Can the CRA challenge a reorganization done before a business sale?

Owners often restructure a company before selling it, for example by moving assets into a holding company. One aim might be to make the shares eligible for the capital gains deduction, which the CRA limits to qualified small business corporation shares and certain farm and fishing property. Each step can be valid alone, but the CRA can examine the whole sequence under section 245 of the Income Tax Act.

What the rule asks

GAAR has two gates. First, the transaction must be an avoidance transaction, meaning it would result in a tax benefit, alone or as part of a series, and it cannot reasonably be considered that obtaining that benefit was not one of its main purposes. A tax benefit includes reducing, avoiding or deferring tax. Second, the result must misuse a provision of the Act or abuse the Act read as a whole. The Act says the rule is not meant to stop taxpayers from obtaining benefits Parliament contemplated.

Why a pre-sale reorganization draws attention

A reorganization shortly before a sale is easy to describe as one link in a series that ends in a lower tax bill, and the Act lets a series be assessed together. A significant lack of economic substance is an important sign of misuse or abuse, and the listed factors include the taxpayer’s opportunity for gain and risk of loss remaining unchanged, for example through a circular flow of funds, offsetting financial positions or the timing between steps, and a purpose that is almost entirely the tax benefit.

What the CRA can do if GAAR applies

The Act lets the tax consequences be set as is reasonable to deny the benefit. That can mean disallowing a deduction, allocating an amount to another person, recharacterizing a payment, or ignoring the usual effect of other provisions. A penalty can apply when the rule is applied to a transaction that was not disclosed to the CRA under the reportable and notifiable transaction rules. A section 85 rollover, elected jointly on CRA form T2057, is a recognized tool, but it does not settle the GAAR question by itself.

Questions to settle before any step is taken

• Does each step have a business reason apart from the tax result, recorded when it was taken?
• Does the owner’s position really change, or does value simply move in a circle?
• Does the result fit the purpose of the provision being relied on?
• Must any step be reported to the CRA as a reportable transaction?