Allan Lanthier
The recent enactment of a private member’s bill to accommodate intergenerational transfers of family businesses has put surplus stripping back in the spotlight. What is surplus stripping and how does it work? Do our tax rules need to be fixed and, if so, how? In this, Part I of a two-part series, we examine the bill and the two government announcements that followed its enactment. Part II will discuss surplus stripping more generally outside the context of intergenerational transfers.
Update
After this article was published, the Federal Court of Appeal (FCA) issued its decision in Deans Knight Income Corporation, a case involving the monetization of tax losses. In general terms, the relevant provisions in the tax act restrict access to a corporation’s tax losses if there is an acquisition of legal (de jure) control of the corporation.
Overturning a decision of the Tax Court of Canada, the FCA concluded that, for purposes of an abuse analysis under the general anti-avoidance rule (GAAR), the object, spirit and purpose of the loss denial rule are not fully reflected in the text of the rule (the text being legal control). The FCA applied GAAR to deny access to the tax losses, stating that the general policy of the tax act is to prevent loss trading whenever a person acquires “actual control” over a corporation’s actions, whether by legal control or otherwise.
Under Bill C-208, the new exception from section 84.1 applies if children or grandchildren of the transferor “control” the purchasing corporation. Having regard to the decision in Deans Knight, a surplus strip in which children or grandchildren acquire no more than legal control may now involve a risk under GAAR, even though the courts have said there is no general policy in the tax act that prohibits surplus stripping.
The recent legislative fiasco involving a private member’s bill intended to facilitate intergenerational transfers of a family business – Bill C-208 – has put surplus stripping back in the spotlight. The bill received royal assent on June 29 and, under the express terms of the Interpretation Act, became law on that date. The bill is deeply flawed and opens the floodgates to aggressive surplus stripping schemes that rely on the lifetime capital gains exemption (LCGE).
The government issued a news release on June 30 stating that legislation to “clarify” the rules for genuine family transfers would be introduced later this year and would take effect Jan. 1, 2022.[1] Opposition MPs and business advocacy groups said they were outraged. How could a bill that is already in force apply only starting next January, and how could the government ignore legislation that Parliament had enacted?
On July 19, one day before the finance committee of the House of Commons was scheduled to meet and grill Finance Department officials regarding how the will of Parliament could be ignored, the government had a change of heart. It issued a second news release stating that “the law is the law,” and that Bill C-208 would stay in force until new rules are drafted and then finalized later this year.[2] The government stated that amendments, with safeguards to address surplus stripping, would be introduced in a bill and apply on the later of Nov. 1, 2021, or the date of publication of final draft legislation.
Until that time, the surplus stripping floodgates created by Bill C-208 are wide open.
What is surplus stripping and how does it work?
In Canada, individuals pay lower tax rates on capital gains than on dividends, and surplus stripping involves an individual receiving after-tax earnings of a corporation as a capital gain rather than as a taxable dividend.
Here’s an example. Mrs. A is a top-rate taxpayer resident in Ontario. Mrs. A owns 100 percent of the shares of Co. A, a corporation that carries on an active business. Mrs. A’s tax basis of the shares is nominal. She would like to take a cash dividend of $100,000 from Co. A, but her tax accountant says her federal-provincial tax rate would be 47.7 percent. However, he has a plan.
In simplified terms, Mrs. A sells shares of Co. A worth $100,000 to one of Co. A’s wholly owned subsidiaries for cash. She has a capital gain – not a dividend – and the capital gain is taxed at a rate of 26.7 percent. This surplus strip saves Mrs. A $21,000 in personal income tax. It is not at all clear that the tax authorities can successfully challenge this plan under existing tax law.[3]
While tax planners have developed a number of ways to access capital gains rates, until the enactment of Bill C-208, section 84.1 of the federal Income Tax Act[4] prevented individuals from stripping cash out of a corporation on a totally tax-free basis by using the LCGE. However, until new intergenerational restrictions are finalized later this year, this is now possible.
Bill C-208
If the tests in Bill C-208 are met, individuals can now strip cash out of private corporations with no personal tax whatever, up to the LCGE limit of $892, 218.[5]
Under section 84.1 of the Act, if an individual sells shares of a corporation (the “subject corporation”) to another corporation (the “purchaser corporation”) with which the individual does not deal at arm’s length, and the purchaser corporation owns more than 10 percent of the share capital of the subject corporation immediately after the sale, the amount of cash or other non-share consideration received by the individual is taxed as a deemed dividend — to the extent that the tax cost of the subject shares includes an amount for which the LCGE was claimed.[6] This rule is in place precisely to curtail the type of surplus-stripping shenanigans described further below.
The rules in Bill C-208
The new rules in Bill C-208 provide that, if an individual sells qualified small business shares or shares of a family farm or fishing corporation to a corporation “controlled” by her children or grandchildren who are at least 18 years of age, section 84.1 of the Act will not apply, and she will benefit from capital gains treatment, including the LCGE.[7] For this exemption to apply, the purchaser corporation must not dispose of the transferred shares for at least 60 months.
Sounds simple enough. What could possibly go wrong?
Surplus strips
The requirement that children or grandchildren control the purchaser corporation – with no requirement that they also own most of its common shares or take over management of the business – is a recipe for high-octane surplus strips that could cost hundreds of millions of dollars in lost tax revenue each year.
Let’s go back to the example with Mrs. A. While she has no plans to sell the business, she wants to strip cash out of it. In light of Bill C-208, her accountant has a new plan. Mrs. A incorporates a new company (Newco), then Mrs. A and her daughter each invest $100 in Newco. Mrs. A receives 100 fully participating common shares, and her daughter 100 fixed-value preferred shares. The preferred shares give the daughter voting control of Newco.
Mrs. A then sells her shares of Co. A to Newco for a promissory note of $892,218.[8] This results in a capital gain to Mrs. A but, after using the LCGE, she pays zero tax. Co. A then pays a tax-free cash dividend of $892,218 to Newco, and Newco repays the promissory note. Mrs. A continues to operate the business and, through the common shares she owns in Newco, to fully benefit from any future earnings and increased value of Co. A’s business.
Bill C-208 has allowed Mrs. A to strip cash of $892,218 out of Co. A at zero tax cost. As a top-rate taxpayer resident in Ontario, her tax savings are $426,000, as compared with the tax that would have applied if Co. A had paid her a dividend. There is one basic test that must be met under Bill C-208: Mrs. A’s children or grandchildren must control Newco — and thanks to $100 of voting preferred shares, her daughter does.
It is unlikely that the tax authorities will be able to successfully challenge this transaction under the general anti-avoidance rule (GAAR). In enacting Bill C-208, Parliament could have chosen either de jure control or a different standard that would have provided more protection against aggressive surplus strips. Parliament opted for the de jure standard, presumably to provide increased certainty and predictability to taxpayers.[9]
Sales of shares of smaller corporations
Bill C-208 tried to restrict the benefit of the new rules to “smaller corporations” and claw back or deny the intergenerational exemption if a corporation’s “taxable capital”[10] is between $10 and $15 million. But the legislation is flawed and fails miserably in this attempt.
The rules state that, for purposes of applying the new exemption, the individual’s LCGE should be reduced by a formula based on taxable capital. But the amount of LCGE that an individual may claim is not relevant for purposes of the exception in Bill C-208. What is relevant is simply whether the seller’s children or grandchildren control the purchaser corporation. In short, the proposed restriction based on taxable capital has no application and is meaningless. So, business owners can use the new rules to strip surplus cash out of their operating companies, no matter how large those corporations may be.[11]
What happens next?
As discussed above, the government’s news release of July 19 states that Bill C-208 will stay in force until new rules are drafted and then finalized later this year, and that these future amendments to the bill will include safeguards to address surplus stripping.
The changes that will be introduced are fairly predictable. New restrictions will likely require that children or grandchildren own all or substantially all of the common shares of the purchaser corporation and indirectly of the subject corporation, and that the children become (or remain) involved in the business on an active and continuous basis. New rules will also restrict the new relief to shares of smaller corporations.
Until that time, tax planners will be flogging an aggressive tax plan that was handed to them on a silver platter. How much tax will be lost in the next three to four months before new rules take effect is unknown, but it will certainly be in the hundreds of millions of dollars. There are more than 1.2 million small- and medium-sized businesses in Canada. If, hypothetically, one percent of these businesses have top-rate owners who strip out cash up to the LCGE limit, the federal-provincial cost would exceed $5 billion.
Once new restrictions are in place, we will be back to old-fashioned surplus strips – shuffling paper around to convert dividend rates to capital gains rates, but without the LCGE. How the government might deal with that issue is discussed in Part II of this article.
Part II: Canada’s tax laws need to be changed to limit surplus stripping
[1] News release dated June 30, 2021, from the Department of Finance.
[2] News release dated July 19, 2021, from the Department of Finance.
[3] While the tax authorities might seek to apply the general anti-avoidance rule, the courts have said there is no general policy in Canadian tax legislation that prohibits surplus stripping.
[4] Referred to herein as the “Act”.
[5] The indexed limit in 2021 for shares of a qualified small business corporation. The LCGE for shares of a family farm or fishing corporation is $1 million.
[6] See subparagraph 84.1(2)(a.1)(ii) of the Act.
[7] It is well-recognized that, under the Act, “control” of a corporation normally refers to de jure control – ownership of a sufficient number of voting shares to elect the board of directors. See for example the 1998 decision of the Supreme Court of Canada in Duha Printers (98 DTC 6334).
[8] If the fair market value of the shares of Co. A is greater than $892,218, Mrs. A should also receive additional common shares of Newco, then Mrs. A and Newco should jointly elect a transfer amount of $892,218 under section 85 of the Act.
[9] See for example the 2020 decision of the Tax Court of Canada in MMV Capital Partners (2020 TCC 82, under appeal). However, as noted in the “Update” further above, the Federal Court of Appeal has now reached a different conclusion than the tax court in Deans Knight Income Corporation (2021 FCA 160).
[10] Defined in subsections 181.2 to 181.4 of the Act.
[11] Even had the claw-back in Bill C-208 been effective (it is not), it would have only fully eliminated the new relief once a corporation’s taxable capital reached $510 million, rather than the intended limit of $15 million. Bill C-208 uses a formula that includes a factor of 0.00225, which is two decimal places too many, creating this absurd result.
