On March 21, 2013, the Supreme Court of Canada dismissed (with costs) the application for leave to appeal in the case of Donna M. Johnson v. Her Majesty The Queen.

The issue in Johnson was the tax treatment of receipts from a Ponzi scheme. The Tax Court (2011 TCC 540) allowed the taxpayer’s appeal and held that the receipts were not income from a source for the purpose of paragraph 3(a) of the Income Tax Act. The Federal Court of Appeal (2012 FCA 253) reversed the lower court’s decision, allowing the Crown’s appeal.

I commented on the decisions of the Tax Court and the Federal Court of Appeal in the March 2013 Ontario Bar Association Tax Section newsletter.

In what circumstances may the Superior Court of Quebec correct a written instrument that does not reflect the parties’ intent?  That is the question that was considered by the Supreme Court of Canada on November 8, 2012 on appeals from decisions of the Quebec Court of Appeal in Agence du Revenu du Québec (formerly the Deputy Minister of Revenue of Quebec) v. Services Environnementaux AES Inc., et al. and Agence du Revenu du Québec v. Jean Riopel, et al.

The panel consisted of McLachlin C.J. and LeBel, Fish, Abella, Rothstein, Cromwell and Karakatsanis JJ. The Court reserved judgment in both cases.

Services environnementaux AES Inc.

Centre technologique AES Inc. (“Centre”) was a wholly-owned subsidiary of Services environnementaux AES Inc. (“AES”). In the context of a corporate reorganization, AES decided to sell 25% of its shares in Centre to a new investor. AES and Centre instructed their advisors that there was to be an exchange of shares under section 86 of the Income Tax Act (“ITA”) and the corresponding provisions of the provincial legislation.

AES believed – mistakenly – that the adjusted cost base of its shares in Centre was $1,217,029. Based on that error, a promissory note of $ 1,217,028 was received by AES as part of the consideration for its shares.

Subsequently, AES received a Notice of Reassessment that added a taxable capital gain of $840,770 to its taxable income. The parties discovered that the adjusted cost base of the shares had been miscalculated and that it was, in fact, only $96,001.

AES filed an application in the Superior Court of Quebec for an order rectifying the written instruments for the transactions. The Superior Court granted the application, noting that its judgment was effective as of the date of the transactions and that it was enforceable against third parties (including tax authorities). The Court of Appeal dismissed the appeal of the Quebec Revenue Agency (QRA).

Riopel

The Riopel case is another case about a corporate reorganization gone wrong.

Mr. Riopel was the sole shareholder of a corporation and held a 60% stake in a second corporation. Ms. Archambeault, Mr. Riopel’s wife, held the remaining 40% of the shares in the second corporation. The parties intended to amalgamate the corporations, with Mr. Riopel as the sole remaining shareholder of the amalgamated corporation. Both shareholders met with a tax advisor and agreed on plan for the reorganization. The parties were clear that the reorganization was to be completed with no immediate tax impact.

However, the Articles of Amalgamation included an error (i.e., the Articles did not reflect the correct share ownership). The shareholders’ professional advisors realized the error, and they tried to correct the situation without notifying the taxpayers.

Subsequently, Ms. Archambeault received a Notice of Reassessment adding a deemed dividend of $335,000 to her taxable income. The shareholders and the corporation brought an application in the Superior Court of Quebec to rectify the written instruments to accord with their true intention (i.e., implementing a reorganization without immediate tax effect).

The Superior Court denied the rectification on the basis that the agreement between the parties was distinct from the mandate given to their advisors. The Court suggested that the error could have vitiated the agreement, but it was not the remedy sought by the parties. The Court added that the error affected both the form and substance of the transactions. Accordingly, rectification was not an appropriate remedy.

That decision was reversed by the Court of Appeal of Quebec. The Court of Appeal applied the reasoning in AES and ordered the rectification so as to give effect to the parties’ common intention.

Position of the Tax Authorities in the Supreme Court of Canada (Oral Argument)

In the Supreme Court, counsel for QRA argued that the rectifications obtained by the taxpayers were not an exercise of interpretation of contracts as permitted by the Civil Code of Quebec (“CCQ”). The contracts in question were clear and should not have been modified, even though the transactions had unintended tax consequences for the parties.

Indeed, tax considerations may be the motivation behind a transaction, but they do not reflect the intent of the parties and are therefore not part of the “scope of the contract”. Thus, according to counsel for QRA, the Court of Appeal erred in rectifying the written instruments in order to make them consistent with the parties’ tax motivations. The parties could have sought cancellation of the contracts, but they failed to do so.

Justice LeBel asked if there was a legal principle that would operate to prevent parties from varying or rescinding a contract. Counsel for QRA responded that there was none, but that such a variation or rescission cannot have retroactive effect with respect to third parties. The situation would be different if the contract was cancelled by the Court since the contract is then deemed to never have existed. In such a case, the QRA would respect the decision of the Court and would assess the taxpayer accordingly.

Justice LeBel also asked if the tax authorities are third parties for the purposes of civil law. QRA’s position is that they are third parties and they have an obligation to apply the law based on the contracts concluded by the taxpayers.

Justice Fish noted that there was no dispute that the parties intended to comply with the provisions of the ITA and that, in this case, they had failed to do so because of human error. Counsel for QRA replied that the only relevant intent was in respect of the actual terms of the contract and not the tax motivation. The CCQ does not operate to vary clear contractual provisions so as to conform to the parties’ tax motivation. A possible remedy would have been the cancellation of the contracts, but that was not what the parties sought.

Counsel for the Attorney General of Canada essentially took the same position. Counsel explained that a party (or parties) cannot rewrite the history of a transaction because of unexpected tax consequences. Counsel emphasized that a distinction must be drawn between the motivation of the parties and the object of the contract. He added that the courts have long recognized that a “mistake in assumption” does not warrant the rectification of a contract. This applies in both common law and civil law.

Position of AES in the Supreme Court of Canada (Oral Argument)

Counsel argued that AES did not ask the Superior Court to modify a contract, but rather to rectify a written instrument to accord with the parties’ common intention in order to reflect the true legal relationship. In this case, the parties intended to complete the transaction in accordance with section 86 of the ITA but the written instrument did not reflect this intention. Accordingly, it was legitimate and necessary for the Superior Court to order rectification.

Justice LeBel asked about the impact of the law of evidence in the context of an application for rectification (i.e., the parol evidence rule). Counsel responded that the restrictions on presenting evidence of a party’s intent did not apply in this case since it has been admitted that the parties’ intention was not correctly reflected in the written document.

Justice LeBel also asked if it was AES’s position that a tax authority is a third party to a contract. Counsel stated that a government has an obligation to enforce tax law based on bona fide legal relationships between the parties. A tax authority would not be a third party because it would have no rights to claim with respect to the rectification of a written instrument. However, on a practical level, it may be appropriate to give the tax authorities an opportunity to be heard.

In closing, counsel stated that an application for rectification in Quebec is based solely on the principles of civil law and that it is not an attempt to “import” a common law concept.

Position of Riopel in the Supreme Court of Canada (Oral Argument)

Counsel stated that this was not a tax case but rather a civil law case. The question that must be asked was the following: Where can the contract be found? It is a mistake to confuse the contract with the written document evidencing it.

The Court of Appeal relied on Article 1425 of the CCQ to grant the application for rectification. Indeed, the application met the three criteria developed by the Court of Appeal in AES (i.e., necessity, legitimacy and no harm to third parties). Moreover, even if the tax authorities should be regarded as third parties, they would not be prejudiced because the rectification had no impact on the tax base.

Justice LeBel noted that numerous errors had been committed. Counsel responded that the errors all had a common origin, namely the Articles of Amalgamation. The number of written instruments to be rectified was not relevant, as long as the purpose was to give effect to the parties’ true intention.

Justice LeBel also wondered if this was an exercise of contractual interpretation. Counsel responded that granting rectification is an operation of correction following the interpretation of the parties’ true intention. Just because the provisions of a contract are clear does not mean that they reflect the parties’ intentions.

*  *  *

As noted above, judgment was reserved in both appeals. We will report on the decisions as soon as they are released.

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

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.

                                                                       *  *  *

[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).

The Supreme Court of Canada will release its decision in The Queen v. GlaxoSmithKline Inc. (F.C.) (33874) on Thursday, October 18, at 9:45 a.m.

In earlier proceedings, the Tax Court dismissed the taxpayer’s appeal, and the Federal Court of Appeal allowed the taxpayer’s appeal (see our posts on those decisions here and here).

The Crown’s factum may be found here, and GSK Canada’s factum here. Oral arguments were heard by the Supreme Court of Canada in January 2012 (see our post on the arguments here). The decision will be the first for the Supreme Court on the issue of transfer pricing.

The two main questions placed before the Supreme Court were:

1. Did the Federal Court of Appeal err by applying the reasonable business person test to the interpretation of s. 69(2) of the Act?
2. Did the Federal Court of Appeal err in interpreting s. 69(2) by failing to apply the arm’s-length principle on a transaction-by-transaction basis and on the basis that members of the multinational group are operating as separate entities?

In a cross-appeal by GSK Canada, the Supreme Court was asked to consider whether the Federal Court of Appeal erred in ordering that the matter be returned to the trial judge for further determination.

We will blog the decision shortly after its release tomorrow.

It’s been just over four months since the Supreme Court of Canada (the “SCC”) heard oral argument in The Queen v. John H. Craig (see our prior blog post for coverage of the hearing and background on section 31), the only section 31 restricted farm loss case to reach the SCC since the oft-criticized Moldowan v. R., 1977 DTC 5213.

Result: Moldowan has been overruled. It took an uncharacteristically short period of time for the SCC to render its judgment – the unanimous decision emphatically stated that “Moldowan cannot stand.”

Justice Rothstein delivered the reasons, which prescribe a new analysis to be undertaken when a taxpayer needs to determine if his or her income from farming activities (such as a horse racing or breeding business), when combined with some other source of income (such as employment or business income) constitutes a “chief source of income.” If this test is satisfied, then the taxpayer may deduct the full amount of any losses from the farming operation against the other source of income, without restriction. If the test is not satisfied, then section 31 restricts the amount of the deductible loss in any given taxation year to $8,750.

The New Test: The new test outlined by the SCC is still a fact-based analysis to be applied to the particular circumstances of the taxpayer, and has two steps:

Step 1: At the outset, a determination needs to be made that the farming business is in fact a business (a source of income from which losses may be deducted), as opposed to a personal endeavour. This test is enunciated in Stewart v. Canada (2002 SCC 46) as the “commercial manner” test, stating that the farming operation is a business if there is no personal or hobby element; or if there is a personal or hobby element, then the venture must be undertaken in a sufficiently commercial manner “in accordance with objective standards of businesslike behaviour” in order to be considered a business.

Step 2: Once it is determined that the farming operation is a business, the taxpayer is entitled to full deduction of farming losses against another source of income if it is determined that farming and the other source of income is his or her chief source of income, based on the following factors, taken together: the amount of capital invested in farming and the other source of income; the income from each of the two sources of income; the time spent on the two sources of income; and the taxpayer’s ordinary mode of living, farming history and future intentions and expectations. To be successful, it must be shown that the taxpayer has invested significant funds and has spent considerable time attending to the farming business and that the taxpayer places significant emphasis on both the farming and non-farming sources of income. Further, it is not necessary that income from the farming business exceed income from the other source of income – this fact is irrelevant to the analysis.

The new test could be described as the “significant endeavors” test – which is much more palatable than the defunct ‘reasonable expectation of profit’ test or ‘three classes of farmer’ test that has now been buried along with Moldowan. RIP.

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.

Reuters recently reported a study showing that corporations face very long odds in tax appeals heard by the United States Supreme Court. There were 919 income tax cases in the Supreme Court of the United States from 1909 to 2011. 364 of those cases involved corporations. In “abuse” cases, the government won 61% of the time. In other cases, the government won 68% of the time. The real story is likely much grimmer since the statistics show that the US Supreme Court only grants review in about 2% of leave applications.

The Canadian Supreme Court heard 356 income tax cases between 1920 and 2003. Of these, the statistics show that the government won 223, or roughly 2/3. The record of Supreme Court tax cases between 2004 and 2012 is essentially similar. While an exact breakdown of corporate cases is not available, anecdotal evidence suggests that the success rate of corporations is roughly 1/3 (a more detailed analysis will be available in the future).

While the Canadian experience appears superficially to mirror the American statistics, a very different story is disclosed by Canadian leave to appeal statistics.

As the chart demonstrates, roughly 12% of leave applications are granted in Canada. Thus, corporations and other taxpayers may have as high as 6 times more likelihood of success in a tax appeal before the Supreme Court of Canada than in cases before the Supreme Court of the United States.

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.

Were your ears ringing this morning? They might have been if you are a racehorse owner or breeder in Canada, or if you are any other type of farmer who earns income from farming and some other source of income and are thus subject to section 31 of the Income Tax Act (the “Act”).

Section 31 of the Act is the restricted farm loss rule that operates to restrict the deductibility of your full farming losses against other sources of income if farming or a combination of farming and some other source of income is not your “chief source of income.”

For the past 35 years, section 31 has been applied to taxpayers on the basis of the Supreme Court of Canada’s decision in Moldowan v. R., 1977 DTC 5213 (S.C.C.), which has resulted in section 31 being one of the most litigated provisions of the Act and replete with confusion, ambiguity and inconsistent results. Finally, the Supreme Court of Canada granted leave in The Queen v. John R. Craig, which was heard this morning by a seven judge panel (Chief Justice McLachlin and Justice Fish were absent). For our earlier blog post on the case (including the factum filed by each party), click here.

The argument took two hours to complete. In the first hour the Court heard argument from counsel representing the Canada Revenue Agency (“Crown Counsel”), which was divided equally into two distinct sets of submissions organized by issue, and argued in succession by two Department of Justice lawyers.

The first issue addressed by Crown Counsel was its assertion that the legal doctrine of stare decisis was misapplied by the Federal Court of Appeal when it decided Craig, which, in the Crown’s submission, suggested that if Moldowan was applied in the manner desired by the Crown, then the case should have ended there with a Crown victory. Madam Justice Abella and Mr. Justice Rothstein took charge of this issue and put Crown Counsel to task with several related questions.

Justice Abella was very active in her questioning and emphasized that the evolution of the principles of statutory interpretation over the course of time makes it appropriate for outdated concepts to be reviewed. Further, the Supreme Court of Canada is THE venue for addressing any inconsistencies and is charged with the task of adjusting the principles for future application if the updated approach yields a different outcome.

It was also emphasized by both Justice Abella and Justice Rothstein that it is appropriate for lower courts to indicate that there is a problem with a prior precedent or an approach to interpretation, since that is the only way the record can be built and the matter brought before the Supreme Court of Canada for final resolution. That’s why they are there.

It was also noteworthy that Crown Counsel stated that the main issue to be decided was stare decisis, whereas Justice Rothstein was clear in his comments that the Supreme Court of Canada is free to overrule itself, and emphasized to Crown Counsel that the real question is whether Moldowan is right or wrong in the face of so much judicial and academic criticism. Those are the submissions he wanted to hear.

The second half of Crown Counsel’s submissions focused on the assertion that the Moldowan analysis of section 31 is correct and should not be disturbed.

Other tidbits from the panel during Crown Counsel’s submissions was Mr. Justice Moldaver’s comment that the ‘government is quite happy with Moldowan’ and Justice Abella’s comment that ‘farming is inherently unreliable as a source of income’ emphasizing the complexity of dealing with farming in the context of tax law. Justices LeBel, Karakatsanis and Cromwell also engaged Crown Counsel with questions during argument.

Mr. Craig’s counsel (“Taxpayer Counsel”) spent his hour focusing on Moldowan and why it needs to be overruled, given current principles of statutory interpretation, its unfairness to taxpayers and emphasizing the better approach taken by the Federal Court of Appeal in Gunn v. R., 2006 DTC 6544 (F.C.A.), which was followed by the Federal Court of Appeal in Craig. Further, it was submitted by Taxpayer Counsel that Mr. Craig would be successful with respect to the section 31 issue even upon strict application of the Moldowan principles.

The Justices were quite engaged in this discussion, which elicited questions or comments from Justices Abella, Moldaver, Cromwell, Karakatsanis, Deschamps and LeBel, all primarily directed at the wording of section 31 and how sense can be made of its wording to create fairness and certainty.

Taxpayer Counsel spent very little time on the stare decisis issue on the basis that, in its submission, the real issue is the correct interpretation of section 31.

After exactly two hours of argument, the far reaching financial implications on racehorse owners, breeders and other part-time farmers is now in the hands of the highest Court in the land to determine the future application of section 31, once and for all. The judgment is expected to be rendered within the next six to twelve months. Stay tuned.

For further background on this issue and a more comprehensive analysis of the history of section 31 prior to the appeal of Craig to the Supreme Court of Canada, click here.

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.

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.

On Friday morning January 13, 2012, the Supreme Court of Canada heard arguments in GlaxoSmithKline Inc. v. The Queen. See our earlier posts on the case here and here.

By way of background, Glaxo Canada purchased ranitidine, the active pharmaceutical ingredient in Zantac, a branded ulcer medication, from a non-arm’s-length non-resident. In 1990-1993, Glaxo Canada paid approximately $1,500 per kg of ranitidine, while generic purchasers of ranitidine were paying approximately $300 per kg. The Minister of National Revenue reassessed Glaxo Canada under former section 69 of the Income Tax Act on the basis that the taxpayer had overpaid for the ranitidine in light of the fact that generic manufacturers were paying considerably less for the same ingredient.

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 Federal Court of Appeal allowed the taxpayer’s appeal. The Court of Appeal held that the lower 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 lower court judgment and sent the matter back to the Tax Court to be reconsidered.

The Crown appealed and Glaxo Canada cross-appealed the portion of the order sending the matter back to the Tax Court. The appeal was heard by a seven-member panel of the Court (Chief Justice McLachlin, Justice Dechamps, Justice Abella, Justice Rothstein, Justice Cromwell, Justice Moldaver and Justice Karakatsanis).

The Crown argued that the analysis under subsection 69(2) required a “stripping away” of the surrounding circumstances of the transaction in question and, in particular, the license agreement pursuant to which Glaxo Canada was entitled to market and sell the drug ranitidine under the brand name Zantac.  Having done that, the only relevant comparator was the price of ranitidine on the “open market”, namely, the price paid for ranitidine by generic drug manufacturers.

The Court asked a number of questions about whether subsection 69(2) (with its reference to “in the circumstances”) makes the ultimate use of the ranitidine relevant to the analysis. Several judges asked whether it made a difference that the ranitidine purchased by Glaxo Canada was to be marketed and sold as Zantac, a branded product that would yield a higher retail price than the equivalent generic product.  Justices Abella and Rothstein were particular active during this discussion.

In stark contrast to the Crown’s position, Glaxo Canada contended that the only question to be answered under subsection 69(2) was whether two arm’s-length parties, sitting across a boardroom table, would arrive at the same deal that was concluded by Glaxo Canada and its non-resident parent company. Justice Abella wondered if, even in those circumstances, an arm’s-length party would pay $1,500 for a kilogram of ranitidine.

Chief Justice McLachlin asked about bundling and its relationship to transfer pricing – if the $1,500/kg price included an amount paid for something other than ranitidine why was it not identified by Glaxo Canada as such and why was withholding tax not remitted thereon under section 212 of the Act? Counsel for Glaxo Canada responded by making two points: First, if a portion of the price paid by Glaxo Canada for ranitidine were more properly characterized as royalties, for example, such amounts would be expenses to Glaxo Canada and thus there was no mischief from a transfer pricing perspective in bundling them into the cost of the goods. Second, it is not the policy or practice of the CRA to require taxpayers to unbundle intellectual property or other intangibles from tangible property as, presumably, the practical burden imposed by such a requirement would be difficult to overstate. It was unclear whether the tension between the issues of bundling and arm’s-length pricing was resolved at the hearing. 

In a nutshell, the choice before the Court is this: Is the fact that the ranitidine purchased by Glaxo Canada was destined to become Zantac relevant to the analysis under subsection 69(2)? Glaxo contends that it is, while the Crown contends that it is not.

On the cross-appeal, Glaxo Canada argued that it had met the case against it on the pleadings and the matter should, therefore, have concluded at the Federal Court of Appeal and should not have been sent back to the Tax Court. There were a number of questions from the bench on that point.    

The panel reserved judgment on both the appeal and cross-appeal.

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.

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.

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.

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.

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

For those who missed the live webcast of the hearing in City of Calgary v. The Queen before the Supreme Court of Canada on November 15, 2011, the archived webcast of the argument is now available.  McLachlin C.J. and LeBel, Deschamps, Rothstein, Cromwell, Moldaver and Karakatsanis JJ. heard the appeal.

Ken S. Skingle, Q.C. argued for the City of Calgary and Gordon Bourgard argued for the Crown. 

For our report on the argument, see our earlier post.  Judgment was reserved.

Earlier today, the Supreme Court of Canada heard arguments in the City of Calgary v. The Queen, the second GST dispute to be heard by Canada’s highest court.  The issue was whether the City was entitled to an input tax credit (“ITC”) in respect of approximately $6.3 million in GST paid in relation to the construction of a municipal transit system.  See our earlier post to read more about the appeal.

Counsel for the City of Calgary faced questioning from the panel (McLachlin C.J., and LeBel, Deschamps, Rothstein, Cromwell, Moldaver and Karakatsanis JJ.) throughout his submissions.  Members of the panel were particularly concerned about whether the City made a “supply” to the Province of Alberta.  If the answer was “no”, the City’s appeal would be dismissed.  Counsel for the City argued that there was a taxable supply in this case, and that there need not be a prior contractual obligation to provide a supply in order for a “supply” (within the meaning of the Excise Tax Act) to exist.  In addition, members of the panel were concerned about the City’s characterization of its agreements with the Province of Alberta, insofar as (in their view) it reflected an artificial view of the relationship between the City and the Province.  In addition, questions were asked regarding whether the agreements were more in the nature of “accountability agreements” (i.e., to ensure public grants were applied for their intended purpose, as the Crown contends) rather than “supply of service agreements” (as the City contends).  Counsel for the City referred the panel to U.K. authorities (including Edinburgh Leisure et al v. Commissioners of Customs and Excise [2005] LLR 41 (VATD Tribunal)) and the Federal Court of Appeal decision of Commission Scolaire des Chênes v. The Queen in support of the City’s position that it made a separate taxable supply of services to the Province, for which it would be entitled to claim ITCs on its taxable inputs.

Counsel for the Crown faced relatively few questions.  In particular, the panel was interested in hearing the Crown’s position on whether the Commission Scolaire des Chênes decision was correct and whether it was distinguishable.  Counsel for the Crown pointed out certain differences between that case and the present case, yet he stated that the Federal Court of Appeal’s analytical approach in the Commission Scolaire des Chênes decision reflected the correct approach.

Counsel for the City made a very brief reply, and the panel reserved its decision.

This morning at 9:30 a.m. catch the live webcast of the arguments in the Supreme Court of Canada in City of Calgary v. The Queen, the second GST dispute to be heard by Canada’s highest court.

See our earlier post to read more about the appeal.

GlaxoSmithKline’s factum has now been filed with the Supreme Court of Canada addressing the arguments set out earlier in the Crown’s factum.  There are no particular surprises.

As noted in our earlier blog post, the Crown was granted leave to appeal the Federal Court of Appeal’s decision and GSK was granted leave to cross-appeal. The Crown contends in its factum that the FCA gave short shrift to the arm’s length principle which it was required to apply under subsection 69(2) of the Income Tax Act as developed in the OECD Guidelines. The Crown argues that the FCA has replaced the arm’s length standard with a “reasonable business person” test.

In its factum, GSK argues that the approach taken by the FCA in determining “reasonable in the circumstances” is consistent with the OECD Guidelines which call for the application of the arm’s length principle in light of the actual business circumstances faced by the taxpayer. Neither subsection 69(2) of the Income Tax Act nor the arm’s length principle require courts to ignore the circumstances of the marketplace. GSK also says that the Crown’s approach effectively reads out the phrase “in the circumstances” as used in subsection 69(2) of the Income Tax Act.

Finally, by way of cross-appeal, GSK takes issue with the FCA’s order that the matter be re-heard by the Tax Court of Canada, contending that that the FCA ought simply to have set the assessments aside.

On January 13, 2012, the Supreme Court of Canada is scheduled to hear an appeal by the Crown and a cross-appeal by GlaxoSmithKline Inc. (“GSK”) in the first transfer pricing case to be heard by the Court.

The Minister of National Revenue reassessed GSK by increasing its income in its 1990 through 1993 taxation years on the basis that it had overpaid its non-arm’s length supplier – a non-resident company – for the purchase of ranitidine, a pharmaceutical ingredient in a drug marketed by GSK in Canada (Zantac).  During that period, GSK paid between $1,512 and $1,651 per kilogram of ranitidine.  According to the Minister, a reasonable amount for GSK to have paid for ranitidine was the price paid by other pharmaceutical companies that were selling generic forms of the drug (i.e., between $194 and $304 per kilogram).

The Tax Court of Canada agreed with the Minister’s position but made a $25 upward adjustment to the price paid by GSK.  The Federal Court of Appeal set aside the decision of the Tax Court of Canada and ordered that the matter be re-heard by the Tax Court of Canada.

The Supreme Court of Canada granted leave to appeal to the Crown and granted leave to cross-appeal to GSK.  The issues raised in this appeal include the following:

(a) Whether identification of the transaction which is the subject of a transfer price analysis is limited by bona fide legal arrangements of the taxpayer.

(b) Whether transfer prices in independent transactions between a Canadian taxpayer and different entities of a multinational group should be assessed separately or bundled together.

(c) Whether, when conducting transfer pricing analysis in Canada, the arm’s length standard has been displaced by the “reasonable business person” test.

(d) Whether the Federal Court of Appeal erred in returning matter to the Tax Court of Canada for rehearing.

For the written submissions of the appellant, see the factum of the Crown.

For the written submissions of the respondent, see the factum of GlaxoSmithKline Inc.

On March 13, 2012, the Supreme Court of Canada is tentatively scheduled to hear an appeal by the trustee of two trusts (St. Michael Trust Corp., as trustee of the Fundy Settlement – a.k.a. the Garron Trust – and the Summersby Settlement – a.k.a. the Dunin Trust).

Each Trust was settled by an individual resident in St. Vincent and had Canadian beneficiaries.  The trustee of each Trust was a Barbados corporation.  In 2000, each Trust disposed of shares it owned in a Canadian corporation to an arm’s length purchaser and thus realized a capital gain.

The capital gains for Canadian income tax purposes were approximately $217 million for the Garron Trust and approximately $240 million for the Dunin Trust.  The capital gain inclusion rate at the relevant time was 2/3, so that the taxable amounts were approximately $145 million for the Garron Trust and approximately $160 million for the Dunin Trust.  The capital gains were not subject to tax in Barbados.  

The purchaser withheld and remitted amounts to the Canadian government in accordance with section 116 of the Income Tax Act.  The trustee sought a return of the withheld amount, claiming an exemption from tax pursuant to paragraph 4 of Article XIV of the Canada-Barbados Income Tax Agreement (1980).  Under the exemption, tax would only be payable in the country in which the seller was resident, and the trustee contended that each Trust was a resident of Barbados.

The Minister of National Revenue assessed on the basis that the exemption in the treaty did not apply because each Trust was a resident of Canada.  The trustee appealed on behalf of the Trusts.  The Tax Court of Canada and the Federal Court of Appeal dismissed the appeals.

For the written submissions of the appellant, see the factum of St. Michael Trust Corp.

For the written submissions of the respondent, see the factum of the Crown.

For the appellant’s response to the Crown’s factum, see the responding factum of St. Michael Trust Corp.

On March 23, 2012, the Supreme Court of Canada is tentatively scheduled to hear the Crown’s appeal in The Queen v. John H. Craig.  The Court will have an opportunity to reconsider its 1978 decision (Moldowan v. The Queen, [1978] 1 S.C.R. 480) which has been relied on in almost every farm loss case since then.

While earning most of his income in his 2000 and 2001 taxation years as a partner of a law firm, Mr. Craig also had income from a business comprising the buying, selling, breeding, and racing of horses.  The Minister disallowed the losses deducted by Mr. Craig in those years in respect of the horse business.

Relying on subsection 31(1) of the Income Tax Act, which restricts farm losses in instances where a taxpayer’s “chief source of income” for a taxation year is neither farming nor a combination of farming and some other source of income, the Minister restricted Mr. Craig’s allowable deductions from the horse business to $8,750 for each year on the basis that his other income was not subordinate to his farming income.

Mr. Craig appealed the Minister’s reassessments.  The Tax Court of Canada allowed Mr. Craig’s appeals, and the Federal Court of Appeal dismissed the Minister’s appeal.

The questions to be addressed in this appeal include the following:

(a) Whether the test to determine whether farming is a “chief source of income” under subsection 31(1) of the Income Tax Act continues to be the test described in the decision of the Supreme Court of Canada in Moldowan.

(b) Whether an appellate court is bound by a previous decision of that appellate court when it is inconsistent with a prior decision of the Supreme Court of Canada.

For the appellant’s written submissions, see the factum of the Crown.

For the respondent’s written submissions, see the factum of Mr. Craig.

On November 15, 2011, the Supreme Court of Canada is scheduled to hear its second GST appeal in The City of Calgary v. The Queen. The first GST appeal was heard in 2009 in United Parcel Service Canada Ltd. v. Canada where it was unanimously decided that a customs broker was entitled to a rebate for overpaying GST.

In this case, the City of Calgary constructed a transit system for the use of Calgary residents pursuant to obligations imposed on it by the City Transportation Act, R.S.A 2000, c. C-14 (the CTA).  In the course of constructing that system, the City entered into funding agreements with the Province of Alberta as contemplated in the CTA.  The City paid GST with respect to purchases made for the construction of the transit system.

Since the provision of a municipal transit service is an exempt supply for purposes of the Excise Tax Act, R.S.C. 1985, c. E-15 (the ETA), the City would not be entitled to claim input tax credits (ITCs) with respect to purchases made for the purpose of providing that exempt supply.

The City took the position that the construction of the transit system (as opposed to its operation) was a separate supply to the Province of Alberta, pursuant to its contracts with the Province, for which the Province paid consideration, pursuant to those contracts.  The City took the position that this separate supply was not an exempt supply and claimed ITCs with respect to that supply.  The Minister rejected the City’s position.

The Tax Court of Canada decided in favour of the City, however, this decision was overturned by the Federal Court of Appeal.

The main issue for the Supreme Court of Canada is whether the City was entitled to an ITC in respect of approximately $6.3 million in GST paid in relation to the construction of a municipal transit system.  In answering this question, the Supreme Court of Canada may provide guidance on the meaning of “supply” for purposes of the ETA.

For the written submissions of the appellant, see the factum of the City of Calgary.

For the written submissions of the respondent, see the factum of the Crown.