A caution to Canadian tax planners: Eyeball Networks Inc. v The Queen
A Butterfly reorganization might trigger derivative tax liability
TORONTO – A butterfly reorganization is a method of splitting a corporation — and thereby its assets — into two or more separate corporations. This is often the case when the shareholders wish to go their separate ways and divvy up the assets of the corporation accordingly.
A butterfly reorganization allows the shareholders to divide the corporation into two or more components on a tax-deferred basis under section 85 of the Income Tax Act while avoiding the deemed capital gain that might otherwise arise under the subsection 55(2), an anti-avoidance rule aimed at preventing capital-gains stripping. (A capital-gains strip is a transaction that's structured to convert what would otherwise be a taxable capital gain into a tax-free intercorporate dividend. Subsection 55(2) pre-empts such a transaction by triggering a capital gain. A butterfly reorganization, however, is exempt from subsection 55(2) under subsection 55(3).)
While numerous variations of the butterfly exist, they all revolve around the same underlying technique: the target corporation divests its assets to one or more new corporations on a tax-deferred basis under section 85. In return, the target corporation receives redeemable shares that have a low paid-up capital and high redemption value. The redemption of the shares results in a non-taxable intercorporate dividend. As a result, the target corporation avoids the capital gain that it would have realized had it divested its assets directly to the individual shareholders.
Section 160 of the Income Tax Act is a tax collection tool. It thwarts a taxpayer who attempts to hide assets from a Canada Revenue Agency tax collector by transferring them to a non-arm's-length party. Basically, if you receive assets or cash from a related party — e.g., a spouse, a child, a business partner, or a trust or corporation in which you have an interest — that has outstanding tax debts, section 160 allows the CRA's tax collectors to pursue you for that person's tax debt. (Your liability, however, is capped at the fair market value of the transferred asset, and it is reduced by the value of what you paid in consideration for that asset. We detail the mechanics of section 160 in the following section.)
In Eyeball Networks Inc. v The Queen (2019 TCC 150), the Tax Court of Canada rendered a controversial decision, holding that section 160 applied to a setoff transaction occurring in the context of a butterfly reorganization. As a result, a corporate taxpayer inherited the income-tax debts of the soon inoperative corporation from which it purchased assets. Even more striking: the parties were unaware of these tax debts because the Canada Revenue Agency hadn't reassessed the defunct corporation until after the reorganization.
After discussing section 160 of the Income Tax Act, this article examines the Tax Court's Eyeball Networks decision.
Section 160 of Canada's Income Tax Act
Section 160 of Canada's Income Tax Act is a tax collection tool. It aims to thwart taxpayers who try to keep assets away from Canada Revenue Agency tax collectors by transferring those assets to friends or relatives.
Section 160 is a harsh rule: It offers no due-diligence defence, it applies even if the transfer wasn't motivated by tax avoidance, and it catches transferees who don't even realize that they're receiving property from a tax debtor (e.g., see: Canada v Heavyside, 1996 CanLII 3932 (FCA), at para 3). In addition, section 160 doesn't contain a limitation period. So, the Canada Revenue Agency can assess you under the rule years after the purported transfer.
Section 160 applies if:
1) A property was transferred;
2) At the time of the transfer, the transferor owed a tax debt to the Canada Revenue Agency;
3) The recipient was, at the time of the transfer, either:
- the transferor's spouse or common-law partner (or a person who has since become the transferor's spouse or common-law partner);
- a person who was under 18 years of age; or
- a person with whom the transferor was not dealing at arm's length—e.g., a trust or corporation in which the transferor has an interest; and
4) The recipient paid the transferor less than fair market value for the transferred property.
When section 160 applies, the transferor and the recipient both become "jointly and severally" liable for the transferor's tax debt. In particular, the recipient becomes independently liable for the transferor's tax debt at the time of the transfer. This means that the Canada Revenue Agency (CRA) can now pursue both the original tax debtor and the recipient for the tax debt. In fact, even if the original tax debtor is later discharged from bankruptcy and thus released from the underlying tax debt, the recipient remains liable to the CRA (e.g.: Canada v Heavyside, ibid.)
The recipient's liability under section 160 is capped, however, at the fair market value of the transferred property. Moreover, the recipient's liability is reduced by the amount of any consideration that the recipient provided for the property. For example, a tax debtor owns a home (with no mortgage) worth $500,000 and owes $1 million to the CRA. If the tax debtor gifts the home to her son, the son's liability under section 160 is $500,000 — i.e., the value of the home. If, on the other hand, the son purchased the home from the tax debtor for $250,000, the son's liability under section 160 is $250,000 — i.e., the value of the home minus the purchase price.
Finally, subsection 160(3) governs how payments apply to discharge the joint liability. A payment by a taxpayer who has inherited liability under section 160 shall reduce both debts — that is, this payment reduces not only the tax debt of the jointly liable taxpayer but also the tax debt of the original tax debtor. But an ordering rule governs a payment by the original tax debtor. The original tax debtor must first pay off all tax debts exceeding the joint debt.
For example, say the original tax debtor owes $1 million, and the joint debtor became jointly liable for $500,000 under section 160.
- If the joint debtor pays off the full $500,000 joint debt, then he extinguishes his liability under section 160, and the original tax debtor's liability is reduced by $500,000.
- If the original tax debtor pays $500,000 toward her tax debt, then she reduces her amount owing by $500,000, but the joint debtor's liability remains unchanged at $500,000.
- If, however, the original tax debtor had paid $750,000 toward her tax debt, then she would reduce her amount owing by $750,000 to $250,000, and the joint debtor's liability would be reduced by $250,000 to $250,000.
In other words, before her tax payments discharge the joint debt, the original tax debtor must first pay off all tax arrears that are solely her own.
Eyeball Networks Inc v The Queen, 2019 TCC 150
Mr. Piche solely owned and operated OldCo, a corporation that developed online-gaming software. He decided that the business's assets would be better served developing video-conferencing technology. Because OldCo associated with the online-gaming industry, which Mr. Piche felt might discourage prospective customers, he decided to create a separate company to operate the new business — hence, Eyeball Networks Inc.
Eyeball, OldCo, and Mr. Piche entered a series of transactions to transfer the business assets from OldCo to Eyeball by means of a tax-deferred rollover under section 85 of the Income Tax Act. The butterfly reorganization unfolded as follows:
- At the outset, Mr. Piche owned common shares in OldCo. At the time, OldCo's net assets were worth $30 million, which consisted of (i) business assets altogether worth $30,175,000 and (ii) commercial liabilities of $175,000. The value of Mr. Piche's OldCo common shares was therefore $30 million.
- Mr. Piche then sold these common shares back to OldCo. In consideration, OldCo issued to Mr. Piche (i) new common shares and (ii) redeemable shares with a redemption amount of $30 million. (A redeemable share is one that the issuing corporation may at any time repurchase for cancellation. The purchase price is the redemption amount, which is payable to the shareholder.)
- By means of a section 85 rollover, Mr. Piche then sold to Eyeball Networks his redeemable shares in OldCo and, in exchange, received shares in Eyeball Networks.
- By means of another section 85 rollover, OldCo sold all its business assets to Eyeball Networks. Eyeball Networks paid the purchase price by (i) assuming OldCo's $175,000 in commercial debts and (ii) issuing to OldCo redeemable shares in Eyeball with a redemption amount of $30 million. Moreover, this asset-purchase agreement included a price-adjustment clause whereby the parties would adjust their consideration should the Canada Revenue Agency dispute the valuation of any transferred asset. (After this transaction, each corporation now owned redeemable shares in the other corporation with a redemption amount of $30 million.)
- Each corporation then redeemed its redeemable shares and issued the other corporation a demand promissory note in the amount of $30 million. That is, OldCo redeemed the OldCo shares held by Eyeball Networks, and Eyeball Networks redeemed the Eyeball shares held by OldCo. As a result, Eyeball Networks received a $30 million promissory note from OldCo, and OldCo received a $30 million promissory note from Eyeball Networks.
- Finally, OldCo and Eyeball Networks agreed to setoff each note against the other, and thereby cancel both promissory notes.
After the reorganization, OldCo effectively ceased operations, and Eyeball Networks carried on business as a developer of video-conferencing technology.
About a year after the reorganization, the Canada Revenue Agency reassessed OldCo for about $14,000. And a about a year after that, the CRA reassessed OldCo yet again for about $113,000. The reassessed amounts related to tax years preceding the reorganization, and, before OldCo was reassessed, Mr. Piche had no indication that OldCo had any outstanding tax liability.
When OldCo failed to satisfy its tax liability, the Canada Revenue Agency assessed Eyeball Networks for OldCo's tax debt under section 160 of the Income Tax Act. The CRA based Eyeball's section 160 assessment on the butterfly reorganization, which by now had taken place about 12 years prior.
Eyeball Networks disputed the section 160 assessment by appealing to the Tax Court of Canada. Eyeball Networks conceded that OldCo had unsatisfied tax debts, and that OldCo had transferred property to Eyeball Networks during the butterfly reorganization—namely, OldCo transferred its business assets to Eyeball Networks. But, Eyeball argued, it had provided consideration by issuing its shares to OldCo, and those Eyeball shares had a value equal to that of the property Eyeball received from OldCo. In addition, even if the estimated value of the property were incorrect, the price-adjustment clause in the asset-transfer agreement would accordingly adjust the value of the shares issued in consideration. In other words, Eyeball Networks argued that section 160 couldn't apply because it paid OldCo an amount equal to the fair market value of the assets it received.
In response, the Crown argued that, although Eyeball provided sufficient consideration by issuing its shares to OldCo, the subsequent transactions—in particular, the share redemption and cross-cancellation of the debt—had nullified that consideration. The Crown urged the Tax Court to adopt a "results-based economic reality" approach to section 160. To this end, the Crown pointed out that, when the reorganization was done, OldCo "had no subsisting valuable consideration in hand" for the assets it transferred to Eyeball.
The Tax Court rejected the Crown's suggested "results-based economic reality" approach to section 160. It reasoned that section 160 applies to a discrete transfer: "the Minister cannot look at the totality of the result of the series of transactions and apply section 160 en bloc [para 50]."
The Tax Court's analysis didn't end there, however. The court observed that the final step of the reorganization—namely, the mutual setoff—was itself a transfer and therefore subject to section 160:
- Logically and empirically, contractual set-off is a legal notion or device which obviates otherwise necessary steps between mutual creditors and debtors. Certain transfers are avoided: firstly, the transfer or conveyance by the first debtor of an amount of money, money's worth or property to satisfy its creditor and, secondly, the re-transfer or re-conveyance by the second debtor (the creditor in the first instance) of a like or differing amount of money, money's worth or property to its creditor (the debtor in the first instance). The avoidance of these steps occurs solely because each is both a creditor and debtor of the other. Through contractual set-off the mutual debtors/creditors accept identical or differing values in full satisfaction of their co-existing debts. [para 52]
- The expunged property comprising the [Eyeball promissory note] held and owned by Oldco is property. At law, as a negotiable instrument it is valuable; that value paid by a willing arm's length purchaser, should Oldco attempt to sell (negotiate) it to someone other than a related party, would undoubtedly be its FMV [fair market value]. The same would be true of the Oldco Note should [Eyeball Networks] have attempted to sell or negotiate it; its FMV would be what an arm's length purchaser would pay for the Oldco Note at the time of its transfer, that is to say its negotiation. [...] This transaction, in the form of contractual set-off, is a "transfer"..."indirectly"... "by any other means whatsoever" [which is the language used in section 160]. [para 54]
After concluding that the setoff transaction was a transfer for the purposes of section 160, the court considered whether Eyeball Networks received property worth more than what it gave. "Yes," the court answered. The Tax Court reasoned that OldCo's promissory note from Eyeball had considerable value as a negotiable bill since its worth was backed by the $30 million of assets that Eyeball now owned. But, the court continued, Eyeball's promissory note from OldCo had little to no value:
- The consideration for the surrender or forgiveness of the valuable [Eyeball] Note was the surrender or forgiveness of the Oldco Note with nominal value. Oldco transferred valuable property (the [Eyeball] Note) for little value (forgiveness of the valueless Oldco Note). It is precisely "at the time" of transfer that the consideration proffered "at such time" was deficient, perhaps well hidden, but insufficient, just the same. [para 57]
As a result, the Tax Court of Canada held that Eyeball Networks was jointly and severally liable for OldCo's tax debts under section 160.
Questioning Eyeball: Will the Decision Stand on Appeal?
The taxpayer has since commenced the process of appealing the Tax Court's decision. On September 9, 2019, Eyeball Networks filed a notice of appeal to the Federal Court of Appeal. It will take some time before the appellate court actually hears the appeal. In the meantime, the Tax Court's decision stands.
The Tax Court's decision turned on two findings: first, a setoff constitutes a transfer of property; and, second, the promissory note from OldCo had little to no value.
Each finding is open to critique.
It's debatable whether the OldCo promissory note was indeed valueless. The court presumably reached this conclusion on the basis of its perception that OldCo had minimal assets. But, at the time of the setoff, OldCo possessed a demand promissory note from Eyeball Networks, and the Eyeball note, as the court acknowledges at paragraph 57 of its decision, "had considerable value as a negotiable bill; its worth was backed by the $30 million [of assets now owned by Eyeball Networks]." Granted, the valuation of the Eyeball note would need to account for the costs of enforcing it against Eyeball. Still, the Eyeball note constituted a valuable asset for OldCo. Importantly, it was an asset giving OldCo a means of discharging its own debts — such as its own promissory note to Eyeball.
Second, a setoff doesn't clearly qualify as a "transfer." A transfer of property requires the transferor to have both divested itself of the property and vested that property in the transferee (see: Fasken Estate v Minister of National Revenue,  Ex. CR 580, at para 12, 49 DTC 491, at page 497.) A setoff is a debtor's right to reduce his own debt by the amount that his creditor owes on another account—that it, it's the cancellation of mutual rights as a creditor. There is no one in whom a property or a right vests, however. So, although a setoff in effect eliminates the need for cross-transfers, it doesn't itself constitute a transfer.
Further, the Eyeball decision leaves behind a scent of arbitrariness. For starters, the Tax Court only took issue with the setoff portion of the reorganization, and it seemingly agreed that the transfers preceding the setoff—including the share redemption and issuance of promissory notes—involved fair-market-value consideration. This suggests that Eyeball Network would have avoided any liability under section 160 if the parties had simply left their mutual debts outstanding. Moreover, the decision suggests that section 160 wouldn't be an issue if, instead of opting for a setoff, the taxpayers had executed the full series of transactions that the setoff otherwise served to render unnecessary. For example, Eyeball Networks obtains a $30 million loan from a third party. Eyeball pays the $30 million to OldCo and thus satisfies the promissory note it issued to OldCo. Now holding $30 million in cash, OldCo pays those funds right back to Eyeball. In doing so, OldCo satisfies the promissory note it issued to Eyeball.
The Federal Court of Appeal will hopefully add some clarity to these issues.
This abridged article was originally published in full on Mondaq. David J. Rotfleisch, CPA, CA, JD, is the founding Canadian tax lawyer of Rotfleisch & Samulovitch, P.C., a Toronto-based boutique income tax law firm (Taxpage.com). With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax litigation. Contact David at firstname.lastname@example.org.