Sale of Tax Losses
The Act contains many provisions that are designed to ensure that a corporation’s tax losses cannot be used by unrelated [or sometimes unaffiliated] persons unless they continue to carry on the corporation’s business with a reasonable expectation of profit.
However, these loss restriction rules generally only apply when the unrelated persons acquire de jure control of the corporation, and not merely de facto control.
We understand that, in recent years, several public transactions, [sometimes euphemistically referred to as corporate “reinventions”, “restart” transactions, or “tech-wreck restructurings”] have been designed to exploit this deficiency. For example, assume that Lossco is a widely held, publicly traded corporation. Lossco is insolvent and has ceased to carry on its business. Lossco has substantial unused non-capital losses. Profitco is an unrelated corporation that carries on a profitable business that is fundamentally different from the former Lossco business. Profitco would like to avail itself of the benefit of Lossco’s tax losses. Accordingly, Profitco transfers a certain amount of cash and the assets of its profitable business to Lossco in exchange for voting common shares and non-voting common shares. These voting and non-voting shares entitle Profitco to only 45% of the votes but substantially all of the value of Lossco. Given that the other shares of Lossco are widely held, Profitco’s 45% of the votes allow it to effectively dictate all appointments to Lossco’s board of directors. The tax losses of Lossco shelter the income from the profitable business that it acquires from Profitco. The cash transferred by Profitco to Lossco is paid to the other shareholders of Lossco, as a dividend or return of capital, as a form of compensation for the use of Lossco’s losses.
Question 1
Does the CRA agree that the loss restriction rules in the Act do not apply to deny the deduction of Lossco’s non-capital losses against the income of the profitable business in this example?
Response 1
The Supreme Court of Canada confirmed, in the case of Duha Printers, that subsection 111(5) contemplates de jure, not de facto, control, and that the general test for de jure control is whether a person enjoys “effective control” over the affairs and fortunes of the corporation, as manifested in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors. The Supreme Court also stated that, in determining whether effective control exists, one must consider:
(a) the corporation’s governing statute;
(b) the share register of the corporation; and
(c) any specific or unique limitation on either the majority shareholder’s power to control the election of the board or the board’s power to manage the business and affairs of the company, as manifested in either:
(i) the constating documents of the corporation; or
(ii) any unanimous shareholder agreement.
Consequently, in a situation such as the one outlined in the example, in order to determine whether Profitco had acquired control of Lossco, one would have to examine all of the constating documents and any unanimous shareholder agreement in respect of Lossco in order to ascertain whether Profitco had acquired effective control of Lossco, as contemplated by the Supreme Court in Duha Printers.
Furthermore, if Profitco together with persons that act in concert or have some common connection with Profitco hold a majority of the voting shares of Lossco, Profitco and those persons could be considered to be a group of persons that has acquired de jure control of Lossco.
Careful consideration would also have to be given to whether any specific anti-avoidance provision in the Act might restrict the deduction of Lossco’s losses. For example:
- If Profitco has a right referred to in paragraph 251(5)(b) in respect of a share, subsection 256(8) could apply to treat Profitco as having acquired control of Lossco, such that subsection 111(5) would apply.
- If the tax losses of Lossco are used to shelter income or gains arising from the disposition of property that it acquired on a rollover basis from Profitco, subsection 69(11) could apply to deny the rollover to Profitco.
- If the property acquired by Lossco from Profitco includes any right to receive payments that were required to be included in Lossco’s income, and that right is held by Lossco on condition that it may revert or pass to Profitco, subsection 112(2.4) could apply to deny a subsection 112(1) deduction to Profitco in respect of dividends that it receives from Lossco.
Other specific anti-avoidance provisions [e.g., paragraph 256(7)(c)] might require consideration, depending on the mechanics of a particular transaction.
Question 2
Assuming that no specific anti-avoidance provision applies to the transactions, would the CRA consider the application of GAAR to such transactions?
Response 2
Yes. The Federal Court of Appeal in OSFC Holdings Ltd. v. R [Footnote 7] concluded that the general policy of the Act is against the trading of non-capital losses by corporations, subject to specific limited circumstances. We are of the view that transactions that are designed to allow a person to acquire a very substantial economic interest in a corporation (for example, perhaps by having both de facto control and a substantial equity interest in the corporation) and to benefit from the corporation’s tax losses, without being subjected to the “same or similar” business restrictions in subsection 111(5), could reasonably be considered to result in an abuse having regard to the general policy of the Act against the trading of non-capital losses by unrelated corporations.