recent decision in 101139810 Saskatchewan Ltd. v. The Queen (2017 TCC 3) reminds taxpayers that caution is required when one is determining whether this type of purpose test is met.

Mr. Case owned one-third of the shares of CSM through his holding company, 8231. In 2008, Mr. Case decided to sell his shares of CSM to the remaining shareholders. Before he did so, he undertook corporate reorganizations to minimize the tax payable. Two new holding companies, 9807 and 9810, were incorporated, and in the course of the reorganizations each holding company received deemed dividends on the redemption of 8231 shares. The shares of 9807 and 9810 were ultimately sold to each of the remaining shareholders' holding companies. Mr. Case realized capital gains on these sales and sheltered a portion by using his capital gains exemption (CGE).

In 2014, the CRA reassessed 9807 and 9810 to recharacterize the deemed dividends received by each as capital gains. The taxpayers argued that subsection 55(2) should not apply because essentially the same capital gains were reported by Mr. Case personally, and therefore there were no significant reductions in the capital gains. Also, applying subsection 55(2) would ignore the economic substance of the transactions and would result in double or triple taxation, which was not the legislative intention.

Favreau J ruled in favour of the minister. Subsection 55(2) applies to a Canadian-resident corporation that has received a taxable dividend; the fact that an individual has realized essentially the same capital gain is irrelevant. Also, since the relevant time is the time immediately before the receipt of the dividend, the capital gains realized by Mr. Case subsequent to the deemed dividends were not relevant to the analysis. Furthermore, nothing in subsection 84(3) or 55(2) suggests that the term "disposition" should be viewed in light of a series of related transactions; accordingly, the transactions should not be analyzed as a whole. Favreau J also rejected the taxpayers' argument that applying subsection 55(2) resulted in multiplication of tax, since there is no general rule against the same amount being taxed twice in the hands of different taxpayers.

This decision adds uncertainty to the already confusing landscape of whether or not a series of transactions should be analyzed as a whole or as separate transactions. The court's position on double taxation is also debatable. The cardinal rule of integration is to ensure that an amount taxed in a corporation is not taxed again when that amount is ultimately extracted by an individual shareholder by way of dividends.

Although this case was decided under former subsection 55(2), taxpayers and their advisers should be mindful of new subsection 55(2.1) when they implement a split-up butterfly. In 101139810 Saskatchewan, the reorganizations were presumably undertaken with the primary purpose of qualifying 9807 and 9810 for small business corporation status, thereby allowing access to the CGE; the share redemptions and the corresponding deemed dividends made it difficult to argue that subsection 55(2) did not apply under the results test.

An alternative would have been to use in-kind intercorporate dividends to move the target assets out of 8231. The taxpayers could have argued that they were not caught by the purpose test because the purpose of the dividends was to access the CGE rather than reduce a capital gain. The two are governed by different provisions of the Act, and cannot be said to be the same. By the same logic, one could argue that the purpose was not a reduction in the fair market value of shares or an increase in the cost of properties, and that new subsection 55(2) should not apply due to subparagraph 55(2.1)(b)(ii).

Jin Wen
Grant Thornton LLP, Toronto

Canadian Tax Focus
Volume 7, Number 2, May 2017
©2017, Canadian Tax Foundation