On April 25, 2013, the Federal Court of Appeal (“FCA”) released its decision in the case of MacDonald v. R (2013 FCA 110) (“MacDonald”). Unfortunately for the taxpayer, the FCA in a unanimous decision overturned the decision of Justice Hershfield of the Tax Court of Canada (the “TCC”) who had previously found in favour of the taxpayer.
Dr. MacDonald was a medical doctor who practised in Canada through a wholly-owned professional corporation (“PC”). In 2002, Dr. MacDonald decided to emigrate to the United States. Dr. MacDonald had incurred capital losses personally that had not been utilized by him and PC had accumulated investment assets creating a value in PC of approximately $525,000. Based on tax advice received, Dr. MacDonald sold his shares of PC to his brother-in-law, James Stewart (“J.S.”) for a promissory note (“J.S. Note”). J.S. then transferred the PC shares to a holding corporation owned by him (“Holdco”) for shares of Holdco and a promissory note (“Holdco Note”) in the same amount as the J.S. Note.
PC paid tax-free dividends to Holdco which, essentially, were used to pay the Holdco Note to J.S. who, in turn, used these funds to pay the J.S. Note to Dr. MacDonald. Finally, PC was liquidated into Holdco and was dissolved. The net assets of PC and the purchase price paid by J.S. for the PC shares were such that J.S. made a “profit” of $10,000 as a result of the transactions. Dr. MacDonald reported a capital gain on the sale of his shares of PC but offset part of this gain with capital losses.
The Minister of National Revenue (the “MNR”) assessed Dr. MacDonald on the basis that subsection 84(2) of the Income Tax Act (Canada) (the “Act”) applied because property of 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 (the “GAAR”) in section 245 of the Act applied.
The amount received by Dr. MacDonald was assessed by the MNR as a dividend rather than as a capital gain under subsection 84(2). Subsection 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 shareholder 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,
(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. [emphasis added]
TCC Analysis and Decision
Justice Hershfield of the TCC held that subsection 84(2) did not apply because Dr. MacDonald had received the funds qua 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. Justice Hershfield found that subsection 84(2) applies where property is distributed on a winding-up for the benefit of a person who is a shareholder at the time of the distribution or appropriation. Justice Hershfield also concluded that subsection 84(2) should not operate beyond its express language to become an anti-avoidance section.
In the TCC’s view, the GAAR was the appropriate anti-avoidance section to apply in this case. With respect to the GAAR, the TCC found that there was no abuse or misuse of the Act and that a taxpayer does not abuse the Act by choosing to enter into a surplus strip transaction rather than a transaction that will trigger a capital gain. As a result, the TCC held that the GAAR was not applicable in this case.
FCA Analysis and Decision
The FCA allowed the Crown’s appeal in the MacDonald case thereby overturning the TCC decision. In a unanimous decision, Justice Near of the FCA found that subsection 84(2) applied and that Justice Hershfield of the TCC had incorrectly interpreted the words “in any manner whatever” contained in subsection 84(2) too narrowly. In the FCA’s view, the conclusion of Justice Hershfield was not consistent with the jurisprudence dealing with the interpretation of subsection 84(2).
The FCA purported to adopt a textual, contextual and purposive approach in interpreting subsection 84(2) which led to its conclusion that this subsection was applicable in Dr. MacDonald’s circumstances. Justice Near stated that this approach required the Court to look to: “(i) who initiated the winding-up, discontinuance or reorganization of the business; (ii) who received the funds or property of the corporation at the end of that winding-up, discontinuance or reorganization; and (iii) the circumstances in which the purported distributions took place.”
Justice Near held that the person receiving the deemed dividend from a corporation under subsection 84(2) need not be a shareholder of the corporation at the time funds are distributed from the corporation to the former shareholder. In this regard, the FCA followed earlier decisions in Smythe v. Minister of National Revenue (69 DTC 5361) and RMM Canadian Enterprises Inc. v. R. (97 DTC 302) and also distinguished the McNichol v. R. (97 DTC 111) case which had supported the taxpayer’s position.
Justice Near distinguished the MacDonald case from McNichol on the basis that the funds of the corporation in McNichol never ended up in the hands of the shareholders since the funds were used to repay a bank debt incurred to purchase the shares. However, in RMM and in MacDonald, the corporation’s funds were used to repay the loan or pay the notes that funded the share purchase.
Unfortunately, Justice Near of the FCA, having concluded that subsection 84(2) applied to the transactions, found it unnecessary to comment upon whether, as the Crown contended, Justice Hershfield erred in finding that the GAAR did not apply on the facts of the MacDonald case. As a result, the comments of Justice Hershfield regarding the Act and surplus stripping were not addressed by the FCA.
Justice Near stated that “[i]n this case, at the end of the winding up, all of PC’s money (net of the $10,000 compensation to the accommodating brother-in-law) ended up through circuitous means in the hands of Dr. MacDonald, the original and sole shareholder of PC who was both the driving force behind, and the beneficiary of, the transactions. In my view, the only reasonable conclusion is that subsection 84(2) applies, as the Crown contends.”
Impact of MacDonald Decision on Pipeline Strategy
The pipeline strategy is typically used in a post-mortem context to avoid exposure to double?tax. The pipeline strategy allows an estate to extract value from a corporation on a capital gain basis by utilizing the increased adjusted cost base of shares in a corporation owned by an estate caused by the deemed disposition occurring on the taxpayer’s death rather than withdrawing the funds from the corporation in the form of dividends. Depending on the type of dividend received, whether eligible or non-eligible and the provincial tax residence of the shareholder, withdrawal of value from the corporation may result in lesser taxes if the funds are taxed as a capital gain rather than as a dividend.
While the MacDonald case did not involve a pipeline strategy in a post-mortem context, the plan effectively utilized the same approach and principles relied upon in a pipeline strategy. Therefore, the favourable decision of the TCC in MacDonald was welcomed by the tax community as an endorsement of the pipeline strategy.
In more recent years, the Canada Revenue Agency (the “CRA”) has taken a more restrictive interpretation of when the pipeline strategy is available without offending subsection 84(2) of the Act. In general terms, the CRA has commented that the pipeline strategy is available only where funds are not withdrawn from the corporation shortly after implementation of the strategy. This CRA administrative position has caused some taxpayers to either delay the withdrawal of funds from the corporation so that the initial steps are not considered to be part of the winding- up of the corporation or to utilize other post-mortem planning approaches such as the subsection 164(6) loss carry-back strategy that results in taxation at dividend rates.
The decision of the FCA gives rise to renewed concern regarding the circumstances in which the pipeline strategy may be available. While the pipeline transaction planning approach should not be viewed as “dead”, the possible application of subsection 84(2) and planning to reduce the likelihood of its application should be considered. For example, assets could be retained within the corporation for a sufficient period of time before distribution so as to ensure that the distribution does not occur “on the winding-up”. The CRA has generally taken the administrative position that a delay of one year or more is acceptable.
It may also be possible to reduce the risk of the application of subsection 84(2) by arranging for the holding corporation to borrow funds that are then used to pay the purchase price for the shares rather than having the purchase price paid with funds that are already within the corporation. A more prudent approach may be to structure a pipeline transaction as an amalgamation of corporations instead of winding-up the existing corporation into the holding corporation.
The broad interpretation given by the FCA to subsection 84(2) may have implications for other planning techniques. For instance, the sale of a business is sometimes structured as a “hybrid” share and asset sale that is intended to allow the vendor to sell shares and benefit from the lifetime exemption for capital gains realized on the disposition of qualified small business corporation shares while allowing the purchaser to be treated as though it had purchased the assets of the business. Since these transactions typically involve the discontinuance of a business by a corporation and funds of the corporation end up in the hands of the vendor, such plans should be re?evaluated in light of the MacDonald decision.
It is also interesting to note that while the CRA relied on subsection 84(2) or alternatively on the GAAR and misuse of subsection 84(2) and the Act as a whole, the decision of the FCA was based solely on subsection 84(2). The MacDonald case, therefore, may have no application to plans that involve transactions similar to those employed by Dr. MacDonald or in a pipeline transaction that achieves corporate distributions that are taxed as capital gains but do not involve the “…winding up, discontinuance or reorganization” of the business of a corporation. Furthermore, the narrow grounds on which the MacDonald case was decided by the FCA and the subsection 84(2) approach taken by the CRA may be interpreted by some as recognition that the Act contains no overriding policy that corporate distributions are to be taxed as dividends rather than capital gains and that GAAR assessments by the CRA based on some sort of general policy against surplus stripping may be unsuccessful.