- Volume 9, Issue 30:
GAAR Case Comment: Lehigh Cement (Tax Court)
- Volume 9, Issue 31:
Department of Finance Releases (New) Draft GST/HST Financial Institution Legislation
GAAR Case Comment: Lehigh Cement (Tax Court)
By: Brian Kearl and Lauchlin MacEachern
The General Anti-Avoidance Rule ("GAAR") contained in section 245 of the Income Tax Act, 1985, c. 1 (5th Supp.) (the "Tax Act") applies to deny a taxpayer a particular tax benefit or result where three conditions are satisfied: (1) the taxpayer enjoyed a "tax benefit"; (2) the taxpayer entered into an "avoidance transaction"; and (3) the taxpayer engaged in "abusive tax avoidance".
A "tax benefit" includes any reduction, avoidance or deferral of tax or a refund of tax or other amount under the Tax Act. An "avoidance transaction" is a transaction undertaken primarily for tax reasons and not for a bona fide commercial, family or charitable purpose where any tax savings are ancillary in the overall plan. Lastly, "abusive tax avoidance" exists where the transaction in question frustrates or defeats the object, spirit or purpose of the provisions relied on to realize the tax benefit.
In Lehigh Cement1 the court considered whether the loan restructuring undertaken by the Appellant constituted an abuse under GAAR of the interest withholding tax exemption contained in previous paragraph 212(1)(b)(vii). During the relevant time and prior to 2008, withholding tax applied to interest payments made by Canadian residents to non-residents subject to certain enumerated exceptions. One of these exceptions was contained in subparagraph (vii) which provided that interest payable by a corporation resident in Canada to an arm's length person not resident in Canada was not subject to withholding tax provided the payer was not obligated to pay more than 25% of the principal amount of the loan within 5 years from the date of the issue of the loan.
Since the relevant years under appeal, subsection 212(b) has been amended to greatly expand the circumstances in which interest payments made to non-residents will not be subject to withholding taxes. In respect of interest paid to arm's length parties the requirement that the payer be a Canadian corporation and restrictions on repayment of capital have been removed.
Notwithstanding the fact that the relevant income tax provision considered in Lehigh Cement has been amended, this case is still relevant because the key issue in this case, whether the Appellant circumvented the arm's length requirement in the exemption to withholding tax on interest payments, would still be relevant under the revised provision.
The relevant facts can be summarized as follows: (1) the Appellant was a Canadian corporation resident in Canada, but was controlled by a publicly traded German company, (2) the Appellant was indebted to a consortium of Canadian banks, (3) indirectly, this debt was eventually assigned to a Belgian company related to the Appellant ("Belgianco"), (3) Belgianco assigned its right to receive the interest payments ("Interest") to be paid by the Appellant under the debt for a five year period to an unrelated Belgian bank ("Bank"), and (4) treating the Interest as coming within subparagraph 212(1)(b)(vii), the Appellant did not withhold tax under Part XIII of the Tax Act.
The Canada Revenue Agency (the "CRA") took the position that the Appellant should have withheld tax on the Interest, assessed the Appellant under Part XIII and imposed a 10% penalty for failure to withhold under section 227 of the Tax Act. The basis for the CRA's position was that GAAR applied to the sale of the Interest to the Bank and the avoidance of withholding tax thereon.
At trial, the Appellant conceded that it had enjoyed a "tax benefit" and that the impugned transactions were "avoidance transactions" under GAAR. In considering whether the Appellant had engaged in "abusive tax avoidance", the last element required to trigger GAAR, the court held that the object, spirit and purpose of subparagraph 212(1)(b)(vii) was:
Justice M.A. Mogan for the court determined that "the Appellant did not borrow any money from [the Bank] or any other non-resident lender. The absence of a non-resident lender causes me to infer that the sale transaction between [Belgianco] and [the Bank] abused subparagraph (vii)."3 The court found that the relationship between the Appellant and the Bank was "wholly dissimilar to the arm's length borrower/lender relationship contemplated by subparagraph (vii)"4, and thus the Appellant, in avoiding withholding on the Interest had defeated or frustrated the object, spirit and purpose of the withholding tax exemption it had relied on.
Both the Appellant and CRA agreed that the Interest did qualify for the subparagraph (vii) withholding tax exemption. As such, CRA had to establish all three elements of GAAR to deny this exemption and assess the Appellant for a failure to withhold tax on the Interest. As the Appellant conceded the first two elements of GAAR (the avoidance of withholding tax was a "tax benefit" and the sale of the Interest was an "avoidance transaction"), CRA was only required to establish that the Appellant misused or abused subparagraph 212(1)(b)(vii) of the Tax Act. Given that the court found the object, spirit and purpose of subparagraph 212(1)(b)(vii) was to facilitate non-arm's length borrowings between Canadian companies and non-resident lenders, and the Appellant never actually borrowed any money from the Bank, it is not surprising that the Appellant failed at the "abusive tax avoidance" stage of GAAR.
Could the impugned transactions have been structured in such a manner as to defeat CRA's "abusive tax avoidance" position? Additionally, did the Appellant commit a strategic error in conceding the existence of an "avoidance transaction" or could the impugned transactions have been designed to support the proposition that they were undertaken primarily for non-tax reasons?
In terms of "abusive tax avoidance", if the Appellant had borrowed from the Bank directly and used the proceeds to repay Belgianco (assuming such an arrangement would have made business sense for Belgianco), there can be little doubt that the Appellant would have succeeded in defeating CRA's misuse and abuse claims.
In terms of "avoidance transaction", if Belgianco had developed a primary bona fide commercial purpose for the sale of the Interest to the Bank (i.e. Belgianco may have needed the cash to fund operations, expansions, acquisitions or debt repayments) and the Appellant had not conceded the existence of an "avoidance transaction", CRA's GAAR assessment would have likely failed.
This decision is a classic example of the need for taxpayers to solidify their non-tax reasons for undertaking a particular tax plan to the point where such non-tax reasons are predominant to an objective observer. The decision is also a reminder that it is imperative to always be mindful of the GAAR arrows in CRA's quiver and the usefulness of considering alternative structures which achieve the same economic result, but which may be more defensible when targeted.
Department of Finance Releases (New) Draft GST/HST
Financial Institution Legislation
By: Michael Bussmann
On January 30, 2003, the Tax Court of Canada issued a decision in State Farm Mutual Auto Insurance Co. v. R. ("State Farm"), finding that a Canadian branch of a foreign corporation was not required to self-assess for GST/HST on costs allocated to the Canadian branch from head office. The basis for the decision was that, in the absence of a statutory deeming provision, the foreign corporation could not make a supply to itself such that the self-assessment provisions of the Excise Tax Act (Canada) (the "Tax Act") did not apply.
The Crown did not appeal the Tax Court's decision, notwithstanding that the self-assessment regime for entities acquiring intangibles and services from outside of Canada had been rendered ineffective by the Court's decision in State Farm.
Indeed, the Crown did not provide any further guidance for 33 months, until November 17, 2005, when the Department of Finance ("Finance") issued a press release and backgrounder explaining how it planned to legislate around this issue (the "Announcement"). There was no draft legislation released at the time of the Announcement.
The first draft legislation was only provided for comment 13 months later, on January 26, 2007, though not tabled in Parliament (the "2007 Legislation") at that time. Finance undertook significant consultations with the financial services community following the release of the 2007 Legislation, but no revised legislation followed.
It was on September 23, 2009, a further 33 months later, and six and a half years after the Tax Court's decision in State Farm, that Finance released a second revised and expanded set of draft legislation (the "New Draft Legislation") for a further round of comment before it is anticipated to be tabled in Parliament.
In this article we describe the main elements of the New Draft Legislation and note the main changes from the 2007 Legislation.
1. Self-Assessment Regime - Revised Rules
The New Draft Legislation, like the 2007 Legislation, goes far beyond merely providing the deeming provision that the Tax Court noted was missing from the Tax Act.
The New Draft Legislation imposes a very rigorous and onerous self-assessment regime on all "financial institutions" (within the meaning of that term in the Tax Act) in respect of services and intangibles acquired and deemed to be acquired by such financial institutions from outside of Canada.
There are two main changes between the 2007 Legislation and the New Draft Legislation. The first is to allow Canadian resident financial institutions to elect to apply a simpler approach to the self-assessment of GST/HST on inputs provided by their foreign branches to their domestic operations. The second is to allow financial institutions to exclude certain financial derivative transactions from the self-assessment rules that apply to imported services.
2. Extended Assessment Period
The New Draft Legislation introduces an extension of the assessment and reassessment period for imported taxable supplies from the normal four year period to seven years.
The seven year limitation period starts on the later of the day on or before which the person was required to file the particular return and the day it was filed. This extended period applies to tax payable from November 17, 2005, corresponding to the date of the Announcement. The usual four year limitation period is maintained for other amounts of tax payable under the Tax Act.
3. Legislative Basis for Information Return for Financial Institutions
At the time of the 2007 Legislation, Finance announced by press release the intention to require financial institutions with total annual revenue in excess of $1 million to file an information return that requires a fairly onerous analysis of certain GST/HST related information.
To date, the Minister has supported the requirement by issuing demands for returns from financial institutions. Indeed, many entities that were not financial institutions have received inquiries from the Canada Revenue Agency ("CRA"). The New Draft Legislation will make the filing of the return a positive obligation even in the absence of receipt of such a demand letter, which obligation will be supported by a penalty.
The information return will have to be filed six months after the end of the fiscal year of a financial institution, starting with fiscal years after 2006.
4. New Extension for Filing of Annual Returns
Possibly to allow additional time to prepare for these information returns, the New Draft Legislation will extend the filing due date of GST/HST returns of financial institutions that are annual filers to six months after the end of the fiscal year.
In parallel, the filing due date of GST/HST returns for selected listed financial institutions that have permanent establishments inside and outside the HST provinces that are monthly and quarterly filers are extended to six months after the end of their fiscal year.
These new filing deadlines are to come into effect for reporting periods of a financial institution starting in 2010.
5. Allocation Regime - Revised Rules
The New Draft Legislation, like the 2007 Legislation, provides detailed rules for financial institutions to allocate inputs between the GST/HST-taxable and GST/HST-exempt parts of their operations. These rules are intended to limit the ability of financial institutions to plan with respect to how to maximize recovery of GST/HST paid on inputs.
The allocation regime requires large banks, insurers and securities dealers to obtain the approval of the CRA for the use of their allocation method, or to use a prescribed input tax credit recovery percentage for GST/HST paid on inputs into both the taxable and exempt operations.
The New Draft Legislation will allow large banks, insurers and securities dealers to use an allocation method that does not receive pre-approval by the CRA, so long as the financial institution can meet certain requirements and establish the CRA has not acted fairly and diligently.
6. Pension Plan Trust Rebate
The Announcement and 2007 Legislation also included a new regime to rebate to single employer pension plan trusts a fixed percentage of the GST/HST incurred by employers and pension plan trusts on pension plan expenses. The proposal was to cap the recovery by employers and pension plan trusts of GST/HST incurred on pension plan expenses.
The New Draft Legislation was released five months after the federal government lost the appeal before the Federal Court in Her Majesty the Queen v. General Motors of Canada Limited, in which General Motors was found to be entitled to fully recover the GST/HST it had paid to investment managers on investment services for its pension plan trusts.
The proposed mechanism would have the effect of deeming all of the GST/HST on pension-related expenses incurred by employers participating in a pension plan to have been paid by the relevant pension entity. The pension entity would then be entitled to claim a rebate of 33% of the GST/HST. The rebate would be available irrespective of the nature of the plan arrangements or, whether the pension entity is registered for the GST/HST.
In addition, new GST/HST elections will allow pension entities and the participating employers to jointly elect to transfer some or all of the entity's rebate entitlement to some or all of the plan's participating employers that are GST/HST registrants. These elections raise interesting issues with respect to the exercise of fiduciary obligations, conflicts of interest, and reversion of plan assets to employers, all of which will need to be considered prior to making any decision to elect.
The only pension entities that would not be eligible for the rebate would be pension entities of pension plans where 10% or more of the contributions to the pension plan are made by "listed financial institutions", for example, banks, credit unions, other lenders, insurers, certain investment plans, etc..
These proposed deeming rules would apply for fiscal years of employers beginning on or after September 23, 2009. With respect to pension entities, the proposed rules would apply to a pension entity's claim periods (i.e., a reporting period if the pension entity is a registrant, or the first two or last two fiscal quarters of a fiscal year if the pension entity is not a registrant) beginning on or after September 23, 2009.
1. Lehigh Cement Ltd. v. R., 2009 TCC 237, 2009 D.T.C. 776. Note that a Notice of Appeal regarding this decision has been filed with the Federal Court of Appeal.
2. Ibid. at 39.
3. Ibid. at 45.
4. Ibid. at 46.
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.