First TCC Loss-Trading Case Applying Deans Knight

On December 27, 2023, the Tax Court of Canada (“TCC”) released its decision for Madison Pacific Properties Inc. v. The King.[1] This is the first loss trading case in the TCC that applied the Supreme Court of Canada’s precedent-setting decision in Deans Knight Income Corp. v. Canada.[2] The TCC found that the use of non-voting shares abused subsection 111(4) of the Income Tax Act (“ITA”) and that the general anti-avoidance rule (“GAAR”) accordingly applied to deny the use of net capital losses.

Facts

The Appellant, Madison Pacific Properties Inc.[3] (“MPP”), was a publicly traded company engaged in the business of mining. As of December 31, 1997, MPP had accumulated $9,688,703 in non-capital losses and $72,718,480 in capital losses. Madison Venture Corporation (“Madison”) and Vanac Development Corp. (“Vanac”), two corporations that were initially at arm’s length with each other and with MPP, each held a portfolio of rental properties.

Through a series of transactions[4] described below, Madison and Vanac accessed MPP’s losses from its mining business to offset income from Madison and Vanac’s real estate businesses:

1. A syndicate – which included (i) Vanac, (ii) a wholly-owned subsidiary of Madison, and (iii) a corporation that was controlled directly or indirectly by the Chair of the Board of Directors of MPP and also owned 6.02% of the shares in MPP at the time – loaned $2.7 million to MPP.
2. MPP spun its mining business out to a subsidiary, 3396061 Canada Inc. (“New Mining Co.”).
3. MPP amended its share capital to create three new classes of shares: Class A Preferred shares, Class B voting shares, and Class C non-voting shares.
4. MPP’s existing shareholders exchanged their old common shares of MPP for Class A Preferred and Class B voting shares of MPP. The Class A Preferred shares were then further exchanged for common shares of New Mining Co.
5. New Mining Co. amalgamated with a subsidiary of a different public mining company, Imperial Metals Corporation, to form Amalco. MPP’s shareholders then exchanged their shares in Amalco for shares of Imperial Metals Corporation, allowing them to continue holding an interest in the mining business.
6. Amalco repaid the syndicate loan from the first step.
7. Madison and Vanac sold MPP various real estate assets in exchange for MPP assuming various liabilities and a mix of Class B voting and Class C non-voting shares of MPP. The Class B voting shares were priced the same as the Class C non-voting shares.
8. MPP was granted various options by Vanac to acquire properties from Vanac in the future.
9. Madison sold additional real estate to MPP in exchange for a mix of Class B voting and Class C non-voting shares. Madison also subscribed for additional Class C non-voting shares. As a result of these two transactions, Madison and Vanac held an equal number of Class B voting shares and Class C non-voting shares in MPP.  

As a result of the above series of transactions, Madison and Vanac each held 23.28% of the Class B voting shares and 50% of the Class C non-voting shares of MPP. Together, Madison and Vanac held only 46.56% of the voting shares of MPP despite owning 92.82% of the total equity of MPP.

MPP used non-capital loss carryforwards and net capital loss carryforwards from its mining activities to reduce its income and capital gains from its real estate business for several years. The Minister of National Revenue (“Minister”) denied the use of the net capital loss carryforwards in MPP’s 2009, 2011, and 2013 taxation years (“Disputed Tax Years”).

Tax Court Decision

The TCC found that the GAAR applied to deny the use of the net capital losses.

The long-standing criteria for the application of GAAR are:

1. there must have been a tax benefit arising from a transaction or series of transactions;
2. the transaction must have been an avoidance transaction; and
3. the avoidance transaction must be abusive.

 

1. Tax Benefit

While the Crown argued that MPP’s use of the losses in the Disputed Tax Years established a tax benefit, the TCC wrote that it was “not that simple”. While in some situations the existence of a tax benefit is obvious, the TCC remarked that this was one of the cases where the transactions that took place would need to be compared to “an alternative series of transactions that would have been carried out but for the desire to obtain the tax benefit”.[5]

The TCC agreed with MPP that the alternative arrangement to which the transactions needed to be compared was where only Class B voting shares had been issued (rather than a mix of Class B voting and Class C non-voting shares). In such an alternative arrangement, MPP argued that Madison and Vanac would each have only owned 46.41% of the voting shares, such that neither of them would have acquired de jure control, and so subsections 111(4) and (5) would not have applied.

However, the TCC concluded that Madison and Vanac constituted a “group of persons”, and accordingly their combined 92.82% of the voting shares (in that alternative arrangement) would have resulted in an acquisition of control such that the losses would not have been preserved. Therefore, the creation and use of the Class C non-voting shares resulted in a tax benefit.

In drawing this conclusion, the TCC analyzed several factors that supported the fact that Madison and Vanac acted in concert.

Madison and Vanac were not simply two groups of shareholders who happened to own shares of MPP but had a pre-existing business relationship (including operating numerous properties as joint ventures) and acted in concert with a common business goal to execute a sophisticated series of transactions. In particular:

1. Madison and Vanac made an uneconomic choice to lend money to an insolvent corporation,
2. Madison and Vanac chose to receive Class C non-voting shares even though they were the same price as the Class B voting shares,
3. Vanac relied entirely on Madison’s legal counsel to effect the transactions, and
4. Madison subscribed for additional Class C non-voting shares at well above market price so that their contribution to MPP was equal to Vanac’s.

The TCC additionally found that Madison and Vanac continued acting in concert after the series of transactions to ensure that they ran MPP without ever acquiring de jure control of MPP. Several factors led to this finding, including that MPP’s Board of Directors consisted of people put forward by, and loyal to, Madison and Vanac.

2. Avoidance Transaction

MPP conceded that, if Madison and Vanac were found to be a group of persons, then the creation and use of Class C non-voting shares would have been avoidance transactions. The TCC viewed this as a logical and appropriate concession and concluded that there “is no doubt” that these were avoidance transactions as their sole purpose was to preserve the losses.

3. Abuse

The TCC began its abuse analysis with the Deans Knight decision that held that the object, spirit, and purpose (“OSP”) of subsection 111(5) is to prevent a corporation from being acquired by unrelated parties in order to deduct its unused losses against income from another business for the benefit of new shareholders.[6] The parties in Madison Pacific Properties agreed that the OSP of subsection 111(4) is “somewhat narrower” than the OSP of subsection 111(5), which was at issue in Deans Knight, because subsection 111(5) permits the deduction of losses if the taxpayer continues to carry on the same or similar business, while subsection 111(4) does not. The TCC concluded therefore that the narrower OSP of subsection 111(4) is “to prevent a corporation from being acquired by unrelated parties in order to deduct its unused net capital losses against new capital gains for the benefit of its new shareholders.”[7]

While Deans Knight confirms that the abuse analysis is comparative, and the result of the transactions needs to be compared against the rationale of the provision in question, the TCC noted that having facts similar to the series of transactions in Deans Knight is not the only way that loss trading can be abusive. Specifically, the TCC did not accept that agreements such as the investment agreement in Deans Knight are key to determining whether there has been an abuse of subsection 111(4). In any event, the TCC concluded that the syndicate loan ensured that the Madison-Vanac group controlled the series of transactions, choosing MPP’s new share structure, who the new directors would be, what new assets MPP would buy and what shares they would receive in consideration, and whether they would have de jure control. The TCC accepted that Matco had a higher level of control than the Madison-Vanac group, and also that Deans Knight did not simply replace the “effective control” or “actual control” tests with a “functional equivalence test that must be met for there to have been abuse. Nonetheless, in Deans Knight, this was a factor showing how subsection 111(5) had been abused, and the TCC took a similar approach in Madison Pacific Properties.[8]

The TCC concluded that the series of transactions fundamentally transformed MPP. Several findings of fact led to this conclusion, including that Madison and Vanac caused MPP to become an empty corporate shell with only unused losses, changed the share structure and business of MPP completely, and fundamentally changed the shareholders. Control also shifted significantly as Madison and Vanac controlled MPP without acquiring de jure control. Madison and Vanac, as a group of persons, held 46.56% of the Class B voting shares at the end of the series of transactions; however, including other shareholders that were loyal to Madison and Vanac, increased this ownership to 51.27% of the Class B voting shares of MPP. In addition, the Class C non-voting shares held by Madison and Vanac had a coattail provision that allowed them to convert those shares into Class B voting shares of MPP in the event of a hostile takeover.

Conclusion

Having concluded that GAAR applied, the TCC denied the deduction of the net capital losses claimed by MPP for the Disputed Tax Years. MPP is liable for additional taxes, estimated interest, and legal costs totaling approximately $6.2 million. This decision is presently under appeal to the Federal Court of Appeal.

The Madison Pacific Properties decision illustrates the impact that Deans Knight has on loss trading cases and showcases that, unsurprisingly, the series of transactions does not have to be identical to that in Deans Knight in order for GAAR to apply. The TCC’s decision may also provide guidance in considering the type of factors that support a finding that two non-arm’s length parties are a “group of persons” for the purposes of the acquisition of control provisions in the ITA.

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