2019-0824561C6 2019 CTF-Q5-212.1 Post-mortem Pipeline Transaction

Principal Issues: Whether a non-resident beneficiary of an estate that has implemented a post-mortem "pipeline" transaction may be subject to section 212.1 of the Act.

Position: Generally yes, subject to the comfort letter issued by the Department of Finance on December 2, 2019.

Reasons: The application of the look-through rules in subsection 212.1(6) of the Act could result in the conditions of subsection 212.1(1) of the Act being satisfied in respect of the non-resident beneficiary.

Author: Dion, Jean-Bernard
Section: 84.1, 212.1

2019 CTF Annual Conference

CRA Roundtable

Question 5: Section 212.1 of the Act and Post-mortem “Pipeline” Transactions

In the 2018 Federal Budget, the Department of Finance expanded the scope of section 212.1 of the Act by including rules in subsections 212.1(5) to 212.1(7) that look through partnerships and trusts so that section 212.1 cannot be frustrated by transactions involving partnerships and trusts.

In general terms, section 212.1 applies when (i) a non-resident person disposes of shares of a corporation resident in Canada to another corporation resident in Canada with which the non‑resident person does not deal at arm’s length and (ii) immediately after the disposition, the Canadian resident corporations are “connected”.

Section 212.1 is a rule that is meant to prevent cross-border surplus stripping and is similar to section 84.1 in the domestic context. However, generally, section 212.1 can result in a dividend deemed to be received by a non-resident of Canada where the fair market value of the non‑share consideration received by the non-resident of Canada exceeds the paid-up capital of the shares disposed of, even where there is full adjusted cost base (“ACB”) in those shares.

The new look-through rules in subsections 212.1(5) to 212.1(7) may apply to certain common transactions. For example, in a post-mortem “pipeline” transaction context, a Canadian resident estate (the “Trust”) could have full ACB and low paid-up capital in shares of a private corporation resident in Canada (“Canco”). If the Trust has a non-resident beneficiary and receives non-share consideration from a non‑arm’s length Canadian resident corporation (“Holdco”), such non-resident beneficiary would be deemed to receive a certain proportion of any non-share consideration received by the Trust on the disposition of the Canco low paid-up capital shares. To the extent that the conditions of subsection 212.1(1) are met, this would result in a dividend deemed to be paid to the non‑resident beneficiary, subject to Canadian withholding tax, notwithstanding the fact that the non-share consideration does not exceed the ACB of the Canco shares.

In this scenario, where section 84.1 would not apply because the Trust has full ACB in the Canco shares, would the CRA seek to apply section 212.1 based on a technical application of the look-through rules, even though the non-share consideration received by the Trust does not exceed the ACB of the shares that are disposed?

CRA Response

Where shares of a corporation resident in Canada are disposed of by a Canadian resident trust, which would include a Canadian resident estate, the look-through rules provided in subsection 212.1(6) would generally apply in respect of each beneficiary of the trust, irrespective of whether the trust has full ACB in the Canadian corporation shares.

In general terms, in the hypothetical scenario presented in the question,

*     pursuant to subparagraph 212.1(6)(b)(i), each person with an interest as a beneficiary under the Trust would be deemed to have disposed of the Canco shares in the proportion that the fair market value of the person’s interest in the Trust is of the total fair market value of all interests in the Trust; and

*     pursuant to subparagraph 212.1(6)(b)(ii), each person with an interest as a beneficiary under the Trust would be deemed to have received from Holdco, and Holdco would be deemed to have paid to each such person, as consideration for the Canco shares deemed to have been disposed of in subparagraph 212.1(6)(b)(i), an amount equal to the proportion of the fair market value of the consideration (other than any share of the capital stock of Holdco) received by the Trust from Holdco for the Canco shares that the fair market value of the person’s interest in the Trust is of the total fair market value of all interests in the Trust.

Consequently, if the application of the look-through rules in subsection 212.1(6) results in the conditions of subsection 212.1(1) being satisfied in respect of the non-resident beneficiary of the Trust, the amount, if any, by which the non-share consideration deemed to have been received by the non-resident beneficiary under subparagraph 212.1(6)(b)(ii) exceeds the paid-up capital of the Canco shares deemed to have been disposed of by the non-resident beneficiary under subparagraph 212.1(6)(b)(i) would generally be deemed to be a dividend paid by Holdco to the non-resident beneficiary.

Based upon the current legislation at the date of the 2019 CTF Annual Conference, it is our view that paragraph 212.1(6)(b) may apply in respect of dispositions of shares by any type of Canadian resident trust. However, as indicated in a comfort letter issued on December 2, 2019, the Department of Finance is prepared to recommend to the Minister of Finance that the Act be amended to exclude certain transactions from the application of paragraph 212.1(6)(b). The excluded transactions would be dispositions of shares by a Canadian resident graduated rate estate (as defined in subsection 248(1)) of an individual who was resident in Canada immediately before the individual's death, provided that those shares were acquired by the estate on and as a consequence of the individual's death. The Department of Finance intends to recommend that this proposed amendment apply to dispositions after February 26, 2018.

Jean-Bernard Dion
2019-082456
December 3, 2019

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