Release date: January 31, 2012
Guests: Marc Vanasse
Running time: 8:50 minutes
In this episode, Marc discusses what surplus stripping is, including some history, if there’s a policy in the Income Tax Act against it, and other sources of information.
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Gerry Lewandowski: In this podcast, we are speaking to Marc Vanasse, a partner and member of PwC’s Tax Controversy and Dispute Resolution group.
Based out of Ottawa, Marc helps clients resolve tax disputes with the CRA and other government bodies. With over 20 years of working in the Income Tax Rulings Directorate of the CRA and another 11 years as part of the GAAR Committee, he brings a wealth of knowledge in many areas including: advance income tax rulings and interpretations, corporate distributions, tax shelters, partnerships, corporate re-organizations, income trusts and green energy initiatives.
It’s great to have you here, Marc.
Marc: I’m pleased to be here.
Gerry: Marc, with all of your experience on the GAAR committee, can you give us some insight on surplus stripping?
Marc: Well, first, let me give you a bit of statistical background that may help our listeners appreciate the volume of surplus stripping files addressed by the CRA over the past 20 years. Since the time the GAAR Committee was established back in the late ’80s, nearly 1000 cases have been heard by the Committee and roughly 30% of these cases focused on two areas. Surplus stripping which I’ll discuss in more detail in a moment, and the avoidance or reduction of capital gains.
Now, briefly put, the avoidance or reduction in capital gains takes many forms and some of the more popular transactions involved the artificial loss creation transactions that have been addressed in three recent Tax Court of Canada decisions (one being the Triad case) and this is using stock dividends. These transactions have been coined often as “value shift” transactions. Other questionable transactions involved arm’s length loss purchases and others using inappropriate adjusted cost base (ACB) increases using the rules in paragraph 88(1)(d).
Gerry: OK – so back to surplus stripping
Marc: Well, it’s important to note that surplus stripping is not a defined term in the Income Tax Act. Basically, it’s when a shareholder takes a shortcut in accessing accumulated surpluses of a corporation, or said in a slightly different way, it’s when a shareholder receives assets of a corporation in a way that attracts less tax than what would have happened if they received that same money as a dividend.
Some of the more important surplus stripping arrangements involved things like the artificial creation of amounts included in the Capital Dividend Accounts through the use of partnerships. This is a result of the different timing in recognizing the income of the partnership and the computation of the ACB of the partnership interest. Other surplus stripping arrangements include paid up capital increases, or shifts, or I’ll use the term “manipulation”. The final surplus stripping arrangement I would like to mention involves the conversion of dividends into capital gains.
Gerry: Now Marc, how serious is surplus stripping?
Marc: As for how serious this is, let’s take for example the simple conversion of dividend income into capital gain for an individual shareholder of a Canadian company. I think there's more activity in this area because of the large rate spread between the tax rate of dividends versus capital gains. Let’s remember that the capital gains inclusion rate fell from 75% to 50% around the year 2000, and depending on your province, a person could have a 14% gap in how they're taxed.
Gerry: Now in your view do you think the Income Tax Act establishes a general policy against surplus stripping?
Marc: In my view, “yes”. The provisions of the Act seems to establish a general policy against the re-characterization of corporate surpluses into something else, for example capital gains. Changing these surpluses (i.e. dividends) into capital gains defeats the purpose regarding the statutory preservation of the "taxation of dividends" which is an essential component of the tax integration system in Canada. Some specific provisions that appear to support this overall scheme includes sections 84, 84.1, 212.1 and subsection 84(2).
There are also many cases that discuss surplus stripping. In particular, there are the cases of Craddock and Smythe the two Supreme Court of Canada decisions in the late 60’s, and more recently the RMM Equilease decision. On the flip side, the Crown has lost both the Evans and Collins & Aikman case which muddies the waters a bit for the crown regarding whether there is a legislative scheme against surplus stripping.
However, in December 2011 the Supreme Court of Canada released its unanimous decision in Copthorne Holdings Ltd where it was held that GAAR applied to the planning engaged by the Copthorne group in which cross-border paid-up capital was duplicated – thus setting up a tax free capital distribution of company surpluses. The Court did not engage in an examination of whether there was a general policy against surplus stripping in the Act. Instead, the Court focussed on the specific rules dealing with the paid up capital (PUC) of an amalgamated company (being subsection 87(3)). I would suggest to our listeners that they read our PwC Tax Memo on the Copthorne decision which provides a more detailed analysis of the decision. This can be found on our PwC Tax Memo publications webpage at www.pwc.com/ca/taxmemo under “Tax memo: Reflections on Supreme Court ruling on GAAR—Copthorne Holdings Ltd”.
In addition, I think section 3 also addresses a legislative scheme in the sense that it identifies various sources of income with its own specific detailed rules in their subdivisions. As an example, the tax rules regarding capital gains in subdivision C are quite different than the taxation of dividends. Arguably, there’s a general policy behind the concept of source of income under section 3 that is there to ensure consistency, predictability and fairness of the tax system.
Gerry: Now, apart from those specific provisions and the court cases you mentioned earlier, are there any other sources of information that you think may need to be considered when looking at a surplus stripping arrangement?
Marc: That's a good question, Gerry.
I think that people should look at the technical notes to old subsection 247(1) that were repealed with the introduction of GAAR. These technical notes address what appears to be the overall policy against surplus stripping by either an inappropriate increase in paid up capital and the distribution of corporate surpluses on a reduced or tax free basis.
Gerry: So, is this all just about the tax rate differences between dividends and capital gains?
Marc: Actually Gerry, there's more to it than that.
In addition to the rate play between the rate on dividend income versus the capital gains rate, if you could convert a dividend into a capital gain, you could potentially be entitled to other incentives like the use of net capital losses, which would not be available to be used against dividend income, and potentially the $750,000 lifetime capital gains exemption.
Gerry: Thank you for your insights in surplus stripping Marc.
Marc: Thank you for the opportunity to be here.
Gerry: For additional information on how PwC’s specialized team can assist companies in the areas of dispute avoidance, tax controversy and dispute resolution, please visit www.pwc.com/ca/tcdr.
Thank you for tuning into Tax Tracks at www.pwc.com/ca/taxtracks.
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