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Testifying Before the House of Commons Standing Committee on Finance

On November 25, 2013, I had the privilege of travelling to Ottawa to appear before the House of Commons Standing Committee on Finance to discuss certain aspects of Bill C-4, the second implementation act for measures proposed in the 2013 federal budget, as well as other measures.  Bill C-4 is at the second reading stage.  The Committee’s work on Bill C-4 began earlier in the month with testimony from government officials.  My task, from a practitioner’s point of view, was to address those provisions that close loopholes in the Income Tax Act.

I read my opening statement (each witness is limited to a five-minute opening) and answered a few questions.  I fielded questions from two members of the Committee (Mark Adler of the Conservatives and Murray Rankin of the NDP who happens to be a fellow graduate of the University of Toronto Faculty of Law and an accomplished litigator).  Both Mr. Adler and Mr. Rankin, along with the other members of the Committee, went out of their way to make me feel welcome.  Much of the time was taken up by a spirited discussion of the proposal to phase out tax credits for investors in Labour Sponsored Venture Capital Corporations (which appear to be predominantly located in the province of Quebec).  The entire meeting was recorded and transcribed.

Around the dinner hour, the Minister of Finance, Hon. Jim Flaherty, appeared before the Committee to describe some of the more important provisions of Bill C-4 and to answer questions from members of the Committee.  Hon. Scott Brison participated in a lively exchange with the Minister.

It was certainly a long day for members of the Committee and their staff.  They prepared for the meeting in the morning and participated in the proceedings from 3:30 p.m. until after 8:30 p.m. - and this was only one of a number of intensive sessions devoted to the close study and consideration of Bill C-4.  I look forward to tracking the progress of Bill C-4 through the House of Commons Standing Committee on Finance as well as the Senate Committee on National Finance.  If everything proceeds according to plan, Bill C-4 may very well become law before the end of the year.

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Testifying Before the House of Commons Standing Committee on Finance

What Kind of Appellate Lawyer was Justice Roberts?

I first heard of John Roberts Jr. when he was nominated to the United States Supreme Court as Chief Justice.  I watched the coverage on C-SPAN which replayed a seminar that he gave to a group of law students on advocacy.  I was quite impressed – but not as impressed as I was after reading this article from The American Lawyer magazine.  Appellate advocates have much to learn from the Chief Justice of the United States:

http://www.americanlawyer.com/PubArticleTAL.jsp?id=1202620317367

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What Kind of Appellate Lawyer was Justice Roberts?

Federal Court of Appeal strikes out a pleading alleging that expenses are non-deductible in light of “egregious and repulsive” conduct by a taxpayer

In a ruling handed down May 6, 2013, the Federal Court of Appeal ordered that portions of a Crown pleading be struck out for suggesting that a deduction may be disallowed on the basis that the conduct of the taxpayer in incurring the expense was “egregious or repulsive”.  Sharlow J. A. wrote the reasons in Canadian Imperial Bank of Commerce v. The Queen, 2013 FCA 122 in which Evans J.A. and Stratas J.A. concurred.

By way of background, the Canada Revenue Agency reassessed CIBC to disallow the deduction of some $3 billion of expenses incurred between 2002 and 2006.  The expenses at issue were incurred to settle litigation in the United States arising from losses suffered due to the collapse of Enron Corporation.  In the U.S. litigation, it was alleged that CIBC participated in the financing of Enron in a manner that made it liable to the complainants.

The Income Tax Act provides the formula for determining a taxpayer’s income for the year for income tax purposes.  Under paragraph 3(a), one component of a taxpayer’s income is income from a business of the taxpayer.  Under subsection 9(1), a taxpayer’s income for a year from a business is the taxpayer’s profit for the year from that business.

The most important limitation on the scope of subsection 9(1) is paragraph 18(1)(a) which provides:

18. (1) In computing the income of a taxpayer from a business […] no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business […];

In 65302 British Columbia Limited v. The Queen, a 1999 decision in which the deduction of a fine was allowed (later to be specifically disallowed by Parliament), Iacobucci J. of the Supreme Court of Canada made the following observation:

It is conceivable that a breach [of the law] could be so egregious or repulsive that the fine subsequently imposed could not be justified as being incurred for the purpose of producing income.

In the contentious part of its pleading, the Crown relied on that obiter statement and offered the following theory of non-deductibility of expenses:

134. The misconduct of [CIBC and its affiliates] was so egregious and repulsive that any consequential settlement payments […] cannot be justified as being incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1)(a) of the [Income Tax] Act. The [CIBC affiliates] knowingly aided and abetted Enron to violate the United States’ federal securities laws and falsify its financial statements. The misconduct of [the CIBC affiliates] in enabling Enron to perpetrate its frauds, known to [CIBC], or the misconduct of [CIBC] itself, was so extreme, and the consequences so dire, that it could not be part of the business of a bank.

The Crown’s contention, in a nutshell, was that an expense incurred due to conduct of the taxpayer that was “egregious or repulsive”, is precluded from deduction by paragraph 18(1)(a) of the Income Tax Act.

The CIBC asked the Tax Court of Canada to strike out that paragraph along with the other portions of the pleading reflecting the same theory.  The Tax Court chose not to do so.  The Federal Court of Appeal disagreed and struck out the contentious paragraph along with the related parts.

In dismissing the Crown’s argument, the Federal Court of Appeal emphasized that “the only question to be asked in determining whether paragraph 18(1)(a) prohibits a particular deduction is this: Did the taxpayer incur the expense for the purpose of earning income?”  The Court concluded by stating that the characterization of the morality of a taxpayer’s conduct is not legally relevant to the application of paragraph 18(1)(a) of the Income Tax Act.

Parties are generally given the opportunity to make whatever arguments they consider necessary to their case with the ultimate determination being made by the trial judge who is in the best position to decide questions of relevance and weight in light of all the evidence.  It is rather unusual for a legal theory, novel though it is, to be taken off the table at such an early stage.  At the same time, courts are increasingly concerned about “proportionality” and are reluctant to allow scarce judicial resources to be spent on matters that are unlikely to have any effect on the outcome of the hearing.  Whatever one’s view of the matter the Crown rarely seeks leave to appeal on procedural points, making it unlikely that this decision will be reviewed by the Supreme Court of Canada.

Notwithstanding the decision of the Federal Court of Appeal, the Crown will still be able to argue that the deductions taken by CIBC ought to be disallowed on a variety of other grounds including:

  • the deduction of the settlement payments does not accord with well accepted business principles;
  • the settlement payments were not made for the purpose of earning income from a business;
  • the settlement payments were outlays on account of capital;
  • the settlement payments were contingent liabilities when made; and
  • the amount of the settlement payments were not reasonable in the circumstances.

Although the taxpayer has prevailed in this battle, the war has just begun.

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This article was first published in the International Tax Review.

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Federal Court of Appeal strikes out a pleading alleging that expenses are non-deductible in light of “egregious and repulsive” conduct by a taxpayer

Rulings and GAAR to be Featured at the Toronto Centre CRA & Professionals Group Breakfast Meeting – June 6, 2013

The June 6th breakfast meeting of the Toronto Centre CRA & Professionals Group promises to be particularly informative. It features presentations from senior Ottawa CRA officials on the work of the Rulings Directorate and the CRA’s administration of the General Anti-Avoidance Rule. This is in addition to the case comments provided by Cliff Rand of Deloitte Tax Law LLP and Arnold Bornstein of the Department of Justice.

Please click here to register for the June 6th breakfast meeting.

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Rulings and GAAR to be Featured at the Toronto Centre CRA & Professionals Group Breakfast Meeting – June 6, 2013

Judicial review applications challenging Minister’s alleged violation of Voluntary Disclosure Policy and MAP agreement allowed to proceed: Sifto Canada Corp. v. MNR

In Sifto Canada Corp. v. Minister of National Revenue, 2013 FC 214, Prothonotary Aalto of the Federal Court rejected the Crown’s motion to strike out judicial review applications filed by Sifto Canada Corp. challenging decisions made by the Minister of National Revenue to:

(a) assess penalties contrary to the terms of the Voluntary Disclosure Program; and

(b) assess transfer pricing adjustments contrary to an agreement between the Competent Authorities of Canada and the United States on the appropriate transfer price under Article XXVI of the Canada-U.S. Tax Treaty (known as the “Mutual Agreement Procedure” or “MAP”).

The Crown made the usual argument that section 18.5 of the Federal Courts Act precludes such judicial review applications (for background, see our earlier post on the JP Morgan decision mentioned below).  Prothonotary Aalto had this to say about the Crown’s argument:

[8]    One of the mantras of the Minister of National Revenue is that the judicial review process should not be used to circumvent the comprehensive code for the assessment and collection of taxes set out in the Income Tax Act (ITA) and for which the Tax Court of Canada (TCC) is given exclusive jurisdiction.  As a general proposition, this is a correct approach to the taxation regime in Canada.  However, cases such as Chrysler Canada [2008 FC 727, aff’d 2008 FC 1049], JP Morgan Asset Management [2012 FC 651, aff’d 2012 FC 1366] and Canadian Pacific Railway [2012 FC 1030; aff’d 2013 FC 161] come to this Court and fall within this Court’s jurisdiction because of their unique factual circumstances.  This case, like those, revolves around a factual scenario which takes it out the pure assessment or appeal regime of the ITA and the jurisprudence recognizes that such matters can come within the jurisdiction of this Court.

Prothonotary Aalto explained his reasoning for allowing the applications to proceed:

[22]    In this case there are agreements which are alleged to have been entered into between Sifto and the Respondent which are alleged to have been breached.  These facts on their face do not engage issues of the correctness of assessments or appeals under the ITA.  They are therefore not bereft of any chance of success.  To the extent the breach of agreements and other allegations made in these applications engage matters beyond the scope of the correctness of an assessment or re-assessment they are not within the jurisdiction of the TCC.

[23]    The conduct of officials in CRA cannot be considered in determining the correctness of assessments [footnote omitted].  Such matters must be asserted in another Court.  Thus, the conduct of CRA officials as asserted by Sifto in this case relating to understandings and agreements cannot be considered by the TCC.

[24]    These applications engage more than a review of assessments to determine their correctness.  Therefore, it cannot be said that these applications are bereft of any chance of success.

In addition to arguing that the applications should be struck out in their entirety, the Crown argued in the alternative that certain allegations should be struck out or that the applications be stayed (by way of ”extension of time”) until the final determination of appeals against the assessments issued as a result of the impugned decisions.  Prothonotary Aalto had little difficulty dismissing each of the Crown’s alternative arguments.

The Crown has already made a motion asking a Federal Court judge to set aside the Prothonotary’s decision.  In light of the decisions of the Federal Court in Chrysler Canada, JP Morgan and Canadian Pacific, the Crown may very well be facing an uphill battle.

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Judicial review applications challenging Minister’s alleged violation of Voluntary Disclosure Policy and MAP agreement allowed to proceed: Sifto Canada Corp. v. MNR

We’ve gone global!

We’ve gone global . . . just like our clients. Today was our first day online at dentons.com giving you a “first look” at the impressive combination of SNR Denton, Salans and FMC to form Dentons. We now have more than 2,500 lawyers and professionals in 79 locations in 52 countries. What does this mean for our tax clients? We can help you access the right value-added tax expertise around the world, particularly when tax authorities in more than one jurisdiction are reviewing your affairs (e.g. simultaneous cross-border audits), when contentious issues arise with the Canada Revenue Agency or when you need to appeal to the Tax Court of Canada.

Questions? Just let us know.

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We’ve gone global!

CRA answers TEI’s questions about its new “risk-based audit process”

The Canada Revenue Agency has now published a set of answers to questions and concerns about the audit process presented to it by the Tax Executives Institute late last year (see our earlier blog post).

One of the highlights is the set of answers by the CRA to a series of questions about its new risk-based audit process.  The questions and answers on that subject are as follows:

Question 12 – Risk-based Audit Process

In 2011 CRA announced it was instituting a risk-based approach to audits whereby CRA would meet with senior representatives of the taxpayer to:

• Explain the redefined risk-based approach to large business compliance and how the approach affects taxpayers;

• Share CRA’s findings and observations noted during the taxpayer’s risk assessment; and

• Understand how the taxpayer manages tax risk at its highest governance levels.

With the first round of meetings with taxpayers complete, TEI has the following questions in respect of the approach:

a) Would CRA share its general observations, findings, trends, or conclusions with respect to the state of tax-risk governance?

Response by CRA:

The Approach to Large Business Compliance is being phased in over a five-year period commencing in 2010-11. During this period, CRA officials conduct meetings with Large Business enterprises’ senior executives to discuss tax compliance and risk of non-compliance associated with their business activities, governance regime, internal controls, and inherent and behavioral risk factors affecting their risk segmentation. At this point in time, it is still premature to draw general conclusions on the state of tax-risk governance. We have noted that there are taxpayers with no formal method of identifying and responding to corporate tax risk. These taxpayers are informed that this lack of tax risk governance, in the absence of other mitigating controls, will weigh negatively on their overall risk rating with the CRA.

b) In the interests of transparency, will CRA consider publishing a document outlining and discussing its review and risk-assessment process?

Response by CRA:

The CRA is of the view that the success of the Approach to Large Business Compliance is based on a well-informed, transparent tri-partite relationship. Providing further information on the risk assessment process in a published document would be in the best interests of all parties. As this initiative unfolds, the CRA will be in a better position to further communicate the risk-assessment process.

c) Has the first round of meetings with taxpayers led CRA to consider changes to its risk-assessment process and will it publicly announce the changes? Will affected taxpayers be apprised of changes to the scope of the risk-management approach that apply to their cases?

Response by CRA:

There have been no major changes in the risk assessment process. As expected, we are fine-tuning our risk assessment process and exploring ways to leverage technology in our drive to a more automated state and enhanced accuracy and efficiency.

d) Will CRA review the risk assessment with the affected taxpayer, including discussing the criteria and factors used to determine a taxpayer’s risk rating? If a taxpayer disagrees with its risk-assessment rating, what steps can it take to address its concerns?

Response by CRA:

During the face-to-face meetings, the taxpayer is informed of their risk rating. At that time, they will be informed of why they have attained this rating and what can be done to reduce the rating in the future. It is, however, not a debating forum where taxpayers can “negotiate” a better rating.

e) Assuming a taxpayer’s risk profile can change over time, will CRA revisit its risk-assessment ratings on a regular basis? If so, how often will the assessment be revised? Will CRA meet again with the taxpayer’s senior executives to review the revised rating?

Response by CRA:

Each taxpayer is risk assessed on a yearly basis based on the latest available information. Currently, as for the meetings, CRA officials are meeting with each Large Business taxpayer and discussing their individual risk rating over the 5-year phase-in period. Once this round of meetings is completed, CRA will consider revisiting taxpayers to review their rating.

f) Can CRA provide any details about the factors affecting a taxpayer’s risk rating?

Response by CRA:

The CRA’s Approach to Large Business Compliance (ALBC) discloses the criteria used in risk evaluating all taxpayers. The large business population is being risk assessed using several techniques, such as:

• Undertaking a historical analysis of audit results and a corresponding analysis of behavioural patterns;

• Examining every large business taxpayer in their TSOs and assessing their risk based on analysis and local knowledge;

• Conducting issue-based risk assessment to determine whether taxpayers are participating in tax planning schemes;

Additionally, consideration is being given to a number of risk factors, such as:

• Audit history;

• Industry sector issues;

• Unusual and/or complex transactions;

• Corporate structure;

• Major acquisitions and disposals;

• International transactions;

• Corporate governance;

• Participation in aggressive tax planning; and

• Openness and transparency.

These factors will vary by taxpayer and the taxpayers will be advised as to the factors considered in their risk assessment when the ALBC approach is discussed, in the face to face meeting that the CRA will hold with them. All factors are considered collectively in arriving a global risk rating for the entity.

g) Will CRA inform other tax jurisdictions (provincial or foreign) of its findings in respect of a taxpayer’s risk rating?

Response by CRA:

CRA has not shared any information related to any taxpayer’s risk rating with any other tax jurisdiction. In the future, any request made by another tax jurisdiction will be reviewed by the CRA on a case by case basis, while respecting the Provision of Information laws outlined in section 241 of the Income Tax Act and the relevant international exchange of information protocols.

h) What guidance has been provided to the TSOs to ensure that the objectives of the new audit approach are applied consistently by all the TSOs?

Response by CRA:

Given the prominence of risk assessment and the impact of risk rating on the design and implementation of the Approach to Large Business Compliance, a national risk assessment calibration committee has been formed to supplement the regional calibration committees thus ensuring national and regional consistency.

In certain other responses, the CRA refers to its strategic plan entitled “Vision 2020″ (question 2) and issues around Scientific Research & Experimental Development (question 3).  Both subjects will be discussed in detail at a breakfast seminar of the Toronto Centre CRA & Professionals Group at the Toronto Board of Trade to be held on Wednesday, February 6, 2013.

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CRA answers TEI’s questions about its new “risk-based audit process”

Tax Executives Institute raises important audit process questions and concerns in its annual meeting with the Canada Revenue Agency

Earlier this month, the Tax Executives Institute, Inc. (TEI) raised a number of important income tax administration issues in its annual meeting with the Canada Revenue Agency. Concerns were expressed about how the CRA conducts and manages large file audits (including the role of the Large File Case Manager or LFCM) as well as the design and development of the CRA’s new risk-based audit process for large businesses.

The agenda for those meetings (which also included the Department of Finance) is here.  TEI plans to publish CRA’s responses as soon as they are released.  The questions and concerns dealing with the audit process in particular are set out below.

7. CRA Audit Practices — Taxpayer Field Experience

CRA and large taxpayers share a common interest and goals in promoting a smooth and efficient audit. The goals include:

• Ensuring that audits are current;

• Avoiding the use of waivers to extend the audit period unnecessarily or habitually;

• Focusing audit queries on high-risk compliance issues;

• Using accepted audit sampling procedures to expand stretched resources;

• Maintaining transparency in decision-making and the determination of tax positions;

• Promoting timely, consistent, and effective issue resolution;

• Deploying human resources as effectively as possible; and

• Maximizing cost controls.

Over the course of the last several years, CRA has developed new audit approaches based upon an enhanced relationship with large taxpayers and a risk-based audit approach. TEI supports CRA’s new audit approach not only because of the common interest and shared goal of promoting efficiency, but because it promotes certainty of tax treatment sooner. That said, many large taxpayers have experienced behaviours seemingly at odds with the shared interests and goals. Examples include:

a) LFCMs are declining to discuss issues (or assert control over certain issues), saying they lack authority to make a decision in respect of subject matter. This suggests that issue resolution may be increasingly managed by CRA Headquarters in Ottawa as opposed to the TSOs. TEI believes that the objectives identified above can be advanced only if the LFCM is empowered to make decisions on issues and taxpayers are able to communicate directly with the decision-makers.

b) Auditors are asking for information on behalf of an undisclosed CRA source or seeking opinions or advice from CRA Headquarters without communicating the issue to the taxpayer or informing the taxpayer of the request. Where an opinion or advice is solicited, the TSO is generally bound by the Headquarters decision even though the taxpayer had little or no input into the development of the facts upon which the opinion is based.

c) Many auditors and LFCMs assert that they have no jurisdiction over specialty areas (e.g., SR&ED, International or Tax Avoidance matters). Thus, there seems to be no overriding coordinator or decision-maker.

d) The scope and nature of the tax treatment of items seem to change dramatically from previous years (i.e., fewer adjustments are proposed, but high-level conceptual challenges to a taxpayer’s filing position are asserted with minimal or no apparent technical analysis). Examples include challenges to reclassify amounts long treated (and frequently reviewed) as current expenses into capital items or challenges to the longstanding (and frequently reviewed) classification of capital items into longer-lived capital asset pools.

e) Adjustments are proposed without discussion or explanation of the technical position despite requests for the rationale, which leaves taxpayers questioning the quality of the audit or propriety of the asserted position. Without discussion, the position can seem arbitrary, and may be a consequence of the Tax Earned by Auditor (TEBA) metric.

f) Information requests or proposals for adjustments are submitted shortly before a taxation year becomes statute barred.

g) Certain audit queries seem intended to audit the taxpayer’s financial statements rather than the tax returns (e.g., there are instances where an auditor is verifying account balances in audited financial statements rather than trying to understand the adjustments on the tax returns to the financial accounts and the rationale for the adjustments).

h) Requests are made for significant amounts of data as opposed to relying on sampling where practical (e.g., requests for all professional fee invoices). In addition, information requests require taxpayers to produce enormous amounts of data within an abbreviated time frame. Response times should be reasonable and proportional to the volume of information requested.

i) Some auditors have refused to make taxpayer-favourable consequential changes and adjustments in subsequent years, even where the changes flow directly from an accepted audit adjustment to an earlier period. Instead, taxpayers are compelled to file amended returns to claim the consequential adjustments.

In addition to a general discussion of the member perceptions of audit behaviours and whether those behaviours are counterproductive to the shared goals of expeditious audits, transparency, and an enhanced relationship, TEI invites a discussion of the following:

a) In connection with the new risk-based audit approach, have quality control reviews been performed on the audit files since the approach was adopted? If not, will the quality control review be conducted on all files or all files above a certain size? Will new roles be created within CRA to conduct the quality control reviews independently of the field auditors?

b) Can CRA confirm whether the TEBA metric has been eliminated, as announced at the May 2012 TEI Annual Conference? If so, what measures will the Agency employ internally and for reporting its activities to other parts of the Government (e.g., Finance, Parliament, and the Auditor General)?

c) What other changes are being implemented at Headquarters and the TSOs to support the risk-based audit initiative?

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12. Risk-based Audit Process

In 2011 CRA announced it was instituting a risk-based approach to audits whereby CRA would meet with senior representatives of the taxpayer to:

• Explain the redefined risk-based approach to large business compliance and how the approach affects taxpayers;

• Share CRA’s findings and observations noted during the taxpayer’s risk assessment; and

• Understand how the taxpayer manages tax risk at its highest governance levels.

With the first round of meetings with taxpayers complete, TEI has the following questions in respect of the approach:

a) Would CRA share its general observations, findings, trends, or conclusions with respect to the state of tax-risk governance?

b) In the interests of transparency, will CRA consider publishing a document outlining and discussing its review and risk-assessment process?

c) Has the first round of meetings with taxpayers led CRA to consider changes to its risk-assessment process and will it publicly announce the changes? Will affected taxpayers be apprised of changes to the scope of the risk-management approach that apply to their cases?

d) Will CRA review the risk assessment with the affected taxpayer, including discussing the criteria and factors used to determine a taxpayer’s risk rating? If a taxpayer disagrees with its risk-assessment rating, what steps can it take to address its concerns?

e) Assuming a taxpayer’s risk profile can change over time, will CRA revisit its risk-assessment ratings on a regular basis? If so, how often will the assessment be revised? Will CRA meet again with the taxpayer’s senior executives to review the revised rating?

f) Can CRA provide any details about the factors affecting a taxpayer’s risk rating?

g) Will CRA inform other tax jurisdictions (provincial or foreign) of its findings in respect of a taxpayer’s risk rating?

h) What guidance has been provided to the TSOs to ensure that the objectives of the new audit approach are applied consistently by all the TSOs?

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Tax Executives Institute raises important audit process questions and concerns in its annual meeting with the Canada Revenue Agency

Tax Court of Canada upholds general policy that settlement agreements should be respected – taxpayer’s waiver of right to appeal was effective

In Noran West Developments Ltd. v. The Queen, the Tax Court of Canada (Justice Brent Paris) upheld the validity of a taxpayer’s waiver of its right to appeal executed following the conclusion of a settlement with the Appeals Division of the Canada Revenue Agency (the “CRA”).  This conclusion was reached, and the Crown’s motion to quash granted, notwithstanding the taxpayer’s valiant attempts to set aside the agreement.

The relevant statutory provision in subsection 169(2.2) of the Income Tax Act:

Waived issues

(2.2) Notwithstanding subsections 169(1) and 169(2), for greater certainty a taxpayer may not appeal to the Tax Court of Canada to have an assessment under this Part vacated or varied in respect of an issue for which the right of objection or appeal has been waived in writing by the taxpayer.

By way of background, the CRA audited a corporate taxpayer (the Appellant) in respect of unreported income from a condominium joint venture which engaged in certain non-arm’s length dispositions.  The auditor reassessed to (a) include $640,000 in the taxpayer’s income for its 2005 taxation year (on the basis of a valuation of the relevant condominium units), (b) recognize a shareholder benefit to the taxpayer’s sole shareholder and (c) apply gross negligence penalties under subsection 163(2) of the Income Tax Act in respect of both reassessments.

The taxpayer filed a notice of objection objecting to the inclusion of the $640,000 in its income (on the basis that the CRA’s valuation was wrong) and the assessment of a subsection 163(2) penalty.  The taxpayer’s sole shareholder filed no objection against his own reassessment.

Following discussions with the taxpayer’s representative, the Appeals Officer offered to settle the matter by (a) reducing the income inclusion by $50,000 (on the basis of a reduced valuation of the relevant condominium units) and (b) reducing the amount of the subsection 163(2) penalty accordingly.  The Appeals Officer sent a standard waiver letter which was signed by the taxpayer’s sole shareholder on behalf of the taxpayer.  It included the usual language in which the signatory attests that he or she is ”familiar with subsection 165(1.2) and 169(2.2) of the Income Tax Act and understand that I will be precluded from filing an objection or an appeal with respect to those issues.”

The CRA reassessed to implement the settlement, but the taxpayer filed an appeal in Tax Court in response.  The Crown moved to quash the appeal on the basis that the taxpayer had waived its right to appeal under subsection 169(2.2) of the Income Tax Act.  In answer to the motion counsel for the taxpayer advanced six arguments, none of which were successful:

1. The waiver agreement was not “in writing” as required by subsection 169(2.2) as the Appeals Officer omitted the taxpayer’s name.

The Tax Court judge concluded that “waived in writing” simply “requires that a waiver be reduced to writing as opposed to one given orally” and proceeded to find that the waiver agreement could not reasonably be read as applying to anyone other than the taxpayer.

2. The waiver agreement is unenforceable as the reassessment contemplated by that agreement would not have been consistent with the facts and the law.

The Tax Court judge found that there were errors in the first reassessment (the one that was settled).  However, the reassessment before the Court was the second reassessment (the one issued as a result of the waiver agreement).  As the second reassessment simply reduced the taxpayer’s income by $50,000 and reduced the subsection 163(2) penalty accordingly, there was no question that such a reassessment is within the CRA’s power.

3. The waiver agreement is invalid because the parties were not ad idem as to the terms of the agreement.  

First, it was said that the taxpayer’s sole shareholder believed that the waiver agreement applied to three taxpayers, not just one.  Therefore, there was no “meeting of the minds”.  Unfortunately for the taxpayer, the judge found that that belief, on the evidence, was “highly unlikely”.  In addition, an adverse inference was drawn from the failure of the taxpayer’s representative to give any evidence at all about what happened at the appeals stage.  The judge also rejected the contention that the sole shareholder believed that issue of beneficial ownership of the condominium units wasn’t covered by the waiver agreement and, therefore, there was no consensus ad idem.  There was no ”beneficial ownership” issue raised in the Notice of Objection, so there could be no reasonable expectation that it would have been reflected in the agreement.  The taxpayer’s final contention was that the sole shareholder did not believe that the waiver agreement dealt with the subsection 163(2) penalty.  As the text of the agreement dealt with the penalty, Justice Paris concluded that:

[61] . . . [i]f a party chooses not to read an agreement with care before signing it, or chooses to skip reading parts of it, I fail to see how he can turn around and allege that his intention did not accord with the written agreement. It must be presumed that, in those circumstances, the party intended to accept the agreement as written.

4. The agreement was vitiated by the CRA as it did not satisfy the terms of the waiver agreement because the subsection 163(2) penalty was incorrectly calculated on the second reassessment. 

Here is the error:

[24]  The respondent’s counsel concedes that an error was made in calculating the amount of the gross negligence penalty in the [second] reassessment and that the penalty was based on unreported income in the amount of $599,760 rather than on $589,760, as agreed. The respondent concedes that the penalty was too high by as much as $1,106. Because this error was only raised by Noran’s counsel shortly before the hearing of the motion, counsel for the respondent advised the Court that she was unable to obtain the exact amount of the error.

The Tax Court judge found himself unable to agree with the proposition that:

[65] . . . any inconsistency between the reassessment and the waiver agreement allows a taxpayer to appeal any aspect of the reassessment as if no waiver had been given.  It does not make sense that any error in reassessing, however minor, could permit a taxpayer to repudiate the waiver entirely.

5. The Tax Court should decline to enforce the waiver agreement on the basis that it is unconscionable. 

This argument was not pressed strongly.  In any event, the judge could find no evidence to support it.

6. The taxpayer is appealing issues other than those dealt with in the waiver agreement. 

This argument was based on the sole shareholder’s belief about what was covered by the agreement (which was rather narrow) rather than the text of the agreement itself.  Justice Paris rejected reliance on subjective belief and concluded that a “reasonable person” standard must be applied:

[74]  When searching for the intentions of the parties, I believe that the search for intention in the case of a waiver is to be conducted in the same manner as for any contract on the basis of the parties’ manifested intention. That intention is determined from the perspective of the objective reasonable bystander. Fridman in the Law of Contract in Canada, refers to the classical formulation of this notion in Smith v. Hughes:

If whatever a man’s real intention may be, he so conducts himself that a reasonable man would believe that he was assenting to the terms proposed by the other party and that other party upon that belief enters into a contract with him, the man thus conducting himself would be equally bound as if he had intended to agree to the other party’s terms.

*  *  *

Underlying this decision is a clear public policy that negotiated settlements, as a general matter, ought to be upheld:

[45] . . . The desirability of upholding negotiated settlements was discussed by Bowie J. in 1390758 Ontario Corp v. The Queen:

[35] I agree with Bowman C.J. and the authors Hogg, Magee and Li that there are sound policy reasons to uphold negotiated settlements of tax disputes freely arrived at between taxpayers and the Minister’s representatives. The addition of subsection 169(3) to the Act in 1994 is recognition by Parliament of that. It is not for the Courts to purport to review the propriety of such settlements. That task properly belongs to the Auditor General.

[36] The reality is that tax disputes are settled every day in this country. If they were not, and every difference had to be litigated to judgment, unmanageable backlogs would quickly accumulate and the system would break down.

[37] The Crown settles tort and contract claims brought by and against it on a regular basis. There is no reason why it should not settle tax disputes as well. Both sides of a dispute are entitled to know that if they invest the time and effort required to negotiate a settlement, then their agreement will bind both parties.

Although the taxpayer was unsuccessful, this decision is ultimately reassuring as the same principle applies to the government - if the CRA attempts to resile from a settlement agreement it too will be confronted by the same underlying public policy, namely, that negotiated settlements of tax disputes should be respected.

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Tax Court of Canada upholds general policy that settlement agreements should be respected – taxpayer’s waiver of right to appeal was effective

Extensive Amendments to Tax Court of Canada Rules (General Procedure) Published in Part I of the Canada Gazette

General Objectives of the Proposed Amendments

The general objectives of the proposed amendments are:

(1) to streamline the process of hearings and to codify the practice relating to litigation process conferences;

(2) to implement new rules and amend existing rules governing expert witnesses and the admissibility of their evidence in the Tax Court of Canada;

(3) to allow the Court to proceed with a hearing of one or more appeals, while other related appeals are stayed pending a decision on the lead cases heard by the Court;

(4) to encourage parties to settle their dispute early in the litigation process; and

(5) to make technical amendments.

Detailed Description of Proposed Amendments

(1) Streamlining the process of hearings and codifying the practice relating to litigation process conferences

A proposed definition of “litigation process conference” is added to section 2. That definition lists the hearings referred to in section 125 and the conferences referred to in subsection 126(2) and sections 126.1 and 126.2.

Amendments are proposed to subsection 123(4) to indicate that the Registrar or a designated person may fix the time and place for the hearing subject to any direction by the Court.

Proposed subsection 123(4.1) indicates that the Court may, on its own initiative, fix the time and place for the hearing.

Proposed subsection 123(6) indicates that, if the time and place for a hearing have been fixed after a joint application of the parties, the hearing should not be adjourned unless special circumstances justify the adjournment and it is in the interest of justice to adjourn it.

Amendments are required to be made to section 125 (Status Hearing) to provide that initial status hearings are ordered to take place approximately two months after the filing of the reply, and further status hearings can take place later in the appeal to ensure the appeal is ready for trial and to fix a trial date. Finally, proposed subsection 125(8) provides that where a party fails to comply with an order or direction made at a status hearing, or if a party fails to appear at a status hearing, the Court may allow or dismiss the appeal or make any other order that is appropriate.

Existing section 126 is replaced by proposed section 126, which is designed to allow the Chief Justice to assign a judge to manage an appeal that is complex, or slow moving, or for some other reason requires ongoing management by a judge. The judge takes responsibility for the progress of the appeal to ensure that the appeal proceeds to trial in a timely way while conserving judicial resources.

Proposed section 126.1 provides that a trial management conference can be held after the appeal hearing date has been set and is presided over by the judge assigned to preside at the hearing. The conference is to ensure that the hearing proceeds in an orderly and organized fashion.

Proposed section 126.2 permits the Court to direct that a conference be held for the purpose of exploring the possibility of settlement of any or all of the issues.

Amendments are required to section 127 to add references to sections 125 and 126, and to proposed section 126.1.

Amendments are required to section 128 to add references to matters related to a settlement or settlement discussions during a litigation process conference.

(2) Implementing new rules and amending existing rules governing expert witnesses and the admissibility of their evidence in the Tax Court of Canada

Subsection 145(1) is amended to replace the reference to “affidavit” by “expert report.”

Proposed subsection 145(2) provides that the expert’s report must set out the proposed evidence of the expert, the expert’s qualifications and be accompanied by a certificate signed by the expert acknowledging that the expert agrees to be bound by the Code of Conduct for Expert Witnesses that is added as a schedule to the Rules to ensure that expert witnesses understand their independent advisory role to the Court. Proposed subsection 145(3) indicates that if an expert fails to comply with the Code of Conduct, the Court may exclude some or all of the expert’s report.

Proposed subsection 145(4) requires a party to seek leave to the Court if they intend to call more than five expert witnesses at a hearing and proposed subsection 145(5) indicates what the Court has to consider in deciding to grant leave.

Proposed subsection 145(6) allows parties to name a joint expert witness.

Existing subsection 145(2) is renumbered subsection 145(7) and specifies the conditions that need to be met in order for evidence of an expert witness to be received at the hearing.

Existing subsection 145(4) is renumbered subsection 145(8) and indicates how evidence in chief of an expert witness is to be given at a hearing.

Proposed subsection 145(9) indicates what may be addressed during a litigation process conference, other than a settlement conference, in respect of expert witnesses.

Proposed subsections 145(10), (11), (12), (13) and (14) introduce new rules that deal with expert conferences.

Existing subsection 145(3) is renumbered subsection 145(15) and is amended to change the number of days, from 15 to 60, for a copy of rebuttal evidence to be served on all parties.

Proposed subsection 145(16) indicates when evidence of an expert witness can be led in surrebuttal of any evidence tendered under subsection (15).

Proposed subsections 145(17), (18), (19) and (20) allow the Court to require that some or all of the experts testify as a panel. Experts are only allowed to pose questions to each other with leave of the Court to ensure the orderly presentation of evidence. The rules governing cross-examination and re-examination will continue to apply to experts testifying concurrently.

(3) Allowing the Court to proceed with a hearing of one or more appeals, while other related appeals are stayed pending a decision on the lead cases heard by the Court

Proposed section 146.1 is intended to apply where there is more than one appeal which has common or related issues of fact or law. It allows the Court to proceed with the hearing of one of the appeals, the lead case, while other related appeals are stayed pending a decision on the lead case. The parties in a related appeal have to agree to be bound, in whole or in part, by the final decision on the lead case.

(4) Encouraging parties to settle their dispute early in the litigation process

The provisions of the Rules addressing offers to settle are designed to encourage parties to settle their dispute early in the litigation process. An early settlement has the added advantage of reducing the costs borne by the parties and conserving judicial resources.

Parties are entitled to make and accept offers of settlement at any time before there is a judgment and any written offer to settle will be considered by the Court in assessing costs under section 147. In addition to this general rule, there is a need to encourage parties to reach an early settlement, ideally before the beginning of the trial or hearing. This is the specific objective of adding subsections 147(3.1) to (3.8).

(5) Making technical amendments

To amend section 6 to provide that the Court may direct that any step in a proceeding may be conducted by teleconference, by videoconference or by a combination of teleconference and videoconference.

To amend section 52 by adding a new subsection to provide that a demand for particulars shall be in Form 52 and shall be filed and served in accordance with the Rules, and to add Form 52 to Schedule I.

To amend sections 53 and 58 to regroup all matters where the Court may strike out or expunge all or part of a pleading or other document under section 53, and all matters relating to the determination of questions of law, fact or mixed law and fact under section 58. As a consequence of these changes, sections 59, 60, 61 and 62 are repealed.

To add subsection 67(7) to provide for when proof of service of a motion must be filed.

To repeal subsection 95(3) as a result of the changes made to the expert witness rules.

To amend subsection 119(3) as a result of the changes made to the expert witness rules.

To amend paragraph 146(1)(d) to change the number of days for service from 10 to 5.

To add subsection 153(3) to provide that the taxing officer may direct that the taxation of a bill of costs be conducted by teleconference, videoconference or by combination of both.

To amend the reference to “issuing a judgment” by “rendering a judgment” in subsection 167(1).

To remove the reference to “and it shall be entered and filed there whereupon section 17.4 of the Act shall be complied with” in subsection 167(3).

*  *  *

The full text of the proposed amendments is here. Interested persons may make representations concerning the proposed Rules within 60 days after December 8, 2012. All such representations must cite the Canada Gazette, Part Ⅰ, and the December 8th date of publication of the notice, and be addressed to the Rules Committee, Tax Court of Canada, 200 Kent Street, Ottawa, Ontario K1A 0M1.

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Extensive Amendments to Tax Court of Canada Rules (General Procedure) Published in Part I of the Canada Gazette

Federal Court decides that JP Morgan’s judicial review application challenging the Minister’s decision to assess Part XIII tax may proceed

In a decision released on November 26, 2012 in JP Morgan Asset Management (Canada) Inc. v. Minister of National Revenue and Canada Revenue Agency (Docket T-1278-11), Justice Leonard Mandamin of the Federal Court dismissed the Crown’s appeal of an order by Prothonotary Aalto in JP Morgan Asset Management (Canada) Inc. v. Minister of National Revenue and Canada Revenue Agency in which the Crown moved unsuccessfully to strike out a judicial review application on the basis that the taxpayer had no possibility of success in seeking to set aside the decision of the Minister of National Revenue (the “Minister”) to assess Part XIII tax in a manner contrary to the Minister’s own policy.

This decision is the latest in a series of defeats for the Crown on this issue.  Since the decision of the Supreme Court of Canada in Canada v. Addison & Leyen Ltd., [2007] 2 S.C.R. 793, there has been a vigorous debate around the limits of judicial review of Ministerial action involving the decision to issue an assessment and the scope of section 18.5 of the Federal Courts Act which reads as follows:

Despite sections 18 and 18.1, if an Act of Parliament expressly provides for an appeal to the Federal Court, the Federal Court of Appeal, the Supreme Court of Canada, the Court Martial Appeal Court, the Tax Court of Canada, the Governor in Council or the Treasury Board from a decision or an order of a federal board, commission or other tribunal made by or in the course of proceedings before that board, commission or tribunal, that decision or order is not, to the extent that it may be so appealed, subject to review or to be restrained, prohibited, removed, set aside or otherwise dealt with, except in accordance with that Act.

The Minister has consistently intepreted the decision of the Supreme Court in Addison & Leyen and section 18.5 of the Federal Courts Act as precluding judicial review of the Minister’s decision to issue an assessment.  Thus far, however, the Crown has been largely unsuccessful in striking out such judicial review applications in Federal Court.  See, for example, the decision of Prothonotary Aalto in Chrysler Canada Inc. v. Canada and the decision of Justice Hughes on appeal in Chrysler Canada Inc. v. Canada.

By way of background, the Minister assessed Part XIII tax against JP Morgan in respect of fees it had paid to non-resident affiliates between 2002 and 2008.  JP Morgan applied for judicial review of the Minister’s decision to assess it for amounts payable under Part XIII of the Income Tax Act.  In particular, JP Morgan alleged that in exercising discretion to assess for years other than the current year and the two immediately preceding years

. . . CRA did not consider, or sufficiently consider, CRA’s own policies, guidelines, bulletins, internal communiqués and practices which would otherwise have limited assessments to the current tax year and the two (2) immediately preceding years.  CRA thus acted arbitrarily, unfairly, contrary to the rules of natural justice and in a manner inconsistent with CRA’s treatment of other tax payers.

The Crown moved to strike the application for judicial review, relying on section 18.5 of the Federal Courts Act.  Citing his earlier decision in Chrysler Canada, the Prothonotary dismissed the Crown’s motion.  He held that JP Morgan’s judicial review application dealt with:

. . . the discretion to assess as described in various policies of CRA.  That decision to apparently depart from policies and assess is subject to judicial review and is the type of situation that is contemplated by Addison & Leyen.  The ITA provides that the Minister “may” assess not “shall” assess which connotes a discretionary decision.  The decision of the Minister to apparently depart from policies is not otherwise reviewable [by the Tax Court of Canada] and therefore is subject to judicial review.

Consistent with his earlier decision in Chrysler Canada, the Prothonotary held that “JP Morgan only seeks judicial review of the decision to reassess which is alleged to be contrary to policies of CRA which were in place.  No attack on the reassessments is in play.” In his view, the case was about the Minister’s discretion to assess, not the assessments themselves.

Justice Mandamin dismissed the Crown’s appeal of the Prothonotary’s decision as he did not find that the Prothonotary’s Order was clearly wrong in that the exercise of discretion was based upon a wrong principle or a misapprehension of the facts and there was no improper exercise of discretion on a question vital to the case arising with the Prothonotary’s dismissal of the Crown’s motion to strike.

It is not yet known whether the Crown will appeal the decision of Justice Mandamin in JP Morgan, but it would not be surprising in light of the fact that several Crown motions to strike such judicial review applications are currently before the Federal Court.

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Federal Court decides that JP Morgan’s judicial review application challenging the Minister’s decision to assess Part XIII tax may proceed

Two Rectification Cases from Quebec to be Heard by the Supreme Court of Canada on November 8, 2012

Two appeals will be heard tomorrow morning by the Supreme Court of Canada in rectification decisions from the Quebec courts. The first appeal is Agence du Revenu du Québec (formerly the Deputy Minister of Revenue of Quebec) v. Services Environnementaux AES Inc., et al. while the second appeal is Agence du Revenu du Québec v. Jean Riopel, et al.  In each case, the Quebec Court of Appeal agreed with the taxpayers that rectification was in order.

The Supreme Court’s summary of the first appeal may be found here.  Each factum in the first appeal may be read here.

The Supreme Court’s summary of the second appeal may be found here.  Each factum in the second appeal may be read here.

The decision of the Quebec Court of Appeal in the first appeal is here.  The decision of the Quebec Court of Appeal in the second appeal is here.

At 9:30 a.m. tomorrow, the live webcast of the hearings may be viewed here or here.  The archived webcast will be available for viewing a day or two later.

The newest member of the Supreme Court of Canada, Justice Richard Wagner, was a member of the panel of the Quebec Court of Appeal that decided the second appeal.  He will, therefore, not hear tomorrow’s appeals.  Accordingly, a maximum of seven judges will be on the panel tomorrow morning.

Postscript: At the conclusion of the hearing, the panel reserved judgment.  During the course of the hearing, highlights of argument were tweeted live @CanTaxLit

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Two Rectification Cases from Quebec to be Heard by the Supreme Court of Canada on November 8, 2012

Another Tax Court hearing ordered for GlaxoSmithKline Inc. on the first transfer pricing case to reach the Supreme Court of Canada

This morning, the Supreme Court of Canada dismissed the Crown’s appeal in The Queen v. GlaxoSmithKline Inc., the first transfer pricing case to be heard by the Supreme Court of Canada under subsection 69(2) of the Income Tax Act (Canada) (the “Act”) and ordered the parties to return to the Tax Court of Canada for the determination of the appropriate transfer price.  The Supreme Court of Canada remitted the matter to the Tax Court of Canada:

[76]   . . . to be redetermined, having regard to the effect of the Licence Agreement on the prices paid by Glaxo Canada for the supply of ranitidine from Adechsa.  The Tax Court judge should consider any new evidence the parties seek to adduce and that he may choose to allow.

The Supreme Court endorsed and elaborated on the legal test set out by the Federal Court of Appeal and rejected the test applied by the Tax Court.  However, it is important to note that subsection 69(2) has been replaced by subection 247(2) of the Act which applies in respect of taxation years and fiscal periods beginning after 1997.  The taxation years at issue in this litigation were 1990-1993.

The reasons for judgment were delivered by Justice Rothstein for a panel of seven (the other members of the panel were the Chief Justice, Justice Deschamps, Justice Abella, Justice Cromwell, Justice Moldaver and Justice Karakatsanis).

By way of background, GlaxoSmithKline Inc. (“Glaxo Canada”) purchased ranitidine, the active ingredient in the anti-ulcer medication called Zantac, from a Swiss non-arm’s length source approved by Glaxo UK (“Adechsa S.A.”) which was part of the Glaxo Group in the U.K.  It did so at a price approximately five times higher than the price at which the same ranitidine was sold in the market to Canadian generic drug manufacturers who did not have the right to manufacture or sell Zantac.

Glaxo Canada could not have gone into the market to purchase ranitidine at the price paid by the generic drug manufacturers and use that ranitidine to manufacture and sell Zantac in Canada.  It had the right to manufacture and sell Zantac in Canada under an agreement with Glaxo Group pursuant to which it was required to purchase all of its ranitidine from Adechsa S.A. at a price determined by Glaxo Group.  Glaxo Canada entered into a Licence Agreement with Glaxo Group which allowed it to manufacture and sell Zantac in Canada in consideration of a royalty payment to Glaxo Group.  Glaxo Canada was also required to purchase the raw ingredient, ranitidine, from a source approved by Glaxo Group (i.e., Adechsa S.A.) under a Supply Agreement between it and Adechsa S.A.  During the years at issue, the price of ranitidine purchased by Glaxo Canada was $1500 per kilogram while identical ranitidine was available and was purchased by generic drug manufacturers at $300 per kilogram.

The 1985 version of subsection 69(2) applicable to the years 1990-1993 reads:

(2) Where a taxpayer has paid or agreed to pay to a non-resident person with whom the taxpayer was not dealing at arm’s length as price, rental, royalty or other payment for or for the use or reproduction of any property, or as consideration for the carriage of goods or passengers or for other services, an amount greater than the amount (in this subsection referred to as “the reasonable amount”) that would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm’s length, the reasonable amount shall, for the purpose of computing the taxpayer’s income under this Part, be deemed to have been the amount that was paid or is payable therefor.

The Decision of the Tax Court of Canada

The issue before the Tax Court was whether the amount paid by the taxpayer to the non-arm’s-length party was “reasonable in the circumstances.”  The Tax Court held that (a) the “comparable uncontrolled price” (or CUP) method was the most accurate way to determine the arm’s-length price for ranitidine and (b) the appropriate comparable transactions were the purchases of ranitidine by the generic manufacturers. Subject to a relatively minor adjustment, the Tax Court dismissed the taxpayer’s appeal.

The Decision of the Federal Court of Appeal

The Federal Court of Appeal allowed the taxpayer’s appeal. The Court of Appeal held that the Tax Court had erred in its application of the “reasonable in the circumstances” test, and that it should have inquired into the circumstances that an arm’s-length purchaser in the taxpayer’s position would have considered relevant in deciding what reasonable price to pay for ranitidine. The Court of Appeal set aside the Tax Court judgment and sent the matter back to the Tax Court to be reconsidered.

The Hearing Before the Supreme Court of Canada

At the hearing, Crown counsel emphasized the fact that the only transaction under review was the purchase of ranitidine.  As counsel put it at the hearing, you don’t throw into the analysis “the whole deal.”  She argued that the only question is “what is an arm’s length price to pay for ranitidine?”  Counsel contended that one must strip away the non-arm’s length circumstance (i.e., the requirement to buy ranitidine at a price set by Glaxo Group).

(a) Questions for the Crown at the Supreme Court Hearing

Justice Abella was concerned about whether it was fair for the Crown to compare (under the CUP method) on the one hand the price paid by Glaxo Canada for ranitidine that was destined to become Zantac and, on the other hand, the price paid by generic drug manufacturers for ranitidine that was not destined to become Zantac.  Justice Abella asked counsel whether “in the circumstances” in subsection 69(2) meant that you look at the whole deal.  Counsel argued that you can’t look at the whole deal.

The Chief Justice focused on the words of 69(2) “that would have been reasonable in the circumstances” and asked Crown counsel what is to be included in “the circumstances”.  Crown counsel contended that the only relevant circumstance is the price of ranitidine paid by the generic drug manufacturers in Canada.  The Crown maintained that one cannot take into account any “non-arm’s length” circumstance (e.g., that Glaxo Canada must pay the price set by Glaxo Group) and that all non-arm’s length circumstances must be stripped out of the analysis under subsection 69(2).

During the Crown’s reply argument, Justice Cromwell described the Crown’s position as: ”Whatever the deal is, we ignore it.”  Crown counsel agreed with that characterization.

Justice Moldaver asked counsel, in light of the decision of Parliament not to use the phrase “reasonable in the circumstances” in the successor provision to subsection 69(2) (subsection 247(2) of the Act), why would the Crown ignore that language and call the whole structure of the deal “background music” and not part of the “circumstances”.

Justice Rothstein remarked that Glaxo Canada was not simply purchasing ranitidine but was purchasing ranitidine for the purpose of resale as Zantac.  If Glaxo Canada went into the market like the generics and purchased ranitidine, they would not have been able to resell it as Zantac and Zantac is their business.  He asked Crown counsel why the words “reasonable in the circumstances” exclude the way that a business plans to use the product it is purchasing.  He noted that there is a “generic market” and a “brand product” market for most drugs.  He asked why those circumstances are not relevant in determining the price someone would pay for ranitidine to be used for “brand product” sales as opposed to ranitidine for ”generic product” sale.

In answer to some of these concerns, counsel referred to paragraph 89 of the reasons for judgment of the Tax Court:

[89]     If the legislature intended that the phrase “reasonable in the circumstances” in subsection 69(2) should include all contractual terms there would be no purpose to subsection 69(2); any MNE would be able to claim that its parent company would not allow it to purchase from another supplier. No MNE would ever have its transfer prices measured against arm’s length prices, because all MNEs would allege that they could purchase only from sources approved by the parent company. The controlling corporation in a MNE would structure its relationships with its related companies, and as between its related companies, in this manner or in some similar manner. There is no question that the appellant was required to purchase Glaxo approved ranitidine. The issue is whether a person in Canada dealing at arm’s length with its supplier would have accepted the conditions and paid the price the appellant did.

Justice Deschamps observed that if the Crown is looking at a transaction with a generic company, it is not looking at the same transaction.  Crown counsel responsed by saying that the transaction at issue is a simple purchase of ranitidine and the Minister is only trying to value that one transaction.

Justice Abella asked counsel whether it is relevant to the pricing analysis that this was not just a purchase of ranitidine but a purchase of ranitidine for the purpose of being sold as Zantac.  Crown counsel maintained that this was just a purchase of ranitidine as subsection 69(2) strips out the non-arm’s length element.

Justice Rothstein asked counsel what there would be to argue if the matter were remitted back to the Tax Court.  Counsel responded that the Minister’s position would be exactly the same (the price paid by Glaxo Canada was not “the reasonable amount”) based on the evidence of what the generic drug manufacturers paid.  The Crown concluded by arguing that you simply cannot find a comparator selling Zantac without the concomitant non-arm’s length circumstances.

(b) Questions for Glaxo Canada at the Supreme Court Hearing

Justice Abella asked counsel whether there was any way of determining whether $1,500 per kilogram was the “fair market value” of the ranitidine to someone in Glaxo Canada’s position.  How do you test the “reasonableness” of the $1,500 per kilo price?  Counsel responded by saying that that wasn’t the Minister’s case.  The Minister simply assessed on the basis that Glaxo Canada paid more than the generics did and that was the only relevant comparator.  Once that theory was set aside by Federal Court of Appeal, that was the end of it.

The Chief Justice asked counsel whether it would be possible for taxpayers to avoid Part XIII tax on royalties for the use of intellectual property if no actual royalty was paid but was, instead, effectively embedded in the cost of the goods.  Counsel replied that such “unbundling” is unnecessary as other provisions deal with abusive tax avoidance such as that.  In any event, there are no such allegations in this case by the Minister (i.e., that “unbundling” is required or that inappropriate tax avoidance has taken place).

The Chief Justice wondered whether the Minister’s allegation that Glaxo Canada paid too much shifted the onus to Glaxo Canada to fully engage in the “unbundling” debate.  Counsel responded that Glaxo Canada paid $1,500 per kilogram to Adechsa S.A. for the ranitidine and paid a separate royalty to Glaxo Group for the use of intellectual property.  The Minister never argued that Glaxo Canada was obliged to do any sort of unbundling in this case.

Justice Rothstein asked counsel whether once the Federal Court of Appeal determined that the wrong test had been applied, it should have remitted the matter back to the Tax Court to determine the non-arm’s length price based on the proper legal test (i.e. taking into account the particular business circumstances around the transaction).  Counsel argued that sending the matter back to the Tax Court would turn the rules of civil litigation in general, and tax litigation in particular, on their heads.  He contended that the Tax Court cannot try a case that was never pleaded by the Crown.  The Chief Justice wondered whether the taxpayer had not discharged its burden of showing that $1,500 per kilogram was “the reasonable amount”.  Counsel responded by observing that Glaxo Canada, at trial, had demolished the basis for the Minister’s assessment and, in light of the judgment of the Federal Court of Appeal, the burden shifts to the Minister – the burden does not remain on the taxpayer to demonstrate why the price charged for the ranitidine was “the reasonable amount”.  Glaxo Canada met the case pleaded against it and the Minister has no right to start all over again in respect of the taxation years at issue.  On the pleadings as they currently stand, there is no case to go back to the Tax Court.

The Decision of the Supreme Court of Canada

In a nutshell, the Court held that the legal test applied by the Tax Court was incorrect as it ignored the Licence Agreement and the Supply Agreement which formed part of the relevant circumstances surrounding the transaction at issue.  As there had been no factual determination of the appropriate transfer price in light of the correct legal test, the Court referred the matter back to the Tax Court to determine the appropriate transfer price.

More detailed commentary will follow in the days to come but, in the meantime, here are some of the more important passages in the decision:

The role of OECD Guidelines

[20]   In the courts below and in this Court, there has been reference to the1979 Guidelines and the 1995 Guidelines (“the Guidelines”).  The Guidelines contain commentary and methodology pertaining to the issue of transfer pricing.  However, the Guidelines are not controlling as if they were a Canadian statute and the test of any set of transactions or prices ultimately must be determined according to s. 69(2) rather than any particular methodology or commentary set out in the Guidelines.

The relevant circumstances

[38]   . . . The requirement of s. 69(2) is that the price established in a non-arm’s length transfer pricing transaction is to be redetermined as if it were between parties dealing at arm’s length.  If the circumstances require, transactions other than the purchasing transactions must be taken into account to determine whether the actual price was or was not greater than the amount that would have been reasonable had the parties been dealing at arm’s length.

                                                                        *  *  *

[42]   Thus, according to the 1995 Guidelines, a proper application of the arm’s length principle requires that regard be had for the “economically relevant characteristics” of the arm’s length and non-arm’s length circumstances to ensure they are “sufficiently comparable”.  Where there are no related transactions or where related transactions are not relevant to the determination of the reasonableness of the price in issue, a transaction-by-transaction approach may be appropriate.  However, “economically relevant characteristics of the situations being compared” may make it necessary to consider other transactions that impact the transfer price under consideration.  In each case it is necessary to address this question by considering the relevant circumstances.

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[44]   Because s. 69(2) requires an inquiry into the price that would be reasonable in the circumstances had the non-resident supplier and the Canadian taxpayer been dealing at arm’s length, it necessarily involves consideration of all circumstances of the Canadian taxpayer relevant to the price paid to the non-resident supplier.  Such circumstances will include agreements that may confer rights and benefits in addition to the purchase of property where those agreements are linked to the purchasing agreement. The objective is to determine what an arm’s length purchaser would pay for the property and the rights and benefits together where the rights and benefits are linked to the price paid for the property.

Stripping out non-arm’s length elements

[47]   There were only two approved sources, one of which was Adechsa.  Thus, in order to avail itself of the benefits of the Licence Agreement, Glaxo Canada was required to purchase the active ingredient from one of these sources.  This requirement was not the product of the non-arm’s length relationship between Glaxo Canada and Glaxo Group or Adechsa.  Rather, it arose because Glaxo Group controlled the trademark and patent of the brand-name pharmaceutical product Glaxo Canada wished to market. An arm’s length distributor wishing to market Zantac might well be faced with the same requirement.

[48]   The effect of the link between the Licence and Supply agreements was that an entity that wished to market Zantac was subject to contractual terms affecting the price of ranitidine that generic marketers of ranitidine products were not.

[49]   As such, the rights and benefits of the Licence Agreement were contingent on Glaxo Canada entering into a Supply Agreement with suppliers to be designated by Glaxo Group.  The result of the price paid was to allocate to Glaxo Canada what Glaxo Group considered to be appropriate compensation for its secondary manufacturing and marketing function in respect of ranitidine and Zantac.

The use of generic comparators

[53]   . . . the generic comparators do not reflect the economic and business reality of Glaxo Canada and, at least without adjustment, do not indicate the price that would be reasonable in the circumstances, had Glaxo Canada and Adechsa been dealing at arm’s length.

Glaxo Canada was paying for more than just ranitidine

[51]   Thus, it appears that Glaxo Canada was paying for at least some of the rights and benefits under the Licence Agreement as part of the purchase prices for ranitidine from Adechsa.  Because the prices paid to Adechsa were set, in part, as compensation to Glaxo Group for the rights and benefits conferred on Glaxo Canada under the Licence Agreement, the Licence Agreement could not be ignored in determining the reasonable amount paid to Adechsa under s. 69(2), which applies not only to payment for goods but also to payment for services.

[52]   Considering the Licence and Supply agreements together offers a realistic picture of the profits of Glaxo Canada.  It cannot be irrelevant that Glaxo Canada’s function was primarily as a secondary manufacturer and marketer.  It did not originate new products and the intellectual property rights associated with them.  Nor did it undertake the investment and risk involved with originating new products.  Nor did it have the other risks and investment costs which Glaxo Group undertook under the Licence Agreement.  The prices paid by Glaxo Canada to Adechsa were a payment for a bundle of at least some rights and benefits under the Licence Agreement and product under the Supply Agreement.

                                                                    *  *  *

[59]   In addition, while, as Rip A.C.J. found, Glaxo Canada’s ranitidine and generic ranitidine are chemically equivalent and bio-equivalent, he also found that there was value in the fact that Adechsa’s ranitidine manufactured under Glaxo Group’s “good manufacturing practices” “may confer a certain degree of comfort that the good has minimal impurities and is manufactured in a responsible manner” (para. 118).  Zantac is priced higher than the generic products, presumably, at least in part, because of that “degree of comfort” that Rip A.C.J. acknowledged.

[60]   These are all features of the Licence Agreement and the requirement to purchase from a Glaxo-approved source that add value to the ranitidine that Glaxo Canada purchased from Adechsa over and above the value of generic ranitidine without these rights and benefits.  They should justify some recognition in determining what an arm’s length purchaser would be prepared to pay for the same rights and benefits conveyed with ranitidine purchased from a Glaxo Group source.  It is only after identifying the circumstances arising from the Licence Agreement that are linked to the Supply Agreement that arm’s length comparisons under any of the OECD methods or other methods may be determined.

Part XIII (withholding) tax

[57]   Although I said above that the purchase price appeared to be linked to some of the rights and benefits conferred under the Licence Agreement, I make no determination in these reasons as to whether the rights under the ranitidine patent granted to Glaxo Canada to manufacture and sell Zantac and the exclusive right to use the Zantac trademark are linked to the purchase price paid by Glaxo Canada to Adechsa.  However, arguably, if the purchase price includes compensation for intellectual property rights granted to Glaxo Canada, there would have to be consistency between that and Glaxo Canada’s position with respect to Part XIII withholding tax.  This issue was not specifically argued in this Court and may be addressed by the parties in the Tax Court and considered by the Tax Court judge when considering whether any specific rights and benefits conferred on Glaxo Canada under the Licence Agreement are linked to the price for ranitidine paid to Adechsa.

Guidelines for the Tax Court of Canada in making its redetermination

[54]   I agree with Justice Nadon that “the amount that would have been reasonable in the circumstances” if Glaxo Canada and Adechsa had been dealing at arm’s length has yet to be determined.  This will require a close examination of the terms of the Licence Agreement and the rights and benefits granted to Glaxo Canada under that Agreement.

                                                                  *  *  *

[61]   I would offer the following additional guidance with respect to the redetermination.  First, s. 69(2) uses the term “reasonable amount”.  This reflects the fact that, to use the words of the 1995 Guidelines, “transfer pricing is not an exact science” (para. 1.45).  It is doubtful that comparators will be identical in all material respects in almost any case.  Therefore, some leeway must be allowed in the determination of the reasonable amount.  As long as a transfer price is within what the court determines is a reasonable range, the requirements of the section should be satisfied.  If it is not, the court might select a point within a range it considers reasonable in the circumstances based on an average, median, mode, or other appropriate statistical measure, having regard to the evidence that the court found to be relevant.  I repeat for emphasis that it is highly unlikely that any comparisons will yield identical circumstances and the Tax Court judge will be required to exercise his best informed judgment in establishing a satisfactory arm’s length price.

[62]   Second, while assessment of the evidence is a matter for the trial judge, I would observe that the respective roles and functions of Glaxo Canada and the Glaxo Group should be kept in mind.  Glaxo Canada engaged in the secondary manufacturing and marketing of Zantac.  Glaxo Group is the owner of the intellectual property and provided other rights and benefits to Glaxo Canada.  Transfer pricing should not result in a misallocation of earnings that fails to take account of these different functions and the resources and risks inherent in each.  As discussed above, whether or not compensation for intellectual property rights is justified in this particular case, is a matter for determination by the Tax Court judge.

[63]   Third, prices between parties dealing at arm’s length will be established having regard to the independent interests of each party to the transaction.  That means that the interests of Glaxo Group and Glaxo Canada must both be considered.  An appropriate determination under the arm’s length test of s. 69(2) should reflect these realities.

[64]   Fourth, in this case there is some evidence that indicates that arm’s length distributors have found it in their interest to acquire ranitidine from a Glaxo Group supplier, rather than from generic sources.  This suggests that higher-than-generic transfer prices are justified and are not necessarily greater than a reasonable amount under s. 69(2).

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Another Tax Court hearing ordered for GlaxoSmithKline Inc. on the first transfer pricing case to reach the Supreme Court of Canada

Supreme Court of Canada declines to hear an appeal on whether an expenditure in the course of a corporate reorganization was on capital or income account

Earlier today, the Supreme Court of Canada (The Chief Justice, Justice Rothstein and Justice Moldaver) dismissed an application for leave to appeal by Imperial Tobacco dealing with the classic distinction between deductible corporate expenditures on income account and non-deductible corporate expenditures on capital account. 

In brief, the taxpayer made a payment to extinguish an employee stock option plan (suggesting that the payment was made on income account) but made the payment during the course of a corporate reorganization (suggesting that the payment was made on capital account). 

The taxpayer’s argument for deductibility was supported by the Tax Court decision in Shoppers Drug Mart Limited v. The Queen (dealing with the very same transaction) while the Crown’s argument for non-deductibility was supported by the earlier Federal Court of Appeal decision in Kaiser Petroleum Ltd. v. The Queen.  

Both the Tax Court of Canada and Federal Court of Appeal followed the reasoning of the Federal Court of Appeal in Kaiser and sided with the Crown, holding that the payment was on capital account.  The decision of the Federal Court of Appeal is now final and binding.

For a brief description of the reasoning of the Federal Court of Appeal, see our earlier blog post.

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Supreme Court of Canada declines to hear an appeal on whether an expenditure in the course of a corporate reorganization was on capital or income account

A triumph of functionalism over formalism: SCC holds that the test for determination of residence of a trust is “central management and control”

Less than a month after hearing oral argument on March 13, 2012, the Supreme Court of Canada today released judgment and reasons for judgment in the Fundy Settlement v. Canada also known as the Garron Family Trust appeals (St. Michael Trust Corp., as Trustee of the Fundy Settlement v. The Queen and St. Michael Trust Corp., as Trustee of the Summersby Settlement v. The Queen).  The Court’s alacrity is remarkable, particularly in light of the fact that it had taken nearly eleven months to release its last tax decision (Copthorne Holdings Ltd. v. The Queen).

See here for a summary of the oral argument before the Supreme Court of Canada and here for the facts, the reasons for judgment of the Tax Court and Federal Court of Appeal and the factum filed by each party in the Supreme Court of Canada.

In Fundy Settlement, a unanimous panel of seven (Justices LeBel, Deschamps, Fish, Abella, Rothstein, Moldaver and Karakatsanis) dismissed the Trustee’s appeals and held that the test for the determination of the residence of a trust is the same test as the corporate test, namely, the place where “central management and control” is exercised.  The reasons were written by the “Court” which further serves to highlight the unanimity of opinion among the judges who heard the appeals.

In a ringing endorsement of the reasoning of Justice Judith Woods of the Tax Court of Canada and Justice Karen Sharlow of the Federal Court of Appeal (both of whom had used a “functional analysis” to decide the issue) the Court explained, in a relatively brief 19 paragraph decision, why it agreed with the lower courts on this issue:

[14]  . . . there are many similarities between a trust and corporation that would, in our view, justify application of the central management and control test in determining the residence of a trust, just as it is used in determining the residence of a corporation.  Some of these similarities include:

1)   Both hold assets that are required to be managed;

2)   Both involve the acquisition and disposition of assets;

3)   Both may require the management of a business;

4)   Both require banking and financial arrangements;

5)   Both may require the instruction or advice of lawyers, accountants and other advisors; and

6)   Both may distribute income, corporations by way of dividends and trusts by distributions.

As Woods J. noted:  “The function of each is, at a basic level, the management of property” (para. 159).

[15]  As with corporations, residence of a trust should be determined by the principle that a trust resides for the purposes of the Act where “its real business is carried on” (De Beers, at p. 458), which is where the central management and control of the trust actually takes place.  As indicated, the Tax Court judge found as a fact that the main beneficiaries exercised the central management and control of the trusts in Canada.  She found that St. Michael had only a limited role ― to provide administrative services ― and little or no responsibility beyond that (paras. 189-90).  Therefore, on this test, the trusts must be found to be resident in Canada.  This is not to say that the residence of a trust can never be the residence of the trustee.  The residence of the trustee will also be the residence of the trust where the trustee carries out the central management and control of the trust, and these duties are performed where the trustee is resident.  These, however, were not the facts in this case.

[16]  We agree with Woods J. that adopting a similar test for trusts and corporations promotes “the important principles of consistency, predictability and fairness in the application of tax law” (para. 160).  As she noted, if there were to be a totally different test for trusts than for corporations, there should be good reasons for it.  No such reasons were offered here.

[17]  For these reasons, we would dismiss the appeals with costs.

In light of its conclusion on the main issue, the Court did not find it necessary to deal with the Crown’s alternative arguments, namely the application of section 94 of the Income Tax Act or the General Anti-Avoidance Rule.

 

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A triumph of functionalism over formalism: SCC holds that the test for determination of residence of a trust is “central management and control”

Argument concludes in Supreme Court of Canada in trust residence appeal (Garron)

Earlier today, the Supreme Court of Canada heard arguments in the Garron appeal.  The reasons for judgment of the Tax Court of Canada and the Federal Court of Appeal, as well as the factum of each party, may be found at our earlier post.

Appellants’ Oral Argument

Counsel for the Appellants argued that the Income Tax Act contemplates that the residence of a trust is to be determined by the residence of the trustee.  It does so through a combination of subsections 104(1) and 104(2).  As a trust itself has no legal personality, Parliament has created a ”deemed individual” character for trusts in the form of the trustee under subsection 104(2).  In the Appellants’ view, subsection 104(1) is critical as it provides the “linkage” between the trust and the trustee.

Justice Abella wondered whether the phrase “ownership or control” in subsection 104(1) suggests that Parliament intended that the “control” test apply in the context of determining the residence of a trust, as the Crown contends.

Justices LeBel and Karakatsanis wondered why one would look to the residence of the trustee when, under subsection 104(2), the trust is considered a separate person.

Justice Rothstein wondered why a trust should be treated differently than a corporation in the sense that both are created in similar ways and both have similar “locational attributes”.  In other words, why can’t we locate the trust outside the place the trustee resides?

Justice Moldaver wondered whether the phrase “unless the context otherwise requires” in subsection 104(1) suggests that Parliament did not want trustees to be set up as straw men outside Canada simply to avoid tax.  Counsel for the Appellants responded that the phrase “unless the context otherwise requires” means that in a provision where it makes no sense for “trust” to mean “trustee” it does not mean “trustee” (e.g. subsection 108(6)).  He also responded that Parliament addresses avoidance concerns elsewhere in the Income Tax Act, including section 94.  He submitted that the rule for the determination of residence of a trust is not the answer to tax avoidance.

Counsel for the Appellants drew to the Court’s attention the (a) affiliated persons rule and (b) qualified environmental trusts rule as both deal with the residence of trustees (as opposed to the residence of trusts).  This makes it clear that the residence of the trustees is what really matters and confirms the “linkage” between trust and trustee.

Counsel for the Appellants also noted that the plan undertaken in this case would not work today in light of the amendments to section 94 of the Income Tax Act and the provisions of the Income Tax Conventions Interpretation Act.

Justice Abella asked whether, in light of the fact that both corporations and trusts manage property, the test ought to be the same for each (i.e. the central management and control test) and where they manage the property should be determined in the same way for both.  Counsel for the Appellants characterized such an approach as “superficial”.

Finally, counsel for the Appellants argued that adoption of the “formalistic” central management and control test will not eliminate the possibility of manipulation.  One could arrange that all meetings at which substantive decisions are made occur outside Canada.  Accordingly, there is no reason to prefer that test over the traditional residence of the trustee test.

Crown’s Oral Argument

Counsel for the Crown argued that the central management and control test is the proper test for determining the residence of a trust for income tax purposes.  She argued that such a test is consistent with the legislative scheme.  She also argued that the rationale for the application of the test in the trust context is the same as the rationale for the application of the test in the corporate context.

Justice Moldaver asked, if Parliament intended the same rule to apply to trusts as to corporations, why the Income Tax Act did not provide that a trust is deemed to be a  corporation rather than an individual.  Crown counsel responded that someone has to be assigned responsibility for administrative functions, as noted by the Federal Court of Appeal, and that is the trustee under subsection 104(1).  Such administrative functions include filing returns, receiving assessments, filing objections and appeals and paying tax debts of the trust.

Citing De Beers Consolidated Mines, Justice Rothstein asked what the result would be if those who actually controlled the trusts met in Barbados and that is where they made all the substantive decisions (i.e. the key decisions affecting the trust property).  After noting that you can’t just leave Canada in order to “paper” such decisions if they were actually made in Canada, Crown counsel admitted that such a trust would be resident in the Barbados if indeed all substantive decisions were made in Barbados.

Justice LeBel asked whether one would have to perform a complete factual enquiry in order to make such a determination.  Crown counsel said yes, just as one would do in the case of a corporation in order to determine the place of central management and control.

Crown counsel listed a number of similarities between corporations and trusts particularly with respect to the managment of property as a function of each.  The question then becomes: where is that management exercised?

Justice Deschamps asked Crown counsel about the two statutory examples cited by counsel for the Appellants, namely, the affiliated persons rule and the qualified environmental trust rule.  She argued that those rules simply dictate where the trustees must reside and nothing else.

Counsel concluded by noting that the central management and control test has been applied for one hundred years and that test should now be adopted to determine where a trust is resident.

The Crown’s Alternative Arguments: Section 94 and GAAR

Junior counsel for the Appellants and the Crown spent approximately ten minutes each arguing the section 94 and GAAR points.  There were no questions directed to the Appellants on these points, but several questions were directed to the Crown.

The Crown contends that even if the trusts were resident in Canada (under either test), the trusts should be deemed not to have been resident in Canada under paragraph 94(1)(b) (the “contribution test”), as the Federal Court of Appeal concluded, on the basis that the trusts “acquired” property without actually “owning” it.  Junior counsel for the Crown was challenged on this point by Justice Rothstein.  He was also challenged when he argued that the GAAR applied.  Justice LeBel admitted that he had “some problems at this stage” with the application of the GAAR under the circumstances.  In addition, Justice Rothstein questioned whether there could be a GAAR case if all substantive decisions had actually made in the Barbados and, therefore, the trusts had satisfied the Crown’s central management and control test.  Junior counsel for the Crown responded by contending that there would be a GAAR case as such trusts, in light of the fact that they have no function to serve, would be artificial entities and devoid of economic substance.

After a very brief reply by counsel for the Appellants, judgment was reserved.

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Argument concludes in Supreme Court of Canada in trust residence appeal (Garron)

Conference on the Copthorne decision at U of T Faculty of Law – January 6, 2012

On December 16, 2011, the Supreme Court of Canada released its much-anticipated decision in Copthorne Holdings Ltd. v. Canada (go here for our blog post on the decision).  Next Friday afternoon, January 6, 2012, the Faculty of Law at the University of Toronto will be hosting an extraordinary event exploring the implications of the decision for the future of the GAAR.  An outstanding array of speakers has been lined up (including FMC’s own Don Bowman).  Spending that Friday afternoon at the Faculty of Law is sure to be one of the best ways to efficiently get up to speed on all the implications of the decision.

For details, please see the attached flyer, or go directly to http://www.copthorne.ca for registration information.

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Conference on the Copthorne decision at U of T Faculty of Law – January 6, 2012

Crown Wins GAAR Case in the Supreme Court of Canada: Copthorne Holdings Ltd. v. The Queen

On December 16, 2011, the Supreme Court of Canada released its latest General Anti-Avoidance Rule (GAAR) decision in Copthorne Holdings Ltd. v. Canada.  The appeal was heard on January 21, 2011 by all nine of the Justices (Chief Justice McLachlin, Justice Binnie, Justice LeBel, Justice Deschamps, Justice Fish, Justice Abella, Justice Charron, Justice Rothstein and Justice Cromwell).  Since the date of the hearing, Justices Binnie and Charron have retired.  This was the fourth GAAR appeal heard by the Supreme Court (the earlier cases were Canada Trustco Mortgage Co. v. Canada, Mathew v. Canada and Lipson v. Canada).

With Justice Rothstein writing for a unanimous Court, the taxpayer’s appeal was dismissed.  In so doing, the Court arrived at the same result as the Tax Court of Canada and the Federal Court of Appeal while, at the same time, providing important guidance for corporate Canada on the interpretation and application of the GAAR particularly in the context of reorganizations and distributions.  The clarity and precision of Justice Rothstein’s reasons should be welcomed by the business community, though the result in this particular case was unfavourable to the taxpayer.

If $96 million was contributed as capital, how can a taxpayer withdraw more than that amount as a tax-free return of capital?  Does the GAAR preclude such a result?  That the Court’s answer to the latter question was “yes” should not be regarded as a general defeat for tax planners.  The encouraging news for tax planners appears most clearly in two paragraphs of the reasons (note the deliberate use of the word “and” in paragraph 121):

[121] Copthorne also argues that the Act does not contain a policy that parent and subsidiary corporations must always remain as parent and subsidiary.  I agree. There is no general principle against corporate reorganization.  Where corporate reorganization takes place, the GAAR does not apply unless there is an avoidance transaction that is found to constitute an abuse.  Even where corporate reorganization takes place for a tax reason, the GAAR may still not apply.  It is only when a reorganization is primarily for a tax purpose and is done in a manner found to circumvent a provision of the Income Tax Act that it may be found to abuse that provision.  And it is only where there is a finding of abuse that the corporate reorganization may be caught by the GAAR.

* * *

[123] While Parliament’s intent is to seek consistency, predictability and fairness in tax law, in enacting the GAAR, it must be acknowledged that it has created an unavoidable degree of uncertainty for taxpayers.  This uncertainty underlines the obligation of the Minister who wishes to overcome the countervailing obligations of consistency and predictability to demonstrate clearly the abuse he alleges.

Background

In a nutshell, a non-resident invested $96 million in a Canadian holding company.  Those funds were then used to purchase Canadian portfolio investments and Canadian real property.  There were a number of subsidiaries and other affiliated corporations through which those investments were made.  About $67 million of that $96 million was, in turn, contributed to a subsidiary.  Following a 1993/1994 series of transactions, that $67 million of PUC was preserved which resulted in aggregate paid-up capital (“PUC”) as between the two companies of $163 million ($96 million plus $67 million).  That amount of PUC was later utilized, in another transaction, to permit the non-resident to withdraw $142 million from Canada free of withholding tax.

It was a set of 1994 proposals by the Department of Finance relating to the foreign accrual property income (“FAPI”) rules which caused the non-resident to monetize certain of his holdings.   This was done by redeeming $142 million of shares without payment of Canadian withholding tax.  What troubled the Minister of National Revenue was that the original investment was $96 million - any amount withdrawn in excess of the original capital contribution ought to have been considered a deemed dividend subject to Canadian withholding tax.

Having made the decision to divest those holdings, the taxpayer’s choice was whether to organize such a divestiture by way of a horizontal amalgamation or a vertical amalgamation.  If divestiture was to be accomplished by way of a horizontal amalgamation, the taxpayer believed that the total amount that could be removed free of Canadian withholding tax was $163 million ($96 million plus $67 million) as subsection 87(3) of the Income Tax Act does not provide for horizontally amalgamated corporations to lose their PUC as would have been the case on a vertical amalgamation (in the latter case, the PUC of the subsidiary would disappear on the amalgamation as the shares in the subsidiaries would necessarily have been cancelled).

There were two sets of transactions which the Crown had to connect in order to succeed under the extended definition of “series” in subsection 248(10) of the Income Tax Act.  There was a series of transactions in 1993/1994 (the sale of VHHC Holdings to Big City, and the subsequent amalgamation of VHHC Holdings with Copthorne I to form Copthorne II) which achieved the result of preserving $67 million of PUC in the subsidiary.  Then there was a transaction in 1995 (Copthorne III redeemed its shares without its shareholder incurring an immediate tax liability) which actually utilized the $67 million of PUC which had been preserved under the 1993/1994 series of transactions.

Was There a Tax Benefit?

In paragraph 37, Justice Rothstein explains why there was clearly a tax benefit:

[37] . . . . The only question was whether the amalgamation would be horizontal or vertical.  As the Tax Court judge pointed out, the vertical amalgamation would have been the simpler course of action.  It was only the cancellation of PUC that would arise upon a vertical amalgamation that led to the sale by Copthorne I of its shares in VHHC Holdings to Big City.  To use the words of Professor Duff, “but for” the difference in how PUC was treated, a vertical amalgamation was reasonable.

Was the Transaction Giving Rise to the Tax Benefit an Avoidance Transaction?

As there was no question about the tax benefit, the first issue was whether there was an “avoidance transaction”.  According to the Crown, the avoidance transaction was the 1993/1994 series of transactions which preserved the $67 million of PUC in the subsidiary as that series of transactions resulted in a tax benefit as part of a larger series (including the 1995 redemption transaction) in which the $67 million of PUC was actually utilized.

One of the Supreme Court’s concerns during oral argument was whether the 1993 series of transactions preserving $67 million of PUC was undertaken primarily for bona fide (i.e non-tax) purposes.  The taxpayer argued that it would have been imprudent, from a business perspective, to have squandered (or failed to preserve) all of the available PUC.  There is no relevant nexus, the taxpayer argued, between the 1993/1994 series of transactions and the 1995 redemption transaction.

During oral argument, considerable time was spent on the question of whether the extended meaning of “series of transactions” in subsection 248(10) of the Income Tax Act could be used to connect transactions where the first series was not undertaken specifically in order to facilitate the second transaction.  The taxpayer argued that the 1995 series could not have been undertaken “in contemplation of” the 1993/1994 series as the 1995 series was prompted by an intervening event (i.e., the proposed change to the FAPI rules).

Justice Rothstein held as follows:

[48] The Tax Court judge was aware both of the intervening introduction of the FAPI rule changes, as well as the time interval between the sale and amalgamation in 1993 and 1994 and the redemption in 1995 (para. 38).  Copthorne argued that these intervening events broke the purported series.  The Tax Court judge agreed that the test should not catch “transactions that are only remotely connected to the common law series” (para. 39).  Nonetheless, she found that there was a “strong nexus” between the series and the subsequent redemption, because “the Redemption   . . . was exactly the type of transaction necessary to make a tax benefit a reality based on the preservation of the PUC” (para. 40).  The Federal Court of Appeal upheld this conclusion, finding that there was no palpable and overriding error of fact. I would also uphold the Tax Court judge’s conclusion for the same reason.

At paragraph 56, Justice Rothstein concluded that, as stated by the Court in Canada Trustco, ”the language of s. 248(10) allows either prospective or retrospective connection of a related transaction to a common law series and that such an interpretation accords with the Parliamentary purpose.”  He therefore agreed with the Tax Court and Federal Court of Appeal that ”the redemption transaction was part of the same series as the prior sale and amalgamation, and that the series, including the redemption transaction, resulted in the tax benefit.” [paragraph 58]

Justice Rothstein’s observations here should be of considerable comfort to tax planners who will look to paragraph 47 in particular:

[47] Although the “because of” or “in relation to” test does not require a “strong nexus”, it does require more than a “mere possibility” or a connection with “an extreme degree of remoteness” (see MIL (Investments) S.A. v. R., 2006 TCC 460, [2006] 5 C.T.C. 2552, at para. 62, aff’d 2007 FCA 236, 2007 D.T.C. 5437).  Each case will be decided on its own facts.  For example, the length of time between the series and the related transaction may be a relevant consideration in some cases; as would intervening events taking place between the series and the completion of the related transaction.  In the end, it will be the “because of” or “in relation to” test that will determine, on a balance of probabilities, whether a related transaction was completed in contemplation of a series of transactions.

Tax planners now know that a transaction will not fall within a series of transactions unless it was undertaken “because of” or “in relation to” the series.  Such a test is far superior to the ”mere possibility” standard.

On the ”avoidance transaction” issue as a whole, Justice Rothstein concluded that:

[60] The Tax Court judge found that the 1993 sale of VHHC Holdings shares from Copthorne I to Big City was an avoidance transaction.  The Federal Court of Appeal agreed.

[61] The sale preserved the PUC of the VHHC Holdings shares when VHHC Holdings and Copthorne I were amalgamated to form Copthorne II, which allowed for the subsequent redemption of Copthorne III shares without liability for tax.  This is a tax purpose.

[62] Copthorne argues that the transactions were undertaken for the purposes of simplifying the Li Group companies and using the losses within the four amalgamated companies to shelter gains also within the four amalgamated companies.  While simplification and sheltering gains may apply to the other transactions, they do not explain the sale of VHHC Holdings shares to Big City.  As the Tax Court judge found, the share sale introduced an additional step into a process of simplification and consolidation.  A vertical amalgamation would have resulted in the same simplification and consolidation.  Moreover, Copthorne has not shown why sheltering gains using losses within the four companies would not have been possible if the companies were amalgamated vertically.

[63] I see no error in the finding of the Tax Court judge that the sale of the VHHC Holdings shares from Copthorne I to Big City was not primarily undertaken for a bona fide non-tax purpose.  The burden was upon Copthorne to prove the existence of a bona fide non-tax purpose (Trustco at para. 66), which it failed to do.  Thus, I would affirm her finding that the sale of the VHHC Holdings shares to Big City was an avoidance transaction.

[64] Because there was a series of transactions which resulted in a tax benefit, the finding that one transaction in the series was an avoidance transaction satisfies the requirements of s. 245(3).

Was the Avoidance Transaction Giving Rise to the Tax Benefit Abusive?

The Crown argued that the role of PUC in the Income Tax Act is to ”benchmark” the total amount that may be repaid to shareholders tax free.  It argued that the taxpayer abused, among other provisions, subsection 87(3) of the Income Tax Act by undertaking a horizontal amalgamation as it did.  The purpose of that provision, the Crown argued, is to prescribe how a taxpayer is to compute PUC on all amalgamations - it instructs taxpayers that they may not amalgamate a parent and a subsidiary without eliminating the PUC of the subsidiary.  The Crown contended that this was, at the end of the day, an amalgamation of a parent and subsidiary to which subsection 87(3) was intended to apply.  The Crown argued that the “result” was a vertical amalgamation and that the GAAR is a “results-based” test.  The result was a vertical amalgamation “by another name” and that is how subsection 87(3) was abused.  The taxpayer “inserted” an avoidance transaction (the 1993 series) which resulted in a vertical amalgamation being done horizontally.  In the final analysis, a subsidiary (with $67 million of PUC) had been amalgamated with the parent (with $96 million of PUC).  As subsection 87(3) is intended to prevent the duplication of PUC, a transaction that avoids the effect of subsection 87(3), but which nevertheless achieves PUC duplication, is abusive and, therefore, properly subject to the GAAR.

Justice Rothstein reviewed the purpose of subsection 87(3) and held as follows:

[88] In any GAAR case the text of the provisions at issue will not literally preclude a tax benefit the taxpayer seeks by entering into the transaction or series.  This is not surprising.  If the tax benefit of the transaction or series was prohibited by the text, on reassessing the taxpayer, the Minister would only have to rely on the text and not resort to the GAAR.  However, this does not mean that the text is irrelevant. In a GAAR assessment the text is considered to see if it sheds light on what the provision was intended to do.

[89] The text of s. 87(3) ensures that in a horizontal amalgamation the PUC of the shares of the amalgamated corporation does not exceed the total of the PUC of the shares of the amalgamating corporations.  The question is why s. 87(3) is concerned with limiting PUC in this way.  Since PUC may be withdrawn from a corporation without inclusion in the income of the shareholder, it seems evident that the intent is that PUC be limited such that it is not inappropriately increased merely through the device of an amalgamation.

[90] Section 87(3) also provides, in its parenthetical clause, that the PUC of the shares of an amalgamating corporation held by another amalgamating corporation is cancelled.  In other words, in a vertical amalgamation, the PUC of inter-corporate shareholdings, such as exists in the case of a parent-subsidiary relationship, is not to be aggregated.  Again, having regard to the fact that PUC may be withdrawn from a corporation not as a dividend subject to tax but as a non-taxable return of capital, the indication is that the parenthetical clause is intended to limit PUC of the shares of the amalgamated corporation to the PUC of the shares of the amalgamating parent corporation.  While the creation of PUC in the shares of downstream corporations is valid, its preservation on amalgamation may be seen as a means of enabling the withdrawal of funds in excess of the capital invested as a return of capital rather than as a deemed dividend to the shareholder subject to tax.

In arguing why such a result was not abusive, the taxpayer had asked the Court to bear in mind the entire scheme of the Income Tax Act, including capital gains tax.  The taxpayer noted that a capital gain of some $150 million was realized under the Income Tax Act on the disposition of the taxpayer’s Canadian investment portfolio.  It was argued that the fact that there was no Canadian tax on that gain by virtue of the Canada-Netherlands Tax Convention was irrelevant – it was Canada’s decision not to tax such gains in the context of the Treaty.

Justice Rothstein responded to this argument as follows:

[100] Copthorne argues that the provisions of the Act relating to capital gains and PUC are part of a single integrated scheme that “provides a complete solution to this situation” and ensures that tax eventually is applied to shareholder returns, either as a deemed dividend or as a capital gain (A.F., at para. 69).

[101] On the basis of the arguments made, I have not been convinced to accept Copthorne’s position.  Capital gains or losses are calculated in relation to the adjusted cost base (“ACB”) of a share, not its PUC.  While PUC relates to shares, ACB relates to a specific taxpayer. PUC depends on the amount initially invested as capital, whereas the ACB reflects the amount the current shareholder paid for the shares.  In some cases the ACB and PUC may be the same, but in others they may not be.  In the case of shares acquired from a prior shareholder it will be unlikely that the ACB will be equal to the PUC.

[102] I would hesitate to conclude that the Act contains a “complete solution” whereby any withdrawal that would not be caught under the PUC-deemed dividend scheme would be caught instead by the capital gains scheme.  An amount returned to a shareholder on a share redemption may be considered a return of capital  rather than a deemed dividend under s. 84(3).  However, the return of capital may reflect either a capital gain or a capital loss, which would be determined in relation to the ACB of the shareholder.

[103] Further, the tax rates applicable to dividends and capital gains are not identical.  With respect to non-resident shareholders, tax treaties may exempt capital gains from tax but not dividends.  This suggests that the capital gains scheme is not an automatic proxy for the PUC-deemed dividend scheme, whereby a taxpayer will always be liable for the same tax under one tax scheme or the other on a redemption.  Copthorne did not cite any sources directly on point.  The capital gains issue was not addressed by either the Tax Court judge or the Federal Court of Appeal.  In the circumstances, Copthorne has not substantiated this argument sufficiently that it can be accepted in this case.

The taxpayer contended that no one would squander a valuable ”corporate attribute” such as PUC by undertaking a vertical amalgamation in which the $67 million of PUC would have vanished.  There was no abuse here as Parliament specifically described in subsection 87(3) a set of circumstances in which PUC would be reduced (i.e., on a vertical amalgamation) but provided no reduction of PUC on a horizontal amalgamation.

On the overall “abuse” analysis, Justice Rothstein concluded as follows:

[124] Copthorne agrees that s. 87(3) would have led to a cancellation of the PUC of the VHHC Holdings shares if it had been vertically amalgamated with Copthorne I.  Instead of amalgamating the two companies, Copthorne I sold its VHHC Holdings shares to Big City, in order to avoid the vertical amalgamation and cancellation of the PUC of the shares of VHHC Holdings.  The transaction obviously circumvented application of the parenthetical words of s. 87(3) upon the later amalgamation of Copthorne I and VHHC Holdings.

[125] The question is whether this was done in a way that “frustrates or defeats the object, spirit or purpose” of the parenthetical words of s. 87(3) (Trustco, at para. 45).  In oral argument, Copthorne argued that by leaving VHHC Holdings and Copthorne in a vertical structure would be “throwing away” the PUC upon amalgamation.  It argued that the purpose of s. 87(3) cannot require shareholders to throw away valuable assets.  However, it must be remembered that there has been a finding of tax benefit (protecting the PUC of the shares of VHHC Holdings of $67,401,279 from withholding tax upon Copthorne III redeeming a large portion of its shares) and an avoidance transaction (the sale of VHHC Holdings from Copthorne I to Big City).  The GAAR analysis looks to determine whether the avoidance of a vertical amalgamation and preservation of the VHHC Holdings’ PUC of $67,401,279 circumvented s. 87(3), achieves an outcome s. 87(3) was intended to prevent or defeats the underlying rationale of s. 87(3).  If such a finding is made, the taxpayer is not “throwing away” a valuable asset.  It is the application of the GAAR that applies to deny the benefit of that “asset” to the taxpayer.

[126] It is true that the text of s. 87(3) recognizes two options, the horizontal and vertical forms of amalgamations.  It is also true that the text does not expressly preclude a taxpayer from selecting one or the other option.  However, I have concluded that the object, spirit and purpose of s. 87(3) is to preclude the preservation of PUC, upon amalgamation, where such preservation would allow a shareholder, on a redemption of shares by the amalgamated corporation, to be paid amounts without liability for tax in excess of the investment of tax-paid funds.

[127] I am of the opinion that the sale by Copthorne I of its VHHC Holdings shares to Big City, which was undertaken to protect $67,401,279 of PUC from cancellation, while not contrary to the text of s. 87(3), does frustrate and defeat its purpose.  The tax-paid investment here was in total $96,736,845.  To allow the aggregation of an additional $67,401,279 to this amount would enable payment, without liability for tax by the shareholders, of amounts well in excess of the investment of tax-paid funds, contrary to the object, spirit and purpose or the underlying rationale of s. 87(3).  While a series of transactions that results in the “double counting” of PUC is not in itself evidence of abuse, this outcome may not be foreclosed in some circumstances.  I agree with the Tax Court’s finding that the taxpayer’s “double counting” of PUC was abusive in this case, where the taxpayer structured the transactions so as to “artificially” preserve the PUC in a way that frustrated the purpose of s. 87(3) governing the treatment of PUC upon vertical amalgamation.  The sale of VHHC Holdings shares to Big City circumvented the parenthetical words of s. 87(3) and in the context of the series of which it was a part, achieved a result the section was intended to prevent and thus defeated its underlying rationale.  The transaction was therefore abusive and the assessment based on application of the GAAR was appropriate.

Although the decision is a defeat for a taxpayer on the facts of the case, the approach used by the Court (particularly the cautionary notes struck in paragraphs 121 and 123) along with the clarity and precision of the reasons written by Justice Rothstein (as adopted by the entire Court) should be generally reassuring to the business community.  Corporate Canada will still be able to engage in tax planning to advance business objectives if the transactions contemplated are adequately supported by non-tax purposes and if the results of those transactions do not circumvent any provisions of the Income Tax Act that are clearly aimed at precluding those results.

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Crown Wins GAAR Case in the Supreme Court of Canada: Copthorne Holdings Ltd. v. The Queen

Copthorne Decision to be Released by Supreme Court of Canada on Friday, December 16, 2011 at 9:45 a.m.

The Supreme Court of Canada announced today that its long-awaited General Anti-Avoidance Rule (GAAR) decision in Copthorne Holdings Limited v. The Queen will be released on Friday, December 16, 2011 at 9:45 a.m.

In preparation for Friday, it will be useful to re-read the decision of the Federal Court of Appeal dismissing Copthorne’s appeal as well as the decision of the Tax Court of Canada dismissing Copthorne’s appeal.

In addition, the written submissions of each party are available at the Supreme Court of Canada’s website and the archived webcast of the hearing may be viewed from the Court’s website as well.  The appeal was heard on January 21, 2011.

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Copthorne Decision to be Released by Supreme Court of Canada on Friday, December 16, 2011 at 9:45 a.m.

Dates for Upcoming Supreme Court of Canada Tax Appeals Confirmed

On December 7, 2011, the Supreme Court of Canada confirmed the hearing dates for the following three income tax appeals (same as the tentative dates provided by the Court earlier):

The Queen v. GlaxoSmithKline Inc. – Hearing Date: January 13, 2012

Garron Family Trust v. The Queen - Hearing Date: March 13, 2012

The Queen v. John H. Craig - Hearing Date: March 23, 2012

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Dates for Upcoming Supreme Court of Canada Tax Appeals Confirmed