Mr. A is the sole shareholder of Aco, which generates an annual profit from its operations of more than $100,000. His Aco shares have a significant fair market value and nominal paid-up capital and adjusted cost base.
In a given year, A transfers a portion of his shares of Aco, having a FMV of $100,000, to Aco in consideration for preferred shares of Aco having a redemption amount of $100,000 and a nominal PUC. As s. 84(5) applies, there is no deemed dividend and A realizes a capital gain of $100,000.
In the same year, A transfers his $100,000 preferred shares of Aco to a Newco formed by him (Bco) in consideration for a demand promissory note of $100,000. As his preferred shares had an ACB for purposes of s. 84.1(2)(a.1) of $100,000, no deemed dividend arises. Aco then redeems the $100,000 of preferred shares (giving rise to a deemed dividend to Bco of that amount – which is not subject to s. 55(2) as Bco had full ACB in those shares), and BCo uses the redemption proceeds to discharge the note owing to A.
CRA stated (TaxInterpretations translation):
The goal of the series of transactions which you presented to us was to convert an annual dividend, which otherwise would have been paid by your corporation, into a taxable capital gain, by the annual conversion, in a taxable transaction, of participating shares in your corporation into preferred shares and the transfer of such preferred shares to a holding company controlled by you….[This] series of transactions constitutes a mechanism for the stripping of surplus of your corporation so that all the conditions for the application of the GAAR are satisfied.