The saying remains true. There are two things you cannot avoid in life: death and taxes. The Supreme Court of Canada ("SCC") recently released a huge judgment on the case of Deans Knight Income Corp. v. Canada, reiterating one of the most important principles of Canadian tax law: the general anti-avoidance rule ("GAAR").
Background
The following sections of the Income Tax Act were at issue in this case:
- 111(1)(a), which "allows non-capital losses to be carried back 3 years or carried forward 20 years in order to offset income in those years"; and
- 111(5), which has the following limiting effect on the above à "if control of the corporation has been acquired, non-capital losses from before the acquisition cannot be carried over, unless the corporation continues the same or similar business that incurred the losses".1
In 2008, a venture capital company called Matco entered into an investment agreement with a struggling corporation, Deans Knight Income Corporation ("DKIC") (F.K.A. Forbes Medi-Tech) whereby the former seized control of the latter, restructured it, renamed it, and changed its business operations. Deans Knight Capital Management ("DKCM") was then brought in by Matco to use DKIC as a corporate vehicle for a stock launch by using its Tax Attributes. The effect of these transactions was the creation of a loophole, offsetting non-capital losses as in s.111(1)(a) of the Income Tax Act, thereby gaining a substantial tax break without triggering the limitation under s.111(5).
Though the transactions were highly complex, their essence and goal was tax avoidance. Corporate transactions motivated in this way are subject to certain specific rules against avoidance. S.111(5) is a prime example of a specific anti-avoidance rule. But since it was not triggered by way of a highly convoluted loophole created by DKIC, the SCC held that the GAAR kicks in to nip the avoidance in the bud.
What is the GAAR?
Section 245 of the Income Tax Act establishes the GAAR, which serves as a "provision of last resort" against tax avoidance, penalizing offenders who abused the system without violating any specific provision of the Act.2 Think of the GAAR like a superhero's sidekick. If a taxpayer can avoid a specific anti-avoidance rule through a loophole, but nevertheless engages in abusive corporate transactions, the sidekick GAAR will swoop in to save the day.
This rule is intended for situations that undermine the rationale and objective of those Income Tax Act provisions relied on by the taxpayer.3 The SCC reiterated the three questions courts and government officials must ask when determining whether the GAAR applies:
- Was there a tax benefit?
- Was the transaction giving rise to the benefit based on avoidance?
- Was this avoidance-based transaction an abuse of the taxation system?
The SCC noted that in situations where there was a series of corporate transactions, the second question can be answered with a 'yes' if at least one of the transactions was for tax avoidance.4 The question of abuse at inquiry number three is where those evaluating corporate transactions look to the rationale behind the provision of the Income Tax Act avoided by the taxpayer.5 If the taxpayer undermined the rationale of the provision, then the transaction was abusive and the GAAR was broken.
How did DKMI break the GAAR?
It was clear on the facts of the case that DKIC received a major tax benefit through an avoidance transaction. So, the SCC honed in on the third step of the GAAR analysis. It was through careful consideration of the "object, spirit and purpose" of s.111(5) that DKIC undermined its rationale.
Justice Rowe, writing for an eight-judge majority, explained how s.111(5) vitiates a corporate taxpayer's ability to carry over past losses only where it has undergone a shift in control and "there is a break from the corporation's past business".6 Prior to its investment agreement with Matco, DKIC was actually a scientific research company. After Matco gained control over DKIC did DKIC switch its business dealings to the financial sector. This directly opposes s.111(5), which is meant to protect the controlling party's interest "in strengthening the corporation's business, rather than using the corporation as a vessel for unrelated activities that would have distorted its identity".7
There was no continuity between the identity of DKIC before and after the series of transactions with Matco and DKCM. DKIC became a corporate vessel for DKCM to use for "an unrelated venture planned by DKCM and selected by Matco".8 Justice Rowe concluded that there was certainly abuse, because the impugned transactions "achieved the very result s.111(5) seeks to prevent" through a series of highly complex dealings which managed to avoid the relevant sections of the Income Tax Act.9
Summary
The GAAR exists to protect the taxation system from abuse by covering up loopholes discovered by taxpayers when abiding by the terms of specific provisions found in the Income Tax Act. It is meant to be a last resort, applying only where a taxpayer successfully avoided a specific anti-avoidance rule. In DKIC v Canada, the appellant corporation engaged in a number of transactions with two other corporations, resulting in a loophole that allowed DKIC to avoid the rule under s.111(5) of the Income Tax Act. The SCC thus held that the GAAR had to apply, as this abuse undermined the rationale and objective of s.111(5). Corporations cannot stave off taxes, and by applying the GAAR, the SCC was able to hold DKIC accountable for its nefarious operations.
If you are considering a scheme that purports to provide you with a huge tax benefit, it is always worth seeking the advice of legal counsel. If you are later on found to have violated the GAAR, severe penalties and interest may apply. Contact a lawyer at DSF today to discuss your tax planning needs.
Footnotes
1. Deans Knight Income Corp. v Canada, 2023 SCC 16 at para 2 [DKIC v Canada]
2. Ibid at para 62.
3. Ibid at para 45.
4. Ibid at para 55.
5. Ibid at para 57.
6. Ibid at para 82.
7. Ibid at para 111.
8. Ibid at para 127.
9. Ibid at para 140.
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