TaxMatters@EY - July 2013

GAAR not applicable to avoidance of “kiddie tax”

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Gwartz et al v The Queen, 2013 TCC 86

Jennifer Smith, Ottawa

In this recent case before the Tax Court of Canada (TCC), the court held that a series of transactions that converted corporate surplus into capital gains realized by minor beneficiaries — and therefore avoided the tax on split income under section 120.4 of the Income Tax Act (the Act), commonly known as the “kiddie tax” — did not constitute abusive tax avoidance under the general anti-avoidance rule (GAAR).

Section 120.4 has since been amended to cover capital gains, so the kind of planning in this case is no longer effective. However, this decision is worth a read because of its discussion of the pertinent principles — in particular, the effect of a subsequent amendment in determining the object, purpose and spirit of a particular provision.


The taxpayers were two discretionary beneficiaries of the Gwartz/Ludwig Family Trust (the trust) and were minors during the relevant taxation years. Their father, Dr. Mark Gwartz, was a dentist. Forest Hill Dental Management Inc. (FHDM) was a management corporation that acted for Dr. Gwartz’s dental practice. The trust held all the common shares and all the Class C preferred shares in FHDM.

A series of transactions was undertaken that had the effect of converting what would have otherwise have been dividends subject to the section 120.4 kiddie tax to capital gains in the hands of the trust.

First, FHDM issued stock dividends of 300,000 “high/low” Class D preferred shares to the trust. These shares had a total redemption amount of $300,000, but the addition to stated capital was limited by corporate resolution to $1 in total. These stock dividends had the effect of shifting value from the FHDM common shares to the newly issued Class D preferred shares.

In each taxation year from 2003 to 2005, the trust sold 75,000 of the Class D preferred shares to Dr. Gwartz in exchange for an interest-bearing promissory note of $75,000. The trust reported a $74,999.50 capital gain in each of those years and allocated those gains to the taxpayers. The taxpayers reported the gains and paid tax based on the appropriate marginal tax rate. At the relevant time, the section 120.4 kiddie tax on split income, which imposes tax at the highest marginal tax rate, applied to dividends received by minors, but not to capital gains.

Early in 2005, Dr. Gwartz sold all his 225,000 Class D preferred shares to a holding company owned by his spouse in return for an interest-bearing promissory note in the amount of $225,000.

On 1 February 2005, FHDM redeemed the Class D preferred shares held by the holding company for $225,000. In its tax return, the holding company reported a deemed dividend of $224,999 in respect of that redemption, and claimed an offsetting deduction under section 112 of the Act. The holding company used the proceeds from the redemption to extinguish its promissory note in favour of Dr. Gwartz, who then used the $225,000 to extinguish his promissory notes in favour of the trust.

The Minister reassessed the taxpayers in respect of their 2003, 2004 and 2005 taxation years, relying on the GAAR to recharacterize the capital gains as dividend income. This resulted in the tax on split income under section 120.4 of the Act applying to the recharacterized income.

The taxpayers appealed to the TCC. While they conceded the existence of a “tax benefit” and an “avoidance transaction,” and admitted that the transactions at issue reflected deliberate tax planning, they argued that there was no misuse or abuse for the GAAR purposes of subsection 245(4) of the Act.

Tax Court of Canada decision

Justice Robert Hogan allowed the taxpayer’s appeal. After restating the three-step framework for the application of the GAAR set out by the Supreme Court of Canada in Canada Trustco, he set out what he considered to be the relevant principles applicable to this case:

  • Tax planning is not per se abusive for the purposes of subsection 245(4). Taxpayers are permitted to choose a course of action that will minimize their tax liability (Canada Trustco, Copthorne).
  • Abusive tax avoidance cannot be found to exist if the taxpayer can only be said to have abused some broad policy that is not grounded in the provisions of the Act (Canada Trustco).
  • Where transactions do not otherwise conflict with the object, spirit and purpose of the provisions of the Act, it is inappropriate to apply the GAAR to deny a tax benefit resulting from a taxpayer’s reliance on a previously unnoticed legislative gap (Lehigh Cement).
  • Surplus stripping does not inherently constitute tax avoidance (Collins & Aikman, Copthorne, McMullen).
  • There is no broad policy in the Act against income splitting (Neuman).
  • A subsequent amendment to the Act that would have defeated a tax avoidance strategy challenged under the GAAR does not in itself indicate whether the strategy was abusive. The amendment must be considered along with all the relevant material to ascertain the object, spirit and purpose of the relevant provisions prior to their amendment.

Bearing these principles in mind, Justice Hogan went on to consider whether the series of transactions undertaken in this case defeated the object, spirit and purpose of section 120.4.

As mentioned, the rules in section 120.4 apply tax at the highest marginal tax rate to split income received by a person who is under the age of 18. At the relevant time, split income included:

  • Dividends from private companies
  • Income from a partnership or trust if such income is derived from providing property or services to, or in support of, a business carried on by a person related to the minor

As a result of the 2011 federal budget proposals, section 120.4 was amended to deem capital gains received by a minor to be ordinary (ineligible) dividends, and therefore subject to the tax on split income, applicable to dispositions after 21 March 2011.

Justice Hogan reviewed the wording of section 120.4 and found it to be notable for its brevity and simplicity, suggesting that Parliament was concerned with providing certainty to taxpayers with respect to its application. He also found that the context of section 120.4 indicated that it was intended to be a narrow and targeted provision. He gleaned this from both the Department of Finance technical notes that accompanied the introduction of section 120.4 and the numerous other provisions in the Act that deal with income splitting, many of which seek to remove its advantages, while a few, such as the RRSP rules, actually facilitate it.

Justice Hogan went on to consider the implication of the 2011 amendment to section 120.4, which extended it to capital gains. A review of the Department of Finance technical notes associated with the amendment did not suggest that Parliament was closing a loophole, but rather that the amendment was intended to broaden the scope of section 120.4.

Justice Hogan distinguished the decisions in Triad Gestco and 1207192, which relied upon the use of high-low shares to generate artificial capital losses. In his view, the capital gains that arose in the Gwartz case were real economic gains that could have been realized by a disposition by the trust of its common shares in FHDM prior to the declaration of the stock dividends. He hinted that the reason for the planning that was undertaken may have been, in part, to avoid the necessity of a valuation of the common shares.


Justice Hogan concluded that the transactions giving rise to the capital gains did not circumvent the application of section 120.4 in a manner that constituted abusive tax avoidance for the purposes of subsection 245(4), and allowed the taxpayers’ appeals.

The Crown did not appeal the decision.