On May 17, 2010, the Federal Court of Appeal (FCA) released its
decision in the case of Lehigh Cement Limited v. R. In a
unanimous judgment, the FCA allowed the taxpayer's appeal and
set aside an assessment issued by the Canada Revenue Agency (CRA)
under the general anti-avoidance rule (GAAR) in the Income Tax
Act (ITA). This assessment had previously been upheld by the
Tax Court of Canada. For the most part, the FCA has exercised
considerable restraint in its appellate review of tax cases
involving the GAAR. While the decision of the FCA in
Lehigh marks just the second time that it has overturned a
decision of the Tax Court involving the application of the GAAR, it
may signal a judicial trend to combat what some Tax Court judges,
and perhaps the FCA, view as the inappropriate use of the GAAR as a
means to fill perceived gaps in the ITA.
In Lehigh, the sole issue to be decided by the FCA was
whether the GAAR was applied properly by the CRA to impose
non-resident withholding tax on interest payments that satisfied
the technical requirements of the exemption in former subparagraph
212(1)(b)(vii) ("Exemption"). In general terms, the
Exemption applied to interest paid or credited by a corporation
resident in Canada to a non-resident person provided that (i) the
payor and the payee dealt at arm's length, and (ii) subject to
certain exceptions, the payor could not be required to pay more
than 25% of the principal amount of the debt within five years of
the date on which the debt was issued.
The relevant facts in Lehigh are straightforward. In the
mid-1980s, the taxpayer, a Canadian-resident affiliate of a
multi-national corporate group, borrowed money from a consortium of
Canadian banks. By 1997, the debt was held by a non-resident
affiliate of the taxpayer. Interest on the debt was subject to
non-resident withholding tax under former paragraph 212(1)(b). In
order to eliminate the withholding tax (i) the terms of the debt
were amended to meet the technical conditions for qualifying for
the Exemption, and (ii) the non-resident affiliate stripped five
years of interest payments on the debt and sold them at a discount
to a Belgian bank with whom the taxpayer dealt at arm's length.
Structured in this manner, the stripped interest payments satisfied
the technical requirements for the Exemption despite the fact that
the principal amount of the debt continued to be held by the
non-resident affiliate. The taxpayer was subsequently reassessed by
the CRA under the GAAR for failing to deduct and remit withholding
tax on the interest payments it made to the Belgian bank.
Since the taxpayer conceded the existence of both a tax benefit and
an avoidance transaction, the first two steps in the three-step
GAAR analysis, the only remaining GAAR issue to be decided by the
Tax Court was whether the transaction resulted in a misuse or abuse
of the Exemption (i.e., the final step of the GAAR analysis).
According to the Supreme Court of Canada in Canada
Trustco, the leading authority on the application of the GAAR,
when determining whether there has been a misuse or abuse of a
provision of the ITA, it is first necessary to interpret the
provision to determine its object, spirit and purpose, with
reference to the text of the provision, its surrounding context and
its legislative purpose. The next step is to determine whether the
transaction in question frustrated that object, sprit and purpose.
In applying this framework, the Tax Court concluded that the
purpose of the Exemption was to assist Canadian corporations in
accessing international capital markets on a competitive basis by
exempting from withholding tax interest paid to arm's length
non-resident lenders. The Tax Court held that the Exemption was
intended to apply only to the "arm's length borrowing of
capital from a non-resident lender." Based on this reasoning,
the Tax Court concluded that even though the interest was being
paid to an arm's length non-resident, the Exemption was abused
by the taxpayer because it did not borrow any money from the
non-resident bank (or any other non-resident lender).
In reversing the Tax Court's decision, the FCA concluded that
the CRA's evidence as to the purpose of the Exemption was
insufficient to satisfy the misuse or abuse test from Canada
Trustco. In particular, the FCA noted that all the commentary
relied upon by the Tax Court related to one statement made in a
budget paper released by the Department of Finance in 1975 (when
the Exemption was first proposed). Against what it considered to be
a "shaky foundation for an assessment under the [GAAR]",
the FCA noted that (i) the wording of the Exemption was clearly
broad enough to apply to an interest strip transaction and only
requires the Canadian resident borrower to deal at arm's length
with the recipient of the interest (and not the owner of the
principal), and (ii) interest stripping transactions are not new or
unusual and, indeed, they were contemplated by another provision of
the ITA at the time the Exemption was enacted. The FCA acknowledged
that the statement in the 1975 budget paper was of some relevance,
but concluded that it was not, in and of itself, sufficient to
establish the legislative purpose behind the Exemption for the
purposes of the GAAR.
In the course of its judgment, the FCA recognized the difficulty
Parliament faces in drafting tax legislation and notes and that,
when doing so, it cannot describe every transaction that is within
or without the intended scope of a provision. However, it also
warns that the fact that a taxpayer relies on a provision of the
ITA in an unforeseen or novel manner does not necessarily mean that
there has been a misuse of the provision. In the words of the FCA,
"the Crown cannot discharge the burden of establishing that a
transaction results in a misuse of [an exemption] merely by
asserting that the transaction exploits a previously unnoticed
legislative gap." These words echo comments by the Tax Court
in Landrus and repeated in Collins & Aikman
to the effect that the CRA's use of the GAAR to fill in what it
perceives to be a possible gap left by Parliament is not
appropriate.
In Lipson, the Supreme Court of Canada was significantly
divided on the question of whether a particular series of
transactions resulted in a misuse or abuse of one or more
provisions of the ITA. The post-Lipson cases, including
Lehigh, reflect a similar lack of consensus within the
judiciary regarding the scope of the GAAR and the application of
the misuse and abuse test. It is hoped that the Supreme Court of
Canada will provide more clarity in the upcoming appeal in the
Copthorne Holdings case.
The FCA's decision in Lehigh is likely to be received
as a taxpayer-friendly approach to applying the GAAR, in that it
appears to impose a significant evidentiary burden on the CRA to
establish misuse or abuse. Based on Lehigh, in order to
successfully defend an assessment under the GAAR, it appears that
the CRA will need to provide compelling evidence of a clear
legislative objective that has been frustrated by the transaction
at issue.
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