Section 84.1
Suppose that a shareholder-employee of a private corporation is departing. She wants to relinquish her shares and receive capital gains treatment (including the lifetime capital gains deduction) on the appreciation in value, but the remaining shareholders lack the cash for a straight buyout of the shares. Redeeming or cancelling the shares solves the cash problem by using the corporation’s funds, but triggers a deemed dividend under section 84.1. One solution is a buyco or sidecar arrangement. These types of arrangements have been called into question by a recent change in the CRA’s administrative policy, but the legal basis for that change is not strong.
Assume that the employees of Opco, a CCPC, own more than 10 percent of Opco’s common shares. Pursuant to a unanimous shareholders’ agreement (USA), on cessation of employment an employee is required to sell his or her Opco shares to a new corporation (Buyco) for a price equal to FMV. Buyco obtains a loan from Opco and purchases the employee’s Opco shares at a price equal to FMV. Subsequent to the transaction, Buyco will transfer the purchased common shares to Opco for FMV consideration.
At the Canadian Tax Foundation’s 2012 annual conference, the CRA indicated that it will no longer issue favourable rulings concerning buyco transactions and the non-application of section 84.1 in these circumstances (2002-0146775). (For a description of the new policy, see “CRA’s GAAR Update,” Canadian Tax Highlights, January 2013.) Specifically, the CRA has concluded that an employee involved in a buyco transaction may not be dealing at arm’s length with the buyco because of the degree of accommodation between the parties. The CRA has not yet issued an official statement concerning buycos, but perhaps one is forthcoming.
The CRA’s revised position on buycos is said to follow recent cases such as Petro-Canada (2004 FCA 158). In Petro-Canada, the court used three questions established as a “framework for analysis” to evaluate whether a non-arm’s-length relationship exists: (1) Is a common mind directing the bargaining for both parties to the transaction? (2) Did the parties to the transaction act in concert without separate interests? (3) Did one party to the transaction exercise de facto control over the other?
When one asks these questions regarding a buyco situation, it must be conceded that at times an employee and an employer may appear to be acting in concert and not at arm’s length. However, the departing shareholder and the other shareholders of the buyco are independent economic parties with independent interests, even if those interests coincide on particular points. In contrast, in Petro-Canada, Petro-Canada was beneficially interested in both the vendor and the purchaser corporations, and thus there was a clear “common mind” behind the actions of both the vendor and the purchasers.
Also, there is no artificiality about the USA. A transaction like the one in the example may be the most significant and substantial transaction of the employee’s life. Normal employment conditions suggest that acting in concert occurs near the beginning of an employment relationship and over the course of the employment relationship, when there is an ongoing relationship to be maintained. In contrast, cessation of employment suggests the end of any compulsion to act in concert. At the close of the employment relationship, the employee’s only interest is her own. Presumably, she wants to maximize her shares’ value and arrange her affairs to obtain the best income tax result allowed by law.