FCA Confirms GAAR Applies To Limited Partner Capital Dividend Tax Plan

• Published date: 12 October 2020
• Subject Matter: Real Estate and Construction, Tax, Real Estate, Income Tax, Capital Gains Tax
• Law Firm: Borden Ladner Gervais LLP
• Author: Ms Siwei Chen and Dana O'Shea

On September 14, 2020, the Federal Court of Appeal (FCA) released its decision dismissing the taxpayer's appeal of the Tax Court of Canada (TCC) decision in Gladwin Realty Corporation v The Queen.¹ The FCA found that the General Anti-Avoidance Rule (GAAR) applied to deny the taxpayer the tax benefit obtained through a complex series of transactions.

What you need to know

• The FCA determined that the taxpayer defeated the rationale underlying the capital dividend account (CDA) regime through its use of the negative adjusted cost base (ACB) rules applicable to limited partnership interests (the Negative ACB Rules).
• The FCA found that the key reason the series of transactions constituted abusive tax avoidance under GAAR was because the taxpayer ceased operations immediately after the series of transactions. This decision left a negative CDA balance, and Gladwin would never have to forgo capital dividends on future additions to CDA as it resets to zero.
• The legislative provision calculating CDA was amended in 2013 to exclude the impact of the Negative ACB Rules, which the FCA found did not reflect new law. Rather, the Court found the amendments were consistent with an existing policy that the Negative ACB Rules have a neutral impact on the CDA balance.
• As a result of the FCA decision, Gladwin will have its CDA balance reduced by $12 million and will be assessed a penalty for having made a capital dividend election in excess of its CDA balance. Gladwin will then have the opportunity to make an election under subsection 184(3) of the Income Tax Act (the Tax Act) to treat the excessive capital dividend as a taxable dividend to avoid the penalty.

Summary of court decisions

Background and facts

Gladwin Realty Corporation Inc. (Gladwin) was a Canadian-controlled private corporation (CCPC) in the real estate business whose ultimate individual shareholders were members of the same family. In 2007 and 2008, Gladwin wanted to sell land and a building located in Ottawa (the Real Estate Assets), with an inherent gain of approximately $24 million.

Rather than selling the Real Estate Assets directly to a purchaser for a taxable capital gain of $12 million and an addition to CDA of $12 million, Gladwin undertook a complex series of transactions involving a limited partnership. The inclusion of the limited partnership allowed Gladwin to use the Negative ACB Rules in subsections 40(3.1) and 40(3.12) of the Tax Act to control Gladwin's CDA balance.

Essentially, the limited partnership triggered one capital gain on the sale of the Real Estate Assets, and Gladwin extracted the value from the sale from the limited partnership. This extraction caused the ACB of its partnership interest to become negative which triggered another capital gain under subsection 40(3.1).

Upon the partnership's allocation of the first capital gain to Gladwin, Gladwin could pay a $24 million capital dividend. Then Gladwin elected under subsection 40(3.12) to trigger a capital loss, which reduced Gladwin's CDA balance to -$12 million. In other words, Gladwin was able to pay out the entire $24 million capital gain from the sale of the Real Estate Assets as a tax-free capital dividend (instead of half). As part of its transaction steps, Gladwin emigrated to the British Virgin Islands (BVI) losing its CCPC status in order to avoid paying refundable tax on its capital gains. Both Gladwin and the limited partnership ceased operations immediately following this series of transactions.

Tax Court of Canada decision

In order for GAAR to apply, there must be:

• a tax benefit;
• avoidance transactions; and
• the avoidance transactions must be abusive.²

Gladwin conceded that the tax...