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Subsection 88(3): A Policy Shift? ....................................................................................................................... 1
Pièces Automobiles Lecavalier: The Application of GAAR to Cross-Border Debt Forgiveness ...................................................................................................................... 3
Update: Prescribed Interest Rate Applicable to the Deemed Interest Income Provision ......................... 7
Tax Update A report on cross-border developments in Canadian tax law / November 2013
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Subsection 88(3): A Policy Shift?by: Angelo Discepola and Robert W. Nearing
On August 19, 2011, the Department of Finance (Canada) released extensive proposed amendments to the foreign affiliate rules, some of which were enacted on June 26, 2013, and which relate to a liquidation and dissolution of a foreign affiliate into a Canadian shareholder and into another foreign affiliate. This paper focuses on the former and highlights what appears to be a significant policy shift.
General Rules on Liquidation and DissolutionSubsection 88(3) of the Income Tax Act (Canada) (Act) is the key operative provision where there has been a liquidation and dissolution of a top tier foreign affiliate. It provides that if at any time a Canadian shareholder receives property (Distributed Property) from a foreign affiliate (Disposing Affiliate) of the Canadian shareholder on a liquidation and dissolution of the Disposing Affiliate and the Distributed Property is received in respect of shares of the capital stock of the Disposing Affiliate that are disposed of on the liquidation and dissolution:
1. the Distributed Property is generally deemed to have been disposed of by the Disposing Affiliate for proceeds of disposition equal to the relevant cost base (defined in subsection 95(4) of the Act generally as the amount that will not trigger any gain or loss) of the Distributed Property provided the liquidation and dissolution is a qualifying liquidation and dissolution (QLAD) as defined in subsection 88(3.1) of the Act or the Distributed Property is a share of the capital stock of another foreign affiliate that was, immediately before the liquidation, excluded property (defined in subsection 95(1) of the Act) of the Disposing Affiliate;
2. if (1) above does not apply to the Distributed Property, the Distributed Property is deemed to have been disposed of by the Disposing Affiliate for proceeds of disposition equal to the Distributed Property’s fair market value;
3. the Distributed Property is deemed to have been acquired by the Canadian shareholder at a cost equal to the Disposing Affiliate’s proceeds of disposition as determined under (1) or (2) above;
4. each share (Disposed Share) of the Disposing Affiliate that is disposed of by the Canadian shareholder pursuant to the liquidation and dissolution is deemed to have been disposed of for proceeds of disposition equal to the Canadian shareholder’s pro rata portion of the net distribution amount (as defined in subsection 88(3.2) of the Act) associated with the class of shares held by the Canadian shareholder; and
5. where the liquidation and dissolution is a QLAD, any loss of the Canadian shareholder in respect of the disposition of the Disposed Share is deemed to be nil.
Net distribution amount is defined to mean the cost to the Canadian shareholder of the Distributed Property as determined under (3) above less all amounts owing (other than unpaid dividends) by or an obligation of the Disposing Affiliate that was assumed or cancelled by the Canadian shareholder in consideration for the Distributed Property. Consequently, where the cost to the Disposing Affiliate of the Distributed Property is equal to or less than the cost to the Canadian shareholder of its Disposed Shares, the liquidation and dissolution should occur on a tax deferred basis for both the Disposing Affiliate and the Canadian shareholder. Since this will often not be the case, the suppression election (discussed below) contained in subsection 88(3.3) of the Act will need to be relied on in most cases.
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Qualifying Liquidation and DissolutionWhere Distributed Property consists of more than shares of another foreign affiliate that are excluded property, the liquidation and dissolution must qualify as a QLAD in order for the liquidation and dissolution to occur on a tax deferred basis. Subsection 88(3.1) defines a QLAD as a liquidation and dissolution in respect of which the Canadian shareholder elects in accordance with Regulation 5911(1) of the Act and the Canadian shareholder:
1. owns at least 90% of the issued and outstanding shares of each class of the Disposing Affiliate; or
2. receives at least 90% of the net assets of the Disposing Affiliate and has at least 90% of the voting power in the Disposing Affiliate’s shares.
Regulation 5911(1) of the Act prescribes that the election for purposes of the QLAD definition must be made in writing on or before:
1. if the taxpayer is a partnership, the earliest of the filing due dates of any member of the partnership for the member’s taxation year that includes the last day of the partnership’s fiscal period that includes the last day of the Disposing Affiliate’s taxation year that includes the time of the distribution of the Distributed Property; and
2. in any other case, the Canadian shareholder’s filing due date for its taxation year that includes the last day of the Disposing Affiliate’s taxation year that includes the time of distribution of the Distributed Property.
Suppression ElectionAs noted above, it is expected that in most circumstances a suppression election will be required in order for the liquidation to occur on a tax deferred basis. Subsection 88(3.3) of the Act provides that where a liquidation is a QLAD of the Disposing Affiliate and the Canadian shareholder would, in the absence of the suppression election, after taking into account any election filed under subsection 93(1) of the Act, realize a capital gain from the disposition of a Disposed Share, the taxpayer may elect that the Distributed Property that was capital property of the Disposing Affiliate be deemed to have been disposed of for proceeds of disposition equal to an amount specified in the election. This enables the Canadian shareholder’s proceeds from the disposition of the Disposed Shares to be reduced so as to defer the gain that might otherwise arise.
Subsection 88(3.4) of the Act sets out the conditions under which a suppression election will be valid. It provides that a suppression election is valid only if:
1. the elected amount in respect of each Distributed Property does not exceed the relevant cost base of the Distributed Property; and
2. the elected amount does not exceed the capital gain that would otherwise have been realized on the Disposed Shares.
Consequently, a Canadian shareholder cannot use the suppression election to realize a loss on the Disposed Shares or trigger a gain on the Distributed Property in circumstances where paragraph 88(3)(a) of the Act applies.
Taxable Canadian Property ElectionLastly, subsection 88(3.5) of the Act deems, for the purposes of paragraph 88(3)(a) of the Act, the Distributed Property to have been disposed of for proceeds of disposition equal to the adjusted cost base of the Distributed Property if the liquidation and dissolution is QLAD, the Distributed Property is taxable Canadian property (other than treaty protected property) that is the share of the capital stock of a Canadian resident corporation and the Canadian shareholder and the Disposing Affiliate jointly elect. As with a QLAD election, regulation 5911(1) of the Act sets out the prescribed rules with respect to both a suppression election and the taxable Canadian property election.
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1 See, for example, the transactions described in Income Tax Ruling ATR-66, “Non-Arm’s Length Transfer of Debt Followed by a Winding-Up and a Sale of Shares,” April 20, 1995.2 See, for example, CRA document no. 2003-0022357, September 25, 2003.3 2013 CCI 310.
CommentsWhat is interesting from a policy perspective is that the foregoing rules apply even where the Canadian shareholder is an individual. This represents a policy shift when compared to subsection 88(1) of the Act. Specifically, subsection 88(1) of the Act does not permit individuals to remove assets from a Canadian corporation on a tax deferred basis. Informal discussions with Department of Finance (Canada) officials on this point indicate that they are of the view that the foregoing rules apply where the Canadian shareholder is an individual but they were unclear as to whether that was the intended result. Consequently, it appears that increased flexibility, and possibly planning opportunities, now exist for individuals who choose to carry on business activities indirectly through a foreign corporation, as compared to a Canadian corporation.
Pièces Automobiles Lecavalier: The Application of GAAR to Cross-Border Debt Forgiveness by: Annie Mailhot-Gamelin
Over the years, taxpayers have developed different techniques for mitigating the potential application of the debt forgiveness rules contained in section 80 of the Income Tax Act (Canada) (Act) in the context of the sale of shares of a corporation with underwater debt owed to its parent.1 One of these techniques involves the subscription by the parent for additional shares of the corporation and the use of the subscription proceeds to repay the debt owed to the parent by the corporation. On a few occasions, the Canada Revenue Agency (CRA) has indicated that it would not apply paragraph 80(2)(g) of the Act in these circumstances, but that the general anti-avoidance rule (GAAR) would likely apply.2 In the recent case of Pièces Automobiles Lecavalier Inc. v. The Queen,3 the Tax Court of Canada (Court) had to consider this issue in a cross-border context. The decision is of particular interest for its analysis of the requirement under GAAR that the transaction giving rise to a tax benefit be an “avoidance transaction” within the meaning of subsection 245(3) of the Act.
Factual Background and Relevant TransactionsHistorically, Pièces Automobiles Lecavalier (PAL) started out as a company owned and operated by the Fugère family, including Roger Fugère Jr. (Mr. Fugère), and was specialized in the recycling of auto parts in Quebec. In 2000, as part of its restructuring plan, Ford U.S., a corporation not resident in Canada, acquired PAL through its Canadian subsidiary, Greenleaf Canada Acquisitions Inc. (Greenleaf). PAL was eventually merged with Greenleaf and its business continued to be carried on through Greenleaf’s Quebec division.
In April 2002, Ford U.S. ceased its recycling activities and Mr. Fugère decided to acquire Greenleaf’s Quebec division. According to his testimony, Mr. Fugère was only interested in acquiring the Quebec assets, but Ford U.S. insisted on effecting the transaction as a sale of the shares of Greenleaf. In September 2002, after lengthy negotiations, the parties finally came to an agreement for the acquisition by 3929761 Canada Inc. (Acquisico), a corporation to be created (which later became the taxpayer), of all the shares of Greenleaf and a debt of approximately $24.5 million owing by Greenleaf to Ford U.S. for an aggregate amount of approximately $9.5 million. Prior to the acquisition, the following transactions were completed
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on October 15, 2002: Ford U.S. subscribed for additional shares of Greenleaf for approximately $15 million and Greenleaf used the subscription proceeds to repay a portion of the debt, thereby reducing the debt to $9.5 million. On December 2, 2002, Acquisico acquired from Ford U.S. all the shares of Greenleaf for $1 and the debt for approximately $9.5 million.
If Acquisico had acquired the shares of Greenleaf and the debt without first reducing the debt, the debt parking rules in subsections 80.01(6) to (8) of the Act would have applied since the debt would have been acquired for less than 80% of its principal amount. If Greenleaf had issued shares to Ford U.S. as consideration for the partial settlement of the debt, the debt forgiveness rules would have applied as a result of paragraph 80(2)(g) of the Act since the fair market value of the shares issued would have been less than the portion of the principal amount of the debt that was repaid. In both cases, this would have resulted in the loss of the tax attributes of Greenleaf and an income inclusion of $5.7 million for the taxpayer under subsection 80(13) of the Act.
The Minister of National Revenue (Minister) alleged that GAAR applied and considered that the taxpayer had realized a gain of approximately $15 million on the forgiveness of the debt. Applying the provisions of section 80 of the Act, the Minister reduced the taxpayer’s tax attributes and made certain adjustments to its taxable income for the taxation years 2002, 2004 and 2005.
Analysis Under GAARThe Court (per Bédard J.) began its analysis with general comments on the application of GAAR. Notably, the Court restated that subject to GAAR, a taxpayer can legally arrange his affairs to minimize the tax payable.4 The Court also reiterated that GAAR should be used only as a tool of last resort.5
1) Tax benefit
The taxpayer conceded the first requirement for the application of GAAR, namely, the existence of a tax benefit (i.e., in this case, the preservation of Greenleaf’s tax attributes which would have otherwise been reduced by the application of section 80 of the Act).
2) Avoidance transaction
With respect to the second requirement, the burden was on the taxpayer to disprove the allegations made by the Minister to the effect that the two “clean-up transactions” (i.e., the share subscription and partial debt repayment) were avoidance transactions within the meaning of subsection 245(3) of the Act since they had no bona fide purpose and were undertaken only to obtain a tax benefit, namely the preservation of Greenleaf’s tax attributes. According to the Minister, these two transactions, together with the sale of the shares of Greenleaf, formed a series of transactions which gave rise to the tax benefit.
The taxpayer first argued that the two clean-up transactions were not part of the same series of transactions as the acquisition of the shares of Greenleaf since they were implemented and imposed by Ford U.S. with no possibility of negotiation by the taxpayer. Instead, there were two distinct series of transactions, each completed by different parties. The evidence submitted by the taxpayer consisted of (i) the testimony of Mr. Fugère and Mr. Lacombe, a Canadian tax accountant who has been working with the Fugère family for several years, and (ii) a document of two pages showing the steps for the clean-up transactions, which would have been sent by fax a few days after the parties reached an agreement in September 2002. These steps had never been discussed by the parties. According to Mr. Fugère and Mr. Lacombe, the reason why Ford U.S. insisted on a sale of shares was to realize its capital loss on the shares of Greenleaf for U.S. tax purposes, which would be available only if the clean-up transactions were completed.
4 Commissioners of Inland Revenue v. Duke of Westminster, [1936] A.C. 1.5 Canada Trustco Mortgage Co. v. Canada, [2005] 2 S.C.R. 601, at para. 21.
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The Court found that the evidence was not sufficient to discharge the taxpayer’s burden. According to the Court, it would have been desirable, even necessary, to have a representative of Ford U.S. testify that Ford U.S. had unilaterally dictated the terms and structure of the transaction. The only documentary evidence submitted by the taxpayer was the two-page document that was neither signed nor dated, and which the Court found to have relatively low probative value. The Court indicated that it would be surprising that a company of Ford U.S.’s size and status would have proceeded with a transaction of over $9 million and dictated its terms by faxing a very rudimentary two-page document to the purchaser. The Court, therefore, concluded that the clean-up transactions and the sale of the shares of Greenleaf formed part of the same series of transactions.
The taxpayer also argued that the clean-up transactions were undertaken for U.S. tax purposes and for reasons specific to Ford U.S., which constituted bona fide non-tax purposes under subsection 245(3) of the Act. The Court recognized that based on the wording of paragraph 245(3)(b) of the Act and the definition of “tax benefit” in subsection 245(1) of the Act, strictly U.S. tax reasons would, in and of themselves, constitute bona fide non-tax purposes, and that internal considerations, whether accounting, economic or other, may in certain circumstances constitute bona fide non-tax purposes. Therefore, if it was reasonable to consider that the clean-up transactions were undertaken primarily for U.S. tax purposes and reasons specific to Ford U.S., they would not constitute avoidance transactions. Again, the only evidence submitted by the taxpayer was the oral testimony of Mr. Lacombe and Mr. Brian Nerney, a former shareholder of a company acquired by Ford U.S. who entered into similar clean-up transactions with Ford U.S. Both witnesses testified that the clean-up transactions were completed by Ford U.S. for U.S. accounting and tax purposes. The Court could not accept their testimony on the basis that it constituted hearsay. The Court drew a negative inference from the fact that no person from Ford U.S. testified in support of the reasons for the clean-up transactions and no U.S. tax expert testified to speak to the U.S. tax consequences of the transactions. After a general review of the case law on the principle of negative inference, the Court concluded that it was justified to apply it in the present case on the basis that: (i) the evidence submitted to the Court was deficient and not credible, and (ii) the reasons given by the taxpayer to justify the absence of such crucial witnesses, namely the lack of cooperation by Ford U.S. and the high costs of bringing a witness to Canada, were not sufficient.6
In obiter, the Court commented on the fact that according to Mr. Lacombe and Mr. Fugère, the Canadian tax consequences of the transactions had not been contemplated until they received the two-page document from Ford U.S. The evidence showed that Mr. Lacombe was aware of the existence of the $24.5 million debt. According to the Court, it is unlikely that an experienced tax specialist did not have the reflex to further inquire when he knew that Acquisico was going to acquire the shares of Greenleaf and its debt for $9.5 million.
Such a situation would have alarmed any tax specialist about the potential application of the debt forgiveness rules. The Canadian tax consequences were too significant not to have been considered.
3) Misuse or abuse
With respect to the third requirement for the application of GAAR, the Minister argued that the avoidance transactions circumvented the object and spirit of section 80 of the Act in general. When a debtor benefits from a forgiveness of debt, its economic power is increased by the amount of the debt. If it deducted expenses in computing its income, such expenses will, in reality, have cost it nothing. In this case, if the debt had not been forgiven in part by the injection of capital and the repayment before the sale, the debt parking rules in subsections 80.01(6) to (8) of the Act would have applied. The Minister also argued that the clean-up transactions resulted in a misuse of paragraph 80(2)(g) of the Act. For its part,
6 The Court, referring to Archambault J.’s decision in Morley v. Canada (2004 TCC 280), indicated that there are legislative means to compel the attendance of a witness. With respect to the question of costs, the Court noted, at paragraph 59 of its decision, that: “[translation] the taxpayer had Mr. Nerney come from Texas to testify for about five minutes on subjects that were on their face hearsay and did not assist the court.”
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the taxpayer argued that section 80 of the Act constitutes a very clear and complete code and for that reason, it is difficult to demonstrate that an underlying tax policy that goes beyond the wording of the Act exists. In addition, the taxpayer argued that there are two aspects to the underlying tax policy of the rules in section 80 of the Act: (i) the increase of economic power of the debtor, and (ii) the deduction for bad debt for the creditor. Here, since Ford U.S. did not claim any deduction for bad debt as a result of the forgiveness of the debt, there was no abuse of the object and spirit of section 80 of the Act.
Applying a textual, contextual and purposive analysis, the Court rejected the taxpayer’s argument that the object and spirit of section 80 of the Act is twofold. The provisions allowing the creditor to benefit from a deduction for bad debt apply in very specific situations, independently and in a context much broader than the context of section 80 of the Act. The Court found no symmetry between the two regimes. The Court then reviewed the object and spirit of the debt parking rules in subsections 80.01(6) to (8) of the Act and concluded that by making a “temporary” capital injection, the taxpayer artificially reduced the debt in order to meet the 80% test and thus avoid the debt forgiveness rules.
In carrying out the transactions this way, the taxpayer benefited from a $24.5 million loan and discharged its obligation to pay an amount of $15 million while benefiting from the deduction of expenses with respect to the full amount of the loan. By undertaking the avoidance transactions, the taxpayer circumvented the application of sections 80 and subsections 80.01(6) to (8) of the Act. The Court found that the avoidance transactions were clearly abusive and the Minister was justified to apply GAAR.
Even if there was no misuse of sections 80 and subsections 80.01(6) to (8) of the Act, the Court held that the application of GAAR would still be justified because the avoidance transactions resulted in a misuse of paragraph 80(2)(g) of the Act. The purpose of this provision is to ensure that the debt forgiveness rules cannot be avoided by transforming a debt into shares having a lesser value. In this case, the additional shares of Greenleaf had full fair market value at the time of their issuance, but their value was reduced immediately after the repayment. Without GAAR, the Court recognized that the transactions would not have triggered the application of paragraph 80(2)(g) of the Act. By effecting the transactions in two steps rather than by directly converting the debt into shares, the taxpayer circumvented the application of 80(2)(g) of the Act and thus avoided the application of the debt forgiveness rules.
ConclusionThis decision will certainly have an impact on transactions implemented to mitigate the application of the debt forgiveness rules as it clearly establishes that these types of transactions can be subject to GAAR. Nonetheless, the Court made interesting comments to the effect that U.S. tax reasons and internal considerations, whether accounting, economic or other, may in certain circumstances constitute bona fide non-tax purposes. Given the clear lack of evidence, the Court had no choice but to conclude that the taxpayer had not discharged its burden to demonstrate that the clean-up transactions were undertaken primarily for non-tax purposes, but it may have reached a different conclusion in other circumstances.
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Update: Prescribed Interest Rate Applicable to the Deemed Interest Income ProvisionIn previous articles discussing the Budget 2012 foreign affiliate “dumping” and shareholders loan rules(see, for example, Budget 2012 Legislation – More Revisions to Foreign Affiliate “Dumping” and ShareholdersLoan Rules in our November 16, 2012 issue), we discussed the interest imputation rules for pertinent loan orindebtedness (PLOI) to non-residents. In particular, we noted the submissions made that the interest imputed under section 17.1 for a PLOI was too high. The Canada Revenue Agency website has been updated recently to include the prescribed interest rate applicable to the deemed interest income provisionThe rate can be found on this page: http://www.cra-arc.gc.ca/nwsrm/rlss/2013/m09/nr130923-eng.html.
Every effort has been made to ensure the accuracy of this publication, but the comments are necessarily of a general nature, are for information purposes only and do not constitute legal advice in any manner whatsoever. Clients are urged to seek specific advice on matters of concern and not rely solely on the text of this publication.
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National Practice Group Leader and Ontario Regional ContactDouglas [email protected]
British Columbia Rosemarie Wertschek, [email protected]
AlbertaRon [email protected]
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