AGGRESSIVE TAX PLANNING: Understanding the Limits

Neufeld Legal: Chris@NeufeldLegal.com - 403-400-4092 / 905-616-8864

Achieving increased tax efficiencies can lead Canadian taxpayers into taking ever-more aggressive tax planning strategies, with the level of "tax structuring" often having a direct correlation with the Canada Revenue Agency's posture towards a particular form of tax structuring. As such, it is important to understand that these tax strategies can not only result in the ire of the Canada Revenue Agency, but also significant penalties and interest, in addition to the loss of the intended tax benefit, if the Canada Revenue Agency is successful in challenging the legitimacy of the taxpayer's tax structuring, especially where the taxpayer failed to constrain their aggressive posture.

As such, tax structuring is all too often a matter of degree, where the taxpayer moves further into a grey area that is ever more susceptible to drawing the attention and opposition of the Canada Revenue Agency and the prospect of an adverse tax outcome. In turn, tax planning strategies entail significant complexity, require meticulous execution, and the underlying transactions must have sufficient non-tax, commercial purpose and economic substance, if they have any chance of withstand a challenge from the Canada Revenue Agency. Instead, when the tax structuring strays to far from the purposes of the Income Tax Act (Canada) and the principle of integration, that is when serious challenges tend to arise for taxpayers.

A. Estate and Succession Planning

Strategies that aim to transfer wealth, freeze the value of assets, and ultimately reduce the tax burden upon the death of the primary shareholder, continue to draw adverse scrutingy from the Canada Revenue Agency.

Estate Freeze: A transaction where a shareholder exchanges their common shares (which hold all future growth) for new fixed-value preferred shares. New common shares (with future growth) are then issued to beneficiaries (e.g., children or a trust). Area of Primary Scrutiny - Valuation: The area of greatest concern for the taxpayer is in ensuring the value of the preferred shares (the "frozen" amount) is the Fair Market Value (FMV) of the corporation at the time of the freeze.
Post-Mortem Pipeline (or Pipeline Planning): A strategy following the death of a corporate shareholder designed to avoid double taxation (capital gains on death + dividend tax on corporate payout). The estate transfers the shares to a new company in exchange for a note, which is then repaid using corporate surplus as a tax-free return of capital. Area of Primary Scrutiny - Timing and Substance: The CRA scrutinizes the time between the death and the corporate reorganization/note repayment. An overly rapid repayment (e.g., within 12-24 months) may be challenged under subsection 84(2) of the ITA as a deemed dividend.
Section 164(6) Loss Carryback Plan: An alternative to the post-mortem pipeline where the estate uses a capital loss realized on a share redemption (within its first tax year) to offset the deemed capital gain in the deceased's terminal return. Area of Primary Scrutiny - Economic Substance: The CRA may challenge structures lacking a genuine economic impact, viewing them as being undertaken solely to generate artificial losses.

B. Corporate Surplus Management

These strategies focus on extracting corporate retained earnings (surplus) from a company to its individual shareholder(s) as a capital gain (which is taxed at a lower rate) rather than as a fully taxable dividend.

Surplus Stripping: A general term for transactions designed to "strip" corporate surplus and convert it into a non-taxable return of capital or a capital gain, often to take advantage of lower capital gains tax rates or the Lifetime Capital Gains Exemption (LCGE). Area of Primary Scrutiny - Specific Anti-Avoidance Rules: The CRA actively applies sections 84.1 and 84(2) of the ITA to recharacterize certain payments as dividends. This area is highly litigious and subject to the GAAR.
Inter-Vivos Pipeline (Surplus Strip via reorganization): A variation of the pipeline plan used while the shareholder is still alive to extract corporate surplus as a capital gain. Area of Primary Scrutiny - General Anti-Avoidance Rule and Section 84(2): Highly scrutinized, as the underlying purpose is often viewed as solely tax-driven avoidance. The use of non-arm's length transactions often triggers specific anti-avoidance provisions.

C. Aggressive Loss Utilization

These strategies focus on acquiring and utilizing existing corporate tax losses or creating artificial losses to reduce current or future taxable income.

Acquisition of Control (AOC) Loss Utilization: Acquiring a corporation primarily for its non-capital loss carryforwards to shelter the acquiring company's future income. Area of Primary Scrutiny - Restrictions on Use: The ITA imposes strict rules on using pre-acquisition losses, limiting them to offset income from the same or similar business carried on by the acquired entity. Transactions designed merely to circumvent these rules are scrutinized under GAAR.
Artificial Loss Creation: Transactions structured to create a capital loss to offset a capital gain realized from another transaction, where the loss lacks true economic substance. Area of Primary Scrutiny - General Anti-Avoidance Rule: The CRA will apply GAAR to deny tax benefits where the loss is deemed artificial or created solely for tax purposes..

For knowledgeable and experienced tax law representation for transactional tax matters and tax planning, contact tax lawyer Christopher R. Neufeld at Chris@NeufeldLegal.com or call 403-400-4092 (Calgary, Alberta) / 905-616-8864 (Toronto, Ontario).

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