THE PURPOSE OF SUBSECTION 55(2)

Transcription

1 THE PURPOSE OF SUBSECTION 55(2) Eoin Brady, CPA, CA PricewaterhouseCoopers LLP Toronto Gwendolyn Watson PwC Law LLP Toronto 2015 Ontario Tax Conference

2 The Purpose of Subsection 55(2) Eoin Brady, PricewaterhouseCoopers LLP Gwendolyn Watson, PwC Law LLP* INTRODUCTION Subsection 55(2) of the Income Tax Act (Canada) 1 is a specific anti-avoidance rule aimed at capital gain strips and has been in the Act for over 30 years. Subject to certain exceptions, subsection 55(2) can apply when the purpose test is satisfied, that is, when the purpose of a dividend (other than a dividend arising under subsection 84(3)) received as part of a transaction or event or a series of transactions or events is to effect a significant reduction in a capital gain that would otherwise be realized on a fair market value disposition of any share (the Current CG Purpose Test ). If subsection 55(2) applies, the amount of the dividend is deemed not be a dividend received by the corporate shareholder, and instead is deemed to be either proceeds of disposition or a gain. In the 2015 federal budget, the Department of Finance ( Finance ) released proposals (the Budget Proposals ) to amend subsection 55(2) to: (i) expand the purpose test in subsection 55(2) to address situations where a dividend is paid to cause the fair market value of any share to fall below its cost or significantly increase the cost of properties of the corporate shareholder (the Proposed Purpose Tests ), and (ii) modify the wording in the Current CG Purpose Test. The Budget Proposals also proposed to limit the scope of certain exceptions to subsection 55(2) and add new rules to address the use of stock dividends which circumvent the effectiveness of subsection 55(2). Following a consultation period, on July 31, 2015, Finance released a revised version of the Budget Proposals to amend section 55 (the Section 55 Proposals ) and detailed explanatory notes (the Explanatory Notes ). 2 No materials changes were made to the Proposed Purpose Tests in the Section 55 Proposals, although minor changes were made to other aspects of the Budget Proposals to correct certain technical anomalies. Once enacted, the Section 55 Proposals will generally be applicable to dividends received after April 20, Compared to other provisions in the Act with purpose tests, the Current CG Purpose Test in subsection 55(2) has historically received less attention from taxpayers due to the availability of the exceptions to subsection 55(2). However, given that the Section 55 Proposals will result in amendments that add the Proposed Purpose Tests to subsection 55(2) and limit the scope of the exceptions, taxpayers will encounter the purpose tests in section 55 more frequently than in the past. Since the release of the Budget Proposals and the Section 55 Proposals, other authors have outlined in detail the changes to subsection 55(2) and supporting rules. These articles are recommended reading for those involved in Canadian tax planning. 3 Because of the abundance of commentary already available, we * A law firm affiliated with PricewaterhouseCoopers LLP. 1 RSC 1985, c. 1 (5 th Supp.) (the Act ). Unless otherwise stated, all statutory references in this article are to the Act. 2 For submissions to Finance, see: letter to Finance by the Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional Accountants of Canada, Re 2015 Federal Budget Amendments to Section 55, May 27, 2015; and letter to Finance by the Society of Trust and Estate Practitioners (Canada), September 30, See, for example: Carolyn Engel, A Review of Common Mistakes and Errors Made by Tax Professionals," 2015 Prairie Provinces Tax Conference (Toronto: Canadian Tax Foundation, 2015) 7:1-25; Kenneth Keung, E. Brady and G. Watson Page 1

3 have chosen to focus on the Proposed Purpose Tests in the Section 55 Proposals. More specifically, our objectives for this article are to provide guidelines that can be used when applying these purpose tests and demonstrate that the original policy objectives in respect of capital gains strips continue to be relevant in considering the Proposed Purpose Tests. This article is divided into three parts. In the first part, we provide an overview of the amendments in the Section 55 Proposals, with a specific emphasis on the changes to the subsection 55(2) exceptions. 4 In the second part, we review the rationale for subsection 55(2) and the guidelines developed by the courts in applying the Current CG Purpose Test. In the third part, we examine the Proposed Purpose Tests and the rationale for these new rules. Our view is there is likely less cause for concern in relation to the Proposed Purpose Tests than may have initially been expected. However, like any purpose test, taxpayers and their advisors should undertake a thorough and documented analysis of the purpose of the payment or receipt of the dividend going forward. PART I: OVERVIEW OF THE SECTION 55 PROPOSALS Subsection 55(2) includes both preconditions to and exceptions from its application. The preconditions include a corporate shareholder holding a share on capital account, the receipt by such shareholder of a dividend, typically as part of a series of transactions or events, for which is entitled to claim an offsetting deduction under any of subsections 112(1) or (2) or 138(6) and the satisfaction of either the purpose or the results test. When the preconditions are met, one of the following exceptions may provide relief from the recharacterization of a dividend under subsection 55(2): the paragraph 55(3)(a) exception, the safe income on-hand exception or the Part IV tax exception. 5 The Section 55 Proposals will modify the purpose test precondition and all of the above-noted exceptions. The ability to rely on the exceptions for relief from proposed subsection 55(2), and in particular the paragraph 55(3)(a) exception, is now restricted. As a result, the Proposed Purpose Tests will be of increased importance compared to the Current CG Purpose Test. To demonstrate the importance of the exceptions to subsection 55(2), we have summarized each exception and the impact the Section 55 Proposals have on the application of each. Section 55 May Now Apply to Every Intercorporate Dividend, (2015) vol. 15, no. 3 Tax for the Owner Manager, 3-4; Carla Hanneman, Reorganization Strategies for Proposed Paragraph 55(3)(a), (2015) vol. 5, no. 3 Canadian Tax Focus, 8-9; Michael Welters et. al., When Intercorporate Dividends are Not Tax-Free, Including Changes to Subsection 55(2) in the Federal Budget, 2015 British Columbia Tax Conference (Toronto: Canadian Tax Foundation, 2015); Manu Kakkar and Marissa Halil, Proposed Subsection 55(2.5): Is the New Definition of Significant Reduction a Boon or a Bane? (2015) vol. 15, no. 4 Tax for the Owner Manager, 4-5; and Angela Ross and Gwendolyn Watson, Draft Legislation Amending Subsection 55(2), (2015) 21 Insurance Planning Another substantive change in the Section 55 Proposals is in respect of stock dividends. Proposed subsections 55(2.2) to (2.4) provide rules to compute the amount of a stock dividend for the purposes of other provisions in section 55. Other authors have discussed these rules in detail. 5 Another exception relates to dividends received as part of a butterfly transaction that meets the requirements of paragraph 55(3)(b). The Section 55 Proposals do not propose to amend paragraph 55(3)(b) and we do not discuss this exception in this article. E. Brady and G. Watson Page 2

4 Paragraph 55(3)(a) Exception Paragraph 55(3)(a) is an exception to the application of subsection 55(2) and generally applies to intercorporate dividends received as part of a related party reorganization. Generally, this exception was available provided that no third party acquires an interest in any related group member as part of the series of transactions or events that includes the receipt of the dividend. This paragraph is proposed to be amended so that it is limited to only those dividends that are deemed to arise on a redemption, acquisition or cancellation of shares under subsection 84(2) or (3). While described as consequential and necessary to ensure that proposed subsections 55(2) to (2.5) cannot be avoided in related party transactions, 6 this proposed change has a material impact beyond those transactions purported to be targeted by the Section 55 Proposals. The result is that paragraph 55(3)(a) will no longer be available to protect intercorporate dividends from the application of proposed subsection 55(2) if they are cash dividends, stock dividends, dividends inkind or dividends under subsection 84(1) arising on an increase in the paid-up capital of the share. When these types of dividends are received, the Proposed Purpose Tests must be met, or the shares must have sufficient safe income on-hand to prevent the application of proposed subsection 55(2). Some may view Finance s new restrictive language in paragraph 55(3)(a) as unwarranted because of the general scheme of the Act that permits tax-free dividends between corporations. However little sympathy can be expected from Finance or the Canada Revenue Agency (the CRA ) as it is well known that basis shifting or basis multiplying was possible under paragraph 55(3)(a). In particular, the Explanatory Notes include the following statement: The amended exception in paragraph 55(3)(a) for related-person dividends is intended to facilitate bona fide corporate reorganizations by related persons. It is not intended to be used to accommodate the payment or receipt of dividends or transactions or events that seek to increase, manipulate, manufacture or stream cost base. So, to access the proposed paragraph 55(3)(a) exception, it will be necessary to redeem or otherwise cancel shares and thereby reduce cost base accordingly. Safe Income On-Hand Exception Under the current rules, subsection 55(2) does not apply to a dividend that reduces a capital gain that is attributable to safe income, which is income as determined in accordance with the rules in subsection 55(5). 7 The CRA s view, only safe income that remains on hand may contribute to an accrued gain on a share. In order to compute safe income on-hand, it is generally necessary to reduce a corporation s Division B income by amounts no longer on-hand. Even though the purpose test in subsection 55(2) will be expanded and the paragraph 55(3)(a) exception will be restricted to certain deemed dividends, the safe income on-hand exception continues to be available. Practically this safe harbor should provide many corporate shareholders, with some 6 Otherwise, so long as a third party does not acquire an interest in the corporate group, a transaction meant to be caught by proposed subparagraph 55(2.1)(b)(ii) could be exempt from the application of subsection 55(2) by virtue of paragraph 55(3)(a). 7 In Ontario Ltd. v. MNR, 93 DTC 427 (TCC), the court held that the starting point for calculating safe income is a corporation s income as computed under Division B of the Act. E. Brady and G. Watson Page 3

5 modifications, with relief from subsection 55(2) as most often dividends are paid from corporate surpluses. So, before undertaking an analysis of the Proposed Purpose Tests, a corporate shareholder may wish to compute their safe income on-hand entitlement in a dividend payer to see if this exception is available. However, those who have computed safe income on-hand know it is fraught with complexity and uncertainty. The code for its computation is incomplete and governed by CRA administrative positions. Common frustrations include assessing what on-hand adjustments are required and when the safe income determination time occurs. Since taxpayers may rely on this exception more often, this may accelerate interpretive guidance from the CRA. In respect of the Budget Proposals and the Section 55 Proposals, there have been changes to the safe income-on hand exception, which is now contained in proposed paragraph 55(2.1)(c). One proposed change is a modification to the text that translates into the on-hand adjustments. Current subsection 55(2) excludes from re-characterization into a capital gain a dividend that is reasonably attributable to safe income. This concept has been interpreted to mean that the safe income otherwise computed should be reduced for amounts that have been distributed from the corporation, most commonly after tax payments of taxes and dividends. 8 The objective of these on-hand adjustments is to ensure that safe income that is not retained by the corporation is not considered reasonably attributable to a capital gain on the shares. Proposed paragraph 55(2.1)(c) will reword the on-hand adjustment. Under the proposed provision, safe income is available when it contributes to the capital gain that could be realized. The reason for change in choice of language is unclear. Finance and the CRA have had the opportunity to make statements on this change, and to date, neither has signaled a policy change. In particular, the Explanatory Notes retain the attributable language in the broad description of safe income. The Explanatory Notes also make it clear that income that has been subject to corporate income tax should be allowed to be paid as a tax-free dividend. If Finance intended to revisit and limit the scope of on-hand adjustments it is not apparent. Instead, Finance reinforced the existing on-hand concepts through the following statements in the Explanatory Notes: and Subsection 55(2) does not apply where the gain that has been reduced is attributable to the share s portion of the income ( safe income ) earned or realized by any corporation Safe income is protected from the application of subsection 55(2) because this income has been subject to corporate income tax and should therefore be allowed to be paid as a tax-free dividend to other Canadian corporations. [Emphasis added] The Explanatory Notes for proposed subsection 55(2.1) do provide a specific but short explanation of the change from attributable to contributed by referencing the need to accommodate the new purposes tests in proposed subparagraph 55(2.1)(b)(ii). While the referenced accommodation is not 8 The CRA s position is non-deductible expenses and certain contingencies should also reduce safe income. See Income Tax Technical News no. 37, February 15, E. Brady and G. Watson Page 4

6 entirely clear, it does provide a direct link between the Proposed Purpose Tests and the assessment of whether the purpose of the dividend where clauses 55(2.1)(b)(ii)(A) or (B) are relevant is in respect of an eventual capital gain. In a recent technical interpretation, 9 the CRA commented on the Budget Proposals in respect of the safe income on-hand changes in proposed subsection 55(2). In this document, the CRA restated its long standing position in respect of safe income on-hand, notwithstanding the change in wording from attributable to contributed. The highlights of the CRA s current position on on-hand adjustments are as follows: The safe income should be reduced by any actual or potential disbursement or outlay arising in the holding period that has not otherwise been deducted in the calculation of the corporation's net income for tax purposes and which would reduce the gain inherent in the particular shares of the corporation. These adjustments are easiest explained to be taxes, dividends and certain contingent or other liabilities. The CRA will follow the approach for phantom income provided by the Federal Court of Appeal in the Kruco case. 10 It is the CRA's position that non-deductible expenses should be deducted as on-hand adjustments. 11 Like the purpose test, the safe income on-hand exception will be more relevant for corporate taxpayers under the Section 55 Proposals. Corporate taxpayers may find safe income on-hand becomes another tax attribute that is computed on an annual basis. The other safe income on-hand related change in the Section 55 Proposals is found in proposed paragraph 55(2.1)(c). This provision specifies that safe income on-hand is accessible only when it contributes to a capital gain. This change may be relevant when there is a dividend paid that increases the cost of property or reduces the fair market value of a share, but the share itself is not in a capital gain position. However as discussed further in Part II, if there is no overall capital gain reduction motive underlying the dividend, then safe income on-hand and proposed subsection 55(2) may not be relevant. Part IV Tax Exception The third main exception from subsection 55(2) is the Part IV tax exception. Subsection 55(2) provides that this provision does not apply to any portion of a taxable dividend that is received by a corporate shareholder which is subject to Part IV tax, provided that the Part IV tax is not refunded as a consequence of a payment of a dividend to a corporation as part of the same series. It is generally accepted that this exception will be available if a dividend refund arises as a result of the payment by the corporate shareholder of a dividend to a shareholder that is an individual, even if that dividend is part of the series that includes the receipt of the dividend by the corporate shareholder. In the Section 55 Proposals, the Part IV tax exception is maintained in the pre-amble to proposed subsection 55(2), but now provides that this exception will be available only if the Part IV tax is not 9 CRA document no C6, May 14, See Income Tax Technical News no. 34, April 27, See Income Tax Technical News no. 37, February 15, E. Brady and G. Watson Page 5

7 refunded as a consequence of a payment of a dividend by a corporation as part of the same series. The Explanatory Notes confirm that the Part IV tax exception will no longer be available where a dividend refund arises as a result of the payment by the corporate shareholder of any dividend as part of the series, including those paid to a shareholder that is an individual. Thus, the Part IV tax exception in the Section 55 Proposals is much narrower than the current exception. PART II: THE CURRENT CG PURPOSE TEST Prior to discussing the Proposed Purpose Tests in the Section 55 Proposals, we believe it is instructive to first examine the rationale behind subsection 55(2) and the guidelines developed by the courts for applying the Current CG Purpose Test. As discussed in more detail in Part III, we believe that although the subject matter of the Proposed Purpose Tests is different, the same overriding policy objective of subsection 55(2) remains intact that is, it is still a specific anti-avoidance rule directed at capital gain strips. As such the guiding principles for applying the Current CG Purpose Test should equally be applicable when working with the Proposed Purpose Tests. Rationale Prior to 1979, the capital gains rules in the former Income Tax Act 12 contained a specific anti-avoidance provision in former subsection 55(1), which was targeted at transactions that artificially or unduly reduced capital gains or increased capital losses. In a 1978 paper, Mr. John Robertson, then Director General, Corporate Rulings Director, Legislation Branch of Revenue Canada, Taxation, speaking on behalf of Revenue Canada, provided some examples of capital gains strips and general guidelines on when these types of transactions would be subject to former subsection 55(1). 13 For example, assume that Holdco owns all of the shares of Opco, and both are taxable Canadian corporations and private corporations. Holdco wishes to sell all of the Opco shares to Purchaser, a taxable Canadian corporation that deals at arm s length with Holdco and Opco for the purpose of the Act. In this fact pattern, Mr. Robertson provided the following examples of capital gains strips: 1. Prior to the sale, Opco: (i) pays a cash dividend to Holdco, (ii) pays a stock dividend to Holdco, or (iii) increases the stated capital of its shares. 2. Instead of selling the Opco shares, Purchaser subscribes for shares of Opco and the shares held by Holdco are purchased for cancellation. 3. Holdco sells the Opco shares to Purchaser in exchange for preferred shares, which is effected on a rollover basis under section 85 or Purchaser them redeems the preferred shares held by Holdco. 14 Mr. Robertson indicated that Revenue Canada s position was that on a sale of the Opco shares, Holdco should realize a capital gain at least equal to the unrealized or untaxed appreciation in the assets of Opco. Further, if an intercorporate dividend is used to reduce a capital gain, and the dividend is not subject to Part IV tax, Revenue Canada would view the transactions as resulting in an artificial or undue reduction of a capital gain. 12 S.C , c. 63, as amended. 13 J. R. Robertson, Recent Developments in Federal Taxation, Report of Proceedings of the Thirtieth Tax Conference, 1978 Conference Report (Toronto: Canadian Tax Foundation, 1980), 52-67, at Mr. Robertson also noted that variations of these transactions were being used to effect asset sales. E. Brady and G. Watson Page 6

8 Notwithstanding Revenue Canada s view that former subsection 55(1) could apply to capital gain strips, the 1979 federal budget introduced predecessor versions of subsections 55(2) to (5), which to a large extent, codified Revenue Canada s position regarding capital gain strips. The 1979 budget commentary explained the rationale for the new rules as follows: Concerns have been expressed as to the legislative scope and intended application of this anti-avoidance provision [former subsection 55(1)]. A number of plans have been developed whereby, as a preliminary step to certain sales of shares, a corporate vendor extracts what are in substance sale proceeds in the form of tax-free intercorporate dividends or deemed dividends to decrease the value or increase the cost base of the shares to the point where capital gains tax is avoided. These tax-free dividends frequently exceed the earnings of the corporation to be sold. Such excessive dividends are usually motivated only by the vendor s desire to reduce his exposure to capital gains tax. As a general rule, the objective of the tax law is that on most arm s-length and on certain non-arm s-length intercorporate share sales, a capital gain should arise at least to the extent that the sale proceeds reflect the unrealized and untaxed appreciation since 1971 in the value of underlying assets. This objective will generally be achieved where tax-free dividends on shares are limited to post-1971 taxed retained earnings. The predecessor versions of subsections 55(2) to (5) were enacted and generally applied to dividends paid after April 21, Former subsection 55(1) was subsequently repealed in 1988 when the general anti-avoidance rule in section 245 was introduced. As is evident from the foregoing description, subsection 55(2) is aimed at situations where a taxpayer is contemplating a sale of shares with an accrued capital gain, and an intercorporate dividend is paid, or deemed to be paid, in order to reduce or eliminate the gain. The basic principle is that a corporate shareholder should be subject to capital gains tax on a sale of shares, to the extent that the gain on the shares represents unrealized or untaxed appreciation in the assets of the underlying corporation. Guidelines for Applying the Current CG Purpose Test The Current CG Purpose Test has by and large remained the same since subsection 55(2) was adopted in By virtue of this test, subsection 55(2) can potentially apply if a taxable dividend (other than a dividend arising under subsection 84(3)) is received by a corporate shareholder as part of a transaction or event, or a series of transactions or events, one of the purposes of which was to effect a significant reduction in the portion the capital gain that, but for the dividend, would have been realized on a fair market value disposition of any share immediately before the dividend (sometimes referred to in this article as a gain-reduction purpose ). The following cases are the key cases where the courts have had the opportunity to consider the Current CG Purpose Test: CPL Holdings Ltd. v. The Queen, 15 Placer Dome Inc. v. The Queen 16 and Meager Creek Holdings Ltd. v. The Queen. 17 We believe that these cases confirm the basic proposition that subsection 55(2) is intended to operate only in situations of genuine tax avoidance. These cases also DTC 5253 (FCTD) DTC 6562 (FCA), aff g 96 DTC 1787 (TCC) DTC 2073 (TCC). E. Brady and G. Watson Page 7

9 provide general guidelines on how taxpayers should approach a purpose analysis under the Current CG Purpose Test. What follows is a discussion of this principle and these guidelines. 18 When do you need to worry about the purpose? Shortly after the introduction of subsection 55(2), Mr. Robertson, again speaking on behalf of Revenue Canada, delivered a paper at the 1981 Annual Canadian Tax Foundation conference. 19 In this paper, Mr. Robertson explained the purpose of subsection 55(2) as follows: The amendments are designed to ensure that while all the existing corporate rollovers will continue to apply, the realized proceeds on a variety of arm s-length intercorporate share sales will not be treated as tax-free intercorporate dividends, but will instead be treated as capital gains. The application of subsection 55(2) is intended to be limited to cases of genuine tax avoidance and common sense should prevail. The very nature of the subsection indicates that the final decision on whether subsection 55(2) applies will depend on the facts of each case. However, a corporation need not be concerned with the application of subsection 55(2) with respect to all dividends received by it. 20 Mr. Robertson then presented a decision chart regarding the application of subsection 55(2), with the starting premise that only those dividends which are lumpy dividends, that is, dividends that are unusually large and not ordinary annual or quarterly dividends that are paid regularly or routinely, need to be examined under subsection 55(2). 21 In the balance of this paper, Mr. Robertson addresses various issues relating to subsection 55(2), including those relating to safe income and butterfly transactions. 22 These foregoing comments are important in the assessment of the current and proposed purpose tests. They specifically confirm that subsection 55(2) is intended to only apply to dividends which significantly reduce a capital gain 23 in respect of an imminent or planned disposition of a share. In other 18 For a more detailed discussion of these cases, see Mark Brender, Subsection 55(2): Part 1, (1997), vol. 45, no. 2 Canadian Tax Journal John R. Robertson, Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55, Report of Proceedings of the Thirty-Third Tax Conference, 1981 Conference Report (Toronto: Canadian Tax Foundation, 1982), Ibid., at Ibid. 22 Mr. Robertson also provided some interesting comments on rules in paragraphs 55(2)(b) and (c), which determine the tax results to the corporate shareholder should the conditions in subsection 55(2) be satisfied. In particular, he clarified that these two paragraphs were not intended to operate together. Paragraph 55(2)(b) applies when a share is disposed of as part of the series and paragraph 55(2)(c) applies when there is a significant increase in a corporation by a person who deals at arm s length with the dividend recipient without any share disposition. Mr. Robertson also stated that a gain realized pursuant to paragraph 55(2)(c) would not be treated as additional proceeds under paragraph 55(2)(b) on an eventual sale. These comments clarify that paragraphs 55(2)(b) and (c) are not intended to address timing issues. See the discussion supra note 19, at The courts have generally held that whether a dividend results in a significant reduction in a capital gain depends on the facts and circumstances. For cases which have discussed the meaning of significant in the context of subsection 55(2), see: Ontario Ltd. v. MNR, 93 DTC 427 (TCC); Trico Industries Limited v. E. Brady and G. Watson Page 8

10 words, a tax motive at the time of the dividend is a necessary prerequisite to the application of subsection 55(2). 24 In this regard, Mr. Roberson notes that a dividend may be received as part of a transaction or event (which, for example, could include a redemption of shares), or it could be received as part of a series of transactions or events. In the latter case, Mr. Robertson notes that it would be important to examine the entire series in order to determine the results and whether there has been tax avoidance. 25 The courts have also recognized the importance of tax motive when generally applying subsection 55(2) and the purpose test specifically. In fact the courts in Trico Industries and CPL Holdings quoted the statements of Mr. Robertson that subsection 55(2) should be limited to genuine cases of tax avoidance. 26 In CPL Holdings, Placer Dome and Meager Creek, each corporate shareholder received one or more dividends and subsequently sold shares shortly after the receipt of the dividends. In Meager Creek, the Tax Court of Canada confirmed the position there must be a link between a dividend and a subsequent sale of shares in order to engage subsection 55(2), and that the mere possibility of any future sale is not sufficient: Also, I cannot accept Respondent s argument that any possible future sale can suffice to bring subsection 55(2) into play. There must be a series of transactions or events contemplated. To accept Respondent s argument could open the door to the subsection being applied to almost any declaration of inter-corporate dividends. 27 Not only have the courts recognized that subsection 55(2) should be limited to cases of genuine tax avoidance, but they have also confirmed that a tax avoidance motive should not be presumed to exist in situations where the receipt of a dividend and a sale of shares occurs at or around the same time. In Placer Dome, the Federal Court of Appeal held that at most, this fact pattern gives rise to a rebuttable presumption: As noted earlier, the Minister maintains that a purpose of a dividend is to effect a significant reduction in realizable capital gains when the dividend is inextricably linked to the disposition of a share. In my view, this argument is premised on the mistaken assumption that the Minister would have been successful in C.P.L. Holdings had the necessary link between payment of the dividend and disposition of the shares been established. While it is true that the Trial Judge in that case held that the subsequent disposition of the shares was not part of the same transaction giving rise to the payment of the dividend, he did not go on to conclude that had he found otherwise the case would have been decided differently. At most, such a link gives rise to the rebuttable MNR, 94 DTC 1740 (TCC); and The Queen v. VIH Logging Ltd., 2005 DTC 5095 (FCA), aff g 2004 DTC 2090 (TCC). 24 The position that the mischief to which a specific anti-avoidance rule is directed should be a guide to its application is not limited to subsection 55(2). This principle has been recognized by the courts in other contexts. See, for example: Canwest Capital Inc. v. The Queen, 97 DTC 1 (TCC); and Lehigh Cement Ltd. v. The Queen, 2014 DTC 5058 (FCA). 25 Supra, note 19, at Trico Industries, at 1744; and CPL Holdings, at paragraph Meager Creek, at paragraph 31. For a similar comment in the context of an analysis of avoidance transaction in subsection 245(1), see MIL (Investments) SA v. The Queen, 2006 DTC 3307 (TCC). E. Brady and G. Watson Page 9

11 inference that a purpose of the transaction was to effect a significant reduction in capital gain. 28 As summarized below, the taxpayers in each of CPL Holdings, Placer Dome and Meager Creek were successful in proving that none of their purposes included a gain-reduction purpose, further supporting the conclusion that the mere coincidence of a dividend and a sale of shares is not in itself sufficient to engage subsection 55(2). What does the purpose mean? A preliminary issue regarding the Current CG Purpose Test is whether the test relates to the actual motives of the parties (i.e., is it subjective) or whether the purpose is something that can inferred from the surrounding circumstances (i.e., is it objective). In Placer Dome, the Federal Court of Appeal noted that whether a particular purpose test is subjective or objective depends on the statutory context in which it appears. Since subsection 55(2) also contains a results test in respect of dividends arising under subsection 84(3), which the court stated invites an objective appreciation of the facts, the court held that the Current CG Purpose Test must be subjective. Consequently, the Current CG Purpose Test looks to the actual motives of the parties and extends a personal invitation to the taxpayer to testify as to his or her state of mind at the time the transaction or transactions were put into effect. 29 The courts have also acknowledged that with a subjective purpose test, identical transactions could lead to different tax results for different taxpayers. Importantly, in considering this point, the courts in CPL Holdings and Placer Dome made a clear distinction between the purpose of a dividend and the result of a dividend. For example, at trial, the Crown in Placer Dome made the following argument regarding the Current CG Purpose Test: He referred to definitions of purpose such as from Black s Law Dictionary: That which one sets before him to accomplish or attain; an end, intention, or aim, object, plan, project. Term is synonymous with ends sought, an object to be attained, an intention etc. and from Shorter Oxford English Dictionary: 1. The object which one has in view. 2. The action or fact of intending or meaning to do something: intention, resolution, determination. He then submitted that a person is presumed to intend the natural consequences of his actions and that in the Appellant s case one of the consequences was the significant reduction of capital gain. 30 The Tax Court of Canada rejected this argument, stating that this approach employed hindsight. On appeal, the Federal Court of Appeal stated that where a transaction has the effect of significantly 28 Placer Dome, FCA, at paragraph Placer Dome, FCA, at paragraph Placer Dome, TCC, at paragraph 29. E. Brady and G. Watson Page 10

12 reducing a capital gain, the Minister may infer that the taxpayer had such a purpose, but it is then open to the taxpayer to rebut this inference. As a subjective test, a related issue in applying the Current CG Purpose Test is whose motive is relevant. In Placer Dome, the Tax Court of Canada examined the purpose from the perspective of both the dividend payer and the dividend recipient, and held that neither party had a gain-reduction purpose. Interestingly, with respect to the dividend recipient, the court based its finding on the fact that the idea to pay a dividend originated with the dividend payer, and since the dividend recipient did not participate in structuring the transaction, the dividend recipient could not have a gain-reduction purpose. On appeal, the Federal Court of Appeal acknowledged that foreign case law suggested that in applying a purpose test, the purpose of both parties to a transaction should be examined. 31 However, the court did not find it necessary to make a specific finding on this point, since the Tax Court of Canada had nonetheless concluded that neither party had a gain-reduction purpose. In Placer Dome, the dividend payers were not wholly-owned subsidiaries of the corporate shareholder, and in fact one of the dividend payers was a public company. In this context, one can understand why the Tax Court of Canada examined the purpose from the perspective of both parties. In CPL Holdings and Meager Creek, the dividend payer was a wholly-owned subsidiary of the corporate shareholder and the Tax Court of Canada appeared to conduct the purpose test analysis on the assumption that the motives of both parties were the same. Who has to prove the purpose and what is the standard of proof? In CPL Holdings, the Tax Court of Canada indicated that the burden of proof in applying the Current CG Purpose Test rests with the corporate shareholder who receives the dividend. Further, since this test uses the phrase one of the purposes, a corporate shareholder must demonstrate that none of the purposes of a dividend was to effect a significant reduction in a capital gain. A corporate shareholder will not meet the burden of proof by showing that the main purpose of a dividend was business related. The Federal Court of Appeal in Placer Dome expressed similar views, also noting that any explanation of purpose must be neither improbable nor unreasonable. 32 How have the courts approached the purpose test? Since the Current CG Purpose Test is a subjective test, the primary manner in which a corporate shareholder may satisfy the test is to provide an explanation of the purpose of a particular dividend. In Placer Dome, the Federal Court of Appeal indicated that mere denial of a gain-reduction purpose, without any explanation, is not sufficient to satisfy the burden of proof. 33 As a practical matter, in assessing the reasonableness of a taxpayer s stated purpose, the courts have looked at the facts and surrounding circumstances, and taxpayers have also called witnesses to substantiate their claims. We have summarized the purpose findings in the key cases where the courts have considered the Current CG Purpose Test in the following table: 31 In this regard, the Federal Court of Appeal cited Bentleys, Stokes & Lowlees v. Beeson, [1952] 2 All ER 82 (CA). 32 Placer Dome, FCA, at paragraph Placer Dome, FCA, at paragraph 20. E. Brady and G. Watson Page 11

13 Case Stated Purpose for Dividend(s) Support Taxpayer Wins? CPL Holdings Creditor proofing Lawsuit launched against taxpayer and witness testimony (individual owner, advisors and third party purchaser of shares) Yes Placer Dome Planning for an exemption from the issuer bid requirements under Ontario securities law Application to Ontario Securities Commission and witness testimony (officers of dividend payer and recipient, advisors and purchaser of shares (who was also the dividend payer)) Yes Meager Creek Anticipated introduction of a dividend distribution tax in the budget Advisor advised 26 other clients to pay dividends and witness testimony (individual owners and advisors) Yes The taxpayers in these cases were successful, largely because they were able to provide an explanation for the dividends paid, which was unrelated to any desire to reduce taxes on the subsequent disposition of shares, and the facts and surrounding circumstances, as well as witness testimony, were consistent with the purpose asserted by the taxpayers. 34 Summary Guidelines The following guidance can be drawn from this case law in respect of the purpose test for subsection 55(2): 1. Subsection 55(2) is intended to only apply to dividends which significantly reduce a capital gain in respect of an imminent or planned disposition of a share. There must be a tax motive. 2. The purpose test is not a results test, nor is it a hypothetical person test. It is subjective and focuses on the motive of the taxpayer. 3. The standard of proof requires that a taxpayer demonstrate that none of the purposes be a reduction in a capital gain. 4. The burden of proof rests with the taxpayer. 5. The motives of the taxpayer in respect of the dividend must be persuasive, supportable, credible and should be corroborated by facts, circumstances and, where feasible, third parties. Following on the last point, it is important to keep in mind there is some judicial support for the CRA to attack the purpose based on the results of a transaction, although as noted, this is a rebuttable presumption at most. For this reason, it is important to ensure the motive for a transaction is understood and documented. In this regard: 34 For an interesting comparison, see the judgement in Groupe Honco Inc. v. The Queen, 2013 DTC 5105 (FCA), aff g 2013 DTC 1032 (TCC), where the taxpayer was unsuccessful in convincing the courts that it did not acquire shares for the main purpose of receiving a capital dividend. E. Brady and G. Watson Page 12

14 1. The motive for a dividend should be known and understood by directors, shareholders, management and other relevant stakeholders. Consider whether different recipients have different purposes and whether payer has any purpose (and if so is there a shareholder directing the payer s purpose). 2. Evidence in respect of the motive is advisable. Minutes of shareholder meetings, corporate resolutions and advisor memorandums can all serve to document the purpose of a dividend. 3. Taxpayers should identify and acknowledge the potential outcomes of the dividend. It is also advisable for taxpayers to address these outcomes in documentation, and specify why they are not relevant to the motive and, where relevant, rely on safe income on-hand. PART III: THE PURPOSE TESTS IN THE SECTION 55 PROPOSALS One of the key changes in the Section 55 Proposals is to add the Proposed Purpose Tests. These proposals also make minor changes to the wording of the Current CG Purpose Test. Like the Current CG Purpose Test, all of these Proposed Purpose Tests focus on taxable dividends received as part of a transaction or event or a series of transactions or events (other than deemed dividends arising on an redemption, acquisition on cancellation of a share by a corporation that issued the share to which subsection 84(2) or (3) apply, as applicable). Under the Section 55 Proposals, the Current CG Purpose Test is retained in proposed subparagraph 55(2.1)(b)(i) and reads as follows: (i) one of the purposes of the payment or receipt of the dividend (or, in the case of a dividend under subsection 84(3), one of the results of which) is to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at fair market value of any share of capital stock immediately before the dividend, or [Emphasis added] As noted by the underlined text, the words one of the purposes of which in the Current CG Purpose Test will be replaced by the words one of the purposes of the payment or receipt of the dividend under the Section 55 Proposals. The Explanatory Notes do not provide any commentary on the reason for the change in the wording. We believe that the likely explanation for this change is that Finance wished to clarify that the purpose of a dividend must be examined from the perspective of both the dividend payer and the dividend recipient, a point that was left open by the Federal Court of Appeal in Placer Dome. Other than this change, the Current CG Purpose Test remains substantially the same and the guiding principles discussed in Part II should continue to apply. Under the Section 55 Proposals, the Proposed Purpose Tests are found in proposed subparagraph 55(2.1)(b)(ii) and read as follows: (ii) the dividend (other than a dividend that is received on a redemption, acquisition or cancellation of a share, by the corporation that issued the share, to which subsection 84(2) or (3) applies) is received on a share that is held as capital property by the dividend recipient and one of the purposes of the payment or receipt of the dividend is to effect (A) a significant reduction in the fair market value of any share, or E. Brady and G. Watson Page 13

15 (B) a significant increase in the cost of property, such that the amount that is the total of the cost amounts of all properties of the dividend recipient immediately after the dividend is significantly greater than the amount that is the total of the cost amounts of all properties of the dividend recipient immediately before the dividend; and Proposed subsection 55(2.5) contains a supporting rule. This provision states that when applying the new purpose test in proposed clause 55(2.1)(b)(ii)(A), whether a dividend causes a significant reduction in the fair market value of any share is to be determined as if the fair market value of the share immediately before the dividend was increased by the amount equal to the amount, if any, by which the fair market value of the dividend received on the share exceeds the fair market value of the share. Based on the Explanatory Notes, this rule appears to be aimed at situations when a dividend is paid on shares with a nominal fair market value. The Explanatory Notes provide the following rationale for these new tests: A recent decision of the Tax Court of Canada held that the current anti-avoidance rule did not apply in a case where the effect of a dividend in kind (consisting of shares of another corporation) was to create an unrealized capital loss on shares (that is, the shares had a cost that exceeded fair market value after the dividend is paid). The unrealized loss was then used to avoid corporate capital gains tax otherwise payable on the sale of another property. These transactions can have an effect identical to transactions that directly reduce a corporate capital gain. Such transactions may be challenged by the Government under the existing general anti-avoidance rule. However, as any such challenge could be both time-consuming and costly, section 55 is being amended to ensure that the appropriate tax consequences apply. Subsection 55(2) is amended to address the same tax policy concern that can arise where dividends are paid on a share not to reduce a capital gain on the share but instead to cause a significant decrease to the fair market value of the share or to cause a significant increase in the total cost amounts of properties of the corporate dividend recipient. Such dividends can result in an undue reduction of corporate capital gains. [Emphasis added] A couple of important observations can be made in respect of these tests. First, the Proposed Purpose Tests are purpose tests, and given that proposed subparagraph 55(2.1)(b)(i) retains a results test, we believe that these purpose tests should likewise be interpreted to be subjective tests. Second, the Explanatory Notes make it clear that although the subject matter of the purpose test in subsection 55(2) is expanded to address significant reductions in the fair market value of a share and significant increases in the cost of property, the overriding policy objective of proposed subsection 55(2) remains the same as before: to target the use of tax free intercorporate dividends that reduce or eliminate capital gains that would otherwise arise on an imminent or planned sale of property. The recent case referred to in the Explanatory Notes is assumed to be D&D Livestock Ltd. v. The Queen. 35 The facts in D&D Livestock are similar to the following example provided in the Budget Proposals: DTC 1251 (TCC). E. Brady and G. Watson Page 14

16 Example Corporation A wholly owns Corporation B, which has one class of shares. These shares have a fair market value of $1 million and an adjusted cost base of $1 million. Corporation A contributes $1 million of cash to Corporation B in return for additional shares of the same class, with the result that Corporation A s shares of Corporation B have a fair market value of $2 million and an adjusted cost base of $2 million. If Corporation B uses its $1 million of cash to pay Corporation A a tax-deductible dividend of $1 million, the fair market value of Corporation A s shares of Corporation B is reduced to $1 million although their adjusted cost base remains at $2 million. At this point, Corporation A has an unrealized capital loss of $1 million on Corporation B s shares. If Corporation A transfers an asset having a fair market value and unrealized capital gain of $1 million to Corporation B on a tax-deferred basis, Corporation A could then sell its shares of Corporation B for $2 million and take the position that there is no gain because the adjusted cost base of those shares is also $2 million. The main difference between this example and the facts in D&D Livestock is that in D&D Livestock HLL, the corporation equivalent to Corporation A in the example, contributed shares with no accrued gain instead of cash to Newco2, the corporation equivalent to Corporation B in the example. In D&D Livestock, following the payment of a dividend in-kind from Newco2 to HLL, HLL transferred shares with an accrued gain to Newco2 under section 85, and then sold the shares of Newco2 to a third party. In effect, HLL was able to use the accrued loss on the Newco2 shares that arose by virtue of the dividend in-kind to shelter a portion of the accrued gain on another property that was then indirectly sold to a third party. Although not discussed in the case, it appears that subsection 55(2) did not apply to the dividend in-kind given that there was no accrued gain on the Newco2 shares at the time this dividend was paid. It is also appears that subsection 112(3) did not apply in respect of the disposition of the Newco2 shares since no capital loss was realized. We believe this illustrates that a significant reduction in a the fair market value of a share, or a significant increase in the cost of property, is not sufficient on its own to engage proposed subsection 55(2). Rather, there must be additional steps taken to utilize the resulting accrued loss or cost to avoid capital gains tax, and the Explanatory Notes confirm this point. In short, a tax motive appears to still be relevant in the context of the Proposed Purpose Tests. Not linking the dividend to the tax motive in the context of a purpose test analysis will result in an incomplete analysis. This specific issue can be seen in a recent CRA comment. On October 9, 2015 at the 2015 APFF Roundtable, the CRA provided its first commentary on the Proposed Purpose Tests. 36 The question posed to the CRA was in respect of a creditor proofing transaction where a dividend was paid by Opco to its shareholder, Holdco followed by Holdco lending the proceeds of the dividend to Opco. Unfortunately, the question posed to the CRA did not require the CRA to provide their view of the purpose of a creditor proofing transaction. Rather the assumptions in the question state that the purpose of the creditor proofing transaction (not the dividend) was to reduce the fair market value of the Opco shares. In their response, the CRA was attuned to this statement and restated it as part of their view that the purpose test in proposed 36 For an English summary, see Neal Armstrong, CRA lets the chips fall where they may in interpreting the new s.55(2) rules, E. Brady and G. Watson Page 15