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GAARbage in… GAARbage out? – Even if you follow the letter of the tax law, can you pass the “smell test”?

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  • GAARbage in… GAARbage out? – Even if you do everything by the letter of the tax law, can you pass the “smell test”? – A June 2018 Federal Court of Appeal ruling might make it difficult?

    By Cory G. Litzenberger, CPA, CMA, CFP, C.Mgr – President & Founder of CGL Strategic Business & Tax Advisors.

    No, those aren’t typos. For the non-tax nerds (ie: normal people) reading this, GAAR is the General Anti-Avoidance Rule under Section 245 of the Income Tax Act. More commonly referred to as “the smell test.” In other words, even if you do everything by the letter of the law, if it looks and smells funny, the government might not agree with you and you might be reassessed.

    To the tax nerds, I will be simplifying this article but with a few legislative references to keep you happy.

    This smell test brings us to the Pomerleau v Canada (2018 CAF 129) ruling issued in French on June 29, 2018 by the Federal Court of Appeal.

    To put this in context, the transactions occurred in 2004 and 2005. We are now looking at items that are 13-14 years old, that were also common practice among many tax practitioners back then.

    Let’s take a high-level approach to see how we got here:

    The taxpayer, Pomerleau, and his family sought tax advice on how to transfer the $3 million family owned business from the parents to their children. There are many provisions that allow us to do this on a tax-deferred (not tax-free) basis.

    The advisors had developed a plan to pass on the family business on this tax-deferred basis, but also thought they had discovered a way to reduce the amount of that deferred tax as well.

    Layman Technical Background

    In tax planning with company shares we have two types of adjusted cost bases (ACB) referred to as “hard ACB” and “soft ACB”. Hard ACB is when tax was fully paid on the transfer or was acquired from someone not related to you. Soft ACB is when you have bought the shares from a related person and that person had used part of their Lifetime Capital Gains Deduction on the sale.

    Hard ACB can be planned with to eventually convert into a shareholder loan without triggering a dividend under 84.1, whereas soft ACB cannot.

    What happened?

    In 1995, the family started to reflect on the continuity of the business. Several decisions were taken. One of those decisions was that the business would be divided among the original shareholder’s four children. As a result, the business was divided as follows: the two daughters obtained part of the business, which consisted of real estate, and the two sons obtained the other part, which consisted of the construction business.

    As part of this transfer of the family business, which had been in the works for over 10 years, a series of transactions was undertaken in 2004 and 2005.

    One of the transactions was the redemption by Pomerleau’s holding company (HoldCo) of its shares. The ACB and the paid-up capital (PUC) of these shares totaled $2 million.

    If the ACB was considered hard ACB, then Pomerleau could sell the shares to a new corporation for a $2M Promissory Note, have the old corporation redeem the shares, pay the $2M to the new corporation (inter-corporate dividends from connected corporations don’t create tax) then use the $2M to pay out the promissory note.

    This is similar to what is done as a pipeline transaction for deceased persons after capital gains have been triggered on death.

    If the ACB is soft ACB, then the transactions above would actually cause a taxable dividend under 84.1 of the Income Tax Act.

    How did we get to $2M of PUC and ACB?

    In 1989 (likely under fears that the capital gains deduction may be eliminated in the next federal election) Pomerleau, his mother, and his sister, all increased their ACB in their Operating Company (OpCo) shares utilizing a provision of the Act under Section 85, that (with a lot of complexity) allows you to sell shares to a corporation in exchange for more shares. If done properly, you can do this with your own corporation and trigger capital gains on purpose in order to use your lifetime capital gains deduction under 110.6 (as was the case here).

    Some of these shares were eventually transferred to Pomerleau from his mother and sister in taxable events. As a result, the shares had both soft and hard ACB at this point.

    Fast forward 15 years.

    Those previously mentioned shares of OpCo were eventually transferred to HoldCo.

    In 2004, as the sole shareholder of HoldCo, Pomerleau wanted to split his $3M company among his children. He had $1M in soft ACB with only $15,000 of PUC (the tax-free amount you can get back) tied up in Class G Preferred Shares (Class G) and had at least $2M in value of Class A common shares with $1M in hard ACB.

    The Transactions and Application of Law

    On January 3, 2005, HoldCo repurchased the $1M of Class G shares that the taxpayer owned, this triggered a deemed dividend under 84(3) and was taxable to Pomerleau.

    When a deemed dividend occurs, the shares are considered to be sold for zero proceeds. Since there was ACB of $1M on those shares, this would be a capital loss.

    40(3.6)(a) deems the loss to be zero since Pomerleau was affiliated with HoldCo because he still owned the Class A shares.

    Since it would not be fair to pay tax on a dividend for something with ACB (meaning someone likely paid tax on it before), then the Act transfers this capital loss that has been denied to ACB of existing shares owned. In this case, the ACB then moved over to the Class A shares under 40(3.6)(b) and 53(1)(f.2).

    This increased the ACB from $1M to $2M.

    So far so good right?

    All that was left was to create a pipeline transaction, so Pomerleau transferred his Class A shares to a newly created corporation using Section 85 for new shares with $2M in ACB, PUC, and Fair Market Value.

    These shares were then repurchased and eventually paid out $2M to Pomerleau with no additional tax.

    So, how was the ACB cooked? Soft or Hard?

    According to the transactions, the ACB would be considered hard.

    Enter the Canada Revenue Agency (CRA) and the smell test (GAAR).

    In order for something to be considered abusive under the GAAR in section 245, there must be:

    1) A tax benefit

    2) An avoidance transaction, and

    3) A misuse or abuse of the Income Tax Act

    Pomerleau’s position (in sort-of-simple terms) = hard ACB and no misuse of the Act

    1) The stop-loss rules of 40(3.6) converted the cost basis from soft ACB to hard ACB.

    2) Section 85 allows for transfers to another corporation, and hard ACB can be used to create Paid Up Capital

    3) 84.1 only creates a dividend for shares that have been redeemed for more than their Paid Up Capital.

    4) Although there was a tax benefit, the motivation for the transactions was to assist in the transfer of the family business.

    5) No misuse of the Act occurred, rather, to the contrary, the Act operated as written.

    The Government’s position (in sort-of-simple terms) = GAAR (it stinks)

    1) Even though you followed the law, we don’t like it and so we think it shouldn’t be treated like this, so we’re going to apply GAAR under Section 245 because we think it smells funny.

    The Lower Court Ruling

    At the Tax Court of Canada, Justice Favreau concluded that the GAAR was applicable in this case since section 84.1 of the Act prevents taxpayers from undertaking surplus stripping transactions on a tax-free basis. In the TCC Justice’s opinion this is what Pomerleau had done in this case, because the series of transactions resulted in the avoidance of the purpose of section 84.1.

    More specifically, Justice Favreau opined that the effect of paragraph 40(3.6) of the Act permitted the taxpayer to increase the PUC of the shares in a subsequent rollover and therefore to avoid the application of section 84.1 of the Act.

    As a result, this planning had the effect of circumventing in an abusive manner the purpose of section 84.1 of the Act (i.e., to prevent surplus stripping on a tax-free basis).

    As a result, the Tax Court of Canada maintained the Minister’s initial assessment, as it determined that the GAAR applied to the series of transactions so that a taxable dividend of $994,628 had to be attributed to the taxpayer.

    The Federal Court of Appeal Decision

    In paragraph 78 of their unanimous ruling, the Federal Court of Appeal asked what is the purpose and spirit of section 84.1?

    Upon analysis, the court decided that the purpose and intent of this provision, is to prevent amounts that have not been taxed to a related person from being distributed tax-free.

    Even though the letter of the law was followed by Pomerleau, the court ruled against him in deciding that the intent and spirit of 84.1 was avoided, and so the GAAR under Section 245 applied.

    Since it was a unanimous ruling, the taxpayer is not able to appeal to the Supreme Court of Canada as a matter of “right” … so we will wait to see if Pomerleau attempts to apply for a “Leave to Appeal” and if he is granted.

    Translation: the smell test said the transactions stink like GAARbage.


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    Local Business

    High Performance Leaders Need Rest and Play

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  • It’s’ spring!

    With the change of season, it’s a great time to reflect on how you might want to adjust using your time and energy.

    How many of us have forgotten how to REST? How many of us have forgotten how to PLAY?

    I am guilty of not being aware of play or creating the rest I needed. I spent YEARS breathing way too fast, racing from task to task and event to event.

    I somehow believed that my worth was attached to what was accomplished. Leaving something undone was actually painful.

    Rest and play are not just important, they are critical.

    Researcher Stuart Brown says that the opposite of play isn’t actually work, it’s depression. Sadly, I know this all too well too.

    What happens to us when we don’t rest and play? Creativity suffers. Relationships suffer. Effectiveness suffers. Clarity and purpose suffer. Decision making ability suffers. Our overall capacity for resilience suffers.

    Can you relate?

    There is one simple metaphor that helps me choose when REST and PLAY are important: an elastic band.

    When we work so hard, give and parent, the elastic band is stretched with each new effort. Some elastics have far more “give” and can stretch great distances, much like each persons ability to work.
    Be careful to not let pride and ego take over here…. elastics have a breaking point. So do we.

    It’s impossible to know when an elastic has reached it’s breaking point. There are clues, but sometimes they surprise us.

    What clues are in your life? Are you paying attention to the clues? Have you already learned this lesson, but need to learn it again?

    Better than stretching an elastic to breaking point, is a the use of an elastic to stretch and release. Work and rest. Play.

    Referring back to the body of research by Dr. Stuart Brown, play is time spent without purpose; time spent when we can lose track of time and self consciousness.
    For me, that usually involves being in nature or in water…. and that is where I find hope, rest, creativity and a tonne of joy.

    Where do you feel like you lose track of time and self consciousness?

    That’s your zone.

    Find it and make sure you refuel.

    The purpose of an elastic is to stretch. For that it must contract.

    Work can be immensely satisfying. For that we must find rest.

    We cannot give something that we don’t have.

    What do you find restful? Where do you lose track of time?

    What resources do you have to employ a period of rest?

    Are your holidays restful and playful for you or are they a different form of work?

    Do you have any practices in place that allow you to shut off your phone?

    Give yourself what you need if you’re feeling stretched and ask yourself what is important. Get curious. Then breathe deep and make some choices.

    There may be hard choices at first. As you get better at playing and resting, you’ll become better at it.
    You’ll thank yourself.


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    Branded Content

    Todayville Top 5 features five facts about favourite fooderie… Earls

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  • Todayville Top 5 is a sponsored segment produced by Jock Mackenzie (learn more about Jock below).   In this feature we learn (you guessed it) 5 things about some really cool aspects of Red Deer that make this city, our home.

    If our very first segment, Jock features a staple in Red Deer’s dining scene since it opened in … well let’s leave that up to Jock.  Welcome to the Todayville Top 5 with Jock Mackenzie.

    Todayville Top 5 Featuring Earls Restaurant

    1 Heritage

    Earls in Red Deer was the seventh-ever Earls in existence. Bill and Rhonda Olafson purchased the franchise and opened the current restaurant in 1984. Chef at the time, Andrew Lam, is still involved. Over the years, additions to the west and north have been added as has the covered, heated patio. The patio is unparalleled by other outdoor dining facilities for comfort and its Hawaii-like greenery. Today there are over 70 Earls restaurants across Canada and the United States. The founder, Leroy Earl “Bus” Fuller, brought A & W to Canada and is also the founder of the Fuller’s and Corkscrew restaurant chains. 

    2 Community Support

    Giving back to the community is a cornerstone of the Earls Red Deer philosophy. Those in need come first: rebuilding the youth camp at Camp Alexo, the Youth and Volunteer Centre, support for the Women’s Shelter at their annual gala, title sponsorship for the last six years at Rotary’s Black Tie Bingo, a 5-year ongoing plan to support the new Child Advocacy Centre, wine and wine service at the preview dinner for the Festival of Trees since the Festival’s inception . . . and many more.

    3 People

    With over 80 people on staff, Earls has provided employment for high school and college students over its 35 year history. The Earls philosophy, the practical skill set, and menu knowledge make up the intensive training each support staff and server undergo. Consistency is a hallmark. Numerous staff members have made life careers at Earls–and that’s one reason why you can count on a great meal every time. 

    4 Menu

    Fresh ingredients are key! The kitchen deals with “just in time” orders so that produce and proteins (delivered three times per week) come fresh to each table. The menu is becoming more and more inclusive–it meets an ever-increasing variety of dietary needs: numerous gluten free and plant-based options are available.             

    5 Interesting tidbits

    Beer? Earls brews its own Rhino beers (pale ale, lager and a seasonal beer) in Surrey, BC at Central City Brewery. There are also local products from Troubled Monk, Blindman and Snake Lake as well as a wide variety of domestic beer.

    Four Earls “Test Kitchen” chefs travel the world looking for new ingredients and dishes. A “Test Kitchen” in Vancouver will roll out a new dish and tailor it to an appropriate market in the 70 locations across North America–the furthest away is Miami. 

    Want to know more?  Click to go to https://earls.ca/locations/red-deer 

     

    Todayville Top 5 features the freelance writings of Jock Mackenzie.

    Jock is an original Red Deerian!  Educated at Lindsay Thurber and Red Deer College (with a stint at the U of A), he became an educator himself, spending 31 years with the Red Deer Public school system.

    It’s safe to say Jock knows Red Deer about as well as anyone (OK.. maybe not Michael Dawe).   As a confirmed life-long learner, Jock never tires of getting to know his surroundings even better.  That’s where the Todayville Top 5 comes in.  In each feature, Jock shares a few ingredients that go into the mix that makes this delicacy called Red Deer the place we want to call home.  As a well organized person who knows you’re busy, he’s choosing just 5 juicy tidbits to share each time.

    If you’d like to be featured by Jock Mackenzie on the Todayville Top 5, just contact us at info@todayville.com.

     


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