The drive to present facts and arguments correctly during litigation can often relegate questions of procedure to a secondary position. But doing so could have grave tax consequences, as demonstrated in a recent decision when the Federal Court of Appeal (FCA) confirmed the classification of a gain on the sale of shares on income account. The focus of Atlantic Packaging Products Ltd. Atlantic Produits D’Emballage Ltée v. The Queen, 2018 TCC 183 (Atlantic Packaging TCC) at the Tax Court of Canada (TCC) level was on the income versus capital classification of a gain under section 54.2 of the Income Tax Act (ITA). Subsequently, however, the FCA upheld the TCC decision based on a point of procedure and confirmed that a new issue cannot be raised on appeal when no new evidence is presented.

The Atlantic Packaging TCC decision

In 2009, Atlantic Packaging, a paper products manufacturer, owned five divisions and agreed to sell its tissue business (the Tissue Division) to a competitor, Cascades Canada Inc. (Cascades). As part of the sale of the Tissue Division, Atlantic Packaging was to form a new corporation and then transfer certain assets of the Tissue Division to the newly formed corporation in exchange for common shares of the newly formed corporation on a tax-deferred rollover basis. After the transfer, Atlantic Packing sold the common shares of the newly formed corporation to Cascades. Atlantic Packaging then reported the gain on the sale of the shares as capital gains on its 2010 tax return, as permitted under section 54.2 of the ITA.

Pursuant to section 54.2, where a person disposes of property that consisted of “all or substantially all” of the assets used in an active business by that person, to a corporation for consideration that includes the shares of the corporation, the shares are deemed to be capital property of that person. Section 54.2 therefore generally only applies if a business fully divests its income generating assets.  Believing it had met those requirements, Atlantic Packaging treated the gain from the transferred common shares of the newly formed corporation on capital account but the Canada Revenue Agency (CRA) disagreed and reassessed the gain to be on income account.

Atlantic Packaging appealed the CRA’s reassessment to the TCC. On appeal, the question before the TCC was whether the transfer of certain assets from Atlantic Packaging to the newly formed corporation represented “all or substantially all of the assets used in an active business” by the Tissue Division, as required by section 54.2.

Although the TCC agreed that there is no clear numerical percentage that can be applied to determine whether the “all or substantially all” requirement was met, the court could take into account the fair market value of the assets when applying the test. The TCC determined that under the fair market value assessment, Atlantic Packaging transferred only 68% of total assets of the Tissue Division to the newly formed corporation. This was not enough to meet the “all or substantially all” requirement in section 54.2 and therefore the shares received by Atlantic Packaging in consideration for the assets transferred were not deemed to be capital property. Atlantic Packaging’s appeal was dismissed, the CRA’s reassessment was upheld and the gain on sale of the shares remained on income account.

The Atlantic Packaging FCA decision

On appeal to the FCA in Atlantic Packaging Products Ltd. v. Canada, 2020 FCA 75 (Atlantic Packaging FCA), Atlantic Packaging did not challenge the use of fair market value as the basis for the “all or substantially all” test. Instead, Atlantic Packaging raised a new question asking whether the shares of the newly formed corporation were capital property of Atlantic Packaging regardless of whether section 54.2 applied.

Before any substantive law could be reviewed, Justice Webb, writing for the FCA, had to first look at a procedural question: could Atlantic Packaging raise this new question on appeal without having raised it originally at the TCC level?

In the TCC original filings, Atlantic Packaging specifically focused its question on section 54.2. The larger question of whether the shares of the newly formed corporation could be otherwise considered capital was simply not raised.

As a general rule, no new issues may be raised on appeal because appeals courts are tasked with ruling specifically on whether the trial court applied the law correctly. However, based on a Supreme Court of Canada precedent, Atlantic Packaging argued in this case that it was raising a new argument and not a new issue. Justice Webb rejected this line of reasoning because Atlantic Packaging’s notices of objection and appeals asked whether the shares of the new formed corporation should be treated as capital property - irrespective of whether section 54.2 applies. This is not a new argument on whether the conditions of 54.2 were satisfied and thus Justice Webb concluded that Atlantic Packaging was trying to raise a new issue and not a new argument.

There are very few instances where the FCA may be allowed to hear a new issue, including if new legal developments had taken place in the interim and/or if it is in the interests of justice. In this case, the FCA concluded that the TCC already had all the evidence it needed to decide the issues in the first place and that no new legal developments had occurred in the interim. This meant that Atlantic Packaging did not have any ground to raise a new issue. It was Atlantic Packaging’s own omission that caused it to miss its opportunity at the TCC level and because of this, it was no longer possible to raise the issue at the FCA. Justice Webb dismissed the appeal.

Disputes procedure should not be overlooked

If Atlantic Packaging had framed its question more broadly at the TCC level or perhaps even at the audit stage, the outcome of the FCA case might have been different. At the very least, the broad question of whether Atlantic Packaging’s shares were held on income or capital account should have been kept at the forefront of the disputes process, which might have changed the focus of the case and minimized tax litigation and related costs. This case is a reminder to taxpayers to be cautious about framing issues right from the audit stage to place themselves in the best possible position throughout a litigation.