If there are any tax-specific terms in this article that you’re unsure about, you can refer to the Glossary of Tax Planning.
s.245 of the Income Tax Act explicitly identifies three types of taxpayer behaviour that are considered improper to have the tax law abused:
- Not paying taxes
- Underpaying taxes
- Deferring tax payments
However, the Canada Revenue Agency also recognizes reasonable circumstances:
- Legislation, such as s.85, allows taxpayers to “properly defer” taxes, and
- If a taxpayer’s primary purpose reasonably contains normal business intentions and not deliberately taking advantage of tax benefits, it is then not considered improper.
This creates a blurry line. To help Canadians understand which actions cross the line, the Canadian government has thoughtfully listed 10+ tax planning methods on its official website and explicitly stated that these methods violate the General Anti-Avoidance Rule (GAAR).
Before delving into these 10+ methods, it’s helpful to have a basic understanding of three concepts:
Retractable shares (Retraction): These are shares that a company can repurchase at a predetermined price and terms in the future. This provides flexibility for a company to reduce the number of shares when necessary, such as to increase earnings per share or return cash to shareholders.
Redemption of shares: Typically refers to a company buying back its issued shares from shareholders at a predetermined price and then cancelling those shares.
Repurchase of shares: Generally refers to a company buying back its own shares either from the open market or directly from shareholders. Companies often use this method to return cash to shareholders and may also increase earnings per share by reducing the total number of shares.
Now let’s take a look at the 10+ illegal “tax avoidance methods” listed by the Canadian government.
Facts
A corporation transfers property used in its business to a related corporation to permit the deduction of non-capital losses of the related corporation. All of the shares of the two corporations have been owned by the same taxpayer during the period in which the losses were incurred.
CRA’s Interpretation
The absence in the Act of restrictions against transferring property between related corporations, the existence of specific provisions permitting the payment of income and the transfer of losses between related corporations and references in the Explanatory Notes Relating to Income Tax Reform indicate that a transfer of the type in question is consistent with the scheme of the Act and, therefore, s.245(2) would not be applied.
However, if a transfer of a property or other transaction is undertaken to avoid a specific rule, such as a rule designed to preclude the deduction of losses after the acquisition of control of a corporation by an arm’s length person, such a transfer would be a misuse of the provisions of the Act and be subject to s.245.
Facts
A person has property with an unrealized capital gain that it wishes to sell to a third party. A related corporation has a net capital loss. Instead of selling the property directly to the third party and realizing a capital gain, the person transfers the property to the related corporation and elects under subsection 85(1) to defer the recognition of the gain. The related corporation sells the property to the third party and reduces the resulting taxable capital gain by the amount of its net capital loss.
CRA’s Interpretation
Subsection 69(11) does not permit a person to transfer property to an unrelated corporation on a tax-deferred basis where it is intended that the unrelated corporation will sell the property and reduce the amount of the gain by amounts of losses or similar deductions which it may claim. By implication, the subsection does permit a transfer to a related corporation on a tax-deferred basis. In these circumstances such a transfer would be acceptable as it is within the object and spirit of the Act.
Facts
Under a typical estate freeze arrangement a parent transfers to a newly-formed corporation all of the shares of an operating company and elects under s.85(1) in order to defer recognition of the gain on the transfer. The consideration for the transfer is preferred shares retractable at the option of the parent for an amount equal to the fair market value of the shares of the operating company transferred. The preference shares carry voting control. A trust for minor children of the parent subscribes for common shares of the new company for a nominal amount.
CRA’s Interpretation
The Explanatory Notes state that estate freezes would not ordinarily result in misuse or abuse given the scheme of the Act including the recently enacted s.74.4(4). s.74.4 was enacted to deal with income splitting and could have application to certain estate freeze arrangements.
s.74.4(2) may apply to deem an amount to be received as interest by an individual who loans or transfers property to the corporation and one of the main purposes of the loan or transfer may reasonably be considered to be to reduce the income of the individual and to benefit a designated person. A designated person is the individuals’ spouse, or a person under 18 who does not deal with the individual at arm’s length or who is the individual’s niece or nephew.
s.74.4(2) will not apply to “attribute” income to the individual throughout a period throughout which the corporation is a small business corporation as defined in s.248(1). In addition, as provided in s.74.4(4), the rule will not apply where the only interest which the designated person has in the corporation is a beneficial interest in the shares of the corporation which are held through a trust and the terms of the trust provide that the person may not obtain the use of any income or capital of the trust while the person is a designated person.
s.245(2) will not apply to the transfer of the shares to the corporation where s.74.4(2) applies to deem the parent to receive an amount as interest. Similarly, s.245(2) would not apply where, for the reasons stated above, s.74.4(2) does not apply to deem the parent to receive an amount as interest.
Similar considerations would apply to other types of estate freezes involving a transfer of property by a parent to a corporation. For example, in an estate freeze carried out pursuant to s.86 of the Act, the parent would dispose of the shares of the operating company and receive preferred shares of the company having a redemption amount equal to the fair market value of the shares disposed of. The disposition of shares by the parent would constitute a transfer of property to the operating company for the purposes of s.74.4(2) of the Act and the application of s.245(2) to the transfer would be determined in the manner described above.
Facts
A taxpayer owns property that, if disposed of in a straightforward manner, would result in the immediate realization of income or a capital gain. The taxpayer and another taxpayer that wants to buy the property (the purchaser) form a partnership and the taxpayer transfers the property into the partnership and elects under s.97(2) to defer the recognition of gain which otherwise would arise. The purchaser contributes cash to the partnership in an amount equal to the fair market value of the property. The taxpayer withdraws all the cash from the partnership and, because of such withdrawal, the taxpayer’s share of the income and loss of the partnership is reduced. The partnership continues to carry on business.
CRA’s Interpretation
The use of the partnership is an attempt to circumvent the provisions that provide that proceeds of disposition of property are to be accounted for at the time of receipt and would be contrary to the scheme of the Act read as a whole. s.245(2) would accordingly apply.
Facts
Each of two private corporations owns less than 10% of the common shares of a payer corporation that is to pay a substantial taxable dividend. The payer corporation will not be entitled to a dividend refund on the payment of the dividend. None of the corporations is related to any of the others. The private corporations form a corporation, Newco, transfer their shares of the payer corporation to Newco in exchange for common shares of Newco and elect under s.85(1) in respect to the transfer. Following the transfer of the payer corporation’s shares to Newco, Newco will be connected with the payer corporation. The payer corporation pays the dividend to Newco, free of Part IV tax. Newco pays the same amount to the private corporations as a dividend, free of Part IV tax. The primary purpose for the transfer of the shares is to avoid the Part IV tax which would be payable if the dividend were received directly by the private corporations.
CRA’s Interpretation
As the transfer of shares to the Newco is part of an arrangement undertaken to avoid the tax required by Part IV of the Act to be paid in respect of dividends received on portfolio shares, the transfer of the shares would be a misuse of a provision of the Act or an abuse of the Act as a whole and s.245(2) would be applied.
Facts
An operating corporation merges with a shell corporation in an amalgamation described in s.87(1) of the Act. This merger is undertaken solely for the purpose of having the rules in s.87(2)(a) deem the taxation year of the operating company to end immediately before the amalgamation, which year end will produce a tax benefit.
CRA’s Interpretation
The definition of “fiscal period” in s.248(1) of the Act states that no change in the usual and accepted fiscal period may be made without the concurrence of the Minister. The use of the rules of s.87(2) to circumvent this requirement would be a misuse of subsection 87(1) and consequently s.245(2) would apply.
Facts
The taxpayer, a Canadian resident who holds land inventory that has appreciated in value wants to transfer the inventory on a rollover basis to a taxable Canadian corporation (the purchaser). Land inventory cannot be transferred on a tax-deferred basis under s.85(1). Since there is no prohibition in s.97(2) against transferring land inventory on a tax-deferred basis to a Canadian partnership, the taxpayer forms a partnership with the purchaser. The taxpayer transfers the land to the partnership and elects under s.97(2) to defer the gain on the transfer. The purchaser contributes a nominal amount of cash for its partnership interest. The vendor transfers the partnership interest to the purchaser in consideration for shares having a fair market value equal to the value of the partnership interest and the parties elect under s.85(1) in respect of the transfer. On the acquisition by the purchaser of the taxpayer’s partnership interest the partnership ceases to exist and s.98(5) applies to deem the purchaser to acquire the land at the amount of the taxpayer’s cost amount of the land.
Interpretation
The result of this series of transactions is that the taxpayer has avoided the recognition of the gain that the words of s.85 imply should be recognized in such circumstances. Although the partnership may carry on business and have a business effect, the formation of the partnership and the transfer of the land are undertaken to circumvent the prohibition in s.85. s.245(2) would apply as the transfer of the land to the partnership is contrary to the scheme of the Act read as a whole taking into account the section 85 prohibition.
Facts
A person who has purchased the debt and shares of a company in financial difficulty (the taxpayer) intends to reorganize the capital of the taxpayer to convert debt into shares. The debt of the taxpayer has a cost to the person that is less than its principal amount. The fair market value of the assets of the taxpayer is less than its principal amount with the result that payment of the debt by the issuance of shares will result in the application of s.80. To avoid this result the taxpayer transfers all of its property to a wholly-owned subsidiary ensuring that the amounts elected under s.85(1) result in the recognition of income from which the losses of the taxpayer may be deducted. The person then forgives the debt. The taxpayer amalgamates with its wholly-owned subsidiary with the result that all of the property of the subsidiary (which was formerly property of the taxpayer) becomes property of the amalgamated company. Section 80 would apply on the forgiveness of debt but only to reduce the adjusted cost base of the shares of the subsidiary. Since these shares are cancelled on the amalgamation, the application of the section is of no effect.
CRA’s Interpretation
In this situation the transfer of the assets of the taxpayer to the wholly-owned subsidiary that is undertaken solely to avoid the results of a straightforward forgiveness of the debt would be subject to s.245(2).
Facts
The owner of real property has agreed to sell the property to an arm’s length purchaser. The purchaser wants to buy the property for cash, but the owner does not want to recognize the sale proceeds in the year of sale. The owner sells the real property to an intermediary company deferring receipt of the proceeds of disposition of the property for more than two years after the date of sale. The intermediary immediately sells the property to the third party for cash. The owner receives interest from the intermediary in respect of the monies received by the intermediary from the third party.
CRA’s Interpretation
As the interposition of the intermediary is made solely to enable the owner of the property to defer recognition of the gain the sale of the real property to the intermediary would be subject to s.245(2).
As a consequence of the introduction of s.245, s.247(1) is repealed. s.247(1) is directed at a transaction or series of transactions one of the purposes of which is to effect a significant reduction of, or disappearance of, assets of a corporation in order to avoid the whole or part of the tax that would have been payable on the distribution of property of a corporation.
In 1986, Revenue Canada, Taxation confirmed that s.247(1) could apply to a transaction or series of transactions that were undertaken to circumvent specific provisions that provided that a shareholder who disposes of shares to the issuing corporation account for an amount received on the disposition as a dividend rather than as proceeds of disposition. The specific rules mentioned at that time were s.84.1 and 212.1 and s.66.3(2), 85(2.1), 192(4.1) and 194(4.1). The latter two subsections have since been repealed and s.85.1(2.1) has been enacted to restrict the increase in paid-up capital on a share for share exchange.
Also, Part II.1 imposes a tax on certain corporations that pay an amount to a taxpayer as a substitute for normal dividends if they pay such amount in a manner that allows the recipient to account for the amount received as proceeds of disposition of property.
Provisions, such as those mentioned above, indicate the circumstances in which amounts received by a shareholder of a corporation from the corporation on a disposition of shares or other property are to be accounted for as a dividend. If as a result of a series of transactions a shareholder realizes a capital gain on the disposition of property and a transaction in the series is an avoidance transaction, s.245(2) will be applied to the transaction if it is determined that the series of transactions was carried out to thwart the purpose of the provision in question.
Facts
A private corporation wishes to provide an annual dividend payment to its individual shareholders as tax-free capital gains. The corporation as part of an arrangement pays a stock dividend to its shareholders where the stock dividend shares received have a low paid-up capital and a high fair market value. As part of the same arrangement the shares are purchased by a corporation related to the issuing corporation or a third party broker or dealer where the purchase price of the shares is funded by the issuing corporation.
Interpretation
As the payment and repurchase of the stock dividend shares is part of an arrangement to avoid the shareholder tax required to be paid on dividends from the corporation, the payment and repurchase would be a misuse of a provision of the Act or an abuse of the Act as a whole and s.245(2) would apply.
s.245(2) may also apply in other situations involving a reduction of assets of a corporation.
Facts
An employee of a private corporation wishes to receive a bonus, salary or a portion of the employer’s profit as a capital gain in order to claim the capital gains exemption. The employee subscribes for preferred shares of the employer, which are redeemable at a premium that reflects a portion of the employees annual salary or the employer’s book profit. Prior to their redemption, the preferred shares are purchased by a company related to the employer corporation, thereby allowing the employee to receive a distribution of surplus as a capital gain.
CRA’s Interpretation
The acquisition of the preferred shares is part of an arrangement designed to avoid the tax that would have been required to be paid on salary. The acquisition therefore results in an abuse of the Act as a whole and s.245(2) would apply.
This is actually the first example in CRA’s interpretation of GAAR, which is a bit complex. So I have created a separate article titled “The Butterfly” to provide an explanation.
