When vendors of Canadian businesses sell shares, the expectation is generally that the sale will be treated as a capital gain for tax purposes with only one-half of any resulting gain subject to tax. The decision in Atlantic Packaging v. The Queen1 seems to challenge this general understanding, requiring shareholders to more carefully consider how they structure their sale transactions.
In the context of a sale transaction, it is not uncommon to transfer a target business into a new company prior to the sale. There is a variety of tax and non-tax reasons for such reorganizations, particularly where the target business is a division of a larger business in the same legal entity or a separate business housed within multiple legal entities with other operations. Once reorganized, the shares of the new company, which now owns the target business assets, are then sold to the purchaser. Generally, such a share sale is considered to be on capital account to the vendor(s) who may realize a capital gain or loss on the transaction, only half of which is included in computing taxable income. Where the share sale is on income account (for example, where the shares are considered inventory) the entire amount of the gain is included in taxable income.
In Atlantic Packaging v. The Queen, Atlantic engaged in a series of steps not dissimilar to those described above. Atlantic is a paper products manufacturer, which has various divisions as part of its overall business. As part of a sale of its “Tissue Division” to an arm’s length purchaser (“Cascades”), Atlantic engaged in a pre-sale reorganization whereby a portion of the assets of its Tissue Division were transferred to a newly incorporated subsidiary (“Newco”) in exchange for shares of Newco. The shares of Newco and the remaining assets of the Tissue Division not transferred to Newco were then sold to Cascades.
Atlantic treated the sale of the Newco shares on account of capital (i.e. realizing a capital gain). The Canada Revenue Agency (CRA) assessed the gain to be on income account. In court, Atlantic argued that section 54.2 of the Income Tax Act (“Act”) applied to deem the Newco shares sold to be capital property. Generally, section 54.2 will deem the shares of a corporation to be capital property where, among other criteria, a person transfers ‘all or substantially all’ of the assets of the business to the corporation. Section 54.2 is often relied upon when individuals, who operate as sole proprietorships, wish to incorporate their business prior to a sale to ensure the shares sold will be considered capital property. In Atlantic, the CRA assessed that the sale of the Newco shares was on income account and therefore denied capital gains treatment on the transaction. The CRA did not consider that the requirements under section 54.2 had been satisfied, in particular, that ”all or substantially all of the assets used in an active business” had been transferred to Newco. As Atlantic put forward no additional arguments, the issue before the court was whether or not the criteria for 54.2 had been satisfied.
Although other interpretations may be acceptable, ’all or substantially all‘ has generally been viewed to be more than 90 per cent of the fair market value of the assets of the business in this particular context. The court determined that Atlantic had transferred assets, which at most represented 68 per cent of the fair market value of all the assets of the Tissue Division . The court also considered that ‘all or substantially all’ could be viewed to mean that the ‘heart of the business’ had been transferred even if the value was less than 90 per cent. However, the court did not find such evidence to support this position either, when looking at the package of assets transferred to Newco. Accordingly, the court found that Section 54.2 did not apply in this instance.
The decision is interesting as historical cases such as Continental Bank2 upheld the general principle that a pre-sale reorganization similar to that completed by Atlantic should not effectively convert a gain that would otherwise be capital in nature (i.e. if the assets were sold directly) to a gain on income account, arguably without the need to rely on section 54.2. Further, historical jurisprudence and CRA guidance has provided that the sale of the shares would not be considered business income where the vendors had no expectation of economic profit or gain on the shares from the time they were acquired to the time they were sold. Nonetheless, with this decision business owners will need to exercise additional caution when undertaking a reorganization prior to sale to ensure capital treatment is retained.
It should be noted that Atlantic has appealed this decision to the Federal Court of Appeal.
This article is the second in a series of articles on tax considerations during mergers and acquisitions. To read about tax deductibility of transaction costs in M&A transactions, click here.
1 Atlantic Packaging Products Ltd. Atlantic Produits D'Emballage Ltée v. The Queen, 2018 CarswellNat 5212, 2018 TCC 183, 2018 D.T.C. 1133 (Tax Court of Canada [General Procedure])
2 Continental Bank of Canada et al. v. The Queen, 94 DTC 1858 (TCC)