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UBC Theses and Dissertations

Capital gains and surplus stripping 1981

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CAPITAL GAINS AND SURPLUS STRIPPING by PETER E. SALVATORI B.A., M c G i l l U n i v e r s i t y , 1970 L.L.B., M c G i l l U n i v e r s i t y , 1975 M.A., M c G i l l U n i v e r s i t y , 1976 THESIS SUBMITTED IN PARTIAL FULFILMENT THE REQUIREMENTS FOR THE DEGREE OF MASTER OF LAWS i n THE FACULTY OF GRADUATE STUDIES ( F a c u l t y o f Law) We a c c e p t t h i s t h e s i s as c o n f o r m i n g t o the r e q u i r e d s t a n d a r d THE UNIVERSITY OF BRITISH COLUMBIA OCTOBER 1981 @ P e t e r E. S a l v a t o r i In presenting t h i s thesis i n p a r t i a l f u l f i l m e n t of the requirements for an advanced degree at the University of B r i t i s h Columbia, I agree that the Library s h a l l make i t f r e e l y a v a i l a b l e f o r reference and study. I further agree that permission for extensive copying of t h i s thesis for scholarly purposes may be granted by the head of my department or by his or her representatives. I t i s understood that copying or pub l i c a t i o n of t h i s thesis for f i n a n c i a l gain s h a l l not be allowed without my written permission. Department of Law The University of B r i t i s h Columbia 2075 Wesbrook Place Vancouver, Canada V6T 1W5 Date OUoUl M\ /-7Q •> ABSTRACT T h i s t h e s i s examines r e c e n t l e g i s l a t i v e developments i n t a x av o i d a n c e law, d e a l i n g s p e c i f i c a l l y w i t h s u r p l u s s t r i p p i n g and c a p i t a l g a i n s b a i l o u t s . S u r p l u s s t r i p p i n g c o n s i s t s i n t h e av o i d a n c e o f the second l e v e l o f t a x on c o r p o r a t e s o u r c e income n o r m a l l y e x i g i b l e when d i v i d e n d s a r e p a i d t o s h a r e h o l d e r s . S u r p l u s , o r d i v i d e n d - s t r i p p i n g , i s t he t a x p a y e r ' s response t o t h e double t a x a t i o n o f c o r p o r a t e e a r n i n g s and has a c c o r d i n g l y been p r a c t i c e d i n Canada s i n c e t h e 1926 r e v i s i o n o f the Income War Tax A c t , 1917, f i r s t i n t r o d u c e d t h i s scheme f o r the t a x a t i o n o f c o r p o r a t i o n s and t h e i r s h a r e h o l d e r s . As a r e s u l t o f changes t o t he Income Tax A c t i n 1977, the scope o f s u r p l u s s t r i p p i n g o p e r a t i o n s was g r e a t l y l i m i t e d and subsequent l e g i s l a t i o n moved t o b l o c k the few r e m a i n i n g p e r c e i v e d abuses. C a p i t a l g a i n s s t r i p s o r b a i l o u t s r e p r e s e n t a much l e s s l o n g - s t a n d i n g problem f o r the f i s c a l a u t h o r i t i e s , b e i n g e s t a b l i s h e d upon the i m a g i n a t i v e c o m b i n a t i o n o f s t a t u t o r y r u l e s and r e s u l t s , some o f wh i c h were passed i n t o law as r e c e n t l y as 1977. C a p i t a l g a i n s s t r i p s i m p o r t t h e abo- l i t i o n o f c a p i t a l g a i n s t a x a t the c o r p o r a t e l e v e l and can e f f e c t i v e l y p r o v i d e i n d i v i d u a l s w i t h u n l i m i t e d d e f e r r a l o f ta x upon the r e a l i z a t i o n o f a p p r e c i a t e d c a p i t a l p r o p e r t y . Thus, c a p i t a l g a i n s s t r i p s , w h i l e perhaps n ot p r e c i p i t a t i n g a s e r i o u s l o s s o f revenue t o the f i s c , undermine t h e p r i n c i p l e o f e q u i t y , a c o r n e r s t o n e o f t a x r e f o r m . Whereas s u r p l u s s t r i p p i n g o p e r a t i o n s have been c u r t a i l e d ( p r i n - c i p a l l y by the e l i m i n a t i o n o f the i n c e n t i v e t o engage i n them) the government has o n l y v e r y r e c e n t l y moved t o e r a d i c a t e c a p i t a l g a i n s a v o i d a n c e w i t h c o m p l i c a t e d and as y e t u n t e s t e d l e g i s l a t i o n . The p r e s e n t s t u d y d e a l s w i t h ; e a c h o f the two t y p e s o f a v o i d a n c e a c t i v i t i e s mentioned i n t h e p r e c e d i n g p a r a - graphs. The f i r s t c h a p t e r t r a c e s t h e e v o l u t i o n o f d i v i d e n d - s t r i p p i n g i n Canada from i t s b e g i n n i n g s t o the time o f the enactment o f the most r e c e n t l e g i s l a t i v e p r o v i s i o n s d e s i g n e d t o combat i t . These a r e a n a l y s e d and commented in.the. second and t h i r d c h a p t e r s o f the t h e s i s . The f o u r t h and f i f t h c h a p t e r s p r e s e n t an i n t e r j u r i s d i c t i o n a l c omparison, i n v e s t i g a t i n g s u r p l u s s t r i p p i n g a c t i v i t i e s and the c o r r e s p o n d i n g e f f o r t s o f the f i s c a l a u t h o r i t i e s t o combat them i n G r e a t B r i t a i n and i n t h e U n i t e d S t a t e s r e s p e c t i v e l y . The s i x t h t h r o u g h t o the eighth c h a p t e r s d e a l i n a s i m i l a r f a s h i o n w i t h c a p i t a l g a i n s s t r i p p i n g . The new Canadian r u l e s a r e d e p l o y e d and c r i t i c a l l y e v a l u a t e d . C a p i t a l g a i n s s t r i p p i n g p r a c t i c e s i n t h e U n i t e d S t a t e s and G r e a t B r i t a i n r e s p e c t i v e l y a r e then s t u d i e d a l o n g w i t h t h e r e l a t e d a n t i - a v o i d a n c e l e g i s l a t i o n . IV TABLE OF CONTENTS . A b s t r a c t i i - i i i I . S u r p l u s S t r i p p i n g 1-19 I I . S e c t i o n 84.1 a) I n t r o d u c t i o n 1-4 b) C o n d i t i o n s o f A p p l i c a b i l i t y . . . . 4-6 c) O p e r a t i o n o f s e c t i o n 84.1 6-10 d) S u b s e c t i o n 84.1(3) Exemption... 11-13 e) S e c t i o n 8 4 . 1 / E s t a t e P l a n n i n g . . . 14-20 f) P e n a l t y and A n o m a l i e s 20-28 g) C o n c l u s i o n 29-31 F o o t n o t e s 32-35 I I I . S e c t i o n 212.1 a) I n t r o d u c t i o n 1-2 b) C o n d i t i o n s o f A p p l i c a b i l i t y . . . . 2-4 c) O p e r a t i o n / T a x Consequences 4-5 d) Comparison S e c t i o n s 84.1/212.1. 5-7 e) S u b s e c t i o n 212.1 A d j u s t m e n t . . . . 7-9 f) C o n c l u s i o n 10-12 F o o t n o t e s 13 IV. S u r p l u s S t r i p p i n g I n G r e a t B r i t a i n 1-16 V. S u r p l u s S t r i p p i n g I n The U n i t e d S t a t e s . . . 1-9 V I . C a p i t a l G a i n s S t r i p p i n g a) I n t r o d u c t i o n 1-5 b) H i s t o r y 5-12 c) Share S a l e s 12-18 d) A s s e t S a l e s 18-20 e) S u b s e c t i o n s 5 5 ( 2 ) - ( 5 ) i ) I n t r o d u c t i o n 20-24 i i ) Non-Arm's L e n g t h 24-29 i i i ) S i g n i f i c a n t R e d u c t i o n -29-30 i v ) B u t t e r f l i e s A r e F r e e 30-37 v) P o s t 71-Income 37-47 v i ) S u b j e c t i v e / O b j e c t i v e 47-56 F o o t n o t e s . . . . 57-60 V I I . C a p i t a l G a i n s I n The U n i t e d S t a t e s a) I n t r o d u c t i o n 1 b) A s s e t S a l e s 1-4 c) Share S a l e s . . 4-12 F o o t n o t e s 13-14 V I I I . C a p i t a l G a i n s S t r i p s I n G r e a t B r i t a i n . . 1-13 B i b l i o g r a p h y 1-3 1 I . SURPLUS STRIPPING I n t r o d u c t i o n D i v i d e n d - s t r i p p i n g i n v o l v e s t h e a v o i d a n c e o f t h e second l e v e l o f t a x a p p l i c a b l e when a s s e t s o f the c o r p o r a t i o n a r e ta k e n o u t o f c o r p o r a t e s o l u t i o n and d i s t r i b u t e d t o t h e s h a r e - h o l d e r s . As j u s t i f i c a t i o n s f o r d i v i d e n d - s t r i p p i n g have o c c a s i o n a l l y been advanced, i t would, b e f o r e d e p l o y i n g t h e h i s t o r i c a l background t o t h e s u b j e c t , be a d v i s a b l e t o b r i e f l y i n v e s t i g a t e t h e s e c l a i m s . D i v i d e n d - s t r i p p i n g i s perhaps j u s t i f i e d by n o t i o n s o f h o r i z o n t a l e q u i t y . The b e n e f i t s o f a v o i d a n c e o f t h e t a x n o r - m a l l y i n c i d e n t a l t o s u r p l u s d i s t r i b u t i o n s was, p r i o r t o the i n t r o d u c t i o n o f c a p i t a l g a i n s t a x , a v a i l a b l e t o t h e s h a r e - h o l d e r s o f p u b l i c companies. By a c q u i r i n g the sh a r e s o f com- p a n i e s r e t a i n i n g and n o t d i s t r i b u t i n g t h e i r e a r n i n g s , i n v e s t - t o r s see t h e market v a l u e o f t h e i r s e c u r i t i e s r i s e . Upon t h e s a l e o f a l l o r a p a r t o f t h e i r s h a r e h o l d i n g , the proceeds o f d i s p o s i t i o n were, b e f o r e 1972, r e c e i v e d as a t a x f r e e c a p i t a l g a i n . The argument may be made t h a t the government's p o l i c y o f d i s c o u r a g i n g d i v i d e n d - s t r i p p i n g i s by comparison u n f a i r t o the s h a r e h o l d e r s o f p r i v a t e c o r p o r a t i o n s T o t h e c o n t r a r y , i t may be q u e s t i o n e d whether the i n t e r e s t s o f s h a r e h o l d e r s i n p u b l i c and c l o s e l y h e l d p r i v a t e companies can u s e f u l l y be compared. S h a r e h o l d e r s o f p u b l i c c o r p o r a t i o n s g e n e r a l l y have no c o n t r o l o v er management and d i v i d e n d p o l i c i e s , a s i t u a t i o n which i s r e v e r s e d i n the case o f most p r i v a t e c o r p o r a t i o n s . 2 I n a d d i t i o n , the s h a r e h o l d e r s o f p u b l i c companies r e a l l y own o n l y t h e i r s h a r e s , and as t h e y d i s p o s e o f t h e s e t h e y d e c r e a s e t h e i r i n t e r e s t i n t h e c o r p o r a t i o n and i t s u n d e r t a k i n g . I n some d i v i d e n d - s t r i p p i n g t r a n s a c t i o n s , the r e a l s o u r c e o f eco- nomic r e t u r n s , t h e b u s i n e s s of the c o r p o r a t i o n , c o n t i n u e s i n - d i r e c t l y t o be the p r o p e r t y o f t h e s e l l i n g s h a r e h o l d e r s f o l - l o w i n g t h e s t r i p o f a s s e t s . The economic j u s t i f i c a t i o n s o f d i v i d e n d - s t r i p p i n g would l i k e l y be t h a t i t i n c r e a s e s t h e amount o f c a p i t a l a v a i l a b l e t o s m a l l , c l o s e l y h e l d companies and opposes the e x p o r t of c a p i t a l t o t a x haven j u r i s d i c t i o n s . The f i r s t c l a i m may be answered by p o i n t i n g o u t t h a t the a c c u m u l a t i o n o f e a r n i n g s i n a c o r p o r a t i o n f o r the purpose of e f f e c t i n g t a x f r e e d i s t r i - b u t i o n s o f s u r p l u s i s not a p r o d u c t i v e use o f c a p i t a l . The e f f e c t s o f t h e second a l l e g e d b e n e f i t a r e perhaps e c o n o m i c a l l y n e g l i g i b l e . A s e l f - e v i d e n t argument a g a i n s t d i v i d e n d s t r i p p i n g would s i m p l y p o i n t t o t h e government's l o s s o f t a x revenues. A l - though the amount of t h i s l o s s was perhaps n o t s i g n i f i c a n t i n the o v e r a l l scheme o f t h i n g s , the t r a n s f e r o f a t a x burden from the p e r s o n s upon whom l i a b i l i t y was meant t o be imposed t o o t h e r t a x p a y e r s , t o the e x t e n t t h a t t h i s might have o c c u r - r e d , was an u n f a i r r e s u l t . Of perhaps g r e a t e r i m p o r t a n c e i s the contempt i n t o which the t a x system was b r o u g h t by the s p e c t a c l e o f s u c c e s s f u l t a x a v o i d a n c e p r a c t i c e d by a r e l a t i v e - l y s m a l l and a f f l u e n t segment o f t h e p o p u l a t i o n . The d e l e - t e r i o u s consequences o f t h i s p u b l i c a t t i t u d e a r e d i f f i c u l t 3 t o a s s e s s w i t h p r e c i s i o n , but i t s p o s s i b l e impact upon a l e v y r e l y i n g upon the s e l f - a s s e s s m e n t system must be r e g a r - ded as c o n s i d e r a b l e . A number o f s o l u t i o n s t o t h e problem of d i v i d e n d - s t r i p p i n g can and a t v a r i o u s t i m e s have been c o n s i d e r e d . Some o f t h e s e c a l l e d f o r t h e e l i m i n a t i o n o f t h e t w o - t i e r system o f t a x a t i o n o f c o r p o r a t e s o u r c e income. Oth e r s recom- mended the n a r r o w i n g o f t h e gap between th e t a x t r e a t m e n t o f c a p i t a l and income r e c e i p t s . O t h e r s s t i l l i n v o l v e d l e s s f a r r e a c h i n g o v e r h a u l s # o f the system, coming t o g r i p s w i t h p a r - t i c u l a r s t r i p p i n g t e c h n i q u e s w i t h p a r t i c u l a r l e g i s l a t i v e p r o - v i s i o n s . B r i e f l y , the b a s i c t y p e s o f s o l u t i o n s t h a t were from time t o time b r o u g h t f o r w a r d a r e as f o l l o w s : 1) I n d u c i n g d i s t r i b u t i o n s o f c o r p o r a t e e a r n i n g s by i m p o s i n g p e n a l t y t a x e s on u n d i s t r i b u t e d s u r p l u s . The amounts taken i n t o income under t h i s p r o p o s a l would be t a x e d a t the s h a r e h o l d e r ' s p e r s o n a l r a t e . 2) Imposing a f l a t r a t e o f c o r p o r a t e t a x f o l l o w e d by t a x f r e e d i s t r i b u t i o n s t o s h a r e h o l d e r s . As t h i s method does not i n t e g r a t e t h e c o r p o r a t e t a x w i t h t h e t a x imposed on i n d i v i d u a l s , i t would te n d t o d e f e a t t h e o b j e c t i v e s o f t h e p r o g r e s s i v e p e r s o n a l t a x r a t e s t r u c t u r e . 3) T a x i n g c u r r e n t income o f the c o r p o r a t i o n i n t h e hands o f t h e s h a r e h o l d e r s based upon t h e i r p r o p o r t i o n a t e share o f e a r n i n g s . T h i s may o r may not be c o u p l e d w i t h t h e a b o l i t i o n o f c o r p o r a t i o n t a x as such. 4) T a x i n g g a i n s r e a l i z e d upon the d i s p o s i t i o n o f 4 c a p i t a l p r o p e r t y , i n c l u d i n g s h a r e s i n a c o r p o r a t i o n , by b r i n g i n g t h e f u l l amount of such g a i n s i n t o income. 5) C o n f e r r i n g d i s c r e t i o n a r y a u t h o r i t y upon a d m i n i - s t r a t i v e o f f i c i a l s t o r e s t r u c t u r e a t a x p a y e r ' s t r a n s a c t i o n s . 6) E n a c t i n g s p e c i f i c o r ' s n i p e r ' a n t i - a v o i d a n c e p r o v i s i o n s d i r e c t e d a g a i n s t p a r t i c u l a r abuses. The l o n g s t r u g g l e between the t a x p a y e r and t h e f i s c f o r the t a x d o l l a r s t o be l e v i e d on s u r p l u s d i s t r i b u t i o n s r e v e a l s t h e p r e d o m i n a t i n g p r e f e r e n c e o f the government f o r the s i x t h a l t e r n a t i v e above d e l i n e a t e d . As we s h a l l see, t h i s has h i s t o r i c a l l y n ot p r o v i d e d a s a t i s f a c t o r y s o l u t i o n t o the problem o f d i v i d e n d - s t r i p p i n g , and t h e e r a d i c a t i o n o f the s t r i p p i n g p r a c t i c e s i s more a consequence o f l e g i s - l a t i v e developments s e r v i n g u n r e l a t e d o b j e c t i v e s o f f i s c a l p o l i c y than o f t h e e f f i c a c y o f t h e government's e f f o r t s t o e l i m i n a t e them. I t s h o u l d be mentioned t h a t some o f t h e o t h e r s u g gested methods o f c o m b a t t i n g d i v i d e n d - s t r i p p i n g have, i n more o r l e s s m o d i f i e d form, a t v a r i o u s t i m e s c o n s t i t u t e d t h e law o f the l a n d . Under the Income War Tax A c t , 1917, 1 f o r example, i t was p r o v i d e d , i n s e c t i o n 3 ( 1 ) ( d ) , t h a t " f o r t h e purpose o f the normal t a x , the income embraced i n a p e r s o n a l r e t u r n s h a l l be c r e d i t e d w i t h the amount r e c e i v e d as d i v i d e n d s upon the s t o c k o r from th e n e t e a r n i n g s o f any company o r o t h e r p e r s o n w h i c h i s t a x a b l e upon i t s income under t h i s A c t . " Thus, c o r p o r a t i o n t a x was p a i d a t the 'normal', f l a t r a t e o f 4% and the d i v i d e n d s p a i d t o i n d i v i d u a l s were n o t i n c l u d e d 5 i n p e r s o n a l income. The concept o f i n t e g r a t i o n a p p l i e d t o t h i s case because i n d i v i d u a l s p a i d t a x a t t h e same b a s i c r a t e as c o r p o r a t i o n s and b o t h t a x p a y i n g groups b e n e f i t e d from the $3,000 p e r s o n a l exemption. The same A c t a l s o adhered t o t h e p h i l o s o p h y o f f o r c i n g c o r p o r a t e d i s t r i b u t i o n s . I n d i v i d u a l s , u n l i k e c o r p o r a t i o n s , were a l s o l i a b l e t o assessment f o r s u r t a x on income e x c e e d i n g $6,000. Thus, under s e c t i o n 3(4) c o r p o r a t e r e t e n t i o n s were p e r m i t t e d o n l y i n c i r c u m s t a n c e s where the M i n i s t e r was "of the o p i n i o n t h a t t h e a c c u m u l a t i o n o f such u n d i v i d e d and u n d i s t r i b u t e d g a i n s and p r o f i t s (was) n o t made f o r the purpose o f e v a d i n g t h e t a x , and (was) not i n e x c e s s o f what (was) r e a s o n a b l y r e q u i r e d f o r t h e purposes o f t h e b u s i n e s s . " Thus, the u n d i s t r i b u t e d income o f the c o r p o r a t i o n was, absent a m i n i s t e r i a l d i r e c t i o n t o t h e c o n t r a r y , a t t r i - b u t e d t o the s h a r e h o l d e r f o r s u r t a x p urposes. The 1917 p o l i c y o f not t r e a t i n g t h e c o r p o r a t i o n as a s e p a r a t e t a x p a y i n g e n t i t y was abandoned as p a r t o f an e x t e n s i v e r e v i s i o n o f the A c t i n 1926. The change was i n t r o - duced i n response t o a p e r c e p t i o n o f p o l i c y t h a t earned income s h o u l d be t a x e d a t a lower r a t e than unearned income. T h i s o b j e c t i v e was seen as p a r t l y r e a l i z e d by i n c l u d i n g d i v i d e n d s i n income and t a x i n g them as o r d i n a r y e a r n i n g s . Combined w i t h t h e amendment, i n 1919, t o s u b s e c t i o n 3(4) p e r m i t t i n g the a c c u m u l a t i o n o f income i n c o r p o r a t i o n s e x c e p t as the M i n i s t e r might o t h e r w i s e d i r e c t , t h e double t a x a t i o n o f c o r p o r a t e s o u r c e income s e t t h e s t a g e f o r t h e 6 l o n g c o n f l i c t s u r r o u n d i n g t h e a v o i d a n c e of t h i s second l e v e l o f t a x . The f i r s t s h o t was a c t u a l l y f i r e d i n 1924 when the Income War Tax A c t was amended by the a d d i t i o n of s u b s e c t i o n 3 ( 9 ) , w h i c h p r o v i d e d t h a t on a w i n d i n g up, d i s c o n t i n u a n c e , o r r e o r g a n i z a t i o n o f a company's b u s i n e s s , the d i s t r i b u t i o n o f i t s p r o p e r t y t o i t s s h a r e h o l d e r s was t o be t r e a t e d as a d i v i d e n d t o t h e e x t e n t o f t h e u n d i s t r i b u t e d income on hand. T h i s s e c t i o n was i n r e s p o n s e t o t h e E n g l i s h C o u r t o f A p p e a l d e c i s i o n 2 in- R v B u r r e l l w hich h e l d such r e c e i p t s t o be on a c c o u n t o f c a p i t a l and hence n o n - t a x a b l e . The p r o v i s i o n was aimed a t t h e a v o i d a n c e o f s u r t a x w h i c h might be p a y a b l e by t h e d i v i d e n d r e c i p i e n t . As i f i n a n t i c i p a t i o n o f t h e a v o i d a n c e e f f o r t s o f t a x p a y e r s , the 1926 A c t a l s o endeavoured t o p r e v e n t t h e c a p i t a l i z a t i o n o f s u r p l u s by t h e i s s u a n c e 3 o f s t o c k d i v i d e n d s , and the d i s t r i b u t i o n o f c a p i t a l s u r p l u s i n advance o f u n d i s t r i b u t e d income upon the redemption.?;. 4 o f s h a r e s o r p u r s u a n t t o a l e g a l r e d u c t i o n o f c a p i t a l . A p r o v i s i o n a l s o deemed a d i v i d e n d t o have been p a i d when 5 s h a r e s were redeemed a t a premium and when a l o a n was made t o a s h a r e h o l d e r . P r o b a b l y the most i m p o r t a n t changes i n t r o d u c e d i n t h e 1926 A c t from an a n t i - a v o i d a n c e p o i n t o f v i e w had t o do w i t h the d e d u c t i b i l i t y o f i n t e r c o r p o r a t e d i v i d e n d s from income of t h e r e c i p i e n t . I t was a p p a r e n t t h a t i n o r d e r t o a v o i d t h e m u l t i p l e t a x a t i o n o f c o r p o r a t e s o u r c e income, some a l l o w a n c e would have t o be made f o r d i v i d e n d s r e c e i v e d by c o r p o r a t e s h a r e h o l d e r s . A c c o r d i n g l y , s u b s e c t i o n 3(12) exempted i n t e r c o r p o r a t e d i v i d e n d s from t a x . A problem was seen t o a r i s e however i n c o n n e c t i o n w i t h i n c e s t u o u s share s a l e s i n w h i c h the s h a r e h o l d e r s o l d h i s s h a r e s i n a s u r p l u s - l a d e n o p e r a t i n g company t o a h o l d i n g company a l s o owned by him i n exchange f o r d e b t w h i c h was s u b s e q u e n t l y d i s c h a r g e d w i t h s u r p l u s o f t h e o p e r a t i n g company p a i d o u t as t a x exempt d i v i d e n d s t o i t s p a r e n t h o l d i n g company. I n o r d e r t o n u l l i f y such schemes, s u b s e c t i o n 4(11) was e n a c t e d t o deem the i n t e r c o r p o r a t e d i v i d e n d t o have been r e c e i v e d by t h e vendor o f t h e s h a r e s . S u b s e c t i o n 4(11) t u r n e d upon the r e c e i p t o f a d i v i d e n d by a c o r p o r a t i o n p a i d out o f t h e r e t a i n e d e a r n i n g s o f a n o t h e r . A means o f b y - p a s s i n g t h e p r o v i s i o n was seen i n h a v i n g t h e a c q u i r i n g c o r p o r a t i o n wind up i t s s u b s i d i a r y i . e . t h e s u b s i d i a r y ' s a s s e t s were r e c e i v e d t a x f r e e , b u t not as a d i v i d e n d . F u r t h e r m o r e , t h e r e c e i p t o f t h e s u b s i d i a r y ' a s s e t s d i d not c r e a t e u n d i s t r i b u t e d income i n t h e p a r e n t h o l d i n g company so t h a t upon i t s l i q u i d a t i o n i t s p r o p e r t i e s , i n c l u d i n g o f c o u r s e t h e s u r p l u s o f i t s former s u b s i d i a r y , might themselves be d i s t r i b u t e d t a x f r e e . By amendment t o t h e A c t i n 1936, s u b s e c t i o n 19(2) aimed a t p l u g g i n g t h i s l o o p h o l e by deeming a d i s t r i b u t i o n i n t h e d e s c r i b e d c i r c u m s t a n c e s : t o be an exempt d i v i d e n d t o t h e r e c i p i e n t . 8 T h i s c r e a t e d u n d i s t r i b u t e d income i n the parent which would be s u b j e c t to tax upon l i q u i d a t i o n of t h a t c o r p o r a t i o n . Another problem arose i n t h a t the terms of s u b s e c t i o n 4(11) r e q u i r e d t h a t the a c q u i r i n g c o r p o r a t i o n be c o n t r o l l e d by the vendor or a c t as the vendor's agent, .trustee, or a t t o r n e y . Thus, s o - c a l l e d 'bootstrap' t r a n s a c t i o n s , i n which an a c q u i r i n g company d e a l i n g a t arm's l e n g t h w i t h the vendor r e c e i v e d a d i v i d e n d out of the a c q u i r e d company's s u r p l u s i n order to r e p l a c e i t s own funds used i n the a c q u i s i t i o n , were not covered by the s u b s e c t i o n . A c c o r d i n g l y , a d i s c r e t i o n i n broad terms was c o n f e r r e d on the Treasury Board i n 1938 to d i r e c t t h a t an i n t e r c o r p o r a t e d i v i d e n d be taxed a t o r d i n a r y r a t e s where i t found t h a t the main purpose of a t r a n s a c t i o n i n v o l v i n g the a c q u i s i t i o n of shares i n a company by another company was "to reduce or a v o i d the tax which would have been p a i d to the shareholders of (the a c q u i r e d c o r p o r a t i o n ) ... .on the d i s t r i b u t i o n to them 7 of ( i t s ) u n d i s t r i b u t e d income." An important development i n the h i s t o r y of d i v i d e n d s t r i p p i n g was the i n t r o d u c t i o n i n 1938 of s e c t i o n 32(A), Q which, as we have seen , c o n f e r r e d d i s c r e t i o n a r y powers upon the Treasury Board to modify or d i r e c t the tax consequences of t r a n s a c t i o n s t a i n t e d by tax avoidance motives. These p r o v i s i o n s are good i l l u s t r a t i o n s of the h i g h water mark of o f f i c i a l d i s c r e t i o n i n f i s c a l matters. In a d d i t i o n to s u b s e c t i o n 3 2 ( A ) ( 3 ) , a l r e a d y d i s c u s s e d , the new l e g i s l a t i o n 9 i n t r o d u c e d the predecessor of s u b s e c t i o n 246(1) , which was 9 i n t e n d e d t o b o l s t e r the p r e v i o u s l y e n a c t e d a n t i - a v o i d a n c e p r o v i s i o n s by c o n f e r r i n g the b r o a d e s t d i s c r e t i o n upon the T r e a s u r y Board t o g i v e such d i r e c t i o n s as i t c o n s i d e r e d a p p r o p r i a t e where i t found t h a t one o f the main purposes o f a t r a n s a c t i o n was improper t a x a v o i d a n c e . S u b s e c t i o n 32(A)(2) was a l s o o f a g e n e r a l n a t u r e , p e r m i t t i n g the T r e a s u r y Board t o deem any payments o r b e n e f i t s r e c e i v e d d i r e c t l y o r i n d i r e c t l y from a c o r p o r a t i o n p o s s e s s i n g u n d i s t r i b u t e d income on hand t o be income o f t h e r e c i p i e n t i n s o f a r as t h e main purpose o f h i s t r a n s a c t i o n s was found t o be t h e r e d u c t i o n o r a v o i d a n c e o f t a x . The above d e s c r i b e d a n t i - a v o i d a n c e measures would seem t o have o p e r a t e d r e a s o n a b l y e f f i c i e n t l y because i n 1930 i t was n e c e s s a r y t o e n a c t s u b s e c t i o n 19(1) which p e r m i t t e d the t a x - f r e e d i s t r i b u t i o n o f pre-1930 r e t a i n e d p r o f i t s . T h i s s u r p l u s had 'bunched' i n l a r g e a c c u m u l a t i o n s and r e s u l t e d i n a v e r y l a r g e t a x l i a b i l i t y t o t h e e s t a t e o f a deceased s h a r e h o l d e r . The payment o f t a x f r e e d i v i d e n d s o u t o f pre-1930 s u r p l u s was a v a i l a b l e u n t i l 1934, when t h e r i g h t was d i s c o n t i n u e d . A g a i n i n : . 1945, however, i n re s p o n s e t o the recommendation o f the I v e s Commission, a scheme f o r the t a x - r e d u c e d d i s t r i b u t i o n o f r e t a i n e d e a r n i n g s was adopted p u r s u a n t t o wh i c h p r i v a t e c o r p o r a t i o n s were p e r m i t t e d t o e l e c t t o pay a t a x r a n g i n g from 15%-33% on pre-1940 e a r n i n g s . F o l l o w i n g the e l e c t i o n and payment o f t h e t a x , t h e s u r p l u s might be d i s t r i b u t e d a t no f u r t h e r t a x c o s t . 10 W i t h the advent of the Income Tax A c t , 194 8, the p r o v i s i o n s a l r e a d y d i s c u s s e d i n c o n n e c t i o n w i t h t h e use o f t a x exempt o r t a x reduced d i v i d e n d s p a i d t o c o r p o r a t i o n s "^ were n o t c a r r i e d f o r w a r d . I n s t e a d , the c o n c e p t o f d e s i g n a t e d s u r p l u s was b r o u g h t i n t o b e i n g i n 1950."'"''" D e s i g n a t e d s u r p l u s a r o s e i n c i r c u m s t a n c e s where c o n t r o l o f a c o r p o r a t i o n p o s s e s s i n g u n d i s t r i b u t e d income on hand was a c q u i r e d by a n o t h e r c o r p o r a t i o n . The b a l a n c e o f t h e UI on hand of the c o n t r o l l e d c o r p o r a t i o n a t i t s l a s t f i s c a l y e a r end p r e c e d i n g the d a t e o f t h e change i n c o n t r o l , minus any d i v i d e n d s t h a t were p a i d i n t h e y e a r c o n t r o l was a c q u i r e d , was ' d e s i g n a t e d ' so t h a t t a x f r e e d i v i d e n d s c o u l d n o t be p a i d o u t o f t h i s f u n d . U n l i k e t h e p r o v i s i o n s o f s u b s e c t i o n 4(1.1) o f the Income War Tax A c t , d e s i g n a t e d s u r p l u s r u l e s sought t o t a x the d i v i d e n d r e c i p i e n t r a t h e r than th e vendor of t h e s h a r e s . I t soon became o b v i o u s t h a t t h e d e s i g n a t e d s u r p l u s c o n c e p t p o s s e s s e d a number of f l a w s . F o r example, income of the a c q u i r e d c o r p o r a t i o n a f t e r t h e change i n c o n t r o l , known as ' c o n t r o l p e r i o d e a r n i n g s ' , might be p a i d out as t a x f r e e d i v i d e n d s t o the c o n t r o l l i n g c o r p o r a t i o n . T h i s , o f c o u r s e , i s because o n l y t h e income on hand i n the a c q u i r e d c o r p o r a t i o n a t t h e time of t h e change i n c o n t r o l was d e s i g n a t e d . The d e f i n i t i o n o f c o n t r o l p e r i o d e a r n i n g s i n s u b s e c t i o n 28(5) o f the A c t made no p r o v i s i o n f o r a r e d u c t i o n i n t h i s a c c o u n t f o r b u s i n e s s l o s s e s o r p r o v i n c i a l 11 income t a x e s p a i d . Thus, the control p e r i o d e a r n i n g s might exceed th e b a l a n c e of p o s t - c o n t r o l u n d i s t r i b u t e d e a r n i n g s on hand i n the a c q u i r e d company. To the e x t e n t t h a t d i v i d e n d s were p a i d out i n e x c e s s of t h e d o l l a r s a c t u a l l y on hand a t t r i b u t a b l e t o p o s t - c o n t r o l e a r n i n g s , the d e s i g n a t e d s u r p l u s was e f f e c t i v e l y reduced. Another problem a r o s e because under t h e d e s i g n a t e d s u r p l u s r u l e s i t was n e c e s s a r y f o r t h e c o n t r o l l e d c o r p o r a t i o n t o p o s s e s s u n d i s t r i b u t e d income on hand a t t h e t ime o f the change i n c o n t r o l . I f t h e s h a r e s o f an o p e r a t i n g company were t r a n s f e r r e d t o a h o l d i n g company b e f o r e i t began b u s i n e s s o p e r a t i o n s , the s u r p l u s l a t e r accumulated i n t h e s u b s i d i a r y would n o t t h e n be d e s i g n a t e d . I t was a l s o p o s s i b l e t o s k i r t t h e p r o v i s i o n s g o v e r n i n g the c oncept o f c o n t r o l by a p p r o p r i a t e l y s t r u c t u r i n g the s h are c a p i t a l o f t h e a c q u i r e d c o r p o r a t i o n p r i o r t o t h e t a k e - o v e r o r by s e l l i n g t o two arm's l e n g t h p u c h a s e r s . I n a d d i t i o n t a x r e d u c t i o n o r a v o i d a n c e might s u c c e s s f u l l y be p r a c t i c e d by o t h e r means. T r a d e r ' s i n s e c u r i t i e s , f o r example, might a c q u i r e the s h a r e s ( e n s u r i n g the t a x f r e e r e c e i p t o f the proceeds t o the v e n d o r s ) , cause the company t o pay o u t a d i v i d e n d e q u a l t o the u n d i s t r i b u t e d s u r p l u s on hand ( t o r e p l a c e a l l o r a p o r t i o n o f the p urchase p r i c e p a i d ) , and r e s e l l the s h a r e s t o the o r i g i n a l owners a t a l o s s , w h i c h , i n v i e w o f the t r a d e r ' s b u s i n e s s , might be deducted from h i s income. I t was a l s o p o s s i b l e t o s e l l the s h a r e s t o a n o n - r e s i d e n t 12 c o r p o r a t i o n c o n t r o l l e d by the vendors and pay o u t t h e s u r p l u s a t t h e reduced t a x c o s t o f 15%, o r t o s e l l t h e s h a r e s t o a t a x exempt p e r s o n . As a r e s u l t o f t h e s e a v o i d a n c e p o s s i b i l i t i e s , s e c t i o n 105 B was e n a c t e d i n 1955 t o p r o v i d e t h a t a 15% t a x was e x i g i b l e on d i v i d e n d s p a i d t o t a x exempt p e r s o n s and t o n o n - r e s i d e n t c o r p o r a t i o n s , and t h a t a 20% t a x was t o be l e v i e d on d i v i d e n d s p a i d t o s hare d e a l e r s . These amendments were however themselves v u l n e r a b l e t o t a x r e d u c t i o n measures l a w f u l l y a v a i l a b l e t o t a x p a y e r s . F o r example, s a l e s t o a s h are d e a l e r c o n t i n u e d t o be a t t r a c t i v e because th e 20% t a x under s e c t i o n 105 B was imposed on t h e amount d i s t r i b u t e d as a d i v i d e n d and not on the s u r p l u s a v a i l a b l e f o r d i s t r i b u t i o n . By p a y i n g l e s s t h a n the s u r p l u s on hand i n the company and e l e c t i n g t o pay t a x on a d i v i d e n d e q u i v a l e n t t o the purchase p r i c e , t h e 20% t a x might be reduced t o 16 2/3%, the share d e a l e r would p a r t i c i p a t e i n the t r a n s a c t i o n a t no economic c o s t , and t h e vendor would e f f e c t i v e l y r e c e i v e the d i s t r i b u t a b l e income a t a v e r y f a v o u r a b l e r a t e even a f t e r compensating the s hare d e a l e r f o r h i s s e r v i c e s . Other s t r i p p i n g p r a c t i c e s a l s o f l o u r i s h e d . These i n v o l v e d e.g. t h e c o n v e r s i o n o f a r e s i d e n t o p e r a t i n g 12 company i n t o a n o n - r e s i d e n t owned i n v e s t m e n t c o r p o r a t x o n , t h e payment o f d i v i d e n d s s u b j e c t t o d e s i g n a t e d s u r p l u s t a x t o a company wh i c h might o f f s e t the t a x w i t h b u s i n e s s l o s s e s , the a c q u i s i t i o n by a s u b s i d i a r y o f t h e s h a r e s o f i t s p a r e n t , and the r e v a l u a t i o n o f a p a r e n t company's a s s e t s t o f a i r market v a l u e , t h a t i s , o f t h e s h a r e s o f i t s s u b s i d i a r y companies, f o l l o w e d by the payment o f a s t o c k d i v i d e n d o u t o f t h e r e s u l t a n t c a p i t a l s u r p l u s w h i c h might i n d i r e c t l y be redeemed t a x f r e e w i t h funds s u b s e q u e n t l y p a i d by t h e s u b s i d i a r y t o t h e p a r e n t . These and o t h e r abuses l e d t o t h e enactment i n 19 6 3 of s e c t i o n 138(A), now s u b s e c t i o n 247(1) which c o n f e r s a d i s c r e t i o n on the M i n i s t e r o f N a t i o n a l Revenue, i n c i r c u m s t a n c e s where he i s o f the o p i n i o n t h a t one o f the purposes of the impugned t r a n s a c t i o n ( s ) i s the a v o i d a n c e o f t a x on s u r p l u s d i s t r i b u t i o n s , t o d i r e c t t h a t a l l o r a p o r t i o n o f t h e amounts r e c e i v e d by a t a x p a y e r a s , i n t e r a l i a , c o n s i d e r a t i o n f o r t h e d i s p o s i t i o n o f any s h a r e s o f a c o r p o r a t i o n , be i n c l u d e d i n computing the t a x p a y e r ' s income f o r t h a t y e a r , o r , where the t a x p a y e r i s an i n d i v i d u a l , be deemed t o have been r e c e i v e d by him as a t a x a b l e d i v i d e n d . I n s p i t e , o r perhaps because o f the o u t c r y s u r r o u n d i n g t h e r e i n t r o d u c t i o n o f m i n i s t e r i a l d i s c r e t i o n i n f i s c a l m a t t e r s , s e c t i o n 138(A), and i t s s u c c e s s o r , have r a r e l y been i n v o k e d by the government. Indeed, i t would appear t h a t broad as i t s terms may be, t h e w o r d i n g of t h i s p r o v i s i o n c o n t i n u e d t o o f f e r o p p o r t u n i t i e s f o r a v o i d a n c e . F o r example, i n t h e case o f s t r i p p i n g t h r o u g h a n o n - r e s i d e n t owned i n v e s t m e n t 13 c o r p o r a t i o n , the f a c t t h a t debt i s t a k e n by t h e vendor from the NRO i n r e t u r n f o r the s h a r e s of t h e o p e r a t i n g company i s s i g n i f i c a n t because s e c t i o n 138(A) t a x e s 'amounts 14 r e c e i v e d ' . I t may be argued t h a t a l t h o u g h t h e debt c o n s t i t u t e s an amount, i t i s n o t r e c e i v e d . The n e x t i m p o r t a n t development b e a r i n g on t h e i s s u e o f d i v i d e n d - s t r i p p i n g i s the work o f t h e C a r t e r Commission, p a r t i c u l a r l y t h o s e p o r t i o n s o f t h e r e p o r t d e a l i n g w i t h c o r p o r a t i o n t a x and t h e t a x a t i o n o f p r o p e r t y 15 g a i n s . W i t h r e g a r d t o c o r p o r a t i o n t a x , the C a r t e r Commission proposed a scheme o f f u l l i n t e g r a t i o n o f p e r s o n a l and c o r p o r a t e income t a x e s . Because t h e f l a t c o r p o r a t i o n t a x r a t e o f 50% was e q u i v a l e n t t o the recommended h i g h e s t p e r s o n a l r a t e , t h e C a r t e r p r o p o s a l n e i t h e r encouraged n o r d i s c o u r a g e d the r e t e n t i o n o f e a r n i n g s . Thus, i n t h e words of the Commission, "(T)he advantages o f , and f a c i l i t y f o r , t a x a v o i d a n c e ^ b y means of " s u r p l u s s t r i p p i n g " t h a t a r e 16 i n h e r e n t i n t h e p r e s e n t t a x s t r u c t u r e would be removed." The o p p o s i t i o n o f the Canadian b u s i n e s s community t o t h e C a r t e r p r o p o s a l s l e d e v e n t u a l l y t o t h e a d o p t i o n o f t h e compromise s o l u t i o n o f p a r t i a l i n t e g r a t i o n , an approach w h i c h i n i t i a l l y i n most cases moderated b u t d i d not e l i m i n a t e the i n c i d e n c e o f double t a x a t i o n (as w e l l as t h e r e s u l t i n g i n c e n t i v e t o s t r i p s u r p l u s ) . A s i m i l a r f a t e b e f e l l the Commission's p r o p o s a l t h a t a l l r e a l i z e d g a i n s from p r o p e r t y be t a k e n i n t o income as p a r t s o f a comprehensive t a x base. Had t h i s recommendation been implemented, a l l s t r i p s o f s u r p l u s based upon t h e t r a n s f o r m a t i o n o f an income i n t o a c a p i t a l r e c e i p t would have been a b o l i s h e d . P a r t l y as a r e s u l t o f the recommendations o f t h e Commons Committee R e p o r t on the White Paper ^', the t a x r e f o r m l e g i s l a t i o n adopted a ' m i d d l e - o f - t h e - r o a d ' s o l u t i o n by b r i n g i n g o n l y o n e - h a l f o f c a p i t a l g a i n s i n t o income, thus p r e s e r v i n g the d i s t i n c t i o n between g a i n s on p r o p e r t y and o r d i n a r y income and p e r p e t u a t i n g t h e r a t i o n a l e u n d e r l y i n g s t r i p s o f c o r p o r a t e s u r p l u s . The t a x r e f o r m amendments o f 1971 r a d i c a l l y a l t e r e d the r u l e s g o v e r n i n g the t a x a t i o n o f s u r p l u s d i s t r i b u t i o n s . Whereas under t h e ' o l d ' A c t a l l d i s t r i b u t i o n s were t a x a b l e t o t h e e x t e n t o f t h e c o r p o r a t i o n ' s u n d i s t r i b u t e d income on hand, t h e new l e g i s l a t i o n r e v e r s e d t h e o r d e r o f d i s t r i b u t i o n s so t h a t s h a r e h o l d e r s might be p e r m i t t e d a t a x - f r e e r e t u r n o f c a p i t a l i n advance o f f u r t h e r d i s t r i b u t i o n s , w h i c h were t o be t a x a b l e as d i v i d e n d s . T h i s change was implemented i n c o n n e c t i o n w i t h t h e c a p i t a l i z a t i o n .of c o r p o r a t i o n s and was i n t e n d e d t o harmonize t h e t a x t r e a t m e n t o f a r e t u r n o f c a p i t a l t o s h a r e h o l d e r s w i t h t h e repayment by t h e c o r p o r a t i o n o f l o a n s made by s h a r e h o l d e r s . I n v i e w o f t h e new r u l e s , i t was n e c e s s a r y t o guard a g a i n s t t h e p o s s i b i l i t y t h a t s u r p l u s might be c o n v e r t e d i n t o c a p i t a l as a r e s u l t o f p r o c e d u r e s a v a i l a b l e under the c o r p o r a t e law and the n r e t u r n e d t o the s h a r e h o l d e r s on a t a x - f r e e b a s i s . The danger was the more menacing i n t h a t p a r a g r a p h 8 9 ( 1 ) ( c ) o f t h e 1972 A c t d e f i n e d p a i d up c a p i t a l as p a i d i n c a p i t a l f o r c o r p o r a t e law pur p o s e s . The con c e p t s o f p a i d up c a p i t a l d e f i c i e n c y and p a i d up c a p i t a l l i m i t were therefore i n t r o d u c e d i n p a ragraphs 89(1)(d) and (e) r e s p e c t i v e l y t o i n d i r e c t l y a r r i v e a t a co m p u t a t i o n o f p a i d up c a p i t a l f o r t a x pur p o s e s . 16 B r i e f l y , t he p a i d up c a p i t a l deficiency./was d e ducted from t h e c o r p o r a t e p a i d up c a p i t a l t o e s t a b l i s h t h e p a i d up c a p i t a l l i m i t o f the c o r p o r a t i o n , o r the amount t h a t might be r e t u r n e d t o s h a r e h o l d e r s t a x f r e e i n advance o f t a x a b l e d i s t r i b u t i o n s . Amounts p a i d i n e x c e s s o f the PUCL were t r e a t e d as d i v i d e n d s . I n 1974-75, e x t e n s i v e amendments t o t h e A c t were e f f e c t e d i n c l u d i n g a r e d e f i n i t i o n ' o f ;;paid~:upcea.pital cto comprise any premiums p a i d upon the i s s u a n c e o f s h a r e s and c o n t r i b u t i o n s t o the c a p i t a l o f the c o r p o r a t i o n , c e r t a i n minor m o d i f i c a t i o n s t o t h e PUCD and PUCL c o m p u t a t i o n s , and the i n t r o d u c t i o n o f the new concept o f debt l i m i t i n s e c t i o n 84.1. The debt l i m i t p r o v i s i o n was s i m i l a r i n p r i n c i p l e and i n purpose t o t h e PUCD and PUCL r u l e s b u t was d i r e c t e d a t a s i t u a t i o n where c o r p o r a t e s u r p l u s was t r a n s l a t e d i n t o debt i n s t e a d o f i n t o p a i d up c a p i t a l i n i n c e s t u o u s share s a l e s . The debt l i m i t e q u a l l e d t h e p a i d up c a p i t a l o f the s h a r e s t r a n s f e r r e d t o the p u r c h a s i n g company, minus t h e p a i d up c a p i t a l o f any sha r e s t a k e n back i n a d d i t i o n t o the d e b t . Any amount d i s t r i b u t e d i n e x c e s s o f t h a t f i g u r e was t r e a t e d as a d i v i d e n d t o t h e s h a r e h o l d e r . These p r o v i s i o n s c o n t i n u e d i n e f f e c t u n t i l t h e i r r e p e a l i n 1977, when the i n c r e a s e i n the d i v i d e n d t a x c r e d i t t o 50% narrowed t h e gap between t h e e f f e c t i v e r a t e o f t a x on r e a l i z a t i o n s o f c o r p o r a t e s u r p l u s i n t h e form o f d i v i d e n d s and r e t u r n s o f c a p i t a l . Indeed, the p r e f e r e n c e f o r c a p i t a l g a i n s t r e a t m e n t remained o n l y f o r s h a r e h o l d e r s exposed t o t h e h i g h e s t m a r g i n a l rates,who b e n e f i t e d t o t h e e x t e n t o f 8%, w h i l e f o r most t a x p a y e r s d i v i d e n d t r e a t m e n t a c t u a l l y i m p o r t e d a more t a x b e n e f i c i a l r e s u l t . I n consequence, th e government a t l a s t d e c i d e d t o c a l l a h a l t t o h o s t i l i t i e s o v e r t h e c o n v e r s i o n o f c o r p o r a t e s u r p l u s a v a i l a b l e f o r payment as d i v i d e n d s i n t o c a p i t a l g a i n s . T h i s change i n p o l i c y a l s o n a t u r a l l y d i c t a t e d the r e p e a l o f the d e s i g n a t e d s u r p l u s p r o v i s i o n s . From March 31, 1977, i t may be s a i d t h a t t h e government i s i n d i f f e r e n t t o t h e manner i n w h i c h c o r p o r a t e s u r p l u s i s r e a l i z e d , s u b j e c t t o t h e e x c e p t i o n s t o be d i s c u s s e d i n t h e f o l l o w i n g c h a p t e r . 18 FOOTNOTES 1. S.C. 1917, c.28. 2. (1924) 2 K.B. 52. 3. IWTA, s. 4 ( 1 2 ) . 4 . I b i d . , s. 4 ( 9 ) . 5. I b i d . , s. 4 ( 1 0 ) . 6. I b i d . , s. 4 ( 8 ) . 7. IWTA, s. 3 2 ( A ) ( 3 ) . 8. Supra, a t pp. 7-8. 9. IWTA, s. 3 2 ( A ) ( 1 ) . 10. IWTA, s s . 14, 1 9 ( 2 ) . 32(A)(2) and ( 3 ) . 11. ITA, 1948, s.28. 12. The t a x p a y e r would f i r s t i n c o r p o r a t e a company i n a t a x haven j u r i s d i c t i o n . T h i s company would i n c o r p o r a t e a sub- s i d i a r y i n Canada and a p p l y p u r s u a n t t o former s e c t i o n 7 0 t o q u a l i f y as a NRO. The t a x p a y e r would then s e l l h i s sh a r e s o f t h e o p e r a t i n g company t o t h e NRO i n r e t u r n f o r debt . The s u r p l u s company would i t s e l f t h e n a p p l y t o be c o n v e r t e d i n t o an NRO p u r s u a n t t o t h e same p r o v i s i o n . T h i s s t a t u s would e n a b l e i t t o pay a t a x f r e e d i v i d e n d t o i t s p a r e n t NRO (a Canadian r e s i d e n t c o r p o r a t i o n n o t s u b j e c t t o w i t h - 19 h o l d i n g t a x ) . The p a r e n t NRO c o u l d t h e n pay a t a x f r e e d i v i d e n d t o i t s t a x haven p a r e n t NRO p u r s u a n t t o former s e c t i o n 1 0 6 ( 1 ) ( a ) . 13 . See, s u p r a , note 12, a t p.12. 14. Report o f the Canadian R o y a l Commission on T a x a t i o n , h e r e i n a f t e r r e f e r r e d t o as t h e C a r t e r Coniriission; v.4,Part B: T a x a t i o n o f Income f l o w i n g t h r o u g h i n t e r m e d i a r i e s , a t pp. 1-94. 15. C a r t e r Commission, v.3, T a x a t i o n o f Income, a t pp. 325-399. 16. Supra, f o o t n o t e 15, a t p.9. 17. House o f Commons, E i g h t e e n t h R e p o r t o f t h e S t a n d i n g Committee on F i n a n c e , Trade, and Economic A f f a i r s , R e s p e c t i n g the White Paper on Tax Reform, (1970). 20 ' I I . S e c t i o n 84.1 (a) I n t r o d u c t i o n One o f the s t r i p s o f c o r p o r a t e e a r n i n g s examined i n the f i r s t c h a p t e r o f t h i s t h e s i s was t h a t i n v o l v i n g t h e i n c e s t u o u s s a l e by a t a x p a y e r o f s h a r e s o f an ^ o p e r a t i n g company t o a h o l d i n g company owned by him i n r e t u r n f o r proceeds of d i s p o s i t i o n a t t r a c t i n g c a p i t a l g a i n s t r e a t m e n t . P a r t V I I t a x was the government's r e s p o n s e , but i n s p i t e o f the d e s i g n a t e d s u r p l u s r u l e s i t was s t i l l p o s s i b l e t o make t a x f r e e payments o u t . o f p o s t - c o n t r o l e a r n i n g s . S t r i p s o f t h i s t y pe were p a r t i c u l a r l y o b j e c t i o n a b l e t o the government p r i o r t o 19 7 2 because under the former A c t c a p i t a l g a i n s were n o t t a x a b l e . They c o n t i n u e d t o be l o o k e d upon w i t h d i s f a v o u r however, even a f t e r t h e i n t r o - d u c t i o n o f c a p i t a l g a i n s t a x , presumable because o n l y one- h a l f o f a c a p i t a l g a i n , as opposed t o t h e f u l l amount o f a t a x a b l e d i v i d e n d , was i n c l u d e d i n i n c o m e . 1 But t h e p r o g r e s s i v e n a r r o w i n g o f the d i f f e r e n c e between the t a x t r e a t m e n t o f d i v i d e n d income and c a p i t a l g a i n s , p a r t i c u l a r l y t h e i n c r e a s e t o 501 i n the d i v i d e n d t a x c r e d i t i n 1977, brought about a change i n a t t i t u d e . I t became a m a t t e r o f i n d i f f e r e n c e t o the government whether c o r p o r a t e s u r p l u s was withdrawn i n the form of d i v i d e n d s o r c a p i t a l g a i n s . Thus the s h a r e h o l d e r won the r i g h t t o choose f o r h i m s e l f the form i n w h i c h c o r p o r a t e s u r p l u s might be d i s - 21 t r i b u t e d . I n t h i s r e g a r d the government demonstrated commendable adherence t o a c o n s i s t e n t p o l i c y . The o b j e c t i o n had h i t h e r t o never been t h a t the s t r i p p e r m i t t e d a premature r e a l i z a t i o n o f the s h a r e h o l d e r ' s e q u i t y . The emphasis a l l a l o n g seems r a t h e r t o have been on the a l l e g e d w r o n g f u l c o n v e r s i o n o f s u r p l u s from a scheme o f l e s s t o a scheme o f more f a v o u r a b l e t a x t r e a t m e n t . Absent t h i s element o f improper c o n v e r s i o n , i t f o l l o w e d t h a t the t a x p a y e r might be p e r m i t t e d a r e t u r n o f c a p i t a l (an amount n o t t a x a b l e i n any case) and a payment i n r e s p e c t o f the remainder o f h i s i n t e r e s t p r o v i d e d i t was s u b j e c t t o some form o f t a x a t the v e r y l a t e s t upon r e c e i p t o f fu n d s . G e n e r a l l y , t h e t a x p a y e r would now r o l l h i s s h a r e s o f the o p e r a t i n g company i n t o t h e h o l d i n g company p u r s u a n t , t o s u b s e c t i o n 8 5 ( 1 ) , t a k i n g back a t l e a s t s h a r e s o f t h e h o l d i n g company and p o s s i b l y a l s o cash and debt i n an amount not e x c e e d i n g the a d j u s t e d c o s t base o f the sh a r e s t r a n s f e r r e d . The r o l l o v e r became n e c e s s a r y when t h e t a x a t i o n o f c a p i t a l g a i n s was i n t r o d u c e d , e x p o s i n g an o r d i n a r y s a l e t o t a x . S u b s e c t i o n 85(1) p r o v i d e s a means whereby c a p i t a l a s s e t s , i n c l u d i n g s h a r e s o f the c a p i t a l s t o c k o f a Canadian c o r p o r a t i o n , may be t r a n s f e r r e d t o a company on a t a x f r e e b a s i s by a t a x p a y e r i n c i r c u m s t a n c e s where t h e t r u e economic i n t e r e s t s o f t h e p a r t i e s have n o t changed. I n o r d e r t o a c c o m p l i s h t h i s t a x f r e e r e s u l t , t h e f i g u r e s e l e c t e d as the deemed proceeds o f d i s p o s i t i o n t o the t a x p a y e r w i l l be t h e a d j u s t e d c o s t base o f the s h a r e s r o l l e d o v e r , and 22 the same amount w i l l c o r r e s p o n d i n g l y be t r e a t e d as the c o s t t h e r e o f t o the t r a n s f e r e e c o r p o r a t i o n . I f a f t e r March 1977 d i v i d e n d t r e a t m e n t o f t h e c o r p o r a t e s u r p l u s t o be d i s t r i b u t e d i s d e s i r e d , t h e t a x p a y e r t a k e s back s h a r e s o f t h e h o l d i n g company w i t h a low p a i d up c a p i t a l . Amounts p a i d upon redemption o f t h e s e s h a r e s i n e x c e s s o f the p a i d up c a p i t a l a t t r i b u t a b l e t h e r e t o would r e s u l t i n a deemed d i v i d e n d under s u b s e c t i o n 84(3) 2 and p r o b a b l y a l s o a c a p i t a l l o s s . I f i n s t e a d t h e t a x p a y e r ' s p r e f e r e n c e i s f o r c a p i t a l g a i n s t r e a t m e n t , he t a k e s back s h a r e s o f the h o l d i n g company w i t h a p a i d up c a p i t a l e q u a l t o t h e f a i r market v a l u e o f the s h a r e s o f t h e o p e r a t i n g company r o l l e d o v e r . Upon redemption o f h i s s h a r e s a t an amount n o t i n e x c e s s o f t h e i r p a i d up c a p i t a l the t a x p a y e r w i l l i n c u r a c a p i t a l g a i n e q u a l t o the e x c e s s o f the amount r e c e i v e d - o v e r t h e a d j u s t e d c o s t base o f t h e s h a r e s t a k e n back (the e l e c t e d amount). I n e i t h e r case the t a x p a y e r may c o n t r o l t h e f l o w o f h i s r e c e i p t s and t h e c o r r e s p o n d i n g i n c i d e n c e o f t a x a t i o n by redeeming h i s s h a r e h o l d i n g i n a p i e c e m e a l f a s h i o n . A problem was seen t o a r i s e however where t h e sha r e s b e i n g r o l l e d i n t o t h e h o l d i n g company were h e l d p r i o r t o 1972 by t h e t r a n s f e r o r . The a d j u s t e d c o s t base o f such s h a r e s , t h a t i s , the amount t h a t might be r e t u r n e d t a x f r e e t o the s h a r e h o l d e r , might g r e a t l y exceed t h e amount a c t u a l l y i n v e s t e d . The d i s c r e p a n c y i s o f c o u r s e e x p l a i n e d by the f a c t t h a t t h e i n c r e m e n t i n t h e v a l u e o f t h e s h a r e s i s , 23 i n an arm's l e n g t h t r a n s a c t i o n , n o n - t a x a b l e t o the e x t e n t o f the V-day v a l u e . I n o t h e r words, t h e a d j u s t e d c o s t base o f such s h a r e s i s n o r m a l l y e s t a b l i s h e d a t a f i g u r e e x c e e d i n g h i s t o r i c c o s t . As i n the case o f t h e p r e - r e f o r m s t r i p s t u r n i n g on the i n c e s t u o u s s a l e o f s h a r e s , funds n o r m a l l y t a x a b l e t o t h e s h a r e h o l d e r as d i v i d e n d income might be c o n v e r t e d i n t o a n o n - t a x a b l e c a p i t a l r e c e i p t . The s i m i l a r i t y was o f c o u r s e n ot l o s t upon t h e government and s e c t i o n 84.1 was the r e s u l t . G e n e r a l l y , depending upon whether h a r d c o n s i d e r a t i o n , d e b t , o r sh a r e s o f t h e p u r c h a s e r c o r p o r a t i o n a r e t a k e n back, s e c t i o n 84.1 w i l l p r o v i d e e i t h e r f o r an immediate OX / d e f e r r e d c a p i t a l g a i n o f t h e V-day v a l u e i n h e r e n t i n t h e sh a r e s t r a n s f e r r e d t o t h e e x t e n t t h a t the aggregate c o n s i d e r a t i o n t a k e n back exceeds t h e p a i d up c a p i t a l o f those s h a r e s . (b) C o n d i t i o n s o f A p p l i c a b i l i t y I n o r d e r f o r s e c t i o n 84.1 t o a p p l y , i t i s n e c e s s a r y t h a t the a c q u i r i n g c o r p o r a t i o n and the c o r p o r a t i o n the s h a r e s o f which a r e a c q u i r e d (the s u b j e c t c o r p o r a t i o n ) be 'connected'. What t h i s means i s t h a t where the a c q u i r i n g company owns l e s s than what i s n e c e s s a r y t o exempt i t from P a r t IV t a x (10% v o t e s and v a l u e s ) , s e c t i o n 84.1 w i l l n o t a p p l y and the t r a n s f e r o r may s t r i p o u t the V-day v a l u e i n h e r e n t i n t h e sha r e s t r a n s f e r r e d t o the e x t e n t t h a t t h e amount o f i n t e r - c o r p o r a t e d i v i d e n d s p a i d p e r m i t s . T h i s scheme s h o u l d however be r e g a r d e d as a t r a d e o f f i n t h a t P a r t IV t a x w i l l be p a y a b l e 24 by the company r e c e i v i n g the d i v i d e n d and w i l l be r e f u n d e d o n l y when t a x a b l e d i v i d e n d s a re i n t u r n p a i d t o t h e s h a r e h o l d e r . I t would o t h e r w i s e be v e r y d i f f i c u l t t o see on what p r i n c i p l e the e x c e p t i o n s h o u l d be made. The V-day v a l u e o f a 10% i n t e r e s t w i l l v a r y c o n s i d e r a b l y from one company t o a n o t h e r , and i f s t r i p p i n g i s improp e r , t h e r e seems l i t t l e r e a s o n t o countenance i t a t a l l . There i s , moreover, n o t h i n g i n the s e c t i o n t o p r e v e n t a t a x p a y e r owning more than 10% from u s i n g t h e connected c o r p o r a t i o n s c o ncept t o s t r i p o u t the V-day v a l u e o f h i s e n t i r e s h a r e h o l d i n g by t r a n s f e r r i n g no more th a n 10% t o as many h o l d i n g companies as a r e n e c e s s a r y t o a c c o u n t f o r h i s i n t e r e s t . Were i t n o t f o r t h e t r a d e o f f i n v o l v i n g P a r t IV t a x such a p r o c e d u r e would p r o b a b l y r e s u l t i n a d i r e c t i o n p u r s u a n t t o s u b s e c t i o n 2 4 7 ( 1 ) . Subparagraphs 84.1(2)(a) and (b) c o n t a i n an extended d e f i n i t i o n o f non-arm's l e n g t h a p p l i c a b l e t o s e c t i o n 84.1 t r a n s a c t i o n s . The t a x p a y e r w i l l be deemed not t o d e a l w i t h t h e a c q u i r i n g c o r p o r a t i o n a t arm's l e n g t h i f he was one o f the same group o f l e s s t h a n s i x p e o p l e who b e f o r e the d i s p o s i t i o n c o n t r o l l e d t h e s u b j e c t c o r p o r a t i o n and a f t e r the d i s p o s i t i o n c o n t r o l l e d the a c q u i r i n g c o r p o r a t i o n . The s h a r e h o l d i n g s o f the t a x p a y e r ' s spouse, of an i n t e r v i v o s t r u s t o f which t h e t a x p a y e r , h i s spouse, o r a c o r p o r a t i o n c o n t r o l l e d by e i t h e r o f them i s a b e n e f i c i a r y , and o f a c o r p o r a t i o n c o n t r o l l e d by the t a x p a y e r , h i s spouse, o r an i n t e r v i v o s t r u s t such as i s above d e s c r i b e d , 25 w i l l be a t t r i b u t e d t o t h e t a x p a y e r f o r the purpose o f d e t e r m i n i n g whether he i s one o f the group o f l e s s t h a n s i x p e rsons t h a t c o n t r o l s a company., I t i s easy t o u n d e r s t a n d the purpose b e h i n d t h i s b r o a d e n i n g o f the non-arm's l e n g t h r u l e . I n any company w i t h ownership d i v i d e d between u n r e l a t e d b u s i n e s s a s s o c i a t e s i t might o t h e r w i s e be p o s s i b l e f o r t h e s h a r e h o l d e r s , assuming none o f them owned more th a n 50% o f t h e o p e r a t i n g company, t o s t r i p o u t t h e V-day v a l u e o f t h e i r s h a r e s by r o l l i n g them i n t o the same h o l d i n g company. F o l l o w i n g the r o l l o v e r each s h a r e h o l d e r would be a t arm's l e n g t h w i t h the h o l d i n g company, a t l e a s t i n s o f a r as may be d e t e r m i n e d under t h e r e l a t e d p ersons r u l e s c o n t a i n e d i n s u b s e c t i o n s 251(1) and ( 2 ) . The government would then be f o r c e d t o r e l y upon t h e d i f f i c u l t f a c t u a l non-arm's l e n g t h c o n c e p t i n o r d e r t o b r i n g t h e m a t t e r w i t h i n t h e p u r v i e w o f s e c t i o n 84.1. The extended d e f i n i t i o n o f non-arm's l e n g t h p r o v i d e d i n s e c t i o n 84.1 4 i s t h e r e f o r e f o r g r e a t e r c e r t a i n t y . (c) O p e r a t i o n o f S e c t i o n 84.1 The purpose o f s e c t i o n 84.1 i s t o p r e v e n t the s t r i p p i n g o f t h e V-day v a l u e i n h e r e n t i n s h a r e s h e l d s i n c e b e f o r e 1972. When an i n d i v i d u a l o r a t r u s t r e s i d e n t i n Canada t r a n s f e r s pre-72 s h a r e s w h i c h are h e l d as c a p i t a l p r o p e r t y t o a h o l d i n g company w i t h w h i c h the t a x p a y e r i s n o t a t arm's l e n g t h , and t h e a c q u i r i n g company i s c o n n e c t e d w i t h the s u b j e c t company, s e c t i o n 84.1 w i l l a p p l y t o t r i g g e r 26 an immediate c a p i t a l g a i n where h a r d c o n s i d e r a t i o n o r cash i s t a k e n back o r a r e d u c t i o n o f the a d j u s t e d c o s t base o f any sh a r e s o r debt r e c e i v e d by the t a x p a y e r t o the e x t e n t t h a t the V-day v a l u e might o t h e r w i s e be p r e m a t u r e l y r e a l i z e d . The c a l c u l a t i o n s a r e done a c c o r d i n g t o t h e f o l l o w i n g f o r m u l a s : The Immediate C a p i t a l G a i n i s The amount by wh i c h the l e s s e r o f 1) The ACB o f t h e s h a r e s t r a n s f e r r e d and 2) Cash and/or t h e FMV o f t a n g i b l e a s s e t ( s ) t a k e n back Exceeds 3) The PUC o f t h e t r a n s f e r r e d s h a r e s The ACB R e d u c t i o n i s The amount by which the l e s s e r o f 1) The ACB o f the s h a r e s t r a n s f e r r e d and The aggregate o f 1) Cash and/or FMV o f t a n g i b l e a s s e t s t a k e n back 2) Debt t a k e n back 3) The PUC o,f s h a r e s t a k e n back Exceeds t h e g r e a t e r o f 1) Cash and/or the FMV o f t a n g i b l e a s s e t s t a k e n back 2) The PUC o f s h a r e s t r a n s f e r r e d Assume t h a t a t a x p a y e r ( o t h e r than a c o r p o r a t i o n ) i n c i r c u m s t a n c e s such as are c o n t e m p l a t e d by s e c t i o n 84.1 t r a n s f e r s s h a r e s w i t h the f o l l o w i n g c h a r a c t e r i s t i c s i n t o a h o l d i n g company PUC 100 ACB 500 FMV 10 00 and t a k e s back s h a r e s o f the a c q u i r i n g company w i t h the f o l l o w i n g a t t r i b u t e s PUC ACB FMV 100 500 1000 27 t o g e t h e r w i t h c a s h o f $400 and a n ote w i t h a f a c e v a l u e o f $100. The deemed proceeds o f d i s p o s i t i o n a r e , p u r s u a n t t o the s u b s e c t i o n 85(1) r o l l o v e r , the a d j u s t e d c o s t base o f the s h a r e s t r a n s f e r r e d o r 500. The immediate g a i n i s The l e s s e r o f 1) The ACB o f s h a r e s t r a n s f e r r e d 500 2) The h a r d c o n s i d e r a t i o n 400 Exceeds 1) The PUC o f s h a r e s t r a n s f e r r e d 300 and t h e a d j u s t e d c o s t base r e d u c t i o n o f t h e s h a r e s and debt i s The l e s s e r o f 1) The ACB o f t h e t r a n s f e r r e d s h a r e s 500 And aggregate o f 1) Hard c o n s i d e r a t i o n 400 2) Debt 100 3) PUC o f s h a r e s t a k e n back 100 Exceeds g r e a t e r o f 1) Hard c o n s i d e r a t i o n 4 00 2) PUC o f s h a r e s t r a n s f e r r e d 100 500 400 100 The a d j u s t e d c o s t base r e d u c t i o n o f 100 w i l l be p r o r a t e d amongst the p a r t i c u l a r s h a r e s and debt a c c o r d i n g to t h e i r r e l a t i v e c o s t t o t h e t a x p a y e r . The c o s t o f the non-share c o n s i d e r a t i o n r e c e i v e d by t h e t a x p a y e r w i l l n o r m a l l y be i t s f a i r market v a l u e . ^ The c o s t o f the s h a r e s t a k e n back, assuming t h a t they a r e p r e f e r e n c e s h a r e s o f one c l a s s , w i l l be The l e s s e r o f T h e i r FMV __1000 And The amount by w h i c h Proceeds (s.85.(1)) 500 Exceeds FMV o f o t h e r c o n s i d . (cash 400, debt 100) 500 0 0 28 The a d j u s t e d c o s t base r e d u c t i o n o f 100 w i l l t h u s be e n t i r e l y a l l o c a t e d t o the debt c o n s i d e r a t i o n t a k e n back, d e c r e a s i n g the c o s t o f the note from 100 down t o n i l . I n t h e f i n a l a n a l y s i s , the t a x p a y e r w i l l have r e c e i v e d $100. f r e e o f t a x , a f i g u r e e q u i v a l e n t t o t h e p a i d up c a p i t a l o f t h e s h a r e s t r a n s f e r r e d t o t h e a c q u i r i n g c o r p o r a t i o n , and any amounts p a i d t o r e t i r e t h e debt w i l l g i v e r i s e t o a f u r t h e r c a p i t a l g a i n o f 100. I t i s t h e r e f o r e a p p arent t h a t s e c t i o n 84.1 has s t r i p p e d t h e t a x p a y e r o f the $4 0 0 p r o t e c t i o n p r e v i o u s l y a f f o r d e d h i s pre-72 s h a r e h o l d i n g by t h e V-day v a l u e . As t h e f o r e g o i n g example i n d i c a t e s , t h e p e n a l t y cannot be a v o i d e d by t a k i n g back s h a r e s o f t h e a c q u i r i n g company w i t h a p a i d up c a p i t a l e q u a l t o t h a t o f the s h a r e s t r a n s f e r r e d i f a d d i t i o n a l c o n s i d e r a t i o n i s r e c e i v e d as w e l l . A l t h o u g h t h e r e w i l l be no immediate c a p i t a l g a i n where o n l y s h a r e s o f t h e p u r c h a s e r a r e t a k e n back, the t a x p a y e r w i l l f a r e no b e t t e r whenever the door i s opened t o a premature r e a l i z a t i o n o f the pre-72 c a p i t a l g a i n s f o l l o w i n g t h e r o l l o v e r . Assume a r o l l o v e r s i t u a t i o n i n v o l v i n g s h a r e s w i t h t h e f o l l o w i n g c h a r a c t e r i s t i c s : Shares T r a n s f e r r e d Shares Taken Back " PUC~100 PUC 1000 ACB 500 (V-Day) ACB 500 FMV 1000 FMV 1000 But f o r t h e o p e r a t i o n o f s e c t i o n 84.1, r e d emption of t h e t a x p a y e r ' s s h a r e s a t t h e i r f a i r market v a l u e would r e s u l t i n r e c o g n i t i o n o f a 500 c a p i t a l g a i n and the t a x f r e e r e c e i p t 500 29 o f t h e pre-72 c a p i t a l i n c r e m e n t . S e c t i o n 84.1 however reduces the a d j u s t e d c o s t base o f t h e s h a r e s t a k e n back as f o l l o w s : L e s s e r o f 1) ACB o f s h a r e s t r a n s f e r r e d 500 And aggregate o f 1) Hard c o n s i d e r a t i o n 0 2) Debt 0 3) PUC o f s h a r e s t a k e n 1000 1 0 0 0 Exceeds g r e a t e r o f 1) Cash t a k e n back 0 2) PUC o f t r a n s f e r r e d s h a r e s 100 -^QQ Too Thus t h e a d j u s t e d c o s t base o f the s h a r e s t a k e n back w i l l e q u a l the p a i d up c a p i t a l o f t h e s h a r e s t r a n s f e r r e d , and any redemption o f t h e s e s h a r e s i n an amount e x c e e d i n g t h e reduced c o s t base o f 100 e f f e c t i v e l y exposes t h e pre-72 i n c r e m e n t t o c a p i t a l g a i n s t a x . The s i t u a t i o n i s n o t improved by h a v i n g the p u r c h a s e r c o r p o r a t i o n s e l l the. t r a n s - f e r r e d s h a r e s . T h i s would r e s u l t i n a $500 c a p i t a l g a i n t o t h e p u r c h a s e r w h i c h , by v i r t u e o f t h e c a p i t a l g a i n s d i v i d e n d account and r e f u n d a b l e t a x p r o v i s i o n s , would a t t r a c t the same t r e a t m e n t as i f t h e g a i n had been r e a l i z e d by the s h a r e h o l d e r d i r e c t l y . A d i s t r i b u t i o n o f t h e r e m a i n i n g $500 would r e s u l t i n an o r d i n a r y t a x a b l e d i v i d e n d . U s i n g the $500 t o p a r t i a l l y redeem t h e t a x p a y e r ' s s h a r e s would p r e c i p i t a t e a f u r t h e r $400 c a p i t a l g a i n . The t a x p a y e r would i n e i t h e r case be i n t h e u n e n v i a b l e p o s i t i o n o f h a v i n g f o r f e i t e d the V-Day v a l u e p r o t e c t i o n i n h e r e n t i n t h e s h a r e s t r a n s f e r r e d . 30 (d)) The S u b s e c t i o n 84.1(3) Exemption S e c t i o n 84.1 i s o b v i o u s l y meant o n l y t o a p p l y where t h e r e e x i s t s a V-Day' v a l u e i n s h a r e s w h i c h may be s t r i p p e d . S u b s e c t i o n 84.1(3) a t t e m p t s t o exempt c e r t a i n f a c t s i t u a t i o n s from the o p e r a t i o n o f the g o v e r n i n g s u b s e c t i o n . Thus, where a share was a c q u i r e d by a t a x p a y e r a f t e r 1971 and i t was owned a f t e r 19 71 and b e f o r e the t a x p a y e r a c q u i r e d i t by a p e r s o n w i t h whom the t a x p a y e r was d e a l i n g a t arm's l e n g t h , s. 84.1 w i l l n o t a p p l y t o a subsequent r o l l o v e r o f t h a t s hare i n t o a h o l d i n g company. One might have thought t h a t a l l r o l l o v e r s o f s h a r e s o f companies formed a f t e r 1971 would l i e beyond th e scope of s e c t i o n 84.1 because presumably no V-Day v a l u e i n h e r e s i n them. The s i m p l e w o r d i n g n e c e s s a r y t o g i v e e f f e c t t o an exemption on t h i s b a s i s i s however not found i n s u b s e c t i o n 8 4 . 1 ( 3 ) . One commentator g i v e s , i n s u b s t a n c e , 7 the f o l l o w i n g e x p l a n a t i o n . A t a x p a y e r might r o l l t h e s h a r e s o f an o p e r a t i n g company i n t o a h o l d i n g company and t a k e back sh a r e s w i t h a p a i d up c a p i t a l e q u a l t o t h a t o f t h e t r a n s f e r r e d s h a r e s , t h e r b y a v o i d i n g the a d j u s t e d c o s t base r e d u c t i o n p r o v i d e d f o r i n s u b s e c t i o n 8 4 . 1 ( 1 ) . T h i s would be f o l l o w e d by a t r a n s f e r o f h i s newly a c q u i r e d s h a r e s o f the h o l d i n g company t o a second h o l d i n g company i n r e t u r n f o r s h a r e s w i t h a p a i d up c a p i t a l e q u a l t o t h e a d j u s t e d c o s t base o f the s h a r e s o f t h e f i r s t h o l d i n g company. These s h a r e s might t h e n be redeemed by t h e second h o l d i n g company. The f i r s t h o l d i n g company would s e r v e m e r e l y as a b u f f e r t o i n s u l a t e t h e t a x p a y e r from th e d e l e t e r i o u s conse- 31 quences o f s e c t i o n 84.1 and as a c o n d u i t f o r d i v i d e n d s e f f e c t i v e l y p a i d by the o p e r a t i n g company t o the second h o l d i n g company. T h i s t r a n s a c t i o n presumably e x p l a i n s why t h e sh a r e t r a n s f e r r e d s h o u l d have been owned " a f t e r 1971 and b e f o r e the t a x p a y e r a c q u i r e d i t by a p e r s o n w i t h whom t h e t a x p a y e r was d e a l i n g a t arm's l e n g t h . " The sh a r e s o f t h e f i r s t h o l d i n g company t a k e n back would a p p a r e n t l y n o t s a t i s f y t h i s c o n d i t i o n and a c c o r d i n g l y s e c t i o n 84.1 would a p p l y t o the subsequent t r a n s f e r o f t h e s e s h a r e s t o t h e second h o l d i n g company w i t h the same consequences as would have o b t a i n e d had t h e t a x p a y e r r o l l e d them d i r e c t l y i n t o t h e f i r s t h o l d i n g company i n c o n t r a v e n t i o n o f s e c t i o n 84.1. However, unimpeachable may be t h i s r e s u l t i n the co n t e m p l a t e d c i r c u m s t a n c e s , i f we a c c e p t t h a t s h a r e s t a k e n a f t e r 1971 by a t a x p a y e r from t h e t r e a s u r y o f a company w i l l b r i n g i n t o p l a y s e c t i o n 84.1 on a subsequent r o l l o v e r o f t h e s e s h a r e s i n t o a h o l d i n g company, by p a r i t y o f r e a s o n i n g s h a r e s a c q u i r e d a f t e r 1971 as e.g. a s t o c k d i v i d e n d o r as an o r i g i n a l a l l o t m e n t s h o u l d be t r e a t e d i n a l i k e manner. I n n e i t h e r case would t h e sh a r e s be owned " a f t e r 19 71 and b e f o r e the t a x p a y e r a c q u i r e d (them) by a perso n w i t h whom the t a x p a y e r was d e a l i n g a t arm's l e n g t h . " T h i s may appear n o t t o be a s i g n i f i c a n t problem because u s u a l l y t h e c o s t base w i l l i n sach c i r c u m s t a n c e s be on a p a r w i t h t h e p a i d up c a p i t a l . However t h i s need n ot n e c e s s a r i l y be t h e ca s e . Where the a d j u s t e d c o s t base has been 'bumped', f o r example 32 as a r e s u l t o f a subparagraph 85(4) (b) t r a n s a c t i o n ( l o s s on d i s p o s i t i o n o f c a p i t a l p r o p e r t y t o a c o n t r o l l e d c o r p o r a t i o n ) o r a s e c t i o n 7 b e n e f i t , the a d j u s t e d c o s t base r e d u c t i o n would p e r m a n e n t l y deny r e c o g n i t i o n o f a l o s s o t h e r w i s e o n l y d e f e r r e d o r t a x the same amount t w i c e . Where a f t e r 1971 a t a x p a y e r a c q u i r e s pre-72 sha r e s i n an arm's l e n g t h t r a n s a c t i o n and l a t e r d i s p o s e s o f them t o a non-arm's l e n g t h p a r t y , w i l l s e c t i o n 84.1 a p p l y on a subsequent r o l l o v e r by t h e new owner o f h i s s h a r e s i n t o a h o l d i n g company? I n p r i n c i p l e o f c o u r s e i t s h o u l d n o t because th e pre-72 v a l u e no l o n g e r i n h e r e s i n t h e s h a r e s . I t w i l l have been p r o p e r l y r e a l i z e d by the f i r s t owner i n the p o s t - 7 1 arm's l e n g t h s a l e . But the w ording i n s u b s e c t i o n 3 l e a v e s the m a t t e r open t o doubt. Can i t be s a i d o f the s h a r e s r o l l e d i n t o t h e h o l d i n g company t h a t t h e y were owned a f t e r 1971 by a p e r s o n w i t h whom the t r a n s f e r o r t a x p a y e r was d e a l i n g a t arm's l e n g t h ? The o n l y d e a l i n g s o f the t r a n s f e r o r i n r e s p e c t o f the s h a r e s were w i t h a non- arm' s l e n g t h p a r t y . I t i s t h e r e f o r e p o s s i b l e t h a t p a r a g r a p h 84.1(2)(a) would a p p l y t o reduce th e new owner's a d j u s t e d c o s t base t o h i s immediate t r a n s f e r o r ' s c o s t . Such a r e s u l t c o u l d not have been i n t e n d e d by t h e l e g i s l a t o r . S u b s e c t i o n 3 g i v e s r i s e t o f u r t h e r q u e s t i o n a b l e r e s u l t s , b u t t h e s e w i l l be examined i n t h e s e c t i o n d e a l i n g w i t h e s t a t e p l a n n i n g . 33 (e) S e c t i o n 84.1 and E s t a t e P l a n n i n g S e c t i o n 84.1 can be most troublesome t o the e s t a t e p l a n n e r who i s s e e k i n g t o ' f r e e z e ' the sh a r e s o f t h e owner o f an o p e r a t i n g company. The e s t a t e f r e e z e i s a p r o c e d u r e whereby t h e b e n e f i c i a l o wnership o f growth a s s e t s may be t r a n s f e r r e d t o t h e i n t e n d e d b e n e f i c i a r i e s i n c i r c u m s t a n c e s where the t r a n s f e r o r may c o n t i n u e , s h o u l d he so d e s i r e , t o e x e r c i s e c o n t r o l o v e r the a s s e t . I n the r e s u l t , t a x e s e x i g i b l e upon t h e d e a t h o f t h e t r a n s f e r o r w i l l i n some measure n o r m a l l y be reduced. I n t h e t y p i c a l c a s e , the f r e e z o r w i l l r o l l h i s s h a r e s o f t h e o p e r a t i n g company i n t o the h o l d i n g company t a k i n g back cash o r debt i n an amount e q u a l t o t h e a d j u s t e d c o s t base o f t h e s h a r e s t r a n s f e r r e d , and redeemable p r e f e r e n c e s h a r e s w i t h a p a i d up c a p i t a l e q u a l t o t h e e x c e s s o f the f a i r market v a l u e o f t h e shares t r a n s f e r r e d o ver the a d j u s t e d c o s t base t h e r e o f . A l t h o u g h t h i s p r o c e d u r e e f f e c t i v e l y d e f e r s t h e t a x o t h e r w i s e p a y a b l e by t h e t r a n s f e r o r on t h e d i s p o s i t i o n o f h i s s h a r e s , a p o s s i b l e element o f double t a x a t i o n a r i s e s i n t h a t the d e f e r r e d g a i n may be t a x e d t w i c e , once when t h e t r a n s f e r o r ' s s h a r e s o f the h o l d i n g company a r e redeeemed ( o r upon h i s death) and a g a i n when t h e h o l d i n g company d i s p o s e s o f the sha r e s o f the o p e r a t i n g company. The dou b l e g a i n can a p p a r e n t l y be a v o i d e d however i f t h e h o l d i n g company i s wound up and i t s a s s e t s a r e d i s t r i b u t e d t o t he b e n e f i c i a r i e s , i f t h e sha r e s a r e p a i d o f f w i t h new 34 debt of the h o l d i n g company, o r i f t h e r e i s a step-up i n t h e b a s i s o f c a p i t a l p r o p e r t y a v a i l a b l e under p a r a g r a p h g 8 8 ( 1 ) ( c ) . The t r a n s f e r o r w i l l want t o ensure t h a t the f a i r market v a l u e o f the c o n s i d e r a t i o n t a k e n back w i l l e q u a l the f a i r market v a l u e o f the s h a r e s t r a n s f e r r e d . Subparagraph 85(1)(e.2) p r o v i d e s t h a t any d e f i c i e n c y w h i c h may r e a s o n a b l y be r e g a r d e d as a g i f t t o t h e o t h e r s h a r e h o l d e r s o f t h e h o l d i n g company may be added t o the e l e c t e d proceeds r e s u l t i n g i n an immediate c a p i t a l g a i n t o the t r a n s f e r o r w i t h o u t , be i t n o t i c e d , a c o r r e s p o n d i n g a d j u stment t o the c o s t bases i n e i t h e r the h o l d i n g company's s h a r e h o l d i n g i n the o p e r a t i n g company o r the s h a r e h o l d i n g s o f t h e b e n e f i t e d s h a r e h o l d e r s i n t h e h o l d i n g company. The d e p a r t m e n t a l view i s t h a t e s t a t e f r e e z i n g i s 9 i n i t s e l f a l e g i t i m a t e t a x p l a n n i n g p r o c e d u r e . D i f f i c u l t y a r i s e s however where the means employed t o e f f e c t i t p r o v i d e a s h a r e h o l d e r w i t h an o p p o r t u n i t y t o withdraw f r e e o f f u r t h e r t a x c o r p o r a t e s u r p l u s n o r m a l l y t a x a b l e as d i v i d e n d income i n h i s hands. That which an e s t a t e f r e e z e and a d i v i d e n d s t r i p have i n common i s the i n c e s t u o u s s a l e element w h i c h p e r m i t s a s h a r e h o l d e r t o go t h r o u g h a form o f s a l e and to r e c e i v e proceeds w h i l e m a i n t a i n i n g c o n t r o l o f t h e a s s e t r o l l e d o v e r . An i m p o r t a n t p o i n t o f d i f f e r e n c e however i s t h a t e s t a t e f r e e z i n g l i m i t s t h e t r a n s f e r o r ' s economic i n t e r e s t i n the p r o p e r t y , e x c l u d i n g f u t u r e growth, whereas f o l l o w i n g a s t r i p i t w i l l c o n t i n u e t o be a b s o l u t e . However,seven""where c o n t r o l i s r e l i n q u i s h e d , t h e d i v i s i o n and a p p o r t i o n m e n t o f 35 t h e i n c i d e n t s o f o wnership i n e s t a t e f r e e z i n g w i l l n o t exempt the t r a n s a c t i o n from the o p e r a t i o n o f t h e new s e c t i o n 84.1 r u l e s . F o r m e r l y , a l t h o u g h o l d s e c t i o n 84.1 and subparagraph 8 9 ( 1 ) ( d ) ( i v . l ) a p p l i e d where debt o r s h a r e s were t a k e n back, the government would not i n v o k e s u b s e c t i o n 247(1) where t h e t r a n s f e r t o t h e h o l d i n g company c o n s t i t u t e d a buy o u t o f t h e t r a n s f e r o r on a c a s h b a s i s . As s e c t i o n 84.1 a p p l i e s i n d i f f e r e n t l y t o c ash t r a n s a c t i o n s as w e l l as t o r o l l o v e r s f i n a n c e d w i t h debt o r share c a p i t a l , t h e r e i s no scope f o r the f a v o u r a b l e e x e r c i s e o f d i s c r e t i o n and a c c o r d i n g l y t h e r e are c i r c u m s t a n c e s , w h i c h w i l l now be examined, where the new p r o v i s i o n s may i n t e r f e r e w i t h the l e g i t i m a t e g o a l s o f t a x p l a n n e r s . I n e s t a t e f r e e z i n g s i t u a t i o n s , t h e t r a n s f e r o r o f pre-72 s h a r e s w i l l n o r m a l l y be l o a t h t o t a k e back s h a r e s w i t h a low p a i d up c a p i t a l because a r e d emption would expose the V-Day v a l u e t o d i v i d e n d t r e a t m e n t . Assume t h a t f a t h e r has pre-72 s h a r e s w i t h the f o l l o w i n g t a x a t t r i b u t e s : PUC 50 ACB 100 (V-Day v a l u e ) FMV 150 I f the f a t h e r s e l l s the s h a r e s t o t h e son's h o l d i n g company a t f a i r market v a l u e , the t r a n s f e r w i l l be caught by s e c t i o n 84.1 and f a t h e r w i l l i n c u r an i n c r e a s e d c a p i t a l g a i n o f 100 (ACB r e d u c t i o n i s e x c e s s o f ACB o f 100 o v e r PUC of t r a n s f e r r e d , o r 50^50 p l u s 50 g a i n d e t e r m i n e d under normal r u l e s ) . F a t h e r t h e r e f o r e d e t e r m i n e s t o s e l l 36 the s h a r e s d i r e c t l y t o h i s son. I n so d o i n g , f a t h e r r e a l i z e s a c a p i t a l g a i n o f 50 and t h e s h a r e s w i l l have f o l l o w i n g c h a r a c t e r i s t i c s i n the son's hands: PUC 50 ACB 150 FMV 150 The t r a n s f e r would t a k e p l a c e a t f a i r market v a l u e because subparagraph 69(1)(b) would o t h e r w i s e i n any event deem t h e f a t h e r t o have r e c e i v e d f a i r market v a l u e , w h i l e t h e son would a p p a r e n t l y n o t b e n e f i t from an i n c r e a s e i n h i s c o s t . Were i t n o t f o r subparagraph 84.1(2)(a) t h i s s t a t e o f f a c t s would l e a d t o a s e r i o u s problem on a subsequent r o l l o v e r o f t h e s h a r e s i n t o a h o l d i n g company by the son, because the amount o t h e r w i s e s u b j e c t t o r e d u c t i o n would r e f l e c t n o t o n l y t h e pre-72 c a p i t a l g a i n s s e c t i o n 84.1 was d e s i g n e d t o p r o t e c t , b u t p o s t - 7 1 c a p i t a l g a i n s as w e l l . Assuming the son i m m e d i a t e l y r o l l e d h i s newly a c q u i r e d s h a r e s i n t o a h o l d i n g company, t a k i n g back s h a r e s w i t h a p a i d up c a p i t a l and a d j u s t e d c o s t base o f 150, s e c t i o n 84.1 would a p p l y t o reduce t h e a d j u s t e d c o s t base o f t h e son's s h a r e s by 100 (amount by wh i c h t h e l e s s e r o f ACB o f t r a n s f e r r e d s h a r e s , o r 150, and PUC o f s h a r e s t a k e n back, o r 150, exceeds PUC o f sh a r e s t r a n s f e r r e d o r 50=100), f i x i n g i t a t 50. On any subsequent redemption o r s a l e o f t h e s h a r e s the son would r e a l i z e a c a p i t a l g a i n o f 100. T h i s would o b v i o u s l y r e s u l t i n an element o f double t a x a t i o n because a c a p i t a l g a i n o f 50 would a l r e a d y have been t a x e d t o t h e f a t h e r . Subparagraph 84.1(2) (a ) t h e r e f o r e p r o v i d e s t h a t f o r t h e 37 purpose o f the s e c t i o n 84 .1 ̂ c a l c u l a t i o n s :-the^cest^df -the s h a r e s t o t h e son w i l l be deemed t o be t h e c o s t t h e r e o f t o t he f a t h e r . When t h e son r o l l s t h e sh a r e s i n t o t he h o l d i n g company, t h e a d j u s t e d c o s t base o f the sh a r e s t a k e n back w i l l be reduced from 150 t o 100 (ACB o f sh a r e s r o l l e d o v e r , o r 100 l e s s the PUC t h e r e o f , o r 50=100). Thus on any subsequent s a l e o r redemption the son w i l l r e a l i z e a c a p i t a l g a i n o f 50. As can be r e a d i l y seen, a l t h o u g h the son i n f a c t has no pre-72 c a p i t a l g a i n s i n r e s p e c t o f the sha r e s a c q u i r e d from f a t h e r , s e c t i o n 84.1 w i l l e f f e c t i v e l y impute them t o h i s s h a r e h o l d i n g t o t h e e x t e n t t h a t they e x i s t e d w h i l e t h e sh a r e s were the f a t h e r ' s p r o p e r t y . Of c o u r s e t h i s can o n l y be j u s t i f i e d on t h e t h e o r y t h a t the son and t h e f a t h e r a r e t o be t r e a t e d as the same p e r s o n f o r t a x pur p o s e s . Even where t h e p a r t i e s a r e , under A c t , non-arm's l e n g t h , t h i s may n o t always be the a p p r o p r i a t e h y p o t h e s i s , as t h e government has i t s e l f on o c c a s i o n come t o realize."'""'" B a s i c a l l y , i n s i t u a t i o n s where t h e t r a n s f e r o r and t r a n s f e r e e t r a n s a c t a t f a i r market v a l u e s and the t r a n s f e r o r r e l i n q u i s h e s c o n t r o l o f the o p e r a t i n g company, the pre-72 c a p i t a l a p p r e c i a t i o n o f h i s s h a r e s s h o u l d n o t be imputed t o the t r a n s f e r e e ' s s h a r e h o l d i n g . I n a d d i t i o n t o the f r e e z e i n v o l v i n g t he t r a n s f e r o f s h a r e s i n t o a h o l d i n g company, growth a s s e t s may be f r o z e n i n e i t h e r o f two o t h e r ways. The ' r e v e r s e f r e e z e ' i s a c c o m p l i s h e d when an o p e r a t i n g company s e l l s i t s a s s e t s and u n d e r t a k i n g t o an o t h e r o p e r a t i n g company, t h e common 38 sh a r e s o f w h i c h a r e owned by the b e n e f i c i a r i e s . The o l d o p e r a t i n g company . t a k e s back s h a r e s and/or debt o f t h e new o p e r a t i n g company w i t h a f a i r market v a l u e and a d j u s t e d c o s t base e q u a l t o t h a t o f the a s s e t s t r a n s f e r r e d . T h i s f a c t s i t u a t i o n i s not c o n t e m p l a t e d by s e c t i o n 84.1 because no s t r i p can r e s u l t . The a d j u s t e d c o s t base and p a i d up c a p i t a l o f t h e f a t h e r ' s s h a r e s o f t h e o l d o p e r a t i n g company are u n a f f e c t e d by the t r a n s a c t i o n so t h a t the t a x consequences o f a redemption o f tho s e s h a r e s , o f a s a l e o f the s h a r e s i n an arm's l e n g t h o r non-arm's l e n g t h t r a n s a c t i o n , o r o f a w i n d i n g up o f the o l d o p e r a t i n g company would be the same as would have o c c u r r e d has the f r e e z e never t a k e n p l a c e . The ' i n t e r n a l f r e e z e ' i n v o l v e s the use o f t h e c a p i t a l r e o r g a n i z a t i o n p r o v i s i o n s o f t h e A c t c o n t a i n e d i n s e c t i o n s 51 and 86. The f r e e z e i s e f f e c t e d by h a v i n g the f r e e z o r c o n v e r t h i s sh a r e s o f the o p e r a t i n g company i n t o non- growth s h a r e s t h e r e o f . T h i s f a c t s i t u a t i o n too i s d i s t i n - g u i s h a b l e from t h a t a g a i n s t which s e c t i o n 84.1 i s d i r e c t e d because, when p r o c e e d i n g under e i t h e r o f s e c t i o n s 51 o r 86, the p a i d up c a p i t a l o f the c o r p o r a t i o n cannot be i n c r e a s e d w i t h o u t t r i g g e r i n g a s e c t i o n 84(1) d i v i d e n d . T h i s e f f e c t i v e l y o b l i g e s the f r e e z o r t o r e c e i v e d i v i d e n d t r e a t m e n t on the redemption o f h i s s h a r e s , and a c c o r d i n g l y w i l l n o t be an 12 a t t r a c t i v e a l t e r n a t i v e f o r a l l t a x p a y e r s . The e s t a t e f r e e z i n g t e c h n i q u e employing the h o l d i n g company i s i t s e l f d i v i s i b l e i n t o two g e n e r a l c a t e g o r i e s : t h a t i n w hich p o r t f o l i o s e c u r i t i e s a re r o l l e d o v e r and t h a t i n 39 w h i c h the s h a r e s o f an o p e r a t i n g company ar e t r a n s f e r r e d t o the h o l d i n g company. I t i s worthy of note t h a t s e c t i o n 84.1 w i l l n o t a p p l y t o the f r e e z i n g o f i n v e s t m e n t s e c u r i t i e s . Thus a s t r i p o f the V-Day v a l u e i n h e r e n t i n such s h a r e h o l d i n g s may be e f f e c t e d e i t h e r upon t h e i r t r a n s f e r t o a h o l d i n g company c a p a b l e o f r e c e i v i n g t a x f r e e i n t e r c o r p o r a t e d i v i d e n d s from an o p e r a t i n g company, o r d i r e c t l y t o t h e o p e r a t i n g company i t s e l f . The f e e l i n g o f the government may be t h a t t h i s case cannot be p r o p e r l y r e g u l a t e d because the owner may s e l l and i m m e d i a t e l y r e a c q u i r e h i s s h a r e h o l d i n g on the market, i n c u r r i n g o n l y i n c i d e n t a l expenses such as b r o k e r a g e c o s t s . However i f t h e owner w i s h e s t o e n j o y a t a x f r e e r e c e i p t o f h i s s h a r e s up t o t h e V-Day v a l u e t h e r e o f and a l s o d e f e r the c a p i t a l g a i n on the d i f f e r e n c e between t h e i r a d j u s t e d c o s t base and f a i r market v a l u e , the r o l l o v e r w i l l c o n t i n u e t o be a t t r a c t i v e . The e v e r p r e s e n t danger o f a d i r e c t i o n p u r s u a n t t o s u b s e c t i o n 247(1) must however be c o n s i d e r e d and a r u l i n g s h o u l d perhaps be o b t a i n e d b e f o r e p r o c e e d i n g . (f.) ;. A v o i d i n g t h e P e n a l t y and Anomalies The p e n a l t y imposed by s e c t i o n 84.1 may be a v o i d e d by t a k i n g back s h a r e s o f the p u r c h a s e r c o r p o r a t i o n w i t h a p a i d up c a p i t a l e q u a l t o t h a t o f the pre-72 s u b j e c t s h a r e s (or combined c a s h , d e b t , and p a i d up c a p i t a l o f s h a r e s t a k e n back not i n e x c e s s of the p a i d up c a p i t a l o f the s h a r e s 40 t r a n s f e r r e d ) . The V-Day v a l u e o f t h e s h a r e s t r a n s f e r r e d remains i n t a c t because t h e r e i s no r e d u c t i o n o f the a d j u s t e d c o s t base o f t h e s h a r e s o f the p u r c h a s e r c o r p o r a t i o n t a k e n back, w h i c h , p u r s u a n t t o s u b s e c t i o n 8 5 ( 1 ) , i s e s t a b l i s h e d a t the a d j u s t e d c o s t base o f the s h a r e s t r a n s f e r r e d . On a sub- sequent d i s p o s i t i o n o f the s h a r e s t a k e n back, t h e t a x p a y e r r e a l i z e s a gain, o n l y on the e x c e s s o f proceeds o v e r t h e e l e c t e d amount, e n j o y i n g f u l l V-Day v a l u e p r o t e c t i o n o f pre-72 g a i n s . The s u b s e c t i o n 85(1) r o l l o v e r would a c c o m p l i s h the e s t a t e f r e e z e , i f one i s i n t e n d e d , and a c c o r d i n g l y i t might appear t h a t m a t t e r s are s a t i s f a c t o r i l y r e s o l v e d b o t h from the government's and the t a x p a y e r ' s p o i n t o f v i e w . U n f o r t u n a t e l y , t h i s c o n c l u s i o n c o u l d n o t be j u s t i f i e d . Q u i t e a p a r t from the q u e s t i o n whether i t i s neces- s a r y o r d e s i r a b l e t o implement s e c t i o n 84.1 by s t r u c t u r i n g the t h r e a t o f a permanent p e n a l t y i n t o the p r o v i s i o n , i t i s s u r e l y i n c o n s i s t e n t t o d i s a d v a n t a g e a t a x p a y e r who does a l l t h a t he can t o comply w i t h o b v i o u s p o l i c y u n d e r l y i n g the s e c t i o n . The purpose o f s e c t i o n 84.1 i s t h e o r e t i c a l l y l i m i t e d t o p r e v e n t i n g the premature r e a l i z a t i o n o f the V-Day v a l u e i n s h a r e s . I d e a l l y , once t h i s o b j e c t i v e has been s e c u r e d , t h e p a r t i c u l a r t a x p a y e r s h o u l d be i n no worse p o s i t i o n t h a n a t a x p a y e r r o l l i n g s h a r e s i n t o a h o l d i n g company i n c i r c u m s t a n c e s where s e c t i o n 84.1 i s i n a p p l i c a b l e . T h i s , however, i s n o t t h e c a s e . The t r a n s f e r o r o f p o s t - 7 1 s h a r e s may redeem the s h a r e s o f the p u r c h a s e r c o r p o r a t i o n t a k e n back. T h i s enables:-jhim t o o b t a i n a r e t u r n o f c a p i t a l 41 and t o choose between d i v i d e n d o r c a p i t a l g a i n s t r e a t m e n t on t h e e x c e s s o f the f a i r market v a l u e o v e r the a d j u s t e d c o s t base o f the s h a r e s t a k e n back (the e l e c t e d amount) w h i l e c o n t i n u i n g t o own the s h a r e s . T h i s f l e x i b i l i t y i s d e n i e d the t r a n s f e r o r o f pre-72 s h a r e s . The t r a n s f e r o r o f pre-7 2 s h a r e s may o r may n o t be a b l e t o recoup h i s o r i g i n a l c o s t depending upon whether h i s o u t l a y r e p r e s e n t s an amount p a i d f o r shares t a k e n from the t r e a s u r y o r a c q u i r e d from a s h a r e h o l d e r . S e c t i o n 84.1 e v i d e n t l y does n o t t a k e i n t o a c c o u n t the p o s s i b i l i t y t h a t the s h a r e h o l d e r who a c q u i r e s s h a r e s b e f o r e 1972 may have done so f o r an amount e x c e e d i n g t h e i r p a i d up c a p i t a l . C o n s i d e r a f a c t s i t u a t i o n i n v o l v i n g s h a r e s w i t h t h e f o l l o w i n g a t t r i b u t e s : PUC 100 PRE-72 COST 1000 ACB 1200 FMV 1500 I f a f t e r 1972 t h e t a x p a y e r r o l l s h i s s h a r e s i n t o a h o l d i n g company i n r e t u r n f o r s h a r e s w i t h a p a i d up c a p i t a l o f 1000, the a d j u s t e d c o s t base o f the s h a r e s t a k e n back w i l l be reduced from 1200 t o 300 (PUC o f s h a r e s t a k e n back, o r 1000 l e s s PUC o f s h a r e s t r a n s f e r r e d , o r 100=900 r e d u c t i o n ) . I n a d d i t i o n t o p a v i n g t h e way f o r an unwarranted c a p i t a l g a i n , s e c t i o n 84.1 w i l l e f f e c t i v e l y deny the t a x p a y e r a r e t u r n o f h i s i n v e s t m e n t . The l a t t e r r e s u l t i s o f c o u r s e a l s o b r o u g h t about where he r o l l s t h e s h a r e s i n t o t h e h o l d i n g company i n r e t u r n f o r s h a r e s t h e r e o f w i t h t h e same p a i d up 42 c a p i t a l i n o r d e r t o a v o i d t h e p e n a l t y . The pre-72 s h a r e h o l d e r who a c q u i r e s h i s s h a r e s from a n o t h e r s h a r e h o l d e r i s a c - c o r d i n g l y s i n g u l a r l y d i s a d v a n t a g e d . The pre-72 s h a r e h o l d e r who a c q u i r e s h i s s h a r e s from the t r e a s u r y o r from a n o t h e r s h a r e h o l d e r i s e f f e c t i v e l y d e n i e d a c h o i c e between c a p i t a l g a i n s and d i v i d e n d t r e a t m e n t on the ex c e s s o f t h e f a i r market v a l u e o v e r t h e a d j u s t e d c o s t base o f the s h a r e s t a k e n back. T h e i r low p a i d up c a p i t a l w i l l ensure t h a t c a p i t a l g a i n s t r e a t m e n t i s s e l e c t e d i n most c a s e s . O t h e r w i s e , on a redemption o f the s h a r e s by the h o l d i n g company t h e V-Day v a l u e would be exposed t o t a x as a d i v i d e n d . I t i s t r u e t h a t t h e redemption might c r e a t e a c a p i t a l l o s s , b u t the l o s s might a l s o v a n i s h under t h e n e u t r a l zone r u l e s u n l e s s an e l e c t i o n has been made under I t a r 26(7) by t h e t a x p a y e r i n r e s p e c t of a l l o f the c a p i t a l p r o p e r t y h e l d by him on V-Day. Even where the e l e c t i o n has been made and t h e l o s s i s a c c o r d i n g l y a v a i l a b l e , the t a x consequences o f e x p o s i n g the V-Day v a l u e to d i v i d e n d t r e a t m e n t a re o n l y m a r g i n a l l y b e t t e r t h a n the c l e a r l y u n s a t i s f a c t o r y r e s u l t s o f s u b j e c t i n g i t t o . t . . . 13 c a p i t a l g a i n s t a x . Where non-arm's l e n g t h t r a n s f e r e e s o f pre-72 s h a r e s who t a k e a f t e r 1971 w i s h t o e s t a b l i s h a s c h e d u l e f o r payment o f the p r i c e , s e c t i o n 84.1 may throw o b s t a c l e s i n t o t h e p a t h o f o r d i n a r y f i n a n c i n g p r o c e d u r e s . I f t h e t a x p a y e r cannot e n j o y a r e t u r n o f c a p i t a l on a redemption of h i s s h a r e s o f t h e h o l d i n g company t a k e n back he w i l l i n c u r 43 a d d i t i o n a l and u n n e c e s s a r y expense i n r e t i r i n g any debt g i v e n t o f i n a n c e the, a c q u i s i t i o n . I n s t e a d o f making payments as they f a l l due w i t h amounts withdrawn from th e o p e r a t i n g company t h r o u g h the h o l d i n g company on a t a x f r e e b a s i s , t h e 14 n e c e s s a r y funds w i l l t a k e t h e form o f t a x a b l e d i v i d e n d s . The government has made i t q u i t e c l e a r t h a t any c o l o u r a b l e a t t e m p t s t o a v o i d s e c t i o n 84.1 w i l l l i k e l y 15 r e s u l t i n a d i r e c t i o n p u r s u a n t t o s e c t i o n 247. Having a l e r t e d t h e r e a d e r t o t h i s w a r n i n g , a few t e c h n i q u e s may b r i e f l y be examined, however t h e y a r e n e i t h e r numerous nor a t t r a c t i v e . A t the o u t s e t , i t s h o u l d be mentioned t h a t w i n d i n g up a Canadian c o r p o r a t i o n p r o v i d e s a l a w f u l means o f r e a l i z i n g the V-Day v a l u e i n pre-72 s h a r e s on a t a x f r e e b a s i s . The V-Day v a l u e w i l l i n such a case t a k e the form o f pre-72 c a p i t a l s u r p l u s . T h i s w i l l o f c o u r s e n o t always be an i n v i t i n g p o s s i b i l i t y , e s p e c i a l l y s i n c e i t w i l l n o r m a l l y r e s u l t i n a t a x a b l e d i v i d e n d on t h e e x c e s s o f t h e amounts d i s t r i b u t e d by the c o r p o r a t i o n t o the s h a r e h o l d e r o v e r the p a i d i n c a p i t a l , the pre-72 c a p i t a l s u r p l u s and, where the company i s a p r i v a t e c o r p o r a t i o n , the c a p i t a l d i v i d e n d a c c o u n t . I n c ases of e q u a l l y d i v i d e d ownership o f t h e o p e r a t i n g company, t h e r e a r e two o t h e r p o s s i b i l i t i e s . The f i r s t o f t h e s e r e q u i r e s a r e o r g a n i z a t i o n o f t h e c a p i t a l o f t h e o p e r a t i n g company so t h a t the s h a r e s a r e d i v i d e d i n t o c l a s s e s w i t h g r e a t e r p a i d up c a p i t a l a t t r i b u t a b l e t o t h e p r o s p e c t i v e 44 t r a n s f e r o r ' s s h a r e s . T h i s might be a c c o m p l i s h e d under s e c t i o n 51 o f t h e A c t . I n o r d e r t o a v o i d a s e c t i o n 84(1) d i v i d e n d , t h i s p r o c e d u r e would i n v o l v e a r e d u c t i o n o f t h e p a i d up c a p i t a l o f t h e shares h e l d by o t h e r s h a r e h o l d e r s i n an amount e q u a l t o the i n c r e a s e i n t h a t o f t h e sh a r e s o f the t r a n s f e r o r . I f t h e i n c r e a s e d p a i d up c a p i t a l o f the t r a n s f e r o r ' s s h a r e s were s u f f i c i e n t t o acc o u n t f o r the d i f f e r e n c e between the p a i d up c a p i t a l and a d j u s t e d c o s t base o f h i s o r i g i n a l s h a r e s , he might p r e m a t u r e l y r e a l i z e the V-Day v a l u e o f h i s pre-72 s h a r e s i n d i r e c t l y f o l l o w i n g a r o l l o v e r o f h i s new sh a r e s i n t o a h o l d i n g company. 1^ The f a c t t h a t the p a i d up c a p i t a l o f s h a r e s t a k e n from t h e t r e a s u r y o f an o p e r a t i n g company i s n o r m a l l y v e r y low o f c o u r s e l i m i t s the u t i l i t y o f t h i s p r o c e d u r e . S e c t i o n 84.1 a p p l i e s o n l y t o t r a n s f e r s by a t a x p a y e r t o a c o r p o r a t i o n w i t h which he does n o t d e a l a t arm's l e n g t h . Where ownership o f t h e o p e r a t i n g company i s e q u a l l y d i v i d e d , s e c t i o n 84.1 might be a v o i d e d by h a v i n g each s h a r e h o l d e r t r a n s f e r h i s s h a r e s t o a s h e l l company formed by a n o t h e r s h a r e h o l d e r i n r e t u r n f o r c a s h and/or debt i n t h e amount o f the a d j u s t e d c o s t base o f the sh a r e s t r a n s f e r r e d , and redeemable p r e f e r e n c e s h a r e s w i t h a h i g h o r low p a i d up c a p i t a l so t h a t t h e d e s i r e d t a x t r e a t m e n t might be o b t a i n e d on the e x c e s s o f the f a i r market v a l u e over t h e a d j u s t e d c o s t base o f the s h a r e s s o l d . I n t h i s way t h e V-Day v a l u e m ight be s t r i p p e d o ut w h i l e t h e s h a r e h o l d e r c o n t i n u e d t o own the same p r o p o r t i o n a t e s h a r e h o l d i n g as b e f o r e . 45 X HOLDCO X&YCO Y HOLDCO X 1 1 1 Y i I Of c o u r s e the e f f i c a c y o f t h i s t e c h n i q u e r e s t s upon t h e assumption t h a t t h e t r a n s f e r r i n g s h a r e h o l d e r s and t h e a c q u i r i n g companies a r e a t arm's l e n g t h . T h i s t r a n s a c t i o n c o u l d n o t be impugned on the b a s i s o f the r e l a t e d p e r s o n s p r o v i s i o n s c o n t a i n e d i n s e c t i o n 251, however i t i s l i k e l y t h a t t h e government would r e g a r d t h i s as a case o f f a c t u a l non-arm's l e n g t h . I n t e r p r e t a t i o n b u l l e t i n IT-419 g i v e s , i n t h i s w r i t e r ' s o p i n i o n , a b r o a d e r r e f e r e n c e t o the f a c t u a l non-arm's l e n g t h c oncept than the d e c i d e d c ases would seem t o j u s t i f y . A l t h o u g h t h e r e i s no doubt t h a t u n r e l a t e d b u s i n e s s a s s o c i a t e s t r a n s a c t i n g a t f a i r market v a l u e s may 17 be non-arm's l e n g t h , ' a c t i n g i n c o n c e r t 1 would seem t o have been a p p l i e d t o date i n c i r c u m s t a n c e s where one p a r t y 18 was the ' g u i d i n g hand 1 o r where b u s i n e s s d e a l i n g s connoted . . 19 a s i n g l e e n t e r p r i s e as opposed t o s e p a r a t e b u s i n e s s e n t i t i e s . However, the c o u r t s have, h i s t o r i c a l l y , g i v e n i n c r e a s i n g l y b r o a d e r scope t o the f a c t u a l non-arm's l e n g t h c o n c e p t and, i n v i e w o f t h e M i n i s t e r ' s c e r t a i n c h a l l e n g e , t h i s d e v i c e i s h a r d l y t o be recommended. As n o t e d , s e c t i o n 84.1 a p p l i e s t o t a x p a y e r s o t h e r than c o r p o r a t i o n s . T h i s may perhaps be r e g a r d e d as a t e c h n i c a l 46 d e f i c i e n c y i n s o f a r as i t e n a b l e s c e r t a i n t a x p a y e r s t o r e a l i z e the V-Day v a l u e i n h e r e n t i n t h e i r s h a r e s w i t h o u t d i s p o s i n g o f them i n an arm's l e n g t h t r a n s a c t i o n . Where the t a x p a y e r r o l l e d h i s s h a r e s i n t o a h o l d i n g company b e f o r e 1972, and t h e c o r p o r a t e s h a r e h o l d e r does n o t c o n t r o l the o p e r a t i n g company, a d i s s o l u t i o n o f the h o l d i n g company w i l l r e s u l t i n the r e c o g n i t i o n o f pre-72 c a p i t a l s u r p l u s (which i n c l u d e s 1971 c a p i t a l s u r p l u s on hand a t December 31, 20 1978 ). The v a l u e i n t h i s a ccount when c r y s t a l l i z e d and p a i d o ut t o the s h a r e h o l d e r w i l l be deemed n o t t o be a d i v i d e n d 21 and w i l l n o t be i n c l u d e d i n income. T h i s c o n s t i t u t e s , of c o u r s e , an anomaly r a t h e r t h a n an a v o i d a n c e o f e v a s i o n t e c h n i q u e . As we have seen, subparagraph 84.1(2) (b) p r o v i d e s t h a t the t a x p a y e r w i l l be deemed n o t t o d e a l w i t h t h e a c q u i - r i n g company a t arm's l e n g t h i f he was one o f the same group of l e s s t h a n s i x per s o n s who b e f o r e t h e d i s p o s i t i o n c o n t r o l l e d the s u b j e c t c o r p o r a t i o n and a f t e r the d i s p o s i t i o n c o n t r o l l e d the a c q u i r i n g c o r p o r a t i o n . Assume t h a t t h e ownership o f Opco i s d i v i d e d amongst t h r e e i n d i v i d u a l s as f o l l o w s : X 25 Y 25 Z 25 X and Y r o l l t h e i r pre-72 s h a r e s i n t o a h o l d i n g company, t a k i n g back s h a r e s c o r r e s p o n d i n g t o t h e i r e q u a l i n t e r e s t s i n the Ho l d c o . X and Y t o g e t h e r do n o t c o n t r o l Opco, and n e i t h e r X nor Y c o n t r o l s Holdco. A l t h o u g h a group o f l e s s than s i x persons c o n t r o l s b o t h companies, i t i s n o t t h e 47 same group. But f o r the l i k e l i h o o d o f a M i n i s t e r i a l d i r e c t i o n o r a c l a i m t h a t X and Y a r e f a c t u a l l y non-arm's l e n g t h , t h i s . f a c t s i t u a t i o n c o u l d r e s u l t i n t h e s t r i p p i n g o f t h e V-Day v a l u e o f the sh a r e s r o l l e d o v e r . S e c t i o n 84.1 f i g u r e s most p r o m i n e n t l y i n e s t a t e f r e e z i n g s i t u a t i o n s , however i t w i l l a p p l y whenever a s h a r e h o l d e r s e l l s pre-72 t o a company w i t h w h i c h he i s n o t a t arm's l e n g t h and the a c q u i r i n g company owns more th a n 10% o f the i s s u e d share c a p i t a l o f t h e s u b j e c t c o r p o r a t i o n . 22 C r o n k w r i g h t , Dart, and L i n d s a y suggest a s i t u a t i o n where the s h a r e s o f one o f two b r o t h e r s who have competed i n b u s i n e s s f o r many y e a r s a r e bought by t h e o t h e r b r o t h e r ' s company f o r ca s h . The V-Day v a l u e o f the s e l l i n g b r o t h e r ' s s h a r e h o l d i n g would i n such a case be exposed t o c a p i t a l g a i n s t a x . Other s c e n a r i o s come t o mind. Once an i n v e s t m e n t r e a c h e s m a t u r i t y , a v e n t u r e c a p i t a l i s t w i l l seek t o d i v e s t h i m s e l f o f h i s s h a r e s . An i n c r e a s i n g l y i m p o r t a n t method o f a c c o m p l i s h i n g t h i s i n v o l v e s t h e r e p u r c h a s e by the company o f t h e i n v e s t o r ' s s h a r e s . I f the j u r i s d i c t i o n i n w h i c h t h e company i s i n c o r p o r a t e d does not p e r m i t buy-backs, the sh a r e s w i l l be r o l l e d i n t o a h o l d i n g company formed i n a j u r i s d i c t i o n w hich does. The i n d i v i d u a l owner o f t h e sh a r e s t r a n s f e r r e d and t h e v e n t u r e c a p i t a l i s t ( i f he i s u n i n c o r p o r a t e d ) w i l l i n such c i r c u m - s t a n c e s be s u b j e c t t o an unwarranted r e d u c t i o n i n t h e c o s t base o f the s h a r e s t a k e n back. 48 (g) .' ) C o n c l u s i o n To c o n c l u d e , s e c t i o n 84.1 i s f r a u g h t w i t h many d i f f i c u l t i e s , i n e q u i t i e s , and a n o m a l i e s . B r i e f l y , i t may a p p l y i n c i r c u m s t a n c e s where i t was never i n t e n d e d t h a t i t s h o u l d . T h i s w i l l be the case i f s u b s e c t i o n 84.1(3) f a i l s t o exempt s h a r e s t a k e n by t h e t a x p a y e r from the t r e a s u r y of a c o r p o r a t i o n formed a f t e r 1971 o r from a non-arm's l e n g t h p a r t y who has h i m s e l f a c q u i r e d the s h a r e s i n an arm's l e n g t h t r a n s a c t i o n a f t e r 1971. S e c t i o n 84.1, c o n t r a r y t o p r i n c i p l e , d i s c r i m i n a t e s between i n d i v i d u a l s who own s h a r e s t o w h i c h i t does n o t a p p l y and i n d i v i d u a l s who own s h a r e s t o which i t does a p p l y b u t who have t a k e n a l l n e c e s s a r y s t e p s t o comply w i t h the u n d e r l y i n g p o l i c y . Thus persons r o l l i n g t h e i r s h a r e s i n t o a h o l d i n g company i n r e t u r n f o r s h a r e s t h e r e o f w i t h the same p a i d up c a p i t a l as t h e s h a r e s t r a n s f e r r e d a r e e f f e c t i v e l y bound t o r e a l i z e t h e i r i n t e r e s t s as c a p i t a l g a i n s and a r e .. d e n i e d a c h o i c e o f t a x t r e a t m e n t on the p o s t - 7 1 e a r n i n g s of the o p e r a t i n g company. T h i s a l s o means t h a t t h e y must t r a n s f e r t h e i r i n t e r e s t s i n t h e o p e r a t i n g company w i t h the d i s p o s i t i o n o f t h e i r s h a r e s i n the h o l d i n g company ( f o r w h i c h t h e r e would o t h e r w i s e be no m a r k e t ) . S h a r e h o l d e r s d n j o y i n g the p o s s i b i l i t y " o f a share redemption do n o t n e c e s s a r i l y 23 have t h i s consequence imposed upon them. S h a r e h o l d e r s who have a c q u i r e d t h e i r i n t e r e s t s from o t h e r s h a r e h o l d e r s (and n o t t h e t r e a s u r y ) b e f o r e 1972 and 49 non-arm's l e n g t h t r a n s f e r e e s f o r v a l u e s o f pre-72 s h a r e s t a k i n g a f t e r 19 71, a r e , upon a r o l l o v e r , d e n i e d a r e t u r n o f c a p i t a l upon t h e i r i n v e s t m e n t . T h i s f o l l o w s from t h e f a c t t h a t r e d emption o f t h e low p a i d up c a p i t a l s h a r e s t a k e n back by t h e pre-72 a c q u i r o r would expose p a r t o f h i s c a p i t a l c o s t t o d i v i d e n d t r e a t m e n t , and the non-arm's l e n g t h t r a n s f e r e e f o r v a l u e would have h i s c o s t reduced t o t h a t o f h i s t r a n s f e r o r , p a v i n g t h e way f o r an u n c a l l e d - f o r c a p i t a l g a i n upon r e d e m p t i o n o f the s h a r e s . I f t h e purc h a s e cannot be funded w i t h the t a x f r e e s u r p l u s o f t h e o p e r a t i n g company, any debt f i n a n c i n g schemes might be s e r i o u s l y compromised. Pu r c h a s e t h r o u g h a h o l d i n g company might have s o l v e d the problem f o r t h e non-arm's l e n g t h t r a n s f e r e e e x c e p t f o r the f a c t t h a t i t would expose h i s t r a n s f e r o r t o c a p i t a l g a i n s t r e a t m e n t o f t h e V-Day v a l u e p r o t e c t i o n o f h i s s h a r e s . S e c t i o n 84.1 u n n e c e s s a r i l y throws o b s t a c l e s i n t o the p a t h o f e s t a t e f r e e z e s u s i n g a h o l d i n g company. The low p a i d up c a p i t a l o f the sh a r e s t a k e n back i m p o r t s b o t h the u n s a t i s f a c t o r i n e s s o f a share redemption ( e x p o s i n g t h e V-Day v a l u e t o t a x as a d i v i d e n d ) and t h e n o n - m a r k e t a b i l i t y o f the s h a r e s f o r o r d i n a r y s a l e (they w i l l n o t t r a n s f e r o wnership o f t h e o p e r a t i n g company). The owner o f pre-72 s h a r e s may t h e r e f o r e shun t h e h o l d i n g company mechanism and, a c c o r d i n g l y , be f o r t u i t o u s l y d e n i e d t h e b e n e f i t s o f t h i s p l a n n i n g t e c h n i q u e . Perhaps a s e c t i o n which p e r m i t t e d t h e premature 50 r e a l i z a t i o n o f the V-Day v a l u e b u t a t some r e a s o n a b l e t a x c o s t would have been p r e f e r a b l e . A d m i t t e d l y such a scheme would be d i f f i c u l t t o put i n p l a c e , because t h e l e n g t h o f time the s h a r e h o l d e r c o n t i n u e d i n d i r e c t l y t o own the sh a r e s o f the o p e r a t i n g company would have t o be f a c t o r e d i n . T h i s p e r i o d would d i f f e r from s h a r e h o l d e r t o s h a r e h o l d e r and would be i n d e t e r m i n a t e when t h e r o l l o v e r and s t r i p took p l a c e . Some form o f r e f u n d a b l e t a x p r o v i s i o n might overcome t h i s problem. I n any c a s e , t h e r e can be l i t t l e doubt t h a t the t e n o r and t h r u s t o f s e c t i o n 84.1 are m i s c o n c e i v e d . Presumably, the abuses i t i s i m p e r f e c t l y d e s i g n e d t o p r e v e n t would o t h e r w i s e be governed by s u b s e c t i o n 2 4 7 ( 1 ) . I n p r i n c i p l e , t h e r e f o r e , s e c t i o n 84.1 s h o u l d be p r o v i d e d f o r t h e g r e a t e r c e r t a i n t y o f t a x a d v i s e r s who might t h e n pursue t h e i r l e g i t i m a t e o b j e c t i v e s f r e e o f the menace o f a m i n i s t e r i a l d i r e c t i o n . U n f o r t u n a t e l y , s e c t i o n 84.1 i t s e l f t h r e a t e n s a permanent p e n a l t y which may be d i f f i c u l t t o a v o i d because o f the v e r b a l a m b i g u i t i e s o f the p r o v i s i o n and which i n any case f o r t u i t o u s l y d i s a d v a n t a g e s c e r t a i n t a x p a y e r s . 51 FOOTNOTES 1. C.W. Primeau, " S u r p l u s S t r i p p i n g : The D e p a r t m e n t a l View," i n 1974 22 Can. Tax. J . , 421 a t p. 426, h e r e i n a f t e r r e f e r r e d t o as Primeau. Subparagraph 5 4 ( h ) ( x ) w i l l , f o r t h e purpose o f d e t e r m i n i n g any c a p i t a l g a i n o r l o s s , reduce t h e proceeds o f d i s p o s i t i o n by the amount o f the deemed d i v i d e n d . 3 . S u b s e c t i o n 186(4) 4. R e l i a n c e upon f a c t u a l non-arm's l e n g t h may c o n t i n u e t o be n e c e s s a r y where th e t r a n s a c t i o n i s governed n e i t h e r by the r e l a t e d p ersons p r o v i s i o n s nor t h e extended d e f i n i t i o n o f non-arm's l e n g t h : see, i n f r a , a t p. 26. 5. See subparagraph 8 5 ( 1 ) ( f ) . F o r t h e c o s t o f p r e f e r r e d s h a r e s t a k e n back see subparagraph 8 5 ( 1 ) ( g ) . 6. F o r i n d i v i d u a l s t a x e d a t the h i g h e s t m a r g i n a l r a t e , t h e consequences o f e x p o s i n g the V-Day v a l u e t o d i v i d e n d o r c a p i t a l g a i n s t r e a t m e n t , even where a c a p i t a l l o s s i s a v a i l a b l e , a re s i m i l a r w i t h perhaps a s l i g h t p r e f e r e n c e f o r d i v i d e n d t r e a t m e n t . Opco Shares T r a n s f e r r e d Holdco Shares Taken Back PUC 100 PUC 1000 ACB 500 (V-Day v a l u e ) ACB 500 FMV 1000 FMV 1000 Case I S e c t i o n 84.1 w i l l reduce t h e ACB o f t h e s h a r e s t a k e n back by 4 00, f i x i n g i t a t the PUC o f t h e s h a r e s t r a n s f e r r e d , o r 100. On a s e c t i o n 84(3) r e d e m p t i o n ( o r on a s e c t i o n 84(4) r e d u c t i o n o f t h e p a i d up c a p i t a l down t o n i l ) o f t h e Holdco s h a r e s t h e t a x p a y e r would t h e r e f o r e i n c u r a c a p i t a l g a i n o f 900, 1/2 o f w h i c h , o r 4 50, would be i n c l u d e d i n income. Taxed a t a m a r g i n a l r a t e o f 61 t h i s would r e s u l t i n t o t a l t a x p a y a b l e o f 450 x 61 = 274.50. 52 Case I I I f t h e Opco s h a r e s were s o l d by t h e H o ldco f o r t h e i r f a i r market v a l u e o f 1000, t h e t a x p a y e r would i n d i r e c t l y a t t r a c t c a p i t a l g a i n s t r e a t m e n t on t h e e x c e s s o f t h e FMV o f 1000 over t h e ACB o f 500, a t a t a x c o s t o f 500 x 1/2 x .61 = 152.50. I f t h e r e m a i n i n g 500 were used up i n a p a r t i a l r e d e m ption o f t h e t a x p a y e r ' s s h a r e s o f H o l d c o , t h e r e would be a f u r t h e r c a p i t a l g a i n o f 500 (proceeds) - 100 (reduced ACB) = 400 a t a f u r t h e r t a x c o s t o f 400 x 1/2 x .61 = 122.00 f o r a t o t a l t a x c o s t o f 274.50. As between Case I and Case I I , the l a t t e r p r o v i d e s more f a v o u r a b l e o v e r a l l r e s u l t s f o r t h e p a r t i c u l a r t a x p a y e r , because the n e x t 500 p a i d t o f u l l y redeem the s h a r e s w i l l a t t r a c t c a p i t a l g a i n s t r e a t m e n t , whereas any a d d i t i o n a l amount p a i d on the s h a r e s i n Case I I (assuming the s h a r e h o l d e r c o n t i n u e s t o own them) w i l l be t a x a b l e as a d i v i d e n d . Case I I I I f i n case I I the a d d i t i o n a l 500 i n t h e Holdco were p a i d out t o t h e s h a r e h o l d e r as a t a x a b l e d i v i d e n d the t a x c o s t would be 152.50 p l u s (500 + ;25.0 x .61-250) o r 207.50 = 360. Case IV I f , i n o r d e r t o a v o i d t h e p e n a l t y , the t a x p a y e r t a k e s back sha r e s o f the Holdco w i t h a PUC o f 100, ACB o f 500, and FMV o f 1000, a redemption o f the Holdco s h a r e s would p r e - c i p i t a t e a deemed d i v i d e n d o f 900 and a s e c t i o n 5 4 ( h ) ( x ) c a p i t a l l o s s o f 1000 (proceeds) l e s s 900 (deemed d i v i d e n d ) 100 l e s s ACB 500 = 400. The t a x c o s t o f the d i v i d e n d would be 900 p l u s 450 = 1350 x .61 - 8.23.50 l e s s 450 = 373.50. Assuming the a v a i l a b i l i t y o f c a p i t a l g a i n s f o r immediate s e t o f f , the t o t a l t a x c o s t would t h e n be 373.50 l e s s (400 x 1/2 x .61) o r 122 = 251.50. Case V S a l e o f the s h a r e s t a k e n back i n Case IV would r e s u l t i n a c a p i t a l g a i n o f 500 and a t o t a l t a x c o s t o f 500 x 1/2 x .61 = 152.50. 7. R.D.Brown, I : l a s t G u n f i g h t a t t h e S u r p l u s S t r i p p i n g C o r r a l , " i n 19 7 8 C o n f e r e n c e Report 590 a t p. 605. 8. John M. Fuke, " E s t a t e P l a n n i n g Today: A Review o f Recent Developments," i n 1975, 23 Can. Tax. J . , 42 a t p.48, h e r e i n a f t e r r e f e r r e d t o as Fuke, and R o b e r t J . D a r t , "Specific Uses o f Companies i n Tax P l a n n i n g , " i n 1979 C onference R e p o r t , 117 a t pp 129-134. 9. Fuke, p. 50, and Primeau, a t p. 4 29. 53 10. See B .J. B r y s o n , " S u r p l u s S t r i p p i n g : The A p p l i c a t i o n o f S u b s e c t i o n 247(1) i n L i g h t o f the 1975 Amendments o f t h e Income Tax A c t , " i n 19 7 5 C o n f e r e n c e R e p o r t , 295 a t pp. 209 - 303. 11. Primeau, a t p.423 and see B r y s o n , f o o t n o t e 10. 12. The r e v e r s e f r e e z e r e q u i r e s , i n a d d i t i o n , t h a t t h e s h a r e - h o l d e r f o r e g o the c o n s i d e r a b l e advantages o f i s o l a t i n g the i n v e s t m e n t p o r t f o l i o from the a c t i v e b u s i n e s s . 13. See f o o t n o t e 6. 14. Non-arm?s l e n g t h t a x p a y e r s would n ot be a b l e t o a v o i d t h i s d i f f i c u l t y by a c q u i r i n g the s h a r e s t h r o u g h a h o l d i n g company. 15. See J .R.Robertson, 19 7 8 C o n f e r e n c e R e p o r t , 52 a t p.59. 16. The low p a i d up c a p i t a l need n o t i n c o n v e n i e n c e a s h a r e - h o l d e r who i s p l a n n i n g t o s e l l h i s s h a r e s : see Sheldon S i l v e r , " S e c t i o n 55 and S u b s e c t i o n 2 4 7 ( 1 ) , " i n 1978 Confer e n c e R e p o r t s , 626 a t p. 635. 17. Pender E n t e r p r i s e s L i m i t e d v MNR, (1965) CTC 91. 18. A n c a s t e r Development Company L i m i t e d v MNR, (1972) CTC 614. 19 . Swiss Bank C o r p o r a t i o n and Swiss C r e d i t Bank v MNR, (1972) CTC 614. 20. S u b s e c t i o n 88(2.1) 21. Subparagraph 8 8 ( 2 ) ( b ) ( i i ) 22. C r o n k w r i g h t , D a r t , and L i n d s a y , " S u r p l u s D i s t r i b u t i o n s and the 19 7 7 Tax Changes," i n 1977 Confe r e n c e R e p o r t , 89 a t p. 12 7. 54 23. Even i f t h e i r Holdco s h a r e s t a k e n back on t h e r o l l o v e r a r e redeemed, they may c o n t i n e t o own s h a r e s t a k e n from t h e t r e a s u r y o f H o l d c o . I n such a case t h e y would c o n t i n u e t o own Opco i n d i r e c t l y and t h e i r s h a r e s o f Holdco would r e f l e c t the p o s t - r o l l o v e r i n c r e m e n t s i n Opco. These s h a r e s might t h e r e f o r e themselves be r o l l e d o v e r i n t o a second Holdco a t some f u t u r e t i m e , a g a i n p e r m i t t i n g t h e s h a r e h o l d e r a c h o i c e as t o t h e t a x t r e a t m e n t o f t h e Opco s u r p l u s . 55 I I I . S e c t i o n 212.1 (a) I n t r o d u c t i o n S e c t i o n 84.1 i s aimed a g a i n s t a s t r i p a c c o m p l i s h e d , f o l l o w i n g an i n c e s t u o u s s hare s a l e , by d i s g u i s i n g a p o r t i o n o f an o p e r a t i n g company's earned s u r p l u s as the c a p i t a l c o s t o f s h a r e s w h i c h may be r e t u r n e d t o the i n v e s t o r f r e e o f t a x . The s t r i p i s made p o s s i b l e because where pre-72 sh a r e s a r e i n v o l v e d the a d j u s t e d c o s t base does n o t c o r r e s p o n d t o the amount i n v e s t e d by t h e t a x p a y e r . S e c t i o n 212.1 i s l i k e w i s e d i r e c t e d a g a i n s t a s t r i p w h i c h t u r n s upon t h e c o n v e r s i o n , t h r o u g h t h e magic o f t h e i n c e s t u o u s share s a l e , o f t a x r e t a i n e d e a r n i n g s i n t o c a p i t a l . I n t h i s case the s t r i p i s s e t up by the f a c t t h a t n o n - r e s i d e n t s a r e by t r e a t y f r e q u e n t l y exempted from c a p i t a l g a i n s t a x t o whic h t h e y would o t h e r w i s e be e x p o s e d . 1 I n the t y p i c a l c a s e , t h e n o n - r e s i d e n t Usco w i s h e s t o a v o i d w i t h h o l d i n g t a x e x i g i b l e upon d i v i d e n d s p a i d t o i t by i t s w h o l l y owned Canadian Opco, a company plump w i t h r e t a i n e d e a r n i n g s and r i p e f o r the p i c k i n g . usco t h e r e f o r e s e l l s the shares o f Canadian Opco t o Canadian H o l d c o , a company c r e a t e d by Usco t o make t h e p u r c h a s e , t a k i n g back c a s h , d e b t , and/or shares o f Holdco w i t h an aggr e g a t e v a l u e e q u i v a l e n t t o t h e f a i r market v a l u e o f t h e Opco s h a r e s t r a n s f e r r e d . Usco w i l l t h e r e f o r e i n c u r a c a p i t a l g a i n e q u a l t o t he e x c e s s o f t h e f a i r market v a l u e o f the Opco s h a r e s o v er t h e i r a d j u s t e d c o s t ; base. The purchase p r i c e i s o f 56 - c o u r s e p a i d w i t h the s u r p l u s o f Opco which i s moved t h r o u g h t o Holdco i n t h e form o f d e d u c t i b l e s e c t i o n 112 d i v i d e n d s , an arrangement f a c i l i t a t e d s i n c e the r e p e a l o f P a r t V I I t a x . As one might e x p e c t , government o f f i c i a l s r e g a r d t h i s p r o c e d u r e as a c o l o u r a b l e attempt t o a v o i d P a r t X I I I t a x , s p e c i f i c a l l y the 25% t a x imposed by p a r a g r a p h 2 1 2 ( 2 ) ( a ) on n o n - r e s i d e n t s r e c e i v i n g amounts from c o r p o r a t i o n s r e s i d e n t i n Canada on a c c o u n t , i n l i e u , o r i n s a t i s f a c t i o n o f t a x a b l e d i v i d e n d s . ^ (b) C o n d i t i o n s o f A p p l i c a b i l i t y S e c t i o n 212.1 w i l l a p p l y whenever, a f t e r A p r i l 10, 1978, 1) a n o n - r e s i d e n t p e r s o n 2) d i s p o s e s o f s h a r e s o f a Canadian company 3) t o a n o t h e r Canadian company 4) w i t h w h i c h he i s not a t arm's l e n g t h , and 5) t h e two Canadian companies a r e 'connected'. The n o n - r e s i d e n t may be an i n d i v i d u a l , a t r u s t o r a 3 c o r p o r a t i o n . F o r g r e a t e r c e r t a i n t y , an expanded d e f i n i t i o n o f non-arm's l e n g t h i s p r o v i d e d i n s u b s e c t i o n 2 1 2 . 1 ( 3 ) . T h i s c o r r e s p o n d s t o the d e f i n i t i o n i n s u b s e c t i o n 84.1(2) (b) a c c o r d i n g t o which the t a x p a y e r i s n o t a t arm's l e n g t h w i t h the p u r c h a s e r c o r p o r a t i o n i f he i s one o f the same group of l e s s than s i x p ersons who c o n t r o l t h e s u b j e c t c o r - p o r a t i o n b e f o r e t h e d i s p o s i t i o n and t h e p u r c h a s e r c o r p o r a t i o n a f t e r t h e d i s p o s i t i o n . There a r e a l s o r u l e s i n p a r a g r a p h 212.1(3) (b) c o r r e s p o n d i n g e x a c t l y t o the r u l e s i n p a r a g r a p h 84.1(2) (c) w h i c h p r o v i d e t h a t s h a r e s owned by the t a x p a y e r ' s spouse, and c e r t a i n non-arm's l e n g t h companies and i n t e r v i v o s 57 t r u s t s w i l l be a t t r i b u t e d t o the t a x p a y e r f o r the purpose of d e t e r m i n i n g whether he was one o f a group o f l e s s t h a n s i x p e rsons t h a t c o n t r o l l e d a company. 4 L i k e s e c t i o n 84.1, s e c t i o n 212.1 r e q u i r e s t h a t t h e p u r c h a s i n g company and t h e company the s h a r e s o f which a r e a c q u i r e d be c o n n e c t e d . T h i s r e q u i r e m e n t was i n t r o d u c e d by r e s o l u t i o n s 25 and 56 r e s p e c t i v e l y o f t h e December 19, 19 7 8 expanded N o t i c e o f Ways and Means M o t i o n . I n b o t h cases t h e A c t f o r m e r l y r e q u i r e d t h a t t h e p u r c h a s i n g c o r p o r a t i o n c o n t r o l the s u b j e c t c o r p o r a t i o n . The changes were o f c o u r s e n e c e s s a r y i f s e c t i o n s 84.1 and 212.1 were t o c o n t i n u e t o mesh w i t h the P a r t IV t a x p r o v i s i o n s . I n 1978 c r i t e r i o n f o r the exemption from P a r t IV t a x went from ' c o n t r o l l e d ' (over 50% v o t e s and v a l u e ) t o 'connected' (over 10% v o t e s 5 : and v a l u e ) . As f i r s t e n a c t e d , s e c t i o n 212.1 a p p l i e d where the n o n - r e s i d e n t and the p u r c h a s i n g c o r p o r a t i o n were non- arm's l e n g t h " i m m e d i a t e l y a f t e r the d i s p o s i t i o n " . T h i s l e d t o an u n f a i r r e s u l t i n c e r t a i n arm's l e n g t h t r a n s a c t i o n s . F o r example, i n a t a k e o v e r by a Usco and i t s Canadian Subco of a t a r g e t Usco and i t s Canadian Subco i n c i r c u m s t a n c e s where th e U.S. and Canadian p u r c h a s e r s a c q u i r e d t h e s h a r e s of the t a r g e t s i n t h e same t r a n s a c t i o n , t h e p u r c h a s i n g Subco and t h e t a r g e t Usco would n o t , " i m m e d i a t e l y a f t e r the d i s - p o s i t i o n " , be a t arm's l e n g t h because th e p u r c h a s i n g Subco ' i s p a r e n t would t h e n own the t a r g e t Usco. The c o n s i d - e r a t i o n t a k e n by the t a r g e t Usco would t h e r e f o r e r e c e i v e 58 d i v i d e n d t r e a t m e n t t o t h e e x t e n t t h a t i t exceeded th e p a i d up c a p i t a l o f i t s Canadian Subco. T h i s would, e f f e c t i v e l y , s u b j e c t the c a p i t a l g a i n t o w i t h h o l d i n g t a x . R e s o l u t i o n 49 o f B i l l C-56 changed the w o r d i n g o f s e c t i o n 212.1 so t h a t the s e c t i o n a p p l i e s where the n o n - r e s i d e n t p e r s o n and t h e p u r c h a s e r c o r p o r a t i o n a r e non-arm's l e n g t h b e f o r e the d i s p o s i t i o n . (c) O p e r a t i o n and Tax Consequences of S e c t i o n 212.1 The consequences of s e c t i o n 212.1 w i l l depend upon the n a t u r e o f t h e c o n s i d e r a t i o n t a k e n back from th e p u r c h a s e r c o r p o r a t i o n by the n o n - r e s i d e n t . Where c a s h o r debt o n l y a r e t a k e n back, t h e e x c e s s o f t h e f a i r market v a l u e o f t h i s c o n s i d e r a t i o n o v e r th e p a i d up c a p i t a l o f the s h a r e s a c q u i r e d by the p u r c h a s e r c o r p o r a t i o n w i l l be t r e a t e d as an immediate t a x a b l e d i v i d e n d s u b j e c t t o w i t h h o l d i n g t a x . Where s h a r e s of t h e p u r c h a s e r o n l y a r e i s s u e d i n payment, the p a i d up c a p i t a l o f t h e s e s h a r e s w i l l be reduced by t h e amount of the e x c e s s o f t h e i r p a i d up c a p i t a l o v e r the p a i d up c a p i t a l o f the s h a r e s t r a n s f e r r e d . T h i s o f c o u r s e paves the way f o r a deemed d i v i d e n d on any s u b s e c t i o n 84(3) r e d e mption o r s u b s e c t i o n 84(4) r e d u c t i o n o f c a p i t a l o f t h e n o n - r e s i d e n t ' s s h a r e s where the amount r e c e i v e d exceeds t h e i r reduced p a i d up c a p i t a l . I n a l l c a s e s , an immediate deemed d i y i d e n d w i l l a r i s e o n l y t o the e x t e n t t h a t t h e a c t u a l amount o f cash o r debt exceeds th e p a i d up c a p i t a l o f the s u b j e c t s h a r e s . 59 T h i s means t h a t where a c o m b i n a t i o n o f c a s h , d e b t , and s h a r e s o f t h e p u r c h a s e r a r e ta k e n back, t h e e x c e s s o f t h e f a i r market v a l u e o f the aggregate c o n s i d e r a t i o n r e c e i v e d o v e r t h e p a i d up c a p i t a l o f t h e s u b j e c t s h a r e s w i l l be a p p l i e d f i r s t t o t h e r e d u c t i o n o f the p a i d up c a p i t a l o f the s h a r e s t a k e n back by the n o n - r e s i d e n t (which d e f e r s the deemed d i v i d e n d u n t i l r e d e mption o f the s h a r e s ) . Where sha r e s o f d i f f e r e n t c l a s s e s o f t h e p u r c h a s e r a r e i s s u e d i n payment, the p a i d up c a p i t a l r e d u c t i o n i s p r o r a t e d amongst t h e s e c l a s s e s on t h e b a s i s o f t h e r e l a t i v e i n c r e a s e i n p a i d up c a p i t a l o f each c l a s s . (e) Comparison o f S e c t i o n s 84.1 and 212.1 I n s p i t e o f t h e many t e c h n i c a l s i m i l a r i t i e s between s e c t i o n s 84.1 and 212.1, t h e r e a r e i m p o r t a n t d i f f e r e n c e s as w e l l . S e c t i o n 84.1 a p p l i e s t o r e s i d e n t t a x p a y e r s o t h e r t h a n c o r p o r a t i o n s whereas s e c t i o n 212.1 a p p l i e s t o a l l n o n - r e s i d e n t p e r s o n s , i n c l u d i n g c o r p o r a t i o n s . As t h e o b j e c t o f the s t r i p r e g u l a t e d by s e c t i o n 84.1 i s t h e premature r e a l i z a t i o n o f a c a p i t a l g a i n , t h e p e n a l t y t a k e s the form o f a r e d u c t i o n i n t h e a d j u s t e d c o s t base of the s h a r e s t a k e n back, r e s u l t i n g i n exposure t o c a p i t a l g a i n s t a x : as the o b j e c t o f the s t r i p t h w a r t e d by s e c t i o n 212.1 i s the t r a n s f o r m a t i o n o f r e t a i n e d e a r n i n g s n o r m a l l y d i s t r i b u t a b l e as t a x a b l e d i v i d e n d s i n t o n o n - t a x a b l e c a p i t a l g a i n s , the adjustment c a l l s e i t h e r f o r t h e r e c o g - n i t i o n o f an immediate o r d e f e r r e d deemed d i v i d e n d (depending, 60 as we have seen, upon the n a t u r e o f t h e c o n s i d e r a t i o n r e c e i v e d by t h e n o n - r e s i d e n t ) . The p e n a l t y i n s e c t i o n 84.1 i s l i m i t e d t o the exce s s o f t h e V-Day v a l u e o f t h e s u b j e c t shares over t h e i r p a i d up c a p i t a l ; t h e p r o v i s i o n s o f s e c t i o n 212.1 w i l l deem a l l s u r p l u s removed from the s u b j e c t c o r p o r a t i o n i n e x c e s s o f i t s p a i d up c a p i t a l t o be a d i v i d e n d . Another i m p o r t a n t p o i n t o f d i f f e r e n c e l i e s i n t he f a c t t h a t where debt i s t a k e n back by t h e non- r e s i d e n t i t w i l l g i v e r i s e t o an immediate t a x l i a b i l i t y , t o the e x t e n t t h a t i t exceeds i n v a l u e t h e p a i d up c a p i t a l o f the s u b j e c t s h a r e s ; under s e c t i o n 84.1 t h e a d j u s t e d c o s t base o f any debt c o n s i d e r a t i o n i s reduced and a c c o r d i n g l y t h e t a x l i a b i l i t y t h e r e o n i s d e f e r r e d . A n o t h e r s i g n i f i c a n t d i f f e r e n c e , p o i n t i n g t o a pos- s i b l e d e f i c i e n c y i n t h e d r a f t i n g o f s e c t i o n 212.1, has t o do w i t h the c h a r a c t e r i s t i c s o f t h e s h a r e s m o d i f i e d by t h e two s e c t i o n s . S e c t i o n 84.1 a p p l i e s o n l y t o reduce the a d j u s t e d c o s t base o f t h e p a r t i c u l a r s h a r e s t a k e n back by the t a x p a y e r from t h e p u r c h a s e r c o r p o r a t i o n . S e c t i o n 212.1, on the o t h e r hand, a p p l i e s t o reduce t h e p a i d up c a p i t a l o f the c l a s s t o which the s h a r e s t a k e n back by the non- r e s i d e n t b e l o n g . Thus, i f a d d i t i o n a l s h a r e s o f t h e c l a s s ( e s ) t a k e n by the n o n - r e s i d e n t a r e h e l d by o t h e r s h a r e h o l d e r s o f t h e p u r c h a s e r c o r p o r a t i o n , , t h e r e d u c t i o n i n p a i d up c a p i t a l w i l l a p p l y t o and f l o a t w i t h t h o s e o t h e r s h a r e s . T h i s w i l l o f c o u r s e r e s u l t i n a b e n e f i t t o the n o n - r e s i d e n t i n t h a t t h e r e d u c t i o n w i l l be d i s t r i b u t e d amongst a l l o f 61 t h e s h a r e s o f the r e l e v a n t c l a s s ( e s ) , C o n y e r s e l y t h e o t h e r s h a r e h o l d e r s may be d i s a d v a n t a g e d by a c o r r e s p o n d i n g r e d u c t i o n i n the p a i d up c a p i t a l o f t h e i r s h a r e s . T h i s does, however, p r e s e n t c e r t a i n p l a n n i n g p o s s i b i l i t i e s . I f , f o r example, th e o t h e r s h a r e h o l d e r s a r e t h e m s e l v e s c o r p o r a t i o n s owned by t h e n o n - r e s i d e n t , the r e d u c t i o n i n the p a i d up c a p i t a l o f t h e i r s h a r e s does n o t c o n s t i t u t e a d e t r i m e n t because s u r p l u s may be moved between c o r p o r a t i o n s on a t a x f r e e b a s i s . Care would have t o be t a k e n t o a v o i d any P a r t IV t a x by e n s u r i n g t h a t t h e s h a r e h o l d e r c o r p o r a t i o n ( s ) and the p u r c h a s e r c o r p o r a t i o n were con n e c t e d . A l t e r n a t i v e l y , even where a new c l a s s o f s h a r e s a r e i s s u e d t o t h e non- r e s i d e n t , a n o t h e r Canadian company w h o l l y owned by t h e n o n - r e s i d e n t might purchase s h a r e s o f the same c l a s s , i n e f f e c t d e c r e a s i n g t h e r e d u c t i o n i n t h e p a i d up c a p i t a l o f the n o n - r e s i d e n t ' s s h a r e s . (d) S u b s e c t i o n 212.1(2) Adjustment The adjustment i n the c o m p u t a t i o n o f the p a i d up c a p i t a l o f the s h a r e s t a k e n back p r o v i d e d f o r i n s u b s e c t i o n 212.1(2) i s made n e c e s s a r y by t h e e x c e s s i v e r e d u c t i o n s e f f e c t e d by s u b s e c t i o n 212.1(1)(b) where th e s h a r e s a r e redeemed i n s u c c e s s i v e s t a g e s and n o t a l l a t once. Assume t h a t s u b j e c t s h a r e s h a v i n g a p a i d up c a p i t a l o f 100,000 are s o l d by t h e n o n - r e s i d e n t i n r e t u r n f o r s h a r e s o f the p u r c h a s e r p o s s e s s i n g a p a i d up c a p i t a l o f 500,000. S u b s e c t i o n 212.1(1)(b) w i l l reduce t h e p a i d up 62 c a p i t a l o f the s h a r e s t a k e n back by 400,000, l e a v i n g a ' p a i d up c a p i t a l o f 100,000. L e t us f u r t h e r assume a subsequent s u b s e c t i o n 84(3) 300,000 redemption o f the non- r e s i d e n t ' s s h a r e s i n the p u r c h a s e r c o r p o r a t i o n . The s u b s e c t i o n 84(3) redemption would t r i g g e r a deemed d i v i d e n d o f 240,000 (300,000 - 3/5 o f PUC o f 100,000 a t t r i b u t a b l e t o s h a r e s redeemed),. P u r s u a n t t o s u b s e c t i o n 212.1(1) (b) t h e r e v i s e d p a i d up c a p i t a l o f t h e s h a r e s would be d e t e r m i n e d as f o l l o w s : PUC r e m a i n i n g ( c o r p o r a t e law) 2 00,000 212.1(1)(b) r e d u c t i o n 400,000 •J PUC o f s h a r e s NIL Thus, the f u l l amount o f t h e r e m a i n i n g 20 0,000 p a i d up c a p i t a l would be b r o u g h t i n t o income on a subsequent redemp- t i o n o f the r e m a i n i n g s h a r e s , f o r a t o t a l deemed d i v i d e n d o f 44 0,000, a f i g u r e 40,000 above t h e o r i g i n a l r e d u c t i o n i n p a i d up c a p i t a l . S u b s e c t i o n 212.1(2) t h e r e f o r e makes the following a d d i t i o n i n t h e c o m p u t a t i o n o f t h e p a i d up c a p i t a l : PUC r e m a i n i n g ( c o r p o r a t e law) 200,000 Le s s 212.1(1)(b) r e d u c t i o n 400,000 P l u s 212.1(2) a d d i t i o n ( l e s s e r o f 212.1(1)(b) r e d u c t i o n and the deemed d i v i d e n d p a i d on r e d e mption o f 3/5 o f s h a r e s 240,000 P a i d up c a p i t a l 40,000 A c c o r d i n g l y , on a r e d emption o f the r e m a i n i n g s h a r e s t h e r e would be a deemed d i v i d e n d o f 200,000 - 40,000 = 160,000, f o r a t o t a l deemed d i v i d e n d o f 400,000. 7' S u b s e c t i o n 212.1(2) i s n e c e s s a r y because s u b s e c t i o n 63 212.1(1) (bO> a p p l i e s i n computing the p a i d up c a p i t a l o f the s h a r e s t a k e n back " a t any p a r t i c u l a r t i me a f t e r March 31, 1977." I f s u b s e c t i o n 212.1(1) (b) were amended t o compute the p a i d up c a p i t a l " i m m e d i a t e l y a f t e r t h e d i s p o s i t i o n " , a p a r t i a l r edemption o f s h a r e s as i n the above example would r e s u l t i n a p a i d up c a p i t a l o f 40,000 f o r t a x purposes r e m a i n i n g a f t e r the r e d u c t i o n and p a r t i a l r e d e mption (3/5 o f the p a i d up c a p i t a l o f 100,000, o r 60,000 i s recouped on the redemption o f 300,000 o f t h e o u t s t a n d i n g 500,000 s h a r e s , l e a v i n g a p a i d up c a p i t a l o f 40,000).8 The s u g g e sted change would a p p r e c i a b l y s i m p l i f y t h e o p e r a t i o n o f s e c t i o n 212.1 and e l i m i n a t e some o f i t s r a t h e r dense and t o r t u o u s w o r d i n g . The d r a f t s m a n p r o b a b l y f e l t t h a t because s u b s e c t i o n 8 9 ( 1 ) ( c ) appears t o d e t e r m i n e p a i d up c a p i t a l by r e f e r e n c e t o the a p p l i c a b l e p r o v i s i o n s o f the c o r p o r a t e , and not t h e t a x law, an " i m m e d i a t e l y a f t e r t h e d i s p o s i t i o n " t e s t would i m p l y t h a t a t any o t h e r t ime p a i d up c a p i t a l means c o r p o r a t e p a i d up c a p i t a l i . e . 200,000 and not 40,000 a f t e r t h e i n i t i a l r e demption i n t h e above example. There i s , however, no c o m p e l l i n g r e a s o n why t h i s s h o u l d be t h e c a s e . The " p a i d up c a p i t a l . . . i n r e s p e c t o f the c l a s s o f s h a r e s " r e f e r r e d t o i n s u b s e c t i o n 89(1) (c) can j u s t as e a s i l y (and more c o n v e n i e n t l y ) be t a k e n as r e f e r r i n g t o t h e reduced p a i d up c a p i t a l o f 40,000 f o r t a x p u r p o s e s . 64 (f) C o n c l u s i o n I t may be argued t h a t s e c t i o n 212.1 i s i n e f f e c t i v e where the r e l e v a n t t a x t r e a t y (which o v e r - r i d e s the d o m e s t i c t a x law) p r o h i b i t s the t a x a t i o n o f t h e n o n - r e s i d e n t ' s 9 c a p i t a l g a m s . However, the deemed d i v i d e n d under s e c t i o n 212.1 i s d e t e r m i n e d w i t h r e f e r e n c e t o the p a i d up c a p i t a l c o n c e p t and n o t a c c o r d i n g t o the u s u a l c a p i t a l g a i n s c r i t e r i a . Thus a t a x l i a b i l i t y may a r i s e under s e c t i o n 212.1 even where no c a p i t a l g a i n , o r perhaps even a l o s s , i s t r i g g e r e d by the s a l e . T h i s w i l l o c c u r when the a d j u s t e d c o s t base o f the s u b j e c t s h a r e s e q u a l s o r exceeds t h e i r f a i r market v a l u e and the p a i d up c a p i t a l i s a lower f i g u r e . Moreover, where s h a r e s o n l y a re t a k e n back by t h e n o n - r e s i d e n t , the c a p i t a l g a i n and s e c t i o n 212.1 t a x l i a b i l i t y w i l l a r i s e a t d i f f e r e n t t i m e s and i n r e s p e c t o f d i f f e r e n t t r a n s a c t i o n s on d i f f e r e n t s h a r e s . Even where c a s h o n l y i s t a k e n back and the amount o f the deemed d i v i d e n d c l o s e l y a p p r o x i m a t e s t h e amount o f the c a p i t a l g a i n , i t i s s t i l l a r g u a b l e t h a t s e c t i o n 212.1 t r a c e s and t a x e s a d i s t r i b u t i o n o f s u r p l u s , e s p e c i a l l y i n view o f the f a c t t h a t the n o n - r e s i d e n t c o n t i n u e s t o own t h e sh a r e s ( a l b e i t i n d i r e c t l y ) . The n o n - r e s i d e n t might perhaps argue t h a t one t a x i s i n e f f e c t s u b s t i t u t e d f o r the o t h e r , and t h a t the government i s a t t e m p t i n g t o do i n d i r e c t l y what i t cannot do d i r e c t l y ( t h i s maxim might a l s o be l e v e l l e d a g a i n s t him). I t might a l s o be argued i n h i s b e h a l f t h a t t h e s u b j e c t 65 s h a r e s , b e i n g a f t e r the d i s p o s i t i o n t h e p r o p e r t y o f a Canadian r e s i d e n t c o r p o r a t i o n , w i l l be s u b j e c t t o c a p i t a l g a i n s t a x i n a subsequent arm's l e n g t h s a l e . T h i s t a x l i a b i l i t y would o f c o u r s e u l t i m a t e l y be borne by t h e n o n - r e s i d e n t h i m s e l f , and would a r i s e o n l y because he ceased t o own t h e s h a r e s d i r e c t l y . I t i s u n l i k e l y t h a t t h i s t r a d e o f f r e a s o n i n g would c u r r y f a v o u r w i t h t h e government o r the c o u r t s , e s p e c i a l l y s i n c e the s t r i p p i n g o f t h e s u b j e c t c o r p o r a t i o n ' s s u r p l u s would permanently reduce t h e g a i n on any s a l e o f t h e sh a r e s and mi g h t , i n d e e d , c o n t r i b u t e t o a l o s s (the p u r c h a s e r c o r p o r a t i o n ' s c o s t w i l l be t h e f a i r market v a l u e o f the s h a r e s b e f o r e the s t r i p ) . I f t h e p u r c h a s e r were, moreover, a mere s h e l l , t h e c a p i t a l g a i n s t a x on t h e s a l e o f t h e sh a r e s o f the o p e r a t i n g company c o u l d e a s i l y be a v o i d e d by s e l l i n g i n s t e a d the s h a r e s o f t h e h o l d i n g company owned by t h e n o n - r e s i d e n t . S e c t i o n 212.1 c o n t a i n s a t l e a s t two t r a p s f o r t h e unwary. As p r e v i o u s l y n o t e d , t h e p a i d up c a p i t a l r e d u c t i o n w i l l a p p l y t o t h e c l a s s ( e s ) o f t h e sh a r e s t a k e n back by the n o n - r e s i d e n t . P u r c h a s e r s a c q u i r i n g s h a r e s o f t h e r e l e v a n t c l a s s ( e s ) from the n o n - r e s i d e n t o r from o t h e r s h a r e h o l d e r s may f i n d t h a t t h e p a i d up c a p i t a l o f t h e i r newly a c q u i r e d s h a r e s i s l e s s than t h e y might o t h e r w i s e c o n c l u d e f o l l o w i n g an e x a m i n a t i o n o f t h e share c e r t i f i c a t e s and b a l a n c e s h e e t . F o r t h i s r e a s o n , the p u r c h a s e r would do w e l l t o e x a c t a w a r r a n t y c o n c e r n i n g the p a i d up c a p i t a l o f the s h a r e s . 66 A n o n - r e s i d e n t p u r c h a s e r o f the s h a r e s o f a Canadian company can i n p r i n c i p l e recoup t h e purch a s e p r i c e i n e i t h e r o f two ways. He may form a h o l d i n g s company t o make the a c q u i s i t i o n o r a c q u i r e t h e s h a r e s d i r e c t l y and s u b s e q u e n t l y r o l l them i n t o a h o l d i n g company. The enactment o f s e c t i o n 212.1 makes t h a t the second method i s t o be a v o i d e d , because t h e purchase p r i c e w i l l be t r e a t e d as a d i v i d e n d t o t h e e x t e n t t h a t i t exceeds t h e p a i d up c a p i t a l o f t h e s h a r e s . T h i s w i l l , o f c o u r s e , s u b j e c t i t t o w i t h h o l d i n g t a x . 67 FOOTNOTES 1. Under subparagraphs 115(1) (a) ( i i i ) and (b) . And see A r t . V I I I , Canada - U.S. C o n v e n t i o n . 2. N o r m a l l y reduced by t r e a t y t o 15%. 3. See d e f i n i t i o n o f 'person' i n s u b s e c t i o n 2 4 8 ( 1 ) . 4 . S e c t i o n 212.1 and s e c t i o n 84.1 share the same l e g i s l a t i v e h i s t o r y . O r i g i n a l l y , as r e s o l u t i o n s 93 and 39 r e s p e c t i v e l y o f B i l l C - l l , t h e non-arm's l e n g t h c r i t e r i o n was the nebulous ' a c t i n c o n c e r t 1 p r i n c i p l e . T h i s was d i s c a r d e d as too vague i n r e s o l u t i o n s 49 and 19 o f B i l l C-56 w h e r e i n t h e ' l e s s t h a n s i x ' t e s t i s adopted. The a t t r i b u t i o n r u l e s t h e r e i n were too broad however, r e f e r r i n g t o ' r e l a t e d p e r s o n s ' ( m o t h e r s - i n - l a w , s i b l i n g s , s o n s - i n - l a w , e t c . ) and were a c c o r d i n g l y e l i m i n a t e d by r e s o l u t i o n s 56 and 2 5 o f t h e expanded N o t i c e o f Ways and Means M o t i o n t a b l e d Dec. 19, 19 78 w h e r e i n t h e p r e s e n t r u l e s were p u t f o r w a r d . 5. S u b s e c t i o n 1 8 6 ( 4 ) . 6. B i l l C - l l , r e s . 93. 7. The for m a t f o r t h i s example i s c u l l e d from C r o n k w r i g h t , 'VS.urplus D i s t r i b u t i o n s and the 1977 Tax Changes," i n 1977 Confer e n c e R e p o r t , a t p. 3 01. 8. Subparagraph 8 4 ( 3 ) ( a ) 9. See Canada - U.S. Tax C o n v e n t i o n , A r t . V I I I . 68 IV. S u r p l u s S t r i p p i n g i n G r e a t B r i t a i n . I n comparing the d i v i d e n d s t r i p p i n g p r o v i s i o n s o f t h e B r i t i s h t a x law, found i n s e c t i o n s 460 e t . seq. o f the Income and C o r p o r a t i o n s Tax A c t , 1970,"'" w i t h t h o s e o f the Canadian A c t , b o t h d i f f e r e n c e s and s i m i l a r i t i e s a r e n o t i c e - a b l e . A b a s i c s i m i l a r i t y w i t h s u b s e c t i o n 247(1) i s found i n the f a c t t h a t p r e v i o u s l e g i s l a t i v e e f f o r t s had proven i n e f f e c t u a l a g a i n s t the t a x p a y e r ' s i n g e n u i t y w i t h the r e s u l t t h a t a b r o a d l y framed d i s c r e t i o n a r y power t o reassess o f f e n d - i n g t a x p a y e r s was c o n f e r r e d by the government upon the f i s c a l a u t h o r i t y . Both p r o v i s i o n s a r e aimed a g a i n s t the t a k i n g o f c o r p o r a t e s u r p l u s o t h e r w i s e a v a i l a b l e f o r d i s t r i - b u t i o n as d i v i d e n d s s u b j e c t t o t a x i n a form i n v o l v i n g no t a x l i a b i l i t y o r a l e s s onerous t a x burden than would be a s s o c i a t e d w i t h a d i v i d e n d . L e a v i n g t h e s e i m p o r t a n t b a s i c s i m i l a r i t i e s t o one s i d e , one d i s c o v e r s t h a t the d i f f e r e n c e s are perhaps more numerous. S e c t i o n 84.1, f o r example, i s meant t o a p p l y t o a v e r y s p e c i f i c f a c t u a l s i t u a t i o n and a c c o r d i n g l y c o n t a i n s m i n u t e l y a r t i c u l a t e d c o n d i t i o n s o f a p p l i c a b i l i t y ; the c o r r e s p o n d i n g p r o v i s i o n s o f the B r i t i s h t a x law a r e g e n e r a l and framed i n t h e w i d e s t terms so as t o c o v e r the b r o a d e s t spectrum o f a v o i d a n c e p r a c t i c e s . U n l i k e s u b s e c t i o n 247(1) of t h e Canadian A c t , s e c t i o n s 460 e t . seq. are e x h a u s t i v e and comprehensive. An i n t e r e s t i n g consequence o f the thoroughness w i t h which the B r i t i s h system has a ttempted t o b l o c k s u r p l u s s t r i p p i n g i s t h e f a c t t h a t t h e 69 a u t h o r i t y t o r e s t r u c t u r e t r a n s a c t i o n s and r e a s s e s t h e t a x - payer has been viewed by the c o u r t s as e n j o i n i n g t h e c o u n t e r - a c t i o n o f t a x advantages whenever c i r c u m s t a n c e s such as 2 a r e c o n t e m p l a t e d i n t h e law are uncovered by the f i s c . Thus, s e c t i o n s 460 e t . seq. have, u n l i k e s u b s e c t i o n 2 4 7 ( 1 ) , been l i t i g a t e d on a number o f o c c a s i o n s . W h i l e s u b s e c t i o n 247(1) extends t o t h e d i s a p p e a r a n c e or r e d u c t i o n o f c o r p o r a t e a s s e t s and t o t h e i r t a x f r e e r e c e i p t as exempt income o r as proceeds of d i s p o s i t i o n , c o n v e r s i o n , o r redemption o f a company's s h a r e s , t h e ambit of s u b s e c t i o n 247(1) i s n e c e s s a r i l y c i r c u m s c r i b e d by more p a r t i c u l a r a n t i - a v o i d a n c e p r o v i s i o n s r e l a t i n g e.g. t o . ' . . 3 . 4 c a p i t a l r e o r g a n i z a t i o n s , b e n e f i t s t o s h a r e h o l d e r s , and 5 the w i n d i n g up o f Canadian companies. S e c t i o n s 460 e t . s e q . , on the o t h e r hand, a r e t r u l y an a n t i - a v o i d a n c e code d e a l i n g w i t h a v o i d a n c e t h r o u g h c a p i t a l i z a t i o n o f r e s e r v e s f o l l o w e d by a l e g a l r e d u c t i o n o f c a p i t a l , t r a n s f e r s o f a s s e t s from one company t o a n o t h e r f o l l o w e d by the l i q u i d a t i o n o f t h e f i r s t company, the c l a i m i n g o f r e f u n d s o f t a x p a i d on d i v i d e n d s r e c e i v e d t h r o u g h th e a r t i f i c i a l c r e a t i o n o f l o s s e s ( a form of s t o p - l o s s p r o v i s i o n ) , s u r p l u s s t r i p p i n g t h r o u g h i n c e s t u o u s s hare s a l e s , and s h a r e h o l d e r b e n e f i t s , t o mention the most i m p o r t a n t a s p e c t s o n l y . The p e r s o n s u b j e c t t o r eassessment p u r s u a n t t o s u b s e c t i o n 247(1) i s he who d i s p o s e s o f the s h a r e s and r e c e i v e s t a x f r e e proceeds whereas i n B r i t a i n t h e r u l e s i n s e c t i o n s 460 and f o l l o w i n g e n v i s i o n the r eassessment f o r t a x 70 o f b o t h p a r t i e s t o a t r a n s a c t i o n . T h i s i s because a t a x advantage may be e n j o y e d by e i t h e r o r b o t h p a r t i e s t o a s h a r e - d e a l i n g o p e r a t i o n . Moreover, the s e c t i o n 4 60 f a c t s i t u a t i o n s c o n t e m p l a t e the improper r e d u c t i o n o f t a x a b l e income t h r o u g h s h a r e - d e a l i n g and t h e r e f o r e the s e c t i o n does not a p p l y e x c l u s i v e l y t o cases i n v o l v i n g t a x f r e e and t a x reduced r e c e i p t s . Perhaps th e s i n g l e most note w o r t h y d i s t i n c t i o n t o be drawn between the Canadian and B r i t i s h systems i s t h a t a l t h o u g h s u r p l u s s t r i p p i n g has v i r t u a l l y been e l i m i n a t e d i n b o t h c o u n t r i e s , t h i s development i s i n the former case a r e s u l t o f changes i n o t h e r a r e a s o f t h e t a x law and not a consequence o f t h e a n t i - a v o i d a n c e 7 l e g i s l a t i o n i t s e l f . S e c t i o n 460 w i l l a p p l y whenever a) any o f the c i r c u m s t a n c e s mentioned i n s e c t i o n 4 61 a r e p r e s e n t and b ) i n consequence of a t r a n s a c t i o n i n s e c u r i t i e s o r t h e combined e f f e c t o f two o r more such t r a n s a c t i o n s , a p e r s o n i s i n a p o s i t i o n t o o b t a i n , o r has o b t a i n e d , a t a x advantage, u n l e s s he shows t h a t the t r a n s a c t i o n o r t r a n s a c t i o n s were c a r r i e d o u t f o r bone f i d e commercial r e a s o n s o r i n the o r d i n a r y c o u r s e o f making o r managing i n v e s t m e n t s , and t h a t none o f them had as t h e i r main o b j e c t , o r one o f t h e i r main o b j e c t s , t o e n a ble t a x advantages t o be o b t a i n e d . The i m p o r t a n t e x p r e s s i o n s c o n t a i n e d i n t h e quoted p a r a - graph are d e f i n e d i n o t h e r s e c t i o n s o f Chapter I o f P a r t XVII (Tax Avoidance) o r have been j u d i c i a l l y c o n s i d e r e d . Thus, the e x p r e s s i o n ' t r a n s a c t i o n s i n s e c u r i t i e s ' i s d e f i n e d i n s u b s e c t i o n 467(1) as i n c l u d i n g " t r a n s a c t i o n s o f whatever d e s c r i p t i o n r e l a t i n g t o s e c u r i t i e s , and i n p a r t i c u l a r - 71 ( i ) t h e p u r c h a s e , s a l e , o r exchange of s e c u r i t i e s , ( i i ) t h e i s s u i n g o r s e c u r i n g the i s s u e o f , o r a p p l y i n g o r s u b s c r i b i n g f o r , new s e c u r i t i e s , ( i i i ) t h e a l t e r i n g , o r s e c u r i n g t h e a l t e r a t i o n o f , the r i g h t s a t t a c h e d t o 8 s e c u r i t i e s " . I n the i m p o r t a n t case o f IRC v P a r k e r , the argument was made t h a t t h e s p e c i f i c i t y o f t h i s p r o v i s i o n e x c l u d e d o t h e r share d e a l i n g t r a n s a c t i o n s , i n t h e p a r t i c u l a r case a r e d e m p t i o n o f s h a r e s . The House of L o r d s r e j e c t e d t h i s c o n t e n t i o n and f a v o u r e d the b r o a d e s t i n t e r p r e t a t i o n o f the e x p r e s s i o n based upon th e phrase " t r a n s a c t i o n s o f 9 whatever d e s c r i p t i o n r e l a t i n g t o s e c u r i t e s " . As i s e v i d e n t from t h e w o r d i n g o f t h e p r o v i s i o n , t r a n s a c t i o n s o t h e r w i s e w i t h i n t h e l e g i s l a t i o n a r e e x c e p t e d i f t h ey a r e u n d e r t a k e n f o r bone f i d e commercial r e a s o n s and do n o t have as one o f t h e i r main o b j e c t s the o b t a i n i n g o f t a x advantages. I t would appear t h a t i n c i d e n t a l t a x advantages e n j o y e d because a p r e d o m i n a t i n g b u s i n e s s or commercial purpose committed t h e t a x p a y e r t o a p a r t i c u l a r c o u r s e o f a c t i o n do not p r e v e n t h i s t r a n s a c t i o n from b e i n g c a r r i e d o u t f o r bone f i d e c o m m e r c i a l r e a s o n s . D e c i s i o n s t a k e n by the d i r e c t o r s o f companies t o implement schemes i n v o l v i n g t a x b e n e f i t s b u t i n i t i a t e d i n o r d e r t o ward o f f t a k e o v e r b i d s o r t o s e c u r e the c o n t r o l o f a company t o t h e f o u n d i n g f a m i l y members 1 1 have been j u d i c i a l l y i n t e r p r e t e d as r e f l e c t i n g t h e n e c e s s a r y b u s i n e s s purpose. I t s h o u l d be n o t e d however t h a t the presence o f an a c c e p t a b l e b u s i n e s s purpose i s not enough t o a v o i d the s e c t i o n i f one 72 o f t h e main purposes of t h e t r a n s a c t i o n i s c o n c e i v e d t o 12 be the o b t a i n i n g o f a t a x advantage. A n o t h e r exemption i s p r o v i d e d i n c ases where the t r a n s a c t i o n i s " i n t h e o r d i n a r y c o u r s e o f making o r managing i n v e s t m e n t s " . T h i s phrase would seem t o r e p r e s e n t l e g i s l a t i v e r e c o g n i t i o n o f c e r t a i n j u d i c i a l c o n c l u s i o n s a r r i v e d a t i n d i v i d e n d - s t r i p p i n g c a ses and w i l l be commented on when those d e c i s i o n s a r e c o n s i d e r e d . The s t a t u t o r y d e f i n i t i o n o f 'tax advantage' and the j u d i c i a l g l o s s on " a s s e t s a v a i l a b l e f o r d i s t r i b u t i o n " w i l l a l s o be d i s c u s s e d i n c o n n e c t i o n w i t h t h e s e t s o f c i r c u m s t a n c e s d e p l o y e d i n s e c t i o n 4 61. As n o t e d , s e c t i o n 4 60(1)(a) i n c o r p o r a t e s as c o n d i t i o n s o f a p p l i c a b i l i t y the p r e s ence of f a c t s i t u a t i o n s s e p a r a t e l y d e s c r i b e d i n s e c t i o n 461. S e c t i o n 461 i s a c c o r - d i n g l y broken down i n t o f i v e groups o f c i r c u m s t a n c e s . S e c t i o n 461A i s d i r e c t e d a g a i n s t ' d i v i d e n d - s t r i p p i n g 1 , as t h a t e x p r e s s i o n i s used i n B r i t a i n . I n t h a t j u r i s d i c t i o n , the income t a x c h a r g e a b l e t o t h e d i v i d e n d r e c i p i e n t i s deducted by the c o r p o r a t i o n a t a s t a n d a r d r a t e . A d j u s t m e n t s may f o l l o w a t t h e s h a r e h o l d e r l e v e l e.g. s u r t a x may be e x a c t e d from a h i g h b r a c k e t t a x p a y e r o r a t a x p a y e r d i s p o s i n g o f a l o s s c l a i m a v a i l a b l e f o r s e t - o f f a g a i n s t t a x p a i d by the company may have a l l o r a p o r t i o n o f t h e amount r e f u n d e d t o him. Thus, ' s t r i p p i n g ' g e n e r a l l y i n v o l v e s t h e r e c e i p t by the t a x p a y e r o f a r e f u n d by r e a s o n o f a l o s s c l a i m , sub- v e n t i o n payment, o r h i s t a x exempt s t a t u s , o f t a x n o t i o n a l l y deducted from th e d i v i d e n d r e c e i v e d . The t y p e s o f a r r a n g e - 73 merits subsumed under t h i s h e a d i n g a r e numerous and v a r i e d , some o f them r e s e m b l i n g t h e schemes f o r m e r l y employed by Canadian t a x p a y e r s . F o r example, sh a r e s o f a company p o s s e s s i n g a l a r g e c r e d i t b a l a n c e i n i t s p r o f i t and l o s s a c c o u n t and l i q u i d a s s e t s a v a i l a b l e f o r d i s t r i b u t i o n might be s o l d . The vendors would r e a l i z e a t a x f r e e c a p i t a l g a i n i n r e s p e c t o f the s u r p l u s on hand. The t a x exempt p u r c h a s e r would then cause the company t o pay him a l a r g e d i v i d e n d from w h i c h he would recoup most o f t h e purchase p r i c e . The s h a r e s would then be r e s o l d t o t h e o r i g i n a l owners a t a c o s t r e f l e c t i n g t h e i r d e p r e c i a t e d v a l u e . T h i s o p e r a t i o n would e f f e c t i v e l y p e r m i t t h e owners t o r e a l i z e t h e d i s t r i b u t a b l e s u r p l u s t a x f r e e , as n o t e d , and a premium on t h e r e p u r c h a s e might be p a i d t o p u r c h a s e r f o r h i s s e r v i c e s . T h i s type o f s t r i p b e a r s c l o s e comparison 12 w i t h the schemes wh i c h were employed i n t h e famous Smythe 13 and Craddock c a s e s i n Canada where as a r e s u l t o f a number of f a c t u a l non-arm's l e n g t h t r a n s a c t i o n s , t h e t a x - p a y e r s hoped t o r e a l i z e c o r p o r a t e s u r p l u s i n t h e form of c a p i t a l g a i n s , t o c o n t i n u e t h e i r ownership o f the c o r p o r a t e a s s e t s , and t o remunerate the p r o f e s s i o n a l ' s t r i p p e r s ' who p a r t i c i p a t e d i n t h e i r m a c h i n a t i o n s w i t h a premium a r i s i n g upon the r e a c q u i s i t i o n o f t h e i r i n t e r e s t s . The m a j o r i t y o f t h e d e c i d e d c ases on d i v i d e n d - s t r i p p i n g do n o t , however, conform t o t h e above p a t t e r n . I f t h e s h a r e s t o be r e s o l d t o t h e o r i g i n a l owners, o r , i n d e e d , t o a t h i r d p a r t y , were h e l d by a t r a d e r i n s e c u r i t i e s , he 74 would i n c u r a l o s s on the r e s a l e which might form t h e b a s i s o f a c l a i m f o r r e f u n d o f t a x deducted by the company 14 from the g r o s s d i v i d e n d . Thus, t a x on the d i v i d e n d would e f f e c t i v e l y be e l i m i n a t e d . T h i s was t h e f a c t p a t t e r n i n G r i f f i t h s v J . P . H a m i l t o n ^ , the f i r s t case o f t h i s type t o be c o n s i d e r e d i n t h e House o f L o r d s , where i t was h e l d t h a t the t a x p a y e r ' s a c t i v i t i e s were d e m o n s t r a b l y o f 16 a share d e a l i n g n a t u r e . Due t o t h e s t r o n g d i s s e n t i n g r e a s o n s o f L o r d s Denning and R e i d , however, the t a x p a y e r ' s l u c k began t o r u n o u t i n subsequent cases o f t h i s t y p e . The f a c t s , t o o , i t s h o u l d be acknowledged, were l e s s 17 f a v o u r a b l e t o the t a x p a y e r . I n some ca s e s t h e l o s s s h a r e s were t r a n s f e r r e d t o an a s s o c i a t e d company, o r were s o l d below f a i r market v a l u e even a f t e r the payment o f 18 d i v i d e n d s . I n o t h e r c a s e s the o r i g i n a l owners o f t h e sh a r e s m a i n t a i n e d an i n t e r e s t i n them i n the form o f a c o n t r a c t u a l r i g h t t o share i n the r e f u n d o f t a x upon r e s a l e o f the s h a r e s , o r the purchase p r i c e was t o be d e t e r - mined i n p a r t w i t h r e g a r d t o the r e f u n d o f t a x . I t s h o u l d be n o t e d t h a t i n o r d e r f o r s e c t i o n 461A t o a p p l y , the t r a n s a c t i o n must be " i n c o n n e c t i o n w i t h the d i s t r i b u t i o n o f p r o f i t s o f a company, o r i n c o n n e c t i o n w i t h the s a l e o r purchase o f s e c u r i t i e s b e i n g a s a l e o r purchase f o l l o w e d by the purchase o r s a l e o f the same o r o t h e r s e c u r i - t i e s " . I n a d d i t i o n i t i s n e c e s s a r y t h a t the s h a r e h o l d e r s h o u l d r e c e i v e "an abnormal amount by way o f d i v i d e n d " . By 'abnormal' i s meant the c i r c u m s t a n c e t h a t the d i v i d e n d 75 s h o u l d f a r exceed i n amount what might be r e g a r d e d as a normal r e t u r n on i n v e s t m e n t . 1 ^ S e c t i o n 461B a l s o i s p r e d i c a t e d on t h e b a s i c assumptions mentioned i n c o n n e c t i o n w i t h "A", t h a t i s , t h e d i s t r i b u t i o n o f c o r p o r a t e p r o f i t s on t h e s a l e o r p u r c h a s e o f s e c u r i t i e s . The d i f f e r e n c e i s t h a t s e c t i o n 461B o p e r a t e s t o deny the d i v i d e n d r e c i p i e n t "a d e d u c t i o n i n the c o m p u t a t i o n of p r o f i t s o r g a i n s by r e a s o n o f a f a l l i n t h e v a l u e o f s e c u r i t i e s r e s u l t i n g from t h e payment of a d i v i d e n d t h e r e o n " , and does n o t d e a l w i t h t h e repayment o f t a x deducted from the d i v i d e n d . Presumably the s e t - o f f by the s h a r e d e a l e r o f b u s i n e s s l o s s e s a g a i n s t b u s i n e s s income upon a d i s p o s i t i o n o f s h a r e s d e p r e c i a t e d i n v a l u e i s here i n t e n d e d , as w e l l as t h e s e t - o f f w h i c h a r i s e s when such s h a r e s a r e c a r r i e d on t h e books o f the company a t f a i r market v a l u e r a t h e r t h a n a t c o s t . S e c t i o n 461C d e a l s w i t h the r e c e i p t by t h e t a x p a y e r o f c o n s i d e r a t i o n f o r t h e s a l e o f h i s s h a r e s of p roceeds which do n o t bear t a x as income. The p u r c h a s e r must sub- s e q u e n t l y r e c e i v e an abnormal amount by way o f d i v i d e n d o r become e n t i t l e d t o a d e d u c t i o n from th e p r o f i t and g a i n s a c c o u n t upon w h i c h th e income t a x i s l e v i e d . I n a d d i t i o n , t h e c o n s i d e r a t i o n must e i t h e r be o r r e p r e s e n t t h e v a l u e o f a s s e t s a v a i l a b l e f o r d i s t r i b u t i o n , be r e c e i v e d i n r e s p e c t o f f u t u r e e a r n i n g s o f the company, o r be o r r e p r e s e n t t h e v a l u e of i t s t r a d i n g s t o c k ( i n v e n t o r y ) . I n t h i s c a s e , the ' person i n question 1' i s n o t the d i v i d e n d r e c i p i e n t b u t t h e 76 vendor of the s h a r e s . Thus, s e c t i o n 4 61C d e a l s w i t h t h e p o s s i b i l i t y , f i r s t e n c o u n t e r e d i n the H a r r i s o n c a s e , t h a t the p u r c h a s e r ' s a c t i v i t i e s , o t h e r w i s e w i t h i n s e c t i o n s 461 A o r B, are u n d e r t a k e n " i n the o r d i n a r y c o u r s e o f making o r managing i n v e s t m e n t s " . The c oncept o f ' a s s e t s a v a i l a b l e f o r d i s t r i b u t i o n ' w i l l be d i s c u s s e d i n c o n n e c t i o n w i t h 461D. S u f f i c e i t here t o say t h a t a l i m i t a t i o n upon 461C i s imposed by the f a c t t h a t ' a s s e t s a v a i l a b l e f o r d i s t r i b u t i o n ' does not i n c l u d e t h e p a i d i n c a p i t a l o f s h a r e s d i s p o s e d o f or o t h e r w i s e d e a l t w i t h . An example of c o n s i d e r a t i o n " r e c e i v e d i n r e s p e c t o f f u t u r e r e c e i p t s o f the company" would be a case i n w h i c h a t a x p a y e r , a n t i c i p a t i n g l a r g e p r o f i t s i n t h e near f u t u r e , had h i s company c r e a t e and i s s u e t o him a c l a s s o f s h a r e s c a r r y i n g r i g h t s t o v e r y h i g h d i v i d e n d s w h i c h he s u b s e q u e n t l y s o l d t o a t h i r d p a r t y , c o n v e r t i n g a t a x a b l e s u r p l u s d i s t r i b u t i o n i n t o a r e c e i p t not a s s e s s a b l e t o t a x as income. The c i r c u m s t a n c e s e n v i s i o n e d by s e c t i o n 4 61D have t o do w i t h t h e r e c e i p t by t h e owner (or former owner) of s h a r e s of consideration as i n 461C i . e . p r i m a r i l y o f a s s e t s 20 o t h e r w i s e a v a i l a b l e f o r d i s t r i b u t i o n as a d i v i d e n d . The c i r c u m s t a n c e s c o n t e m p l a t e d i n s e c t i o n 4 61D have t o do w i t h the ' d i s t r i b u t i o n o f p r o f i t s ' o f a company and t h e argument might t h e r e f o r e be made t h a t a p u r c h a s e and s a l e , i n w h i c h the p u r c h a s e r c o r p o r a t i o n r e c e i v e s an a s s e t i n r e t u r n f o r d i s b u r s e m e n t o f t h e p u r c h a s e p r i c e , cannot be r e g a r d e d as 21 a ' d i s t r i b u t i o n ' . The p o i n t i s o f i n t e r e s t because s e c t i o n 77 4 61D has been i n v o k e d i n s i t u a t i o n s i n v o l v i n g t h e i n c e s t u o u s s a l e o f s h a r e s p r e c e d i n g the t a x f r e e (or t a x reduced) e x t r a c t i o n o f s u r p l u s i n t h e form o f t h e purch a s e p r i c e . I n 22 IRC v C l e a r y , the t a x p a y e r s o l d s h a r e s o f her w h o l l y owned company t o another w h o l l y owned company, t a k i n g t h e s u r p l u s o f the l a t t e r company as a t a x - f r e e c a p i t a l g a i n . I n r e sponse t o the t a x p a y e r ' s c l a i m t h a t t h e r e was no r e d u c t i o n i n the a s s e t s o f the company a v a i l a b l e f o r d i s t r i - b u t i o n , and t h a t t h e r e f o r e t h e r e was no ' d i s t r i b u t i o n ' , V i s c o u n t D i l h o r n e drew a t t e n t i o n t o the p a r t i c u l a r words employed t o d e f i n e t h e s e e x p r e s s i o n s . As ' d i s t r i b u t i o n ' i n c l u d e d a " t r a n s f e r o r r e a l i z a t i o n ( i n c l u d i n g a p p l i c a t i o n 23 i n d i s c h a r g e o f l i a b i l i t i e s ) " and as ' p r o f i t s ' meant 24 " r e f e r e n c e s t o income, r e s e r v e s , o r o t h e r a s s e t s " , h i s L o r d s h i p had l i t t l e d i f f i c u l t y i n f i n d i n g t h a t the t r a n s f e r o f c o r p o r a t e a s s e t s i n s a t i s f a c t i o n o f a c o n t r a c t u a l l i a b i l i t y t o make payment c o n s t i t u t e d a ' d i s t r i b u t i o n o f p r o f i t s 1. An o t h e r i m p o r t a n t i s s u e i n t h e case had t o do w i t h whether o r not the t a x p a y e r had s e c u r e d a 'tax ad v a n t a g e 1 by 25 w i t h d r a w i n g the s u r p l u s i n t h e form o f a c a p i t a l r e c e i p t . "Tax advantage" i s d e f i n e d i n s u b s e c t i o n 466(1) as "a r e l i e f o r i n c r e a s e d r e l i e f from, o r repayment o r i n c r e a s e d repayment o f , t a x , o r the a v o i d a n c e o r r e d u c t i o n of a charge t o t a x o r an assessment t o t a x o r the avo i d a n c e o f a p o s s i b l e assessment t h e r e t o , whether the avo i d a n c e o r r e d u c t i o n i s e f f e c t e d by r e c e i p t s a c c r u i n g i n such a way t h a t the r e c i p i e n t 78 does n o t pay o r bear t a x on them, o r by a d e d u c t i o n i n computing p r o f i t s and g a i n s . " P e n n y c u i c k J . a t t r i a l s a i d t h a t i n d e c i d i n g whether 'avoidance o r r e d u c t i o n (has been) e f f e c t e d by r e c e i p t s a c c r u i n g i n such a way t h a t t h e r e c i p i e n t does n o t pay o r b ear t a x on them': i t i s n e c e s s a r y t o compare l i k e w i t h l i k e , t h a t i s t o say, one must l o o k a t t h e a c t u a l t r a n s a c t i o n w h i c h c o m p r i s e s the r e c e i p t and see whether, upon a n o t h e r form o f t r a n s - a c t i o n p r o d u c i n g the same r e s u l t , t h e r e c e i p t would have been t a x a b l e . One cannot f o r t h i s purpose l o o k a t t h e a c t u a l t r a n s a c t i o n by way o f s a l e under w h i c h , a l t h o u g h c o n t a i n i n g a common element, produces a d i f f e r e n t r e s u l t . So, i t seems t o me, one cannot l o o k ' t o t h e a c t u a l t r a n s - a c t i o n by way o f s a l e , under w h i c h a member o f a company t r a n s f e r s p r o p e r t y t o the company e q u i v a l e n t t o the amount p a i d by t h e company t o t h e member, and compare t h a t t r a n s a c t i o n w i t h a s i m p l e r e c e i p t by t h e member from th e company w i t h o u t c o n s i d e r a t i o n . 26 Thus, P e n n y c u i c k J . was o f t h e o p i n i o n t h a t o n l y i f proceeds o f disposition, ( r a t h e r than a d i v i d e n d ) might have been r e c e i v e d a t g r e a t e r t a x c o s t s h o u l d one t a x r e s u l t be s u b s t i t u t e d f o r a n o t h e r . F o l l o w i n g P e n n y c u i c k J.'s judgement, but b e f o r e the C l e a r y a p p e a l was h e a r d i n t h e House o f L o r d s , t h e same i s s u e was c o n s i d e r e d by t h e C o u r t i n P a r k e r where L o r d W i l b e r f o r c e c o n c l u d e d t h a t the d e f i n i t i o n t u r n e d s i m p l y upon the d i f f e r e n c e between t a k i n g a r e c e i p t i n a n o n - t a x a b l e way i n p r e f e r e n c e t o a p o s s i b l e t a x a b l e 27 way. I n the C l e a r y a p p e a l , t h e r e f o r e , V i s c o u n t D i l h o r n e 7 9 m e r e l y r e i t e r a t e d the p o s i t i o n p r e v i o u s l y t a k e n by L o r d 2 8 W i l b e r f o r c e , r e v e r s i n g P e n n y c u i c k J . As we have seen, i n o r d e r f o r 4 61D t o a p p l y , t h e "person i n q u e s t i o n ' must r e c e i v e c o n s i d e r a t i o n as i n 461C, c o m p r i s i n g " a s s e t s a v a i l a b l e f o r d i s t r i b u t i o n by 29 way o f d i v i d e n d " . I n IRC v Brown the t a x p a y e r s o l d t h e s h a r e s o f f i v e companies owned by h i m s e l f t o a n o t h e r company owned by him i n r e t u r n f o r 3'0> OOOjf i n d e b e n t u r e s , 25:, O O o d l i n c a s h , 1 0 0 , 0 0 0 ^ o n l o a n . Because the p u r c h a s e r c o r p o r a t i o n was u n p r o f i t a b l e , i t borrowed the 2 5 , 0 0 0 0 J £ c a s h c o n s i d e r a t i o n from th e bank. When t h e t a x p a y e r was r e a s s e s s e d under s e c t i o n 460 and 461D, t h e d e f e n c e was r a i s e d t h a t t h e 25^000 J£ d i d n o t r e p r e s e n t " a s s e t s a v a i l a b l e f o r d i s t r i b u t i o n by way o f d i v i d e n d " because i t was n o t c o n s i s t e n t w i t h sound commercial p r a c t i c e f o r t h e d i r e c t o r s o f a company t o pay d i v i d e n d s w i t h borrowed money. However, a l t h o u g h t h e company was u n p r o f i t a b l e i . e . i t s c u r r e n t l i a b i l i t i e s exceeded i t s c u r r e n t a s s e t s , i t m a i n t a i n e d a h e a l t h y b a l a n c e i n i t s p r o f i t and l o s s a c c o u n t so t h a t payment of a d i v i d e n d would n o t have been c o n t r a r y t o law. Megarry J . , r e f u s i n g t o a p p l y a s t a n d a r d o f prudence o r r e a s o n a b l e n e s s , a c c e p t e d the revenue's c o n t e n t i o n t h a t amounts l e g a l l y a v a i l a b l e f o r d i s t r i b u t i o n a r e w i t h i n t h e 30 s e c t i o n . I t must be remembered t h a t s e c t i o n 461D a p p l i e s o n l y i n the case of companies under th e c o n t r o l o f not more th a n f i v e p e r s o n s and t o c o r p o r a t i o n s n o t l i s t e d on a p r e s c r i b e d s t o c k exchange ( c l o s e c o r p o r a t i o n s ) . 80 Thus, i t would seem t h a t the s t r i p p i n g o f s u r p l u s t h r o u g h the i n c e s t u o u s s a l e o f s h a r e s o f an o p e r a t i n g company t o a h o l d i n g company i s e f f e c t i v e l y b a r r e d by t h e above d i s c u s s e d p r o v i s i o n s o f the B r i t i s h t a x law. As i f s e n s i b l e t o the arguments o f t h e t a x p a y e r i n t h e C l e a r y case t o t h e e f f e c t t h a t a s a l e d i d not i n v o l v e a ' d i s t r i b u t i o n o f p r o f i t s ' , p a r a g r a p h 461E was e n a c t e d t o p r o v i d e , i n more e x p l i c i t t e rms, t h a t a t r a n s f e r , d i r e c t l y o r i n d i r e c t l y , o f a s s e t s o f a c l o s e company t o a n o t h e r c l o s e company, o r a t r a n s a c t i o n i n s e c u r i t i e s i n w h i c h two o r more c l o s e companies a r e i n v o l v e d , i s a c i r c u m s t a n c e upon w h i c h a s e c t i o n 460 assessment may be made. Any p o s s i b i l i t y o f s t r i p p i n g on t h e Canadian model i s t h e r e f o r e p r e c l u d e d by the comprehensiveness o f the B r i t i s h t a x a v o i d a n c e l e g i s - l a t i o n . By way o f c o n c l u s i o n , i t i s n e c e s s a r y t o p o i n t o u t t h a t p u r s u a n t t o s u b s e c t i o n 460 (3.) " t h e t a x advantages o b t a i n e d o r o b t a i n a b l e by (the t a x p a y e r ) i n consequence (of any t r a n s a c t i o n o r t r a n s a c t i o n s ) s h a l l be c o u n t e r a c t e d by such o f the f o l l o w i n g a d j u s t m e n t s , t h a t i s t o say an a s s e s s - ment, the n u l l i f y i n g o f a r i g h t t o repayment, o r t h e r e q u i r i n g o f the r e t u r n o f a repayment a l r e a d y made...or t h e c o m p u t a t i o n o r r e c o m p u t a t i o n o f p r o f i t s o r g a i n s , o r l i a b i l i t y t o t a x On such b a s i s as the Board may s p e c i f y . " The 'Board" r e f e r r e d t o i s a s p e c i a l t r i b u n a l o f t h e Chairman o f t h e Board o f R e f e r e e s and two o r more o t h e r p e r s o n s a p p o i n t e d by t h e L o r d C h a n c e l l o r . 81 FOOTNOTES 1. As amended by the F i n a n c e A c t 1973 (c.51) s c h . 11, p a r a . l , o r i g i n a l l y FA 1960, s. 28. 2. IRC v P a r k e r . (1966) AC 141; IRC v C l e a r y , (1968) AC 766. 3. ITA s. 84. 4 . ITA s. 15 5. ITA s. 88 (2) (b) ( i i i ) . 6. They do n o t , however., c o v e r the f u l l gamut o f a v o i d a n c e p r a c t i c e s p r o h i b i t e d under t h e law. Bondwashing and t r a n s f e r s o f income and o f a s s e t s abroad are d e a l t w i t h i n o t h e r c h a p t e r s o f P a r t X V I I I . 7. Namely, the i n c r e a s e i n 19 7 7 o f t h e d i v i d e n d t a x c r e d i t w h ich l a r g e l y n e g a t i v e t h e b e n e f i t s o f r e a l i z i n g upon an i n v e s t m e n t w i t h a c a p i t a l r e c e i p t r a t h e r than w i t h a d i v i d e n d . 8. Supra, f o o t n o t e 2, a t p.2. 9. I b i d . , p e r L o r d Guest, a t pp. 172-173. 10. IRC v B r e b n e r , (1967) 2 AC 18. 11. H a s l o c h v IRC (1971) 47 T.C. 50. 12. (1967) CTC 498, a f f ' d . (1969)CTC 558. 13. (1968) CTC 379, a f f ' d . (1969) CTC 566. 82 14. Income Tax A c t , 1952, s.341. 15. (1962) 1 A l l E.R. 909. 16. T h i s was so i n s p i t e o f the f a c t t h a t t h e t a x p a y e r ' s o b j e c t s had been expanded i n o r d e r f o r i t t o c a r r y on a s hare t r a d i n g b u s i n e s s , a t a r g e t company 'pregnant w i t h d i v i d e n d ' had been l o c a t e d , the money t o purchase th e t a r g e t ' s s h a r e s was borrowed, i t was the o n l y t r a n s a c t i o n o f i t s k i n d u n d e r t a k e n i n t h e y e a r , and i t was made w i t h the i n t e n t i o n o f o b t a i n i n g a r e f u n d o f t a x and n o t f o r t h e o r d i n a r y t r a d i n g purpose o f e a r n i n g commercial p r o f i t s . 17. P e t r o t i m S e c u r i t i e s L i m i t e d v A y r e s (1964) 1 A l l E.R. 269; Ridge S e c u r i t i e s L i m i t e d v IRC (1964) 1 A l l ER 276 18. I n l a n d Revenue Commissioners v FS S e c u r i t i e s L t d . , (1964) 2 A l l ER 691; FA and AB Lupton (1971) 3 A l l ER 948 (HL); B i s h o p v F i n s b u r y S e c u r i t i e s L t d . , (1966) 3 A l l ER 105. 19. ICTA, 1970, s. 4 6 7 ( 3 ) . 20 . I t s h o u l d be n o t e d i n t h i s c o n n e c t i o n t h a t ' c o n s i d e r a t i o n ' i s d e f i n e d as i n c l u d i n g "the r e c e i p t o f any money o r money's worth": 476 (2) (c) . 21. Cases such as Hague v IRC, (1968) 44TC 619; IRC v H o r r o c k s , (1968) 44TC 645, and n o t a b l y IRC v P a r k e r , s u p r a , f o o t n o t e 2, a t p.2, i n v o l v i n g t h e l e g a l r e d u c t i o n o f c a p i t a l f o l l o w i n g t h e c a p i t a l i z a t i o n o f s u r p l u s o t h e r w i s e a v a i l a b l e f o r d i s - t r i b u t i o n as a d i v i d e n d are i n d i s p u t a b l y w i t h i n t h e p r o v i s i o n . 22 . (1968) AC 766. 23. ICTA (1970) s. 467 (2) (c) . 24. ICTA (1970) s. 467 (2) (b) . 25. ICTA (1970) s. 4 6 0 ( 1 ) . 83 26. (1965) Ch. 1098, a t pp. 1110-1111. 27. Supra, f o o t n o t e 2, a t p. 17 8. 28. Supra, f o o t n o t e 22, a t p. 7 82. 29. (1971) 47 TC 217. 30. I b i d . , a t p. 235. 84 V. S u r p l u s S t r i p p i n g i n t h e U n i t e d S t a t e s As we have seen, i n Canada t h e i n c r e a s e i n t h e d i v i d e n d t a x c r e d i t t o 50% i n 1977 r e s u l t e d i n the government's i n d i f f e r e n c e t o t h e manner i n w h i c h t a x p a y e r s d e c i d e d t o r e a l i z e the d i s t r i b u t a b l e s u r p l u s o f c o r p o r a t i o n s . The d i s c r e p a n c y between c a p i t a l g a i n s and d i v i d e n d t r e a t m e n t o f c o r p o r a t e e a r n i n g s thus came o f f i c i a l l y t o be r e g a r d e d as u n i m p o r t a n t . I n t h e U n i t e d S t a t e s , a p r o g r e s s i v e r a t e s c h e d u l e t a x e s income r e c e i v e d by i n d i v i d u a l s a t a maximum r a t e o f 70%, whereas l o n g - t e r m c a p i t a l g a i n s a r e t a x a b l e o n l y a t a r a t e o f 28%, b e i n g 40% o f t h e r a t e a p p l i c a b l e t o income r e c e i p t s o f t h e h i g h e s t b r a c k e t t a x p a y e r . As might be a n t i c i p a t e d , t h i s d i s c r e p a n c y i n t a x burdens has o c c a s i o n e d a number of schemes aimed a t t r a n s f o r m i n g the c o r p o r a t e s u r p l u s a v a i l a b l e f o r d i s t r i b u t i o n as a d i v i d e n d i n t o c a p i t a l g a i n s . These m o s t l y t u r n on t h e use o f the US 2 3 p r o v i s i o n s g o v e r n i n g l i q u i d a t i o n s , p r e f e r r e d s t o c k b a i l o u t s , 4 s o - c a l l e d ' c o l l a p s i b l e c o r p o r a t i o n s ' , and what i s of s p e c i a l i n t e r e s t i n the c o n t e x t o f t h e p r e s e n t s t u d y , ' i n c e s t u o u s ' 5 share s a l e s i n v o l v i n g a f f i l i a t e d c o r p o r a t i o n s . The w r i t e r proposes t o d e a l w i t h the l a s t o f the n o t e d a v o i d a n c e p r a c t i c e s , and t o d i s c u s s a l s o .the^countermeasures^adopted by the f i s c a l a u t h o r i t y i n response t o t h i s p l a n n i n g d e v i c e . I n c e s t u o u s Share S a l e s t o A f f i l i a t e d C o r p o r a t i o n s The a v o i d a n c e d e v i c e aimed a t p r o c u r i n g the r e c e i p t 85 o f c o r p o r a t e s u r p l u s a t c a p i t a l g a i n s r a t e s w h i c h b e a r s c l o s e s t resemblance w i t h t h e t y p e s of d i v i d e n d s t r i p p i n g schemes f o r m e r l y p o p u l a r amongst Canadian t a x p a y e r s i n v o l v e s the s a l e o f s h a r e s o f one c o r p o r a t i o n t o i t s a f f i l i a t e by the c o n t r o l l i n g s h a r e h o l d e r . Schemes o f t h i s n a t u r e a r e r e f l e c t e d i n two b a s i c f a c t s i t u a t i o n s . Shares of a p a r e n t c o r p o r a t i o n might be bought by i t s s u b s i d i a r y and s h a r e s i n a " b r o t h e r - s i s t e r " c o n t r o l l e d group might be a c q u i r e d by c o r p o r a t i o n s i n t h e group. Where s h a r e s i n a p a r e n t c o r p o r a t i o n a r e a c q u i r e d by a s u b s i d i a r y , o r s h a r e s i n a company a r e a c q u i r e d by a r e l a t e d company, the n e t economic e f f e c t o f t h e t r a n s a c t i o n i s s i m i l a r t o a r e d e m p t i o n o f s h a r e s . The f a c t t h a t a n other c o r p o r a t i o n owns the s h a r e s t r a n s f e r r e d by t h e t a x p a y e r i s g e n e r a l l y o f no economic consequence. A c c o r d i n g l y , the problem of s u r p l u s s t r i p p i n g t h r o u g h i n c e s t u o u s s h a r e s a l e s has i n t h e U n i t e d S t a t e s been a s s i m i l a t e d t o the law r e l a t i n g t o r edemptions and p a r t i a l l i q u i d a t i o n s , w hich i n t u r n p r o v i d e s r u l e s f o r d e t e r m i n i n g the t a x consequences i . e . c a p i t a l g a i n s o r d i v i d e n d t r e a t m e n t , o f v a r i o u s buy-back t r a n s a c t i o n s . T h i s c h a r a c t e r i z a t i o n o f the i n c e s t u o u s s hare s a l e i s s e t out i n s e c t i o n 304. S e c t i o n 304 p r o v i d e s , f i r s t l y , t h a t i n the case o f s h a r e s a c q u i r e d by a r e l a t e d c o r p o r a t i o n from t h e c o n t r o l l i n g s h a r e h o l d e r s , the s a l e proceeds a r e t o be t r e a t e d as a d i s - t r i b u t i o n i n redemption o f t h e s t o c k o f the a c q u i r i n g c o r - o r a t i o n , and the s h a r e s a r e r e c e i v e d by i t as a c o n t r i b u t i o n t o c a p i t a l . However, i n a p p l y i n g the r u l e s c o n t a i n e d i n Code 86 s e c t i o n 302 a p p l i c a b l e t o redemptions and t h e i r t a x consequences, the r e l e v a n t d e t e r m i n a t i o n s a r e made w i t h r e s p e c t t o the s h a r e s t r a n s f e r r e d t o the p u r c h a s e r c o r p o r a t i o n . I n the e vent t h a t a p p l i c a t i o n o f t h e s e c t i o n 302 r u l e s r e s u l t s i n a d i s t r i b u t i o n r a t h e r t h a n i n a s a l e o r exchange, the amount o f the d i v i d e n d i s d e t e r m i n e d w i t h r e g a r d t o the p o s t 1913 s u r p l u s o f the a c q u i r i n g c o r p o r a t i o n . I n a case where s h a r e s o f a p a r e n t c o r p o r a t i o n a r e a c q u i r e d by a s u b s i d i a r y , t h e r e d emption i s t r e a t e d as 7 b e i n g o f the s h a r e s o f the i s s u i n g , p a r e n t c o r p o r a t i o n . The t r a n s a c t i o n i s e s s e n t i a l l y r e g a r d e d as a d i s t r i b u t i o n o f t h e proceeds t o the p a r e n t , f o l l o w e d by a d i s t r i b u t i o n g t o the vendor by t h e p a r e n t i n exchange f o r i t s own s h a r e s . T h i s o f c o u r s e means t h a t t h e s e c t i o n 302 p r i n c i p l e s a r e a p p l i e d i n r e s p e c t o f the s h a r e s o f the i s s u i n g p a r e n t , b u t a l s o i m p o r t s the consequence t h a t the proceeds a r e added t o the p o s t 1913 e a r n i n g s and p r o f i t s a ccount o f the p a r e n t c o r p o r a t i o n , i n c r e a s i n g the amount t h a t w i l l be t r e a t e d as s u r p l u s a v a i l a b l e f o r d i s t r i b u t i o n o f a d i v i d e n d ( s h o u l d a d i v i d e n d be found) and making i t u n l i k e l y t h a t any sums w i l l be r e c e i v e d f r e e o f t a x i n r e d u c t i o n o f b a s i s o r as a c a p i t a l g a i n where the b a s i s i s e l i m i n a t e d e n t i r e l y . Indeed, the p r o b a b l e r e s u l t i n any case i n which market v a l u e i s p a i d f o r the s h a r e s i s a l o s s o f b a s i s p r o t e c t i o n t o t h e t r a n s f e r o r . 87 I n e i t h e r o f the above d i s c u s s e d h y p o t h e t i c a l r e d e mption s i t u a t i o n s , i t i s n e c e s s a r y t h a t t h e t r a n s f e r o r ( s ) c o n t r o l each of the two c o r p o r a t i o n s . C o n t r o l i s d e f i n e d f o r t h i s purpose as "ownership o f s t o c k p o s s e s s i n g a t l e a s t 50% o f t h e t o t a l combined v o t i n g power o f a l l c l a s s e s o f s t o c k e n t i t l e d t o v o t e , o r a t l e a s t 50% o f t h e t o t a l 9 v a l u e o f s h a r e s o f a l l c l a s s e s o f s t o c k " . C o n t r o l e x e r c i s e d i n d i r e c t l y t h r o u g h a c o r p o r a t i o n i s i n c l u d e d w i t h i n t h e d e f i n i t i o n . The a t t r i b u t i o n r u l e s c o n t a i n e d i n IRC s e c t i o n 318(a) a r e a l s o i n c o r p o r a t e d by r e f e r e n c e i n t o s e c t i o n 304. S i n c e s e c t i o n 304 t r e a t s i n c e s t u o u s s hare s a l e s as tantamount t o s t o c k r e d e m p t i o n s , a l b e i t h y p o t h e t i c a l r e d e m p t i o n s , i t i s n e c e s s a r y t o c o n s u l t s e c t i o n 302 i n d e t e r m i n i n g the t a x consequences of t h e r e d e m p t i o n . Redemptions can t a k e v a r i o u s forms and t h e i r n e t economic e f f e c t t o t h e s h a r e h o l d e r v a r y w i t h the c i r c u m s t a n c e s . The redemption o f s t o c k i n a one man c o r p o r a t i o n i s r e a l l y c l o s e l y analogous t o a d i v i d e n d payment because the s h a r e h o l d e r ' s economic i n t e r e s t and c o n t r o l o v e r the c o r p o r a t i o n and i t s a s s e t s remain u n d i s t u r b e d . F o r the same r e a s o n s , a p r o - r a t a r e - demption o f w i d e l y h e l d s t o c k i s a l s o e q u i v a l e n t t o a d i v i d e n d payment. A t t h e o t h e r extreme, a r e d e m p t i o n w h i c h t o t a l l y e l i m i n a t e s a s h a r e h o l d e r ' s o w n e r s h i p , a c t u a l and c o n s t r u c t i v e , i n a c o r p o r a t i o n i s comparable t o a s a l e o f t h e s t o c k t o a t h i r d p a r t y p u r c h a s e r - S e c t i o n 302 s e t s o u t the c r i t e r i a w hich c h a r a c t e r i z e the p a r t i c u l a r r e d e mption as b e l o n g i n g t o one o r the o t h e r o f t h e s e two c a t e g o r i e s . T h i s 88 o p e r a t i o n w i l l i n t u r n d e t e r m i n e whether the s h a r e h o l d e r ' s r e c e i p t s w i l l a t t r a c t c a p i t a l g a i n s o r d i v i d e n d t r e a t m e n t . S e c t i o n 302 must be r e a d a g a i n s t t h e backdrop o f s e c t i o n 301, whi c h p r o v i d e s t h a t "except as o t h e r w i s e p r o v i d e d i n t h i s c h a p t e r , a d i s t r i b u t i o n o f p r o p e r t y . . . made by a c o r p o r a t i o n t o a s h a r e h o l d e r made w i t h r e s p e c t i i t o i t s s t o c k s h a l l be t r e a t e d (as a d i v i d e n d d i s t r i b u t i o n ) . The e x c e p t i o n s t o t h i s r u l e a r e c o n t a i n e d i n s u b s e c t i o n 3 0 2 ( 1 ) , ( 2 ) , ( 3 ) , and(4) and p r o v i d e f o r s a l e o r exchange i . e . c a p i t a l g a i n s t r e a t m e n t whenever the redemption i s not s u b s t a n t i a l l y d i s p r o p o r t i o n a t e , the redemption i s i n complete t e r m i n a t i o n o f the s h a r e h o l d e r ' s i n t e r e s t , o r t h e redemption i s t h a t o f s t o c k o f c e r t a i n r a i l w a y companies p u r s u a n t t o r e o r g a n i z a t i o n s o f c a p i t a l . Redemptions "not e s s e n t i a l l y e q u i v a l e n t t o a d i v i d e n d " might a t f i r s t g l a n c e seem t o be the b r o a d e s t o f the e x c e p t i o n s . However, the s p e c i f i c i t y o f t h e o t h e r c r i t e r i a have tended t o c o n f i n e i t s o p e r a t i o n w i t h i n a v e r y narrow compass. A c c o r d i n g l y , i n U n i t e d S t a t e s v 12 D a v i s the Supreme C o u r t h e l d t h a t the t e s t was whether t h e r e had been a s i g n i f i c a n t change i n t h e r e l a t i v e economic i n t e r e s t o f t h e s h a r e h o l d e r i n t h e company. The pr e s e n c e o r absence o f a t a x s a v i n g m o t i v e o r b u s i n e s s purpose i s , i t would appear, i m m a t e r i a l . T h i s p o s i t i o n i s a l s o r e f l e c t e d i n t h e r e g u l a t i o n s , where i t i s s a i d t h a t a p r o - r a t a r e d emption w i l l be t r e a t e d as a d i v i d e n d where 13 t h e c o r p o r a t i o n has b u t one c l a s s o f s h a r e s o u t s t a n d i n g . 89 Presumably, a p r o - r a t a , redemption i n cases where t h e c o r - p o r a t i o n had s e v e r a l c l a s s e s o f s h a r e s might q u a l i f y as not " e s s e n t i a l l y e q u i v a l e n t t o a d i v i d e n d " i n s o f a r as the r i g h t s t o p a r t i c i p a t e i n p r e s e n t o r f u t u r e p r o f i t s , t o share i n the a s s e t s upon a l i q u i d a t i o n o f the company, o r t o e x e r c i s e v o t i n g c o n t r o l o f the c l a s s o f s h a r e s redeemed might be a l t e r e d r e l a t i v e t o the r i g h t s i n h e r i n g i n s h a r e s o f o t h e r c l a s s e s . S u b s e c t i o n 302(b)(2) p r o v i d e s f o r t h e case o f redemptions which a r e " s u b s t a n t i a l l y d i s p r o p o r t i o n a t e " . I n o r d e r f o r a redemption t o q u a l i f y under t h i s p r o v i s i o n t h r e e c o n d i t i o n s must be s a t i s f i e d . The s h a r e h o l d e r must, i m m e d i a t e l y a f t e r t h e r e d e m p t i o n , own l e s s t h a n 50% o f the t o t a l combined v o t i n g power o f a l l c l a s s e s o f s h a r e s . The redemption must a l s o r e s u l t i n a t l e a s t a 20% r e d u c t i o n i n the s h a r e h o l d e r ' s p r e - r e d e m p t i o n s t o c k o wnership. A s i m i l a r r e q u i r e m e n t i s t h a t t h e redemption must e l i m i n a t e a t l e a s t 20% o f the s h a r e h o l d e r ' s p e r c e n t a g e o f ownership o f common s t o c k , b o t h v o t i n g and n o n - v o t i n g . The a t t r i b u t i o n r u l e s i n s e c t i o n 318 w i l l apply>i however, i n c i r c u m s t a n c e s where s h a r e s a r e h e l d b e n e f i c i a l l y f o r t h e t a x p a y e r by an e n t i t y o r where t h e r e i s s h a r e o w n ership by f a m i l y members. The l a s t e x c e p t i o n o f p r a c t i c a l i m p o r t a n c e i s f o r redemptions i n t e r m i n a t i o n o f the s h a r e h o l d e r ' s i n t e r e s t . I t s h o u l d be n o t e d t h a t the a t t r i b u t i o n r u l e s o f s e c t i o n 318 a p p l y t o such redemptions so t h a t ' s a l e or.exchange' 90 t r e a t m e n t i s . v i r t u a l l y p r e c l u d e d f o r c l o s e , f a m i l y c o r p o r a t i o n s . However, c o n s t r u c t i v e ownership r u l e s can be waived i f t h e s h a r e h o l d e r d i v e s t s h i m s e l f o f any i n t e r e s t i n t h e company ( i n c l u d i n g employment as a d i r e c t o r , o f f i c e r , o r employee), r e f r a i n s from a c q u i r i n g such an i n t e r e s t i n the t e n y e a r s f o l l o w i n g the r e d e m p t i o n , and he d i d n o t a c q u i r e , i n t h e t e n y e a r s p r e c e d i n g the re d e m p t i o n , s t o c k from any p e r s o n whose ownership would be a t t r i b u t e d t o him by v i r t u e o f s e c t i o n 318. .91 FOOTNOTES 1. G a i n s r e s u l t i n g from the d i s p o s i t i o n o f c a p i t a l p r o p e r t y h e l d f o r a p e r i o d o f more than one y e a r : IRC s.1201. 2. IRC s s . 331-337. I n t h i s case a company i s l i q u i d a t e d , s e c u r i n g t o the s h a r e h o l d e r c a p i t a l g a i n s t r e a t m e n t o f t h e s u r p l u s a v a i l a b l e f o r d i s t r i b u t i o n as a d i v i d e n d , and t h e c o r p o r a t e a s s e t s a r e t h a n r o l l e d i n t o a new c o r p o r a t i o n a t the 'bumped' c o s t base ( e q u a l t o t h e i r f a i r market v a l u e ) . No s p e c i a l s t a t u t o r y p r o v i s i o n i s d i r e c t e d a t t h i s p a r t i c u l a r problem. One o f t h e two major p l a n s o f a t t a c k i s u s u a l l y employed, one h a v i n g t o do w i t h t h e c h a r a c t e r i z a t i o n o f the t r a n s a c t i o n as b e i n g e q u i v a l e n t i n n e t economic e f f e c t w i t h the payment o f a d i v i d e n d t o s h a r e h o l d e r s , and t h e o t h e r s t r e s s i n g t h e c l o s e a n a l o g y o f t h e s t e p s t a k e n w i t h a s t a t u t o r y r e o r g a n i z a t i o n i n v o l v i n g the r e c e i p t by the s h a r e h o l d e r o f 'boot' t a x a b l e as o r d i n a r y income. 3. IRC s. 306. P r e f e r r e d s t o c k b a i l o u t s i n v o l v e t h e non- t a x a b l e d i s t r i b u t i o n o f s t o c k d i v i d e n d s f o l l o w e d by t h e i r s a l e t o t h i r d p a r t i e s , a p r o c e d u r e w h i c h s e c u r e s t o t h e vendor t a x on the proceeds a t c a p i t a l g a i n s r a t e s . Sub- sequent redemptions i n t e r m i n a t i o n o f t h e t h i r d p a r t y ' s i n t e r e s t a l s o r e s u l t i n t a x a t c a p i t a l g a i n s r a t e s , w h i c h , s i n c e the c o s t base o f t h e s h a r e s a p p r o x i m a t e s t h e i r f a i r market v a l u e , n o r m a l l y g i v e s r i s e t o no t a x l i a b i l i t y . IRC s e c t i o n s 305 and 306 e f f e c t i v e l y p r o v i d e f o r d i v i d e n d t r e a t m e n t o f such s t o c k d i s t r i b u t i o n s and r e d e m p t i o n s . 4 . IRC s. 341. The g e n e r a l r u l e w i t h r e g a r d t o c o r p o r a t e l i q u i d a t i o n s i n the U n i t e d S t a t e s i s t h a t t h e r e has been a s a l e or exchange o f t h e s t o c k i n r e t u r n f o r t h e a s s e t s d i s t r i b u t e d by t h e company (IRC s.331). T h i s r e s u l t s i n t a x a t c a p i t a l g a i n s r a t e s on the e x c e s s o f t h e d i s t r i b u t e d amount o v e r t h e a d j u s t e d c o s t base o f the i n t e r e s t s u r r e n d e r e d . The c o l l a p s i b l e c o r p o r a t i o n d e v i c e t u r n s on t h e l i q u i d a t i o n o f a company b e f o r e t h e e x p e c t e d r e t u r n s from th e s a l e o f t h e c o r p o r a t e a s s e t have been r e a l i z e d . The d i f f e r e n c e between t h e s h a r e h o l d e r ' s o r i g i n a l c a p i t a l c o n t r i b u t i o n and t h e f a i r market v a l u e o f the p r o p e r t y d i s t r i b u t e d a t t r a c t s t a x a t c a p i t a l g a i n s r a t e s . The c o s t base o f the a s s e t i s i n the s h a r e h o l d e r ' s hands 'bumped' t o f a i r market v a l u e so 92 t h a t no t a x i s p a y a b l e upon a subsequent s a l e o f t h e a s s e t by the s h a r e h o l d e r . IRC s e c t i o n 341 t r a n s l a t e s t h e g a i n r e a l i z e d upon l i q u i d a t i o n i n t o o r d i a n r y income. 5. IRC s. 304. 6. IRC s. 3 0 4 ( b ) ( 1 ) . 7. IRC s. 3 0 4 ( a ) ( 2 ) ( A ) and ( B ) . 8. IRC s. 304 ( b ) ( 2 ) ( B ) . 9 . IRC s. 304 ( c ) ( 1 ) . 10. IRC s. 318, e n t i t l e d " c o n s t r u c t i v e ownership o f s t o c k " , a t t r i b u t e s t o the t a x p a y e r s t o c k owned by members of h i s f a m i l y ( p a r e n t s , c h i l d r e n , g r a n d c h i l d r e n , and s p o u s e s ) , by p a r t n e r s h i p s , t r u s t s , and c o r p o r a t i o n s , where he o r a f a m i l y member i s the b e n e f i c i a l owner o f the s t o c k , and s t o c k i n r e s p e c t o f which he e n j o y s an o p t i o n t o a c q u i r e . 11. IRC s. 301 ( a ) . 12. 397 US 301 (1970). 13. Reg. 1.302-2(b). 93 V I . CAPITAL GAINS STRIPPING a) I n t r o d u c t i o n I t i s sometimes s a i d t h a t t h e t a x law r e l a t i n g t o c o r p o r a t i o n s has come f u l l c i r c l e . Where once the e f f o r t s o f t a x p l a n n e r s were aimed a t t r a n s f o r m i n g t a x a b l e d i v i d e n d s i n t o exempt c a p i t a l g a i n s , the new game has t o do w i t h the c o n v e r s i o n o f c a p i t a l g a i n s i n t o exempt d i v i d e n d s . To the d i s i n t e r e s t e d b y s t a n d e r , t h e r e might w e l l appear t o be some i r o n y i n t h i s r e v e r s a l , however i n t h e l i g h t o f developments i n t h e f e d e r a l income t a x o v e r t h e c o u r s e o f the l a s t t e n y e a r s the s i t u a t i o n i s p e r f e c t l y c o m p r e h e n s i b l e . What i s more, the two t y p e s of a v o i d a n c e p r a c t i c e s a r e o n l y s u p e r f i c i a l l y s i m i l a r . The c l a s s i c d i v i d e n d s t r i p was e s s e n t i a l l y a non-arm's l e g t h t r a n s a c t i o n i n w h i c h th e t a x p a y e r went t h r o u g h a form o f s h a r e s a l e i n o r d e r t o r e c e i v e c o r p o r a t e s u r p l u s f r e e o f t a x on d i v i d e n d d i s t r i b u t i o n s . Where the s o u r c e o f w e a l t h was a b u s i n e s s p o s s e s s i n g i n h e r e n t v a l u e , t h e t a x p a y e r ' s ownership was o c c a s i o n a l l y i n d i r e c t l y c o n t i n u e d . The b e n e f i t s o f d i v i d e n d s t r i p p i n g schemes were c o n f e r r e d upon i n d i v i d u a l s c o n t r o l l i n g companies and a c c o r d i n g l y t h e s e a c t i v i t i e s were e s s e n t i a l l y c o n f i n e d t o d e a l i n g s i n the s h a r e s o f c l o s e l y h e l d , p r i v a t e c o r p o r a t i o n s . By c omparison, c a p i t a l g a i n s s t r i p s , as the phrase would s u g g e s t , a r e not aimed a t 9 4 a v o i d i n g the second l e v e l o f t a x on c o r p o r a t e s o u r c e income. Moreover, t h e y i n v o l v e bone f i d e arm's l e n g t h d i s p o s i t i o n s (not i n c e s t u o u s s a l e s ) o f any c a p i t a l p r o p e r t y (not j u s t s h a r e s ) . F u r t h e r m o r e , though t h e n a t u r e o f the b e n e f i t s d i f f e r a c c o r d i n g t o whether t h e t a x p a y e r i s an i n d i v i d u a l o r a c o r p o r a t i o n , t h e advantages o f c a p i t a l g a i n s s t r i p s a r e n o t a v a i l a b l e t o i n d i v i d u a l s o n l y , but a c c r u e t o any t a x a b l e p e r s o n d i s p o s i n g o f a p p r e c i a t e d c a p i t a l p r o p e r t y . The i n c e n t i v e t o a v o i d c a p i t a l g a i n s t a x was o f c o u r s e contemporaneous w i t h t h e i n t r o d u c t i o n o f a c a p i t a l g a i n s t a x i n Canada as p a r t o f the 1972 r e f o r m package. S e c t i o n 2 o f t h e Income Tax A c t b r i n g s ' t a x a b l e income' i n t o charge and s e c t i o n 3 i n c l u d e s i n t h e c o m p u t a t i o n o f income f o r m u l a one h a l f o f a l l c a p i t a l g a i n s n e t o f c a p i t a l l o s s e s f o r t h e y e a r . The C a r t e r Commission had advocated the i n c l u s i o n i n income o f a l l r e c e i p t s , i n c l u d i n g c a p i t a l g a i n s , a f f e c t i n g an i n c r e a s e i n the t a x p a y e r ' s command o v e r l i m i t e d r e s o u r c e s . T h i s recommendation was based upon t h e f o u r major p o l i c y c o n s i d e r a t i o n s o f v e r t i c a l and h o r i z o n t a l e q u i t y , n e u t r a l i t y , and c e r t a i n t y . 1 H o r i z o n t a l e q u i t y i m p o r t s the same t a x t r e a t m e n t o f t a x p a y e r s i n s i m i l a r c i r c u m s t a n c e s i . e . e n j o y i n g r e c e i p t s i n the same amount. V e r t i c a l e q u i t y ensures t h a t t a x p a y e r s who a r e i n unequal economic c i r c u m s t a n c e s a r e t r e a t e d u n e q u a l l y e.g. i n c r e a s e s i n economic power t h r o u g h a p p r e c i a t i o n o f c a p i t a l a s s e t s i s g e n e r a l l y the p r e s e r v e o f upper income groups. I f t h e i r 95 g a i n s from p r o p e r t y escaped t a x a t i o n , t h e s e groups would e f f e c t i v e l y b e n e f i t from a lower average r a t e o f t a x than wage-earners who a r e un a b l e t o a c q u i r e i n v e s t m e n t p r o p e r t i e s . T h i s d i s p a r i t y between upper and lower income groups would i n c r e a s e e x p o n e n t i a l l y where a p r o g r e s s i v e r a t e s c h e d u l e , such as Canada has adopted, i s i n p l a c e . The f u l l i n c l u s i o n o f c a p i t a l g a i n s i n income would have e l i m i n a t e d a l l a v o i d a n c e t e c h n i q u e s aimed a t cha n g i n g t h e t a x c h a r a c t e r o f a r e c e i p t from income t o c a p i t a l and v i c e - v e r s a . As we have seen, a good d e a l o f e f f o r t and expense has gone i n t o c o m b a t t i n g t h e more obnoxious a v o i d a n c e p r a c t i c e s - . Even where t h e r e i s no. attempt a t t a x av o i d a n c e , t h e i n c l u s i o n o f a l l r e c e i p t s i n a comprehensive t a x base would do away w i t h the d i f f i c u l t and sometimes a r t i f i c i a l d i s t i n c t i o n s t h a t judges a r e c o n s t a n t l y c a l l e d upon t o make w i t h r e s p e c t t o t h e t a x c h a r a c t e r o f a r e c e i p t . A l t h o u g h t h e government o f the day g e n e r a l l y s h a r e d t h e same p e r c e p t i o n s o f p o l i c y , the C a r t e r Commission p r o p o s a l s were n o t a c c e p t e d . Perhaps p a r t l y as a r e s u l t o f s u b m i s s i o n s made by the F i n a n c e , Trade, and E c o n o m i c ' A f f a i r s committee 2 o f the House , t h e h y b r i d system a d o p t i n g the p r e f e r e n t i a l t r e a t m e n t o f c a p i t a l g a i n s was i n t r o d u c e d . I t i s beyond the scope o f the p r e s e n t a n a l y s i s t o t r e a t e x h a u s t i v e l y o f t h e economic arguments f o r and a g a i n s t c a p i t a l g a i n s t a x . To b u t b r i e f l y m e ntion the most i m p o r t a n t , i t has been c l a i m e d t h a t c a p i t a l g a i n s r e p r e s e n t l e s s t a x - p a y i n g c a p a c i t y t h a n o r d i n a r y income r e c e i p t s because they 96 a r e l e s s r e g u l a r , a r e f r e q u e n t l y u n f o r e s e e n , and may be soon folowed by c a p i t a l l o s s e s . As a p r u d e n t man t h e r e f o r e does not r a i s e h i s l e v e l o f consumption i n r e sponse t o t h e s e i n c r e m e n t s they do n o t c o n s t i t u t e s u i t a b l e o b j e c t s o f t a x a t i o n . The p o i n t i s a l s o sometimes made t h a t t h e t a x f u r n i s h e s an example o f d o u b l e t a x a t i o n . S i n c e c a p i t a l a p p r e c i a t i o n i s f r e q u e n t l y a measure o f t h e i n c r e a s e d income an a s s e t i s e x p e c t e d to y i e l d i n f u t u r e , c a p i t a l g a i n s taxes, e f f e c t i v e l y t a x e d t h a t which w i l l be t a k e n i n t o income a t a l a t e r d a t e . F u t h e r arguments p o i n t t o the i l l u s o r y n a t u r e o f c a p i t a l g a i n s as m e r e l y r e f l e c t i n g changes i n i n t e r e s t r a t e s o r s h i f t s i n t h e g e n e r a l p r i c e l e v e l , and t o the d e l e t e r i o u s consequences o f t h e t a x on i n d i v i d u a l and c o r p o r a t e s a v i n g , c a p i t a l i n v e s t m e n t , m o b i l i t y o f c a p i t a l , and r i s k t a k i n g . The o p p o s i n g p h i l o s o p h y argues t h a t w i n d f a l l g a i n s i n c r e a s e the t a x p a y e r ' s c a p a c i t y t o pay t a x e s p r e c i s e l y because they are not i n c l u d e d i n consumption e x p e n d i t u r e s . Moreover, on t h e g e n e r a l l y a c c e p t e d d e f i n i t i o n o f income as c o n s i s t i n g o f consumption p l u s s a v i n g , no double t a x a t i o n o c c u r s where g a i n s are t a x e d on the r e a l i z a t i o n o f an a s s e t because the t a x p a y e r can i n c r e a s e h i s consumption i n an amount e q u a l t o the g a i n . Assuming he chooses t o r e i n v e s t t h e proceeds o f d i s p o s i t i o n , he s h o u l d , a r g u a b l y , be i n no b e t t e r p o s i t i o n t h a n a t a x p a y e r i n v e s t i n g s o l e l y w i t h a f t e r t a x d o l l a r s d e r i v e d from s a v i n g s . Gains on b o n d h o l d i n g s "due t o downward f l u c t u a t i o n s i n i n t e r e s t r a t e s a r e o n l y i l l u s o r y 97 i f t he a s s e t i s not s o l d and t h e proceeds not used f o r consumption purposes o r f o r new i n v e s t m e n t o p e r a t i o n s ( t h e s e b e i n g t h e modus o p e r a n d i o f t h e s p e c u l a t o r ) . As f o r t h e c l a i m t h a t a l a r g e component of any g a i n can be d i s c o u n t e d f o r i n f l a t i o n , the answer can be made t h a t i n f l a t i o n - a r y p r e s s u r e s are b r o u g h t t o bear upon o t h e r s o u r c e s o f economic r e t u r n . The C a r t e r Commission c o n s i d e r e d t h e p o s s i b l e n e g a t i v e i m p l i c a t i o n s o f t h e t a x f o r p e r s o n a l and c o r p o r a t e s a v i n g s , f i n d i n g t h a t t h e s e would be reduced 3 by a n e g l i g i b l e amount. There i s , f u r t h e r m o r e , no e v i d e n c e t o show t h a t c a p i t a l g a i n s i n f a c t d i m i n i s h b u s i n e s s i n i t i a t i v e and r i s k t a k i n g . To t h e e x t e n t t h a t t h e r e t u r n on i n v e s t m e n t i s e x p e c t e d t o t a k e the form o f o r d i n a r y income, c a p i t a l g a i n s t a x i s i r r e l e v a n t . Where c a p i t a l g a i n s are t a x e d i n f u l l , t h e y are exposed t o no g r e a t e r r t a x burden than o r d i n a r y income. Where g a i n s on p r o p e r t y r e c e i v e p r e f e r e n t i a l t a x t r e a t m e n t , the i n c e n t i v e t o t r a n s f o r m b u s i n e s s income i n t o c a p i t a l g a i n s i s p r e s e n t . Though the m o b i l i t y o f c a p i t a l i s c e r t a i n l y i m p a i r e d by t h e t a x , i t can be argued t h a t t h i s i s a b e n e f i c i a l r e s u l t , e n c o u r a g i n g s t a b i l i t y and r e s p o n s i b i l i t y i n i n v e s t m e n t d e c i s i o n s and c o r r e s p o n d i n g l y 4 d i s c o u r a g i n g l e s s p r o d u c t i v e , t r a n s i t o r y o w n e r s h i p , b) H i s t o r y The l y n c h - p i n i n c a p i t a l g a i n s s t r i p p i n g schemes i s the i n t e r c o r p o r a t e ^ d i v i d e n d which may be deducted from income p u r s u a n t t o s u b s e c t i o n s 112(1) and 1 1 3 ( 1 ) . 98 I t i s perhaps i r o n i c t h a t a p r o v i s i o n i n t r o d u c e d f o r t h e r e l i e f o f the t a x p a y e r s h o u l d o ver many decades have shown i t s e l f t o be the t a x a v o i d e r s most s e r v i c e a b l e t o o l . Under 5 the Income War Tax A c t , a l l s h a r e h o l d e r s , i n c l u d i n g c o r p o r a t i o n s , r e c e i v e d d i v i d e n d s from t a x a b l e c o r p o r a t i o n s f r e e o f t a x . The r a t e s d i d n o t d i s c r i m i n a t e between i n d i v i d u a l and c o r p o r a t e t a x p a y e r s , so t h a t t h e c o r p o r a t i o n was e s s e n t i a l l y r e g a r d e d as a c o n d u i t and a c o n v e n i e n t p o i n t i n t h e income f l o w a t w h i c h t o impose th e t a x . Not l o n g a f t e r w a r d s , t h e r a t e s o f t a x a p p l i c a b l e t o i n d i v i d u a l s and c o r p o r a t i o n s began t o d i f f e r and the double t a x a t i o n o f c o r p o r a t e s o u r c e income was i n t r o d u c e d . A p e r c e i v e d e v i l r e s u l t i n g from t h i s change was the p o s s i b l e p y r a m i d i n g o f t a x where d i v i d e n d s were p a i d t o c o r p o r a t e s h a r e h o l d e r s . A c c o r d i n g l y , the Income War Tax A c t was amended i n 19 2 6 t o p e r m i t t h e t a x f r e e r e c e i p t o f i n t e r c o r p o r a t e d i v i d e n d s . T h i s development t h e r e f o r e moderated the t h e n r e c e n t tendency t o r e g a r d c o r p o r a t i o n s and t h e i r s h a r e h o l d e r s as d i s t i n c t t a x p a y i n g e n t i t i e s . As we have seen, the r u l e was i m m e d i a t e l y p u t t o use i n v a r i o u s t y p e s o f d i v i d e n d s t r i p p i n g t r a n s a c t i o n s which l e a d t o the i m p o s i t i o n , i n t h e form o f d e s i g n a t e d s u r p l u s , o f r e s t r i c t i o n s on t h e a b i l i t y o f c o r p o r a t i o n s t o t r a n s f e r s u r p l u s w i t h o u t t a x c o s t s t h r o u g h d i v i d e n d payments. A f u r t h e r l i m i t a t i o n on t h e t a x f r e e movement of s u r p l u s a t t h e c o r p o r a t e l e v e l i s found i n the t a x imposed upon the d i v i d e n d income d e r i v e d from p o r t f o l i o i n v e s t m e n t s 99 o f p r i v a t e c o r p o r a t i o n s . The o b v i o u s p o l i c y o f t h e P a r t IV t a x p r o v i s i o n s i s t o p r e v e n t t h e undue d e f e r r a l o f i n v e s t m e n t income th r o u g h the use o f p e r s o n a l h o l d i n g companies. And e x c e p t i o n t o t h e P a r t IV t a x r u l e s was p r o v i d e d f o r d i v i d e n d s r e c e i v e d from c o n t r o l l e d c o r p o r a t i o n s on the h y p o t h e s i s t h a t such amounts were n o t p r o p e r l y the i n v e s t m e n t income of the r e c i p i e n t and d i d not i n v o l v e a c o n t r o l o f income f l o w s g r e a t e r than a l r e a d y e x i s t e d . I n an e f f o r t t o encourage e q u i t y p a r t i c i p a t i o n i n s m a l l b u s i n e s s e n t e r p r i s e , t h e ' c o n t r o l ' t e s t was i n 1977 reduced t o a 'connected', o r 10% v o t e s and v a l u e r e q u i r e m e n t where t h e payor o f the d i v i d e n d was a C a n a d i a n - c o n t r o l l e d p r i v a t e c o r p o r a t i o n . T h i s has o f c o u r s e f a c i l i t a t e d a v o i d a n c e schemes t u r n i n g on t h e use o f t a x f r e e i n t e r c o r p o r a t e d i v i d e n d s , p a r t i c u l a r l y i n c o n n e c t i o n w i t h the r e d e m p t i o n o f s h a r e s p o s s e s s i n g a low p a i d up c a p i t a l . I t i s i m p o r t a n t t o n o te t h a t the 10% ownership r e q u i r e m e n t must be p r e s e n t o n l y p r i o r t o the r e d e m p t i o n , and not a f t e r payment o f the d i v i d e n d when the s h a r e h o l d e r may no l o n g e r own any s h a r e s o f the payor. A n o t h e r i m p o r t a n t 1977 development was t h e i n c r e a s e i n t h e d i v i d e n d t a x c r e d i t . T h i s narrowed th e gap between c a p i t a l r e c e i p t s and payments t a k e n i n t o income as d i v i d e n d s . T h i s gap had p r e v i o u s l y been th e b a t t l e g r o u n d f o r t a x p a y e r s and revenue o f f i c i a l s b u t a d i f f e r e n c e o f 8% i n f a v o u r o f c a p i t a l g a i n s t r e a t m e n t b e n e f i t i n g o n l y the h i g h e s t income group e v i d e n t l y d i d n o t j u s t i f y t h e expense and a d m i n i s t r a t i v e c o m p l e x i t y o f p r o l o n g i n g the war. T h i s l e d d i r e c t l y t o 100 the r e p e a l o f d e s i g n a t e d s u r p l u s . As we s h a l l see, one v a r i e t y o f s t r i p r e q u i r e s a p r e l i m i n a r y r o l l o v e r o f t h e s h a r e s o f an o p e r a t i n g company i n t o a h o l d i n g company, f o l l o w e d by t h e removals o f the. operating? company:1 s; s u r p l u s t o the h o l d i n g company by means o f d i v i d e n d payments. Under the former d e s i g n a t e d s u r p l u s p r o v i s i o n s , the o p e r a t i n g company's p r e - a c q u i s i t i o n s u r p l u s would be l o c k e d i n by a 25% t a x p a y a b l e by t h e d i v i d e n d r e c i p i e n t and o n l y p o s t - a c q u i s i t i o n s u r p l u s might be moved up t o the p a r e n t h o l d i n g company. T h i s would however n o t p r e s e n t a problem where the s h a r e s o f t h e o p e r a t i n g company had been t r a n s f e r r e d t o the h o l d i n g company e a r l y on. I n such a c a s e , the ' c o n t r o l p e r i o d e a r n i n g s ' i . e . p o s t - a c q u i s i t i o n s u r p l u s , would l i k e l y a pproximate t h e s u r p l u s on hand. A l s o , even i n c i r c u m s t a n c e s where d e s i g n a t e d s u r p l u s would have p r e s e n t e d a problem, a l t e r n a t i v e means o f a c c o m p l i s h i n g t h e s t r i p , a s s e t s a l e s f o r example, might have o f f e r e d a s o l u t i o n . There can be no doubt, however, t h a t t h e r e p e a l o f d e s i g n a t e d s u r p l u s has p r o v i d e d t h e t a x p l a n n e r w i t h g r e a t e r f l e x i b i l i t y . I n a d d i t i o n , i t i s w o r t h m e n t i o n i n g i n a g e n e r a l way t h a t the government's d e c i s i o n t o abandon the t a x p r o b a b l y encouraged c a p i t a l g a i n s s t r i p s f o r no o t h e r r e a s o n t h a n i t c r e a t e d a f a v o u r a b l e c l i m a t e f o r a c q u i s i t i o n s , f a c i l i t a t i n g them by p e r m i t t i n g t h e e a r n i n g s o f t h e t a r g e t t o be used i n t h e f i n a n c i n g o f t a k e o v e r s . P r i o r t o t a x r e f o r m i n 1972, c o r p o r a t e s u r p l u s d i s t r i b u t i o n s were t r e a t e d as d i v i d e n d s t o the e x t e n t o f 101 any u n d i s t r i b u t e d income on hand. Amounts d i s t r i b u t e d i n e x c e s s o f UIOH upon a l i q u i d a t i o n o f t h e c o r p o r a t i o n o r a redemption o f s h a r e s were r e g a r d e d as a r e t u r n o f c a p i t a l . ^ The t a x r e f o r m l e g i s l a t i o n r e v e r s e d t h i s o r d e r o f d i s t r i b u t i o n s , p e r m i t t i n g a n o n - t a x a b l e r e t u r n o f p a i d up c a p i t a l , a concept o r i g i n a l l y d e f i n e d so as t o c o r r e s p o n d w i t h c o r p o r a t e p a i d up c a p i t a l , i n advance o f f u r t h e r d i s t r i b u t i o n s , w h i c h were t o be t r e a t e d as d i v i d e n d s . The p a i d up c a p i t a l c o ncept was t h e n seen as o n l y p a r t i a l l y f u l f i l l i n g i t s promise o f p e r m i t t i n g the s h a r e h o l d e r a r e c o v e r y o f h i s i n v e s t m e n t because where s h a r e s were i s s u e d a t a premium o r where p r o p e r t y was c o n t r i b u t e d t o a c o r p o r a t i o n l a r g e amounts o f p a i d i n c a p i t a l were not r e f l e c t e d i n t h e p a i d up c a p i t a l o f the s h a r e s . I n o r d e r t o b r i n g c o n t r i b u t e d s u r p l u s and share premium a c c o u n t s i n t o p a i d up c a p i t a l , t h e l a t t e r e x p r e s s i o n was r e d e f i n e d i n 1974. The d e t e r m i n a t i o n o f p a i d up c a p i t a l was g r e a t l y c o m p l i c a t e d however, because i t now r e q u i r e d the c o m p u t a t i o n o f c o n t r i b u t e d s u r p l u s from the i n c e p t i o n o f the company (as w e l l as t h e p a i d up c a p i t a l d e f i c i e n c y o f the c o r p o r a t i o n which when deducted from t h e p a i d up c a p i t a l f i x e d t h e amount t h a t might be d i s t r i b u t e d t a x f r e e , known as t h e p a i d up c a p i t a l l i m i t ) . As p a r t o f the movement towards s i m p l i f i c a t i o n of. the-'1 t a x system which came t o f r u i t i o n i n 1977, the d e f i n i t i o n o f p a i d up c a p i t a l was once more made t o agree w i t h c o r p o r a t e p a i d up c a p i t a l . When c o r p o r a t e s u r p l u s was d i s t r i b u t e d as a d i v i d e n d 102 t o t h e e x t e n t o f income on hand, the s h a r e h o l d e r c o u l d c l e a r l y n o t c o n t r o l the n a t u r e o f h i s r e c e i p t s . I f the payor c o r p o r a t i o n p o s s e s s e d l i t t l e i n the way o f e a r n i n g s , a l a r g e payment would n a t u r a l l y t a k e t h e form o f c a p i t a l . Under a d e f i n i t i o n o f p a i d up c a p i t a l such as was i n t r o d u c e d i n 1974, c h o i c e i s a l s o l a c k i n g because p a i d up c a p i t a l i s s t a t u t o r i l y d e t e r m i n e d . When i n 1977 p a i d up c a p i t a l was once more brou g h t i n t o l i n e w i t h p a i d up c a p i t a l f o r c o r p o r a t e law pu r p o s e s , the t a x p a y e r a c q u i r e d a measure o f c o n t r o l o v e r t h e t a x consequences a t t a c h i n g t o h i s r e c e i p t s . T h i s freedom was the more u s e f u l as the above n o t e d i n c r e a s e i n the d i v i d e n d t a x c r e d i t made t h e c h o i c e o f d i v i d e n d o r c a p i t a l r e c e i p t s upon t h e r e a l i z a t i o n o f t h e i r i n v e s t m e n t o f i n t e r e s t t o i n d i v i d u a l s h a r e h o l d e r s who would d e c i d e i n f a v o u r o f one o r the o t h e r i n accordance w i t h t h e i r m a r g i n a l r a t e s . I n a s u b s e c t i o n 85(1) r o l l o v e r s i t u a t i o n , f o r example, a t a x p a y e r d e s i r i n g c a p i t a l g a i n s t r e a t m e n t on the e x c e s s o f h i s r e c e i p t s over the e l e c t e d amount might t a k e back redeemable^. no par v a l u e p r e f e r e n c e s h a r e s w i t h a redemption amount e q u a l t o the f a i r market v a l u e o f t h e p r o p e r t y r o l l e d i n t o t h e c o r p o r a t i o n . The p a i d up c a p i t a l o f no par v a l u e s h a r e s i s t h e amount p a i d f o r them o r the f a i r market v a l u e o f p r o p e r t y i n c o n s i d e r a t i o n o f which they a r e i s s u e d . Thus, upon a subsequent redemption o f t h e s h a r e s , no deemed d i v i d e n d would a r i s e and the amounts r e c e i v e d i n exce s s o f the e l e c t e d amount (and ACB) would be t r e a t e d f o r t a x purposes as a c a p i t a l g a i n . D i v i d e n d 103 t r e a t m e n t c o u l d now a l s o e a s i l y be s e c u r e d upon a buy-back of s h a r e s . T h i s was e s p e c i a l l y a t t r a c t i v e t o c o r p o r a t e s h a r e h o l d e r s because d i v i d e n d s would be deducted from income p u r s u a n t t o s u b s e c t i o n 1 1 2 ( 1 ) . Assuming t h a t t h e t a x p a y e r had a p r e f e r e n c e f o r d i v i d e n d t r e a t m e n t , he might t a k e back redeemable p r e f e r e n c e s h a r e s w i t h a low par v a l u e . Thus, upon a share r e d e m p t i o n , the d i f f e r e n c e between the p a i d up c a p i t a l (par v a l u e ) and t h e redemption amount (FMV) would come i n t o income as a d i v i d e n d and t o t h e e x t e n t 7 o f t h e d i v i d e n d t h e r e would be no c a p i t a l g a i n . A 1974 development t h a t i s l a r g e l y r e s p o n s i b l e f o r o p e ning the door t o c a p i t a l g a i n s s t r i p s was the r e p e a l o f the r e q u i r e m e n t i n s u b s e c t i o n 85(1) t h a t the t r a n s f e r o r own 80% o f a l l c l a s s e s o f the t r a n s f e r e e c o r p o r a t i o n . The new r u l e s t i p u l a t e d o n l y t h a t t h e t r a n s f e r o r s h o u l d t a k e back s h a r e s o f the t r a n s f e r e e . P r i o r t o 1974 t a x p a y e r s f r e q u e n t l y engaged i n s t e p t r a n s a c t i o n s i n o r d e r t o a v o i d the 80% r u l e . F o r example, owners of u n i n c o r p o r a t e d b u s i n e s s e s w i s h i n g t o combine t h e i r o p e r a t i o n s and t o conduct them i n c o r p o r a t e form would f i r s t r o l l a s s e t s i n t o s e p a r a t e companies and then amalgamate. A p a r t from the added expense o f d u p l i c a t i n g the i n i t i a l s t e p , t h e r e was c o n s i d e r a b l e doubt as t o t h e p r o p r i e t y o f t h i s p r o c e d u r e . F e e l i n g s t h a t t h e 80% r e q u i r e m e n t was too r e s t r i c t i v e t h u s l e d t o the change i n the r u l e . An i m p o r t a n t consequence o f the new development, however, was t h a t t h e s u b s e c t i o n 85(1) r o l l o v e r might be employed as a method of d i s p o s i n g o f e l i g i b l e 104 p r o p e r t y t o a Canadian c o r p o r a t i o n i n an arm's l e n g t h t r a n s a c t i o n . As time passed and e n a b l e d t a x p l a n n e r s t o adopt a c r i t i c a l p e r s p e c t i v e on the above d e s c r i b e d developments, i t became c l e a r t h a t a number o f schemes might be d e v i s e d t o v i r t u a l l y e l i m i n a t e the i n c i d e n c e o f c a p i t a l g a i n s t a x a t the c o r p o r a t e l e v e l and t o p r o v i d e i n d i v i d u a l s d i s p o s i n g o f c a p i t a l a s s e t s t o c o r p o r a t i o n s w i t h u n l i m i t e d d e f e r r a l o f t a x . The f o l l o w i n g a r e the t y p e s o f arrangements employed by t a x p l a n n e r s t o a c h i e v e t h e s e r e s u l t s . c) Share s a l e s C o n s i d e r the f o l l o w i n g c o r p o r a t e s t r u c t u r e : X I HOLDCO OPCO The c a p i t a l g a i n s t a x n o r m a l l y a p p l i c a b l e t o a s a l e by Holdco of i t s a p p r e c i a t e d Opco sha r e s might be e l i m i n a t e d by h a v i n g Opco pay a cash d i v i d e n d t o Holdco s u f f i c i e n t i n amount t o reduce t h e f a i r market v a l u e o f the Opco s h a r e s t o t h e i r a d j u s t e d c o s t base. N e e d l e s s t o say, t h e s u r p l u s o f Opco c o u l d be removed on a t a x f r e e b a s i s by means o f a s u b s e c t i o n 112(1) i n t e r c o r p o r a t e d i v i d e n d . A minor v a r i a t i o n on t h i s f a c t s i t u a t i o n w h i c h perhaps i n v o l v e s a s t e p t r a n s a c t i o n 105 problem o c c u r s where X r o l l s h i s s h a r e s o f Opco i n t o Holdco p r i o r t o payment o f the d i v i d e n d and t h e s a l e o f t h e Opco s h a r e s . I t may happen t h a t t h e earned s u r p l u s i n Opco a v a i l a b l e f o r d i s t r i b u t i o n as a d i v i d e n d t o Holdco w i l l be i n s u f f i c i e n t t o b r i n g t h e f a i r market v a l u e o f t h e sh a r e s i n l i n e w i t h t h e i r a d j u s t e d c o s t base. I n such a c a s e , thought might be g i v e n t o r e a p p r a i s i n g the c a p i t a l a s s e t s o f t h e o p e r a t i n g company and c r e a t i n g an a p p r a i s a l s u r p l u s out o f wh i c h a d i v i d e n d can be p a i d under t h e c o r p o r a t e law (assuming, o f c o u r s e , t h a t Opco has s u f f i c i e n t c ash on hand) . As an a l t e r n a t i v e t o t h e payment o f a c a s h d i v i d e n d , Opco might i n c r e a s e i t s p a i d up c a p i t a l by c a p i t a l i z i n g e a rned, c o n t r i b u t e d , o r a p p r a i s a l s u r p l u s . S u b s e c t i o n 84(1) p r o v i d e s t h a t a deemed d i v i d e n d t o Holdco w i l l r e s u l t from t h i s t r a n s a c t i o n . T h i s p r o c e d u r e w i l l a l s o 'bump1 t h e a d j u s t e d c o s t base o f t h e Opco sh a r e s t o Holdco by o p e r a t i o n o f p a r a g r a p h 5 3 ( 1 ) ( b ) , so t h a t i t might e q u a l t h e f a i r market v a l u e o f t h e s h a r e s and p e r m i t t h e i r d i s p o s i t i o n w i t h o u t t a x c o s t . T h i s scheme would however n o t appear t o be u n i v e r s a l l y a v a i l a b l e , as not a l l c o r p o r a t i o n s t a t u t e s p e r m i t an i n c r e a s e i n p a i d up c a p i t a l w i t h o u t a c o r r e s p o n d i n g a i n c r e a s e i n i s s u e d c a p i t a l . Where t h i s i s a problem, the payment by Opco o f a s t o c k d i v i d e n d c o u l d l e a d t o t h e same r e s u l t . l i t s h o u l d be n o t e d t h a t t h i s a l t e r n a t i v e i s a v a i l a b l e o n l y i f Opco i s a p r i v a t e c o r p o r a t i o n . Only t a x a b l e d i v i d e n d s r e c e i v e d by 106 a c o r p o r a t i o n may be deducted from income, and, by v i r t u e o f t h e d e f i n i t i o n o f ' d i v i d e n d ' i n s u b s e c t i o n 2 4 8 ( 1 ) , s t o c k d i v i d e n d s p a i d by p u b l i c c o r p o r a t i o n s a f t e r March 31, 1977 ar e n ot ' d i v i d e n d s ' . The amount o f a s t o c k d i v i d e n d i s the amount o f the s u r p l u s c a p i t a l i z e d i n r e s p e c t o f i t , and t h i s f i g u r e a l s o c o n s t i t u t e s i t s c o s t t o t t h e s h a r e h o l d e r under p a r a g r a p h 5 2 ( 3 ) ( a ) . The amount o f the s t o c k d i v i d e n d s h o u l d be s u f f i c i e n t t o r a i s e t h e average a d j u s t e d c o s t ' b a s e o f a l l s h a r e s o f Opco h e l d by Holdco t o the f a i r market v a l u e o f the Opco s h a r e s . T h i s upward a v e r a g i n g i s p r o v i d e d f o r by the ' i d e n t i c a l p r o p e r t i e s ' r u l e c o n t a i n e d i n s e c t i o n 47 o f the A c t . Where the s h a r e s o f Opco were i s s u e d p r i o r t o 1971, I t a r 2 6 ( 8 ) . p r o v i d e s t h a t t h e a d j u s t e d c o s t base of the new p o s t - 7 1 s h a r e s w i l l n o t be averaged i n w i t h t h a t o f t h e pre-72 s h a r e s . T h i s does n o t p r e s e n t any s p e c i a l d i f f i c u l t y however because t h e s t o c k d i v i d e n d w i l l a l s o reduce the f a i r market v a l u e o f p r e v i o u s l y i s s u e d s h a r e s so t h a t the proceeds o f d i s p o s i t i o n may y e t not exceed the a d j u s t e d c o s t base o f t h e s h a r e s . As a f u r t h e r a l t e r n a t i v e t o the above d e s c r i b e d measures, Opco might purchase a l l o f i t s s h a r e s but one f o r c a n c e l l a t i o n from H o l d c o . S u b s e c t i o n 84(3) p r o v i d e s t h a t i n such c i r c u m s t a n c e s Holdco w i l l be deemed t o have received-, a d i v i d e n d e q u a l t o the excess o f t h e amount p a i d o v e r t h e p a i d up c a p i t a l o f the s h a r e s . The o n l y a p p a r e n t t a x c o s t would be the s m a l l g a i n from t h e d i s p o s i t i o n o f the o u t s t a n d i n g s h a r e . T h i s p r o c e d u r e would seem t o i n v o l v e c e r t a i n r i s k s however. Holdco and Opco a r e not a t arm's l e n g t h . A c c o r d i n g l y the 107 Opco sh a r e s must e i t h e r be bought back a t t h e i r f a i r market v a l u e o r , by v i r t u e o f s e c t i o n 69, Holdco w i l l be deemed t o have r e c e i v e d proceeds o f d i s p o s i t i o n e q u a l t o t h e f a i r market v a l u e . I n t h e former -case, i t i s d i f f i c u l t t o see what would be l e f t i n the c o r p o r a t i o n o f any v a l u e , as t h e share v a l u e s presumably r e p r e s e n t p a i d up c a p i t a l , earned s u r p l u s and o t h e r s u r p l u s a c c o u n t s , and t h e a p p r e c i a t e d v a l u e of g o o d w i l l and o t h e r a s s e t s . I n t h e l a t t e r c a s e , assuming the s h a r e s o f Opco had been redeemed a t l e s s t h a n t h e i r f a i r market v a l u e , t h e deemed proceeds o f d i s p o s i t i o n ( t o g e t h e r w i t h the a c t u a l proceeds) might so f a r exceed t h e deemed d i v i d e n d t h a t a c a p i t a l g a i n might a r i s e . N e e d l e s s t o say, t h i s would c o n s t i t u t e a c o u n t e r p r o d u c t i v e r e s u l t . P r o b a b l y the b e s t c o u r s e would be t o have Opco r e p u r c h a s e b u t a p o r t i o n o f Holdco's s h a r e h o l d i n g , r e d u c i n g t h e f a i r market v a l u e o f the r e m a i n i n g Opco s h a r e s so t h a t i t approximated t h e i r a d j u s t e d c o s t base. The r e m a i n i n g s h a r e s would then be d i s p o s e d o f by Holdco t o t h e p u r c h a s e r . In a case where the l i q u i d a s s e t s o f t h e o p e r a t i n g company were i n s u f f i c i e n t t o pay a cash d i v i d e n d t o the h o l d i n g company, or where an a p p r a i s a l s u r p l u s o r o t h e r s u r p l u s account f a i l e d t o s u p p l y a fund f o r c a p i t a l i z a t i o n and the f o r c i n g o u t o f a deemed d i v i d e n d , the buyer might i n j e c t the n e c e s s a r y cash ( e f f e c t i v e l y t h e purc h a s e p r i c e ) by s u b s c r i b i n g f o r s h a r e s o f the o p e r a t i n g company. These a s s e t s might t h e n be used t o pay a d i v i d e n d t o t h e h o l d i n g company o r t o r e p u r c h a s e t h e Holdco's s h a r e s f o r c a n c e l l a t i o n . 108 I t would, o f c o u r s e , be n e c e s s a r y f o r the p u r c h a s e r t o t a k e back s h a r e s o f a d i f f e r e n t c l a s s t h a n a re owned by the h o l d i n g company (as w e l l as t o t a k e a t l e a s t one common share i f the Holdco s h a r e s a r e t o be c a n c e l l e d ) . As the p u r c h a s e r ' s s h a r e s would n o t be redeemed, i t would a l s o be a d v i s a b l e t o g i v e them a h i g h p a i d up c a p i t a l (where the p u r c h a s e r i s an i n d i v i d u a l ) t o a v o i d the l o c k i n g i n o f the i n v e s t m e n t c a p i t a l . C a p i t a l g a i n s s t r i p p i n g manoeuvres were a l s o a v a i l a b l e where a s h a r e h o l d e r wished t o be cashed o u t . T h i s s i t u a t i o n would o f c o u r s e f r e q u e n t l y a r i s e i n c o n n e c t i o n w i t h p r i v a t e c o r p o r a t i o n s t h e c o n s t i t u t i o n a l documents of which imposed s h a r e t r a n s f e r r e s t r i c t i o n s p r o h i b i t i n g s a l e s t o o u t s i d e r s . I t would be n e c e s s a r y as a p r e l i m i n a r y s t e p t o r e o r g a n i z e t h e c a p i t a l o f the c o r p o r a t i o n t o g i v e t h e vendor a d i f f e r e n t c l a s s o f s h a r e s t h a n were h e l d by t h e r e m a i n i n g s h a r e h o l d e r s . The change would n o r m a l l y i n v o l v e t h e c o n v e r s i o n o f common i n t o redeemable p r e f e r e n c e s h a r e s p o s s e s s i n g a low p a i d up c a p i t a l and might be e f f e c t e d p u r s u a n t t o s e c t i o n s 51 o r 86. The s e l l i n g s h a r e h o l d e r would o f c o u r s e have t o r o l l h i s s h a r e h o l d i n g i n t o a h o l d i n g company e i t h e r p r i o r t o o r f o l l o w i n g the r e o r g a n i z a t i o n . A p o r t i o n o f the cash d i v i d e n d r e c e i v e d by the Holdco would i n e f f e c t r e p r e s e n t earned o r o t h e r s u r p l u s a t t r i b u t a b l e t o o t h e r s h a r e s . A l t e r n a t i v e l y , any o f the measures p r e v i o u s l y d i s c u s s e d h a v i n g t o do w i t h the payment o f a deemed d i v i d e n d by the c a p i t a l i z a t i o n o f s u r p l u s p r i o r t o a 109 t a x f r e e s a l e o f the Opco sh a r e s t o the r e m a i n i n g s h a r e h o l d e r s might be implemented. I t s h o u l d be remembered i n a l l c a s e s however t h a t a d i v i d e n d i s p a y a b l e out o f e a r n i n g s o r s u r p l u s , and t h a t i f the g o o d w i l l v a l u e o f the Opco a t t r i b u t a b l e t o the vendor's s h a r e s exceeds t h e b a l a n c e i n t h e s e a c c o u n t s , payment of the d i v i d e n d would p r o b a b l y o f f e n d t h e r e l e v a n t c o r p o r a t e law. Where t h i s i s a c o n c e r n , thought s h o u l d be g i v e n t o h a v i n g the r e m a i n i n g s h a r e h o l d e r s c o n t r i b u t e c a p i t a l o r make l o a n s t o t h e c o r p o r a t i o n i n the n e c e s s a r y amount. Ano t h e r u s e f u l d e v i c e o f s p e c i a l i n t e r e s t i n a c q u i s i t i o n t r a n s a c t i o n s i n v o l v i n g p u b l i c companies i s t h e s h a r e f o r share exchange s e t o u t i n s e c t i o n 8 5.1. Where the s e c t i o n 85.1. r o l l o v e r i s employed, a c h o i c e o f c a p i t a l g a i n s o r d i v i d e n d t r e a t m e n t on the r e a l i z a t i o n o f h i s i n v e s t m e n t may be o f f e r e d the s h a r e h o l d e r o f t h e t a r g e t i f t h e p l a n o f arrangement, amalgamation, o r o t h e r g o v e r n i n g document p e r m i t s him t o e l e c t e i t h e r f o r a c l a s s o f redeemable s h a r e s p o s s e s s i n g a p a i d up c a p i t a l e q u a l t o the redemption amount ( f o r a c a p i t a l gain) o r f o r s h a r e s w i t h a p a i d up c a p i t a l e q u a l o n l y t o the a d j u s t e d c o s t base o f t h e s h a r e s g i v e n up ( f o r a deemed d i v i d e n d ) . I n the l a t t e r c a s e , i f the s h a r e h o l d e r o f t h e t a r g e t i s a c o r p o r a t i o n , the d i v i d e n d w i l l pass t a x f r e e and t h e vendor w i l l have a v o i d e d c a p i t a l g a i n s t a x on the d i s p o s i t i o n o f t h e s h a r e s . The same share exchange mechanism i s a v a i l a b l e under s u b s e c t i o n 85(1) where the s h a r e s o f a p r i v a t e o r p u b l i c company w i t h l i t t l e 110 d i s p e r s a l o f s h a r e o w n ership a r e r o l l e d i n t o t h e p u r c h a s e r c o r p o r a t i o n . d) A s s e t S a l e s The f o r e g o i n g p r o c e d u r e s a l l i n v o l v e t h e s a l e , exchange, r e d e m p t i o n , o r r e p u r c h a s e f o r c a n c e l l a t i o n o f the vendor's s h a r e s . C a p i t a l g a i n s s t r i p s may a l s o be implemented where a s s e t s a r e d i s p o s e d o f by a c o r p o r a t i o n r e s i d e n t i n Canada t o a t a x a b l e Canadian c o r p o r a t i o n . These . t r a n s a c t i o n s d i f f e r somewhat from o r d i n a r y a s s e t s a l e s however, i n t h a t t h e r o l l o v e r p r o v i s i o n i n s u b s e c t i o n 85(1) i s n e c e s s a r i l y employed as p a r t o f t h e a v o i d a n c e scheme. Thus the p u r c h a s e r w i l l n o t b e n e f i t from a h i g h e r c o s t f o r o p ening i n v e n t o r y , an i n c r e a s e d b a s i s f o r c a p i t a l c o s t a l l o w a n c e purposes o r f o r the w r i t e - o f f o f e l i g i b l e c a p i t a l e x p e n d i t u r e s , e t c . The t a x a t t r i b u t e s o f t h e s e p r o p e r t i e s w i l l f l o w t h r o u g h t o t h e p u r c h a s e r . A c c o r d i n g l y the p r i c e p a i d i n ' a s s e t ' a c q u i s i t i o n s o f t h i s t y p e would l i k e l y be d i s c o u n t e d i n a manner n o r m a l l y e n c o u n t e r e d i n share s a l e s . I n ' a s s e t ' s a l e s i t i s u n n e c e s s a r y f o r t h e s h a r e h o l d e r s o f Opco t o f i r s t r o l l t h e i r s h a r e s i n t o a h o l d i n g company as the o p e r a t i n g company, denuded o f i t s a s s e t s and under- t a k i n g , would i t s e l f be t r a n s f o r m e d i n t o an i n v e s t m e n t h o l d i n g company. The a s s e t s a r e o f c o u r s e exchanged f o r 'high-low' redeemable p r e f e r e n c e s h a r e s w h i c h a r e i m m e d i a t e l y bought back by the p u r c h a s e r c o r p o r a t i o n . The i n t e r c o r p o r a t e M l d i v i d e n d i s o f c o u r s e p a i d w i t h o u t t a x c o s t and t h e vendor c o r p o r a t i o n i s l e f t w i t h t a x f r e e d o l l a r s r e a l i z e d from t h e s a l e o f i t s b u s i n e s s and p r o p e r t i e s . A g a i n , P a r t IV t a x w i l l be a c o n c e r n , e s p e c i a l l y where a s m a l l b u s i n e s s i s b e i n g a c q u i r e d by a l a r g e r e n t e r p r i s e , and use o f a ' c l e a n 1 , w h o l l y owned s u b s i d i a r y o f the p u r c h a s e r c o r p o r a t i o n formed i n o r d e r t o make the a c q u i s i t i o n may be n e c e s s a r y t o g uarantee t h a t the vendor t a k e s back a t l e a s t a 10% o r , i f t h e buyer i s a p u b l i c company, a 51% i n t e r e s t i n the payor c o r p o r a t i o n . The p l a n n i n g t e c h n i q u e s t h a t have been d e s c r i b e d i m p o r t e d t h e v i r t u a l a b o l i t i o n o f c a p i t a l g a i n s t a x a t t h e c o r p o r a t e l e v e l t o g e t h e r w i t h u n l i m i t e d d e f e r r a l o f t a x f o r i n d i v i d u a l s d i s p o s i n g o f c a p i t a l p r o p e r t y h e l d by c o r p o r a t i o n s t h e y c o n t r o l . F o l l o w i n g a c a p i t a l g a i n s s t r i p , the vendor c o r p o r a t i o n would n o r m a l l y be l e f t w i t h l i q u i d a s s e t s a v a i l a b l e f o r a l l manner of i n v e s t m e n t o p e r a t i o n s . Thus the r o l l o v e r and i n t e r c o r p o r a t e d i v i d e n d p r o v i s i o n s were employed n o t m e r e l y t o a c c o m p l i s h a t a x f r e e exchange o f a s s e t s , b u t t h e t a x s h e l t e r e d r e a l i z a t i o n o f a p p r e c i a t e d c a p i t a l a s s e t s . I t i s o f c o u r s e t r u e t h a t i n d i v i d u a l s h a r e h o l d e r s b e n e f i t e d o n l y t o t h e e x t e n t t h a t c o r p o r a t e d i s t r i b u t i o n s were d e f e r r e d , b u t Revenue Canada has always p r o p e r l y r e g a r d e d the u n l i m i t e d d e f e r r a l o f t a x as e q u i v a l e n t t o t h e non-payment o f t a x . C o n s i d e r i n g t h e e f f e c t s o f i n f l a t i o n and the income e a r n i n g c a p a c i t y o f the t a x d o l l a r s w i t h h e l d , the government's p o s i t i o n i s e n t i r e l y 112 c o m p r e h e n s i b l e . Moreover, the i n d i v i d u a l s h a r e h o l d e r might f u r t h e r b e n e f i t from the anomalies o f the d i v i d e n d t a x c r e d i t where e.g. a spouse w i t h no o t h e r s o u r c e o f income were p a i d d i v i d e n d s on s h a r e s a c q u i r e d i n t h e h o l d i n g company. I n a d d i t i o n , the p o s s i b i l i t y o f t a k i n g r e c e i p t s i n e x c e s s o f the c o s t o f the s h a r e s as d i v i d e n d s o r c a p i t a l g a i n s , depending upon the most t a x b e n e f i c i a l r e s u l t , remained open t o the s h a r e h o l d e r . e) S u b s e c t i o n s 5 5 ( 2 ) - ( 5 ) i ) I n t r o d u c t i o n F o r some time the government's p o l i c y p o s i t i o n on c a p i t a l g a i n s s t r i p s was e x p r e s s e d i n t h e s o - c a l l e d 'Robertson r u l e s ' , a c c o r d i n g t o w h i c h the c a p i t a l g a i n was a r t i f i c i a l l y reduced i f i t was l e s s than the p o s t - 7 1 i n c r e a s e i n t h e v a l u e o f g o o d w i l l and o t h e r c a p i t a l a s s e t s 9 o f the c o r p o r a t i o n . The government's response t o c a p i t a l g a i n s s t r i p s had t o be c a r e f u l l y c o n s i d e r e d because the a v o i d a n c e t e c h n i q u e s employed by the t a x p a y e r depended upon s t a t u t o r y r u l e s and r e s u l t s t h a t s e r v e d i m p o r t a n t p o l i c y o b j e c t i v e s . R e s t r i c t i o n s on t h e use o f r o l l o v e r s , : f o r example, might s e r i o u s l y i m p a i r genuine c o r p o r a t e r e o r g a n i z a t i o n s and l i m i t a t i o n s on t h e a b i l i t y o f c o r p o r a t i o n s t o pay t a x f r e e i n t e r c o r p o r a t e d i v i d e n d s might l e a d t o t h e p y r a m i d i n g o f t a x on c o r p o r a t e s o u r c e income. I n s t e a d o f amending t h e r u l e s a l r e a d y i n p l a c e , t h e government e v e n t u a l l y d e c i d e d T13 t o l a u n c h i t s a t t a c k upon c a p i t a l g a i n s s t r i p s t h r o u g h a new a n t i - a v o i d a n c e p r o v i s i o n . The r e s u l t ' i s a somewhat l o o s e l y d r a f t e d m i n i a t u r e code d e s i g n e d t o c a t c h and d e a l w i t h the many v a r i o u s c a p i t a l g a i n s a v o i d a n c e schemes. The f o l l o w i n g f e a t u r e s s t a n d o u t i n b o l d e s t r e l i e f . 1) The payment o f a d e d u c t i b l e i n t e r c o r p o r a t e d i v i d e n d ;to a c o r p o r a t i o n r e s i d e n t i n Canda i s i d e n t i f i e d as the l y n c h p i n o f a l l c a p i t a l g a i n s s t r i p s and a c c o r d i n g l y c o n s t i t u t e s t h e most b a s i c c o n d i t i o n o f a p p l i c a b i l i t y o f the new r u l e s . 2) A 'purpose' and, i n t h e case o f i n t e r - c o r p o r a t e d i v i d e n d s a r i s i n g under s u b s e c t i o n 84(3) ( e s s e n t i a l l y redemptions and o t h e r buy-backs) a ' r e s u l t s ' t e s t . I t i s perhaps n o t e n t i r e l y c l e a r from the w o r d i n g o f s u b s e c t i o n 55(2) whether t h e 'purpose' o r ' r e s u l t ' i s t h a t o f t h e d i v i d e n d or o f "a t r a n s a c t i o n o r e vent o r a s e r i e s o f t r a n s a c t i o n s o r e v e n t s " . There i s no doubt, however, t h a t t h e s p e c i f i c purpose o r r e s u l t must be "a s i g n i f i c a n t r e d u c t i o n i n the p o r t i o n o f the c a p i t a l g a i n t h a t , but f o r the d i v i d e n d , would have been r e a l i z e d on a d i s p o s i t i o n a t f a i r market v a l u e o f any s hare of c a p i t a l s t o c k i m m e d i a t e l y b e f o r e the d i v i d e n d " . An i m p o r t a n t q u e s t i o n w i t h f a r r e a c h i n g i m p l i c a t i o n s b e a r i n g upon the i n t e r p r e t a t i o n and a d m i n i s t r a t i o n o f t h e new p r o v i s i o n s , i s t h e n a t u r e o f the s u b s e c t i o n 55(2) purpose t e s t . T h i s m a t t e r w i l l be l a t e r t a k e n up i n d e t a i l . 3) The l i m i t a t i o n t o be imposed upon the payment o f t a x f r e e i n t e r c o r p o r a t e d i v i d e n d s i s i t s e l f c i r c u m s c r i b e d 114 by the p r i n c i p a l exemption f o r "income earned o r r e a l i z e d by any c o r p o r a t i o n a f t e r 1971 and b e f o r e the d i v i d e n d was r e c e i v e d " .' What t h i s means i s t h a t t o the e x t e n t t h a t t h e d i s t r i b u t i n g c o r p o r a t i o n p o s s e s s e s post-1971 t a x r e t a i n e d e a r n i n g s , i t may pay p r e - s a l e t a x f r e e i n t e r c o r p o r a t e d i v i d e n d s w i t h o u t r e g a r d f o r t h e new r u l e s . T h i s i s a c l e a r e x p r e s s i o n o f the u n d e r l y i n g p o l i c y . P o s t - 7 1 income has a l r e a d y borne t a x a t t h e c o r p o r a t e l e v e l and w i l l ( i n t he case o f p u b l i c c o r p o r a t i o n s e s p e c i a l l y ) be t a x e d a g a i n when r e c e i v e d by the s h a r e h o l d e r . As f o r pre-7 2 income and o t h e r p r e - r e f o r m a s s e t v a l u e s o f the c o r p o r a t i o n , t h e s e w i l l be r e f l e c t e d i n the a d j u s t e d c o s t base o f the s h a r e s . Thus, a l l t h a t i s l e f t as a t a r g e t f o r t h e new r u l e s i s an i n t e r c o r p o r a t e d i v i d e n d p a r t l y o r w h o l l y r e p r e s e n t i n g the i n c r e a s e a f t e r 1971 i n the v a l u e o f g o o d w i l l and o t h e r c a p i t a l a s s e t s , e f f e c t i v e l y t h e v a l u e s w h i c h would be r e c o g n i z e d as g a i n s upon a s a l e o f tho s e a s s e t s . I n a d d i t i o n t o the i m p o r t a n t exemption f o r p o s t - 7 1 income, s u b s e c t i o n 55(2) i s a l s o i n a p p l i c a b l e i n c i r c u m s t a n c e s where the d i v i d e n d , though d e d u c t i b l e , i s s u b j e c t t o p a r t IV t a x . 4) The t a x consequences o f p a y i n g a d i v i d e n d i n ex c e s s o f post- 7 1 income are d e l i n e a t e d i n paragraphs 5 5 ( 2 ) ( a ) , ( b ) , and ( c ) . P a r a g r a p h 5 5 ( 2 ) ( a ) p r o v i d e s t h a t , e x c e p t f o r t h e purpose o f computing the d i v i d e n d r e c i p i e n t ' s c u m u l a t i v e d e d u c t i o n a c c o u n t , t h e d i v i d e n d s h a l l be deemed not t o be a d i v i d e n d . The main consequences o f p a y i n g a 115 d i v i d e n d i n c o n t r a v e n t i o n o f the new r u l e s a re s e t out i n paragraphs 55(2) (b) and (c) . Pa r a g r a p h 55(2) (b) p r o v i d e s t h a t where a c o r p o r a t i o n has d i s p o s e d o f the share the g a i n from the d i s p o s a l o f which was unduly reduced by the d i v i d e n d , the d i v i d e n d s h a l l be deemed t o be proceeds o f d i s p o s i t i o n . ' ' " ^ Where a c o r p o r a t i o n has not d i s p o s e d o f t h e s h a r e , p a r a g r a p h 5 5 ( 2 ) ( c ) p r o v i d e s t h a t the d i v i d e n d w i l l be deemed t o be a g a i n o f t h e c o r p o r a t i o n f o r the y e a r i n which the d i v i d e n d i s r e c e i v e d . P a r a g r a p h 5 5 ( 2 ) ( c ) i s t i e d t o t h e f a c t p a t t e r n i n subparagraph 55(3) (a) ( i i ) , i n which a p u r c h a s e r i n j e c t s funds i n t o the t a r g e t c o r p o r a t i o n p u r s u a n t t o a s u b s c r i p t i o n f o r s h ares and t h e s e funds are th e n d i v e r t e d t o t h e c o r p o r a t e vendor whose i n t e r e s t i n t h e t a r g e t company i s n o t c o m p l e t e l y t e r m i n a t e d . A consequence o f the c a p i t a l g a i n / p r o c e e d s o f d i s p o s i t i o n dichotomy i s t h a t t h e s a l e by a p a r e n t o f i t s sh a r e s i n a s u b s i d i a r y may g i v e r i s e t o l a r g e proceeds o f d i s p o s i t i o n f o r the y e a r o f s a l e . I n c i r c u m s t a n c e s where the s u b s i d i a r y has p a i d d i v i d e n d s i n e x c e s s o f p o s t - 7 1 income o v e r a p e r i o d o f y e a r s , p a r a g r a p h 55(2)(b) w i l l deem the f u l l amount o f t h e d i v i d e n d s t o be proceeds o f d i s p o s i t i o n and, as such, w i l l t r e a t the amount as h a v i n g been r e c e i v e d f o l l o w i n g the d i s p o s i t i o n . - ' - 1 T h i s r e s u l t i s perhaps p a r t i c u l a r l y h a r s h i n v i e w o f t h e f a c t t h a t p a r a g r a p h 55(2) (f) w i l l p e r m i t t h e t a x p a y e r an e l e c t i o n t o reduce t h e amount of t h e d i v i d e n d w h i c h i s . ' o f f s i d e ' i . e . i n e x c e s s o f p o s t - 71 income, o n l y where t h e r e has been a r e p u r c h a s e by t h e 116 c o r p o r a t i o n o f i t s own s h a r e s , and not an arm's l e n g t h s a l e t o a t h i r d p a r t y . Indeed, t h e need would seem t o be g r e a t e r i n c i r c u m s t a n c e s where t h e d i v i d e n d i s r e c e i v e d o t h e r w i s e than as a s u b s e c t i o n 84(3) d i v i d e n d . ( i i ) Non-Arm's Le n g t h E x c e p t i o n A f u r t h e r l i m i t a t i o n on the scope o f s u b s e c t i o n 55(2) i s found i n the r e q u i r e m e n t ( i n subparagraphs 55(3) ( a ) ( i ) and ( i i ) ) t h a t t h e p r o p e r t y be d i s p o s e d o f t o an arm's l e n g t h p u r c h a s e r , o r t h a t t h e i n c r e a s e i n i n t e r e s t i n the the t a r g e t be t h a t o f an arm's l e n g t h p a r t y . As a r e s u l t o f t h s e l f - e v i d e n t c o n d i t i o n , i t was a l s o n e c e s s a r y t o guard a g a i n s t t h e p o s s i b i l i t y t h a t t h e p a r t i e s might s t r u c t u r e t h e i r t r a n s a c t i o n s so as t o b r i n g themselves w i t h i n t h e s t a t u t o r y c o n c e p t o f r e l a t e d n e s s s e t o u t i n s u b s e c t i o n s 251(2 ) o r (3) of the A c t . C o n s i d e r t h e f o l l o w i n g example: X BUYCO OPCO a s s e t s s h a r e s 49% SUBCO T L---.--«.v * 51% Buyco, w i s h i n g t o a c q u i r e t h e a s s e t s o f Opco, i n c o r p o r a t e s Subco t o make t h e a c q u i s i t i o n . Opco th e n r o l l s i t s a s s e t s i n t o Subco i n r e t u r n f o r 'high-low' redeemable p r e f e r e n c e s hares c a r r y i n g w i t h them v o t i n g c o n t r o l o f t h e Subco. The subsequent redemption o f t h e Subco s h a r e s h e l d by Opco would t h e n n o t be "a d i s p o s i t i o n o f p r o p e r t y t o a p e r s o n w i t h whom (Opco) was d e a l i n g a t arm's l e n g t h " w i t h i n subparagraph 5 5 ( 3 ) ( a ) ( i ) . The d i v i d e n d upon t h e redemption would however 117 n e v e r t h e l e s s be caught because t h e r e would r e s u l t a s i g n i f i c a n t v o t i n g and p r o p r i e t a r y i n c r e a s e i n t h e i n t e r e s t i n 'any' c o r p o r a t i o n i . e . the Subco o f a c o r p o r a t i o n , t h e Buyco, w h i c h i s a t arm's l e n g t h w i t h t h e Opco w i t h i n sub- p a r a g r a p h 5 5 ( 3 ) ( a ) ( i i ) . L e t us now assume t h a t i n s t e a d o f h a v i n g the Opco a c q u i r e v o t i n g c o n t r o l o f Subco, Subco s u b s c r i b e s f o r sh a r e s o f Opco c a r r y i n g w i t h them v o t i n g c o n t r o l o f Opco w i t h t h e r e s u l t t h a t Opco and Subco a r e non-arm's l e n g t h p u r s u a n t t o subparagraph 2 5 1 ( 2 ) ( b ) ( i ) . The sh a r e s o f Opco t a k e n by Subco have a p a i d up c a p i t a l e q u a l t o t h e i r c o s t and f a i r market v a l u e . Opco then r o l l s i t s a s s e t s i n t o Subco i n r e t u r n f o r p r e f e r e n c e s h a r e s as b e f o r e , and t h e s e a r e s u b s e q u e n t l y redeemed, r e s u l t i n g i n a deemed d i v i d e n d t o Opco. L a t e r the Opco s h a r e s h e l d by Subco a r e r e p u r c h a s e d 12 f o r c a n c e l l a t i o n a t no t a x c o s t t o e i t h e r p a r t y . Upon t h e redemption o f t h e Subco s h a r e s h e l d by Opco, t h e r e i s n e i t h e r a d i s p o s i t i o n o f p r o p e r t y t o a p e r s o n a t arm's l e n g t h w i t h Opco ( 5 5 ( 3 ) ( a ) ( i ) ) , nor an i n c r e a s e i n the i n t e r e s t o f any p e r s o n a t arm's l e n g t h w i t h Opco i n any c o r p o r a t i o n (55(3) (a) 13 ( i i ) ) because Buyco and Opco a r e non-arm's l e n g t h . On a buy-back o f the Opco sh a r e s h e l d by Subco, t h e r e i s , by r e a s o n o f X r e a c q u i r i n g c o n t r o l o f Opco, an i n c r e a s e i n t h e i n t e r e s t i n Opco o f a p e r s o n a t arm's l e n g t h w i t h Subco, however t h e r e i s no d i v i d e n d on t h e buy-back because t h e sh a r e s r e p u r c h a s e d have a h i g h p a i d up c a p i t a l and were i s s u e d s o l e l y i n o r d e r t o b r i n g Subco and Opco i n t o a non-arm's 118 14 l e n g t h r e l a t i o n s h i p . I n o r d e r t o d i s c o u r a g e such schemes, s u b s e c t i o n 55(4) p r o v i d e s as f o l l o w s : Where i t may r e a s o n a b l y be c o n s i d e r e d t h a t t h e p r i n c i p a l purpose o f one o r more t r a n s a c t i o n s o r e v e n t s was t o cause two o r more pe r s o n s t o no t d e a l w i t h each o t h e r a t arm's l e n g t h so as t o make s u b s e c t i o n 2 i n a p p l i c a b l e , f o r the purposes o f t h a t s u b s e c t i o n , t h o s e persons s h a l l be deemed t o d e a l w i t h each o t h e r a t arm's l e n g t h . Thus, i n the second example c o n s i d e r e d above, the ' p r i n c i p a l p urpose' o f the i s s u a n c e o f v o t i n g s h a r e s o f Opco t o Subco i s t o b r i n g them i n t o a non-arm's l e n g t h r e l a t i o n s h i p so as t o make s u b s e c t i o n 55(2) i n a p p l i c a b l e . A c c o r d i n g l y , the p a r t i e s w i l l be deemed t o be a t arm's l e n g t h . The ' p r i n c i p a l purpose' r e q u i r e m e n t i s an i m p o r t a n t f e a t u r e o f s u b s e c t i o n 55(4) which can, i n u n u s u a l c i r c u m s t a n c e s , come i n t o s p e c i a l prominence. C o n s i d e r the f o l l o w i n g example: OPCO | BUYCO | | 49% jSUBCO 1 K" .. a s s e t s -„ 14 9% | 5 1 % "L JSUBCO 2 I"' I I .J s h a r e s 51? The ownership o f S I i s d i v i d e d between Buyco and S2 on the b a s i s o f 49% and 51% i n t e r e s t s r e s p e c t i v e l y . S2 i s o r i g i n a l l y the w h o l l y owned s u b s i d i a r y o f S I , however t h e redeemable p r e f e r e n c e s h a r e s t a k e n by Opco as p a r t o f the s u b s e c t i o n 85(1) r o l l o v e r o f i t s a s s e t s i n t o t h e S2 c a r r y w i t h them__ v o t i n g c o n t r o l . Upon the redemption o f t h e S2 sha r e s h e l d 119 by Opco, subparagraph 5 5 ( 3 ) ( a ) ( i ) p r o v i d e s t h a t t h e d i v i d e n d a v o i d s the consequences o f pa r a g r a p h 55(2) (b) because Opco and Subco 2 a r e non-arm's l e n g t h ( p u r s u a n t t o subparagraph 2 5 1 ( 2 ) ( b ) ( i ) ) . I n a d d i t i o n , t h e r e i s no i n c r e a s e i n t h e i n t e r e s t o f a p e r s o n a t arm's l e n g t h w i t h Opco i n S2 because subparagraph 2 5 1 ( 2 ) ( b ) ( i ) and s u b s e c t i o n 251(3) p r o v i d e t h a t Opco and SI a r e a l s o non-arm's l e n g t h . I t might be argued t h a t a l t h o u g h Buyco has n e i t h e r a p r o - p r i e t a r y nor a v o t i n g i n t e r e s t i n S2 i t s i n d i r e c t economic i n t e r e s t i n S2 i s i n c r e a s e d by v i r t u e o f S i ' s r e a c q u i s i t i o n o f a 100% i n t e r e s t i n S2. The w r i t e r s u b m i t s t h a t t h i s does no t p r e s e n t a problem because n e i t h e r S i ' s d i r e c t nor Buyco's i n d i r e c t economic i n t e r e s t i n S2 i s i n c r e a s e d f o l l o w i n g the redemption o f the s h a r e s h e l d by Opco. S2 has e l i m i n a t e d i t s l i a b i l i t y on t h e s h a r e s b u t has a l s o commensurately d e c r e a s e d i t s a s s e t v a l u e . Assuming t h a t the i n c e s t u o u s i n t e r c o r p o r a t e s h a r e h o l d i n g p r e - e x i s t s , the t r a n s f e r o f the Opco a s s e t s and i s unconnected w i t h t h e r o l l o v e r , a s t r o n g case can be made f o r s a y i n g t h a t t h e ' p r i n c i p a l purpose' o f t h e i s s u a n c e o f v o t i n g s h a r e s o f S2 t o Opco was not t o b r i n g t h e p a r t i e s i n t o a non-arm's l e n g t h r e l a t i o n s h i p . The phrase ' p r i n c i p a l purpose' c l e a r l y s u g g e s t s the s p e c i f i e d purpose must predominate over o t h e r purposes w h i l e the i s s u a n c e o f S2 sh a r e s t o Opco i s done as much t o a c c o m p l i s h t h e r o l l o v e r o f a s s e t s (a common f e a t u r e o f t h e t y p e s o f t r a n s a c t i o n s under d i s c u s s i o n ) as t o c r e a t e a non-arm's l e n g t h r e l a t i o n s h i p . 120 The exemption f o r non-arm's l e n g t h t r a n s a c t i o n s i s perhaps e x p l a i n e d i n p a r t by a d e s i r e t o p r e s e r v e t h e t a x f r e e consequences o f e s t a t e f r e e z i n g o p e r a t i o n s . The r e s u l t i s t h a t e s t a t e f r e e z i n g w i l l p e r m i t the f r e e z o r t o r e a l i z e h i s i n v e s t m e n t i n the o p e r a t i n g company f r e e o f t a x (and s u b s e c t i o n 55(2)) by means of t h e r o l l o v e r and i n t e r c o r p o r a t e d i v i d e n d r u l e s and t h e exemption i n s u b s e c t i o n 55(3) f o r non-arm's l e n g t h t r a n s a c t i o n s . I n o r d e r t o a c c o m p l i s h t h i s , i t w i l l o f c o u r s e be n e c e s s a r y f o r the f r e e z o r t o r o l l h i s p r e f e r e n c e s h a r e s i n t o a p e r s o n a l h o l d i n g company p r i o r t o t h e i r r e demption. The f a i r n e s s o f p e r m i t t i n g non-arm's l e n g t h p a r t i e s engaged i n e s t a t e f r e e z i n g t r a n s a c t i o n s t o e n j o y the b e n e f i t s o f c a p i t a l g a i n s s t r i p s i s perhaps q u e s t i o n a b l e . Once the f u t u r e growth: and, perhaps, v o t i n g c o n t r o l has been t r a n s f e r r e d t o t h e n e x t g e n e r a t i o n , i t i s a r g u a b l e t h a t t h e o b j e c t s o f the f r e e z i n g p r o c e d u r e have been a c h i e v e d . The n o t i o n t h a t t h e t a x consequences t o the f r e e z o r ought t o be d e f e r r e d s h o u l d , i t would seem, be premised upon the a s sumption t h a t the r e c e i p t and use o f the proceeds a r e a l s o d e f e r r e d . T a k i n g a t a x f r e e i n t e r c o r p o r a t e d i v i d e n d i n s a t i s f a c t i o n o f h i s i n t e r e s t i n the o p e r a t i n g company p e r m i t s t h e f r e e z o r t o t r a n s f o r m t h e proceeds i n t o new and d i f f e r e n t i n v e s t m e n t forms as he d e s i r e s . T h i s f e a t u r e o f t h e t r a n s a c t i o n s t r o n g l y s u g g e s t s t h a t a d i s p o s i t i o n has o c c u r r e d i n an economic sense. There would seem t o be no c o m p e l l i n g r e a s o n t o e x t e n d the d e f e r r a l advantage a v a i l a b l e 121 t o the f r e e z o r beyond t h a t e f f e c t e d by the t a x f r e e t r a n s f o r m a t i o n o f h i s i n t e r e s t from a p a r t i c i p a t o r y t o a n o n - p a r t i c i p a t o r y one. ( i i i ) S i g n i f i c a n t R e d u c t i o n I t i s f u r t h e r r e q u i r e d t h a t the r e d u c t i o n i n t h e c a p i t a l g a i n be ' s i g n i f i c a n t ' . No i n d i c a t i o n i s g i v e n r e g a r d i n g meaning of t h i s e x p r e s s i o n . I s a $5,000 r e d u c t i o n i n what would o t h e r w i s e be a $15,000 g a i n ' s i g n i f i c a n t ' ? P r o b a b l y i t i s . But what o f a $5,000 r e d u c t i o n o f a $500,000 o r $5,000,000 g a i n ? C e r t a i n l y the r e d u c t i o n s i n the g a i n i n the two l a t t e r mentioned cases a r e l e s s s i g n i f i c a n t than i n the former c a s e . I n t h e f i r s t example the g a i n i s reduced by 1/3, w h i l e i n t h e r e m a i n i n g two i t i s reduced by 1/100 and 1/1000 r e s p e c t i v e l y . I t i s l i k e l y t h a t the government would t e n d t o r e g a r d t h e measure o f what i s s i g n i f i c a n t s t r i c t l y i n terms of d o l l a r s r a t h e r than i n terms o f f r a c t i o n s o f the t o t a l g a i n . Any l o s s o f t a x revenues on $5,000 i s ' s i g n i f i c a n t ' t o t h e government r e g a r d l e s s o f the amount o f the g a i n which i s r e c o g n i z e d as a r e s u l t o f t h e t r a n s a c t i o n . I t s h o u l d be n o t e d , however, t h a t t h e r e d u c t i o n which must be ' s i g n i f i c a n t 1 i s i n the p o r t i o n o f t h e g a i n o t h e r w i s e r e a l i z a b l e . The word ' p o r t i o n ' would c l e a r l y suggest a p a r t o r f r a c t i o n o f the g a i n r a t h e r than a s p e c i f i c amount. Moreover, i f what i s ' s i g n i f i c a n t ' does n o t v a r y from case t o case by comparison w i t h the r e c o g n i z e d g a i n , but i s a c o n s t a n t amount i n d o l l a r s f o r a l l t r a n s a c t i o n s , why would th e l e g i s l a t o r n ot s i m p l y 122 s t i p u l a t e i n p r e c i s e terms t h e amount i n t e n d e d ? ( i v ) B u t t e r f l i e s A re F r e e P a r a g r a p h 5 5 ( 3 ) ( b ) c o n t a i n s an e x c e p t i o n t o t h e normal r u l e s i n s u b s e c t i o n 55(2) i n o r d e r t o p r e s e r v e t h e t a x f r e e consequences o f c e r t a i n c o r p o r a t e d i v i s i o n s o r break-ups commonly r e f e r r e d t o i n t a x j a r g o n as ' b u t t e r f l i e s ' . A f a i r l y t y p i c a l s i t u a t i o n would a r i s e i n c i r c u m s t a n c e s where e q u a l owners o f an o p e r a t i n g company w i s h e d t o p a r t company and d i v i d e t h e c o r p o r a t e a s s e t s between them. F o r con v e n i e n c e , suppose t h a t t h e a s s e t s c o n s i s t o f two s e p a r a t e b u s i n e s s e s and i t i s agreed t h a t each o f t h e s h a r e h o l d e r s i s t o be l e f t w i t h one o f the b u s i n e s s e s f o l l o w i n g the r e o r g a n i z a t i o n . s h a r e s The above diagram, known as the 'two-winged b u t t e r f l y ' , i l l u s t r a t e s t he f o l l o w i n g s t e p s : 1) The i n d i v i d u a l s h a r e h o l d e r s o f Opco, X and Y, r o l l t h e i r Opco s h a r e s i n t o p e r s o n a l h o l d i n g companies XCO and YCO, t a k i n g back s h a r e s o f the h o l d i n g companies w i t h the same p a i d up c a p i t a l as the t r a n s f e r r e d s h a r e s o f Opco: 2) new OXCO and OYCO a r e formed as s u b s i d i a r i e s o f Opco; 3) Opco r o l l s t h e a s s e t s t o be d i v i d e d a c c o r d i n g t o the i n t e n d e d o w n e r ship i n t o OXCO 123 and OYCO i n r e t u r n f o r redeemable sh a r e s p o s s e s s i n g a low p a i d up c a p i t a l and a redemption amount e q u a l t o t h e f a i r market v a l u e s o f the t r a n s f e r r e d b u s i n e s s e s ; 4) XCO s u b s c r i b e s f o r common sha r e s o f OXCO, and YCO f o l l o w s s u i t i n r e s p e c t o f OYCO common s h a r e s ; 5) OXCO and OYCO purcha s e a l l o f t h e i r s h a r e s f o r c a n c e l l a t i o n from Opco; 6) Opco purchases i t s s h a r e s owned by XCO and YCO, o r i s wound up; 7) t h e w h o l l y owned s u b s i d i a r i e s OXCO and OYCO a r e wound up i n t o XCO and YCO r e s p e c t i v e l y . I n the f i n a l a n a l y s i s , i t i s appa r e n t t h a t each o f s h a r e h o l d e r s X and Y i s l e f t w i t h h i s own o p e r a t i n g company. Where i t was d e s i r a b l e , the o p e r a t i n g and i n v e s t m e n t incomes might be k e p t s e p a r a t e s i m p l y by d i s p e n s i n g w i t h the l a s t s t e p . A more f r e q u e n t l y encountered' v a r i a t i o n o f t h e above t r a n s a c t i o n i n v o l v i n g l e s s c o m p l e x i t y and expense i s t h e s o - c a l l e d ' s i n g l e - w i n g e d b u t t e r f l y 1 . Assume t h e same b a s i c f a c t s i t u a t i o n as i n the p r e v i o u s example. X Y Y 50% OPCO 50% a s s e t s 100% YCO sh a r e s In t h e above diagram, Y has t r a n s f e r r e d h i s sha r e s i n Opco to YCO i n exchange f o r common sha r e s o f YCO p o s s e s s i n g t h e same p a i d up c a p i t a l as the t r a n s f e r r e d shares o f Opco. The a s s e t s o f t h e b u s i n e s s t o be c a r r i e d on by YCO a r e t r a n s f e r r e d by OPCO, a g a i n p u r s u a n t t o s u b s e c t i o n 8 5 ( 1 ) , i n r e t u r n f o r p r e f e r e n c e s h a r e s w i t h a redemption amount e q u a l t o t h e f a i r market v a l u e o f t h e b u s i n e s s and w i t h 124 a low p a i d up c a p i t a l . The YCO p r e f e r e n c e s h a r e s h e l d by OPCO s h o u l d amount t o a t l e a s t a 10% v o t i n g and v a l u e i n t e r e s t i n o r d e r t h a t , upon t h e i r r e d e m p t i o n , t h e t a x a b l e d i v i d e n d may pass f r e e o f P a r t IV t a x . OPCO purchases f o r c a n c e l l a t i o n i t s s h a r e s h e l d by YCO and YCO redeems i t s p r e f e r e n c e s h a r e s h e l d by OPCO. I t w i l l be no t e d t h a t the movement o f cash i n t h i s o p e r a t i o n i s c i r c u l a r , w i t h t h e net r e s u l t a g a i n b e i n g t h a t each i n d i v i d u a l i s l e f t w i t h h i s own o p e r a t i n g company. Such then a r e the t y p e s o f t r a n s a c t i o n s e x c l u d e d by p a r a g r a p h 55(3)(b) from the ambit o f s u b s e c t i o n 5 5 ( 2 ) . A major l i m i t a t i o n o f t h i s e x c e p t i o n i s t h a t the f a i r market v a l u e o f each type o f p r o p e r t y d i s t r i b u t e d must approximate t h a t p r o p o r t i o n o f the f a i r market v a l u e o f p r o p e r t y o f t h a t type owned by the d i s t r i b u t i n g company b e f o r e t h e d i v i s i o n t h a t the f a i r market v a l u e o f the r e c e i v i n g company's s h a r e h o l d i n g (or the s h a r e h o l d i n g o f a pe r s o n who owns the r e c e i v i n g company's shares) i n the d i s t r i b u t i n g company i s o f the f a i r market v a l u e o f t h e d i s t r i b u t i n g company's s h a r e s . The o b v i o u s o b j e c t i v e o f t h i s r a t h e r t o r t u o u s w o r d i n g i s t o ensure t h a t a c o r p o r a t e d i v i s i o n i s n o t employed f o r the purpose o f c a s h i n g a s e l l i n g s h a r e h o l d e r o u t on a t a x f r e e b a s i s . I f , f o r example, the law merely r e q u i r e d t h a t t h e a s s e t s be d i v i d e d i n p r o p o r t i o n t o the r e s p e c t i v e e q u i t y i n t e r e s t s o f the s h a r e h o l d e r s i n t h e d i s t r i b u t i n g company, o n l y l i q u i d a s s e t s might be a l l o c a t e d t o the s e l l i n g s h a r e h o l d e r . The 'each type o f p r o p e r t y ' s t i p u l a t i o n would appear t o be i n f l e x i b l e and a r b i t r a r y . I n t e r p r e t e d c o n s e r v a t i v e l y , 125 the p r o v i s i o n would deny the exemption f o r c o r p o r a t e d i v i s i o n s where the c o r p o r a t i o n owned but one type o f p r o p e r t y . The government has l e t i t be known t h a t f a v o u r a b l e r u l i n g s w i l l be g i v e n so l o n g as the d i s t r i b u t i o n a p p o r t i o n s 'hard' and ' l i q u i d * a s s e t s i n p r o p o r t i o n t o the r e l a t i v e e q u i t y i n t e r e s t s such t h a t each s h a r e h o l d e r g e t s h i s p r o - r a t a share o f each type o f a s s e t . A l t h o u g h t h i s i s h e l p f u l i n g i v i n g t h e p a r a - graph some scope i n w h i c h r e a s o n a b l y t o o p e r a t e , d i f f i c u l t i e s may c o n t i n u e t o a r i s e . B e f o r e d e a l i n g w i t h t h e s e , i t might be w e l l t o mention t h a t p a r a g r a p h 55(3) (b) perhaps i t s e l f c r e a t e s an o p p o r t u n i t y f o r c a p i t a l g a i n s a v o i d a n c e . T h i s l o o p h o l e would be the more u s e f u l t o t a x p a y e r s because of the s p e c i f i c i t y o f the new r u l e s . Cases s t r i c t l y w i t h i n t h e exemption o f p a r a g r a p h 55(3)(b) might be u n a s s a i l a b l e under s u b s e c t i o n 5 5 ( 1 ) . X and Y each own a s s e t s (or groups o f a s s e t s ) used i n b u s i n e s s . The a s s e t s a r e o f the same type and p o s s e s s the same f a i r market v a l u e . Each would l i k e t o exchange h i s a s s e t s f o r t h o s e o f t h e o t h e r on a t a x f r e e b a s i s . They each r o l l t h e i r a s s e t s i n t o a s h e l l c o r p o r a t i o n and t a k e back common sh a r e s e q u a l i n v a l u e and i n number. A s i n g l e o r two-winged b u t t e r f l y i s then used t o d i v i d e t h e c o r p o r a t e a s s e t s among the s h a r e h o l d e r s w i t h each t a k i n g t h e p r o p - e r t i e s f o r m e r l y b e l o n g i n g t o the o t h e r . As n o t e d , t h e government has l e t i t be known t h a t 'types o f a s s e t s ' w i l l be t a k e n t o mean 'h a r d 1 and ' l i q u i d ' a s s e t s . T h i s i n t e r p r e t a t i o n does not l e n d s u f f i c i e n t f l e x - i b i l i t y t o the s e c t i o n . F o r example, where two b u s i n e s s e s 126 o f e q u a l v a l u e a r e b e i n g conducted by a s i n g l e company and two e q u a l owners w i s h t o be l e f t each w i t h one b u s i n e s s f o l l o w i n g t h e r e o r g a n i z a t i o n , a problem w i l l a r i s e where the h a r d and l i q u i d a s s e t s o f t h e two b u s i n e s s e s a r e not of the same t y p e . Even i f the v a l u e s o f the two b u s i n e s s e s a r e r o u g h l y the same, the f a i r market v a l u e s o f t h e hard and l i q u i d a s s e t s may not be e q u a l . C o n s i d e r two b u s i n e s s e s w i t h the f o l l o w i n g a s s e t s and v a l u e s breakdown: B u s i n e s s 1 B u s i n e s s 2 G o o d w i l l 200 Hard 700 L i q u i d 600 T o t a l 1500 G o o d w i l l 1000 Hard 100 l i q u i d 400 T o t a l 1500 I t can be argued from a p o l i c y p o i n t o f view t h a t the r o l l - o v e r ought t o be p r e s e r v e d i n a t r a n s f e r o f t h e s e b u s i n e s s e s i n t o s e p a r a t e companies. N e i t h e r s h a r e h o l d e r , however, c o n t i n u e s t o own a 50% i n t e r e s t i n t h e h a r d and l i q u i d a s s e t s o f the d i s t r i b u t i n g company. I n c e r t a i n c i r c u m s t a n c e s , c o m p l i a n c e w i t h p a r a g r a p h 55(3)(b) may demand a d d i t i o n a l , e x p e n s i v e , and u n n e c e s s a r y t a x p l a n n i n g . C o n s i d e r t h e f o l l o w i n g c o r p o r a t e s t r u c t u r e : B 50% | ^ ^ " 5 0 % I 100% %\ ^ ^ 5 0 % \ ^ YCO sh x c o ares; ZCO redeemable 100% p r e f e r e n c e s h a r e s YCO A and B a r e e q u a l s h a r e h o l d e r s o f XCO, an o p e r a t i n g company. YCO, a l s o an o p e r a t i n g company, i s t h e w h o l l y owned s u b s i d - i a r y o f XCO. A and B would l i k e t o p a r t company w i t h B t a k i n g 127 o v e r the b u s i n e s s o f YCO and X c o n t i n u i n g t o own t h e XCO b u s i n e s s . The b u s i n e s s e s a r e o f e q u a l v a l u e . B would l i k e t o c o n t i n u e o p e r a t i n g the YCO as a s u b s i d i a r y i n o r d e r t o keep the i n v e s t m e n t and a c t i v e b u s i n e s s incomes s e p a r a t e , and he i s the s o l e s h a r e h o l d e r o f ZCO, an i n v e s t m e n t s h o l d i n g company. A handy method f o r r e o r g a n i z i n g the c o r p o r a t e s t r u c t u r e s a c c o r d i n g t o the c l i e n t ' s d e s i r e s would be f o r XCO t o r o l l t h e YCO s h a r e s i n t o ZCO i n exchange f o r redeemable p r e f e r e n c e s h a r e s . B a l s o r o l l s h i s XCO s h a r e s i n t o ZCO. T h i s i s f o l l o w e d by a r e p u r c h a s e f o r c a n c e l l a t i o n o f the XCO s h a r e s h e l d by ZCO and a redemption o f the ZCO s h a r e s h e l d by XCO. I n the r e s u l t , B d i v i e s t s h i m s e l f o f h i s XCO s h a r e s , and YCO i s the w h o l l y owned s u b s i d i a r y o f ZCO. U n f o r t u n a t e l y , paragraph 55(3). (b) would not appear t o p e r m i t t h i s r e s u l t . A s e c u r i t y r e p r e s e n t i n g an i n v e s t m e n t i n a s u b s i d i a r y may be c l a s s i f i e d as a!hard a s s e t . Even though the s h a r e s i n e f f e c t r e p r e s e n t a c o m b i n a t i o n o f h a r d and l i q u i d a s s e t s v e s t e d i n the s u b s i d i a r y , the d i s t r i b u t i o n t o ZCO w i l l c o n s t i t u t e a t r a n s f e r o f more than 50% o f t h e f a i r market v a l u e s o f the h a r d and l i q u i d a s s e t s o f XCO. In o r d e r t o accomodate p a r a g r a p h 55(3)(b) i t i s n e c e s s a r y f i r s t t o wind up YCO i n t o XCO, t r a n s f e r t h e YCO b u s i n e s s i n t o ZCO and r o l l t h e i n v e s t m e n t p r o p e r t i e s o f ZCO ( i n c l u d i n g t h e YCO shares) i n t o a new c o r p o r a t i o n . A l t e r n a t i v e l y , the YCO b u s i n e s s c o u l d be t r a n s f e r r e d i n t o a new c o r p o r a t i o n . T h i s i n v o l v e s t h e u n n e c e s s a r y f o r m a t i o n and d i s s o l u t i o n o f 128 companies. I t i s i m p o r t a n t t o note t h a t the ' p r i n c i p a l purpose' t e s t i n 55(3) (b) i s extended by i n c l u d i n g i n t h e s e r i e s o f t r a n s a c t i o n s o r ev e n t s "any r e l a t e d t r a n s a c t i o n s o r e v e n t s completed i n c o n t e m p l a t i o n o f the s e r i e s . " I n t e r e s t i n g l y , the e x t e n s i o n t o t h e purpose t e s t would seem t o co n t e m p l a t e t r a n s a c t i o n s o r e v e n t s completed f o l l o w i n g the r e o r g a n i z a t i o n . C o n s i d e r the s i t u a t i o n where V owns a l l o f t h e sh a r e s o f OPCO, which c a r r i e s on two b u s i n e s s e s . The a s s e t s o f t h e b u s i n e s s which V w i s h e s t o s e l l a ccount f o r 1/4 o f t h e f a i r market v a l u e o f OPCO and t h e a s s e t s o f the b u s i n e s s t o be r e t a i n e d r e p r e s e n t the b a l a n c e o f OPCO's n e t w o r t h . The r e l e v a n t v a l u e s a r e $25,000 and $75,000 r e s p e c t i v e l y and the f a i r market v a l u e s o f t h e a s s e t s o f b o t h b u s i n e s s e s a r e e q u a l l y d i v i s i b l e i n t o h a r d and l i q u i d a s s e t s . V makes a c o n t r i b u t i o n of $50,000 t o t h e c a p i t a l o f OPCO. P s u b s c r i b e s f o r s h a r e s o f OPCO, i n j e c t i n g $50,000 i n t o t h e company and t a k i n g back s h a r e s w i t h a f a i r market v a l u e e q u a l t o 1/4 o f V's s h a r e - h o l d i n g . A f t e r a s h o r t p e r i o d o f t i m e , the company i s s p l i t i n t o two s e p a r a t e p a r t s w i t h P t a k i n g t h e s m a l l e r b u s i n e s s 15 as w e l l as h i s 1/4 share o f OPCO's ha r d and l i q u i d a s s e t s . I n t h e c i r c u m s t a n c e s , t h e t r a n s a c t i o n c o m p l i e s w i t h the p r o v i s i o n s o f pa r a g r a p h 5 5 ( 3 ) ( b ) . P w i l l t a k e a p p r o x i m a t e l y 1/4 o f the ha r d and l i q u i d a s s e t s o f OPCO, a f r a c t i o n on a l l f o u r s w i t h h i s s h a r e h o l d i n g i n t h a t company. Whether o r not i t i s caught by t h e p r o v i s o r e s p e c t i n g a d d i t i o n a l p l a n n i n g depends upon the view t a k e n o f the e x p r e s s i o n " r e l a t e d 129 t r a n s a c t i o n s o r e v e n t s completed i n c o n t e m p l a t i o n o f t h e s e r i e s " . (v) The Concept o f P o s t - 7 1 Income: C o m p u t a t i o n a l R u l e s and Comment. S u b s e c t i o n 55(5) c o n t a i n s a number o f r u l e s a p p l i c a b l e t o the c o m p u t a t i o n o f p o s t - 7 1 income. P a r a g r a p h 5 5 ( 5 ) ( a ) p r o v i d e s t h a t where th e s a l e p r i c e o f s h a r e s i s based upon an e a r n - o u t , t h a t i s , where th e p r i c e i s t i e d t o t h e f u t u r e p r o f i t a b i l i t y o f t h e company, the t a x p a y e r cannot c l a i m t h a t the a v o i d e d g a i n i s a t t r i b u t a b l e t o p o s t - 7 1 income earned f o l l o w i n g the s a l e . T h i s i s a good i n d i c a t i o n o f t h e o f f i c i a l p o l i c y v iew t h a t r e s t r i c t s p o s t - 7 1 income t o t a x r e t a i n e d income on hand. A l t h o u g h t h i s r e s t r i c t i o n may be a p p r o p r i a t e i n the case o f e a r n - o u t s , t h e r e are c i r c u m s t a n c e s i n w h i c h i t s v a l i d i t y i s q u e s t i o n a b l e . These w i l l be examined l a t e r . P a r a g r a p h 55(5)(b) c o n t a i n s p r o v i s i o n s d e s i g n e d t o make ad j u s t m e n t s t o the p o s t - 7 1 income o f p u b l i c c o r p o r a t i o n s , and t o t a k e account o f c e r t a i n d e d u c t i o n s from D i v i s i o n B income which do n o t i n v o l v e a c t u a l d i s b u r s e m e n t s . A c c o r d i n g t o subparagraph 5 5 ( 5 ) ( b ) ( i ) and p a r a g r a p h 5 5 ( 5 ) ( c ) t h e i n v e n t o r y and s c i e n t i f i c r e s e a r c h a l l o w a n c e s are added back t o p o s t - 7 1 income. These d e d u c t i o n s do not i n v o l v e t h e r e d u c t i o n o f p o s t - 7 1 t a x r e t a i n e d e a r n i n g s and a c c o r d i n g l y w i l l c o n t i n u e t o be r e f l e c t e d i n the share v a l u e s and t h e g a i n s from the d i s p o s i t i o n o f s h a r e s . The d e c i s i o n was t h e r e f o r e t a k e n t o p e r m i t the removal o f t h e s e amounts by means of d i v i d e n d payments p r i o r t o the s a l e o f t h e s h a r e s . 130 Subparagraph 5 5 ( 5 ) ( b ) ( i ) b r i n g s i n t o p o s t - 7 1 income "h t h e amount, i f any, by w h i c h the aggregate o f t h e c a p i t a l g a i n s o f the c o r p o r a t i o n f o r the p e r i o d exceeds th e a g g r e g a t e o f i t s c a p i t a l l o s s e s f o r t h e p e r i o d . " T h i s r e p r e s e n t s t h e n o n - t a x a b l e % o f c a p i t a l g a i n s which i s not b r o u g h t i n t o income by s u b s e c t i o n 3 ( b ) . These funds w i l l i n c r e a s e the f a i r market v a l u e o f a p u b l i c c o r p o r a t i o n ' s s h a r e s and i n c r e a s e the g a i n upon t h e i r d i s p o s i t i o n . I f a p u b l i c c o r p o r a t i o n c o u l d n o t pay out t h e s e sums as a p r e - s a l e d i v i d e n d , the f u l l amount o f i t s c a p i t a l g a i n s would e f f e c t - i v e l y be s u b j e c t t o t a x because h o f t h e g a i n would come i n t o income when r e a l i z e d and t h e r e m a i n i n g h would i t s e l f be t a x e d as a g a i n upon a s a l e o f the c o r p o r a t i o n ' s s h a r e s . P r i v a t e c o r p o r a t i o n s o f c o u r s e have a v a i l a b l e t h e o p t i o n o f p a y i n g out the n o n - t a x a b l e h o f c a p i t a l g a i n s by e l i m i n a t i n g the b a l a n c e i n t h e c a p i t a l d i v i d e n d a c c o u n t . Such d i v i d e n d s a r e not t a x a b l e d i v i d e n d s and a c c o r d i n g l y a r e not caught by s u b s e c t i o n 5 5 ( 2 ) . Subparagraph 5 5 ( 5 ) ( b ) ( i i i ) i n c l u d e s i n t h e p o s t - 7 1 income c o n c e p t the untaxed p o r t i o n o f r e c e i p t s from the d i s p o s i t i o n o f e l i g i b l e c a p i t a l p r o p e r t y t o t h e e x t e n t t h a t s u b s e c t i o n 14(1) b r i n g s t h e s e amounts i n t o income. T h i s p r o v i s i o n i s t h u s i n the same s p i r i t as t h a t d e a l i n g w i t h the untaxed h o f r e a l i z e d c a p i t a l g a i n s . The untaxed p o r t i o n o f such r e c e i p t s a r e not added t o the p o s t - 7 1 income o f p u b l i c c o r p o r a t i o n s where none o f the p roceeds a r e b r o u g h t 131 i n t o income b u t s e r v e i n s t e a d t o reduce t h e c o r p o r a t i o n ' s c u m u l a t i v e e l i g i b l e c a p i t a l . Presumably, t h i s i s because amounts me r e l y r e d u c i n g the a m o r t i z e d amount a r e not s u b j e c t t o t a x . Pa r a g r a p h 55(5)(b) t a k e s i n t o account t h e p o s s i b i l i t y t h a t p a r t o f t h e f a i r market v a l u e o f a c o r p o r a t i o n ' s s h a r e s may be a t t r i b u t a b l e t o an i n v e s t m e n t i n a f o r e i g n a f f i l i a t e . A f o r e i g n a f f i l i a t e i s d e f i n e d i n p a r a g r a p h 95(1) (d) as a n o n - r e s i d e n t c o r p o r a t i o n a t l e a s t 10% o f t h e e q u i t y o f which i s owned by a Canadian r e s i d e n t c o r p o r a t i o n . I t i s a l s o r e c o g n i z e d t h a t the Canadian c o r p o r a t i o n ' s s h a r e s might r e f l e c t v a l u e s a t t r i b u t a b l e t o income earned o r r e a l i e d by the f o r e i g n a f f i l i a t e a f t e r 1971 and which might n o r m a l l y be r e c e i v e d as a t a x f r e e d i v i d e n d p u r s u a n t t o s u b s e c t i o n 1 1 3 ( 1 ) . The income o f a f o r e i g n a f f i l i a t e i s a c c o r d i n g l y deemed t o be t h e amount t h a t would have been d e d u c t i b l e p u r s u a n t t o s u b s e c t i o n s 113(1)(a) and (b) on t h e assumptions t h a t 1) the Canadian c o r p o r a t i o n owned a l l o f t h e f o r e i g n a f f i l i a t e ' s s t o c k , 2) t h a t a l l o f the s h a r e s had been d i s p o s e d o f f o r t h e i r f a i r market v a l u e , and 3) t h a t t h e Canadian c o r p o r a t i o n had made a 93(1) e l e c t i o n i n r e s p e c t o f the f u l l p r oceeds o f d i s p o s i t i o n . S u b s e c t i o n 93(1) p e r m i t s a c o r - p o r a t i o n r e s i d e n t i n Canada t o e l e c t t o t r e a t t h e proceeds of d i s p o s i t i o n o f the sh a r e s o f a f o r e i g n a f f i l i a t e as a d i v i d e n d . The d i v i d e n d w i l l be d e d u c t i b l e however o n l y t o t h e e x t e n t p e r m i t t e d by s u b s e c t i o n 1 1 3 ( 1 ) . T h i s p r o v i s i o n a p p l i e s t o d i v i d e n d s p a i d o u t o f exempt, t a x a b l e , and p r e - 132 a c q u i s i t i o n s u r p l u s o f t h e f o r e i g n a f f i l i a t e . I t s h o u l d be n o t e d , however, t h a t p a r a g r a p h 55(5) (a) r e f e r s o n l y t o t h e p o r t i o n o f the d i v i d e n d a t t r i b u t a b l e t o exempt and t a x a b l e s u r p l u s . Indeed, a p o r t i o n o f t h e t a x a b l e s u r p l u s i t s e l f may be e x c l u d e d s i n c e p a r a g r a p h 55(5)(d) makes no r e f e r e n c e t o p a r a g r a p h 113(1) (c) , which adds t o the d e d u c t i b l e d i v i d e n d amounts p a i d i n r e s p e c t o f n o n - b u s i n e s s income t a x . T h i s o m i s s i o n may be e x p l a i n e d by the f a c t t h a t t h e r e w i l l be no such t a x i . e . w i t h h o l d i n g t a x p a i d i n t h e f o r e i g n j u r i s - d i c t i o n because the s u b s e c t i o n 93(1) e l e c t i o n g i v e s r i s e t o a deemed, not an a c t u a l d i v i d e n d . As f o r t h e p r e - a c q u i s i t i o n s u r p l u s o f the f o r e i g n a f f i l i a t e , presumably i t would be r e - f l e c t e d i n t h e a d j u s t e d c o s t base o f i t s s h a r e s h e l d by t h e Canadian c o r p o r a t i o n and a c c o r d i n g l y c o u l d not c o n t r i b u t e to a c a p i t a l g a i n upon a d i s p o s i t i o n o f t h o s e s h a r e s . A p o s s i b l e problem i n t h i s r e g a r d i s the case o f a Canadian c o r p o r a t i o n a c q u i r i n g the s h a r e s o f a f o r e i g n a f f i l i a t e w i t h p o s t - 7 1 income. The a d j u s t e d c o s t base o f t h e f o r e i g n a f f i l i a t e ' s s h a r e s would t h e n , i t i s s u b m i t t e d , be p r o p e r l y i n c l u d e d i n the p o s t - 7 1 income o f the Canadian c o r p o r a t i o n . A nother p o s s i b l e a r e a o f d i f f i c u l t y l i e s i n t h e f a c t t h a t t h e s u b s e c t i o n 93(1) e l e c t i o n can be made o n l y i n r e s p e c t o f exempt and t a x a b l e s u r p l u s as computed a t the l a s t y e a r end. The amount o f the deemed d i v i d e n d w h i c h may be d educted p u r s u a n t t o p aragraphs 113(1)(a) and (b) i . e . t h e p o s t - 7 1 income o f t h e f o r e i g n a f f i l i a t e , w i l l t h e r e f o r e not t a k e 133 i n t o a ccount c u r r e n t exempt and t a x a b l e s u r p l u s . These amounts may t h e r e f o r e u n duly i n c r e a s e t h e g a i n from th e d i s p o s i t i o n o f t h e s h a r e s by l i m i t i n g t h e amount of t h e p r e - s a l e d i v i d e n d t h a t the Canadian c o r p o r a t i o n may pay o u t t o i t s p a r e n t . Once the d e d u c t i b l e p o r t i o n o f t h e s u b s e c t i o n 93(1) d i v i d e n d i s d e t e r m i n e d , the p o s t - 7 1 income o f the f o r e i g n a f f i l i a t e may be computed by t a k i n g t h a t f r a c t i o n o f the d i v i d e n d t h a t i s the Canadian c o r p o r a t i o n ' s p e r c e n t a g e ownership of t h e f o r e i g n a f f i l i a t e . T h i s f o l l o w s from th e use o f the words " r e a s o n a b l y a t t r i b u t a b l e t o a n y t h i n g o t h e r than (post-71 income)" i n s u b s e c t i o n 5 5 ( 2 ) . As n o t e d , the Canadian c o r p o r a t i o n ' s i n t e r e s t may v a r y from 10% t o 100%. Having examined the r u l e s r e l a t i n g t o t h e c o m p u t a t i i o n o f p o s t - 7 1 income, th e c o n c e p t i t s e l f may be e v a l u a t e d from a p o l i c y p o i n t o f v i e w . I t s h o u l d be n o t e d a t t h e o u t s e t t h a t an ' o n s i d e ' d i v i d e n d may be p a i d out o f t h e p o s t - 7 1 income o f 'any' c o r p o r a t i o n . T h i s p r o v i s i o n a c c o u n t s f o r t h e p o s s i b i l i t y t h a t p a r t o f the v a l u e o f the company's sh a r e s may d e r i v e from th e p o s t - 7 1 income of a s u b s i d i a r y . A 1 100% B I 100% C I n t h e above example, B has no p o s t - 7 1 income, however company C, i n w h i c h B owns a 4 0% i n t e r e s t , has p o s t - 7 1 134 income o f $100,000. I n t h e c i r c u m s t a n c e s , i t would be r e a s o n a b l e t o c o n c l u d e t h a t C's p o s t - 7 1 income c o n t r i b u t e s $40,000 (40% x $100,000) t o the v a l u e o f B's s h a r e s . A c c o r d i n g l y , i t would be p e r m i s s i b l e and a d v i s a b l e f o r B t o pay an exempt d i v i d e n d t o A p r i o r t o a s a l e o f t h e B s h a r e s by A. As i s c l e a r from th e above example, o n l y t h a t p o r t i o n o f the g a i n r e a l i z a b l e on a s a l e o f t h e B s h a r e s t h a t i s ' r e a s o n a b l y a t t r i b u t a b l e ' t o C's p o s t - 7 1 income may be removed p r i o r t o t h e s a l e . Thus, d i v i d e n d s i n e x c e s s o f $40,000 would be caught by s u b s e c t i o n 5 5 ( 2 ) . The ' r e a s o n a b l y a t t r i b u t a b l e ' r e q u i r e m e n t i s c l e a r l y e n v i s i o n e d as a c c o m p l i s h - i n g a number o f o b j e c t i v e s . F o r example, i t i s c l e a r t h a t p o s t - 7 1 income means income computed f o r the purposes o f d i v i s i o n B. L o s s e s and amounts p a i d f o r t a x e s and as d i v i d e n d s do n o t reduce D i v i s i o n B income, and y e t , by r e a s o n o f t h e ' r e a s o n a b l y a t t r i b u t a b l e ' t e s t , i t would appear t h a t p o s t - 7 1 income does not i n c l u d e such amounts. The government's p o s i t i o n , i n s o f a r as i t might be d e t e r m i n e d , would seem t o be t h a t p o s t - 7 1 income i s r e f l e c t e d i n a c o r p o r a t i o n ' s s h a r e s on a d o l l a r f o r d o l l a r b a s i s . However, the e x t e n t t o w h i c h a g a i n r e a l i z e d upon the d i s p o s i t i o n o f s h a r e s i s reduced by l o s s e s and d i v i d e n d s may not even r o u g h l y a pproximate the a r i t h m e t i c t o t a l o f t h e s e amounts. F o r example, a p r i c e might be a r r i v e d a t with r e g a r d t o a c o r p o r a t i o n ' s income e a r n i n g performance as measured by i t s 135 p r o f i t s o v e r a s p e c i f i e d p o s t - 7 1 p e r i o d o f y e a r s . The impact o f a l o s s i n c u r r e d i n one y e a r might be d i s c o u n t e d as an u n c h a r a c t e r i s t i c e r r o r i n judgement made by management o r as a r e s u l t o f c i r c u m s t a n c e s e n t i r e l y beyond t h e c o r p o r a t i o n ' s c o n t r o l . The g a i n '.reasonably a t t r i b u t a b l e ' t o p o s t - 7 1 income might t h e r e f o r e n o t be reduced by the l o s s on a d o l l a r f o r d o l l a r b a s i s . The argument i s perhaps b e t t e r made i n t h e case o f d i v i d e n d s p a i d t o s h a r e h o l d e r s . D i v i d e n d p o l i c i e s might r e a s o n a b l y be r e g a r d e d as h a v i n g no b e a r - i n g whatsoever upon a p r i c e t i e d t o p o s t - 7 1 e a r n i n g s . The same might be s a i d o f t a x e s p a i d by t h e c o r p o r a t i o n . F u r t h e r a l o n g t h e s e l i n e s , what o f p o s t - 7 1 income which has been t r a n s f o r m e d i n t o i n c r e a s e d p l a n t c a p a c i t y ? Though not i n l i q u i d form, the p o s t - 7 1 income c o n t i n u e s t o have a b e a r i n g on t h e f a i r market v a l u e o f the c o r p o r a t i o n ' s s h a r e s and upon the g a i n r e a l i z e d upon a d i s p o s i t i o n o f them. What o f the case o f a s u b s i d i a r y which a c q u i r e s the sha r e s o f an o t h e r c o r p o r a t i o n o u t o f p o s t - 7 1 income and s h o r t l y t h e r e a f t e r d i s p o s e s o f the newly a c q u i r e d s h a r e s a t c o s t ? The proceeds o f d i s p o s i t i o n a r e n o t income f o r t h e purposes o f D i v i s i o n B, b e i n g i n s t e a d a r e t u r n o f c a p i t a l . Thus the money cannot be r e c h a r a c t e r i z e d as ,post-71 income and would (unduly) i n c r e a s e the g a i n on a d i s p o s i t i o n o f t h e a c q u i r i n g company's sh a r e s by i t s p a r e n t . C a p i t a l c o s t a l l o w a n c e e n t e r s i n t o t h e c o m p u t a t i o n o f D i v i s i o n B income by r e a s o n o f p a r a g r a p h 20(1) (a) . C o n s i d e r 136 the case o f a w h o l l y owned s u b s i d i a r y p o s s e s s i n g no p o s t - 7 1 income but h a v i n g $300 a v a i l a b l e f o r d i s t r i b u t i o n t o i t s p a r e n t . The $300 r e p r e s e n t s t h e d i f f e r e n c e between a c c e l e r a t e d c a p i t a l c o s t a l l o w a n c e t a k e n and the a c t u a l d e p r e c i a t i o n booked i n an a c c o u n t i n g sense. The d i s c r e p a n c y i s s i g n i f i c a n t o n l y from the p o i n t o f view o f t i m i n g because c a p i t a l c o s t a l l o w a n c e c l a i m e d i n f u t u r e y e a r s w i l l f a l l below the de- p r e c i a t i o n shown i n the f i n a n c i a l statements.; Assuming t h a t no p r e - s a l e d i v i d e n d i s p a i d t o the p a r e n t , a d i s p o s i t i o n o f the s u b s i d i a r y ' s s h a r e s would e f f e c t i v e l y expose a p o r t i o n o f the c a p i t a l c o s t a l l o w a n c e c l a i m e d t o c a p i t a l g a i n s t a x . The p u r c h a s e r would not o b t a i n t h e b e n e f i t o f an i n c r e a s e i n the c o s t base of the d e p r e c i a b l e p r o p e r t y , b e i n g l i m i t e d t o t a k i n g d e p r e c i a t i o n on t h e b a l a n c e o f the s e l l e r ' s undepre- c i a t e d c a p i t a l c o s t . The o b j e c t i v e s o f t h e c a p i t a l c o s t a l l o w - ance system would thus seem t o be d e f e a t e d . The government would presumably argue t h a t t h e $300 does not r e p r e s e n t t a x r e t a i n e d e a r n i n g s i . e . e a r n i n g s w h i c h have borne t a x , however i t w i l l i n f a c t be t a k e n i n t o income a t a l a t e r d a t e when the c a p i t a l c o s t a l l o w a n c e f a l l s below the a c t u a l d e p r e c i a t i o n 17 booked f o r the y e a r . I t i s n o t u n l i k e l y t h a t s l i p p a g e i n t h e c oncept of p o s t - 7 1 income w i l l o c c a s i o n c h a l l e n g e s t o t h e g overn- ment's i n t e r p r e t a t i o n o f the new r u l e s . T h i s p o s s i b i l i t y i s n a t u r a l l y enhanced t o t h e e x t e n t t h a t t h e t a x p a y e r ' s c i r c u m s t a n c e s e v i d e n c e a genuine h a r d s h i p c a s e . I t may be t h a t some s a c r i f i c e o f e q u i t y i s j u s t i f i e d by e x p e d i e n c e , 137 however the j u s t i f i c a t i o n o f f i s c a l c o n v e n i e n c e v a r i e s i n i n v e r s e p r o p o r t i o n w i t h t h e f r e q u e n c y o f h a r d s h i p c a s e s and w i t h t h e i r g r a v i t y . The 1977 t a x changes s e r v i n g t o s t i m u l a t e c o r p o r a t e 18 a c q u i s i t i o n s have been n o t e d . The y e a r s s i n c e 1977 have i n d e e d seen an i n c r e a s e i n t a k e o v e r s , b o t h f r i e n d l y and h o s t i l e . An i m p o r t a n t and c o n t r o v e r s i a l f a c e t o f c o r p o r a t e a c q u i s i t i o n s i s t h e m i n o r i t y squeeze-out w h i c h i n v o l v e s the e l i m i n a t i o n o f m i n o r i t y s h a r e h o l d e r s who r e s i s t t h e t a k e - o v e r . A t a x p l a n n i n g t e c h n i q u e o f t e n employed t o h e l p appease the m i n o r i t y i n v o l v e s o f f e r i n g t h e s e s h a r e h o l d e r s the c h o i c e o f r e a l i z i n g upon t h e i r i n v e s t m e n t w i t h a c a p i t a l g a i n o r a deemed d i v i d e n d . C o r p o r a t e m i n o r i t y s h a r e h o l d e r s ( i n c l u d i n g i n v e s t m e n t s h o l d i n g companies) w i l l n a t u r a l l y p r e f e r d i v i d e n d t o c a p i t a l g a i n s t r e a t m e n t upon g i v i n g up t h e i r s h a r e s . S u b s e c t i o n s 55 (2)-(5) w i l l now a p p l y t o t h e s e t r a n s a c t i o n s so t h a t d i v i d e n d s p a i d i n e x c e s s o f p o s t - 7 1 income o f the t a r g e t w i l l be t r e a t e d as proceeds of d i s p o s i t i o n t o t h e r e c i p i e n t . The argument can be made t h a t where the t a k e - o u t i s e s s e n t i a l l y compulsory and c o n t r a r y t o the d e s i r e s o f the vendors t h e y s h o u l d be o f f e r e d the o p p o r t u n i t y o f t r a n s f o r m i n g the p roceeds i n t o new and independent i n v e s t m e n t forms a t no t a x c o s t . Even i f t h i s p o s i t i o n i s r e j e c t e d , a m b i g u i t i e s i n t h e p o s t - 7 1 income concept might e a s i l y l e a d t o c o n f u s i o n i n t y p i c a l t a k e o v e r s i t u a t i o n s . C o n s i d e r th e f o l l o w i n g 138 c o r p o r a t e s t r u c t u r e : MINCO I n d i v i d u a l S h a r e h o l d e r s PRIVCO P r i v c o , a p r i v a t e h o l d i n g company, owns a l l o f the Opco s h a r e s and 80% o f t h e t a r g e t ' s s h a r e s . P r i v c o w i s h e s t o combine the o p e r a t i o n s o f Opco and T a r c o . 10% o f t h e m i n o r i t y s h a r e s a r e h e l d by Minco, a Canadian c o r p o r a t i o n , and 10% a r e owned by i n d i v i d u a l s . The n e c e s s a r y s h a r e h o l d e r ' s r e s o l u t i o n s a r e passed and Tarco and Opco amalgamate. P u r s u a n t t o the terms o f t h e amalgamation agreement the s h a r e s o f the amalgamated company t a k e n back by the m i n o r i t y may be redeemed by i t o r bought by P r i v c o . The f i r s t o p t i o n would s e c u r e t o the s h a r e - h o l d e r deemed d i v i d e n d t r e a t m e n t w h i l e the second would r e s u l t i n a c a p i t a l g a i n t o t h e s h a r e h o l d e r . P r i o r t o the amalgamation, Opco had $100,000 of p o s t - 7 1 income, w h i l e T arco had o n l y $1,000 o f p o s t - 7 1 income, most of i t s v a l u e b e i n g due t o g o o d w i l l a p p r e c i a t i o n . There i s , o f c o u r s e , the q u e s t i o n t o c o n s i d e r whether th e use o f the word ' r e a s o n a b l y ' i n s u b s e c t i o n 55(2) would r e q u i r e t h a t t h e post-r71 income be a l l o c a t e d amongst a l l the s h a r e h o l d e r s i n a ccordance w i t h t h e i r p r o p o r t i o n a t e s h a r e h o l d i n g i n t e r e s t s , o r whether a g r e a t e r amount might be a l l o c a t e d 139 t o t h e s e l l i n g s h a r e h o l d e r ' s s t o c k . Assuming t h a t the p o s t - 7 1 income were a p p o r t i o n e d r a t e a b l y amongst the s h a r e h o l d e r s i n a ccordance w i t h t h e i r r e l a t i v e i n t e r e s t s i n Amalco, would th e amount of p o s t - 7 1 income a v a i l a b l e f o r d i s t r i b u t i o n t o t h e m i n o r i t y s h a r e h o l d e r s r e p r e s e n t t h e i r p r o p o r t i o n a t e share o f $101,000 (the p o s t - 7 1 income of Amalco) o r $1,000 ( t h a t o f the p r e d e c e s s o r c o r p o r a t i o n T a r c o ) ? I t would appear that "the c a p i t a l g a i n t h a t , b u t f o r the d i v i d e n d , would have been r e a l i z e d on a d i s p o s i t i o n a t f a i r market v a l u e o f any share o f c a p i t a l s t o c k i m m e d i a t e l y b e f o r e t h e d i v i d e n d " means the c a p i t a l g a i n t h a t would have a r i s e n on a d i s p o s i t i o n o f the p r e f e r e n c e s h a r e s o f Amalco. U n l e s s s u b s e c t i o n 55(2) i n t e n d s t h a t the a t t r i b u t e s o f n o n - e x i s t e n t c o r p o r a t i o n s be t a k e n i n t o a c c o u n t , Amalco r e p r e s e n t s the o n l y company t o which i t might a p p l y i n the c i r c u m s t a n c e s . I n o t h e r words, Minco would appear t o e n j o y a b e n e f i t i n t h e i n c r e a s e o f p o s t - 7 1 income a v a i l a b l e f o r d i s t r i b u t i o n upon redemption o f the Amalco sh a r e s h e l d . T h i s might p e r m i t the r e c e i p t o f t h e proceeds t a x f r e e o r , assuming a p a r a g r a p h 55 (f) e l e c t i o n , a t a reduced t a x c o s t . ( v i ) S u b j e c t i v e o r O b j e c t i v e Purpose? . In o r d e r f o r s u b s e c t i o n 55(2) t o a p p l y , one o f the purposes o f the t r a n s a c t i o n o r s e r i e s o f t r a n s a c t i o n s must be the r e d u c t i o n o f the c a p i t a l g a i n t h a t would have been r e a l i z e d on t h e d i s p o s i t i o n o f any s h a r e . A d i f f i c u l t and 140 and i m p o r t a n t q u e s t i o n c e n t e r s upon whether t h i s purpose t e s t c r e a t e s a c o n d i t i o n o f a p p l i c a b i l i t y o f an o b j e c t i v e o r a s u b j e c t i v e n a t u r e . I n o t h e r words, the q u e s t i o n i s whether a p a r t i c u l a r m o t i v a t i o n o r o b j e c t i v e i . e . t h e r e d u c t i o n o f a c a p i t a l g a i n , must be a s c r i b e d t o t h e t a x p a y e r o r whether a l l t h a t i s n e c e s s a r y i s t h a t a r e d u c t i o n i n t h e g a i n s h o u l d i n f a c t r e s u l t from th e payment o f the d i v i d e n d . F o r example, a p a r e n t c o r p o r a t i o n adopts o v e r many y e a r s , and i n c o n n e c t i o n w i t h some b u s i n e s s p urpose, th e p r a c t i c e o f h a v i n g i t s w h o l l y owned s u b s i d i a r y pay d i v i d e n d s which commonly exceed the p o s t - 7 1 income o f t h e s u b s i d i a r y . A t the t ime th e d i v i d e n d s a r e p a i d , t h e p a r e n t has no i n t e n t i o n o f d i s p o s i n g o f the s u b s i d i a r y ' s s h a r e s . An a t t r a c t i v e o f f e r f o r t h e s e s h a r e s i s made by a p r o s p e c t i v e b u yer. The s h a r e s a r e s o l d and t h e g a i n i s reduced by r e a s o n of t h e p r i o r y e a r s ' d i v i d e n d p o l i c i e s . I f the s u b s e c t i o n 55(2) purpose t e s t r e q u i r e s some p o s i t i v e element of i n t e n t i o n t o r e a p a f i s c a l b e n e f i t , i t would be open t o the p a r e n t t o argue t h a t none of the purposes of the d i v i d e n d payments was the r e d u c t i o n o f t h e c a p i t a l g a i n . I t must be remembered however t h a t any 'secondary' i n t e n t i o n o f the p a r e n t t o reduce the g a i n i n the event o f a f u t u r e s a l e o f the shares would s u f f i c e t o b r i n g s u b s e c t i o n 55(2) i n t o p l a y , because th e r e d u c t i o n o f g a i n need be b u t one o f the t a x p a y e r ' s p u r p o s e s . On the o t h e r hand, i f t h e a c t u a l r e d u c t i o n i n the amount o f the g a i n s u f f i c e s t o e s t a b l i s h t h e r e q u i s i t e p urpose, t h e n th e d i v i d e n d would be r e g a r d e d 141 as t a x a b l e proceeds o f d i s p o s i t i o n p u r s u a n t t o p a r a g r a p h 5 5 ( 2 ) ( b ) . I t i s a t l e a s t a r g u a b l e t h a t t h e b e t t e r v i e w i s t h a t 'purpose' r e f e r s t o the a c t u a l consequences of a t r a n s a c t i o n o r s e r i e s o f t r a n s a c t i o n s r a t h e r t h a n t o any t a x - s a v i n g m o t i v a t i o n o f t h e t a x p a y e r . The p l a i n words o f the s t a t u t e speak o f the purposes o f t r a n s a c t i o n s , n o t o f t a x p a y e r s . I n a d d i t i o n , the s u b s e c t i o n 55(2) purpose t e s t i s e f f e c t i v e l y q u a l i f i e d and c i r c u m s c r i b e d by t h e ' r e s u l t s ' t e s t i n s u b s e c t i o n 55(3).The l a t t e r s u b s e c t i o n can be r e g a r d e d as i m p o s i n g n e c e s s a r y r e s t r a i n t s on a s u b s e c t i o n 55(2) o b j e c t i v e purpose t e s t t h a t would o t h e r w i s e o p e r a t e where t h e r e had been no d i s p o s i t i o n o f p r o p e r t y o r i n c r e a s e i n i n t e r e s t o f an arm's l e n g t h p u r c h a s e r i n any c o r p o r a t i o n . Presumably, a s u b j e c t i v e purpose t o reduce a g a i n would always r e s u l t e i t h e r i n a d i s p o s i t i o n o r i n c r e a s e such as a r e c o n t e m p l a t e d i n subparagraphs 55(3) (a) ( and ( i i ) . The d i s c r e p a n c y between a 'purpose' and ' r e s u l t s ' t e s t i n s u b s e c t i o n 55(2) would then be e x p l a i n e d by the.. f a c t t h a t s i n c e s u b s e c t i o n 84(3) t r a n s a c t i o n s always i n v o l v e a d i s p o s i t i o n , the s t i p u l a t i o n i n e x p r e s s terms o f a ' r e s u l t s ' t e s t was i n t h e p a r t i c u l a r case b o t h p o s s i b l e and a p p r o p r i a t e . N e i t h e r an o b j e c t i v e nor a s u b j e c t i v e purpose t e s t s e r v e s the p o l i c y and e q u i t y o b j e c t i v e s o f t h e new r u l e s i n a l l c i r c u m s t a n c e s . C o n s i d e r th e f o l l o w i n g c o r p o r a t e s t r u c t u r e : 142 VENDCO 100% HOLDCO BUYCO 100% SUBCO Vendco owns a l l o f the Holdco s h a r e s and Holdco i n t u r n owns the Subco s h a r e s . Vendco would l i k e t o d i s p o s e o f t h e Holdco s h a r e s t o Buyco f o r $1,000. N e i t h e r Holdco nor Subco p o s s e s s any po s t - 7 1 income however Subco has s u r p l u s o f $300 a v a i l a b l e f o r d i s t r i b u t i o n under the r e l e v a n t c o r p o r a t e law. Subco pays t h i s amount out as a d i v i d e n d t o H o l d c o . T h i s t r a n s a c t i o n 1 c r e a t e s p o s t - 7 1 income i n t h e Holdco because d i v i d e n d s r e c e i v e d a re i n c l u d e d i n the com p u t a t i o n o f income f o r the purposes o f D i v i s i o n B. T h e r e f o r e , p r i o r t o the s a l e o f the Holdco s h a r e s t o Buyco, a d i v i d e n d o f $300 may be p a i d t o Vendco o ut o f Holdco's p o s t - 7 1 income t h a t reduces t h e market v a l u e o f the Holdco s h a r e s and t h e g a i n r e a l i z a b l e upon t h e i r d i s p o s i t i o n . I t would appear t h a t t h i s o p e r a t i o n e f f e c t i v e l y p e r m i t s the r e d u c t i o n o f the g a i n i n e x c e s s o f t h e po s t - 7 1 income on hand i n the c h a i n p r i o r t o the s e r i e s o f t r a n s a c t i o n s . I n t h e above i l l u s t r a t i o n , t he d i v i d e n d from Holdco t o Vendco c o u l d n o t be impugned because i t . i s p a i d o u t o f po s t - 7 1 income. Assuming t h a t s u b s e c t i o n 55(2) c o n t a i n s 143 a s u b j e c t i v e purpose t e s t , i t would be d i f f i c u l t f o r t h e government t o argue t h a t the t a x p a y e r ' s purpose was t o r educe th e g a i n t h a t would have a r i s e n on a s a l e o f t h e Subco s h a r e s h e l d by Holdco because the t a x p a y e r (Vendco) m a n i f e s t l y had no i n t e n t i o n o f d i s p o s i n g o f the Subco s h a r e s . I f , however, the o b j e c t i v e purpose t e s t i s a p p l i e d , i t i s p o s s i b l e t o say t h a t one o f t h e purposes i . e . consequences o r r e s u l t s , o f t h e Subco-Holdco d i v i d e n d i s the r e d u c t i o n o f t h e c a p i t a l g a i n t h a t , but f o r t h e d i v i d e n d , would have been r e a l i z e d on a d i s p o s i t i o n o f t h e Subco s h a r e s . Support f o r a s u b j e c t i v e purpose t e s t can, however, be found i n t h e f o l l o w i n g example. C o n s i d e r a g e n u i n e , bone f i d e e s t a t e f r e e z e i n w h i c h the f r e e z o r does not r o l l h i s p r e f e r e n c e s h a r e s i n t o a p e r s o n a l h o l d i n g company but redeems them i n s t e a d i n a p i e c e m e a l f a s h i o n i n g r a d u a l , t a x a b l e d i s p o s i t i o n s . The funds used t o redeem h i s s h a r e s are f u n n e l l e d t h r o u g h t o the h o l d i n g company (owned and c o n t r o l l e d by t h e n e x t g e n e r a t i o n ) by Opco but exceed th e p o s t - 7 1 income o f Opco. The c h i l d r e n then d e c i d e t o s e l l t he Opco s h a r e s t o a p u r c h a s e r i n a c a s h t r a n s a c t i o n . Assuming t h a t the s u b s e c t i o n 55(2) purpose t e s t i s r e a l l y more i n the n a t u r e o f a r e s u l t s t e s t , i t f o l l o w s t h a t one o f t h e 'purposes' of t h e d i v i d e n d p a i d by Opco t o Holdco i s t o reduce th e g a i n t h a t would have been r e a l i z e d (and, i n d e e d , t h a t was r e a l i z e d ) upon the d i s p o s i t i o n o f the Opco s h a r e s . T h i s r e s u l t i s c l e a r l y u n s a t i s f a c t o r y and r e s u l t s i n a measure 144 o f double t a x a t i o n ( e q u a l t o the amount o f the o f f e n d i n g d i v i d e n d ) i n t h a t amounts upon wh i c h c a p i t a l g a i n s t a x has been p a i d by the f r e e z o r w i l l s u b s e q u e n t l y be t r e a t e d as proceeds o f d i s p o s i t i o n t o the n e x t g e n e r a t i o n . I n such c i r c u m s t a n c e s , the t a x p a y e r ' s c l a i m t h a t i t was m a n i f e s t l y n o t the purpose o f any t r a n s a c t i o n t o e l i m i n a t e o r reduce the g a i n from the d i s p o s i t i o n o f any share i s most p e r s u a s i v e . A l t e r n a t i v e l y , the argument might be made t h a t t h e d i v i d e n d was n o t r e c e i v e d as p a r t o f a s e r i e s o f t r a n s a c t i o n s o r ev e n t s t h a t r e s u l t e d i n a d i s p o s i t i o n o f any p r o p e r t y , i n accordance w i t h subparagraph 5 5 ( 3 ) ( a ) ( i ) . I n o r d e r t o be a ' p a r t ' o f a t r a n s a c t i o n o r s e r i e s o f t r a n s a c t i o n s presumably more i s r e q u i r e d t h a n t h a t the d i v i d e n d s h o u l d precede the d i s p o s i t i o n o r i n c r e a s e i n i n t e r e s t . On the o t h e r hand, a c a u s a l c o n n e c t i o n between the d i v i d e n d and th e reduced g a i n i s a l l t h a t i s c a l l e d f o r t o make o f the ' d i v i d e n d a ' p a r t ' under a s t r a i g h t f o r w a r d r e s u l t s t e s t . I n t h e f i n a l a n a l y s i s , t h e purpose o f the s e r i e s o f t r a n s a c t i o n s w i l l be d e a l t w i t h as any q u e s t i o n o f f a c t . The s u b j e c t i v e m o t i v a t i o n s o f the t a x p a y e r w i l l be r e l e v a n t o n l y t o t h e e x t e n t t h a t t h e e v i d e n c e o t h e r w i s e adduced i s ambiguous. The 'purpose' then i s i n d e e d t h a t o f t h e ' s e r i e s o f t r a n s a c t i o n s ' r a t h e r than o f t h e t a x p a y e r , as the s t a t u t o r y language would s u g g e s t , however i t i s s u b m i t t e d t h a t s u b s e c t i o n 55(2) c l e a r l y c o n t e m p l a t e s the p o s s i b l e c o - e x i s t e n c e o f a g a i n - r e d u c i n g d i v i d e n d w i t h a p r e d o m i n a t i n g b u s i n e s s purpose, j u s t as s u b s e c t i o n 247(2) e n v i s i o n s t h e f i s c a l p r o p r i e t y o f 145 f a m i l y members owning n o n - a s s o c i a t e d C a n a d i a n - c o n t r o l l e d p r i v a t e c o r p o r a t i o n s . I n t h e case o f the l a t t e r s u b s e c t i o n , none o f the main purposes o f t h e t a x p a y e r ' s t r a n s a c t i o n s may be t a x a v o i d a n c e ; i n t h e case o f s u b s e c t i o n 55(2) t a x a v o i d a n c e may n o t be 'one o f t h e p u r p o s e s ' . I n e i t h e r s i t u a t i o n , t h e heavy onus w i l l be on t h e t a x p a y e r t o e x t r i c a t e h i m s e l f from th e p r o v i s i o n s o f t h e law, but i m p r e c i s i o n s i n the s t a t u t o r y language w i l l l i k e l y f a c i l i t a t e h i s t a s k . O c c a s i o n a l l y , i t may be p o s s i b l e f o r a s i t u a t i o n i n p r i n c i p l e w i t h i n the intendment o f s u b s e c t i o n s 5 5 ( 2 ) - ( 5 ) t o a v o i d the consequences o f the p r o v i s i o n s because t h e i r w o r d i n g cannot, on a n a t u r a l and p l a i n r e a d i n g , c o v e r the p a r t i c u l a r c a s e . C o n s i d e r the s i m p l e s i t u a t i o n where the Opco r o l l s i t s a s s e t s i n t o t h e Buyco i n r e t u r n f o r redeemable p r e f e r e n c e s h a r e s s t r u c t u r e d such as t o g i v e r i s e t o a deemed d i v i d e n d upon re d e m p t i o n . A t a x f r e e s u b s e c t i o n 112(1) d i v i d e n d i s r e c e i v e d by Opco. The ' t a x a b l e d i v i d e n d ' t o w h i c h s u b s e c t i o n 55(2) r e f e r s can o n l y be t h e s u b s e c t i o n 112(1) d i v i d e n d . The s h a r e s r e f e r r e d t o can o n l y be the s h a r e s o f Opco o r the redeemable Buyco s h a r e s . Opco s h a r e s : Can i t be s a i d t h a t one o f t h e r e s u l t s o f the s e r i e s o f t r a n s a c t i o n s i s t o reduce th e c a p i t a l g a i n t h a t , b u t f o r the d i v i d e n d , would have been r e a l i z e d on a d i s p o s i t i o n o f t h e Opco sha r e s i m m e d i a t e l y b e f o r e t h e d i v i d e n d ? I t i s a p p a r e n t l y n e c e s s a r y t h a t t h e r e d u c t i o n i n t h e c a p i t a l g a i n on t h e h y p o t h e t i c a l s a l e o f the Opco sha r e s s h o u l d have 146 a r i s e n 'but f o r t h e d i v i d e n d ' . T h i s i s , i t would seem, why t h e imagined g a i n i s computed on the b a s i s o f a d i s p o s i t i o n ' i m m e d i a t e l y b e f o r e the d i v i d e n d ' . But t h e g a i n on t h e s a l e of t h e Opco sh a r e s would n o t be reduced by t h e d i v i d e n d a r i s i n g from t h e redemption o f t h e Buyco s h a r e s because the same v a l u e s would be r e f l e c t e d i n t h e Opco s h a r e s b e f o r e as w e l l as a f t e r t h e payment o f t h e d i v i d e n d . No r e d u c t i o n o c c u r s , t h e n , 'but f o r the d i v i d e n d ' . I n o r d e r t o r e a d t h e p r o v i s i o n i n a manner f a v o u r a b l e t o the government, i t would be n e c e s s a r y t o u n d e r s t a n d 'but f o r t h e d i v i d e n d ' t o mean 'but f o r the s e r i e s o f t r a n s a c t i o n s ' o r , more p r e c i s e l y , 'assuming the t a x p a y e r had not r e c e i v e d a d i v i d e n d but had d i s p o s e d o f the Opco s h a r e s i n s t e a d ' . A p l a i n r e a d i n g o f the p r e s e n t w o r d i n g would however suggest t h a t t h e payment o f the d i v i d e n d i t s e l f has some impact on t h e quantum o f t h e u n r e a l i z e d g a i n from a d i s p o s i t i o n o f the Opco s h a r e s . I t i s s u b m i t t e d t h a t t h e awkwardness o f a p p l y i n g the s t a t u t o r y language t o the suggested f a c t p a t t e r n d e r i v e s from the f a c t t h a t t h e wording c o n t e m p l a t e s and i s b e t t e r adapted t o the f o l l o w i n g s i t u a t i o n . HOLDCO| | o i v i d e n d PURCHASER OPCO 147 p r e - s a l e d i v i d e n d i s p a i d t o t h e Holdco p r i o r t o a d i s p o s i t i o n o f the s h a r e s of Opco. Here the d i v i d e n d e i t h e r d e c r e a s e s the f a i r market v a l u e o f the Opco s h a r e s (assuming i t i s a cash d i v i d e n d ) so t h a t i t a p p r o x i m a t e s t h e i a d j u s t e d c o s t base, o r (assuming i t i s a deemed d i v i d e n d a r i s i n g from e.g. a c a p i t a l i z a t i o n o f s u r p l u s ) i n c r e a s e s t h e a d j u s t e d c o s t base o f t h e Opco s h a r e s so t h a t i t e q u a l s t h e i r f a i r market v a l u e . On a s a l e o f t h e Opco sh a r e s by H o l d c o , i t can perhaps more c o n v e n i e n t l y be s a i d t h a t t h e r e has been a r e d u c t i o n i n the c a p i t a l g a i n t h a t , b u t f o r the d i v i d e n d , would have been r e a l i z e d upon t h e i r d i s p o s i t i o n i m m e d i a t e l y b e f o r e the d i v i d e n d . Buyco s h a r e s : Can i t be s a i d t h a t the r e s u l t o f the d i v i d e n d i s t o reduce th e g a i n t h a t would have been r e a l i z e d , but f o r the d i v i d e n d , on a d i s p o s i t i o n a t f a i r market v a l u e o f the redeemable Buyco s h a r e s i m m e d i a t e l y b e f o r e t h e d i v i d e n d ? I t would appear t h a t i t cannot. The c i r c u m s t a n c e s c l e a r l y p o i n t t o t h e c o n c l u s i o n t h a t the o n l y l i k e l y d i s p o s i t i o n o f the Buyco s h a r e s i s t h e a n t i c i p a t e d r edemption o f them by Buyco, a t r a n s a c t i o n t h a t would g i v e r i s e t o a deemed d i v i d e n d , not a c a p i t a l g a i n . Are we then t o assume an i m p r o b a b l e d i s p o s i t i o n t o a t h i r d p a r t y where none i s contemplated? Suppose t h a t t h e redeemabl Buyco s h a r e s a r e i n terms n o t t r a n s f e r a b l e . Are we t o imagine a d i s p o s i t i o n o f s h a r e s h a v i n g d i f f e r e n t a t t r i b u t e s t h a n t h e Buyco s h a r e s i n f a c t p o s s e s s ? The 'any s h a r e ' r e f e r r e d t o i n t h e s u b s e c t i o n can o n l y mean a r e a l and 148 e x i s t i n g s h a r e , and not an imagined one. T h e r e f o r e i t would appear t h a t t h e s u b s e c t i o n cannot a p p l y t o t h e s h a r e s o f Buyco. I t i s a c c o r d i n g l y s u b m i t t e d t h a t t h e normal ' a s s e t ' t ype o f s u b s e c t i o n 55(2) t r a n s a c t i o n i s n o t e a s i l y i n c l u d e d w i t h i n the w ording o f the p r o v i s i o n . 149- FOOTNOTES 1. 3 Report o f The R o y a l Commission On T a x a t i o n , a t pp. 331-336. 2. House o f Commons, 18th Report o f t h e S t a n d i n g Committee on F i n a n c e , Trade, and Economic A f f a i r s , 1970. 3. C a r t e r Commission, s u p r a , f o o t n o t e 1, a t pp. 139-140. 4. See g e n e r a l l y B i n a v i n c e , "The G e n e r a l P r i n c i p l e s i n the T a x a t i o n o f C a p i t a l G ains and L o s s e s " , i n Hansen, K r i s h n a , and R e n d a l l , E s s a y s i n Canadian T a x a t i o n , pp. 351- 411, e s p e c i a l l y 351-359, and see S e l t z e r , 'The N a t u r e and Tax Treatment o f C a p i t a l Gains and L o s s e s , > : 19 50, a t pp. 1-24, 83-108, 281-318, and D a v i d , • A l t e r n a t i v e Approaches t o C a p i t a l G ains Taxation,',', 1968, pp. 1-8, 43-59, 198-208. 5. S.C. 1917, c.28. 6. T h i s scheme was made n e c e s s a r y by the d e c i s i o n i n t h e E n g l i s h case I n l a n d Revenue Commissioners v B u r r e l l (1924) 2 K. B. 52, whi c h l a i d down the r u l e t h a t amounts p a i d t o s h a r e h o l d e r s upon a c o r p o r a t e l i q u i d a t i o n were c a p i t a l d i s - t r i b u t i o n s . I n the days when c a p i t a l g a i n s were n o t t a x a b l e , t h i s p r o v i d e d an easy e x p e d i e n t f o r t a x p a y e r s s e e k i n g t o c o n v e r t a c o r p o r a t i o n ' s accumulated e a r n i n g s i n t o t a x f r e e r e c e i p t s . 7. ITA s. 5 4 ( h ) ( x ) . 8. T h i s would appear t o be the case i n B r i t i s h Columbia and A l b e r t a . S e c t i o n 32(2) o f the OBCA d e f i n e s ' i s s u e d c a p i t a l ' a t t r i b u t a b l e t o no p a r v a l u e s h a r e s t o i n c l u d e "such amounts as from time t o time by by-law o f the c o r p o r a t i o n may be t r a n s f e r r e d t h e r e t o " . P u r s u a n t t o s u b s e c t i o n 21(1) the 150 d i r e c t o r s may pass b y - l a w s . . . t o r e g u l a t e . . . ( g ) t h e c onduct i n a l l o t h e r p a r t i c u l a r s o f t h e a f f a i r s o f t h e c o r p o r a t i o n " . Under the CBCA t h e r e can be o n l y no par v a l u e s h a r e s (subsec- t i o n 2 4 ( 1 ) ) . S u b s e c t i o n 26(1)(1.4) says "Where a c o r p o r a t i o n proposes t o add any amount t o a s t a t e d c a p i t a l a ccount i t m a i n t a i n s i n r e s p e c t o f a c l a s s o r s e r i e s o f s h a r e s , i f / ( a ) t h e amount t o be added was n o t r e c e i v e d by t h e c o r p o r a t i o n as c o n s i d e r a t i o n f o r the i s s u e o f s h a r e s , and/(b) th e c o r - p o r a t i o n has i s s u e d any o u t s t a n d i n g s h a r e s o f more th a n one c l a s s o r s e r i e s , the a d d i t i o n t o the s t a t e d c a p i t a l a c count must be approved by s p e c i a l r e s o l u t i o n . . . S u b s e c t i o n s 26(1) and (1.1) r e q u i r e a ' s t a t e d c a p i t a l a c c o u n t ' t o be m a i n t a i n e d f o r each c l a s s and s e r i e s o f i s s u e d s h a r e s and t o add t o the a p p r o p r i a t e account th e c o n s i d e r a t i o n i t r e c e i v e s f o r any s h a r e s i t i s s u e s . Under s u b s e c t i o n 54(1) o f t h e Quebec Company A c t "The d i r e c t o r s o f a company may make a by-law t o i n c r e a s e t h e c a p i t a l s t o c k t o any amount wh i c h t h e y c o n s i d e r r e q u i s i t e f o r the due c a r r y i n g out o f i t s o b j e c t s " . The by-law may p r o v i d e f o r t h e i n c r e a s e o f the p a i d up c a p i t a l o f a company w i t h par v a l u e o r no par v a l u e s h a r e s t h r o u g h the c a p i t a l i z a t i o n o f i t s s u r p l u s a c c o u n t s . The by-law must be c o n f i r m e d by supplementary l e t t e r s p a t e n t . 9. J . R . R o b e r t s o n , "Recent Developments i n F e d e r a l T a x a t i o n , " i n 19 7 8 C o n f e r e n c e R e p o r t , 52 a t pp. 58-59. 10. The k i n d s o f f a c t s i t u a t i o n here e n v i s i o n e d c o m p r i s e a s s e t s a l e s where p r e f e r r e d s h a r e s a r e redeemed f o l l o w i n g a r o l l - o v e r o f a s s e t s o r s h a r e s , o r f o l l o w i n g a c a p i t a l r e o r g a - n i z a t i o n , and share s a l e s where e.g. the s h a r e s o f a sub- s i d i a r y a r e d i s p o s e d o f f o l l o w i n g the payment o f a d i v i d e n d t o t h e p a r e n t . That the f u l l amount o f the d i v i d e n d w i l l be t r e a t e d as proceeds o f d i s p o s i t i o n w i l l n o t p r e s e n t a problem from a p o l i c y p o i n t o f view i n t h e case o f a s u b s e c t i o n 84(3) r e d emption o f p r e f e r r e d s h a r e s . The amount r e c e i v e d w i l l e q u a l the f a i r market v a l u e o f the c a p i t a l a s s e t s o l d and the amount o f t h e d i v i d e n d s h o u l d i n such cases be t h e d i f f e r e n c e between th e a d j u s t e d c o s t base of the a s s e t s (and s h a r e s t a k e n back) and t h e i r f a i r market v a l u e . I n o t h e r words, the d i v i d e n d s h o u l d e q u a l t h e g a i n a v o i d e d . I f , however, th e p a i d up c a p i t a l o f t h e p r e f e r e n c e s h a r e s were u n d u l y low (below the ACB o f the s h a r e s ) a p o r t i o n o f t h e ACB p r o t e c t i o n would be l o s t . I n t h e case of d i v i d e n d s p a i d by a s u b s i d i a r y t o i t s p a r e n t p r i o r t o a d i s p o s i t i o n o f t h e s u b s i d i a r y ' s s h a r e s , on the o t h e r hand, any ' t a i n t i n g ' o f t h e d i v i d e n d s w i l l cause them t o be t r e a t e d i n t h e i r f u l l amount as proceeds o f d i s p o s i t i o n . Where o f f e n d i n g d i v i d e n d s a r e p a i d out over a p e r i o d o f y e a r s t h e i r amount might 151 g r e a t l y exceed th e p o s t - 7 1 in c r e m e n t i n t h e v a l u e o f c a p i t a l a s s e t s o f t h e c o r p o r a t i o n . 11. I t appears from subparagraphs 5 5 ( 3 ) ( a ) ( i ) and ( i i ) t h a t t h e new r u l e s w i l l a p p l y o n l y i f t h e r e has been 1) a d i s p o s i t i o n o f p r o p e r t y o r 2) an i n c r e a s e i n the i n t e r e s t o f a p u r c h a s e r i n t h e t a r g e t . The payment o f a n n u a l d i v i d e n d s by a s u b s i d i a r y t o i t s p a r e n t does n o t meet the r e q u i r e m e n t i n 2 above, however a s a l e by a p a r e n t o f i t s s h a r e s i n a s u b s i d i a r y i s a d i s p o s i t i o n o f p o r p e r t y w i t h i n c o n d i t i o n 1. Where t h e r e has been a d i s p o s i t i o n o f p r o p e r t y (a s h a r e ) , p a r a g r a p h 55(2) (b) t r e a t s t h e r e c e i p t as proceeds o f d i s p o s i t i o n . I t i s o n l y where the share has n o t been d i s p o s e d o f t h a t t h e r e c e i p t may be t r e a t e d as "a g a i n o f t h e c o r p o r a t i o n f o r t h e y e a r i n w h i c h th e d i v i d e n d was r e c e i v e d " (paragraph 5 5 ( 2 ) ( c ) ) . I n o t h e r words, pa r a g r a p h 55(2) (c) and subparagraph 55(3) (a) ( i i ) a r e d i r e c t e d a t the s i t u a t i o n where funds a r e i n j e c t e d i n t o an o p e r a t i n g company by a p u r c h a s e r and are s u b s e q u e n t l y used t o pay a d i v i d e n d t o the c o r p o r a t e vendor w i t h o u t a d i s p o s i t i o n t a k i n g p l a c e . T h i s might be done f o l l o w i n g a r e o r g a n i z a t i o n o f t h e t a r g e t ' s c a p i t a l s t r u c t u r e and would i n v o l v e p a y i n g d i v i d e n d s upon a l e g a l r e d u c t i o n o f c a p i t a l i n r e s p e c t o f f i x e d - v a l u e , p r e f e r e n c e s h a r e s . 12. S i n c e t h e i r p a i d up c a p i t a l e q u a l s t h e i r f a i r market v a l u e and r e d emption amount, as w e l l as t h e i r ACB, no deemed d i v i d e n d o r t a x a b l e g a i n a r i s e s as a r e s u l t o f t h i s o p e r a t i o n . 13. ITA 2 5 1 ( 2 ) ( b ) ( i ) and ( 3 ) . 14. Supra, f o o t n o t e 13. 15. I t i s n e c e s s a r y f o r V t o make the c o n t r i b u t i o n t o c a p i t a l and f o r P t o i n j e c t t w i c e the purchase p r i c e i n o r d e r t o guarantee t h a t t h e n e c e s s a r y 1/4 f r a c t i o n o f t h e hard and l i q u i d a s s e t s o f Opco be r e f l e c t e d i n P's p r o p o r t i o n a t e s h a r e h o l d i n g . 16. I n s o f a r as t h e ' r e a s o n a b l y a t t r i b u t a b l e ' t e s t i s viewed by the government as r e s t r i c t i n g the c o n c e p t o f p o s t - 7 1 income t o t h e a l g e b r a i c sum o f t a x r e t a i n e d e a r n i n g s on hand i n the company, a problem perhaps a r i s e s i n c o n n e c t i o n w i t h 152 purchase and s a l e t r a n s a c t i o n s employing a m u l t i p l e o f e a r n i n g s f o r m u l a i n r e s p e c t o f income earned a f t e r 1971. M i g h t the t a x p a y e r argue t h a t a d i v i d e n d e q u a l t o the t o t a l g a i n can be p a i d as ' r e a s o n a b l y a t t r i b u t a b l e ' t o p o s t - 7 1 income? 17. I t s h o u l d be n o t e d t h a t the new r u l e s can perhaps work t o t h e t a x p a y e r ' s advantage w i t h r e g a r d t o c a p i t a l c o s t a l l o w a n c e . Where, i n s t e a d o f s e l l i n g a s s e t s i n a c a s h t r a n s a c t i o n , t h e c o r p o r a t e t a x p a y e r r o l l s them i n t o t h e p u r - c h a s e r c o r p o r a t i o n i n r e t u r n f o r redeemable p r e f e r e n c e s h a r e s , s u b s e c t i o n 55(2) w i l l a p p l y t o i h e d i v i d e n d r e c e i v e d upon the redemption t o t r e a t as a c a p i t a l g a i n t h a t w hich would have been t a k e n c o m p l e t e l y i n t o income as r e c a p t u r e d d e p r e c i a t i o n had t h e a s s e t s been s o l d . T h i s b e n e f i t may, however, be r e l a t i v e l y u n i m p o r t a n t . The vendor may have t o compensate th e p u r c h a s e r w i t h a l o w e r p r i c e because t h e r e i s no i n c r e a s e i n the c o s t base o f t h e a s s e t s t r a n s f e r r e d p u r s u a n t t o t h e r o l l o v e r . T h i s c o u l d account i n f u l l f o r the t a x s a v i n g . I n f a c t , the vendor f i n d s h i m s e l f i n much the same p o s i t i o n as a p a r t y t o a share as opposed t o an a s s e t s a l e . 18. Supra, a t pp. 5-12. To t h e s e might be added the r e l a x e d r u l e s c o n c e r n i n g the f l o w t h r o u g h o f l o s s e s upon amalgama- t i o n s and w i n d i n g s - u p . 19. The amount added t o the c o s t base cannot exceed th e f a i r market v a l u e o f the p r o p e r t y as a t the d a t e t h e p a r e n t l a s t a c q u i r e d c o n t r o l o f the s u b s i d i a r y , see ITA 8 8 ( 1 ) ( d ) ( i i ) . T h i s would be the f a i r market v a l u e o f the p r e f e r e n c e s h a r e s a t t h e time o f t h e i r a c q u i s i t i o n by Opco. A f u r t h e r l i m i - t a t i o n on the step-up i n c o s t base i s t h a t i t cannot exceed th e d i f f e r e n c e between th e n e t a s s e t v a l u e o f the s u b s i d i a r y and t h e a d j u s t e d c o s t base o f t h e s u b s i d i a r y ' s s h a r e s , ITA 88 (1) (d) ( i i i ) . 153 V I I . C a p i t a l Gains S t r i p p i n g i n the U n i t e d S t a t e s (a) I n t r o d u c t i o n C a p i t a l g a i n s s t r i p p i n g t h r o u g h the use o f t a x f r e e i n t e r c o r p o r a t e d i v i d e n d s i s perhaps a l e s s t r o u b l e s o m e problem f o r the f i s c a l a u t h o r i t i e s i n the U n i t e d S t a t e s than i t i s i n Canada. Indeed, th e s u b j e c t o f c a p i t a l g a i n s s t r i p s has r e c e i v e d q u i t e l i m i t e d j u d i c i a l a t t e n t i o n , w i t h o n l y one case f o r m u l a t i n g t h e i s s u e s i n the same manner t h a t d i s c u s s i o n has e v o l v e d on the t o p i c i n Canada. 1 I t i s moreover i m p o r t a n t t o note a t t h e o u t s e t t h a t o f t h e two major v a r i e t i e s o f c a p i t a l g a i n s s t r i p s , i n v o l v i n g the t r a n s f e r o f a s s e t s o r s h a r e s , o n l y the l a t t e r w a r r a n t s e x t e n s i v e a n a l y s i s because the former i s e f f e c t i v e l y p r e c l u d e d by d i f f e r e n c e s i n the Canadian and U.S. r u l e s r e l a t i n g t o c o r p o r a t e r e o r g a n i z a t i o n s , s hare r e d e m p t i o n s , and s u r p l u s d i s t r i b u t i o n s . (b) A s s e t S a l e s As we have seen, c a p i t a l g a i n s s t r i p s o f a s s e t s i n Canada t y p i c a l l y i n v o l v e the exchange p u r s u a n t t o s u b s e c t i o n 85(1) o f a s s e t s o f t h e vendor f o r redeemable p r e f e r e n c e s h a r e s o f the p u r c h a s e r c o n d i t i o n e d so as t o g i v e r i s e t o a t a x f r e e deemed d i v i d e n d upon t h e i r r e d e m p t i o n . T h i s e f f e c t i v e l y a v o i d s the c a p i t a l g a i n s n o r m a l l y r e a l i z e d by the vendor c o r p o r a t i o n upon an arm's l e n g t h d i s p o s i t i o n o f a p p r e c i a t e d c a p i t a l p r o p e r t y . I n a d d i t i o n , the t a x b e n e f i t s e c u r e d t o i n d i v i d u a l s engaged i n such t r a n s a c t i o n s 154 i s t h e d e f e r r a l o f t a x on d o l l a r s r e c e i v e d p u r s u a n t t o t h e share redemption and h e l d by the c o r p o r a t i o n f o r i n v e s t m e n t , s a v i n g s , o r b u s i n e s s p u r p o s e s . The American r o l l o v e r p r o v i s i o n t h a t b e a r s c l o s e s t comparison w i t h s u b s e c t i o n 85(1) t r a n s f e r s i s t y p e C, d e f i n e d i n s e c t i o n 3 6 8 ( a ) ( 1 ) ( C ) o f the I n t e r n a l Revenue Code t o c o n s i s t i n the a c q u i s i t i o n by one c o r p o r a t i o n o f s u b s t a n - t i a l l y a l l o f the a s s e t s o f a n o t h e r c o r p o r a t i o n i n exchange f o r v o t i n g s h a r e s o f the a c q u i r i n g c o r p o r a t i o n . The t y p e C r e o r g a n i z a t i o n would seem a s e r v i c e a b l e t o o l w i t h which t o i n i t i a t e a c a p i t a l g a i n s s t r i p on the Canadian model, however the American r o l l o v e r s a r e c i r c u m s c r i b e d by j u d i c i a l d o c t r i n e s and l i m i t a t i o n s w h i c h r e n d e r them un- s u i t a b l e f o r the purpose o f s t r i p p i n g g a i n s on p r o p e r t y . Of p a r t i c u l a r i n t e r e s t i n c o n n e c t i o n w i t h t ype C r e o r g a n i z a t i o n s i s the c o n t i n u i t y o f i n t e r e s t d o c t r i n e w h i c h r e q u i r e s t h a t t h e r e be a c o n t i n u i t y o f i n t e r e s t o f t h e t r a n s f e r o r i n the a s s e t s r o l l e d o v e r . The case on p o i n t i s C o r t l a n d S p e c i a l t y 2 Co. v CIR i n w h i c h the c o u r t made i t v e r y c l e a r t h a t t h e p r o v i s i o n c o u l d n o t be employed as p a r t o f a s a l e t r a n s a c t i o n . G e n e r a l l y , i t may'ibe s a i d o f a l l American r e o r g a n i z a t i o n p r o v i s i o n s t h a t t h e y cannot be m o t i v a t e d by t a x m i n i m i z a t i o n c o n s i d e r a t i o n s and must c o n s t i t u t e bone f i d e r e c o n s t r u c t i o n s u n d e r t a k e n f o r p r e d o m i n a t i n g b u s i n e s s p u r p o s e s . The r e d emption o f p r e f e r r e d s h a r e s evokes i n the U.S. s t r o n g t a x a v o i d a n c e c o n n o t a t i o n s . P r e f e r r e d s t o c k b a i l o u t s were f o r many y e a r s a means o f w i t h d r a w i n g t h e earned s u r p l u s 155 3 o f c o r p o r a t i o n s a t c a p i t a l g a m s r a t e s . A c c o r d i n g l y , IRC s e c t i o n 306 deems p r e f e r e n c e s h a r e s i s s u e d under s p e c i f i e d c o n d i t i o n s t o be ' s e c t i o n 306 s t o c k " , and t r e a t s t h e amounts r e c e i v e d as d i v i d e n d s i n s t e a d o f as a r e t u r n o f c a p i t a l t o th e e x t e n t o f t h e d i s t r i b u t i n g c o r p o r a t i o n ' s e a r n i n g s and p r o f i t s . One o f t h e s p e c i f i e d c i r c u m s t a n c e s i n v o l v e s 4 s t o c k r e c e i v e d i n a c o r p o r a t e d i v i s i o n o r r e o r g a n i z a t i o n . A l l o t h e r f a c t o r s b e i n g e q u a l , t h i s t a x t r e a t m e n t would seem t o encourage a v o i d a n c e u s i n g t a x f r e e o r t a x reduced d i v i d e n d s . However, s t r i p s based on s u b s e c t i o n 84(3) o f t h e Canadian A c t n o r m a l l y i n v o l v e the r e a l i z a t i o n o f the s h a r e - h o l d e r ' s e n t i r e i n t e r e s t i n the redeeming c o r p o r a t i o n . T h i s i s what b r i n g s about t h e t a x - f r e e r e c e i p t o f l i q u i d a s s e t s t h a t i s so o f f e n s i v e t o the government. I n the U n i t e d S t a t e s , an e x c e p t i o n from the 306 d i v i d e n d t r e a t m e n t i s p r o v i d e d i n s u b s e c t i o n 306(b)(1) f o r d i s p o s i t i o n s t h a t t e r m i n a t e the s h a r e h o l d e r ' s i n t e r e s t i n t h e c o r p o r a t i o n . I n such c i r c u m s t a n c e s t h e s h a r e h o l d e r i s g i v e n c a p i t a l g a i n s t r e a t m e n t o f h i s r e c e i p t s o v e r h i s b a s i s i n t h e s h a r e s . N e e d l e s s t o say, t h i s i s p r e c i s e l y the r e s u l t t h a t t h e t a x p a y e r i s s e e k i n g t o a v o i d i n c a p i t a l g a i n s s t r i p p i n g s i t u a t i o n s . S i m i l a r c o n s i d e r a t i o n s govern the redemption 5 o f a s h a r e h o l d e r ' s i n t e r e s t r e p r e s e n t e d by common s h a r e s . As n o t e d , the b e n e f i t s s e c u r e d t o i n d i v i d u a l s i n c a p i t a l g a i n s s t r i p s ( . p a r t i c u l a r l y t o s e l l e r s o f s m a l l b u s i n e s s e s ) i s the d e f e r r a l o f t a x on what w i l l n o r m a l l y be t a k e n i n due c o u r s e i n t o income as a d i v i d e n d . The accumu- 156 l a t i o n o f e a r n i n g s i n American c o r p o r a t i o n s f o r o t h e r t h a n b u s i n e s s purposes i s p r o s c r i b e d by the accumulated e a r n i n g s t a x o f IRC s e c t i o n 531 and t h e p e n a l t y t a x e s on p e r s o n a l h o l d i n g companies i n s e c t i o n s 541-547. The d e f e r r a l advantages s e c u r e d t o i n d i v i d u a l s i n Canada would a c c o r d i n g l y be i m p o s s i b l e i n the U n i t e d S t a t e s . (c) Share S a l e s The Code p r o v i s i o n s d e a l i n g w i t h d i v i d e n d s r e c e i v e d by c o r p o r a t i o n s i s s e c t i o n 243. The Code p o l i c y i n essence a f f i r m s t h e p r i n c i p l e t h a t c o r p o r a t e s o u r c e income s h o u l d n o t bear t a x when d i s t r i b u t e d as d i v i d e n d s t o c o r p o r a t e s h a r e h o l d e r s . I n g e n e r a l , the scheme o f s e c t i o n 243 i s t o a l l o w a t l e a s t an 85% d e d u c t i o n from income of d i v i d e n d s r e c e i v e d by a d o m e s t i c c o r p o r a t i o n from a n o t h e r d o m e s t i c c o r p o r a t i o n ^, a 100% d e d u c t i o n f o r d i v i d e n d s r e c e i v e d by an a f f i l i a t e d c o r p o r a t i o n out o f e a r n i n g s and p r o f i t s o f • 7 the payer accumulated whxle the c o r p o r a t i o n s were a f f i l i a t e d and a 100% d e d u c t i o n from income o f a d i v i d e n d r e c e i v e d by an a f f i l i a t e d c o r p o r a t i o n where b o t h c o r p o r a t i o n s b e l o n g t o g a group f i l i n g a c o n s o l i d a t e d r e t u r n . 9 I n Waterman Steamship Company v Commissioner , the F e d e r a l C o u r t of A p p e a l h e l d t h a t t h e p r e - s a l e payment o f a g a i n r e d u c i n g d i v i d e n d from a s u b s i d i a r y t o i t s p a r e n t c o r p o r a t i o n i m p r o p e r l y a v o i d e d c a p i t a l g a i n s t a x . The Waterman case was d e c i d e d i n 1966 f o r t h e 1955 t a x a t i o n y e a r . I n 1966 amendments t o the IRC r e g u l a t i o n s p r o v i d e d t h a t a 157 p a r e n t c o r p o r a t i o n f i l i n g a c o n s o l i d a t e d r e t u r n w i t h i t s s u b s i d i a r y c o u l d i n c r e a s e the b a s i s o f i t s s h a r e s i n i t s s u b s i d i a r y by. t h e amount o f e a r n i n g s and p r o f i t s o f t h e s u b s i d i a r y f o r t h e y e a r . T h i s i s a c c o m p l i s h e d by deeming a d i v i d e n d t o be p a i d by t h e s u b s i d i a r y t o i t s p a r e n t , f o l l o w e d by a deemed c o n t r i b u t i o n t o the c a p i t a l o f the sub- s i d i a r y by t h e p a r e n t . As t h e e a r n i n g s and p r o f i t s a c c o u n t o f one o f t h e s u b s i d i a r i e s was adequate t o pay a p r e - s a l e d i v i - dend s u f f i c i e n t i n amount t o reduce the c a p i t a l g a i n t o n i l , t h e Waterman f a c t s i t u a t i o n would t o d a y , by o p e r a t i o n o f law, g i v e r i s e t o no g a i n . ^ The Waterman case c o n t i n u e s t o be o f i n t e r e s t , however, because the 'deemed d i v i d e n d ' e l e c t i o n cannot be e x e r c i s e d u n l e s s t h e r e a r e no m i n o r i t y shareholders 1 1 a n d a f f i l i a t e d c o r p o r a t i o n s have e l e c t e d t o f i l e c o n s o l i d a t e d r e t u r n s (an e l e c t i o n w h i c h may be d e c l i n e d f o r good b u s i n e s s r e a s o n s ) . The q u e s t i o n t h e n becomes whether g a i n r e d u c i n g p r e - s a l e d i v i d e n d s may be deducted from income p u r - 12 suant t o IRC 243 (a) (3) , o r whether t h e Waterman p r i n c i p l e s o v e r - r i d e the s t a t u t o r y p r o v i s i o n . I n Waterman Steamship, a p a r e n t c o r p o r a t i o n , Waterman, was o f f e r e d $3,500,000 f o r i t s two s u b s i d i a r y companies. T h i s f i g u r e a l s o r e p r e s e n t e d the a d j u s t e d c o s t base o f the s u b s i d i a r i e s ' a s s e t s , so t h a t a s a l e o f t h o s e a s s e t s a t the p r i c e o f f e r e d would n o t g i v e r i s e t o a c a p i t a l g a i n . The p u r c h a s e r was, however, u n w i l l i n g t o a c q u i r e t h e a s s e t s o f the s u b s i d i a r i e s because c e r t a i n v a l u a b l e non- t r a n s f e r a b l e r i g h t s were v e s t e d i n them. The a l t e r n a t i v e o f 158 a share t r a n s a c t i o n was n o t a t t r a c t i v e t o Waterman because i t s b a s i s i n the s h a r e s amounted t o o n l y 700,000. Upon a share s a l e Waterman would t h e r e f o r e r e a l i z e a c a p i t a l g a i n o f $3,500,000 - $700,000 = $2,800,000. A scheme was embarked upon i n o r d e r t o s a t i s f y t h e demands o f b o t h p a r t i e s . One o f the Waterman s u b s i d i a r i e s , p o s s e s s i n g a s u f f i c i e n t b a l a n c e i n i t s post-1913 e a r n i n g s and p r o f i t s a c c o u n t , p a i d a d i v i d e n d o f $2,800,000 t o i t s p a r e n t , e f f e c t i v e l y r e d u c i n g the t o t a l p urchase p r i c e o f t h e s h a r e s o f b o t h s u b s i d i a r i e s t o $700,000, the amount o f Waterman's b a s i s i n t h e s t o c k o f the s u b s i d i a r i e s . S i n c e Waterman f i l e d a c o n s o l i d a t e d r e t u r n w i t h i t s a f f i l i a t e s , t he d i v i d e n d would i n the o r d i n a r y c o u r s e be r e c e i v e d f r e e o f t a x . An i m p o r t a n t f a c t u a l d e t a i l o f t h e case was t h a t t h e d i v i d e n d was p a i d i n t h e form o f a p r o m i s s o r y n o t e , w i t h the p u r c h a s e r c o r p o r a t i o n n ot o n l y u n d e r t a k i n g t o guarantee payment by the s u b s i d i a r y b u t i n f a c t s u p p l y i n g i t w i t h t h e n e c e s s a r y funds by way o f l o a n . The s u b s i d i a r y then d i s c h a r g e d i t s note t o Waterman. A c c o r d i n g l y , t h e Commissioner asked the Tax C o u r t t o d i s r e g a r d the d i v i d e n d payment as a sham and t o r e c a s t t h e t r a n s a c t i o n i n t h e mould o f a r e c e i p t by Waterman's o f t h e p u r c h a s e p r i c e w i t h the s u b s i d i a r y a c t i n g as a c o n d u i t f o r t h e movement of c a s h . Thus, the Waterman f a c t p a t t e r n may be compared w i t h t h e c a p i t a l g a i n s s t r i p s p r a c t i c e d i n Canada i n v o l v i n g the i n j e c t i o n by t h e p u r c h a s e r o f l i q u i d a s s e t s i n t o t h e t a r g e t company c o u p l e d w i t h the subsequent payment o f a 159 d i v i d e n d t o the s e l l i n g c o r p o r a t i o n . The m a j o r i t y d e c i s i o n o f the Tax C o u r t found i n f a v o u r o f the t a x p a y e r , f i r s t l y on t h e b a s i s o f h i s r i g h t t o a r r a n g e h i s own a f f a i r s i n such a way as t o m i n i m i z e h i s t a x burden and, s e c o n d l y , because a t t h e time the d i v i d e n d was p a i d t h e vendor m a i n t a i n e d i t s b e n e f i c i a l i n t e r e s t i n t h e s h a r e s . The d i s s e n t i n g Judges, l e d by Judge Tannenwald, h e l d t h a t no d i v i d e n d whatsoever had been p a i d by t h e s u b s i d i a r y and t h a t the p u r p o r t e d d i v i d e n d i n f a c t c o n s t i t u t e d payment by the p u r c h a s e r o f the p r i c e . 1.3 On a p p e a l t o t h e F i f t h C i r c u i t C o u r t o f A p p e a l s , the d e c i s i o n o f the Tax C o u r t was r e v e r s e d and r e p l a c e d w i t h a r u l i n g t h a t the d i v i d e n d was i n 'substance' th e payment of the purchase p r i c e . I n view o f the u n u s u a l f i n a n c i n g arrangements o f the p a r t i e s , the case might have been l i m i t e d t o i t s p a r t i c u l a r f a c t s so t h a t t h e payment o f a c a s h p r e - s a l e d i v i d e n d out o f post-1913 e a r n i n g s and p r o f i t s w i t h the l i q u i d a s s e t s o f t h e s u b s i d i a r y (not o f the p u r c h a s e r l o a n e d o r o t h e r w i s e made a v a i l a b l e t o the s u b s i d i a r y ) would not f a l l w i t h i n i t s h o l d i n g . The g e n e r a l i t y o f the language employed by t h e C o u r t however makes i t c l e a r t h a t a l l g a i n r e d u c i n g d i v i d e n d s a r e s u s p e c t . Judge Wisdom, f o r example, s p e c u l a t e d t h a t "a new h o r i z o n o f t a x a v o i d a n c e p o s s i b i l i t i e s would be opened by a l l o w i n g . . . . c o r p o r a t i o n s w i t h w h o l l y owned s u b s i d i a r i e s . . . . t o c i r c u m v e n t c a p i t a l g a i n s t r e a t m e n t t h r o u g h 14 a p r e - s a l e e x t r a c t i o n o f e a r n i n g s , and p r o f i t s " . 160 The American p r o v i s i o n p e r m i t t i n g t h e a d j u s t m e n t o f t h e p a r e n t ' s b a s i s i n i t s s h a r e s o f i t s s u b s i d i a r y t o t a k e a c c o u n t o f t h e s u b s i d i a r y ' s e a r n i n g s perhaps s u g g e s t s t h a t t h e new c a p i t a l g a i n s s t r i p p i n g r u l e s i n s u b s e c t i o n s 55(2) - (5) o f the Canadian A c t r e p r e s e n t a c o m p a r a t i v e l y awkward s o l u t i o n . Why n o t s i m p l y i n t r o d u c e a s i m i l a r a d justment t o t h e c o s t base of s h a r e s h e l d by Canadian c o r p o r a t i o n s ? T h i s s i m p l e e x p e d i e n t would u n f o r t u n a t e l y n o t be o f use i n Canada because t h e i n c r e a s e i n t h e c o s t base would o n l y reduce the s i z e o f t h e p r e - s a l e d i v i d e n d t o be p a i d i n o r d e r t o reduce the f a i r market v a l u e o f t h e s h a r e s t o be s o l d t o t h e i r a d j u s t e d c o s t base. I n Canada, a d i v i d e n d i s f o r t a x p u r p o s e s , s u b j e c t t o t h e l i m i t e d e x c e p t i o n f o r s t o c k d i v i d e n d s p a i d by a p u b l i c c o r p o r a t i o n a f t e r March 31, 197 7, e s s e n t i a l l y t h e same as d i v i d e n d s p a i d under the r e l e v a n t c o r p o r a t i o n law. Thus, a d i v i d e n d may, under normal c i r c u m s t a n c e s , be p a i d o u t o f c o n t r i b u t e d o r a p p r a i s a l s u r p l u s . Moreover, under th e p r e s e n t scheme o f d i s t r i b u t i o n s a l l amounts r e c e i v e d upon a buy-back o f s h a r e s i n e x c e s s o f t h e i r p a i d up c a p i t a l may be d e t e r m i n e d by agreement o f the c o r p o r a t i o n and i t s ( p r o s p e c t i v e ) s h a r e h o l d e r . By c o n t r a s t , i n t h e U n i t e d S t a t e s a d i v i d e n d i s d e f i n e d f o r t a x purposes i n s e c t i o n 316(a) as "any d i s t r i b u t i o n o f p r o p e r t y made by a c o r p o r a t i o n t o i t s s h a r e h o l d e r s - (1) o u t o f i t s e a r n i n g s and p r o f i t s f o r t h e t a x a b l e y e a r . . . " Thus, a d i v i d e n d f o r t a x purposes need n o t c o r r e s p o n d i n a l l c ases w i t h t h e d i v i d e n d s p e r m i t t e d under 161 the s t a t e l a w s , and i s s t r i c t l y l i m i t e d t o the b a l a n c e a v a i l a b l e f o r d i s t r i b u t i o n i n t h e post-1913 e a r n i n g s and p r o f i t s a c c o u n t . I n a d d i t i o n , s u b s e c t i o n 316(a) a l s o p r o v i d e s , by c r o s s - r e f e r e n c i n g w i t h s e c t i o n 301, t h a t a l l amounts r e c e i v e d i n e x c e s s o f post-1913 e a r n i n g s and p r o f i t s w i l l be r e c e i v e d i n r e d u c t i o n o f t h e b a s i s i n t h e s h a r e s and a d d i t i o n a l amounts w i l l be t r e a t e d as a c a p i t a l g a i n o f t h e s h a r e h o l d e r . B e a r i n g i n mind the American t a x law o f d i v i d e n d d i s t r i b u t i o n s , Judge Wisdom's a n x i e t y c o n c e r n i n g the p o s s i b l e use o f t a x - f r e e i n t e r c o r p o r a t e d i v i d e n d s i n c a p i t a l g a i n s s t r i p p i n g t r a n s a c t i o n s t h e r e f o r e i s perhaps not j u s t i f i e d . As the American d i v i d e n d can o n l y be p a i d out o f p r o f i t s , i t would appear t h a t a v o i d a n c e i s r e a l l y a n o n - i s s u e and t h a t the upward adjustment t o t h e c o s t base o f t h e s u b s i d i a r y ' s s h a r e s c o n s t i t u t e s l e g i s l a t i o n i n t r o d u c e d t o r e l i e v e the c o r p o r a t e s h a r e h o l d e r from the burden o f double t a x a t i o n . I n c i r c u m s t a n c e s where the a d j u s tment t o b a s i s cannot be made i . e . t h e r e a r e m i n o r i t y s h a r e h o l d e r s o r t h e a f f i l i a t e d c o r p o r a t i o n s have not e l e c t e d t o f i l e a c o n s o l i d a t e d r e t u r n , s u b s e c t i o n 2 4 3 ( a ) ( 3 ) , a l l o w i n g the 100% d e d u c t i o n f o r d i v i d e n d s r e c e i v e d by an a f f i l i a t e d company, s h o u l d a p p l y t o a p r e - s a l e d i v i d e n d p a i d by a s u b s i d i a r y t o i t s p a r e n t and t h e Waterman d e c i s i o n s h o u l d be d i s r e g a r d e d o r l i m i t e d t o i t s p a r t i c u l a r f a c t s . The I n t e r n a l Revenue S e r v i c e would seem t o have d e c i d e d i n f a v o u r o f r e s t r i c t i n g the scope of Waterman. Revenue R u l i n g 75-493, which i n p a r t d i s t i n g u i s h e s Waterman from a s u b s e q u e n t l y 162 d e c i d e d case ^ , emphasizes t h a t " . . . t h e funds t o pay the d i v i d e n d were a c t u a l l y f u r n i s h e d by t h e buyer; t h a t amount was c o n s i d e r e d as p a r t o f the purchase p r i c e p a i d by t h e buyer o f the s t o c k o f the s u b s i d i a r y . Thus, t h e form o f the t r a n s a c t i o n was a sham d e s i g n e d t o d i s g u i s e t h e s u b s t a n c e o f the t r a n s a c t i o n . " The above quoted passage a l s o p o i n t s t o a n o t h e r element o f the Waterman d e c i s i o n w h i c h perhaps s e r v e s t o s e p a r a t e i t from t h e b a s i c p o l i c y i s s u e s s u r r o u n d i n g c a p i t a l g a i n s a v o i d a n c e t h r o u g h i n t e r - c o r p o r a t e d i v i d e n d payments. I t i s c l e a r t h a t b o t h t h e revenue a u t h o r i t i e s and the a p p e a l s c o u r t c o n s i d e r e d t h a t the p a r t i e s t o the s a l e t r a n s a c t i o n i n f a c t themselves r e g a r d e d the d i v i d e n d t o be p a r t o f the purchase p r i c e . I n C o u r t H o l d i n g Co. v Commissioner a c o r p o r a t i o n engaged i n p r o t r a c t e d .nego- t i a t i o n s c o n c e r n i n g the s a l e o f i t s s o l e a s s e t , an a p a r t - ment b u i l d i n g . An o r a l agreement, w h i c h was not b i n d i n g by r e a s o n o f s t a t e S t a t u t e o f Frauds l e g i s l a t i o n , marked t h e c u l m i n a t i o n o f the p a r t i e s ' d i s c u s s i o n s . P r i o r t o the e x e c u t i o n o f i a h agreement however, the c o r p o r a t i o n ' s s o l i c i t o r a d v i s e d a g a i n s t i t s consummation because o f t h e u n f a v o u r a b l e t a x consequences o f an a s s e t s a l e . A new arrangement was s t r u c k upon whereby the s h a r e h o l d e r s would s e l l t h e a s s e t t o the p u r c h a s e r f o l l o w i n g t h e l i q u i d a t i o n o f the company. I n l o o k i n g a t t h e subst a n c e o f t h e m a t t e r , th e Supreme C o u r t d e c i d e d t h a t t h e n e g o t i a t i o n s i n d i c a t e d c o n c l u s i v e l y t h a t t h e i n t e n t i o n o f t h e p a r t i e s had t h r o u g h o u t 163 been t h a t the company s h o u l d s e l l t h e b u i l d i n g and t h a t t h e l a s t - m i n u t e i n t e r p o s i t i o n o f the s h a r e h o l d e r as vendor and the l i q u i d a t i o n o f the company were a c t s inconsistent w i t h the n e g o t i a t i n g p o s i t i o n s w h i c h had been adopted. From t h i s case i s d e r i v e d the American d o c t r i n e t h a t t h e form o f a t r a n s a c t i o n must r e f l e c t t h e s u b s t a n c e of the p r e c e d i n g n e g o t i a t i o n s , and i t would appear t h a t t h i s c o ncept i n f l u e n c e d t h e d e c i s i o n i n Waterman Steamship. P a r e n t h e t i c a l l y , i t i s o f c o u r s e a l s o n e c e s s a r y i n Canada t o c o n s t r u e a document w i t h due r e g a r d t o s u r r o u n d i n g c i r c u m s t a n c e s i n cases o f a m b i g u i t y . Upon such a l e g a l c o n s t r u c t i o n , however, i t would be s u r p r i s i n g t o f i n d a Canadian c o u r t d i s r e g a r d i n g an u n e q u i v o c a l document brought f o r w a r d by t h e p a r t i e s as r e p r e s e n t i n g t h e i r agreement on t h e b a s i s t h a t t h e 'substance o f n e g o t i a t i o n s ' i n d i c a t e d a c o n t r a r y i n t e n t i o n . The d o c t r i n e o f the 'substance' (as i n s u b s t a n c e v e r s u s form) w h i c h i n t h e U n i t e d S t a t e s e f f e c t i v e l y p e r m i t s the j u d i c i a l r e c o n s t r u c t i o n o f t r a n s a c t i o n s i n a ccordance w i t h t h e i r p e r c e i v e d t r u e n a t u r e s , was perhaps th e p r i n c i p a l ground of d e c i s i o n i n Waterman Steamship. The view t h a t t h e payment o f the d i v i d e n d was m e r e l y a s u b t e r f u g e masking the r e a l t r a n s a c t i o n would appear t o be t i e d t o a s i t u a t i o n where a d i v i d e n d i s p a i d w i t h funds i n j e c t e d i n t o t h e c o r - p o r a t i o n by t h e p u r c h a s e r . Presumably, payment o f a d i v i d e n d w i t h l i q u i d a s s e t s on hand i n t h e c o r p o r a t i o n would not be s u b j e c t t o t h e Waterman p r i n c i p l e . 164 To c o n c l u d e , i t would seem t h a t d e s p i t e t h e d e c i s i o n i n Waterman Steamship, a p r e - s a l e e x t r a c t i o n o f earned s u r p l u s t h r o u g h i n t e r c o r p o r a t e d i v i d e n d s w i l l n o t c o n s t i t u t e proceeds o f d i s p o s i t i o n t o t h e d i v i d e n d r e c i p i e n t , u n l e s s the funds used t o pay the d i v i d e n d were s u p p l i e d by t h e p u r c h a s e r . The f a c t t h a t d i v i d e n d s can i n t h e U n i t e d S t a t e s be p a i d o ut o f e a r n i n g s and p r o f i t s would seem t o put t h e p r e - s a l e removal o f earned s u r p l u s beyond r e p r o a c h from a p o l i c y p o i n t o f v i e w because t h e funds d i s t r i b u t e d w i l l a c c o r d i n g l y n o t r e p r e s e n t the a p p r e c i a t i o n o f g o o d w i l l and o t h e r c a p i t a l a s s e t s o f t h e c o r p o r a t i o n the s hares o f wh i c h a r e t o be s o l d . ' A s s e t ' t ype s t r i p s c annot be p r a c t i c e d i n t h e U n i t e d S t a t e s because o f fundamental d i f f e r e n c e s i n t h e r e o r g a n i z a t i o n and s u r p l u s d i s t r i b u t i o n r u l e s . 165 FOOTNOTES 1. Waterman Steamship Company v Commissioner, 430 F.2nd 1185. 2. 60 F.2d. 937. 3. These schemes i n v o l v e d the i s s u a n c e o f n o n - t a x a b l e p r e f f e r e d s t o c k d i v i d e n s which were s u b s e q u e n t l y redeemed. 4 . IRC s.306(c) (1) (B) . 5. IRC s.302(b)(3) 6. IRC s.243(a)(1) 7. IRC s . 2 4 3 ( a ) ( 3 ) . A f f i l i a t e d c o r p o r a t i o n s a r e , e s s e n t i a l l y , c o r p o r a t i o n s under common c o n t r o l . 8. The 15% i n c l u s i o n i n income o f i n t e r c o r p o r a t e d i v i d e n d s r e c e i v e d from n o n - a f f i l i a t e d d o m e s t i c c o r p o r a t i o n s does n ot r e p r e s e n t a p a r t i a l w i t h d r a w a l from t h e n o t i o n t h a t i n t e r - c o r p o r a t e d i v i d e n d s s h o u l d pass t a x f r e e . H i s t o r i c a l l y , the p r o v i s i o n i s connected w i t h the i n t r o d u c t i o n i n 1935 o f a g r a d u a t e d c o r p o r a t e income t a x . One o f t h e dangers p e r c e i v e d as f l o w i n g from t h i s development was t h e p o s s i b i l i t y t h a t t a x p a y e r s might employ m u l t i p l e c o r p o r a t i o n s i n o r d e r t o expose the income earned by a s i n g l e e n t e r p r i s e t o a lower e f f e c t i v e r a t e o f t a x . The 15% i n c l u s i o n o f i n t e r - c o r p o r a t e d i v i d e n d s was r e g a r d e d as d i s c o u r a g i n g t h i s r e s u l t . A t the time t h i s r u l e was i n e f f e c t , no d i s t i n c t i o n was made between a f f i l i a t e d and n o n - a f f i l i a t e d c o r p o r a t i o n s . W i t h the drawing o f t h i s d i s t i n c t i o n i n 1964, t h e f u l l d e d u c t i b i l i t y o f i n t e r c o r p o r a t e d i v i d e n d s p a i d w i t h i n an a f f i l i a t e d group was p e r m i t t e d . 9. Supra, f o o t n o t e 1, a t p . l . 166 10. Regs. 1 . 1 5 0 2 - 3 2 ( b ) ( 1 ) ( i ) , ( b ) ( 2 ) ( i i i ) , ( e ) , 1 . 1 0 5 - l ( e ) . 11. Regs. 1 . 1 5 0 2 - 3 2 ( f ) ( 2 ) . 12. Supra, a t p. 4. 13. 430 F.2nd. 1191. 14 . I b i d . , a t p. 1195. 15. Casner v Commissioner, 450 F.2d. 379, 1971. 16. 450 F.2d. 379. 167 V I I I . C a p i t a l Gains S t r i p p i n g i n G r e a t B r i t a i n One type o f c a p i t a l g a i n s t a x a v o i d a n c e would seem to be p o s s i b l e i n B r i t a i n , however such a c t i v i t i e s would appear a l s o t o be c o n f i n e d w i t h i n a narrower compass th a n was t h e case i n Canada p r i o r t o t h e r e c e n t l e g i s l a t i v e changes. The w r i t e r w i l l p r o v i d e a b r i e f background on t h e B r i t i s h c a p i t a l g a i n s t a x b e f o r e comparing th e r e l e v a n t c o r r e s p o n d i n g p r o v i s i o n s o f the B r i t i s h and Canadian t a x systems. F o r c o n v e n i e n c e , s t r i p s a r e r o u g h l y c l a s s i f i e d as those i n v o l v i n g p a r e n t - s u b s i d i a r y r e l a t i o n s and t h o s e f e a t u r i n g t a x f r e e r o l l o v e r s . C a p i t a l g a i n s t a x was f i r s t i n t r o d u c e d i n B r i t a i n i n 19 62 i n the form o f a charge on s h o r t - t e r m c a p i t a l g a i n s . The r e l e v a n t time p e r i o d s were t h r e e y e a r s i n t h e case o f l a n d and, f o r a l l o t h e r a s s e t s , s i x months. The s h o r t - term c a p i t a l g a i n s t a x was c o n t i n u e d , w i t h m o d i f i c a t i o n s , even a f t e r the i n t r o d u c t i o n , w i t h the coming o f the F i n a n c e A c t , 1965, o f a c a p i t a l g a i n s t a x on g a i n s not p r e v i o u s l y t a x a b l e . I n 1970, however , Case V I I (the s h o r t - t e r m g a i n s p r o v i s i o n ) was a b o l i s h e d , making the s u b s i s t i n g t a x on c a p i t a l g a i n s o f g e n e r a l a p p l i c a b i l i t y . C a p i t a l g a i n s t a x may be e x a c t e d f o l l o w i n g the d i s p o s a l by a p e r s o n o f c e r t a i n a s s e t s . A t a x l i a b i l i t y , o r l o s s a l l o w a n c e , . h a s always been i n e f f e c t i n r e s p e c t o f the d i s p o s i t i o n o f 'revenue', as opposed t o c a p i t a l , a s s e t s o f a t r a d e , p r o f e s s i o n , o r v o c a t i o n . The c a p i t a l g a i n s r u l e s e x c l u d e from t h e i r o p e r a t i o n such g a i n s and l o s s e s as a r e 168 w i t h i n t h e g e n e r a l Income and C a p i t a l Gains Tax A c t ambit. A l l o f the f a c t o r s r e l e v a n t i n Canada t o a d e t e r - m i n a t i o n o f whether a r e c e i p t i s o f an income o r c a p i t a l n a t u r e a r e t a k e n i n t o account i n B r i t a i n f o r the purpose o f c h a r a c t e r i z i n g the proceeds o f d i s p o s i t i o n o f a s s e t s . The b a s i c r a t e f o r the t a x a t i o n o f c a p i t a l g a i n s i s 30% f o r i n d i v i d u a l s and c o r p o r a t i o n s . As t h e c o r p o r a t i o n t a x l i a b i l i t y exceeds the t a x on c h a r g e a b l e g a i n s , t h e r e i s c l e a r l y an advantage i n a c o r p o r a t i o n t a k i n g a c a p i t a l r e c e i p t i n p r e f e r e n c e t o an income r e c e i p t . C h a r g e a b l e g a i n s a r e measured as the d i f f e r e n c e between t h e c o n s i d e r a t i o n r e c e i v e d f o r t h e d i s p o s a l and t h e ' a l l o w a b l e e x p e n d i t u r e ' , w hich i n c l u d e s c o s t , maintenance, and t h e expenses o f the d i s p o s a l . A l l o w a b l e l o s s e s may be s e t - o f f a g a i n s t c h a r g e a b l e g a i n s f o r the p e r i o d and any unused l o s s e s may be c a r r i e d f o r w a r d i n d e f i n i t e l y (but n o t b a c k ) . I n d i v i d u a l s r e c e i v e an exemption f o r the f i r s t 3,000.£ g a i n , however t h i s r e l i e f i s not a v a i l a b l e t o c o r p o r a t i o n s . C e r t a i n l i m i t a t i o n s on the use by B r i t i s h t a x p l a n n e r s o f t h e t y p e s o f schemes employed by Canadian t a x p a y e r s t o a v o i d c a p i t a l g a i n s t a x a r e imposed by d i f f e r e n c e s i n the B r i t i s h laws g o v e r n i n g d i v i d e n d d i s t r i b u t i o n s . The t r a d i n g and i n v e s t m e n t income o f a UK company i s n o t s u b j e c t t o income t a x , b e a r i n g c o r p o r a t i o n t a x i n s t e a d . A l t h o u g h o n l y one c o r p o r a t i o n t a x i s a c t u a l l y l e v i e d , i t i s e f f e c t i v e l y p a i d i n two i n s t a l l m e n t s . When a d i v i d e n d d i s t r i b u t i o n i s made t o s h a r e h o l d e r s a f r a c t i o n e q u a l t o 3/7 t h s o f the 169 d i v i d e n d i s f o r w a r d e d t o the I n l a n d Revenue.''" C o r p o r a t i o n t a x i s a g a i n p a y a b l e a t the end o f t h e company's a c c o u n t i n g p e r i o d , b u t t a x p a i d c o n c u r r e n t l y w i t h d i v i d e n d s may be matched a g a i n s t the t a x p a y a b l e upon p r o f i t s . A t a x c r e d i t e q u a l t o the ACT (advance c o r p o r a t i o n tax) p a i d i s a c c o r d e d the s h a r e h o l d e r and the d i v i d e n d i s g r o s s e d up by the amount of the c r e d i t . F o r s h a r e h o l d e r s whose t o t a l income i s l e s s than 10 ,00o£after p e r s o n a l d e d u c t i o n s , the a p p l i c a t i o n f o t h e 30% b a s i c r a t e w i l l r e s u l t i n no t a x p a y a b l e . UK r e s i d e n t c o r p o r a t i o n s a r e n o t s u b j e c t t o c o r p o r a t i o n t a x o r amounts r e c e i v e d p u r s u a n t t o " q u a l i f y i n g d i s t r i b u t i o n s " 3 w hich i n c l u d e s a l l d i s t r i b u t i o n s w i t h two minor e x c e p t i o n s . A ' d i s t r i b u t i o n ' i s d e f i n e d i n s e c t i o n 2 3 3 o f the Income and C o r p o r a t i o n Tax A c t , 1 9 7 0 , as i n c l u d i n g any d i v i d e n d p a i d by t h e company. Thus, i n t e r c o r p o r a t e d i v i d e n d s may be r e c e i v e d t a x f r e e , however the payor c o r p o r a t i o n w i l l n e v e r t h e l e s s be r e q u i r e d t o pay advance c o r p o r a t i o n t a x o f 3 / 7 t h s o f t h e d i s t r i b u t e d amount. T h i s t a x may o f c o u r s e be s e t - o f f a g a i n s t the 'mainstream' c o r p o r a t i o n t a x l i a b i l i t y a t the t e r m i n a t i o n o f t h e p a y o r ' s a c c o u n t i n g p e r i o d , however i n c i r c u m s t a n c e where the ACT exceeds the t a x p a y a b l e on p r o f i t s i . e . d i s t r i b u t i o n s exceed e a r n i n g s f o r the p e r i o d , t h e r e l i e f w i l l be d e l a y e d t o a f u r t h e r p e r i o d . An i m p o r t a n t e x c e p t i o n t o the t a x c o s t s i n c i d e n t a l t o i n t e r c o r p o r a t e d i v i d e n d payments i n B r i t a i n a p p l i e s i n 170 the case o f "group income", which i s e f f e c t i v e l y t h e income r e s u l t i n g from i n t e r c o r p o r a t e t r a n s f e r s w i t h i n a r e l a t e d group o r c o n s o r t i u m , f o r p r e s e n t purposes from a p a r e n t t o i t s w h o l l y o r p a r t i a l l y owned s u b s i d i a r y . Thus, an o p p o r t u n i t y i s c r e a t e d f o r a t l e a s t one v a r i e t y o f c a p i t a l g a i n s s t r i p , t h a t t u r n i n g on the payment by t h e s u b s i d i a r y t o t h e p a r e n t o f a d i v i d e n d p r i o r t o t h e s a l e by t h e p a r e n t o f t h e ; s u b s i d i a r y ' s s h a r e s . I n t h i s c o n n e c t i o n , a r e l e v a n t a n t i - a v o i d a n c e p r o v i s i o n would appear t o be s e c t i o n 2 6 o f t h e C a p i t a l G ains Tax A c t , 1979, wh i c h p r o v i d e s , i n t e r a l i a , 26(1) T h i s s e c t i o n has e f f e c t as r e s p e c t s t h e d i s p o s a l o f an a s s e t i f a scheme has been e f f e c t e d o r arrangements have been made (whether b e f o r e o r a f t e r t h e d i s p o s a l ) whereby - (a) the v a l u e o f the a s s e t has been m a t e r i a l l y reduced and (b) a t a x - f r e e b e n e f i t has been o r w i l l be c o n f e r r e d - ( i ) on the p e r s o n making t h e d i s p o s a l or a p e r s o n w i t h whom he i s c o n n e c t e d , o r ( i i ) s u b j e c t t o s u b s e c t i o n (3) below, on any o t h e r p e r s o n S u b s e c t i o n 2 f u r t h e r p r o v i d e s , i n t e r a l i a , t h a t "a b e n e f i t i s c o n f e r r e d on a p e r s o n i f he b e c o m e s : e n t i t l e d t o any money o r money's wor t h . " A d i v i d e n d would thus seem t o be w i t h i n t h e d e f i n i t i o n o f ' b e n e f i t ' c o n t a i n e d i n t h e s e c t i o n . S u b s e c t i o n 7, however, p r o v i d e s , i n t e r a l i a , t h a t : I n r e l a t i o n t o t h e d i s p o s a l by a company o f an a s s e t c o n s i s t i n g o f s h a r e s i n a n o t h e r company t h e r e f e r e n c e i n s e c t i o n ( 1 ) ( a ) above t o a r e d u c t i o n i n t h e v a l u e o f t h e a s s e t does not i n c l u d e a r e f e r e n c e t o any r e d u c t i o n a t t r i b u t a b l e t o - (a) t h e payment o f a d i v i d e n d by the second company a t a time when i t and t h e f i r s t company a r e members of t h e same group o f companies... 171 'Group o f companies' i s a t e c h n i c a l e x p r e s s i o n d e f i n e d i n s e c t i o n 272 o f the Income and C o r p o r a t i o n s Taxes A c t , 1970, t o i n c l u d e , i n t e r a l i a , "a p r i n c i p a l company, and a l l i t s 5 75% s u b s i d i a r i e s . . . " Thus, d i v i d e n d payments made by a w h o l l y owned o p e r a t i n g s u b s i d i a r y t o i t s p a r e n t h o l d i n g company would n o t o n l y be r e c e i v e d f r e e o f t a x b u t would seem a l s o t o by-pass the r e l e v a n t a n t i - a v o i d a n c e p r o v i s i o n s o f t h e C a p i t a l Gains Tax A c t . I n the w r i t e r ' s s u b m i s s i o n , t h i s opens the door t o c a p i t a l g a i n s s t r i p s '.in B r i t a i n because i t i s t h e r e w e l l e s t a b l i s h e d t h a t a r e s e r v e fund r e s u l t i n g from t h e r e v a l u a t i o n o f u n r e a l i z e d f i x e d a s s e t s (an a p p r a i s a l s u r p l u s ) c o n s t i t u t e s a l e g i t i m a t e fund from w h i c h t o pay d i v i d e n d s . ^ On the o t h e r hand, c o n t r i b u t e d s u r p l u s , o r share premium a c c o u n t s , a r e r e g a r d e d as c a p i t a l i n n a t u r e and a c c o r d i n g l y a r e u n a v a i l a b l e as a so u r c e o f funds f o r the payment o f d i v i d e n d s . Such r e s e r v e s can, • however, be c a p i t a l i z e d by e.g. a 'bonus i s s u e ' ( s t o c k d i v i d e n d ) and s u b s e q u e n t l y p a i d o u t p u r s u a n t t o a l e g a l and s e l e c t i v e r e d u c t i o n o f c a p i t a l . As we have seen, Canadian c a p i t a l g a i n s s t r i p s f r e q u e n t l y t u r n upon t h e buy-back by a c o r p o r a t i o n o f i t s own shares e i t h e r by way o f r e p u r c h a s e f o r c a n c e l l a t i o n o f common s h a r e s o r the redemption o f p r e f e r r e d s h a r e s . I n B r i t a i n , t h e common law r u l e p r o h i b i t i n g t h e r e p u r c h a s e by a company o f i t s own sha r e s c o n t i n u e s t o be r i g o r o u s l y a p p l i e d and i s m i t i g a t e d o n l y by e x c e p t i o n s f o r buy-backs 7 p u r s u a n t t o c o u r t o r d e r and f o r t h e redemption o f p r e f e r e n c e 172 s h a r e s which a r e redeemable e i t h e r u n c o n d i t i o n a l l y o r a t t h e g o p t i o n o f t h e company. A d i s p o s a l o f redeemable s h a r e s would, hoever, i n v o l v e a c a p i t a l g a i n s t a x l i a b i l i t y because B r i t i s h c o r p o r a t i o n s do not e n j o y the l u x u r y o f c o n t r o l l i n g t h e t a x c h a r a c t e r o f r e c e i p t s t o t h e s h a r e h o l d e r s i n r e s p e c t o f t h e i r s h a r e s . A ' c a p i t a l d i s t r i b u t i o n ' i . e . g i v i n g r i s e t o c a p i t a l g a i n s t a x l i a b i l i t y , i s d e f i n e d as any d i s t r i b u t i o n " e x c e p t a d i s t r i b u t i o n w hich i n the hands o f t h e r e c i p i e n t 9 c o n s t i t u t e s income f o r t h e purpose o f Income Tax". Under p a r a g r a p h 233(2)(b) o f the ICTA a ' d i s t r i b u t i o n ' means "any . . . d i s t r i b u t i o n out o f a s s e t s o f t h e company, e x c e p t so much of t h e d i s t r i b u t i o n , i f any, as r e p r e s e n t s a repayment o f c a p i t a l on the s h a r e s " . I t would appear, t h e r f o r e , t h a t c a p i t a l g a i n s s t r i p s based upon the r e p u r c a h s e by a c o r p o r a t i o n o f t h e common o r p r e f e r r e d s t o c k a r e e f f e c t i v e l y p r e c l u d e d by d i f f e r e n c e s i n the B r i t i s h t a x law r e l a t i n g t o s u r p l u s d i s t r i b u t i o n s . Even assuming t h a t the same t a x consequences f o l l o w e d from the buyback o f s h a r e s i n B r i t a i n as i n Canada, d i f f e r e n c e s i n t h e i r r o l l o v e r p r o v i s i o n s would n o t p e r m i t t h e e s t a b l i s h - ment o f s i m i l a r g a i n s a v o i d a n c e d e v i c e s . Take the example o f an i n t e r n a l r e o r g a n i z a t i o n o f c a p i t a l i n v o l v i n g t h e c o n v e r s i o n o f common t o p r e f e r r e d s h a r e s p r e l i m i n a r y t o the redemption o f th o s e s h a r e s f o r deemed d i v i d e n d t r e a t m e n t . The B r i t i s h coun- t e r p a r t t o s e c t i o n s 51 and 86 o f t h e Canadian A c t i s s e c t i o n s 77 e t . s e q . o f the CGTA, 19 7.9, p r o v i d i n g f o r the new s h a r e h o l d i n g . 173 Paragraph, 77(2) (B) , which reads as follows, i s p a r t i c u l a r l y relevant: 77(2) . . . r e o r g a n i z a t i o n s o f a company's s h a r e c a p i t a l i n c l u d e s (b)> any case where t h e r e a r e more than one c l a s s o f sha r e s and the r i g h t s a t t a c h e d t o s h a r e s o f any c l a s s a r e a l t e r e d . However, s e c t i o n 77 r e o r g a n i z a t i o n s must be s c r u t i n i z e d i n the l i g h t o f s e c t i o n 25 CGTA, an a n t i - a v o i d a n c e p r o v i s i o n aimed a g a i n s t 'value s h i f t i n g ' . " ^ V a l u e s h i f t i n g i n v o l v e s the t r a n s f e r o f v a l u e from s h a r e s h e l d by a p e r s o n h a v i n g c o n t r o l o f t h e c o r p o r a t i o n t o sha r e s h e l d by a n o t h e r p e r s o n . Thus, t o the e x t e n t t h a t v a l u e passes o u t o f the s h a r e s owned by the p e r s o n h a v i n g c o n t r o l o f t h e company, t h e r e i s a p a r t d i s p o s a l o f h i s s h a r e h o l d i n g which may r e s u l t i n a c a p i t a l g a i n . The o b v i o u s example i s t h a t o f an i n d i r e c t g i f t , b u t a s i t u a t i o n where the vendor took back a f i x e d v a l u e s e c u r i t y i n r e t u r n f o r h i s common shares would p r o b a b l y a l s o be w i t h i n t h e p r o v i s i o n . Shares c o n d i t i o n e d so as not t o p a r t i c i p a t e i n f u t u r e growth o f t h e company might be r e g a r d e d as l e s s v a l u a b l e t h a n p r o p r i e t a r y s h a r e s . Any m o d i f i c a t i o n i m p o r t i n g i n any way the d e p r e c i a t i o n o f t h e i n t e r e s t ..formerly h e l d would r e s u l t i n t h e - r e c o g n i t i o n f o r c a p i t a l g a i n s purposes o f the monetary v a l u e o f t h e e l i m i n a t e d r i g h t s . The d e f i n i t i o n s p r o v i d e d i n s e c t i o n 77 and t h e b a s i c r o l l o v e r c o n t a i n e d i n s e c t i o n 78 w i t h r e s p e c t t o i n t e r n a l r e o r g a n i z a t i o n s o f share c a p i t a l a p p l y m u t a t i s mutandis t o the s e c t i o n 85 'amalgamation' p r o v i s i o n s ( i n f a c t , a share f o r s h are exchange r o l l o v e r ) , and the more complex s e c t i o n 174 86 'scheme o f r e c o n s t r u c t i o n o r amalgamation' ( c o m p r i s i n g a c t u a l mergers and c o r p o r a t e r e o r g a n i z a t i o n s f e a t u r i n g t h e t a x f r e e exchange o f a s s e t s f o r sh a r e s and i n v o l v i n g s e v e r a l c ompanies). L i k e i t s Canadian c o u n t e r p a r t t h e s e c t i o n 85 share f o r share exchange has been used i n B r i t a i n i n c o n n e c t i o n w i t h g a i n s a v o i d a n c e schemes, though t h e s e d i d n o t f e a t u r e the use o f t a x - f r e e i n t e r c o r p o r a t e d i v i d e n d s T h e e s s e n t i a l 12 f a c t s i n F l o o r v D a v i s a r e t h a t the t a x p a y e r exchanged h i s s h a r e s o f an o p e r a t i n g company f o r sh a r e s o f a h o l d i n g company owned by him. The s h a r e s t a k e n back by t h e t a x p a y e r o f c o u r s e p o s s e s s e d the same a d j u s t e d .cost .base as the sh a r e s 13 g i v e n up , however the s h a r e s o f t h e t a r g e t e n j o y e d a step-up i n b a s i s t o the a c q u i r i n g c o r p o r a t i o n . The a c q u i r i n g c o r p o r a t i o n p r o m p t l y d i s p o s e d o f the t a r g e t ' s s h a r e s t o a UK s u b s i d i a r y o f an /American p a r e n t , r e a l i z i n g no c a p i t a l g a i n on t h e s a l e because o f t h e i n c r e a s e i n c o s t base o f t h e a c q u i r e d s h a r e s (as i n Canada, the c o s t base i s 'bumped' because, i n s p i t e o f the r o l l o v e r , the a c q u i r i n g c o r p o r a t i o n has i n e f f e c t p a i d t h e f a i r market v a l u e ) . The problem o f s e c u r i n g the newly r e c e i v e d l i q u i d a s s e t s o f t h e h o l d i n g company (the p u r c h a s e p r i c e ) t o t h e s h a r e h o l d e r on a t a x - f r e e b a s i s was a c c o m p l i s h e d by h a v i n g a Caymen I s l a n d s c o r p o r a t i o n s u b s c r i b e f o r p r e f e r e n c e s h a r e s o f t h e h o l d i n g company, w h i c h was p r o m p t l y l i q u i d a t e d . Thus, t h e B r i t i s h s t r i p was even more e f f e c t i v e than Canadian s t r i p s i n t h a t t h e t a x was not o n l y d e f e r r e d , but a b s o l u t e l y a v o i d e d a t the s h a r e h o l d e r 175 l e v e l . I n t h e C o u r t o f A p p e a l , the Crown argued t h a t t h e s a l e by the h o l d i n g company of the t a g e t ' s s h a r e s t o t h e p u r c h a s e r was ' i n s u b s t a n c e ' s i m p l y a d i r e c t d i s p o s a l by the t a x p a y e r o f h i s s h a r e s i n t h e o p e r a t i n g company, and t h a t the t r a n s a c t i o n a c c o r d i n g l y gave r i s e t o a c a p i t a l g a i n s t a x l i a b i l i t y . On t h i s p o i n t , S i r John P e n n y c u i c k had t h e f o l l o w i n g t o say: I t seems t o me t h a t t h i s c o n t e n t i o n d i s r e g a r d s t h e l e g a l e f f e c t o f what were a d m i t t e d l y genuine t r a n s a c t i o n s and r e a l l y seeks t o r e s u r r e c t t h e c o n c e p t i o n o f s u b s t a n c e w h i c h was b u r i e d i n t h e House of L o r d s i n IRC v Duke o f W e s t m i n s t e r . 14 The l e g i s l a t i v e r e s ponse t o t h i s s t a t e o f a f f a i r s was the a n t i - a v o i d a n c e p r o v i s i o n s o f s e c t i o n s 87 and 88 o f t h e C a p i t a l G ains Tax A c t , 1979. S e c t i o n 87(1) i n essence p r o v i d e s t h a t the c a p i t a l g a i n s r o l l o v e r s i n s e c t i o n s 85 and 86 w i l l n o t a p p l y " u n l e s s t h e exchange, r e c o n s t r u c t i o n , o r amalgamation i n q u e s t i o n i s e f f e c t e d f o r bone f i d e c ommercial r e a s o n s and does not form p a r t of a scheme o r arrangement o f which the main pu r p o s e , o r one o f t h e main p u r p o s e s , i s a v o i d a n c e o f l i a b i l i t y t o c a p i t a l g a i n s t a x o r 15 c o r p o r a t i o n t a x . " - > I t s h o u l d be n oted t h a t i t i s n o t enough t h a t the t r a n s a c t i o n s be implemented f o r bone f i d e c ommercial r e a s o n s . None o f the main purposes o f t h e 'scheme o r arrangement' may be a v o i d a n c e o f t a x . T h i s p r e c l u d e s use by the t a x p a y e r o f the argument t h a t arrangements i n c i d e n t a l t o an arm's l e n g t h d i s p o s i t i o n o f c a p i t a l p r o p e r t y a r e u n d e r t a k e n f o r bone f i d e commercial r e a s o n s . 176 A p l a n o f a v o i d a n c e such as t h a t e f f e c t e d i n F l o o r v D a v i s would now presumably be caught by the terms o f s e c t i o n 87. I t s h o u l d be o b s e r v e d , however, t h a t t h e scheme i n t h a t case was e s p e c i a l l y o f f e n s i v e t o t h e f i s c because the proceeds o f d i s p o s i t i o n r e c e i v e d by t h e h o l d i n g company were i m m e d i a t e l y d i s t r i b u t e d t o the s h a r e h o l d e r s t a x - f r e e by r e a s o n o f a d d i t i o n a l p l a n n i n g manoeuvres. I t must a l s o be remembered t h a t s e c t i o n s 85 and 86 a r e r o l l o v e r p r o v i s i o n s d e s i g n e d t o s e r v e the purpose o f a v o i d i n g t a x . P o s s i b l y , a mere r o l l o v e r o f the s h a r e s o f an o p e r a t i n g company i n t o a h o l d i n g company i n r e t u r n f o r t h e s h a r e s o f the h o l d i n g company c o u l d n o t , i n i t s e l f , be impugned. I n t h i s c o n n e c t i o n , the p e r i o d o f t ime e l a p s i n g between the r o l l o v e r and t h e s a l e by the h o l d i n g company, might d e t e r m i n e th e l e g i t i m a c y o f t h e t r a n s a c t i o n . The s i t u a t i o n s u g g e s t s comparison w i t h r e o r g a n i z a t i o n r o l l o v e r s i n the U n i t e d S t a t e s , where the q u e s t i o n o f the permanence o f t h e changes brought about can d e t e r m i n e t h e . l e g i t i m a c y o f the p l a n . The fundamental d i s t i n c t i o n i s perhaps between systems which p e r m i t the use o f r o l l o v e r s : i n c o n n e c t i o n w i t h s a l e s (as i n Canada) and systems which do n o t (the U n i t e d S t a t e s ) . i n Britain-, i t would appear t h a t r e o r g a n i z a t i o n s must be such i n the t r u e sense o f the word and n o t mere d e v i c e s employed t o b r i n g about d i f f e r e n t r e s u l t s . T h i s a s p e c t i s p a r t i c u l a r l y e v i d e n t w i t h r e s p e c t t o 'schemes o f r e c o n s t r u c t i o n o r amalgamation' q u a l i f y i n g f o r r o l l o v e r t r e a t m e n t under s e c t i o n 86. As n o t e d , t h e s e i n c l u d e f a c t s i t u a t i o n s i n w h i c h "177 a s s e t s o f one company a r e t r a n s f e r r e d t o a n o t h e r i n r e t u r n f o r s h a r e s o f t h e second c o r p o r a t i o n . The ' c o n t i n u i t y o f i n t e r e s t 1 d o c t r i n e would seem t o be f i r m l y i m p l a n t e d i n En g l a n d w i t h r e s p e c t t o such t r a n s a c t i o n s . I n Re South A f r i c a S upply and C o l d S t o r a g e Co. L t d . , B u c k l e y J . su g g e s t e d t h a t t h i s arrangement " i n v o l v e s , I t h i n k , t h a t s u b s t a n t i a l l y the same b u s i n e s s s h a l l be c a r r i e d on and sub- 16 s t a n t i a l l y the same persons s h a l l c a r r y i t on." A 'statement' i . e . r u l i n g r e l a t i n g t o t h e s e c t i o n 86 p r o v i s i o n s now c l e a r l y r e i t e r a t e s the same p h i l o s o p h y , as f o l l o w s : A scheme o f r e c o n s t r u c t i o n e n t a i l s t h e second company c a r r y i n g on s u b s t a n t i a l l y the same b u s i n e s s and h a v i n g s u b s t a n t i a l l y t h e same members as the f i r s t . 17 178 FOOTNOTES 1. FA 1980, s. 20. 2 . The 3/7th o f the d i v i d e n d t h a t i s p a i d as ACT, and w h i c h may be c l a i m e d as a c r e d i t , i s a f r a c t i o n o f the n e t amount, o r 30% o f the g r o s s amount o f t h e d i v i d e n d . 3. FA 1972. s . 8 4 ( 4 ) . 4 . s. 233(2)(a) D i s t r i b u t i o n s r e c e i v e d by UK r e s i d e n t c o r p o r a t i o n s are c a l l e d 'Franked Investment Income' (FA 1972, s . 8 8 ( l ) e t . seq. and see a l s o Income and Cor- p o r a t i o n Taxes A c t , 1970 (c.10) s. 254 e t seq.) Together w i t h the c r e d i t s f o r ACT p a i d by the payer c o r p o r a t i o n , 'Franked Investment Income 1 may be s e t o f f a g a i n s t t h e d i v i d e n d . 5. s. 2 7 2 ( 1 ) ( b ) . 6- Dimbula V a l l e y (Ceylon) Tea Co. L t d . v L a u r i e (19 61) Ch. 353. 7. Companies A c t , 1948, s. 66(1) 8. I b i d . , s. 5 8 ( 1 ) . 9. CGTA 1979, s. 7 2 ( 5 ) ( b ) . 10. CGTA, 1979, s u b s e c t i o n 25(2) p r o v i d e s t h a t " i f a p e r s o n h a v i n g c o n t r o l o f a company e x e r c i s e s h i s c o n t r o l so t h a t v a l u e passes o u t o f sha r e s i n t h e company owned by him o r a per s o n w i t h whom he i s co n n e c t e d , o r o u t o f r i g h t s i n t h e company e x e r c i s e a b l e by him o r by a pe r s o n w i t h whom he i s co n n e c t e d , and pas s e s i n t o o t h e r s h a r e s i n o r r i g h t s o v e r the company, t h a t s h a l l be a d i s p o s a l o f the s h a r e s o r r i g h t s o u t o f w h i c h the v a l u e passes by t h e pe r s o n by whom the y were owned o r e x e r c i s e a b l e . " 179 11. ITA, s. 85.1 12. (1978) L.R. Ch. D i v . , 295(C.A.); a f f ' d (1980) AC 695. 13 . CGTA, 1979, s. 78. 14. Supra, f o o t n o t e 12, a t p. 307; IRC v Duke o f W e s t m i n s t e r , (1936).AC 1. 15. S e c t i o n 88, i n e f f e c t , s e t s out an advance r u l i n g s p r o c e d u r e . 16. (1904) 2 Ch., 268 a t p. 286. 17. Statement D14. (1979) STI 274 a t 281. 180 BIBLIOGRAPHY B i t t k e r , B o r i s I . , and James S. E u s t i c e . F e d e r a l Income T a x a t i o n Of C o r p o r a t i o n s And S h a r e h o l d e r s , 4 t h . ed., B o s t o n : Warren, Gorham, & Lamont, 1979. Brown, R.D., and Thomas E. M c D o n n e l l . " C a p i t a l G ains S t r i p s : A C r i t i c a l Review Of The New P r o v i s i o n s , " i n R e p o r t of the P r o c e e d i n g s o f the T h i r t - S e c o n d Tax C o n f e r e n c e , 51-83. T o r o n t o : Canadian Tax F o u n d a t i o n , 1980. B r y s o n , B r i a n J . " S u r p l u s S t r i p p i n g : The A p p l i c a t i o n s Of S u b s e c t i o n 247(1) I n L i g h t Of The 1975 Amendments To The Income Tax A c t , " i n Report o f t h e P r o c e e d i n g s of the Twenty-Seventh Tax C o n f e r e n c e , 295-303. T o r o n t o : Canadian Tax F o u n d a t i o n , 1975. C o u z i n , R o b e r t . "Of Arm's Length And Not D e a l i n g T h e r e a t , " Canadian Tax J o u r n a l , 26 (1978), 271-286. C r o n k w r i g h t , G l e n E., R o b e r t J . D a r t , and Robert F. L i n d s a y . " C o r p o r a t e D i s t r i b u t i o n s And The 1977 Tax Changes," i n R eport o f the P r o c e e d i n g s o f t h e Twenty-Ninth Tax , C o n f e r e n c e , 279-363. T o r o n t o : Canadian Tax F o u n d a t i o n , 1977. D a r t , R o b e r t J . " D e s i g n a t e d Surplus-Why?", Canadian Tax J o u r n a l , 21 (1973), 495-511. . " S e c t i o n 85: P a i d Up C a p i t a l And 1971 C a p i t a l S u r p l u s , " i n Report o f t h e P r o c e e d i n g s of the T w e n t y - S i x t h Tax C o n f e r e n c e , 2 8-52. T o r o n t o : Canadian Tax F o u n d a t i o n , 1974. F r i e s e n , R.A. " P a i d Up C a p i t a l - P a r t I , " i n Report o f t h e P r o c e e d i n g s o f t h e Twenty-Eigth Tax C o n f e r e n c e , 267-280. T o r o n t o : Canadian Tax F o u n d a t i o n , 1977. . " S p e c i f i c Uses Of Companies i n Tax P l a n n i n g , " i n R e p o r t o f the P r o c e e d i n g s o f the Twenth-Ninth Tax C o n f e r e n c e , 117-154. T o r o n t o : Canadian Tax F o u n d a t i o n , 1977. F r i e s e n , R.A., and D.Y. T i m b r e l l . "Shams And S i m u l a c r a I I - The C a p i t a l Gains A s p e c t , " Canadian Tax J o u r n a l , 27 (1979), 135-144. I l e r s i c , A.R. "Tax E v a s i o n I n The U n i t e d Kingdom," Canadian Tax J o u r n a l , 27(1979), 428-432. . " C a p i t a l Taxes I n The U n i t e d Kingdom," Canadian Tax J o u r n a l , 29 (1981), 39-43. 181 K e l l o u g h , Howard J . , and Randolph B. Z i e n . "Dept L i m i t : A Lawyer's View," Canadian Tax J o u r n a l , 24 (1976), 451-456. L i n d s a y , Robert F. 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