FCA: Value-Shifting Transaction Abuses Stop-Loss Rules

2763478 Canada Inc.
(2018 FCA 209) concerned the use of a "paper loss"—as opposed to an economic loss—to shelter capital gains. The FCA upheld the TCC decision (2017 CCI 98) that GAAR applied to disallow the taxpayer's use of the capital loss. The FCA decision highlights the fact that parents and their children are not affiliated for the purpose of the stop-loss rules, despite the strong familial relationship. Although this suggests an opportunity—to craft a transaction exploiting this lack of affiliation, hopefully in such a way that the risk of GAAR applying is minimal—it appears that amendments to subsection 55(2) subsequent to the events of this case make it difficult or impossible to create such a paper loss.

The creation of the paper loss at issue resulted from a series of transactions in regard to the sale of an operating corporation, Groupe AST, to an arm's-length party. An individual, Mr. Jobin, owned Groupe AST and the corporate appellant (276). A new holding corporation (Holdco) was created. 276 transferred its shares of Groupe AST to Holdco at their fair market value of approximately $13 million in exchange for the issuance to 276 of class A shares of Holdco. As a result of this transfer and other transactions in the series, 276 realized capital gains. Holdco subsequently sold its shares of Groupe AST to the arm's-length party without realizing a capital gain. Several months later, Holdco declared a stock dividend on its shares held by 276, and issued preferred shares with a fixed redemption value equal to the approximately $13 million value of the class A shares. As a result, the value of the Holdco shares lay with the newly issued class B shares; the class A shares had a large unrealized capital loss, and the class B shares had a large unrealized capital gain. 276 subsequently sold its Holdco class A shares to a holding corporation owned by Jobin's son (Sonco)—for estate-freeze reasons, according to the taxpayer—and realized a capital loss on the sale.

Generally speaking, a loss realized on a disposition by a corporation to an affiliated person will be denied under subsection 40(3.4). However, since 276 and Sonco were not affiliated within the meaning of section 251.1, the stop-loss rule did not apply, allowing 276 to apply the capital loss against the capital gains realized in the reorganization. The minister disallowed the capital loss on the basis of GAAR, which was upheld by the TCC.

The FCA distinguished a "paper loss" from an "economic loss" or "true loss." Under paragraph 3(b), the increase in the value of property becomes a taxable source of income only when the property is disposed of and the gain is recognized. The FCA held that the recognition of a capital loss should follow the same logic. Allowing a paper loss to offset a true gain would frustrate the object, spirit, and purpose of the capital gains regime. In this case, 276 retained all the economic value but tried to reduce that value with a paper loss and was unsuccessful for the good reasons provided by both the TCC and the FCA.

Jin Wen
Grant Thornton LLP, Toronto

Canadian Tax Focus
Volume 9, Number 1, February 2019
©2019, Canadian Tax Foundation