2018-0780041C6 2018 CTF - Q5 - GAAR on PUC reduction

Principal Issues: Whether GAAR is applicable to PUC reduction without payment to avoid possible gain on wind-up or amalgamation under 88(1)(b) or 87(11)(a).

Position: The scheme of the act requires a gain to be realized on the winding-up of a subsidiary when the PUC on the shares of the subsidiary exceeds their ACB, in the event where the net cost amount of the assets of the subsidiary is equal to or exceeds the PUC of the shares of the subsidiary. Depending on circumstances, the CRA may seek to apply GAAR to a PUC reduction without payment prior to a winding-up, amalgamation or redemption of shares.

Reasons: See below.

Author: Ton-That, Marc
Section: 245(2), 88(1)(b), 87(11)(a)

2018 CTF Annual Conference

CRA Roundtable

Question 5: Application of GAAR to transactions involving PUC reduction without payment of shares to avoid 88(1)(b) gain on wind-up

A corporation is being wound-up into its parent in a winding-up to which subsection 88(1) is applicable.  The PUC of the shares of the corporation has not been calculated and it is also not clear whether the application of paragraph 88(1)(b) to the winding-up would result in a gain to the parent.  Would the CRA consider that GAAR is not applicable if the paid-up capital ("PUC") of the corporation is reduced to nil without any payment to avoid any gain that could otherwise potentially result from the application of paragraph 88(1)(b)?

CRA Response

At the 2006 APFF Annual Conference Round Table (see document 2006-019601) we offered the view that, generally, we would not invoke GAAR to counter a PUC reduction without payment on shares of a corporation in order to avoid a possible gain pursuant to paragraph 88(1)(b) on such shares on a wind-up of the corporation to which subsection 88(1) applies.

We subsequently observed that the tax community has come to regard the indiscriminate reduction of PUC without payment prior to any wind-up or short-form amalgamation as a sensible planning step.  However, we would like to clarify that the "generally" qualifier in our 2006 comment does not apply in all cases as there are circumstances where a redemption of the shares or a subsection 88(1) wind-up (or subsection 87(11) amalgamation) can result in a capital gain on the shares and where the PUC reduction without payment offends the scheme of the Act and the relevant provisions such that the GAAR applies.

The scheme of the Act, taking into account subsections 40(1), 40(3), 84(3) and 112(1), the definition of "proceeds of disposition" in section 54, paragraphs 88(1)(b) and 87(11)(a) and subparagraph 53(2)(a)(ii), requires a gain to be realized on the winding-up of a subsidiary when the PUC on the shares of the subsidiary exceeds their ACB, in the event where the net cost amount of the assets of the subsidiary is equal to or exceeds the PUC of the shares of the subsidiary.

A redemption of shares would yield the same results.  When the amount of proceeds on redemption received by a shareholder exceeds the PUC of the shares, the excess constitutes a dividend to the shareholder.  However, if the PUC of the shares exceeds their ACB, the excess results in a gain.

Below are examples of simple situations where we would seek to apply GAAR and others where we would not:

Example 1:

*     Subco was formed by Xco with an injection of capital of $1,000.  The PUC of the shares of Subco is $1,000.  Parentco subsequently acquired Subco for $1.  On the winding-up of Subco into Parentco, Subco owned assets with a cost amount of $1,000 and Subco had no liabilities and no retained earnings.  Furthermore, no retained earnings were realized by Subco after its acquisition of control by Parentco.

*     In this situation, the cost amount of assets of Subco was not increased by income realized by Subco after its acquisition of control by Parentco.  This indicates that Parentco has made a bargain purchase of tax attributes in the assets of Subco.  The scheme of paragraph 88(1)(b) dictates a gain to be realized by Parentco on the winding-up of Subco in the amount of $999, being the bargain made by Parentco.

*     The CRA would seek to apply GAAR to a reduction of PUC without payment on the shares of Subco prior to the winding-up of Subco.

Example 2:

*     Subco was formed by Xco with an injection of capital of $1,000.  The PUC of the shares of Subco is $1,000.  Subco realized a non-capital loss of $1,000 with the investment made by Xco.  Parentco then acquired Subco for $1.  Subsequent to the acquisition, Subco realized income of $1,000 (reflected in the cost amount of its assets).  The income of Subco was sheltered by its losses.  On a cumulative basis, Subco had no retained earnings.  Subco was then wound-up into Parentco.  At the time of winding-up, Subco owned assets with a cost amount of $1,000 and Subco had no liabilities and no retained earnings.

*     On the surface, this situation is identical to the situation illustrated in Example 1 and the application of paragraph 88(1)(b) would result in a gain of $999 on the shares of Subco.  However, in this situation, the increase in the cost amount of assets of Subco was due to the income realized by Subco after its acquisition of control by Parentco.  Even though such income was sheltered by the loss of Subco, Parentco did not realize a bargain purchase in the tax attributes in the assets of Subco.  The use of loss of Subco is a permissible transaction under subsection 111(5) to the extent the conditions under that subsection are met and the acquisition of Subco by Parentco is not part of a loss trading transaction.  But for some corporate law restriction in some jurisdictions, Subco could have paid a safe income dividend of $1,000 to Parentco that would either reduce the FMV of the shares of Subco or increase their ACB by $1,000 prior to the winding-up and no gain would result from the application of paragraph 88(1)(b).

*     The CRA would not seek to apply GAAR to a reduction of PUC without payment on the shares of Subco prior to the winding-up of Subco in this situation, to the extent that the gain that would otherwise result from the application of paragraph 88(1)(b) can be supported by income realized by Subco after its acquisition of control by Parentco.

Example 3:

*     Parentco owned all the shares of Subco with a PUC of $1,000 and an ACB of $1,000.  Subco borrowed $2,000 from a 3rd party.  Subco acquired assets with a cost amount of $3,000.  The assets of Subco subsequently lost all their value.  Parentco took the position that Subco became insolvent because it was unable to pay off its debt and did not have any commitment or any undertaking from Parentco to support its debt.  The FMV of the shares of Subco was also nil.  Parentco claimed a capital loss of $1,000 under subection 50(1) prior to winding up Subco.  As a result, the ACB of the shares of Subco is reduced to nil.  On the winding-up of Subco, Parentco assumed Subco's debt.

*     As the cost amount of assets of Subco is $3,000 and the net cost amount, as determined under subparagraph 88(1)(d)(i), is $1,000, Parentco ought to realize a capital gain of $1,000 under paragraph 88(1)(b) on the wind-up.  This is akin to the situation where Parent has realized a bargain purchase of the tax attributes in the assets of Subco.  If the gain was not realized, Parentco would have taken 2 deductions for the same loss of $1,000, i.e., Parentco would have realized a loss of $1,000 on its shares of Subco (under subsection 50(1) if Subco was determined to be insolvent) and a loss of $1,000 on the assets of Subco (the other loss of $2,000 on the assets is supported by the debt assumed by Parentco).

*     If subsection 50(1) applied to allow a capital loss of $1,000 on the shares of Subco, the CRA would seek to apply GAAR to a reduction of PUC without payment on the shares of Subco prior to the winding-up of Subco.

Example 4:

*     Shareholders of DCco transfer shares of DCco having an aggregate PUC of $10,000 and an ACB of $1,000 to TCco in consideration for shares of TCco.  The shares of DCco have a FMV in excess of the PUC.  The transfer of shares of DCco is made as part of a distribution of property of DCco to TCco.  The DCco shares owned by TCco are subsequently redeemed and the dividend from such redemption is exempt from the application of subsection 55(2) under either paragraph 55(3)(a) or 55(3)(b).

*     The excess of PUC over ACB of the shares of DCco in this situation could imply that the shareholders may have realized a bargain purchase of the tax attributes of the assets of DCco.

*     In this situation, since the main concern of paragraphs 55(3)(a) and 55(3)(b) is to allow for a tax-free reorganization, the CRA would not attempt to challenge a reduction of PUC on the shares of DCco that are held by TCco prior to their redemption where the potential gain on the shares of DCco is transferred to the shares of TCco that are held by the shareholders, i.e., where the PUC and ACB of the shares of TCco held by the shareholders are equal to the PUC and ACB respectively of the shares of DCco held by the shareholders at the beginning of the series of transactions.

The above examples are of a general nature.  In addition to finding the misuse or abuse of the Act that results from a transaction, the application of GAAR depends on specific facts and circumstances, i.e., the transaction must be found to be an avoidance transaction and a tax benefit results from the transaction or the series of transactions that includes the transaction.  Please come forward with a ruling request should there be any uncertainty in this area.

The CRA's position expressed above will apply on a prospective basis to PUC reductions without payment effected after March 31, 2019.

Marc Ton-That
2018-078004
November 27, 2018

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