84.1 Gotcha

Assume that A and B, who deal at arms length, own 55 and 20 common shares in the capital of Opco respectively. A and B also own 95 and 5 common shares in the capital of Holdco respectively. Assume that B’s tax adviser suggests to her that she can sell her common shares in the capital of Opco to Holdco for a purchase price equal to $400,000 cash. What could possibly go wrong? See Emory v. The Queen, 2010 TCC 71, for the answer to that question.

In Emory, the taxpayer undertook a transaction as summarized above. The Court made no finding on whether the taxpayer dealt at arm’s-length with the controlling shareholder (‘B’ in the example above), but even if the Court had done so it would have made no difference. The taxpayer was deemed not to deal at arms length with Holdco because of paragraph 84.1(2)(b) of the Income Tax Act (Canada), which provides as follows:

(2) For the purposes of this section,

[…]

(b) in respect of any disposition described in subsection (1) by a taxpayer of shares of the capital stock of a subject corporation to a purchaser corporation, the taxpayer shall, for greater certainty, be deemed not to deal at arm’s length with the purchaser corporation if the taxpayer

(i) was, immediately before the disposition, one of a group of fewer than 6 persons that controlled the subject corporation, and

(ii) was, immediately after the disposition, one of a group of fewer than 6 persons that controlled the purchaser corporation, each member of which was a member of the group referred to in subparagraph (i);

Under subsection 84.1(2.2) a group of persons is deemed to be any collection of two or more persons, and “a corporation that is controlled by one or more members of a particular group of persons in respect of that corporation is considered to be controlled by that group of persons”.

As a result of these deeming rules, the taxpayer in Emory was deemed not to deal at arms length with Holdco because she was part of a group of two individuals who controlled Opco immediately before the transaction and part of the same group that controlled Holdco immediately after the transaction (where Holdco also controlled Opco immediately after the transaction). What was the result? Instead of being able to claim the capital gains exemption in respect of the entire proceeds received for her shares in Opco, Ms. Emory was treated as having received a deemed dividend in a total amount equal to $492,387. Ouch.

The taxpayer’s lawyer attempted to argue that the result flowing from the black letter of the law should not apply to his client, to which the Tax Court responded as follows:

1. Subparagraphs 84.1(2)(b)(i) and (ii) are not meaningless. Paragraph 84.1(2)(b) provides the framework for the expansion of the meaning of the term “arm’s length.” (¶30)
2. “I can understand why counsel would suggest that these rules could have inappropriate results. For many years, commentators have noted that section 84.1 is a trap for the unwary. See, for example, the article by Peter Bowen referred to above. However, Parliament has clearly provided for this result, presumably in order to limit the potential for abuse.” (¶32)
3. The CRA did not make public pronouncements respecting section 84.1 that conflict with the position it took in this case. (¶34)
4. The position taken in this case did not conflict with Silicon Graphics Ltd. v. The Queen, 2002 FCA 260: “The statutory provision that was relevant in Silicon Graphics was the definition of “Canadian-controlled private corporation” in subsection 125(7) of the Act. It did not contain deeming rules similar to those at issue here.” (¶36)
5. This interpretation did not render meaningless the word “particular” in s. 84.1(2.2)(c). (¶38)
6. The plain meaning interpretation of 84.1 was not counter to the purpose of section 84.1:
   

   [40] I also disagree with this submission. It is clear that section 84.1 is an anti-avoidance provision that is designed to prevent the tax-free extraction of corporate surplus. It is also clear, though, that the provision could potentially overreach its anti-avoidance objective in certain cases. This result was clearly intended by Parliament, in my view.

   [41] It is perhaps worth mentioning that section 84.1 would not have applied to the disposition by the appellant of shares of Sona if the appellant had not owned any shares in Ontario Inc. The fact that the appellant owned a small number of shares in Ontario Inc. has unfortunately resulted in the application of this section.

Emory is a perfect example of how the black letter of the Act will apply regardless of anyone’s conception of common sense. Arguably, the taxpayer had, in substance, sold her interest in Opco. Her ongoing indirect 5% interest could be seen as a portfolio investment. Such an argument, however, could not be advanced because the clear rules in the Act dictated a different result. Tax advisors beware!