This article was originally published in Blakes Bulletin on Tax and Corporate Finance, April 2004
The Federal Court of Appeal (FCA) recently dismissed the Crown’s appeals in Canada Trustcoand Imperial Oil with respect to the application of the general anti-avoidance rule (GAAR) in the Canadian Income Tax Act.
In each case, the Crown appealed the application of the saving provision that prevents GAAR from being applied to avoidance transactions where the transactions do not constitute either a misuse of the provisions of the Act or an abuse having regard to the provisions of the Act read as a whole. The recent decisions of the FCA suggest that even transactions primarily motivated by tax considerations will not be subject to GAAR if they comply with the Act unless a very clear "misuse or abuse" has occurred.Transactions resulting in corporate loss trading are subject to GAAR, but neither transferring unrestricted depreciation deductions, nor taking advantage of tax loopholes, appear to be.
GAAR applies to a series of transactions that is an "avoidance transaction" (i.e., it resulted in a tax benefit and was primarily tax motivated), unless the series does not result in a misuse or abuse. In OSFC Holdings, the FCA designed the two part framework for assessing whether a "misuse" or "abuse" has occurred. The two part framework requires a court to identify the "relevant policy" – the object and spirit or scheme of the allegedly misused provision or of the Act read as a whole.Then, the facts are assessed to determine whether the series constitutes a misuse or abuse having regard to that identified policy.
Arguably, the most controversial part of the framework espoused in OSFC Holdingsis that, in ascertaining the relevant policy that forms the basis for the analysis, reference to extrinsic aids such as technical notes, the writings of legal authors and commentators, enacting notes, Hansard, budget speeches, commission reports, etc., is specifically permitted. Concern developed over the use of such non-legislative aids to guide the application of GAAR, a reaction contemplated by the FCA in OSFC Holdingsand addressed by its emphatic holding that any such identified "policy" had to be "clear and unambiguous". Anything less would represent a "complete abdication by Parliament of its role as lawmaker in favour of the subjective judgment of the Court".
In OSFC Holdings, interests in a partnership that held a portfolio of non-performing mortgage assets were transferred to arm’s length purchasers. Because the partnership was formed by one corporate partner contributing the mortgage portfolio to the partnership to gain its partnership interest, the loss on the transfer of the devalued portfolio was "denied" to the transferor/ corporate partner, and the amount of that denied loss was added to the partnership’s tax cost for the portfolio, all due to the operation of the stop-loss provision then in force (subsection 18(13) of the Act). Subsequent arm’s length owners of the partnership interests were able to reap the tax benefits (losses) that flowed once the partnership sold or wrote-down the value of the underlying mortgage portfolio.
The FCA could identify no policy that had been misused in the application of the operative stop-loss rule; on the contrary, it operated precisely as it was intended to operate, by denying an artificial loss to the original partner that transferred the devalued portfolio to the partnership and preserving the loss by adding it to the partnership’s tax cost.The FCA did, however, identify a clear and unequivocal policy in the Act that prohibits corporate loss trading amongst arm’s length parties by considering, among other things, the change of control rules in the Act. Since the portfolio’s value dropped during the period that it was owned by a corporation, the FCA concluded that the transactions "abused" the Act by effectively transferring the losses arising in a corporation to arm’s length parties in contravention of that policy.
In Canada Trustco, the FCA was concerned with the transfer of capital cost allowance (CCA) between parties to transactions designed to legally effect the sale of trailers, their subsequent lease and ultimate sub-lease back to the original owner.The transactions were designed to create minimal financial risk to any party – loans were secured with rental assignments from bank accounts containing prepaid rent financed by sale proceeds, etc. The result of the transactions was that the "purchaser" in the transactions, Canada Trustco Mortgage Co. (CT), became entitled to the CCA deductions relating to the trailers. Since trailers are exempt property for the purpose of the specified leasing property rules, CT was not restricted in deducting the CCA against any source of income.
The FCA dismissed the Crown’s appeal of the Tax Court of Canada decision on "misuse or abuse" without hearing from CT’s counsel.The tax results in the transactions stemmed from very deliberate provisions of the Act – specific exemptions to the specified leasing property rules and the financial sale/leaseback provisions.The FCA was not prepared to entertain an appeal on the basis of a vague policy that the taxpayer deducting CCA must have some threshold "true economic risk or ownership".
In Imperial Oil, the FCA again refused to lower the bar on "clear and unambiguous policy". Imperial made short-term loans totalling $500 million to subsidiaries of Canadian chartered banks that were outstanding over its taxation year end. Since those bank subsidiaries were not themselves "financial institutions", Imperial could, and did, claim an investment allowance for those loans, saving approximately $750,000 in large corporations tax (LCT). Since those loans were repaid before the respective subsidiaries’ taxation year ends, no LCT was payable by any of them in respect of the loans.
The FCA rejected each of the Crown’s numerous proposals of "policy".The most notable, perhaps, was the Crown submission that the LCT provisions present a clear and unambiguous policy that large corporations should pay a minimum amount of tax in order to reduce federal deficits.The FCA acknowledged that this may, in fact, have been Parliament’s general intention in introducing LCT in 1989 – to ensure that large corporations paid their "fair share" of federal tax irrespective of the availability of usual income tax shelter, but it ultimately concluded that those general statutory objectives were of only peripheral relevance, providing no more than broad context for the relevant provisions.
The Crown argued that this "policy" was violated when a loan was made by Imperial to any corporation with a fiscal year end different from its own.The FCA rejected this argument, because accepting it would make GAAR applicable to every transaction entered into for the purpose of reducing a taxpayer’s LCT – a result clearly inconsistent with the "misuse or abuse" analysis. The FCA reasoned that accepting the Crown’s view of the relevant "policy" would require it to apply GAAR to loans from LCT payors to unrelated corporations with less than $10 million of assets if the loan’s primary purpose and result were to reduce LCT. Neither the policy objectives nor the function of the investment allowance (which it agreed was to prevent double taxation) mandate that result.
The FCA recognized that Imperial took advantage of a loophole in the statutory scheme, namely the failure to deal with the consequences of different corporate year ends. It concluded, however, that Parliament virtually invited such LCT reduction transactions and Imperial’s acceptance of that virtual invitation was no misuse or abuse.
Good News/Bad News
The good news is that the only clear and unequivocal policy that has been identified by the FCA to have been violated is the restriction of corporate loss trading amongst unrelated corporations. This suggests not only that "policy" used to establish "misuse or abuse" be found within the Act (and not, for example, in the broad Parliamentary objective of raising tax revenue), but also that the provisions of the Act ought to suggest that policy very clearly.The FCA continues to adhere to the very high standard for "clear and unequivocal policy" set by it in OSFC Holdings.
The bad news is that notwithstanding that the FCA was requested by the taxpayer in each of the decisions to reconsider the respective Tax Court of Canada conclusions that the impugned transactions constituted "avoidance transactions" for the purposes of GAAR, neither panel reviewed nor decided the matter. Although each lower court decision acknowledged a bona fide business purpose and/or ordinary business characteristics, the transactions in each were found to be avoidance transactions. In the decision of the Tax Court of Canada in Canada Trustco, Miller T.C.J. suggested that the term "avoidance transaction" has a "bad rap", writing that "avoidance transactions" is not "a dirty word". Both cases suggest that an alarmingly low threshold of tax motivation is necessary to conclude that a transaction is an "avoidance transaction".
This judicial trend necessarily expands the GAAR net in Canada. Pessimists can conclude easily that this low threshold of tax motivation required to find an "avoidance transaction" proves the theory that "misuse or abuse" is GAAR.
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