On December 16th last the Supreme Court of Canada ("SCC") released its long anticipated decision in the case of Copthorne Holdings Ltd. v. The Queen ("Copthorne"). The reason that this decision was long anticipated is that it represents only the third time that the SCC has addressed the application of the so-called "general anti-avoidance rule" or "GAAR", found in section 245 of the Canadian Income Tax Act ("ITA"), since the GAAR was introduced into the ITA in 1988.
The Copthorne case revolved around the characterization of a distribution by the taxpayer to its non-resident parent corporation. Briefly, the taxpayer contended that the distribution consisted of a non-taxable return of "paid-up capital" ("PUC", being, in general terms, the amount received by a corporation on the issuance of its shares). The Canada Revenue Agency ("CRA") took the position that the PUC in question had been created or preserved in a manner that constituted a misuse or abuse of the provisions of the ITA and that, therefore, the GAAR should apply to re-characterize the distribution as a taxable dividend, not as a non-taxable return of PUC. In short, the SCC agreed with the CRA.
The facts of the case are extraordinarily complex, even for a tax planning case. In very general terms, the case involved two sets of transactions. One aspect of the decision of the SCC, an aspect of some considerable importance, is the determination of whether the two sets of transactions were part of one series of transactions. This was a threshold issue because, in the circumstances, the GAAR could only apply if this were the case.
The first set of transactions involved a loss consolidation. Canadian tax law does not provide for consolidated reporting within a corporate group, nor does it explicitly provide for loss transfers within such a group. However, certain loss consolidation transactions are tolerated by the CRA and, therefore, are not unusual when one corporation within a group has income or a gain and another has unused tax losses. In this case, the loss consolidation transactions involved a transfer of the shares of one group member, "VHHC Holdings", held by its parent corporation, "VHHC Investments", to another group member which was a predecessor to the taxpayer. The loss consolidation transaction was not impugned by the CRA.
At the end of the loss consolidation transaction, the predecessor of the taxpayer was left holding shares of "VHHC Holdings" the PUC of which was high but the fair market value of which was nominal. This is important because the PUC of those shares had, as its source, the same funds that had been invested into VHHC Investments, which shares (with their high PUC and nominal value) were still held within the group (in other words, the funds had made their way down the chain of corporations, creating PUC at each level).
A decision was taken to merge several group corporations, including the predecessor of the taxpayer and its then wholly owned subsidiary, VHHC Holdings. A vertical amalgamation of VHHC Holdings with its then parent, the predecessor of the taxpayer, would have caused the high PUC of the shares of the capital of VHHC Holdings to disappear. Accordingly, the shares of the capital of VHHC Holdings were first sold to the parent of the predecessor to the taxpayer, "Big City", and the predecessor to the taxpayer and VHHC Holdings were merged by way of a horizontal amalgamation, thereby preserving the PUC of the shares of the capital of VHHC Holdings. The decision to effect this merger by way of the horizontal amalgamation, rather than a vertical amalgamation, was a key factor in the SCC decision.
The second set of transactions, effected approximately two years later, involved the transfer of the shares of the capital of both the processor of the taxpayer and of VHHC Investments to another group member resident in Barbados, following which the two Canadian corporations, and two other Canadian corporations in the group, were amalgamated to form the taxpayer. This was then followed by a redemption of shares of the capital of the taxpayer held by its Barbadian parent corporation.
The taxpayer took the position that the redemption did not trigger a deemed dividend for its non-resident parent because the PUC of the shares redeemed exceeded the amount paid to the parent on the redemption. The CRA, in essence, contended that the PUC of the shares should not include the PUC derived from the shares of the capital of VHHC Holdings with the result that the share redemption by the taxpayer gave rise to a deemed dividend paid to its parent on which the taxpayer should have withheld Canadian tax.
The first question addressed by the SCC was whether the first set of transactions and the second set were part of one series of transactions. The Court held that they were, based upon the extended definition of a "series" found in subsection 248(10) of the ITA which includes in a series any "related transaction" completed "in contemplation of" the series. This aspect of the decision is interesting in itself, but is not the focus of this commentary.
The SCC also agreed with the CRA that the GAAR should apply to redetermine the PUC of the shares redeemed by the taxpayer. In particular, the SCC agreed that the PUC of the redeemed shares should not include the PUC derived from the shares of the capital of VHHC Holdings. At the risk of oversimplifying the well considered and reasoned decision of the Court, the following are some observations on the reasons of the Court:
- "taxpayers are entitled to select courses of action or enter into transactions that will minimize their tax liability (see Duke of Westminster)";
- "The GAAR is a legal mechanism whereby Parliament has conferred on the court the unusual duty of going behind the words of the legislation to determine the object, spirit or purpose of the provision or provisions relied upon by the taxpayer. While the taxpayer's transactions will be in strict compliance with the text of the relevant provisions relied upon, they may not necessarily be in accord with their object, spirit or purpose. In such cases, the GAAR may be invoked by the Minister. The GAAR does create some uncertainty for taxpayers. Courts, however, must remember that s. 245 was enacted 'as a provision of last resort' ";
- Because of the potential to affect so many transactions, the court must approach a GAAR decision cautiously. It is necessary to remember that "Parliament must...'be taken to seek consistency, predictability and fairness in tax law'...For this reason, 'the GAAR can only be applied to deny a tax benefit when the abusive nature of the transaction is clear' " (emphasis added).
In using the emphasized words in the last bullet above, the SCC was quoting itself from the Canada Trustco decision. However, the words are reminiscent of the Federal Court of Appeal ("FCA") decision in OSFC Holdings, in which that court stated:
to deny a tax benefit where there has been strict compliance with the Act, on the grounds that the avoidance transaction constitutes a misuse or abuse, requires that the relevant policy be clear and unambiguous. The Court will proceed cautiously in carrying out the unusual duty imposed upon it under subsection 245(4). The Court must be confident that although the words used by Parliament allow the avoidance transaction, the policy of relevant provisions or the Act as a whole is sufficiently clear that the Court may safely conclude that the use made of the provision or provisions by the taxpayer constituted a misuse or abuse.
In answer to the argument that such an approach will make the GAAR difficult to apply, I would say that where the policy is clear, it will not be difficult to apply. Where the policy is ambiguous, it should be difficult to apply (emphasis added).
It is interesting to note that both the SCC decision in Copthorne and the FCA decision in OSFC Holdings were written by Justice Marshall Rothstein. These two decisions are, arguably, the best written and best reasoned GAAR decisions to date. They also provide clear guidance on when the GAAR should be applied, which is not very often, and only when "the abusive nature of the transaction is clear" or when the relevant policy is "clear and unambiguous".
OFSC Holdings involved a series of transactions intended to circumvent the loss streaming rules applicable upon a corporate acquisition of control. In that case the FCA did not have too much difficulty finding a general scheme of the ITA against corporate loss trading, a conclusion that is hard to question.
It is perhaps more difficult to find a general scheme of the ITA in respect of PUC and corporate distributions than it is in respect of corporate loss trading (although some would argue that such a scheme is present, and that one only needs to look harder to find it, although perhaps this means that it is not "clear and unambiguous"). In its decision, the SCC relied heavily on the fact that had the merger of the predecessor of the taxpayer and its wholly owned subsidiary, VHHC Holdings, been effected as a vertical amalgamation the PUC in issue would not have survived the merger because subsection 87(3) of the ITA would have eliminated it. The Court held that by effecting the merger as a horizontal amalgamation, rather than a vertical amalgamation (which would have been a simpler way of achieving the same non-tax, commercial result), constituted an abuse of subsection 87(3) of the ITA. This conclusion was heavily influenced by the fact that the PUC had, as its source, the same original funds, as described above.
It is probably safe to say that the CRA won in Copthorne because it had really good facts. These facts presented to the Court a fairly clear case of duplication of PUC through the investment of funds down a corporate chain, and also allowed the Court to draw a fairly clear comparison between the elimination of that PUC on a simple transaction (the vertical amalgamation which could have been effected) versus the preservation of it on a more complicated transaction (the horizontal amalgamation that was effected) and the avoidance of subsection 87(3) as a result.
However, the importance of Copthorne is not in what it tells us about PUC planning transactions, but what it tells us about the GAAR. As noted above, it is interesting to note the similarities between the reasons in Copthorne and OSFC Holdings. Hopefully those decisions, particularly the portions referred to above, will guide the courts (and the CRA?) in their future considerations of the application of the GAAR. In particular, in addressing the misuse or abuse question necessary for determining if the GAAR is applicable to a particular transaction, hopefully the Copthorne criterion ("the GAAR can only be applied to deny a tax benefit when the abusive nature of the transaction is clear"), and the similar OSFC Holdings criterion (the GAAR should be applied, which is not very often, and only when "the abusive nature of the transaction is clear" or when the relevant policy is "clear and unambiguous") will be our guides.
No doubt many tax professionals in Canada will continue to decry the "uncertainty" and "arbitrary nature" of the GAAR, as they have for over 20 years. On the other hand, it is interesting to note that officials of the CRA and the Department of Finance can often be heard expressing concern that the courts have applied the GAAR in too restrictive a manner. If the courts are hearing complaints from both ends of the spectrum, perhaps they have hit the "Goldilocks zone".
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.