Tax Free Deemed Dividends Under CRA Microscope

The Tax Court of Canada (Descarries Et Al. v. The Queen (2014) TCC 75) recently had occasion to consider an interesting tax planning scheme that ultimately fell foul of the General Anti-Avoidance Rule (GAAR).  

The issue was whether or not there is a specific scheme under the Act for taxing any direct distribution of surplus of a Canadian corporation as a taxable dividend in the hands of individual shareholders and a specific scheme under the Act against indirect surplus stripping.  Here’s the case:

Wishing to sell a real estate company, Oka Inc. (Oka), a group of siblings did not like the tax ramifications they faced as a result. The tax consequences included realizing a deemed dividend of $625,000 and a capital loss of $350,000. Their advisor suggested that there was another way. Here’s what they did to wind up Oka Inc.:

- Under Section 85 of the Income Tax Act (the Act), they made an internal exchange of their shares for shares with a stepped-up adjusted cost base.  This resulted in a capital gain

- They then transferred those shares to a new numbered company (#Co) with a stepped-up capital;

- Most of their shares from #Co were then redeemed with funds from a loan from Oka to the #Co.  The result was a capital loss to offset the gains realized earlier.

- After selling the real estate from Oka, Oka as wound up; so was the #Co.

In effect, these siblings realized a deemed dividend of only $275,000 (i.e., $625,000-$350,000) and no net capital gain (or loss).

The TCC found that this tax plan abused the object of s. 84.1. The transactions were carefully designed to be well beyond the specific scope of ss. 84(2) and 84.1, but a GAAR analysis was invoked by the Court to hold that the transactions abused the object, spirit and purpose of the impugned provisions. At paragraph 59 the Honourable Justice Hogan stated:

“The result of all three transactions described above is that the tax-exempt margin made it possible for part of Oka's surplus to be distributed to the appellants tax-free in a manner contrary to the object, spirit or purpose of section 84.1 of the Act. For these reasons, I find that this provision was applied in an abusive fashion."

Descarries is an interesting read for those looking for a recent GAAR analysis, although it was heard under the Informal Procedure and therefore carries less precedential muster.

Regardless, the CRA is not content with the reasons for the decision. Expect to hear more in the future, on appeal to the Federal Court of Appeal or the Supreme Court of Canada.