Canada: Corporate Tax Litigation: Recent Developments of Importance

Last Updated: January 31 2006

Article by Guy Du Pont and Nicolas X. Cloutier

The most salient trends in Canadian tax litigation in 2005 are embodied by the following cases, dealing with the general anti-avoidance rule, interest deductibility, requests for information or documents, deduction of foreign exchange losses and the surrogatum principle.

General Anti-Avoidance Rule

In October, the Supreme Court of Canada released its judgments in Mathew v. Canada1 and The Queen v. Canada Trustco,2 its first decisions on the general anti-avoidance rule (GAAR). GAAR was introduced in 1987 to provide tax authorities with a broad statutory tool to combat "abusive" tax avoidance. The Supreme Court confirmed the lower court’s decisions.

The Supreme Court ruled that three requirements must be established before GAAR can be applied and set out the following interpretive framework.

First, there must be a tax benefit, which is a reduction, deferral or avoidance of tax.

  • The existence of a benefit is a matter of fact (not law).
  • The magnitude of the benefit is not relevant at this stage, so long as a benefit exists.
  • The onus is on the taxpayer to establish that there is no benefit.
  • It may be necessary to compare the transaction or series of transactions to possible alternate arrangements to determine if there is a tax benefit.

Second, at least one of the transactions must be an avoidance transaction.

  • An avoidance transaction is a transaction resulting in a benefit alone or as part of a series of transactions.
  • A series of transactions includes transactions completed "in relation to" or "because of" the series (whether before or after the series).
  • Transactions that may reasonably be considered to have been undertaken primarily for family, investment or other nontax purposes, even if they do not have a business purpose per se, are immune from GAAR.

Thirdly, the avoidance transaction must be clearly abusive.

  • The object, spirit and purpose of the relevant Income Tax Act provisions must be determined. In doing so, courts should not look for an overriding policy not anchored in the interpretation of the relevant statutory provisions. It then must be established that an avoidance transaction defeats or frustrates such object, spirit or purpose.
  • In making this determination, a single, unified textual, contextual and purposive approach must be followed. There are no separate misuse and abuse analyses, as the Federal Court of Appeal (FCA) had earlier ruled.
  • The abusive nature of the transaction must be clear—doubt should be resolved in the taxpayer’s favor.
  • The onus is on the Crown, not the taxpayer, to establish abuse. In Canada Trustco and Mathew, the only issue before the Supreme Court was whether the transactions in question were abusive.

In Canada Trustco, the Crown asserted that GAAR should apply to deny the taxpayer’s capital cost allowance deduction (in what was allegedly a circular leasing transaction without real economic risk on the part of the lessor), mainly on the basis that the taxpayer had mitigated its financial risk or, in other words, that "cost" within the meaning of the relevant provisions means "economic cost," net of risk mitigation. The Supreme Court rejected this approach as a narrow "economic substance" determination, not supported by the Income Tax Act, and held that the taxpayer’s benefit was within the object, spirit or purpose of the relevant provisions.

Conversely, in Mathew, the Supreme Court ruled against the taxpayers, finding that the transactions, which in effect permitted the taxpayers to acquire losses of an arm’s length party, frustrated the object, spirit or purpose of the relevant legislative provisions, which was to limit loss sharing to non–arm’s length parties.

In conclusion, the Supreme Court decisions, while acknowledging that GAAR is not a bright-line test, affirmed that the Income Tax Act, including GAAR, must be interpreted to preserve consistency, predictability and fairness so that taxpayers may manage their affairs intelligently.

Interest Deductibility

In Quebec v. Moufarrège3, the Supreme Court once again addressed the issue of interest deductibility.

The facts of the case were as simple as they could be. The taxpayer borrowed money to acquire condominium units in the Vancouver area. The real estate market performed poorly, the taxpayer sold the units at a loss, reimbursed part of the loan with the proceeds of disposition and claimed the interest deduction on the balance. Similarly, the taxpayer also borrowed money to purchase shares of a company operating a golf course. The company went bankrupt, and the taxpayer kept claiming the interest deduction on the loan after the bankruptcy. The Deputy Minister of Revenue of Quebec denied the deductions.

The Court of Quebec dismissed the taxpayer’s appeal. The Quebec Court of Appeal reversed the decision and allowed the interest deduction on both loans, mainly on the basis that, once the taxpayer had met the well-established tests for interest deductibility—(a) amount paid or payable in the year; (b) pursuant to a legal obligation to pay interest; (c) on borrowed money used for the purpose of earning nonexempt income from a business or property; and (d) a reasonable interest amount—the interest remains deductible as long as the connection between the loan and the business or property is maintained, even if the business or property has no "reasonable expectation of income" in each year. In other words, for the court of appeal, the reasonable expectation of income test applies only at the time of the original use and for every subsequent use of the money, and not in each year the deduction is claimed by the taxpayer.

In a very short judgment which neither recites the legislative provisions in issue nor summarizes the judgments below or the taxpayer’s arguments, the Supreme Court reversed the court of appeal. First, the Supreme Court stated, referring to Bronfman Trust,4 that it is the "current rather than the original use that is relevant in assessing the deductibility of interest payments," suggesting, in the context of the Moufarrège case, that the business or property must be used for the purpose of earning nonexempt income in each year the deduction is claimed. That proposition is difficult to reconcile with the requirement that it is the money that must be used (exchanged), not the business or property.

Secondly, the Supreme Court stated, referring to its decision in Stewart,5 that "when a reasonable expectation of income disappears, so does the right to a deduction." That proposition is hard to reconcile with the relevant legislative provisions (sections 128, 129 and 160 of the Taxation Act, Quebec), taken together with Stewart, where the Supreme Court held that the test of "reasonable expectation of income" must be applied at the time of the investment (or, implicitly, reinvestment).

Requests for Information or Documents

The Income Tax Act generally allows the Canada Revenue Agency (CRA) to request that any resident or nonresident carrying on business in Canada provide any "foreign-based information or document" that may be relevant for the administration or enforcement of that Act. This requirement can be set aside or varied by a judge if it is found to be unreasonable.

In Saipem Luxembourg v. Canada,6 the taxpayer was served with a request to provide all its Canadian and foreign corporate records for two years to enable the CRA to assess whether it had a permanent establishment in Canada. The issue was whether the requirement was so broad as to be unreasonable.

The FCA applied the standard of reasonableness established in Law Society of New Brunswick v. Ryan,7 which involves asking, "[A]fter a somewhat probing examination, can the reasons given, when taken as a whole, support the decision?"—the issue being whether the information was relevant to the administration of the Income Tax Act, not whether it is relevant to determine the taxpayer’s tax liability.

The FCA concluded that an audit cannot be conducted solely on the basis of material provided by the person audited, as the CRA must have the possibility to verify that no further records exist. The FCA also emphasized that "[i]n the absence of bad faith or other improper motive, the appropriateness of an audit is outside the mandate of the [c]ourt." Accordingly, the FCA found the requirement not unreasonable, and dismissed the appeal. The taxpayer filed an application for leave to appeal to the Supreme Court on September 1, 2005.

Generally, the CRA can also request that a taxpayer disclose information in respect of named third parties for a purpose related to the administration and enforcement of the Income Tax Act. To obtain information in respect of unnamed persons, the CRA must obtain a court order, which will be issued only if a judge is satisfied that the unnamed person or group of persons is ascertainable and the demand is made for the purpose of verifying the compliance of the person or group of persons with the Income Tax Act.

In Canada v. Artistic Ideas,8 the taxpayer was involved in "buylow/ donate-high" "art flips," where taxpayers would purchase artwork at a low price, have the artwork valued at a higher price and donate it to registered charities, claiming a deduction based on the higher valuation. The taxpayer refused to disclose the names of the donors and of the charities unless the CRA obtained prior judicial authorization requiring it to do so. It was established that the CRA only intended to audit the donors.

The FCA found that any requirement for information or documents with respect to unnamed persons that the CRA intended to audit had first to be authorized by a judge. Therefore, the FCA found that the CRA was entitled to the names of the charities without prior judicial authorization, as the CRA had no intention of auditing them, but not to the names of the donors, who were to be audited.

Unfortunately, according to that judgement, little seems to prevent the CRA from requiring from third parties without prior judicial authorization the names of persons not under audit, then reviewing the information and later deciding to audit these third parties on the basis of the information so obtained.

Deduction of Foreign Exchange Losses

In both of Imperial Oil Ltd. v. The Queen9 and Inco Ltd. v. The Queen,10 the FCA allowed a foreign exchange loss arising from the settlement of a foreign currency debt to be deducted as a discount on an obligation, thereby reversing the positions of the CRA and of the tax court.

In October 1989, Imperial Oil issued three 30-year debentures with a face value of US$100 million each at a discount of 1.199 percent. The exchange rate for U.S. dollars to Canadian dollars was 1.17660. In October of 1999, Imperial Oil redeemed some of the debentures early. At the time of redemption, the U.S. dollar had appreciated to 1.48192, increasing the cost of redemption by over $27 million.

The foreign exchange loss would normally be reported as a capital loss deductible against any capital gain in the year. However, Imperial Oil sought to deduct the loss as an expense against income. It filed a notice of appeal in the tax court arguing that subsection 39(2) of the Income Tax Act had no application and that foreign exchange losses were deductible under paragraph 20(1)(f).

The tax court held that only the original issue discount was deductible as a discount on an obligation, though it calculated the Canadian dollar value of the discount using the 1999 exchange rate, not the 1989 rate, which resulted in a larger deduction. The foreign exchange loss suffered upon redemption was held to be a capital loss.

In both 1989 and 1992, Inco Ltd. issued U.S. currency debentures, the former at a discount rate of 2.6 percent, the latter at their face amount. Inco amortized the discount and deducted the sum as financing expenses, deductions the CRA did not challenge in assessing Inco for the 1989 to 1993 taxation years. The proceeds of the debentures were never converted into U.S. dollars, and Inco used exclusively its U.S. currency in order to redeem or purchase a portion of the debentures for cancellation in 2000 on the open market.

As was the case for Imperial Oil, between the time the debentures were issued and their purchase or redemption, the U.S. dollar appreciated in value, and Inco sought to deduct the loss against income. The CRA disallowed the deduction and Inco appealed to the tax court.

The tax court agreed with Imperial Oil that foreign exchange losses are not deductible as a discount on an obligation, but did so on different grounds. First, the court rejected the possibility of a deduction, since it concluded that in fact Inco had not incurred any loss. Given that the money generated from the issuance of the debentures had never been converted from U.S. funds and Inco subsequently used U.S. funds to retire the debentures, ostensibly Inco had sought to deduct a loss that did not exist. Moreover, the tax court concluded that the term "principal amount" refers to the face amount of the instrument and must be determined at the moment of issuance of the debenture, not its redemption.

In Imperial Oil, the FCA allowed both the appeal and the cross-appeal. Both parties agreed that a payment had been made "in satisfaction of a principal amount" and that the discount could be deducted from income. However, they disagreed about the manner in which the "principal amount" was to be determined. The Crown argued that the principal amount should be set at issuance. Imperial Oil argued it should be set at redemption. The FCA examined the meaning of the term "principal amount" in the Income Tax Act, which refers to the "maximum amount payable on account of an obligation." It held that since the Canadian dollar equivalent payable on a foreign currency loan can fluctuate with the exchange rate, so too does the "maximum amount payable." Thus the principal amount must be determined upon redemption, when the maximum amount is locked in.

In reaching its decision, the FCA applied the principle enunciated in Gaynor v. Minister of National Revenue,11 that "if a foreign currency transaction is an element of any computation required by a statutory formula, the amount of the foreign currency must be converted to Canadian dollars at the conversion rate prevailing at the time of the transaction." The FCA found that the Gaynor principle applied not just to capital gains and losses but also to the computation of income.

Inco’s appeal was rejected on the grounds that the issues raised in the appeal were indistinguishable from those decided in Imperial Oil.

On May 19, 2005, both Imperial Oil Ltd. and Inco Ltd. were granted application for leave to appeal to the Supreme Court.

The Surrogatum, or "In Lieu Of," Principle

In Tsiaprailis v. Canada,12 the Supreme Court had to determine the tax treatment of a lump sum received in settlement of a lawsuit the taxpayer had brought against an insurance company after it ceased the payment of long-term disability benefits, claiming that the taxpayer was no longer totally disabled following a serious car accident. The CRA assessed the lump sum less legal fees as employment income. The taxpayer appealed the assessment.

The tax court found in the taxpayer’s favor, holding that the lump sum could not be described as an amount "payable on a periodic basis" and "pursuant to a disability insurance plan." The majority of the FCA allowed the Crown’s appeal, dividing the lump sum payment into three parts for benefits in arrears, future benefits and costs. The FCA held that the portion attributed to arrears was properly taxable as employment income and that the fact that the monies were received in a lump sum made them no less "payable […] on a periodic basis."

On appeal to the Supreme Court, the taxpayer argued that the payment for past benefits was not made "pursuant to" the insurance policy, as it was paid to obtain a release from liability under the policy. In a 4-3 split decision, the Supreme Court confirmed the FCA decision.

The majority of the Supreme Court applied the surrogatum principle, which essentially dictates that the tax treatment of an item will depend on what the amount received was intended to replace, and concluded that a portion of the lump sum was intended to replace past benefits, which were taxable. Five letters exchanged between the taxpayer’s attorney and the insurance company, in which the parties allocated the settlement between arrears, future benefits and costs, supported this finding. Furthermore, the majority considered that to not view accumulated arrears as an actual component of the settlement payment would render the surrogatum principle meaningless.

On the other hand, the minority found that the lump sum payment was not made "pursuant to" but rather "resulting from" an insurance policy. Furthermore, the minority held that the parties had simply considered quantum of accumulated arrears as a gauge to the reasonableness of the ultimate settlement amount, thus finding that even if the surrogatum principle applied, it would not lead to liability under the Income Tax Act.

Generally, Part XIII of the Income Tax Act provides that nonresidents are liable for a tax withheld on every amount that a resident pays to the nonresident, inter alia, as, on account of, or "in lieu of" the payment of rent.

In Transocean Offshore Ltd. v. Canada,13 the question at issue was whether the words "in lieu of rent" were broad enough to cover an amount of $40 million paid to the taxpayer to compensate for the rent that would have been paid by Petro-Canada and others for the use of an offshore drilling rig, had the charter agreement for the rig not been repudiated further to unforeseen difficulties and cost before the commencement of the rental term.

In applying for a refund of the withholding, the taxpayer submitted that "in lieu of rent" included only payments made as compensation for the past or current use of property. The appeal was dismissed by the tax court. The FCA also dismissed the appeal and found that the legislative provisions should be interpreted, in conformity with the ordinary meaning of the words, to also include the amount paid as compensation for the anticipatory breach of a rental agreement. Furthermore, the FCA found that the application of the surrogatum principle was not needed, given that the words "in lieu of" expressed a "similar idea." An application for leave to appeal to the Supreme Court was filed on September 12, 2005.

1 2005 CSC 58.

2 2005 CSC 54.

3 2005 SCC 53.

4 [1987] 1 S.C.R. 32, and other judgments to the same effect.

5 [2002] 2 S.C.R. 1082.

6 2005 FCA 218.

7 [2003] 1 S.C.R. 247.

8 2005 FCA 68.

9 2004 FCA 36.

10 2005 FCA 38.

11 94 DTC 5288 (FCA).

12 2005 CSC 8.

13 2005 FCA 104.

This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.