Sample Chapter Tax and Family Business Succession Planning,

Transcription

1 Sample Chapter Tax and Family Business Succession Planning, 3rd Edition Chapter 10: Spinouts

2 Sample Chapter Tax and Family Business Succession Planning, 3rd Edition Chapter 10: Spinouts The attached sample chapter, which is a work in progress, has been prepared to illustrate the general form and content of the forthcoming volume, Tax and Family Business Succession Planning, 3rd Edition. The contents of the chapter may be subject to change, and may contain grammatical or other editorial errors or omissions. In any event, it does not purport and is not intended to be advice on any particular matter. The authors do not accept any responsibility or liability to any person in respect of anything done or omitted to be done by any such person in reliance, sole or partial, on the whole or any part of the contents of this sample. This sample is made available solely for evaluation purposes.

3 Chapter Spinouts CONTENTS Paragraph Introduction General Example of Spinout Transaction Subsection 55(2) Significant Exceptions to Subsection 55(2) Purifications and Asset Protection Spinouts Series of Transactions or Events Case Law Series of Transactions/Transactions in Contemplation of Series U.K. Case Law Canadian Case Law Spinouts to Family Members Paragraph 55(3)(a) and Related Provisions Examples of Spinouts Example 3: Spinout to Family Trust Example 4: Spinout to Children Series of Transactions Introduction At various points during the life of a business and a succession plan, it will be advisable to effect a divisive reorganization whereby the assets of a corporation are spun out into sister corporations or to a holding company. A

4 414 Tax and Family Business Succession Planning spinout transaction contemplates the division of a corporation s assets among its shareholders in a series of tax-deferred transfers. Within the context of succession planning, some of the reasons for such a spinout are as follows: (a) Asset Protection. To enhance the protection of particular assets from creditor claims. For example, if real estate or other valuable investment assets are held in the same corporation as business operations subject to potential creditor risk, it may be advisable to spin these out to a separate sister corporation. (b) Spinout to Certain Family Members. To divide up the corporation s assets, e.g., so that specific assets will be held by a particular family member. As will be seen later in the Chapter, this can be difficult to achieve, short of a true proportional butterf ly. Alternatively, a spinout reorganization might be used, for example, to cash-out Freezor so that the children can operate the business. (c) Small Business Corporation Status. In order to maintain status as a small business corporation. This status is essential in order to utilize a number of provisions under the Act, including the capital gains exemption. (For further discussion, reference should be made to 1005.) (d) Wholesale Division. To split the frozen corporation amongst the children, for example, after the death of the Freezor. Unfortunately, one instance in which this may be advisable is if the succession plan has not worked and there are various assets which the children now wish to split-up amongst themselves and go their separate ways. A spinout reorganization might also be effected prior to a sale to a third party, e.g., to remove assets not to be sold and/or to ensure that the corporation s shares qualif y for the capital gains exemption. For some examples of spinouts in this context, reference should be made to General Example of Spinout Transaction The objective of a butterf ly-t ype transaction is to separate the interests of shareholders and in effect demerge the corporation. For example, an operating corporation with a number of businesses or properties might be owned by t wo holding companies, with equal shareholdings, that wish to 1002

5 Ch. 10/Spinouts 415 separate their interests. The operating corporation might wind up and distribute one-half of its assets to each holding company, which would then continue as independent operating companies. This procedure may not be feasible if the assets have appreciated in value over cost (or have other deferred tax exposure), because of the operation of subsection 69(5). In this case, a butterf ly transaction might be adopted. Suppose, for example, that t wo individual shareholders, Mr. Louis and Ms. Prasad, each own 50% of the shares of an operating company ( Opco ) and wish to separate their interests. They might undertake the following procedure: Example 1 (a) Each shareholder would form a holding company (Louis Holdco, and Prasad Holdco, respectively) to which he or she would transfer shares of Opco, making an election under subsection 85(1). (b) As shown in Figure X, Opco would transfer one-half of its assets to each of these holding companies in consideration for shares (and possibly a note receivable from the holding companies), making elections under subsection 85(1). The shares of the holding companies held by Opco would have a paid-up capital which would not exceed the cost amount of the assets of Opco (net of assumed liabilities). 1 (c) Louis Holdco and Prasad Holdco would redeem their shares held by the operating company producing a deemed dividend to the operating company but no capital gain. (d) Opco would wind up, distributing its assets (cash or notes of the holding companies) to the holding companies, producing a deemed dividend to the holding companies but not a capital gain. 1 Subsection 85(2.1), which normally restricts paid-up capital to the elected amount, is subject to section 84.1 and section 212.1, neither of which is applicable here. 1002

6 416 Tax and Family Business Succession Planning Figure X Mr. Louis Ms. Prasad Louis Holdco Prasad Holdco 50% Common 50% Common Preferred Shares Preferred Shares Assets Opco Assets If structured properly, the entire transaction would take place free of tax. The deemed dividends would not be taxed by virtue of the intercorporate dividend deduction found in subsection 112(1). As will be seen shortly, the proper structuring of the foregoing transaction involves the avoidance of subsection 55(2), which potentially transmogrifies the deemed dividends mentioned above into deemed capital gains. Note: In the foregoing example, it is possible to transfer Opco s assets directly into Louis Holdco and Prasad Holdco, respectively because neither of these corporations controls Opco; other wise, corporate law issues arise, forcing a more complex reorganization. 1002

7 Ch. 10/Spinouts Subsection 55(2) Central to such a divisive reorganization is the potential application of subsection 55(2) of the Act. Essentially, subsection 55(2) provides that intercorporate dividends, which would generally pass free of tax under Part I of the Act, pursuant to subsection 112(1), will be treated as capital gains to the recipient if received as part of a transaction or series of transactions, the purpose of which or in the case of a dividend pursuant to subsection 84(3), the result of which was to effect a significant reduction in the capital gain that would have been realized on a sale of shares at fair market value, assuming the dividend had not been paid. It is important to realize that by virtue of subsection 248(10), a dividend declared in contemplation of a series of steps to effect a reduction in what would other wise be a capital gain, may also lead to the tax results described under subsection 55(2). Safe Income. Subsection 55(2) does allow an inter-corporate taxable dividend to pass tax-free, provided it is wholly paid out of income earned or realized (per subsection 55(2)), by the payor corporation after 1971, after the acquisition of the shares on which the dividend is paid (or deemed to be paid) and before safe income determination time, (which is determined with reference to certain transactions within the series of transactions or events in question). This income is referred to as safe income. 2 The CRA has discussed the components of safe income and, in general, the application of subsection 55(2) in a number of instances. See especially Robertson, Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55, Canadian Tax Foundation 1981 Conference Report, 81; Hiltz, Section 55: An Update, 1984 CMTC 40; and Read, Section 55: A Review of Current Issues, Canadian Tax Foundation 1988 Conference Report, 18:1. The CRA takes the position that any portion of a dividend which is derived from non-safe income will cause the entire dividend to be considered a capital gain. Consequently, it is imperative that a thorough calculation of safe income be done before any dividends are declared where a third party sale might occur. It is important to realize that safe income does not necessarily equal the retained earnings of the corporation. In calculating the safe income of the corporation or of particular shares of the corporation, the guidelines in 2 Per subsection 55(1), safe-income determination time for a transaction or event or a series of transactions or events means the time that is the earlier of: (a) the time that is immediately after the earliest disposition or increase in interest described in any of subparagraphs (3)(a)(i) to (v) that resulted from the transaction, event or series, and (b) the time that is immediately before the earliest time that a dividend is paid as part of the transaction, event or series. 1003

8 418 Tax and Family Business Succession Planning the above-noted articles should be followed, as well as the statutor y requirements of subsection 55(5). Safe income is pro-rated over all shares outstanding at the time the dividend is paid. The first dividends paid on a share come from the share s safe income. Thus, it is possible to pay a series of dividends in order to minimize the possibility that a portion of a dividend comes from unsafe earnings. In the alternative, paragraph 55(5)(f) allows a dividend to be designated as two separate dividends. The CRA has indicated that it would accept multiple paragraph 55(5)(f) designations if there was reasonable doubt as to different components of safe income. 3 In the case of uncertainty, therefore, where a dividend is paid, it should be designated as a number of dividends so that as much as possible of the dividend will be considered to be paid out of safe income Significant Exceptions to Subsection 55(2) Apart from dividends paid out of the safe income, subsection 55(3) contains t wo significant exceptions to subsection 55(2): Paragraph 55(3)(a) is generally directed at limiting the operation of subsection 55(2) in cases where the reorganization is part of a transaction or event, or a series of transactions or events where there is not a sale or other disposition of assets on a rollover basis to an unrelated person, 4 nor a transaction that increases such a person s percentage or value of a corporation. The subsection imposes a number of technical tests pertaining to unrelated persons (as defined in subsection 55(3.01)), all of which must be met in order for the exception to subsection 55(2) (which other wise triggers deemed capital gains) to be applicable. It should be noted that the paragraph 55(3)(a) exemption may not be applicable in a number of situations which might normally be considered to be within a related person milieu. 3 CRA Doc. No. ACC9323, August 14, This Technical Interpretation adds restrictions that were not expressed by Michael Hiltz in his 1984 Corporate Management Tax Conference paper Section 55: An Update, in Selected Income Tax Aspects of the Purchase and Sale of a Business, 1984 Corporate Management Tax Conference (Toronto: Canadian Tax Foundation, 1984). 4 I.e., a person who is unrelated to the dividend recipient. 1004

9 Ch. 10/Spinouts 419 For a summar y of paragraph 55(3)(a) and related provisions, reference should be made to Paragraph 55(3)(b) contains the so-called butterf ly exception. This provision essentially allows a corporation to distribute its assets among its shareholders, so long as each shareholder receives its proportional share of each type of property of the corporation. The CRA has stated that there are essentially three types of property: cash and near cash, business assets, and investment assets. The intricacies of paragraph 55(3)(b) are beyond the scope of this book. For more information on the butterfly transaction, see Sider & Ton-That, Understanding Section 55 and Butter f ly Reorganizations (CCH Canadian Limited, 1999). In most situations where family business succession planning is involved, a spinout will be accomplished through the paragraph 55(3)(a) exemption if possible. For one thing, while paragraph 55(3)(a) certainly can have complexities in certain situations (especially where spinouts to family members are involved), paragraph 55(3)(b) is even more complex and, as mentioned above, is limited to a proportional division of assets. The intricacies of the paragraph 55(3)(a) exception come into play where there are issues as to whether unrelated persons are involved in a transaction, particularly spinouts to family members. In this respect, it should be noted that, for the purpose of section 55, siblings are deemed to be at arm s length and unrelated to one another so that the spinout of assets to children could be quite problematic, short of a full-scale proportional butterf ly. Before getting into such intricacies, let us deal with examples where the parties to the reorganization are related. This tends to be the case for capital gains purifications (where no third-part y sale is contemplated, at least) and asset-protection spinouts, as these may involve that split-up of corporatelevel assets where the shareholder is a single individual or spouses Purifications and Asset Protection Spinouts If it is desired to keep the operating company in existence and simply purif y it for the purposes of the small business corporation rules/capital gains crystallization, or spinout assets to achieve a degree of asset 1005

10 420 Tax and Family Business Succession Planning protection, as illustrated in Figures A and B, a paragraph 55(3)(a) spinout could be implemented as follows. Example 2 (a) A new holding company ( Newco ) would be incorporated with both common shares and a fixed number of preferred shares, whose redemption amount would equal the fair market value of the consideration received on the first issuance of the preferred shares (the Newco Redemption Amount). (b) The operating corporation s ( Opco ) share capital would be reorganized pursuant to subsection 86(1) so that the existing issued common shares owned by the shareholder(s) are changed into for new common shares and preferred shares, whose redemption value would equal the fair market value of the assets to be transferred (the Opco Redemption Amount ). (c) Opco would transfer its investment assets to Newco in exchange for all of Newco s preferred shares pursuant to subsection 85(1), at an elected amount equaling the cost amount of those assets i.e., no immediate tax consequences (see Figure A). (d) The preference shares of Opco would be rolled into Newco under subsection 85(1) in exchange for common shares in Newco for an elected amount equal to the cost base of the preferred shares, usually low (see Figure B). (e) Newco would redeem its preferred shares held by Opco in consideration for a non-interest bearing demand promissor y note, the principal amount of which would be the Newco Redemption Amount (the Newco Note ). (f ) Opco would redeem its preferred shares held by Newco, in exchange for the cancellation of the Newco Note. ( g) There will be a tax-free inter-corporate dividend under subsection 84(3) to Newco and Opco for the excess of the redemption proceeds over the paid-up capital of the preferred shares. 1005

11 Ch. 10/Spinouts 421 Figure A David Common Shares Preferred Shares Opco Preferred Shares Investment Assets Newco Figure B David Common Shares Common Shares Opco Preferred Shares Preferred Shares Newco Investment Assets Notes: When Opco reorganizes its share capital under subsection 86(1), and there is a significant cost base in the pre-existing common shares of Opco, it would be averaged pro rata as to the fair market value in the course of the section 86 reorganization. The cost base allocable to the redeemable/retractable shares would disappear as a result of the rollover of those shares by Opco to Newco pursuant to subsection 85(1) (as noted in paragraph (d) above, and their consequent redemption (per paragraph (e)). 1005

12 422 Tax and Family Business Succession Planning One way of eliminating this problem would be to issue the preferred shares as a so-called high-low stock dividend, so that the cost base of the common shares would not average with the preferred shares. The significance of low stated capital is that this will minimize the deemed dividend by virtue of the issuance of the preferred shares, since this is based on the increase in stated capital thereof. In some provinces, e.g., British Columbia, it is clear that a high-low stock dividend can be paid. In others, such as Ontario and Alberta, there has in the past been some debate as to whether this is permissible under corporate law. Consequently, both provinces have recently passed legislation which eliminates the uncertaint y. The Newco and Opco redemption amounts are based on the fair market value of the non-business assets of Opco. This number is partially based on the fair market value of Opco. The value of an operating company is not a hard and fast science, and any value may be open to dispute by the CRA. Therefore, it is advisable to utilize special shares (as noted in the above example) rather than common shares so as to be able to have formula redemption and price adjustment clauses in the event that there is a dispute in the value of the non-business assets. 5 The result of the foregoing transactions would be that the investments would be owned by Newco, and the business assets would be owned by Opco. Opco would then meet the definition of a small business corporation in the event that a cr ystallization of the capital gains exemption is desired. In addition, the removal of investment assets will hopefully result in an additional degree of asset protection. It should be noted that, because it does not involve a pro rata distribution of different t ypes of properties, this last example contemplates a paragraph 55(3)(a) situation e.g., where there is only one owner-manager. Where there is more than one (unrelated) owner-manager, the abilit y to utilize the purification process outlined may be restricted, for example, due to the application of subparagraph 55(3)(a)(ii), which, in essence, knocks out the paragraph 55(3)(a) exemption when there is a significant increase in the interest in any corporation of persons unrelated to the corporation prior to the butterfly. The CRA has taken the position that a significant increase in a corporation can be either a proportionate increase or a dollar value increase. In the multiple owner-manager situation, the incorporation of Newco and the transfer of shares to Newco by each owner-manager could be interpreted as a significant increase of each owner-manager in Newco. If this 5 However, as noted at 210, it appears that the CRA is not willing to recognize the effect of a price adjustment clause in connection with shares issued pursuant to a stock dividend freeze on the basis that the stock dividend freeze does not involve a transfer of property in a non-arm s length transaction (see Doc. No , April 1, 2003 (French only)). 1005

13 Ch. 10/Spinouts 423 is the case, the inter-corporate deemed dividends on the cross-redemption of shares may fall afoul of subsection 55(2), and be deemed to be capital gains. It should be noted in this regard that siblings are considered to deal at arm s length and be unrelated to each other by virtue of paragraph 55(5)(e). 6 As stated previously, two objectives of the type of reorganization depicted above could be maintenance of small business corporation status and asset protection. Small Business Corporation ( SBC ): SBC status has become increasingly significant due to various income tax provisions which depend on this status. Besides being a prerequisite for the small business capital gains exemption, it is also significant with respect to the following: the corporate attribution rules; allowable business investment losses; the 10-year reserve for intergenerational transfers; and the capital gains deferral for investments in small business per recently enacted section A small business corporation (defined in subsection 248(1)) must, first of all, be a Canadian-controlled private corporation. Second (subject to subsection 110.6(15), which refers to the valuation of life insurance policies and proceeds and ignoring net income stabilization accounts), all or substantially all of the fair market value of the assets of the corporation must be attributable to assets that are: used principally in an active business carried on primarily in Canada by the corporation or a corporation related to it. The meaning of the term active business as presently found in subsection 125(7) applies to this paragraph (see section 248(1) active business definition): shares or indebtedness of one or more small business corporations that are connected (see below) 7 with the particular corporation; or any combination of the assets described above. 6 There was some initial concern as to whether the CRA would apply GA AR to this method of purification. Paragraph 15 of Information Circular IC 88-2 provides an example of a situation in which a corporation was purified. The CRA indicated that GA AR would not be applied in the particular circumstances described. The example did not mention the use of section 85 rollovers to defer taxable gains on appreciated assets in the course of implementing the purification procedures. However, purifications involving section 85 rollovers have generally become accepted practice. 7 Within the meaning of subsection 186(4) on the assumption that the small business corporation is at the time a payer corporation within the meaning of that subsection. 1005

14 424 Tax and Family Business Succession Planning Basically, a corporation is connected with another corporation if it controls that other corporation (within the extended meaning of subsection 186(2) of the Act) or owns more than 10% of the voting issued share capital and shares representing a fair market value in excess of 10% of the total fair market value of all issued capital of that corporation. The CR A uses a 90% or more benchmark in respect of the all or substantially all test. (For further discussion, reference should be made to 402, Chapter 4, Capital Gains Exemption, Cr ystallization & Multiplication, et seq.) Asset Protection. It should be noted that, if asset protection is an objective of the transaction, certain transfers of propert y discussed in the foregoing discussion may be subject to the various statutor y provisions that are intended to protect creditors interests. In the above discussion, it should be noted that the butterf lies basically involve the spin out of corporate assets through the redemption of shares, i.e., vis-à-vis holding companies which may be formed to receive the assets. Accordingly, the solvency tests found in subsection 32(2) of the OBCA relating to the redemption of shares would come into play where the shares involved in the butterfly are redeemable. If the shares involved are not redeemable, there is also a solvency test under subsection 30(2) of the OBCA relating to the reacquisition of such shares by the corporation. If the solvency tests are not met, there could be directors liabilit y within subsection 130(2) of the OBCA, or the violation could form the basis of an oppression action by creditors. Even if these solvency tests are met, there is also the possibilit y that aggrieved creditors could bring other actions. (For further discussion, reference should be made to Chapter 7, Asset Protection; the solvency tests of various provisions of the OBCA are summarized at 708a.) Note on Part IV Tax Where there is a cross-redemption of shares, as shown in the above examples, the effect of refundable tax balances should be considered carefully. The CRA has taken the position that where the two corporations are connected, as would t ypically be the case with a purification, a crossredemption of shares causes a cascade effect with respect to Part IV tax and dividend refunds: where a dividend refund is generated on a redemption, there will be corresponding Part IV tax to the recipient corporation. The redemption of the recipient corporation s shares, in turn, generates a dividend refund, based at least in part on such Part IV tax. This in turn enlarges Part IV tax to the first corporation, thus enlarging its dividend 1005

15 Ch. 10/Spinouts 425 refund and therefore the amount of Part IV tax to the recipient corporation, and so on. The result a mathematical iterative (circular) calculation whereby the dividend refund and Part IV tax cascade appears to generate significant Part IV tax/dividend refund. (A similar calculation was upheld by the Tax Court of Canada in Les Entreprises Michele L Heureux Inc. v. The Queen, 94 DTC 1693.) One possible solution to this Part IV tax problem would be to structure the transaction so that the cross-redemption of shares could straddle a yearend. One share redemption would happen before the year-end and the other after. The ordering of redemptions would depend on where the taxpayer wanted the RDTOH to end up. In a typical purification, the paid-up capital will be lower in the corporation which is being purified: the paid-up capital of the recipient corporation will normally ref lect the cost base of assets transferred (see subsection 85(2.1)). Under these circumstances, the corporation with the higher paid-up capital (t ypically the recipient) will experience a significant net liability for Part IV tax, while the payor corporation will enjoy a net dividend refund. Although it appears that the net result is self-cancelling, it should be remembered that there could be cash f low problems/opportunities, e.g., due to differing year-ends and so on. It further appears that if the deemed dividends in respect of both corporations are equal, the final position (when the reorganization is considered in isolation, at least) may be that each corporation will experience a self-cancelling liabilit y for Part IV tax equal to its dividend refund and that each corporation will continue to have a balance of RDTOH at the beginning of its next fiscal period equal to its opening balance before the butterf ly transaction. In this respect, it may be possible to limit or reduce the recipient corporation s paid-up capital under applicable corporate law, such that the amount of the deemed dividend generated by each corporation would be identical. Of course, the foregoing is not a problem if there is no refundable tax balance to begin with. (There may be different effects depending on whether both corporations are connected with one another, or dividends are paid other than as a result of the butterfly.) For further discussion of the cascade effect see Part IV Complications in Butterfly Transactions, Christopher J. Potter, 1992 Canadian Tax Journal, Vol. 4, p. 992 et seq. 1005

16 426 Tax and Family Business Succession Planning 1006 Series of Transactions or Events As stated previously, the so-called paragraph 55(3)(a) exemption may be critical to a spinout. Central to this is the concept of whether the purification is part of a series of transactions involving a sale or other disposition of assets on a rollover basis to an unrelated person, or a transaction that increases such a person s percentage or value of a corporation. Subsection 248(10) states that a series of transactions or events will include any related transactions or events completed in contemplation of the series. The CRA appears to take a very wide view of the application of subsection 248(10). The following is CR A s standard response regarding the issue: A preliminar y transaction will form part of a series determined with reference to subsection 248(10) if, at the time the preliminary transaction is carried out, the taxpayer intends to implement the subsequent transactions constituting the series, and the subsequent transactions are eventually carried out. Thus, the preliminar y and subsequent transactions will be part of a series even though at the time of the completion of the preliminary transaction the taxpayer either had not determined all the important elements of the subsequent transactions including, possibly, the identity of other taxpayers involved or had lacked the ability to implement the subsequent transactions. 8 The CRA s views on this and related issues are also discussed in Hiltz, Section 245 of the Income Tax Act, Canadian Tax Foundation 1988 Conference Report, 7:1; Robertson, Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55, Canadian Tax Foundation 1981 Conference Report, 81; Hiltz, Section 55: An Update, Canadian Tax Foundation 1984 Cor porate Management Tax Conference, 40; and Read, Section 55: A Review of Current Issues, Canadian Tax Foundation 1988 Conference Report, 18:1. The CRA has also commented as to the application of subsection 248(10) in a technical interpretation involving three scenarios regarding tax-free inter-corporate dividends included in a series of transactions designed to purif y a corporation The shareholders have no intention to sell their shares in the next three years. 8 Revenue Canada Round Table, 1992 APFF Conference, Question See, for example, Michael Hiltz, Section 245 Update in Report of Proceedings of the Fortieth Tax Conference, 1988; Conference Report (Toronto: Canadian Tax Foundation, 1989) 7:1-9, at 7:6; CRA Doc. No , December 23, See also Doc. No. AC57939, June 30, 1989, among others. 1006

17 Ch. 10/Spinouts The shareholders have not identified a purchaser and there is a general intention to sell the shares in the next three to five years. 3. The shareholders have identified a purchaser and it is anticipated that the shareholders will sell their shares within the year. The CRA s response was as follows: 1. In situation 1, the fact that the shareholders have no intention of selling their shares within the next three years is not conclusive that the receipt of the dividends is not part of the series which includes an eventual sale of the shares to an arm s length person. The facts of each particular situation would have to be reviewed to determine whether subsection 55(2) would apply to the series of transactions. 2. Where, at the time the dividends are received the shareholders have an intention to sell their shares, the purification and the eventual sale, would generally be considered to be part of the same series of transactions determined with reference to subsection 248(10), not withstanding the fact that the shareholders had not identified a purchaser and that the eventual sale may not be completed for several years. 3. The purification and the eventual sale, in such a situation, would be considered to be part of the same series of transactions, determined with reference to subsection 248(10), since the shareholders intend to sell their shares and a purchaser had been identified at the time of the reorganization. Within the context of purification transactions, such expansive views on the application of subsection 55(2) by virtue of the series of transaction provisions are premised on the notion that, in most situations, a shareholder who causes a purification reorganization to be carried out does so in order that the capital gains exemption will be available upon a disposition of the shares. In such cases, the shareholder would therefore have some intention at the time of the reorganization of eventually selling the shares. 10 With respect to the potential application of the general anti-avoidance rule in subsection 245(2), the CR A referred to paragraph 15 of Information Circular 88-2, which provides that a transaction entered into to purif y a corporation is within the scheme of the Act, and accordingly, 10 See Doc. No , June 30, See also notes to the introductory portion of 414a for further comments on the CRA s view of the application of subsection 248(10) in the context of a purification. 1006

18 428 Tax and Family Business Succession Planning subsection 245(2) would not normally be applied to the claim for the capital gains exemption Case Law Series of Transactions/Transactions in Contemplation of Series Besides continually emerging Canadian case law on series of transactions and transactions in contemplation of a series, there is considerable U.K. case law on the former issue. In fact, as elaborated below, the Canadian law in this area is very much influenced by U.K. case law U.K. Case Law The English courts have considered the concept of a pre-ordained series of transactions in a series of cases 11 which focus on the concept that the series must be pre-ordained, in essence, conf ining a series of transactions to a situation where it was practically certain that the other steps would follow; only then could it be said that the steps were pre-ordained. This would not be the case if the terms on which the subsequent steps are to take place are not settled at the time of the first. The common law interpretation of the phrase series of transactions in the English cases was adopted by the Federal Court of Appeal in OSFC Holdings Ltd. v. The Queen, 2001 DTC However, as discussed below, the current state of the law appears to be that subsection 248(10) significantly extends the common law meaning of this phrase Canadian Case Law At time of writing, the Supreme Court of Canada had rendered two simultaneous decisions that defined series of transactions in connection with the general anti-avoidance rule (subsection 245(2)). 12 Both decisions were substantially consistent with the law as previously decided in the U.K. courts as well as the Court of Appeal in OSFC. 13 In fact, the ruling in OSFC remains entrenched in the heart of the Supreme Court s rulings. 11 Including Furniss v. Dawson, [1984] A.C. 474 (H.L.) and Craven v. White, [1989] A.C. 459 (H.L.). These cases are discussed in some detail by John Tiley, in his article, Series of Transactions, Canadian Tax Foundation 1988 Conference Report, 8:1. 12 Canada Trustco Mortgage Co. v. Canada, 2005 DTC 5523 and Mathew v. Canada, 2005 DTC Because of the nature of the transaction in issue, the third Supreme Court of Canada GA AR case, Lipson et al. v. The Queen, 2009 DTC 5015, said little about series of transactions and subsection 248(10). 13 I.e., ignoring subsection 248(10). 1007

19 Ch. 10/Spinouts 429 In OSFC, which also considered the concept in connection with the general anti-avoidance rule (subsection 245(2)), the Federal Court of Appeal indicated that subsection 248(10) broadened the meaning of series from that defined in the British cases. The OSFC case involved a series of transactions whereby mortgages in loss positions were transferred to a partnership. After this series was completed, a buyer (OSFC) was found which was not identified at the time of the series. OSFC became the majority interest partner and then syndicated its interest in the partnership. The Federal Court of Appeal held that the introduction of the buyer was in contemplation of the series of transactions involving the formation of the partnership. In other words, the concept of contemplation includes a retroactive reference to a previous series. In respect of series of transactions, Rothstein, J. stated: I would, subject to subsection 248(10), adopt the House of Lords approach. Thus, for there to be a series of transactions, each transaction in the series must be pre-ordained to produce a final result. Pre-ordination means that when the first transaction of the series is implemented, all essential features of the subsequent transaction or transactions are determined by persons who have the firm intention and ability to implement them. That is, there must be no practical likelihood that the subsequent transaction or transactions will not take place [paragraph 24]. In respect of subsection 248(10), Rothstein, J. stated: Subsection 248(10) requires three things: first, a series of transactions within the common law meaning; second, a transaction related to that series; and third, the completion of the related transaction in contemplation of that series [paragraph 35]. Thus, before applying subsection 248(10), series must be construed according to its common law meaning, which I have found to be preordained transactions which are practically certain to occur. To that is added any related transactions or events completed in contemplation of the series. Subsection 248(10) does not require that the related transaction be pre-ordained. Nor does it say when the related transaction must be completed. As long as the transaction has some connection with the common law series, it will, if it was completed in contemplation of the common law series, be included in the series by reason of the deeming effect of subsection 248(10). Whether the related transaction is completed in contemplation of the common law series requires an assessment of whether the parties to the transaction k new of the common law series, such that it could be said that they took it into account when deciding to complete the transaction. If so, the transaction can be said to be completed in 1009

20 430 Tax and Family Business Succession Planning contemplation of the common law series [paragraph 36 emphasis added]. 14 The appellant in OSFC had filed leave to appeal to the Supreme Court of Canada, however, the Supreme Court declined to grant leave. The Supreme Court s decision in Canada Trustco echoed OSFC and said: The meaning of the expression series of transactions under s. 245(2) and (3) is not clear on its face. We agree with the majority of the Federal Court of Appeal in OSFC and endorse the test for a series of transactions as adopted by the House of Lords that a series of transactions involves a number of transactions that are pre-ordained in order to produce a given result with no practical likelihood that the pre-planned events would not take place in the order ordained : Craven v. White, [1989] A.C. 398, at p. 514, per Lord Oliver; see also W.T. Ramsay Ltd. v. Inland Revenue Commissioners, [1981] 1 All E.R. 865 [paragraph 25]. However, the Supreme Court then expanded on the interpretation of in contemplation found within the definition of series of transaction in subsection 248(10) and said: Section 248(10) extends the meaning of series of transactions to include related transactions or events completed in contemplation of the series. The Federal Court of Appeal held, at para. 36 of OSFC, that this occurs where the parties to the transaction knew of the... series, such that it could be said that they took it into account when deciding to complete the transaction. We would elaborate that in contemplation is read not in the sense of actual knowledge but in the broader sense of because of or in relation to the series. The phrase can be applied to events either before or after the basic avoidance transaction found under s. 245(3). As has been noted: It is highly unlikely that Parliament could have intended to include in the statutor y definition of series of transactions related transactions completed in contemplation of a subsequent series of transactions, but not related transactions in the contemplation of which taxpayers completed a prior series of transactions [paragraph 26 emphasis added]. Thus, the knew of and took it into account language articulated in OFSC were subject to the elaboration that in contemplation is read not in the sense of actual knowledge but in the broader sense of because of 14 In Doc. No , December 3, 2002, the CRA indicated that the OFSC decision is consistent with the CRA s longstanding interpretation, as expressed by the standard response quoted earlier. 1009