Will CRA invoke GAAR where paid up capital (“PUC”) is reduced in the following examples to nil in order to avoid a potential s. 88(1)(b) gain on a wind up?
Example 1
Subco was formed by Xco with an injection of capital of $1,000 (being the PUC of Subco’s shares). Parentco acquired Subco for $1. On the winding-up of Subco into Parentco, Subco had assets with a cost amount of $1,000, and no liabilities or retained earnings (nor were retained earnings realized by it after its acquisition by Parentco).
Example 2
Subco was formed by Xco with an injection of capital of $1,000 (being the PUC of Subco’s shares), and Subco realized a non-capital loss of $1,000 before Parentco acquired it for $1. Subco then realized income of $1,000 (reflected on the cost amount of its assets) that was sheltered, so that on a cumulative basis it had no retained earnings. Subco was then wound-up into Parentco. At that time, it had assets with a cost amount of $1,000 and no liabilities or retained earnings.
Example 3
Parentco owned all Subco shares which have a PUC and ACB of $1,000. Subco used $2,000 borrowed from a third party to acquire assets with a cost amount of $3,000 – which subsequently lost all their value. Parentco claimed a s. 50(1) loss $1,000 (thereby reducing the shares’ ACB to nil) prior to winding up Subco and assuming Subco's debt.
Before commenting specifically, CRA noted that if the shares of the subsidiary instead were redeemed, the excess of the redemption proceeds over the ACB of the shares would produce a capital gain if the PUC of the shares exceeded the redemption proceeds.
Example 1
CRA indicated that since the cost amount of the assets of Subco was not increased by income earned or realized by Subco after its acquisition of control by Parentco, this indicated that Parentco has made a bargain purchase in the form of the tax attributes in the assets of Subco, so that the scheme of s. 88(1)(b) dictated that a gain be realized by Parentco on the winding up of Subco in the amount of $999. Thus, CRA would apply GAAR to a reduction of PUC without payment prior to the winding up of Subco.
Example 2
Here, the increase in the cost amount of Subco’s assets of Subco resulted from income realized after Subo’s acquisition by Parentco. Even though the income was sheltered by the loss, Parentco did not realize a bargain purchase in the tax attributes of Subco’s assets If the corporate law permitted, all of Subco’s assets could have been paid to Parentco as a safe income dividend. GAAR would not be applied to a PUC reduction.
Example 3
The net cost amount of the assets of Subco is $1000, and consequently Parentco should realize a capital gain of $1000 on the winding up of Subco, under s. 88(1)(b). Parentco would essentially have taken two deductions for the same loss of $1000 – first the $1000 loss on the Subco shares under 50(1), and an additional loss of $1000 on the assets of Subco.