Possible Anomaly in the Passive Income SBD Grind?

Owner-managers can potentially avoid the passive income SBD grind in paragraph 125(5.1)(b) when triggering corporate capital gains by winding up and dissolving the corporation holding the investments in the same year.

Example 1

Consider a Holdco that wholly owns an Opco that claims the SBD annually. Both companies have a December 31 year-end. Holdco owns investments with an accrued capital gain of $1 million. In year 1, Holdco sells the investments and realizes a capital gain. As a result, in year 2, Opco loses the SBD entirely since an associated corporation (Holdco) has investment income above $150,000 in the preceding year. This is presumably the expected operation of these rules as envisioned by the government.

Example 2

Suppose that in addition to owning Opco, Holdco also owns a second wholly owned subsidiary, Realestateco, which holds land with an accrued capital gain of $1 million. All three companies (Holdco, Opco, and Realestateco) have a December 31 year-end. In year 1, Realestateco disposes of the land and realizes a capital gain. Before the end of that year, Realestateco is wound up and legally dissolved.

In year 1, Opco and Realestateco are associated; however, Opco's SBD for year 1 should be preserved since there was no investment income prior to year 1 in the associated group. In year 2, Opco calculates its passive income SBD grind by adding up the year 1 investment income of corporations that it is associated with in year 2. In year 2, Opco and Realestateco are not associated since Realestateco was dissolved before the start of year 2. Even though Realestateco had a sizable capital gain in year 1, it is not considered for Opco's SBD grind.

The above result may appear anomalous in view of the policy purpose of the passive income SBD grind, as illustrated by example 1. Still, none of the specific anti-avoidance rules appear to deal with this situation. The Budget Implementation Act, 2018, No. 1 contains an anti-avoidance rule that targets circumstances where a short taxation year is triggered to defer the application of these rules, but this applies only for 2018 transactions. There are also two deemed association rules, neither of which should apply because Realestateco no longer exists: (1) subsection 125(5.2) deems two corporations that are related—but otherwise not associated—to be associated if a loan or transfer was made between them to avoid association and thereby avoid the SBD grind; and (2) subsection 256(2.1) deals with the separate existence of companies to avoid association.

A taxpayer could easily have performed all of the above steps without any view to a tax advantage; the windup of a real estate holding corporation after the sale of the underlying real estate was a common transaction before these rules existed (although a windup in the same year may have been unusual). However, it is also possible to plan into this situation. For instance, it may be possible to preserve the SBD while deliberately triggering capital gains to access corporate funds at the integrated capital gains tax rate, as in example 3 below.

Example 3

Consider example 1, in which the investments are in Holdco, except that (1) before triggering the capital gain in year 1, Holdco transfers the investments to a newly formed corporation (CGco) on a tax-deferred basis under subsection 85(1); and (2) before the end of year 1, CGco is wound up and legally dissolved with any CDA and RDTOH consolidated into Holdco.

By the same analysis as in example 2, CGco's capital gain is not considered for Opco's passive income SBD grind. Of course, this situation may be thought of as deliberately seeking a tax advantage, and hence GAAR must be considered.

Martin Lee and Thanusan Raveendran
Markham, ON

Canadian Tax Focus
Volume 9, Number 4, November 2019
©2019, Canadian Tax Foundation