The taxpayer's shareholders circumvented the rule in s. 87(3), which required that the paid-up capital ("PUC") of a subsidiary corporation disappear on a vertical amalgamation, by arranging for the subsidiary corporation in question ("VHHC Holdings" - whose shares had a high PUC but a low value) to be first distributed to the non-resident parent of the parent of VHHC Holdings ("Copthorne I") before Copthorne I and VHHC Holdings were amalgamated horizontally to continue as a predecessor of the taxpayer. The taxpayer subsequently took advantage of the PUC which had been preserved by these transactions by making a substantial distribution of PUC to its non-resident parent.
The Court found that this preservation of PUC gave rise to a tax benefit. As per Trustco, a tax benefit can be established by comparing the taxpayer's situation with an alternative arrangement that would be reasonable but for the alleged tax benefit. Rothstein J. stated (at paras. 36-38):
As found in Trustco, the existence of a tax benefit can be established by comparison of the taxpayer’s situation with an alternative arrangement (para. 20). If a comparison approach is used, the alternative arrangement must be one that “might reasonably have been carried out but for the existence of the tax benefit” (D. G. Duff, et al., Canadian Income Tax Law (3rd ed. 2009), at p. 187). By considering what a corporation would have done if it did not stand to gain from the tax benefit, this test attempts to isolate the effect of the tax benefit from the non-tax purpose of the taxpayer.
Copthorne argues that an amalgamation while VHHC Holdings was owned by Copthorne I - a vertical amalgamation - "was never a live and reasonable option" and thus the Minister should not have used such a comparison. ... Copthorne says that a taxpayer would never have chosen this higher tax option, and thus that such option was unreasonable.
... As the Tax Court judge pointed out, the vertical amalgamation would have been the simpler course of action. It was only the cancellation of PUC that would arise upon a vertical amalgamation that led to the sale by Copthorne I of its shares in VHHC Holdings to Big City. To use the words of Professor Duff, "but for" the difference in how PUC was treated, a vertical amalgamation was reasonable.
The comparison was entirely appropriate. Copthorne has not satisfied its onus of showing that there was no tax benefit.