Landmark Decisions in Canadian Tax Law
In 1988 the Canadian Minister of Finance announced a proposal to introduce into Canadian tax law a legislated anti-avoidance rule of general application. This rule has since come to be known as the "general anti-avoidance rule" or "GAAR". GAAR was introduced into the Canadian Income Tax Act (the "Tax Act") after many years of "cat and mouse" games between tax practitioners and tax policy makers, when Canada's tax policy makers seemed to be introducing, on almost a weekly basis, new, specific anti-avoidance rules aimed at the latest tax structure devised by clever Canadian tax practitioners. The need for such a rule of general application, at least from the tax policy makers' perspective, was evidenced by the repeated failure in the Canadian tax courts of the Canada Revenue Agency ("CRA") to apply concepts such as "sham", "substance over form", "economic substance" or "business purpose".
After 17 years, Canadian taxpayers and their advisers finally have guidance from our highest Court, the Supreme Court of Canada, on the application of GAAR. More specifically, on October 19, 2005 the Supreme Court of Canada released its decisions in The Queen v. Canada Trustco Mortgage Company ("Canada Trustco") and in Mathew v. The Queen ("Mathew ") . Both decisions were made by a unanimous court, with one decision falling in favour of the taxpayer and the other in favour of the Minister of National Revenue (the "Minister").
In the Canada Trustco and Mathew cases the Supreme Court of Canada indicated that the application of the GAAR involves a three step analysis. In its view, in determining whether the GAAR applies to a particular transaction or series of transactions, it must be determined whether: (i) there is a "tax benefit" that would arise from a transaction or series of transactions but for the application of the GAAR; (ii) the transaction is an "avoidance transaction", in the sense of the transaction not being "arranged primarily for bona fide purposes other than to obtain the tax benefit"; and (iii) there was "abusive tax avoidance", in the sense that it cannot be reasonably concluded that the tax benefit arising from the transaction or series of transactions would be consistent with the object, spirit or purpose of the provisions being relied upon by the taxpayer or of the Tax Act read as a whole.
The Supreme Court of Canada expanded on this third step by engaging in a two-part inquiry. The Court indicated that first, courts must conduct a unified textual, contextual and purposive analysis of the provisions giving rise to the tax benefit, having regard to the scheme of the Tax Act, in order to determine why they were put in place and why the benefit was conferred. Second, courts must examine the factual context of the case in order to determine whether the avoidance transaction defeated or frustrated the object, spirit or purpose of the provisions in issue.
The Supreme Court of Canada further held that the burden is on the taxpayer to refute points (i) and (ii) above, but the burden is on the Minister to prove the abusive tax avoidance. 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 the abusive tax avoidance allegations. The GAAR may be applied to deny a tax benefit only after it is determined that it was not reasonable to consider the tax benefit to be within the object, spirit or purpose of the provisions relied upon by the taxpayer. In the end, if the existence of abusive tax avoidance is unclear, the benefit of the doubt goes to the taxpayer.
Perhaps even more importantly, the Supreme Court of Canada stated that the Tax Act "continues to permit legitimate tax minimization" and that one of its tasks in applying the GAAR is to ensure that it applies in a manner that achieves "consistent, predictable and fair" results so that "taxpayers may manage their affairs intelligently".
In Canada Trustco, the transaction at issue was a leveraged sale-leaseback in which capital cost allowance was claimed on accelerated write-off equipment acquired in a transaction structured so that the taxpayer had only minimal economic risk because of a significant prepayment of the lease amounts. The Supreme Court of Canada, in finding in favour of the taxpayer and against the application of the GAAR, characterized the transaction at issue as being an ordinary sale-leaseback and, therefore, found that it did not fall outside the "object, spirit or purpose" of the capital cost allowance provisions of the Tax Act, and that there was no clear and discernible policy that, in the absence of a specific at-risk rule, "cost" meant anything other than the outlay made, regardless of how the purchase of the asset was financed. The Court specifically rejected the CRA's argument that concepts such as "economic risk" should have any bearing on the computation of cost or the potential application of the GAAR. As such, the GAAR could not apply to disallow the tax benefit.
The facts in the companion case Mathew involved a series of transactions resulting in the transfer of a loss from an insolvent corporation, through a partnership, to taxpayers dealing with the corporation at arm's length. In general terms, the transactions at issue in the case involved the transfer of assets by the insolvent corporation to a non-arm's length partnership and the purported application of certain "loss-denial rules" generally applicable to non-arm's length transactions, and the subsequent acquisition of partnership interests by the taxpayers with a view to participating in the tax losses triggered on the disposition of the loss assets by the partnership.
The Supreme Court of Canada held that to allow the taxpayers to claim the losses would defeat the purposes of the relevant sections of the Tax Act. The Court held that the loss denial rules in the Tax Act preserve and transfer a loss under the assumption that a loss should not be realized for tax purposes on a non-arm's length transfer, but only on the subsequent realization of the loss by the transferee. In the Supreme Court of Canada's view, the use of these loss-denial rules to preserve and sell an unrealized loss to an arm's length party resulted in abusive tax avoidance.
The decisions of the Supreme Court of Canada have finally provided some much needed guidance at the highest level in the manner in which to apply the GAAR, and should assist taxpayers and their advisers to better rely on a consistent, predictable and fair application of the GAAR and the Tax Act.
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