Creation of Capital Losses
We understand that many transactions are being done which are designed to create a capital loss for income tax purposes. As a simple example:
A corporation (“Xco”) disposes of a particular capital property (“gain property”) for its fair market value to an arm’s-length person and receives only cash consideration. Xco realizes a significant capital gain on the sale.
Xco incorporates a new corporation (“Newco”) and uses all the cash proceeds that it received on the sale of the gain property to subscribe for common shares of Newco. The common shares of Newco will have a fair market value, paid-up capital and adjusted cost base equal to the subscription amount.
Newco declares and pays a stock dividend on the common shares in the form of redeemable/retractable preferred shares (“high/low shares”) having an aggregate redemption/retraction amount equal to the fair market value of the common shares of Newco immediately before the declaration of the stock dividend but a nominal amount of paid-up capital. The payment of the stock dividend in this situation effectively reduces the fair market value of the common shares of Newco while leaving the adjusted cost base and paid-up capital of such shares unchanged. Further, by virtue of the definition of “amount” in subsection 248(1), since the paid-up capital of the high/low shares of Newco will be only increased by a nominal amount, the amount of the stock dividend in this situation will be nominal.
Xco will then sell the common shares of Newco for their nominal fair market value to a person who is not otherwise affiliated with Xco. Xco will claim a capital loss on the sale and use it to offset the capital gain Xco realized on the sale of the gain property.
Question
On the assumption that no specific anti-avoidance provisions apply to this type of transaction, would the CRA apply GAAR?
Response
The CRA will apply GAAR to these types of situations. In our view, the above described transactions result in the creation of an artificial capital loss to Xco because Xco has simply transferred the full fair market value of the common shares of Newco to the high/low shares of Newco and has not suffered a true economic loss. In our view, former subsection 55(1) was directed at transactions, such as the one described above, that were designed to artificially or unduly reduce a capital gain or increase or create a capital loss on the disposition of a property (see Russell H. Daggett v. MNR [Footnote 17]. The explanatory notes dealing with the repeal of former subsection 55(1) indicate that GAAR is intended to replace this former anti-avoidance provision.