Proposed Amendments to Subsection 85.1(4)

Proposed legislation, released on August 9, 2022, seeks to expand the scope of subsection 85.1(4)—an anti-avoidance rule relating to transfers of FA shares under subsection 85.1(3)—in order to address certain perceived gaps in the existing legislation. Parallel amendments are also proposed for the similar anti-avoidance rule in subsection 87(8.3), which applies to so-called triangular foreign mergers. The discussion below focuses only on subsection 85.1(4).

In general, subsection 85.1(3) allows a taxpayer to transfer, on a rollover basis, shares of a first-tier FA of the taxpayer (“the first affiliate”) to another corporation that is, immediately following the transfer, an FA of the taxpayer (“the second affiliate”), provided that the consideration received by the taxpayer includes shares of the second affiliate. It is a commonly used provision that facilitates tax-deferred reorganizations of directly held FAs.

Without an appropriate safeguard, the provision could be used in unintended ways. For example, the capital gain that would otherwise be realized on the outright sale of a directly held FA could be deferred by the initial transfer of the shares of the first affiliate, on a rollover basis, to a second affiliate, which would then sell the shares of the first affiliate to a subsequent acquiror. Provided that the shares of the first affiliate are excluded property, the capital gain realized by the second affiliate could be deferred offshore as hybrid surplus until the proceeds are repatriated to Canada. Subsection 85.1(4) addresses this concern by denying rollover treatment under subsection 85.1(3) in situations where all or substantially all of the property of the first affiliate is excluded property at the time of the initial transfer and the transfer is part of a series of transactions undertaken for the purpose of selling the first affiliate to a subsequent acquiror who is dealing at arm’s length with the taxpayer, with a limited exception for subsequent acquirors that are FAs of the taxpayer in which the taxpayer has a qualifying interest.

Given that subsection 85.1(4) has generally been viewed as an adequate safeguard, it is somewhat surprising that the draft technical amendments include a proposal to expand the scope of the provision. The key changes are discussed below.

Purpose Test

The existing language in subsection 85.1(4) requires the initial transfer to be part of a series of transactions undertaken for the purpose of selling the shares of the first affiliate to a subsequent acquiror. The proposed amendments eliminate the purpose test and simply require the initial transfer to be part of a series of transactions that includes another disposition of the shares of the first affiliate or certain other properties that derive a portion of their value from the shares of the first affiliate. The elimination of the purpose test is potentially significant, given the possible breadth of what can constitute a series of transactions, and the uncertainty that this can produce for taxpayers. This is especially so because of the expanded scope of subsequent acquirors and subsequent dispositions under the proposed amendments, as discussed below. At a minimum, the new wording places a significant burden on taxpayers to carefully consider the meaning of the term “series” as established under common law and expanded by subsection 248(10). In this context, some limited comfort may be gleaned from the jurisprudence, which clarifies that for two events to be part of the same series, one needs to be undertaken “because of” or “in relation to” another, and the connection between the events needs to be closer than an extreme degree of remoteness or a mere possibility (see, for example, OSFC Holdings Ltd. v. The Queen, 2001 FCA 260 and Copthorne Holdings Ltd. v. Canada, 2011 SCC 63). Nevertheless, reliance on such positions is at best unappealing, given that it requires taxpayers to prove a negative when defending against assertions made by tax authorities who undertake audits with the benefit of hindsight.

Subsequent Acquirors

Currently, rollover treatment is denied only where the subsequent acquiror is an arm’s-length person, other than an FA of the taxpayer in which the taxpayer has a qualifying interest. Under the proposed amendments, rollover treatment is denied where the subsequent acquiror is either an arm’s-length person or a non-arm’s-length non-resident person, other than a controlled FA of the taxpayer (within the narrower meaning in section 17, which requires the FA to be controlled by the taxpayer and other non-arm’s-length Canadian residents).

Expanding the scope of subsequent acquirors to include non-arm’s-length non-resident persons is presumably intended to address a concern that subsection 85.1(3) could be used as a means of moving a directly held FA out from under Canada on a tax-deferred basis. To illustrate, assume that a non-resident corporation (NRco) owns all of the shares of a Canadian corporation (Canco), which in turn owns all of the shares of two FAs (FA1 and FA2), and assume, furthermore, that there is a desire to transfer the shares of FA1 from Canco to NRco. Under current law, if Canco were to transfer the shares of FA1 to FA2 for additional shares of FA2, and FA2 were then to sell the shares of FA1 to NRco, subsection 85.1(4) would have no application, because the subsequent acquiror (NRco) is not an arm’s-length person. Under the proposed amendments, the initial transfer would be within the scope of subsection 85.1(4) because the subsequent acquiror (NRco) is a non-arm’s-length non-resident person.

Similarly, narrowing the carve-out for subsequent FA acquirors so as to include only FAs that are controlled by the taxpayer and other non-arm’s-length Canadian residents, as opposed to FAs in which the taxpayer has a qualifying interest (generally 10 percent ownership of the affiliate based on votes and value), is intended to limit the opportunity to transfer a directly held FA out from under Canada. However, abandoning a “votes and value” test in favour of a test of voting control may open up opportunities to transfer the economics associated with the ownership of an FA out from under Canada, if not to establish de jure control—a result that is presumably unintended.

Subsequent Dispositions

Under existing law, subsection 85.1(4) applies in situations where a share of the first affiliate that is transferred to the second affiliate is disposed of on a subsequent disposition. Under the proposed amendments, this application is expanded to include situations where certain other property is disposed of on a subsequent disposition. The types of property that fall within the scope of this amendment include any property that is substituted for the share of the first affiliate, as well as any other property any of the FMV of which is derived, directly or indirectly, from the share of the first affiliate. The purpose of these changes is to prevent a taxpayer from avoiding subsection 85.1(4) by structuring the subsequent disposition as an indirect disposition of the shares of the first affiliate—for instance, by transferring the shares of the first affiliate to a second affiliate, which, in turn, transfers the shares of the first affiliate to a third affiliate, after which the second affiliate sells the shares of the third affiliate to a subsequent acquiror. Conceptually, this makes sense. However, the drafting of the “indirect” concept is extremely broad. For instance, it seems that the transfer of a first affiliate from a Canadian corporation to a second affiliate followed by an outright sale of the second affiliate by the Canadian corporation is caught by the proposed amendments, even though the subsequent disposition in this case is taxable in Canada without any opportunity for deferral. Similarly, it appears that the transfer of a first affiliate from a Canadian corporation to a second affiliate, followed by an outright sale of the Canadian corporation by its shareholder(s), is caught by the amendments, because the FMV of the shares of the Canadian corporation is derived, in part, from the underlying shares of the first affiliate. Presumably this is unintended; it would seem appropriate to consider only subsequent dispositions by FAs of the taxpayer.

Furthermore, it seems that the broad drafting of the “indirect” concept could lead to other inappropriate results. For instance, in the example above, if all of the shares of the first affiliate are transferred to the second affiliate for 100 shares of the second affiliate, and then to the third affiliate for 100 shares of the third affiliate, after which a single share of the second affiliate is sold to a subsequent acquiror, it would seem that rollover treatment is denied for all of the shares of the first affiliate because the single share of the second affiliate that is disposed of to the subsequent acquiror derives a portion of its FMV from each underlying share of the first affiliate. This is an unexpected result, because it would seem appropriate to deny rollover treatment only on a proportionate basis.

Once again, the expanded wording requires taxpayers to place greater reliance on the position that subsequent dispositions are not part of the same series.

Excluded Property

As noted above, subsection 85.1(4) is aimed at preventing the inappropriate deferral of tax in respect of gains on the shares of an FA that qualify as excluded property at the time of their subsequent disposition by another FA. Under current law, excluded property status is tested, indirectly, by considering whether all or substantially all of the property of the first affiliate is excluded property at the time of the initial transfer. Under the proposed amendments, excluded property status is considered to exist if either of the following two tests is met: (1) all or substantially all of the property of the first affiliate is excluded property at the time of the initial transfer, or (2) the shares of the first affiliate are excluded property at the time of the subsequent disposition. The addition of the second test addresses a concern that a first affiliate with property that includes non-excluded property could be transferred to a second affiliate, purified, and then sold to a subsequent acquiror at a time when the shares of the first affiliate qualify as excluded property. At the same time, there could be situations where all or substantially all of the property of the first affiliate is excluded property at the time of the initial transfer, but the shares of the first affiliate, or any other shares that derive their value from those shares, are not excluded property at the time of the subsequent disposition. In such cases, the initial transfer would be denied rollover treatment even though the subsequent disposition gives rise to FAPI. Given that the relevant test for deferral is whether the shares of the first affiliate are excluded property at the time of the subsequent disposition, it is not clear why the test at the time of initial transfer was retained along with the new test at the time of the subsequent disposition, rather than the initial test simply being replaced with the new test, which appears to be the more relevant and appropriate one.

Conclusion

While there are valid concerns underlying the proposed amendments to subsection 85.1(4), the drafting of the proposed amendments introduces a number of potential issues and pitfalls of which taxpayers need to be aware. We hope that some of these issues will be addressed before the proposed amendments are passed into law.

David Bunn
Deloitte LLP, Toronto

Mark Dumalski
Deloitte LLP, Ottawa