The taxpayer, a paper products manufacturer, engaged in a hybrid transaction in which it sold some of the assets of its “Tissue Division” directly to a third-party purchaser (“Cascades”) and rolled the balance of them down to a Newco under s. 85(1) for Newco shares and sold the Newco shares to Cascades. CRA assessed on the basis that the sale of the Newco shares was on income account. The only issue before Graham J was whether s. 54.2 deemed the Newco shares to be capital property, which required that the drop-down transaction be considered to be the transfer of substantially all the assets of an active business.
Graham J found that "the test in section 54.2 is intended to be a somewhat flexible test but … there is no reason not to consider the fair market value of the assets when applying the test.” From the FMV perspective, the transferred assets represented about 68% of the assets of the Tissue Division – and perhaps significantly less, given that some of the Tissue Division assets had not been valued. He also was receptive to arguments that, given the flexibility of the test, he should also consider whether the dropped-down assets represented “the heart of the business of the Tissue Division,” but did not find any such indication on the evidence.
Accordingly, s. 54.2 did not apply, and it was unnecessary for him to go on to consider whether the Tissue Division was a separate business or merely a division of a larger business. However, Graham J stated (at para. 9):
[H]ad I had to decide this issue, the inconsistent filing positions taken by the Appellant would have hurt its case. The Appellant had a history of treating its operations as a single business when claiming capital cost allowance. The Appellant continued that single-business approach when determining the cost of the assets that were rolled into 722, yet treated the Tissue Division as a separate business when selling the common shares that the Appellant received from 722 on that rollover. I would have struggled with an outcome that gave the Appellant the benefit of single-business treatment for all of its prior tax years and for the first part of the sale transaction, yet gave it the benefit of separate-business treatment for the second half of that same transaction. Either the Tissue Division was a business or it was not. The Appellant should not have had it both ways.