Capital dividends and anti-avoidance considerations

Most accountants and lawyers who deal with Canadian private corporations know that certain amounts can be received by shareholders tax free. Specifically, tax free capital dividends can be paid to the shareholders of Canadian private corporations pursuant to subsection 83(2) of the Income Tax Act (the “Act”) which states:

83(2) Capital dividend [not taxable] — Where at any particular time after 1971 a dividend becomes payable by a private corporation to shareholders of any class of shares of its capital stock and the corporation so elects in respect of the full amount of the dividend, in prescribed manner and prescribed form and at or before the particular time or the first day on which any part of the dividend was paid if that day is earlier than the particular time, the following rules apply:

1. the dividend shall be deemed to be a capital dividend to the extent of the corporation’s capital dividend account immediately before the particular time; and
2. no part of the dividend shall be included in computing the income of any shareholder of the corporation

The tax free capital dividend relies on a positive balance in the corporation’s “capital dividend account” which is defined is subsection 89(1) of the Act. The definition of “capital dividend account” is horrendously complex. In general, the computation of the “capital dividend account” includes the tax free portion of capital gains (the 50 percent non-taxable amount) and certain life insurance proceeds realized by a corporation. The policy reason behind the capital dividend account is to preserve the integrity of tax free amounts that would otherwise be tax free if such amounts were realized directly in the shareholder’s hands. To the extent that the “capital dividend account” did not allow such amounts to be removed from the corporation tax free, there would be a large disincentive to realize capital gains in a company since the otherwise tax free portion of capital gains could only be removed to the shareholders by way of a taxable dividend. US citizens who are resident in Canada should be aware, however, that the receipt of capital dividends are taxable for US purposes. The payment of tax free capital dividends, however, are subject to an anti-avoidance rule in subsection 83(2.1) which says:

83(2.1) Idem [anti-avoidance] — Notwithstanding subsection (2), where a dividend that, but for this subsection, would be a capital dividend is paid on a share of the capital stock of a corporation and the share (or another share for which the share was substituted) was acquired by its holder in a transaction or as part of a series of transactions one of the main purposes of which was to receive the dividend,

1. the dividend shall, for the purposes of this Act (other than for the purposes of Part III and computing the capital dividend account of the corporation), be deemed to be received by the shareholder and paid by the corporation as a taxable dividend and not as a capital dividend; and
2. paragraph (2)(b) does not apply in respect of the dividend. [Emphasis added]

Subsection 83(2.1) is, like most anti-avoidance rules, very broad. It utilizes words like “main purposes” and the phrase “series of transactions”. Accordingly, if a capital dividend is paid on the share of a capital stock of a corporation and the share is acquired in a transaction or as part of a series of transactions one of the main purposes of which was to receive the capital dividend then the capital dividend shall be deemed to be a taxable dividend. When the Department of Finance introduced subsection 83(2.1) into the Act in 1988, it revealed the policy intent behind the provision in its Technical Notes:

“New subsection 83(2.1) provides an anti-avoidance rule which applies where one of the main purposes of an acquisition of shares is to acquire a right to a capital dividend. For example, a private corporation controlled by non-residents who would be taxable on capital dividends may be willing to sell shares to another corporation and thereby transfer its capital dividend account in order to permit that other corporation to reduce the taxes payable on distributions to its domestic shareholders. In addition, a corporation not in a position to pay dividends itself may be willing to sell shares and thereby transfer its capital dividend account to another corporation the shareholders of which would not be taxable on the distribution. New subsection 83(2.1) is intended to apply to dividends paid in these circumstances.”

There has not been any case law regarding subsection 83(2.1) until now. On September 4, 2012 the Tax Court of Canada released its decision in Groupe Honco Inc. et. al v. The Queen 2009-2134 (it)(g). The abridged facts were as follows:

1. Mr. Bédard owned all the shares of “Old Supervac”. Mr. Bédard was terminally ill and given his illness “Old Supervac” had serious financial problems in 1998.
2. In late 1998, Mr. Bédard accepted an arm’s length offer from Mr. Lacasse which provided that one of Mr. Lacasse’s companies, “New Supervac”, would purchase inventory from “Old Supervac” and lease all of Supervac’s business assets for a dollar. It also provided that “New Supervac” would have the right to acquire all of the shares of “Old Supervac”. In 1999, Mr. Lacasse exercised his right to have “New Supervac” buy the business assets that had been rented until then and to buy the shares of “Old Supervac”.
3. “Old Supervac”, had tax losses being carried forward and therefore one of the objectives of Mr. Lacasse was to utilize “Old Supervac’s” tax losses against the future income of “New Supervac”. Accordingly, following the acquisition, “New Supervac” and “Old Supervac” were amalgamated into “New Supervac Amalco”.
4. It appears that “Old Supervac” must have owned a life insurance policy with a death benefit of $750,000 on the life of Mr. Bédard. After Mr. Bédards passing, the life insurance death benefit appears to have been received by “Old Supervac” (or perhaps “New Supervac Amalco”…this was not entirely clear from the case). Accordingly the capital dividend account of “New Supervac Amalco” would have been increased by such amount.
5. Capital dividends were then paid to the shareholders of “New Supervac Amalco”. The Canada Revenue Agency then reassessed the recipients of the capital dividends on the basis that “New Supervac Amalco” did not have a capital dividend account because of the application of subsection 83(2.1).

It was the taxpayer recipient’s position that the principal purpose for which “New Supervac” acquired the shares of “Old Supervac” was:

1. to perfect and complete its plan to recover its substantial investment in Supervac’s structure;
2. to avoid the requirement for New Supervac to obtain certain certification that it required to carry on its business; and
3. to acquire Old Supervac’s business loss carry-forwards and deduct them from its future income.

The Tax Court of Canada disagreed. Paragraphs 29, 30 and 34 of the decision concluded:

[29] In all of these circumstances, I am simply unable to conclude that the taxpayers have discharged their burden of proof of establishing that the assessments were incorrect and that the acquisition of the capital dividend account, the value of which resided in its eligibility for distribution by way of capital dividend, was not among the principal purposes for New Supervac’s acquiring the Old Supervac shares. In matters of intention in particular, the availability of contemporaneous corroborative evidence from written documents or from third parties takes on somewhat greater significance. In this case, it appears that the structuring and negotiation of the transactions was done by Groupe Honco’s outside lawyer and Mr. Lacasse and, from the seller’s point of view, by Old Supervac’s lawyer, perhaps aided by its accountant.

[30] Clearly, Old Supervac’s advisors were well aware of the existence and value of the capital dividend account. They had declared a capital dividend to Mr. Bédard’s widow. It is reasonable to assume that the sellers, that is, the shareholders of Old Supervac, in trying to maximize the proceeds they received, would have sought some recognition of the value of this intangible asset in the form of a tax account. They did not testify.

[34] For these reasons, the taxpayers have not met their onus or satisfied their burden of proof and I am unable to be satisfied on a preponderance of the evidence that the acquisition of the capital dividend account and the payment of the capital dividends were not one of the principal purposes of the series of transactions. For these reasons the appeals must be dismissed.

The Court thus found that subsection 83(2.1) applied and that the payment of the capital dividends were therefore taxable dividends and not tax free. Besides making for an interesting read, the decision reminds us not to underestimate the power of anti-avoidance rules. Had the parties done a better job of establishing and documenting non-tax purposes for the acquisition of the Old Supervac shares, the Court might have ruled differently. Careful planning is always needed when dealing with broad anti-avoidance rules.