In a clear and concise judgment, the Tax Court of Canada applied section 84.1 of the Income Tax Act (ITA) to a disposition of shares by the taxpayer, resulting in a taxable dividend of $400,000 instead of a capital gain eligible for the capital gains exemption. Although Justice Judith Woods agreed with the taxpayer’s counsel that section 84.1 is a “trap for the unwary” and appeared to have some sympathy for the taxpayer’s position, she nevertheless felt bound to apply the clear wording of the provision.
The facts were as follows:
• In July 2001, the taxpayer and Mr. Xuening • Chen held 20 and 55 common shares, respectively, of Sona Computer Inc. Between them, they owned all of the company’s shares.
• In July 2001, the taxpayer, Chen and Sam Damm held 24, 25 and 51 common shares, respectively, of Foxwise Technologies Inc. This represented all of the shares of Foxwise.
• 1514488 Ontario Inc. (Ontario Inc.) was incorporated in June 2002. At all material times, the taxpayer and Chen held five and 95 common shares of Ontario Inc., respectively, which represented all of the common shares of Ontario Inc.
• On 3 September 2002, the taxpayer and Chen disposed of their shares of Sona and Foxwise to Ontario Inc. The taxpayer received $400,000 as consideration. Chen received as consideration 1,100 special shares of Ontario Inc. by way of “rollover” pursuant to section 85 of the ITA.
• The taxpayer’s adjusted cost base of her shares of Sona and Foxwise was $2,000 and $24, respectively. Of the $400,000 proceeds that the taxpayer received, only a nominal amount was attributable to the Foxwise shares.
The taxpayer claimed the capital gains exemption in respect of the gain realized by her on the sale of the Sona shares, but the Minister reassessed her on the basis that section 84.1 applied, resulting in deemed dividend treatment.
Section 84.1 applies where an individual disposes of shares of a Canadian-resident corporation (the subject corporation) to another corporation (the purchaser corporation) with which the transferor does not deal at arm’s length, and immediately after the disposition, the subject corporation is connected with the purchaser corporation. The policy of section 84.1 is well understood: it is designed to prevent the tax-free removal of taxable corporate surplus through a non-arm’s-length transfer of shares by an individual to a corporation.
In this case, the only issue was whether the taxpayer and the purchaser corporation, Ontario Inc., were not dealing at arm’s length, since all of the other conditions for the application of section 84.1 were satisfied. The court held that this condition was also satisfied: the taxpayer was not dealing at arm’s length with Ontario Inc., even though she held only 5% of its common shares. This resulted from the combined application of the deeming provisions[Note 1] in section 84.1 that deem an individual not to deal at arm’s length with the purchaser corporation if:
• Immediately before the sale, the taxpayer was one of a group of fewer than six persons that controlled the subject corporation (in this case, Sona); and
• Immediately after the sale, the taxpayer was one of a group of fewer than six persons who controlled the purchaser corporation (in this case, Ontario Inc.), each member of which was a member of the group that controlled the subject corporation.
Were it not for the other deeming rules, discussed below, neither of the above requirements would have been met, since the taxpayer did not act in concert with Chen, and therefore could not be part of a group that controlled either Sona or Ontario Inc. (see Silicon Graphics Ltd. v the Queen, 2002 FCA 260), and Chen controlled each of these corporations on his own. However, the deeming provisions in section 84.1 extend the meaning of a “group” as follows:
• A group is any two or more persons who own shares of a particular corporation.
• A corporation that is controlled by one or more members of a group is considered to be controlled by the group.
• A corporation may be controlled by a person or group notwithstanding that it is also controlled or deemed to be controlled by another person or group.
As a result, the taxpayer and Chen were considered to be a group that controlled Sona before the sale, and that controlled Ontario Inc. after the sale, and the taxpayer was deemed not to deal at arm’s length with Ontario Inc. This is a harsh result, given that the taxpayer only owned 5% of the shares of Ontario Inc. (and could have avoided the application of section 84.1 had she sold these shares to Chen prior to the sale of theSona and Foxwise shares to Ontario Inc.).
As Justice Woods pointed out, it is in accordance with the plain meaning of section 84.1. Counsel for the taxpayer submitted that this plain meaning was contrary to the purpose of section 84.1. However, Justice Woods indicated that section 84.1 could “overreach” its anti-avoidance objective in certain cases, and that this result was clearly intended by Parliament.
Note 1. Income Tax Act, paragraph 84.1(2)(b) and paragraphs 84.1(2.2)(b), (c) and (d).
Jennifer Smith, LLB, is an executive director in the Ottawa tax practice with Ernst & Young LLP. She can be reached at jennifer.j.smith@ca.ey.com.
