Mr. McClarty was an employee of Clifton Associates Ltd. and resigned in June 2001. In August 2001, he and three former employees formed Projectline Solutions Inc. (PSI), and managed to win contracts in the same industry as Clifton. Each of the four shareholders held the shares personally.
Throughout the period 2001 to 2006, Clifton threatened legal action against Mr. McClarty, so he sought some creditor proofing and protection. His accountant advised him to undertake certain transactions.
In October 2002, McClarty Professional Services Inc. (MPSI), a holding company, was incorporated and the McClarty Family Trust (the Trust) was formed. Mr. and Mrs. McClarty were the trustees of the Trust and, along with their three minor children, the beneficiaries.
Mr. McClarty held 100% of the Class A voting shares of MPSI and the Trust held 100% of the Class B non-voting shares. MPSI then subscribed for 31 Class A shares of PSI. The other three business partners held the remaining classes of shares of PSI personally.
On 30 September 2003, MPSI declared a stock dividend on its Class B shares held by the Trust. The stock dividend consisted of 48,000 Class E non-voting preferred shares (Class E preference shares) of MPSI with a paid-up capital (PUC) and adjusted cost base (ACB) of $1 in total and a redemption price of $1 per share. The Trust sold these Class E preference shares to Mr. McClarty for a $48,000 promissory note, resulting in a capital gain of almost $48,000, which was distributed to the three minor beneficiaries by way of promissory notes of approximately $16,000 each. This capital gain was reported in each of the minors’ tax returns.
On the same day, Mr. McClarty paid $48,000 to MPSI in repayment of previous shareholder loans. MPSI used this money to make a shareholder loan of $48,000 to the Trust. The Trust then loaned the $48,000 to Mr. McClarty as a trustee loan. Mr. McClarty then paid another $48,000 to MPSI in repayment of other shareholder loans. This circular flow of funds had the effect of increasing Mr. McClarty’s debt with the Trust, providing for increased creditor proofing.
On 17 December 2003, Mr. McClarty incorporated 101051392 Saskatchewan Ltd. (101 SK). He was the sole director and shareholder. The purpose of 101 SK was to capture future investments and facilitate the creditor protection scheme.
On 31 December 2003, Mr. McClarty sold the Class E preference shares to 101 SK in return for a $48,000 promissory note. On the same day, MPSI redeemed the Class E preference shares for $48,000. While 101 SK received a deemed dividend, no tax was payable, as the deemed dividend was received from a taxable Canadian corporation.
On the same day, 101 SK paid $48,000 to Mr. McClarty, who then repaid part of his debt to the Trust. The Trust paid the $48,000 to MPSI in satisfaction of the shareholder loan it had received. MPSI then paid the $48,000 to Mr. McClarty as repayment of another shareholder loan. At the end of December 2003, Mr. McClarty owed $48,000 to the Trust, and the Trust owed $16,000 to each of the minor beneficiaries.
The transactions in 2004 proceeded in a similar way as the 2003 transactions, with some minor changes in the shareholder loan amounts. At the end of December 2004, Mr. McClarty owed $104,400 to the Trust and the Trust owed $32,000 to each of the minor beneficiaries.
The Minister applied the GAAR, recharacterizing the $48,000 of capital gains each year in the Trust as dividends. The Minister also recharacterized the distributions to the minor beneficiaries as dividends instead of capital gains. The Minister’s concern was that Mr. McClarty was able to split income with his children despite the kiddie tax rules in section 120.4. At the time, because the transactions were structured to provide the children with capital gains instead of dividends, the kiddie tax did not apply.
Tax Court of Canada decision
TCC Justice François Angers used the GAAR framework by the Supreme Court of Canada in Canada Trustco as follows:
- Is there a tax benefit resulting from a transaction or series of transactions?
- Is the transaction an avoidance transaction, in that it was not reasonably undertaken or arranged primarily for a bona fide purpose other than to obtain a tax benefit?
- Was there abusive tax avoidance, in that the tax benefit was not reasonably consistent with the object, spirit or purpose of the provisions of the Act?
The taxpayers (i.e., the Trust and the three minor beneficiaries) conceded that there was a tax benefit resulting from the transactions.
Based on the evidence that indicated that Mr. McClarty was under threat of legal action by Clifton up to 2006, even though no legal action was ever commenced, Justice Angers found that the transactions at issue were undertaken primarily for creditor proofing. The stock dividend resulted in a shift of the value of the assets from MPSI to the Trust, which was consistent with creditor proofing.
Justice Angers found that while some creditor protection could have been achieved had a dividend been paid to the Trust and funds loaned to Mr. McClarty, it would have been less effective because of the higher tax rate on the dividend to the minor beneficiaries and would have resulted in fewer funds available.
The TCC determined that the entire series of transactions was triggered by the desire to protect the assets of MPSI in anticipation of the legal threat. The sale of shares by the Trust to Mr. McClarty and subsequent sales to 101 SK were found to have been done to lessen the tax consequences of the creditor-proofing plan and would never have been undertaken in the absence of the need to protect MPSI’s assets.
Justice Angers concluded that every single transaction constituting the series was made with a bona fide purpose other than to obtain the tax benefit, since the primary motivating element behind each transaction was protection of the assets.
Abusive tax avoidance
Since the judge found that there was no avoidance transaction, there was no need to determine whether there was abusive tax avoidance.
However, Justice Angers did indicate that there was definitely a gap left in section 120.4 of the Act that should be filled by Parliament and not by using the GAAR. Subsection 120.4(3) of the Act was added for transactions after 22 March 2011, to deem a capital gain to be a dividend obtained through a disposition of shares to a non-arm’s-length person.
The TCC looked at the issue of whether the transactions were undertaken for a bona fide purpose and found that the testimony and evidence supported the primary non-tax purpose: creditor proofing.
Instead of examining the purpose of each transaction individually, Justice Angers concluded that all the transactions had a bona fide purpose because of the primary motivating factor behind each. Further, there was no tax avoidance transaction despite the fact that an alternative transaction could have been undertaken that would have resulted in higher taxes.
The most interesting aspect of this case is that the amounts at issue are relatively small ($48,000 of capital gains per year). This may signal that the Minister is invoking the GAAR more frequently irrespective of how much is at stake.