Non-Arm’s-Length as a Matter of Fact: ABIL Denied

Since the notion of a factual non-arm’s-length relationship can be difficult to apply in practice, the court’s finding of such a relationship in Keybrand Foods Inc. v. Canada (2020 FCA 201) is refreshing for its commonsense clarity: “[W]here a person pays in excess of $14 million for shares that do not have any value, the magnitude of the discrepancy raises doubts that the parties were dealing with each other at arm’s length” (paragraph 69).

Keybrand and its parent, BWS, were guarantors of loans from GE Capital to a startup corporation, Vidabode. BWS had a minority interest in Vidabode. Vidabode defaulted on its loan repayments, and as a result GE Capital called in its outstanding loans. Possibly in order to avoid having to make good on its guarantee directly, Keybrand acquired new shares in Vidabode, and Vidabode used the funds to repay its debt to GE Capital. Even though the undisputed value of the shares was nil, the shares were issued at one dollar per share. Vidabode later filed for bankruptcy. Keybrand claimed an ABIL on one-half of the investment in Vidabode’s shares.

The FCA denied the ABIL through the application of paragraph 251(1)(c), which specifies that it is a question of fact whether unrelated persons are dealing with each other at arm’s length at a particular time.

In considering whether to apply this paragraph, the FCA noted that Vidabode was financially dependent on either Keybrand or one or more of the other companies in the group to repay GE Capital, since no other shareholders were willing or able to advance any funds and Vidabode would otherwise have had to cease operations. Additionally, there was a lack of negotiation with respect to the terms and conditions of the share subscription, including the share price. Thus, Keybrand controlled both sides of the transaction related to the issue of shares by Vidabode to Keybrand; this was also the situation in Robson Leather Company (77 DTC 5106 (FCA)) and Swiss Bank Corporation (71 DTC 5235 (Ex. Ct.); aff’d [1974] SCR 1144). Considering these decisions, and noting the peculiar economics of the transaction cited in the quotation above, the FCA concluded that Keybrand and Vidabode were not dealing with each other at arm’s length at the time of the share investment.

The next step in the FCA’s reasoning was to apply paragraph 69(1)(a). This provision states that when a taxpayer acquires property from a person with whom the taxpayer was not dealing at arm’s length for an amount in excess of FMV, the taxpayer shall be deemed to have acquired the property at FMV. Applying this paragraph, the FCA deemed the shares to have a cost basis of nil. Thus, the disposition of the shares (presumably under the subsection 50(1) election for an insolvent corporation) involved proceeds of zero and a cost basis of zero, so the ABIL was denied.

The TCC, in contrast, had come to the same conclusion about the ABIL but followed a different route. The TCC found a non-arm’s-length relationship by applying subsection 256(5.1), which deems that one corporation controls another where a corporation has direct or indirect influence that, if exercised, would result in control in fact of another corporation. The FCA disagreed with this approach, explaining that subsection 256(5.1) should be used only to determine the relationship between corporations. Non-arm’s-length versus arm’s-length status should be assessed on the basis of the facts of a particular transaction under paragraph 251(1)(c), and not in relation to the entities as a whole under subsection 256(5.1).

For further discussion of this and other issues in the case, see The Arnold Report, posting no. 194, January 13, 2021.

Abby Yang and Alicia Wang
KPMG LLP, Calgary

Canadian Tax Focus
Volume 11, Number 1, February 2021
©2021, Canadian Tax Foundation