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GAAR at 25: Panelists Discuss Lessons Learned and Challenges

On September 26, 2013, the Canadian Tax Foundation Young Practitioners Group (Toronto) convened a panel discussion titled “GAAR at 25: Lessons Learned & Current Challenges” on the General Anti-Avoidance Rule (“GAAR”) in section 245 of the Income Tax Act (“ITA”).

The panelists included Justice Karen Sharlow (Federal Court of Appeal), Justice Patrick Boyle (Tax Court of Canada), Phil Jolie (formerly of the Canada Revenue Agency), Ed Kroft (Blake, Cassels & Graydon LLP), Patricia Lee (Department of Justice) and Shawn D. Porter (Deloitte LLP and formerly at Department of Finance).

The general view of the panelists was that the potential application of GAAR in a specific case is very fact-dependent, and that the jurisprudence on the legal analysis continues to evolve. In the future, the focus will remain on how to interpret the “misuse and abuse” test within section 245.

Impact of GAAR

The panel discussed whether the GAAR has had an impact in deterring taxpayers from engaging in aggressive tax planning. Phil Jolie was of the view that it has not been a major deterrent as some abusive transactions are still not caught under GAAR, whereas Ed Kroft and Shawn D. Porter noted that the GAAR has had somewhat of a “chilling” effect in tax planning, particularly with public companies concerned about reputational risk.

Smell Test

There was a general consensus among the panelists that there is an element of a “smell test” in the GAAR. When evaluating whether GAAR should apply, Justice Boyle admitted there is an element of using one’s “nose” or getting in touch with one’s “spidey sense” and Justice Sharlow noted that she would determine if something “weird” was happening before undertaking the legal analysis as to whether the GAAR may apply.

These comments, made in jest by the panelists, convey the difficulties of analyzing complex transactions to determine whether a situation fits within the object and spirit of the Act under GAAR.

The other panelists noted that this may raise difficulties for tax practitioners who are asked to provide GAAR opinions to clients. The panelists advised that prudent counsel should address the evolving nature of GAAR jurisprudence in any opinion to a client on an issue where the GAAR could be engaged.

Current Litigation

Patricia Lee noted that the Department of Justice is currently litigating 44 cases where GAAR is a “live” issue. The cases include the following types of transactions:

  • Value shifting and capital loss creations;
  • Reverse attributes with trusts;
  • Base averaging of shares sold to a spouse;
  • Surplus stripping and, in particular, cross-border surplus stripping;
  • Manipulation of adjusted cost base of property;
  • Acquisition of tax credits and change in control; and
  • Leveraged donation cases.

The panelists concluded that, even after 25 years, there remains a degree of uncertainty in respect of the engagement and application of the GAAR.

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GAAR at 25: Panelists Discuss Lessons Learned and Challenges

Canada Revenue Agency provides update on Rulings and GAAR at Toronto Centre CRA & Professionals Group Breakfast Seminar

On June 6, 2013, at the Toronto Centre CRA & Professionals Breakfast Seminar, the Canada Revenue Agency discussed (a) recent developments at the Income Tax Rulings Directorate and (b) the process through which the General Anti-Avoidance Rule in section 245 of the Income Tax Act may be applied in the course of an audit.

Income Tax Rulings Directorate Update

Mickey Sarazin, Director General of the CRA’s Income Tax Rulings Directorate in Ottawa, presented on recent developments at Rulings. A brief overview of the issues he discussed is as follows:

  • Rulings continues its efforts to reduce “red tape”. Specifically, Rulings is seeking to:
    • make its tax information accessible and clear,
    • update its technology,
    • provide a “Tell us once” service standard,
    • reduce reporting requirements,
    • increase timeliness of its rulings.
  • Rulings will be unveiling pre-ruling consultations, which will allow taxpayers to meet with Rulings to discuss potential transactions before a formal ruling application is filed.
  • Rulings has started internal cross-country education sessions to raise awareness about its centres of expertise and certain subject areas.
  • By Fall 2013, Rulings will have added 26 new employees.
  • Hot issues by Division include:
    • Reorganizations and Resources Division – What transactions may be included in a “series of transactions” under subsection 55(2) of the Act.
    • Business/Personal Division – Whether certain arrangements are qualifying private health services plans.
    • International Division – Foreign affiliate dumping rules, upstream loans, and foreign entity classification.
    • Financial Institutions and Trusts Division – Real estate investment trusts and the prohibited investment rules.

The GAAR Process

Yves Moreno, Manager, Income Tax Rulings Directorate, and Suzanne Saydeh, Manager, GAAR and Technical Support Section at the Aggressive Tax Planning Division of the International and Large Business Directorate and member of the CRA’s GAAR Committee, presented on the process regarding the application (or potential application) of the GAAR.

  • Typically, an auditor in a local Tax Services Office will identify a transaction (or series of transactions) to which the GAAR may apply. In addition, the Aggressive Tax Planning Division may identify potential transactions/facts in the course of a review of applications for clearance certificates, rollover transactions, or foreign reporting information. The Aggressive Tax Planning Division may also review certain aggressive transactions with a view to identifying other similarly-situated taxpayers who may have undertaken similar transactions. 
  • The auditor will collect the relevant facts surrounding the transaction (or series of transactions). The auditor will draft a proposal letter that will include a detailed analysis of the potential application of the GAAR. The auditor will invite the taxpayer to provide a response to the proposal letter.
  • Once the auditor receives the taxpayer’s representations, the auditor will make a referral to the Aggressive Tax Planning Division. The referral will include the auditor’s proposal letter, the taxpayer’s representations, the auditor’s response (if any), and any other information that may be relevant to the file (i.e., statute-barred years, etc.).
  • Where the GAAR would be the primary basis of the assessment and there is a “new issue”, the referral is made before the proposal letter is issued to the taxpayer. Where the GAAR would be a secondary basis of the assessment, the referral is made before issuing the assessment.
  • The Aggressive Tax Planning Division is the “gatekeeper” that seeks to ensure the consistent application of the GAAR. It does not “rubber stamp” the referrals, but performs its own analysis in consultation with other CRA Divisions, the Department of Finance, and the Department of Justice. Once its analysis is complete, the Aggressive Tax Planning Division determines whether the matter should be referred to the GAAR Committee.
  • If the Aggressive Tax Planning Division’s view is that the GAAR may apply, the file is referred to the GAAR Committee. If the Aggressive Tax Planning Division’s view is that the GAAR does not apply, it will provide that view to the auditor without referral to the GAAR Committee.
  • For files referred to the GAAR Committee, if there is a “new issue”, the Aggressive Tax Planning Division will draft a referral. If there are no “new issues”, the Aggressive Tax Planning Division will provide a recommendation to the GAAR Committee.
  • The referral to the GAAR committee includes the auditor’s views, the taxpayer’s representations, and the Aggressive Tax Planning Division’s views.
  • The GAAR Committee comprises members from the CRA, Department of Finance and Department of Justice. The GAAR Committee meets periodically to consider the referrals. The Committee members consider the file beforehand, and the meetings allow the committee members to discuss and develop a view on the matter.
  • (As an aside, the CRA stated that it does not believe that the materials and deliberations of the GAAR Committee are subject to disclosure under the Access to Information Act (see, in particular, sections 21 and 24 of that Act)).
  • The GAAR Committee will provide a recommendation on the application of the GAAR in a particular case.

The CRA also provided the following statistics:

  • Since 1988, 1,125 files have been referred to the GAAR Committee. Of those files, the GAAR Committee has recommended that the GAAR be applied in 865 files. Of those files, the GAAR was the primary basis of assessment in 378 files, and a secondary basis of assessment in 487 files.
  • 52 files have been litigated. Of these cases, the Crown and the taxpayer have each won 26 cases.
  • 75 percent of the cases that have been litigated focused on whether there was misuse or abuse of the Act (or another statute).
  • Since the Supreme Court’s decision Canada Trustco Mortage Co. v. The Queen (2005 SCC 54), the Crown has been successful in 18 cases, and the taxpayer has been successful in 13 cases. The CRA attributes this to its better understanding of the interpretation and application of the GAAR.

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Canada Revenue Agency provides update on Rulings and GAAR at Toronto Centre CRA & Professionals Group Breakfast Seminar

The Gwartz Decision: The GAAR Is Not a Filler

In Brianne Gwartz v. The Queen, 2013 TCC 86, the Crown attempted to utilize the GAAR to recharacterize as dividends certain capital gains which had been realized by a family trust and allocated to the minor-aged taxpayers in 2003, 2004 and 2005.  The Crown argued that the transactions giving rise to the GAAR circumvented section 120.4 (the “kiddie tax”) which was amended in 2011 to apply to certain capital gains paid to minors.

The taxpayers conceded the existence of a “tax benefit” and an “avoidance transaction”, leaving the only issue being whether there existed “abusive tax avoidance”.  The Tax Court of Canada made some interesting comments about the application of the GAAR generally and specifically as it related to this case, the main points of which can be summed up as follows:

1      Tax planning is not inherently abusive for the purposes of ss. 245(4):  Taxpayers are entitled to plan their affairs in such a way that will minimize tax liability.  Choosing a course of action that minimizes the tax liability is not necessarily abusive [paras. 45 and 46].

2      GAAR cannot be used to fill in the gaps:  Abusive tax avoidance cannot be found to exist if a taxpayer can only be said to have abused some broad policy that is not in itself grounded in the provisions of the Act.  “[I]t is inappropriate, where the transactions do not otherwise conflict with the object, spirit and purpose of the provisions of the [Act] to apply the GAAR to deny a tax benefit resulting from a taxpayer’s reliance on a previously unnoticed legislative gap” [para 47].

3      There is no broad policy in the Act against surplus stripping:  In this case, the Crown contended that the taxpayers contravened the general policy against surplus stripping, but dropped this position at trial.  The Court noted that courts have held that surplus stripping does not inherently constitute abusive tax avoidance [para 50].

4      There is no broad policy in the Act against income splitting:  The Court noted that the increasing marginal tax rates and the choice to tax the individual as the basic taxable unit create incentives under the Act for taxpayers to split their income with their family members [para. 52].

5      The significance of subsequent amendments as an indicator of the policy underlying previous versions of a provision:  The Court noted subsequent amendments do not necessarily in themselves provide an indicator of some policy underlying the prior versions of a legislative provision.  Subsequent amendments must be considered along with all other relevant material to ascertain the object, spirit and purpose of the provision.  In certain circumstances, a subsequent amendment might suggest that the provision’s object or spirit were frustrated by the tax avoidance strategy. In other circumstances, it might suggest that Parliament simply changed its mind and now intends to prevent something that initially was not intended to be captured by the provision [para 57].

The Court ultimately allowed taxpayers’ appeals, finding that the object, spirit and purpose of section 120.4 of the Act were not indicative of a general policy against surplus stripping.  The Court held that the fact that specific anti-avoidance provisions were enacted at the time that 120.4 was enacted provided an indicator that Parliament was fully aware of the manner in which taxpayer’s could distribute corporate surplus.  Parliament’s exclusion of capital gains from section 120.4 was thus deliberately not intended to capture the transactions at issue.  In furtherance of this conclusion, the Court, by reviewing external evidence such as the 1999 Budget Plan and Notices of Way and Means Motions, found that the subsequent amendments to 120.4, which added only certain capital gains transactions, was evidence that “…Parliament decided not to cover capital gains when the measure was first enacted, and chose to do so on a prospective basis only in respect to a narrow subset of capital gains transaction.” [para. 74]

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The Gwartz Decision: The GAAR Is Not a Filler

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

Taxpayer entitled to disclosure of the “policy” underlying statutory provisions allegedly abused in GAAR cases

On December 20, 2012, the Tax Court ruled on a motion under Rule 52 of the Tax Court of Canada Rules (General Procedure) (the “Rules”) to require the Minister to comply with a demand for particulars specifying how the Income Tax Act (the “Act”) was abused in a General Anti-Avoidance rule (“GAAR”) case.

In Birchcliff Energy Ltd. v The Queen (2012-10887(IT)G), the Minister alleged that the GAAR should apply because the series of transactions (the “Transactions”) undertaken by the taxpayer resulted in a misuse of 10 sections of the Act and an abuse of the Act as a whole. In response, the taxpayer sought an order requiring the Minister to disclose the policy behind each section of the Act that was allegedly abused and how the Transactions abused that policy.

The Tax Court held that the Minister must disclose the object, spirit, and purpose of the provisions of the Act (the “Policy”) that the assessor relied upon in making the assessment. The Minister does not need to disclose the actual Policy that will be argued at trial, or the way that the Policy was abused.

Arguments

The taxpayer argued that in making a GAAR assessment, the Minister must assume as a fact the Policy and an abuse of that Policy. Relying on Johnston v M.N.R. (1948 S.C.R. 486), the taxpayer argued that the Crown had a duty to disclose “precise findings of fact and rulings of law which have given rise to the controversy”. The taxpayer also argued that there was a heightened obligation on the Minister to be specific in cases of misconduct, negligence, or misrepresentation, relying on Chief Justice Bowman’s decision in Ver v Canada ([1995] T.C.J. No. 593). Misuse or abuse, it was argued, belonged in the category of offenses requiring more precise disclosure.

The Minister, on the other hand, argued that the Policy was a conclusion of law, not fact and that only allegations of fact must be disclosed in particulars. The Minister raised a “slippery slope” argument, suggesting that this ruling could require the Crown to explain its legal interpretation of all provisions of the Act in the future. Although the Minister acknowledged that Trustco v Canada (2005 SCC 54) placed the burden of identifying the Policy on the Crown, that burden did not apply to pleadings. The Minister also argued that disclosing the Policy would not help the Appellant because the Minister could still argue a different policy at trial.

Decision

The Tax Court highlighted the unique nature of GAAR, and stated that any disclosure requirements from this case would only apply to GAAR assessments. Justice Campbell Miller specifically pointed to the Crown’s burden to prove the Policy in GAAR cases as evidence of its unique requirements.

Justice Miller separated the elements of the Policy into two distinct categories:

1)      The actual Policy that would be argued and decided at trial (the “True Policy”), and

2)      The fact that the Crown relied on a particular Policy when determining that GAAR should be applied (the “Historical Policy”).

The Court held that the True Policy was a question of law that should ultimately be decided by the court. This policy was open to change throughout the course of litigation and did not need to be disclosed to the Appellant at this stage.

The Historical Policy, however, was held to be “a material fact, not an assumption, but the fact the Minister relied upon x or y policy underlying the legislative provisions at play in the case.” Taxpayers are entitled in pleadings to know the basis of the assessment. Disclosing the Historical Policy would be similar to disclosing the legislation upon which non-GAAR assessments are made. The Court distinguished the Historical Policy from the type of materials to which the taxpayer was denied access in Mastronardi v The Queen (2010 TCC 57), a recent Tax Court decision holding that the Minister did not need to disclose the extrinsic materials on which the Minister relied in determining the Policy. In Mastronardi, the materials sought to be disclosed were evidence that could be used to prove the policy, rather than the material fact of which policy was relied on (evidence itself is not a material fact).

The Historical Policy that must be disclosed is not the Policy of each identified section in isolation. The Minister must identify the collective policy of all of the identified provisions together that the Crown relied on in making the assessment. The Historical Policy should be disclosed under paragraph 49(1)(e) of the Rules as “any other material fact”.

With regards to the Appellant’s request for information on how the Policy was abused, the Court held that it was not required to be disclosed. Abuse is a conclusion of law to be determined by the court based on the Policy and the facts of the case. The Minister did not assume how the Policy was abused as a fact. The Minister concluded, based on the Policy and the facts assumed, that there was an abuse.

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The Tax Court has reiterated that the taxpayer is entitled to know the basis of the assessment made against him.  Such an approach is consistent with principles of fundamental fairness and is entirely in keeping with the letter and spirit of the Rules.

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Taxpayer entitled to disclosure of the “policy” underlying statutory provisions allegedly abused in GAAR cases

GAAR Did Not Apply In Respect of Capital Gains Allocated to Minor Beneficiaries of a Family Trust

On March 21, 2012 the Tax Court of Canada issued judgment in the decision of McClarty Family Trust et al v. The Queen. The Minister of National Revenue (the “Minister”) had applied the general anti-avoidance rule (the “GAAR”) in section 245 of the Income Tax Act (the “Act”) to re-characterize capital gains reported by the McClarty Family Trust (“MFT”) as taxable dividends. However, the Court agreed with the appellants’ submissions that the transactions in issue were undertaken primarily for the purpose of placing Darrell McClarty, the father of the minor beneficiaries of the MFT, beyond the reach of creditors and allowed the appeal.

The Minster’s argument was that pursuant to a series of transactions, Darrell McClarty was able to split business income with his minor children in a manner that avoided the tax on split income in section 120.4 of the Act (as it existed in 2003 and 2004).

Darrell McClarty was the owner of all of the issued and outstanding Class A voting shares of McClarty Professional Services Inc. (MPSI). The MFT owned all of the issued and outstanding Class B, non-voting common shares. MPSI, in turn, owned 31% of Projectline Solutions Inc., which earned business income from the provisions of geotechnical engineering services.

In 2003 and 2004, the MFT received stock dividends consisting of Class E common shares of MPSI. The Class E shares had low paid-up capital and a high redemption value. After the Class E shares were received by the MFT, the MFT sold them to Darrell McClarty for fair market value, realizing capital gains. The capital gains were then distributed to the minor beneficiaries of the MFT, and thereby not subject to tax under section 120.4 of the Act.

Through a series of loans between Darrell McClarty, MPSI and the MFT, Mr. McClarty ended up owing $104,400.37 in outstanding promissory notes to the MFT and the MFT had outstanding promissory notes in the amount of $96,000 owned to its minor beneficiaries. The Minister argued that the creditor protection objectives were essentially ineffective and that the circular flow of loans disguised the true intention of the plan, which was to distribute funds to minor beneficiaries in a manner that would not subject them to the tax on split income in section 120.4.

However, the Court accepted Mr. McClarty’s evidence that he was motivated to protect assets from his former employer, who was a potential judgment creditor in relation to allegations of improper use of software belonging to the former employer. The Court also agreed that because of the liabilities of Mr. McClarty and the MFT noted above, the creditor protection objectives were achieved.

It was also argued that the protection from creditors would have been achieved simply by paying dividends to the beneficiaries of the MFT and therefore the declarations of stock dividends amounted to avoidance transactions. However, the Court accepted the Appellants’ argument that the transfer of wealth from MPSI was undertaken to provide protection from creditors without attracting significant tax costs. The transactions were not avoidance transactions because it was acceptable to undertake creditor proofing transactions in a manner that attracted the least possible tax. Furthermore, the transaction would never have occurred in the absence of the need to protect MPSI’s assets.

The Court therefore concluded that because there were no avoidance transactions under subsection 245(3) of the Act, there was no need to continue the analysis to determine if there was abusive tax avoidance. However it did note that to the extent that there was a gap in the legislation, which allowed for the distribution of capital gains to minor beneficiaries of a trust in a manner that was not taxable under section 120.4 of the Act, it was inappropriate for the Minister to use the GAAR to fill in the gaps.

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GAAR Did Not Apply In Respect of Capital Gains Allocated to Minor Beneficiaries of a Family Trust

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)

Panel of Tax Experts Debates Impact of Copthorne Decision at Canadian Tax Foundation Seminar

On Thursday, January 26, 2012, in the ballroom of the historic Fairmont Royal York Hotel in downtown Toronto, the Canadian Tax Foundation hosted a lively panel discussion on the recent Supreme Court of Canada (“SCC”) decision in Copthorne Holdings Ltd. v. The Queen. The event was also webcast, with an audience from coast to coast in Canada, and internationally as far away as France and New Zealand.

The decision in Copthorne centred on whether a “doubling-up” of paid-up capital (“PUC”) amounted to abusive tax avoidance that should be subject to the application of the general anti-avoidance rule (“GAAR”). For more on the Copthorne decision, see our previous post here.

The esteemed panel included a diverse group of tax experts. Madame Justice Karen Sharlow of the Federal Court of Appeal and Mr. Justice Wyman W. Webb of the Tax Court of Canada provided judicial insights into the potential ramifications of the SCC’s decision in Copthorne. Noted tax litigators Al Meghji of the private bar and Elizabeth Chasson of the Department of Justice considered the impact that the decision may have on the tax dispute resolution process, particularly in instances where the Canada Revenue Agency (“CRA”) is seeking to impose the GAAR. Tim Wach, a tax planner in private practice who was previously seconded to the Department of Finance, and Wayne Adams, former Director General, Income Tax Rulings at CRA rounded out the panel.

The discussion, moderated by Justin Kutyan, Pooja Samtani and Timothy Fitzsimmons of the CTF’s Young Practitioner’s group in Toronto, began with several panel members expressing their opinions on whether the decision in Copthorne changed their understanding of the application of the GAAR. Mr. Adams indicated that the SCC seems to have affirmed the CRA’s application of the GAAR where taxpayers have “created” tax attributes or have otherwise engaged in “sleight of hand”. Madame Justice Sharlow noted that the impact of Copthorne cannot be fairly assessed separate and apart from particular fact situations which will be presented to the courts in due course. Mr. Meghji said that, in his opinion, the approach taken by the Supreme Court is notably distinct from the approach taken in other international GAAR cases, particularly those coming from Australia and New Zealand.

The panel was also asked for their views on the impact of the Copthorne decision on the meaning of “series of transactions” as it is used in Canadian tax law generally. Mr. Wach expressed the view that he did not think that the decision required the Department of Finance to revise the extended meaning of “series of transactions” in subsection 248(10) of the Income Tax Act (Canada). Mr. Adams noted that, in his view, the Court validated the CRA’s approach to the concept of a “series of transactions” as it has been applied for the last 15 years (in contrast, he noted, to earlier cases in the which the SCC emphatically rejected CRA’s approach in other areas). The panel session also included a rather animated debate among the panel members on the role of the GAAR Committee in light of Copthorne and whether the positions taken by individual members of the GAAR Committee would be relevant to a Court in deciding a GAAR case.

The panel engaged in a lively discussion touching on many aspects of the Copthorne decision, the meaning of “series of transactions” and the GAAR more generally. While there was agreement among certain panel members on some issues, there was also respectful disagreement on many others with each member of the panel expressing his or her views with considerable passion and conviction.

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Panel of Tax Experts Debates Impact of Copthorne Decision at Canadian Tax Foundation Seminar

“Copthorne and the Future of GAAR”: Report from the Conference at the U of T Faculty of Law

On Friday January 6, 2012, the University of Toronto and the University of British Columbia National Centre for Business Law presented a panel discussion on the recent decision of the Supreme Court of Canada in Copthorne Holdings Ltd. v. The Queen.

The discussion, held at Flavelle House at the University of Toronto’s Faculty of Law, was hosted by U of T’s Professor Ben Alarie. The panelists included Professor David Duff (UBC Faculty of Law), Deen Olsen (Department of Justice), Mark Brender (Osler Hoskin and Harcourt LLP), Robert Couzin (Couzin Taylor LLP), Phil Jolie (Canada Revenue Agency), and Professor Tim Edgar (Osgoode Hall Law School).

The general view of the panelists was that the decision was well-written and comprehensive, but does not add much that is new or insightful to the existing GAAR jurisprudence.

Deen Olsen noted that there are six points the Department of Justice believes are important in interpreting the Supreme Court’s reasoning about “series of transactions”:

    1. “Series of transactions” in subsection 248(10) is to be interpreted expansively.
    2. The taxpayer bears the onus of rebutting the Minister’s assumption that particular transactions form part of a series.
    3. Which transactions are included in a series will depend of the facts of each case.
    4. A “strong nexus” is not required for a transaction to be included in a series.
    5. Transactions will not be included in a series where subsequent transactions are only a mere possibility or connected with an extreme degree of remoteness.
    6. The analysis of whether certain transactions form part of a series may be undertaken prospectively or retrospectively.

Phil Jolie stated that it will be “business as usual” for the CRA with respect to its approach to the application of the GAAR. Mr. Jolie noted a few specific points regarding the CRA’s interpretation of the decision:

    1. The decision does not say that a comparison of the difference in tax result between dividend treatment and capital gains treatment is irrelevant to the GAAR analysis.
    2. Though the decision does not say that there is a general anti-surplus stripping policy in the Income Tax Act, the CRA may still be able to argue in “bits and pieces” based on the jurisprudence that such a policy does exist.
    3. Despite the Court’s comment that the GAAR does not include a “smell test”, such a test does likely exist and the CRA’s analysis of a transaction will look at any anomalous result (i.e., the bad smell) but the CRA will ask why the result is anomalous and whether an argument exists that the outcome was the result of an abuse of the Act (in other words, the smell test is part of the process but not the end of the process).
    4. The Court’s statement that it must be “clear” that the taxpayer abused the Act must mean that the Minister must prove the abuse on a “balance of probabilities”.
    5. Paid up capital, as a tax attribute, is likely becoming less valuable because of the reduction of the withholding rate on dividends to 5% in the tax treaties between Canada and its major trading partners.
    6. There is likely no anti-PUC trading scheme in the Act because the Act is not concerned with PUC trading in the same way that it is concerned with, and precludes, loss trading (i.e., the prohibition on loss trading is intended “to keep factories open” whereas an anti-PUC trading regime would not accomplish that goal).

The afternoon concluded with remarks by the former Chief Justice of the Tax Court of Canada, Donald G.H. Bowman, who noted that the unanimous 9-0 decision was a credit to Chief Justice Beverley McLachlin as the Court produced a well-written and sensible decision, which many in the tax community had wished for in Lipson v. The Queen.

The Copthorne decision will continue to provoke analysis and discussion.  The conversation will continue with a second conference in Toronto sponsored by the Canadian Tax Foundation on January 26.

 

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“Copthorne and the Future of GAAR”: Report from the Conference at the U of T Faculty of Law

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.

A General Anti-Avoidance Rule (GAAR) for the United Kingdom?

Plus ça change, plus c’est la même chose. The United Kingdom is now seriously considering the introduction of a form of GAAR after having relied for years on judicial doctrines of anti-avoidance as expounded in such cases as WT Ramsay Ltd v. IRC, [1981] STC 174 (HL); CIR v. Burmah Oil Co. Ltd., [1982] STC 30 (HL); Furniss v. Dawson, [1984] STC 153 (HL); Craven v. White, [1988] STC 476 (HL); Ensign Tankers (Leasing) v. Stokes (HMIT), [1992] STC 226 (HL).  The most recent report is dated November 11, 2011 and is entitled “GAAR Study: A study to consider whether a general anti-avoidance rule should be introduced into the UK tax system“.

The uncertain and indeed sometimes contradictory principles developed in the U.K. cases have impelled an Advisory Committee consisting of a distinguished group of practitioners, academics and judges led by Graham Aaronson, Q.C. to advocate a “moderate” rule that targeted “abusive” arrangements, but to reject a “broad spectrum” general anti-avoidance rule. It is difficult for Canadians who have lived for over 20 years with the GAAR in section 245 of the Income Tax Act and observed the Canadian courts in scores of cases grapple with concepts such as “abuse”, “misuse” or “avoidance transactions” not to view with a measure of smug satisfaction – indeed Schadenfreude – the spectacle of a high level panel wrestling with such philosophical conundrums as the distinctions between “contrived and artificial schemes”, “abnormal arrangements” and “responsible tax planning”. The problem in the United Kingdom of codifying an anti-avoidance rule is similar to that in the United States where the judicial anti-avoidance doctrines applied in different circuits have necessitated the enactment of an amendment to § 7701(o) of the Internal Revenue Code to include a complex codification of the economic substance doctrine, one of the principal pillars of United States anti-avoidance jurisprudence. The Advisory Panel has performed a creditable task by analyzing the very problems that Canadian courts have been struggling with since the inception of the Canadian version of GAAR. The philosophical predilection of the United Kingdom courts embodied in Ramsay and its progeny may well influence the interpretation of the English GAAR just as the Duke of Westminster‘s case has implicitly survived GAAR in Canadian jurisprudence and has influenced its interpretation and evolution.

We can expect to see substantial refinement in the development of the “moderate” (or “targeted”) anti-avoidance rule (“TAAR” as opposed to “GAAR”) to ensure that it conforms to the stated objectives of the rule in that it

(a) deters or counteracts contrived, artificial and abusive schemes;

(b) does not undermine or discourage competitiveness that arises from “responsible” tax planning;

(c) eliminates uncertainty in predicting the tax consequences of arrangements that results from, inter alia

(i) “notoriously long and complex” tax legislation;

(ii) differing interpretations of arrangements by courts and tribunals; and

(iii) a battery of specific anti-avoidance rules.

Graham Aaronson and the Advisory Committee are to be commended for producing a competent and commonsensical report that responds realistically to a serious issue. The legislative implementation of the proposals is not certain. The possibility of GAAR was explored in the United Kingdom in 1998 and came to nothing. It may be assumed that if the proposals are enacted, it will take many years for the United Kingdom courts to develop principles that will clarify the application of the rule, in the same way in which the Supreme Court of Canada has reduced the Canadian version of GAAR to manageable proportions in Canada Trustco.

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A General Anti-Avoidance Rule (GAAR) for the United Kingdom?

Tax Court of Canada: The GAAR Does Not Apply to Disallow Deduction of a $5.6 Million Business Loss

On October 28, 2011 the Tax Court of Canada released Judgment and Reasons for Judgment of the Honourable Justice Judith Woods in Global Equity Fund Ltd. v. Her Majesty The Queen, 2011 TCC 507.  Global Equity Fund Ltd. (“Global”) had appealed the application of the General Anti-Avoidance Rule (the “GAAR”) by the Minister of National Revenue (the “Minister”) to disallow the deduction of a $5,600,250 business loss incurred on the sale of shares in a private corporation.

The Court found that the loss was produced after Global subscribed for shares of a new subsidiary corporation, which then issued preferred shares to Global which were redeemable and retractable for $5,600,250 but had a paid up capital of $56 and which resulted in an income inclusion of $56.  The stock dividend had the effect of reducing the fair market value of the shares of the new subsidiary to a nominal amount but did not affect Global’s adjusted cost base in those shares.  Global then disposed of the common shares to a newly settled family trust at a loss in the amount of $5,600,250.

The Court did not accept Global’s argument that the transactions leading up to the loss were implemented for creditor protection purposes.  Accordingly the Court held that a number of transactions in issue were avoidance transactions within the meaning of subsection 245(3) of the Income Tax Act (the “Act”).

The Court also noted that this case was similar to two recent decisions of the Tax Court of Canada where similar strategies were used by other taxpayers to create capital losses. In both cases (Triad Gestco Ltd. v. The Queen, 2011 TCC 259 and 1207192 Ontario Ltd. v. The Queen, 2011 TCC 383) the Tax Court upheld the application of the GAAR to deny the losses.  The Court noted that both of these decisions are under appeal to the Federal Court of Appeal.

However, in Global’s case the Court was not prepared to accept the Crown’s argument that the object and spirit of the provisions of the Act identified by the Crown evidenced a policy to disallow losses realized within an economic unit to real losses.  The Court held that Parliament did not intend that the object and spirit of provisions identified by the Crown which targeted capital losses were intended to inform as to the object and spirit of the provisions relied upon by Global in the facts of this case.

Relying on the Supreme Court of Canada decision in Canada Trustco Mortgage Co. v. The Queen (2005 SCC 54), Justice Woods held that the provisions in the Act relied upon by Global to produce the losses had not been misused and she was also unable to discern a general policy from these provisions that restricted business losses in the manner suggested by the Crown.  The Tax Court rejected the Crown’s argument that there was a general restriction against the deduction of artificially-created business losses.  For all of these reasons the Tax Court held that the Minister had not met the onus of establishing abusive tax avoidance under subsection 245(4) of the Act and allowed the appeal.

[Note: The author, along with Jehad Haymour of Fraser Milner Casgrain LLP, acted as counsel for Global - Ed.]

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Tax Court of Canada: The GAAR Does Not Apply to Disallow Deduction of a $5.6 Million Business Loss

Latest GAAR Decision by the Tax Court of Canada: 1207192 Ontario Limited v. The Queen

On September 7, 2011, the Tax Court of Canada released its reasons for judgment in 1207192 Ontario Limited v. The Queen, the latest general anti-avoidance rule (GAAR) case to be considered by the Tax Court.

In short, the Minister applied the GAAR to deny a capital loss of $2,999,900 realized by the taxpayer in its taxation year ending February 28, 2003 on the disposition of common shares it held in a corporation (Newco).  The Tax Court (per Paris J.) found that the GAAR applied and dismissed the taxpayer’s appeal.

The facts can be briefly summarized as follows: The loss on the common shares was generated by the declaration of a stock dividend by Newco on the common shares prior to the disposition by the taxpayer.  The payment of the stock dividend had the effect of decreasing the value of the taxpayer’s common shares in Newco by an amount equal to the value of the stock dividend.  The stock dividend consisted of preferred shares with a low paid-up capital and a high redemption amount.

After the payment of the stock dividend, the taxpayer’s loss on the common shares was crystallized by a disposition of those shares to a family trust of which the beneficiaries were family members of the sole shareholder of the taxpayer corporation.  The capital loss was used by the taxpayer to offset a capital gain of $2,974,386 it realized during its 2003 taxation year.

The Tax Court concluded that (a) there was an avoidance transaction, as one of the transactions in the series was undertaken primarily to obtain a tax benefit, and (b) there was an abuse or misuse, as the transactions undertaken by the taxpayer frustrated the spirit and purpose of the capital loss provisions of the Income Tax Act (namely paragraphs 38(b), 39(1)(b) and 40(1)(b)).

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Latest GAAR Decision by the Tax Court of Canada: 1207192 Ontario Limited v. The Queen