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Largely in
response to the guidelines proposed by the Supreme Court of Canada in the Stubart decision four years earlier in 1988 Parliament
enacted the GAAR. The GAAR seeks to prevent abusive tax avoidance schemes that
would otherwise be permissible under a literal interpretation of the Act but
would in fact frustrate the proper application of the Act. Until recently it
has seldom been used; and still rarer discussed. The relevant portions of the
Act are as follows:
245 (1) In this section,
“tax benefit” means a reduction, avoidance or deferral
of tax or other amount payable under this Act or an increase in a refund of tax
or other amount under this Act;
“tax consequences” to a person means the amount of
income, taxable income, or taxable income earned in Canada of, tax or other
amount payable by or refundable to the person under this Act, or any other
amount that is relevant for the purposes of computing that amount;
“transaction” includes an arrangement
or event.
(2) Where a transaction is an avoidance transaction,
the tax consequences to a person shall be determined as is reasonable in the
circumstances in order to deny a tax benefit that, but for this section, would
result, directly or indirectly, from that transaction or from a series of
transactions that includes that transaction.
(3) An avoidance transaction means any transaction
(a) that, but
for this section, would result, directly or indirectly, in a tax benefit,
unless the transaction may reasonably be considered to have been undertaken or
arranged primarily for bona fide purposes other than to obtain the tax benefit;
or
(b) that is part of
a series of transaction, which series, but for this section, would result,
directly or indirectly, in a tax benefit, unless the transaction may reasonably
be considered to have been undertaken or arranged primarily for bona fide
purposes other than to obtain the tax benefit.
(4) For greater certainty, subsection 245(2) does not
apply to a transaction where it may reasonably be considered that the
transaction would not result directly or indirectly in a misuse of the
provisions of this Act or an abuse having regard to the provisions of this Act,
other than this section, read as a whole.
The Facts and History of Canada Trustco
In 1996
Canada Trustco Mortgage Company (“CTMC”) entered a
leveraged sale lease-back strategy for the purchase of trailers, which
permitted the CTMC to claim a substantial capital cost allowance (“CCA”) at a
minimal of risk. In 2002 the Minister of National Revenue reassessed CTMC on
its 1997 taxation year and denied the CCA. CTMC appealed.
At the Tax
Court of Canada the judge found an avoidance transaction giving rise to a tax
benefit under ss. 245(1) and (3) of the Act. However,
the GAAR did not apply because the CCA provisions allowed CTMC to deduct CCA
based on “cost”. The Minister appealed.
The
Minister faired no better on appeal. A unanimous Federal Court of Appeal
dismissed the appeal citing OSFC Holdings Ltd. v. Canada, 2001 FCA 260. In
interpreting the policy underlying the CCA, Evans J.A. held that “costs” meant
“legal” costs, being the purchase price paid by the taxpayer, not “real” or
“economic” costs as alleged by the Minister. Thus, when the CCA provisions were
read as a whole there was no clear and unambiguous policy underlying those
provisions that would render the transaction a misuse or abuse of those provisions. The Minister appealed to the Supreme Court of
Canada.
The Facts and History of Mathew
Through a series
of transactions involving the use of a partnership vehicle an insolvent
corporation (“STC”), in the business of lending money, sold its unrealized losses
from its mortgage investment business to several arm’s length investors. The
losses were used by the arm’s length investors to reduce their taxable incomes.
The Act specifically prohibits
the transfer of losses between taxpayers, except in specific circumstances such
as for the transfer of such losses to a related party. The liquidator for STC
could not realize on the losses because of the insolvency but could maximize
its returns if it could sell its losses to a third party for a fee.
The strategy called for the unrealized
losses to be first transferred from STC to a non-arm’s length party, Partnership
A, for a 99% interest in Partnership A. In turn Partnership B, a party at arm’s
length from STC, acquired a 99% interest in Partnership A. Under the
partnership rules, it was presumed that the accrued losses could then flow to
each of the individual investors in proportion to their relative interest in
Partnership B.
As a result of sales or
write-downs of STC’s mortgage investments in 1993
Partnership A realized a significant loss of which 99% was allocated to
Partnership B. Partnership B allocated these losses amongst its investors. In
turn each investor used their share of the loss to reduce their taxable incomes
in 1993 and 1994.
The Minister of National Revenue
reassessed the investors and denied the deductions. The investors appealed.
The Tax Court
judge followed the decision of the Federal Court of Appeal in OSFC
and dismissed the appeal. The investors appealed.
At the
Federal Court of Appeal the investors lost again. The Federal Court of Appeal
followed OSFC in denying the appeal. The investors appealed to the
Supreme Court of Canada.
The Supreme Court of Canada
The Court
laid down seven guiding principles for the application of the GAAR which are
summarized in Canada Trustco at ¶ 66:
1.
Three requirement must be established to permit
application of the GAAR:
(1)
A tax
benefit resulting from a transaction or part of a series of transactions
(s. 245(1) and (2));
(2)
that the transaction is an avoidance transaction in the sense that it cannot be said to have
been reasonably undertaken or arranged primarily for a bona fide purpose other than to obtain a tax benefit; and
(3)
that there was abusive tax avoidance in the sense that
it cannot be reasonably concluded that a tax benefit would be consistent with
the object, spirit or purpose of the provisions relied upon by the taxpayer.
2.
The burden is on the taxpayer to refute (1) and
(2), and on the Minister to establish (3).
3.
If the existence of abusive tax avoidance is
unclear, the benefit of the doubt goes to the taxpayer.
4.
The courts proceed by conducting a unified
textual, contextual and purposive analysis of the provisions giving rise to the
tax benefit in order to determine why they were put in place and why the
benefit was conferred. The goal is to arrive at a purposive interpretation that
is harmonious with the provisions of the Act that confer the tax benefit, read
in the context of the whole Act.
5.
Whether the transactions were motivated by any
economic, commercial, family or other non-tax purpose may form part of the
factual context that the courts may consider in the analysis of abusive tax
avoidance allegations under s. 245(4). However, any finding in this respect
would form only one part of the underlying facts of a case, and would be
insufficient by itself to establish abusive tax avoidance. The central issue is
the proper interpretation of the relevant provisions in light of their context
and purpose.
6.
Abusive tax avoidance may be found where the
relationships and transactions as expressed in the relevant documentation lack
a proper basis relative to the object, spirit or purpose of the provisions that
are purported to confer the tax benefit, or where they are wholly dissimilar to
the relationships or transactions that are contemplated by the provisions.
7.
Where the Tax Court judge has proceeded on a
proper construction of the provisions of the Income Tax Act and on findings supported by the evidence, appellate
tribunals should not interfere, absent a palpable and overriding error.
Three Step Analysis
The application of the GAAR
involves a three step process as set out in ss. 245
(1), (2), (3) and (4) of the Act.
First, the transaction or a part
of a series of transactions must give rise to a tax benefit. This is a factual
determination. The taxpayer has the burden of refuting the Minister’s allegation.
Second, the transaction or a part
of a series of transactions must be an avoidance transaction, such that it is
not arranged primarily for a bona fide purpose other than to obtain a tax
benefit. This removes from scrutiny under the GAAR those transactions that may
reasonably be viewed as arranged primarily for a non-tax purpose, including
those primarily for a family, investment or business purpose. It also does not
permit “recharacterization” of the transaction by
comparison with some alternative transaction that might have achieved a similar
result with higher tax consequences. It is a factual determination. Here too
the taxpayer bears the burden of refuting the Minister’s allegation.
Third, the avoidance transaction
must be an abusive avoidance transaction, such that it cannot be reasonably
concluded that a tax benefit would be consistent with the object, spirit or
purpose of the provisions relied upon by the taxpayer. It requires a two part
inquiry involving mixed fact and law. First, the provisions relied upon to obtain
the tax benefit must be reviewed to determine their object, spirit and purpose.
Second, the avoidance transaction must be reviewed to see if it defeats or
frustrates that purpose.
Interpretively, the use of the
double negative in the language of s. 245(4) gives rise to a presumption that
the tax benefit arising from the literal
interpretation of the Act is not abusive. Such a transaction should be allowed
unless the abusive nature of the transaction is clear. Once a taxpayer shows
compliance with the literal wording of a provision, he should not be required
to disprove he has violated the object, spirit or purpose of the provision. The
Minister should bear the burden of showing that the object, spirit or purpose
of the provision has been defeated or frustrated. It therefore falls upon the
Minister to identify the object, spirit or purpose of the provision.
The Canada Trustco
Decision
There was
no dispute that the sale lease-back strategy produced a tax benefit and was an
avoidance transaction. In dismissing the Minister’s appeal Chief Justice McLachlin and Justice Major, for the whole of the Court,
found that the scheme did not defeat or frustrate the object, spirit or purpose
of the CCA provisions or the Act as a whole. The CCA provisions specifically defined
“costs” as the amount paid to acquire the asset, not the “real” or “economic” cost as alleged by the Minister.
This was consistent with the well-established and generally understood use of
the term “cost”. Therefore, the CCA provisions and the Act as a whole permitted
the deduction of CCA based on the interpretation of cost put forth by CTMC.
The Mathew Decision
The
taxpayers in Mathew faired less well than their counterparts in Canada
Trustco. The tax benefit and the avoidance
transaction were not disputed. The general policy of the Act is to prohibit the
transfer of losses between taxpayers, except where specifically permitted for a
particular purpose. The purpose of s. 18(13) is to prevent a transferor in the
business of lending money from realizing a superficial loss, except where the
loss is transferred to a non-arm’s length party because the transferor and the
transferee are for tax purposes the same and the loss, at disposition, is
superficial and will be realized by the transferor, through the non-arm’s
length party, at some later date. To allow an arm’s length party to participate
in the loss would defeat or frustrate the wall intentionally created by
Parliament to prevent the trading of losses between taxpayers. In dismissing
the appeal Chief Justice McLachlin and Justice Major,
for the whole of the Court, agreed with conclusions of Dussault
T.C.J. and endorsed them.
For further
information please do not hesitate to contract the author of this
Article, Robert Omura
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