A recent case from the Tax Court of Canada ruled against a taxpayer who implemented a tax plan known as the “half-loaf” plan. The purpose of a half-loaf plan is essentially to multiply the life time capital gain exemption between two spouses.
The “half-loaf” plan works by having a spouse acquire one-half of an identical property (typically shares of a company) from a spouse in two separate transactions. In the first transaction, the spouse pays fair market value which results in the spouse having a high adjusted cost base (“ACB”) in the shares acquired (equal to the fair market value paid). In the second transaction, the spouse acquires shares of the same class on a rollover basis, which results in the spouse initially having an ACB equal to the other spouse’s ACB (which is typically a nominal amount). Pursuant to section 47 of the Act, there is an averaging of ACB where a taxpayer acquires identical properties with the result being that the transferee spouse owns shares with an ACB equal to one-half of the current fair market value of the shares. The spouse then sells all of her shares to a third party and realizes a capital gain calculated on the difference between the sale proceeds and her averaged ACB. Some or all of the resulting capital gain is sheltered by the spouse’s lifetime capital gain exemption.
The basic facts of Gervais are as follows. Mr. Gervais and his brother were the only shareholders of Vulcain Alarm Inc. (the “Target”). In or around May or June 2002, an arm’s length purchaser, BW Technologies Ltd. (the “Purchaser”) made an offer to acquire all of the shares of the Target. On or around September 2002, Mr. Gervais and his brother reorganized the share capital of the Target such that Gervais held (among other shares) 2,087,778 Class “E” Preferred shares in the share capital of the Target (the “Preferred Shares”). The redemption amount of the Preferred Shares was $1.00 per share, or $2,087,778 in aggregate. In or around September, 2002 and after the deal with the Purchaser was approved by the shareholders of the Target, Gervais sold one-half of his Preferred Shares to his spouse Lysanne Gendron (“Disposition 1”) for proceeds of $1,043,889. The consideration paid by Lysanne was a promissory note in the amount of $1,043,889 payable over five years, in five equal annual instalments and with interest at the annual rate of 4.5%. Four days later, Gervais gifted the remaining half of the Preferred Shares to Lysanne (“Disposition 2”). On October 7, 2002, all of the shares of the Target including the Preferred Shares were sold to the Purchaser (“Disposition 3”).
In Disposition 1, Gervais elected out of the spousal rollover provision in subsection 73(1) of the Income Tax Act (Canada) (the “Act”). On his 2002 tax return, Gervais reported Disposition 1 as a capital gain of $1,000,000 (the ACB of the shares was $43,889) and utilized his remaining capital gain exemption. On Disposition 2, the spousal rollover under subsection 73(1) was relied on and Gervais was deemed to have disposed of the Preferred Shares for an amount equal to the ACB of $43,889 and Lysanne was deemed to have acquired the shares for an amount equal to the ACB of $43,889.
Lysanne was fully aware of the impending sale to the Purchaser prior to acquiring the Preferred Shares. In the purchase and sale agreement in respect of Disposition 1, Lysanne agreed to not sell the Preferred Shares to anyone other than the Purchaser without the consent of Gervais.
The issues before the Tax Court of Canada were: (i) whether the sale to the Purchaser of the Preferred Shares acquired under Disposition 1 should be on account of income or capital in the hands of Lysanne; (ii) whether the characterization of Disposition 2 is necessarily the same as Disposition 1; (iii) depending on the responses to the first two issues, what impact does the identical property rules in section 47 of the Act have; and (iv) whether the general anti-avoidance rule applies and, if so, what is the consequence.
In looking at the first issue, the court found that the sale of the Preferred Shares to the Purchaser that were acquired under Disposition 1 was on account of income and not capital in the hands of Lysanne. The Court considered whether a sale generates a capital gain from the disposal of an investment or income from the nature of trade. In support of its conclusion that the sale was on account of income and not capital, the Court found that Lysanne had the intention of selling the Preferred Shares to the Purchaser before she acquired them; there was no income earned on the shares while she held them; the Preferred Shares were sold within two weeks after the acquisition; and there was no cash on closing paid in respect of the Preferred Shares in Disposition 1.
Justice Jorre went on to say that the commercial nature of the transaction was the time value of money. Lysanne acquired the Preferred Shares under Disposition 1 without any immediate requirement to pay and prior to having any obligation to pay, received sale proceeds from the disposition of the Preferred Shares to the Purchaser. This was considered to be a financial advantage to Lysanne.
Conversely, the Court found that the gifted shares which were subsequently sold to the Purchaser was on account of capital in the hands of Lysanne. The Court found that the acceptance of a gift is very different than the purchase of goods as the intentions are different. The intention to accept is not the same as the intention to buy, because the decision to give something falls within the donor and not the person receiving the gift.
In considering the application of section 47 of the Act, the Court stated that the purpose of the identical properties rules is to calculate the ACB of two or more identical properties and the relevance of ACB of a property is for determining a capital gain. As the sale of the Preferred Shares to the Purchaser acquired under Disposition 1 was held to be on account of income, the Court found that section 47 is inoperative and no averaging of ACB is to occur in respect of the Preferred Shares acquired by Lysanne in Dispositions 1 and 2.
Interestingly, the ACB of the Preferred Shares acquired by way of a gift was held to be $0 as the Court said that subsection 10(1.01) applied. This is a curious conclusion given the Court held that the sale of Preferred Shares to the Purchaser that were gifted under Disposition 2 was considered on account of capital. It seems that instead, subsection 73(1) should have applied to cause the ACB of the gifted shares to be $43,889.
Finally, the Court held that the attribution rules in section 74.2 of the Act applied to the gift and therefore, the resulting $1,000,000 capital gain was attributed back to Gervais. Unfortunately for the taxpayers, the result of all of this was that Gervais, after the application of the attribution rule, realized a capital gain that was taxable to him and therefore Lysanne was not able to shelter any capital gain with her available lifetime capital gain exemption.
This case has some very interesting results. Query whether a small dividend paid before Disposition 3 on the preferred shares acquired under Disposition 1 would have been a bar to the Court concluding the disposition was on account of income. Additionally, perhaps Lysanne could have made an election under subsection 39(4) of the Act to ensure capital treatment instead of income treatment.
Implementing a half-loaf plan subsequent to this case should be carefully considered and consultation with a tax advisor is highly recommended.