Analysis of 84 (2, MacDonald Case, McNichol and the Pipeline)

The following is an extract of chapter 4 of the paper ‘A critical analysis of the revised interpretation of section 84(2) and the impacts on pipeline planning in estates, trusts and reorganizations resulting from MacDonald’ written as part of the LLM (tax law) program at York University for Professor Joseph Frankovic.

The MacDonald case has left its mark on the risks associated with a pipeline transaction and the interpretation of the text of section  84(2) of the Act.

Section 84(2)

S 84(2) of the Act discusses the dividend treatment of funds or property of a corporation resident in Canada that have been distributed on the winding-up, discontinuance or reorganization of its business.  This section, its interpretation and application before and after the Macdonald case will be examined in this chapter.

Section 84(2) reads as follows:

“84(2) Distribution on winding-up etc. Where funds or property of a corporation resident in Canada have at any time after March 31, 1977 been distributed or otherwise appropriated in any manner whatever to or for the benefit of the shareholders of any class of shares in its capital stock, on the winding-up, discontinuance or reorganization of its business, the corporation shall be deemed to have paid at that time a dividend on the shares of that class equal to the amount, if any, by which

(a) the amount or value of the funds or property distributed or appropriated, as the case may be, exceeds

(b) the amount, if any, by which the paid-up capital in respect of the shares of that class is reduced on the distribution or appropriation, as the case may be,

And a dividend shall be deemed to have been received at that time by each person who held any of the issued shares at that time equal to that proportion of the amount of the excess that the number of the shares of that class held by the person immediately before that time is of the number of the issued shares of that class outstanding immediately before that time.”

The Macdonald Case

In the case of MacDonald V. R (2013 FCA 110) (MacDonald), Dr. MacDonald who practiced in Canada via a professional corporation (PC) decided to move to the United States.  The move would otherwise result in a deemed disposition of all his assets.  Dr. MacDonald had incurred capital losses personally.  His PC had accumulated investment assets creating a value in the PC of approximately $525,000.  Dr. MacDonald sold his shares of PC to his brother-in-law (BL) for a promissory note.  BL then transferred the PC shares to a holding corporation (Holdco) owned by himself for shares and a promissory note.

PC then paid a tax-free dividend to Holdco, which used the funds to pay the Holdco note to BL.  BL then repaid the loan to MacDonald.  Finally, the PC was liquidated into Holdco and was dissolved.  The transactions closely follow those of the pipeline transaction detailed in the previous chapter, utilizing option A in step 4.

The minister of national revenue (MNR) assessed Dr. MacDonald on the basis of subsection 84(2) because property of the PC had otherwise been appropriated for the benefit of Dr. MacDonald on the winding-up and discontinuance of PC’s business, or alternatively that the general anti-avoidance rule (GAAR) in section 245 applied. The MNR assessed the amounts received as a dividend and not a capital gain.

The Tax Court of Canada (TCC) held that 84(2) did not apply because Dr. MacDonald had received the funds as a creditor and not as a shareholder of PC and that subsection 84(2) was not intended to cover payments arising as consideration on a share sale.  The TCC also held that section 84(2) should not operate beyond its express language to become a GAAR.

The Federal Court of Appeal (FCA) allowed the MNR appeal and overturned the TCC ruling.  The FCA found that 84(2) applied and narrowed in on the words “in any manner whatever” within that section.  The FCA cited a textual, contextual and purposive approach requiring the court to look at “1) who initiated the winding-up, discontinuance or reorganization of the business; 2) who received the funds or property of the corporation at the end of that winding-up, discontinuance or reorganization; and 3) the circumstances in which the purported distributions took place.”

The FCA found in MacDonald that 84(2) applied by using a textual, contextual and purposive approach.  Noting the purpose of the series transactions was to result in a capital gains treatment of the funds extracted, the approach used by the FCA focused on the textual and underlined its understanding of the words “in any manner whatever”.   Citing Justice Bowman in RMM, the FCA noted these words have the widest importance and cover many ways corporate funds can end up in the hands of the shareholder.

Similarly, in using Bonnar’s words in his Evans obiter, the SCC has noted we cannot find there is some overarching principle in the Act that requires corporate distributions to shareholder be taxed as dividends. The approach taken by the FCA in MacDonald does not consider the act as a whole, but rather seems to read in an overarching principal to apply dividends in facts of that case based on the funds in the corporation ending up in the hands of Dr. MacDonald in any manner whatever.

 

The FCA did not look at the GAAR.  However, it could be argued that the contextual approach is consistent with reasons provided in Copthorne for why GAAR did not apply and should not apply in this case.  The TCC ruling on GAAR would therefore stand.

In the Macdonald case, the FCA cited a distinction between the facts of that case and the McNichol case.  The distinction had a significant impact on reaching a different conclusion in McNichol on the application of 84(2).

 

The McNichol Case

Acknowledging the purpose of the McNichol transactions was also to access capital gains treatment instead of dividends while using the pipeline transaction, the shareholder in that case used an external lender to finance the transaction.  The funds used to pay the shareholder originated from the external lender and not from the original operating company.  It is also notable that the subsequent amalgamation by the purchaser of the original company was not on advice of the original shareholders.

In McNichol, the taxpayers were partners in a law practice and equal shareholders in a company that owned the office building that the law practice operated out of.  In 1988 two of the partners withdrew from the firm and in 1989 the building was sold for $600,000.  Capital dividends were distributed to the shareholders at that time, leaving $318,000 in cash in the corporation.  A wind-up of the corporation at this time would have resulted in a dividend under s 84(2).

On the advice of their tax practitioner, the taxpayers sold the corporation to an unrelated third-party corporation for $300,000.  The purchaser company borrowed the $300,000 from a bank to pay the taxpayers, pledging the $318,000 cash balance as collateral.   The taxpayers reported the share sale as a disposition of capital property and claimed the LCGE against the gain, resulting in little tax payable.  A few weeks later the purchaser corporation amalgamated with its now subsidiary company and repaid the loan to the bank.  These transactions closely relate to the pipeline steps detailed in chapter 2, using external bank financing on step 3.

The Minister reassessed the taxpayer based on the general anti-avoidance rule (GAAR) under section 245, section 84(2) and 84.1 to tax the taxpayers for the sale of their shares as deemed dividends.  The taxpayers appealed.

The appeal was dismissed on the GAAR issue.  However, the ruling noted that section 84(2) did not apply.  The $300,000 payment made by the purchaser was not a distribution of the funds by the corporation that was purchased on the winding-up of its business.  As such, the funds received by the taxpayers did not result in a deemed dividend.  Evidence clearly demonstrated the purchaser used borrowed money from the bank for the purchase of the shares.  The cash balance in the company purchased remained in the purchased company’s account until the amalgamation of the purchaser company and the purchased company.  The ruling in the McNichol case and the clarification by the appeal ruling in the McDonald case stating that their judgement does not change the McNichol case provides direction in how to reduce the application of 84(2) in a pipeline transaction.  It would be strategic to arrange for the holding corporation to borrow funds from a bank that are used to pay the purchase price for the shares rather than having the purchase price paid with funds that are already within the corporation.

As is evident with the McNichol case, if the technical requirements of subsection 84(2) are not met, the Minister may attempt to apply the GAAR.  The GAAR is designed to prevent what the Department of Finance refers to as “abusive tax avoidance” and will apply to any transaction that is considered to be an “avoidance transaction”, as defined in subsection 245 (3). If the GAAR applies, then the income tax consequences will be determined “as is reasonable in the circumstances” to deny the tax benefit that results from the offensive transactions.

GAAR

Part XVI of the act discusses tax avoidance, commencing with s 245. GAAR was introduced in 1988 to provide Canada Revenue Agency (CRA) with a tool to target tax avoidance and abuses.  In general terms, an “avoidance transaction” is defined as a transaction which, either by itself or as part of a series of transactions, results in a tax benefit of any kind.  It does not, however, include a transaction or series of transactions undertaken primarily for a bona fide purpose other than to obtain a tax benefit.

The broad wording of the GAAR provides the CRA with considerable discretion respecting its interpretation of “abusive” versus “legitimate” tax planning. However, the ultimate interpretation of the GAAR and its application to any transaction is left to the Courts.

Subsequent to McNichol, in Canada Trustco, the SCC contended the cost of assets that were purchased by a mortgage lender and then leased back to the vendor, resulting in revenues from the leased asset being offset by capital cost allowance (CCA).  This case was found not to be GAAR as the third requirement noted below was not met.

The Supreme Court of Canada decisions set forth three requirements that must be established to permit application of the GAAR:

1. There must be a tax benefit resulting from the transaction;
2. There must be an “avoidance transaction”, meaning that the transaction cannot be said to have been reasonably undertaken or arranged primarily for a bona fide purpose other than to obtain a tax benefit; and
3. There must be abusive tax avoidance, meaning that the tax benefit is not consistent with the object, spirit or purpose of the tax rules relied upon by the

The “Tax Benefit” and “Avoidance Transactions”

Notwithstanding potential arguments to the contrary, it is likely that a court would find that the transactions noted in a pipeline transaction would result in a tax benefit within the meaning of subsection 245(1) because the transaction would achieve capital gains treatment rather than a dividend tax or a double tax.  This was noted as such in the McNichol case.

With the level of intentional planning involved in a pipeline, it is also likely the transaction would be considered an “avoidance transaction” within the meaning of subsection 245(3) because the transaction is achieved through a series of deliberate steps aimed to provide an economic benefit.  This was also found to be the case in McNichol.

It would then be imperative to demonstrate that the transaction is not an abusive tax avoidance for GAAR to not apply.

“Abusive Tax Avoidance”

The third stage of the GAAR test involves determining whet her there has been a misuse or abuse of the provisions of the Act such that the object, spirit, or purpose of the tax rules relied upon by the taxpayer are violated. This requirement, contained in subsection 245(4), ensures that the CRA may only rely on the GAAR as a provision of last resort.

Taxpayers are entitled to select courses of action or enter into transactions that will minimize their tax liability, and, as a result, a taxpayer who chooses a course of action that minimizes his or her tax liability should not necessarily be considered to have engaged in abusive tax avoidance for the purposes of subsection 245(4).

In order to determine whether a transaction or a series of transactions misuse or abuse the provisions of the Act, a court must first determine the “object, spirit or purpose of the provisions” having regard for the scheme of the Act, the relevant provisions and permissible extrinsic aids.

In McNichol it was determined the transaction was designed to effect a distribution of surplus that resulted in a misuse of sections 38 and 110.6 of the Act and as such, the transaction was a an abuse of the provisions of the Act read as a whole.  Similarly, in RMM Canadian Enterprises, Justice Bonner noted the Act, read as a whole would envisage the distribution of corporate surplus to shareholders be taxed as a dividend.  However, those cases did not have the benefit of the guidance from the Supreme Court of Canada on section 245.  It is now generally accepted that there is no scheme in the Act against surplus stripping, such as the transactions described for a pipeline transaction. For example, in Collins & Aikman Products Co. v. R., 2009 TCC 299, aff’d by the FCA, Justice Boyle found no scheme in the Act relating to surplus stripping.

Justice Bonner has also since provided obiter in Evans v. The Queen (2005 TCC 684) where he said the SCC has noted we cannot find there is some overarching principle in the Act that requires corporate distributions to shareholder be taxed as dividends.  Specific sections of the Act cannot be ignored to result in tax as dividends.  Justice Bonner also noted at paragraph 34 “ Counsel argues that this case is similar to Justice Bonner’s decision in McNichol v. The Queen, 97 DTC 111 and mine in RMM Canadian Enterprises Inc. et al., v. The Queen, 97 DTC 302. These cases were early general anti-avoidance rule cases and we did not have the benefit of the Supreme Court of Canada’s guidance that we have today. If we had had the benefit of the Supreme Court of Canada’s views, our analysis might have been quite different.”

Similarly, Campbell J. in Copthorne Holdings Ltd. v. The Queen, 2007 DTC 1230, wrote, at paragraph 73 “While the Act contains many provisions, which seek to prevent surplus stripping, the analysis under subsection 245(4) must be firmly rooted in a unified textual, contextual and purposive interpretation of the relevant provisions. As such, reliance on a general policy against surplus stripping is inappropriate to establish abusive tax avoidance.”

The TCC concluded in the MacDonald case that the avoidance transaction was not abusive and therefore GAAR did not apply.  The appeals court stated it did not rule on the GAAR application because that court found that 84(2) applied and therefore the GAAR issue did not need to be considered.  However, in its textual, contextual and purposive approach to 84(2) the FCA considered  “1) who initiated the winding-up, discontinuance or reorganization of the business; 2) who received the funds or property of the corporation at the end of that winding-up, discontinuance or reorganization; and 3) the circumstances in which the purported distributions took place.”  A tax practitioner should therefor consider these three determinants in a pipeline plan.

As outlined above, given that the preponderance of the current jurisprudence that there is no scheme in the Act against surplus stripping, a court properly instructed should conclude that the GAAR does not apply because it is not an abusive tax avoidance to use a series of transactions that result in capital gains treatment.  The transactions outlined in chapter 2 detailing the pipeline transaction would not result in the GAAR.

Operating Business for a Period of Time

At the 2011 STEP Conference CRA Round Table, the CRA provided comment on the application of 84(2) in a pipeline under two instances.  “1) The funds or property of ACo would be distributed to the estate in a short time frame following the death of Mr. A. 2) The nature of the underlying assets of ACo would be cash and ACo would have no activities or business (“cash corporation”).”  The CRA went on to comment “we note that we have issued several favorable rulings wherein we have concluded that subsection 84(2) would not apply to the proposed full or partial pipeline strategies.14  These situations, in contrast to the examples noted above, did not involve cash corporations.  Furthermore, in each case the taxpayers’ proposed transactions contemplated, among other things, the continuation of the business for a period of at least one year, followed by a progressive distribution of the corporation’s assets over an additional period of time.” (STEP, 2011 question 5).  In a 2016 ruling, the CRA provided guidance on a pipeline transaction that included a portfolio of investments held in a corporation in which the loan from the pipeline transaction was repaid over 30 months.  The CRA ruled that 84.1, 84(2) and 245(2) would not apply (CRA, 2017).  At the Canada Tax Foundation Prairie Tax Conference in 2012 CRA Round Table, the CRA stated they would not differentiate between an active business corporation and a corporation earning income from property in the context of applying 84(2) (Canada Tax Foundation, 2012).

Reorganization of a business

Within the definition of 84(2), much discussion has been had on the winding-up and discontinuance of a business.  Some thought should be given to the definition of reorganization.  In the TCC ruling on MacDonald, Justice borrows from Justice in MuCMullen v. R (2007) for defining reorganization in the context of 84(2).  It is noted the words “winding-up” and “discontinuance” contain an “element of finality”.  Those words proceed reorganization within the same sentence  It was therefore logical to assume “reorganization” meant the conclusion of the business in one form and its continuance in another. This definition is not broad as was noted in McMullen and in Kennedy v. MNR (1972).   Where the same company continues the same business in the same manner and in the same form – there is no fresh organization and therefore the 84(2) requirements for reorganization would not be met.

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