Beware of incomplete or ineffective transactions

Executing a corporate transaction or restructuring covers a wide range of corporate operations, from the incorporation and issuance of shares, to the transfer of shares or assets, the rollover of shares or assets, the liquidation of a company or the amalgamation of several companies. If such a transaction is reviewed by the tax authorities, assessed, interpreted or even challenged in court, the preliminary question, which may seem trivial, is first to determine whether the transaction itself has actually taken place as a matter of law.

It is important to ensure, first and foremost, that the transaction itself complies with and is valid under the laws applicable to it, and that all its components have been respected. This is the doctrine of the incomplete or ineffective transaction, which seeks to establish whether a transaction had legal substance and whether all the steps were effectively and completely executed. In simple terms, this can be summed up by asking the following questions:

• Has a trust been validly constituted?
• Has the signatory been validly authorized?
• Has payment for the transaction been made and consideration received?
• Did the transfer of shares or assets actually take place?

These questions are important because the taxpayer’s tax and civil liability is based on what happened, and not on what a party in retrospect would have rather done¹.

Almost 40 years ago, the Supreme Court of Canada confirmed the rule that no tax planning transaction can be recognized for tax purposes unless it has been validly established in accordance with the general rules of law. It is possible to lose a tax benefit if a transaction is deemed incomplete or ineffective because it failed to comply with essential legal requirements². E.g. the payment for shares, the issuance of shares or a demand note as part of a rollover, even if the payment is only one dollar.

Every action taken by the parties must have been done in accordance with applicable law. It is not sufficient to employ devices to achieve a desired result without ensuring that those devices are not simply cosmetically correct, that is, correct in form, but, in fact, are in all respects legally correct, real transactions³.

It’s worth going back to the basic principals in order to discuss the effects of contracts between parties, as contracts are at the heart of many corporate transactions. Contracts create a duty of performance between the parties to a contract, hence the principle that any contract validly formed binds the parties who have entered into it⁴. And the binding force of the contract obliges each party to respect it and the obligations arising from it.

In today’s fast-changing transactional environment, this serves as a reminder that the incomplete or ineffective transaction doctrine can be used as an argument to contest a transaction, and when the required legal formalities to give effect to a transaction have not been complied with, the taxpayer will then be taxed according to the results obtained.

In conclusion, any transaction or operation of any kind needs to be meticulously planned, fully executed and carefully documented, all in order to avoid unexpected and sometimes unfortunate consequences.

We invite you to contact the AVENS team for the analysis or drafting of proposed corporate transactions or operations