The General Anti-Avoidance Rule

Tax Law for LawyersJune 1, 2011

Ed Kroft Q.C.Ian MacGregor, Q.C.Deen OlsenEd Harris Q.C.

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Introduction

Almost 24 years since GAAR was announced (June 1987 Tax Reform) and almost 23 years since enactment (September 1988)Landmark decision of SCC in Canada Trustcoand Kaulius on October 19, 2005SCC decided Lipson case in January 2009SCC heard Copthorne case on January 21, 2010

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Introduction (cont’d)

A number of lower court decisions have emerged in the last 5 yearsDesmarais, Overs, McMullen, CECO, MacKay, Evans, Copthorne, Univar Canada, MIL Investments, Collins & Aikman, Lehigh Cement, Remai, Garron, Antle, LandrusProvincial GAAR assessment being raised (OGT Holdings, Kebet Holdings, and Husky Energy)

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The Current CRA Environment

Tax avoidance = “aggressive tax planning”Aggressive international tax planning initiatives (AITP)Challenges to international transactionsCollaboration in CRA seems to have increased with the reorganization (ILBD)

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The Current CRA Environment (cont’d)

Use of specific anti-avoidance rules (95(6)), 103, 237.1, 84.1, 69(4), 247)

Univar Canada, Aventis, Lehigh Cement (95(6))Baxter (237.1)Penn West, Lebow, Stow (103)Husky (87(4) and 69(4))Emory (84.1)

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The Current GAAR Landscape

Cases at Tax Court of Canada level at various stagesAudit activity on various projects which involve the application of provincial GAAR legislationRulings still being provided on GAAR

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Focus of the Presentation

How have the courts interpreted the GAAR?Where might the jurisprudence be tending?What type of transactions are before the courts?What types of transactions are being challenged at the audit level?Some predictions about GAAR in tax practice

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GAAR Statistics March 2011

GAAR Statistics as of March 31, 2011

Issue Y N N/A Total %Foreign Tax Credit 13 3 2 18 2%Income Splitting 8 3 1 12 1%Partnership Issues 16 6 3 25 2%Kiddie Tax 75 6 8 89 8%Offshore Trusts 14 1 2 17 1%Cross-Border Lease 11 0 0 11 1%Part XIII Tax 3 9 5 17 1%Losses, Rental 11 2 0 13 1%Kiwi Loan 14 0 0 14 1%Losses, Stop Loss 10 5 5 20 2%Charitable Donations 14 10 5 29 3%Capital Gain 24 9 10 43 4%Interest Deductibility 18 17 15 50 4%Debt Parking 17 7 3 27 2%Indirect Loan 28 3 5 36 3%Debt Forgiveness 33 10 8 51 4%Losses, Capital & Non-Capital 37 18 14 69 6%Loss creation via stock dividend 64 0 2 66 6%Part I.3 Tax 38 11 7 56 5%Provincial GAAR 0 3 5 8 1%Surplus Strips 123 32 34 189 17%Tower Structure 4 3 3 10 1%Treaty Exemption Claim 5 2 3 10 1%Miscellaneous (see page 2) 109 95 57 261 23%

689 255 197 1141 100%

Cases referred to GAAR committee: 944* see note below

GAAR Applied 689 73%GAAR not applied 255 27%

GAAR as primary position 318 46%GAAR as secondary position 371 54%

* Note: Statistics do not take into account the following: - RRSP Project 1363 files - Barbados Spousal Trust proj 78 filesIn these cases GAAR was applied as a secondary position

- More than 300 files to which the Provincial GAAR was applied

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How Have The Courts Interpreted The GAAR?

Categories of casesCases decided before the Supreme Court of Canada in Canada Trustco and Kaulius (16 cases)The Supreme Court of Canada: Canada Trustcoand KauliusPost-Trustco interpretation by the Tax Court and Federal Court of Appeal (10 cases)Lipson in the Supreme Court of CanadaPost-Lipson cases in the lower courtsCopthorne in the Supreme Court of Canada

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Canada Trustco: Summary of the SCC’s Approach – Basic Principles

To permit application of the GAAR, there must be (a) tax benefit, (b) avoidance transaction and (c) abusive tax avoidanceThe burden is on the taxpayer to refute (a) and (b), and on the Minister to establish (c)

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Canada Trustco: Summary of the SCC’s Approach (cont’d)

If abusive tax avoidance is unclear, the benefit of the doubt goes to the taxpayerThe courts conduct a unified textual, contextual and purposive analysis of the provisions giving rise to the tax benefit

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Canada Trustco Summary of the SCC’s Approach (cont’d)

Whether the transactions were undertaken for a non-tax purpose may be relevant but is by itself insufficient in establishing abusive tax avoidanceThe appellate courts should not interfere with the trial court’s conclusion, absent a palpable and overriding error

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Canada Trustco Summary of the SCC’s Approach (cont’d)

Abusive tax avoidance may be found where:documented relationships and transactions lack a proper basis relative to the object, spirit or purpose of the provisions conferring the benefit, or where they are dissimilar to the transactions contemplated by the provisions

A provision of last resort (Canada Trustco Mortgage Co. v. The Queen, 2005 SCC 54 at para. 21)

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Subsection 245(3) of the Act

Subsection 245(3) of the Act states:“An avoidance transaction means any transaction

that, but for this section, would result, directly or indirectly, in a tax benefit, unless the transaction may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit; orthat is part of a series of transactions, which series, but for this section, would result, directly or indirectly, in a tax benefit, unless the transaction may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit”

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“Avoidance Transaction” - Canada Trustco

The function of subsection 245(3) was found by the Supreme Court of Canada to be as follows:

“… to remove from the ambit of the GAAR transactions or series of transactions that may reasonably be considered to have been undertaken or arranged primarily for a non-tax purpose. The majority of tax benefits claimed by taxpayers on their annual returns will be immune from the GAAR as a result of s. 245(3).”

Canada Trustco, supra, paragraph 21

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“Avoidance Transaction” - Canada Trustco

Involves an examination of the relationships between the parties and the relevant transactions leading to an objective assessment of the relative importance of the purposes of the transactionBurden is on the taxpayer to prove these factsA non-tax purpose is broader than a business purpose and may include family or investment purposes

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“Avoidance Transaction” - Canada Trustco

“If at least one transaction in a series of transactions is an "avoidance transaction", then the tax benefit that results from the series may be denied under the GAAR. This is apparent from the wording of s. 245(3). Conversely, if each transaction in a series was carried out primarily for bona fide non-tax purposes, the GAAR cannot be applied to deny a tax benefit”.

Canada Trustco, supra, paragraph 34

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“Avoidance Transaction” – Judicial Consideration

Subsection 245(3) has not been subject to extensive judicial consideration In many appeals to the Tax Court of Canada and the Federal Court of Appeal, the taxpayers have conceded that the transactions at issue were “avoidance transactions” within the meaning of ss. 245(3) of the Act (e.g. Canada Trustco, Kaulius, Lipson)

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Subsection 245(3): Series of Transactions and “Avoidance Transactions”

Canada Trustco (para 23-26) briefly discussed this concept Not clear on faceAgreement with FCA in OSFC (Rothstein, J.) and H.L. concept (Craven, Ramsay) –“Common Law Test”

preordained to produce a given resultnot practical likelihood that the pre-planned events would not take place in order ordained

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Subsection 245(4) of the Act

Subsection 245(4) of the Act states:Subsection (2) applies to a transaction only if it may reasonably be considered that the transaction:

would, if this Act were read without reference to this section, result directly or indirectly in a misuse of the provisions if any one or more of

(i) this Act,(ii) the Income Tax Regulations,(iii) the Income Tax Application Rules,(iv) a tax treaty, or(v) any other enactment that is relevant in computing tax or any other amount payable by or refundable to a person under this Act or in determining any amount that is relevant for the purpose of that computation; or

would result directly or indirectly in an abuse having regard to those provisions, other than this section, read as a whole

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“Abuse” or “Misuse” Issues – Subsection 245(4)

Some issues emerging from the case law:What is abusive?Why do similar cases get decided differently?Who has to prove it?What is the role of economic substance?

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Canada Trustco: “Misuse” or “Abuse” –Subsection 245(4)

The analysis of a misuse and abuse is inseparableSpecific provisions must be interpreted in their legislative contextThe “economic substance” is only relevant where the statutory provisions focus on economic concepts

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Canada Trustco: “Misuse” or “Abuse” –Subsection 245(4)

Whether the transactions were motivated by a non-tax purpose may be relevant but is by itself insufficient to establish abusive tax avoidanceThe Crown has the onus of proving abusive tax avoidance

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Kaulius: Application of Canada Trustco (2005 – SCC)

Appeal of the taxpayer dismissedThe use of the partnership rules by persons who deal at arm’s length with the original vendor would frustrate or defeat the object, spirit or purpose of the statutory preservation of the losses on the transfer to the partnership The provisions of the Act establish a general policy against the transfer or sharing of losses between arm’s-length taxpayers, subject to specific exceptions intended to promote a particular purpose

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GAAR Jurisprudence After Canada Trustco/Kaulius

Lipson (SCC) – 4 to 3 for Crown – abuse of attribution rules; interest expense okMacKay (FCA) – leave to SCC denied –“avoidance transaction”Landrus (FCA) - affiliated loss rules – “bright line” test and GAARRemai (FCA) – charitable donation deductible

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GAAR Jurisprudence After Canada Trustco/Kaulius (cont’d)

Lehigh Cement (FCA) – non-resident withholding tax on sale of stripped coupons – TCC reversed –taxpayer winsCollins & Aikman Products (FCA) – surplus stripping –taxpayer winsGarron (FCA) - Barbados trusts/estate freeze/use of treaty – GAAR not applicable but trusts resident in CanadaAntle (FCA) - capital gains step-up plan using a Barbados Treaty – TCC found GAAR applicable to ignore transfer to Barbados Trust

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The GAAR Scorecard 2005 (Post-Canada Trustco)to May 2011

GAAR APPLIESKaulius (SCC)

Loss TransferDesmarais

Surplus StripLipson (SCC)

Reverse Attribution/Interest CECO (TCC)

Ptshp/Disguised ProceedsOGT Holdings (QCA)

Quebec ShuffleCopthorne (SCC under reserve)

Duplication of PUCMacKay (FCA)

- Withholding Tax

GAAR DOES NOT APPLY/NOT NEEDEDCanada Trustco (SCC)

Cost & “Economic Substance”Evans (TCC)

Surplus Strip/Income Splitting Overs (TCC)

Reverse Attribution/InterestMIL (FCA)

Treaty ShoppingUnivar (TCC)

Tiered FinancingMcMullan (TCC)

Capital Gains StripRemai (FCA)

Charitable Donations

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The GAAR Scorecard 2005 (Post-Canada Trustco)to May 2011 (cont’d)

GAAR APPLIESAntle (FCA) (Leave to SCC

Sought) - Capital Gains, Step-Up

Strategy Using Barbados Trust (finding of TCC only)

GAAR DOES NOT APPLY/NOT NEEDEDLandrus (FCA)

Terminal Loss RecognitionCollins & Aikman (FCA)

Surplus StrippingGarron (FCA) (Leave to SCC Sought)

Barbados Trust PlanMaréchaux [GAAR argued – not needed]

(Leave to SCC Sought)Leveraged Donation

Envision [GAAR argued – not needed] (Appealed to FCA)

Broken AmalgamationHusky (Alta QB)

Finco interest shiftLehigh (FCA)

Withholding Tax

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Some Trends in Post-Trustco Case Law

Not meant to fill legislative gaps (Lehigh Cement Limited v. The Queen, 2010 FCA 124 & Collins & Aikman Products Co. v. The Queen, 2009 TCC 299 at para. 109) Overall result of transactions is important (Lipson 2009 SCC 1)

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Some Trends in Post-Trustco Case Law (cont’d)

GAAR does not incorporate an economic substance test (Canada Trustco Mortgage Co. v. The Queen, 2005 SCC 54 at para. 57 & Lipson v. The Queen, 2009 SCC 1 at para. 38)

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Some Trends in Post-Trustco Case Law (cont’d)

No need for GAAR if transactions don’t workGarron Family Trust (Trustee of) v. The Queen, 2010 FCA 309Maréchaux v. The Queen, 2010 FCA 287 Antle 2010 FCA 280

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Supreme Court of Canada and the GAAR

From Canada Trustco to Lipson and on to Copthorne

Diverging viewsImplications for “certainty, predictability andfairness”

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Shams and GAAR

The sham doctrine: what does it mean?Faraggi c. The Queen, 2008 FCA 398 at para 59

“… the existence of a sham under Canadian law requires an element of deceit which generally manifests itself by a misrepresentation by the parties of the actual transaction taking place between them. When confronted with this situation, courts will consider the real transaction and disregard the one that was represented as being the real one.”

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Shams and GAAR (cont’d)

Antle v. The Queen, 2010 FCA 280 at para. 20

“In so holding, the Tax Court judge misconstrued the notion of intentional deception in the context of a sham. The required intent or state of mind is not equivalent to mens rea and need not go so far as to give rise to what is known at common law as the tort of deceit … It suffices that parties to a transaction present it as being different from what they know it to be. …”

See also, Labow v. The Queen, 2010 TCC 408 (under appeal)

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Copthorne Holdings Ltd. v The Queen, 2009 DTC 5101 aff’d 2009 FCA 163

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NON Resident Corp

CANCOSubject CorporationResident in Canada

Low PUC - Defined in s.89(1)

Low ACB - Defined as cost

High FMV

Deemed Dividend: s.84(3) - subject to withholding tax - ss.212(2)

Capital Gain: Treaty exemption

Copthorne Holdings Ltd. v The Queen, 2009 DTC 5101 aff’d 2009 FCA 163

Cross Border PUC: The Situation

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Copthorne: The Origins

VHHC Holdingsss. 87(3) would eliminate the PUC of VHHC Holdings on any amalgamation with VHHC Investments and Copthorne

Copthorne I VHHC Investments

PUC/ACB=$97 MFMV= $30 M

PUC/ACB= $67 MFMV= $1,000

PUC/ACB=$1FMV=$150 M

Big City LI GROUPRelated Group

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Copthorne: The Start

Big City LI GROUP

Copthorne I VHHC Investments

VHHC Holdings

PUC/ACB=$1FMV=$150 M

PUC/ACB=$97 MFMV= $30 M

PUC=$67 MACB=$1,000FMV=$1,000

s. 87(3) would eliminate the PUC of VHHC Holdings on any amalgamation with Copthorne-vertical amalgamation

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The Avoidance Transaction: The Share Sale

BIG CITY LI GROUP

PUC=$1ACB=$1FMV=$150 M

PUC=$97 MACB=$97 MFMV=$1,000

Copthorne I VHHC Investments

VHHC Holdings

PUC=$67 MACB=$1,000FMV=$1,000

Related Group

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First Amalgamation: Copthorne I and VHHC Holdings

Big City LI GROUP

Copthorne II VHHC Investments

PUC=$67 MACB=$1,000FMV=$150 M

PUC=$97 MACB=$97 MFMV=$30 M

ss. 87(3) does not eliminate PUC of VHHC Holdings on a horizontal amalgamation

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Second Amalgamation - Copthorne III

PUC=$164 M (97 +67)ACB=$97 MFMV=$180 M (30 +150)

LI INVESTMENTS

Copthorne III

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LI INVESTMENTS

COPTHORNE III

PUC=$164 MACB=$97 MFMV=$180 M

Capital gain on the Redemption is Treaty Protected, no tax in Netherlands

Redemption at 150 M-FMV of Copthorne I

MNR applies GAAR to “subtract” duplicated PUC of 67 M down to PUC of 97 M-Withholding Tax

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Tax Court

The series of transactions undertaken resulted in a misuse of the provisions of ss. 89(1), 84(3), and 87(3)(a) of the Act, in that they were used to artificially increase PUC on an amalgamation with the subsequent return of this increase to the shareholder on a tax-free basis, the very result that the provisions were intended to prevent.When the many transactions were “distilled down to the essential core”, it is clearly an abuse of the Act to which section 245 should apply.

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Federal Court of Appeal

When the entire series of transactions is considered, it was apparent that the underlying principles respecting the calculation of PUC were offended. The court focused on the appellant’s abuse of the provisions relating to amalgamations: the computation of the PUC of the shares of Copthorne II (formed as a result of the amalgamation of Copthorne I and VHHC Holdings) and of the shares of Copthorne III (formed as a result of the amalgamation of Copthorne II and VHHC Investments).

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Federal Court of Appeal (cont’d)

The purpose of the requirement that the PUC of inter-corporate shareholdings be extinguished on an amalgamation is to avoid duplicative increases in computing the PUC of the amalgamated corporation. This requirement had been circumvented in an abusive manner

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Copthorne - SCC

Leave to appeal to the SCC has been granted with costs (per McLachlin, C.J., Abella J. and Rothstein J.)As per the SCC Case Summary, the issues under appeal are:

applicability of GAAR to deny a tax benefitconflicting trends in the case law arising from a misinterpretation of the SCC’s statements in Canada Trustco regarding the concept of “series of transactions” as defined in s. 248(10) of the Act

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Copthorne – SCC (cont’d)

interaction of the GAAR with other statutory schemesexamination of the FCA decision:

does the decision create considerable uncertainty for amalgamations and paid-up capital?did the FCA misdirect itself and err?

The hearing was on January 21/11Will the Crown lose because it could not clearly point to why the series was abusive?

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GAAR Court Decisions Pending

Triad Gestco Ltd. – TCC (April 23/10) – value shift/capital loss1207192 Ontario Limited – TCC (December 1/10) – value shift/capital lossGlobal Equity Fund – TCC (January 17/11) –value shift/capital loss

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GAAR Cases in Tax Court Process

Kossow – leveraged donations – trial in progress – began April 26/11Edwards – leveraged donations – discovery processDynacast Canada – denial of section 113(1) deduction – settled October 22/10Future Electronic – denial of 20(12) and 126 FTC – settled March 1/11McClarty Trust - kiddie tax avoidance –scheduled for June 15/11

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GAAR Cases in Tax Court Process cont’d

Rodan Energy – section 80 abuse? Consent to Judgment – December 1/10Lehigh Cement – second tier financing –GAAR dropped – 95(6) issueSpruce Credit Union – alleged abuse ofintercorporate dividend deduction and “double” deduction of deposit insurance premiums (trial scheduled for June 14 - 16/11)

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GAAR Cases in Tax Court Process (cont’d)

Jobin, Mastronardi, Gendron – section 47 ACB averaging – discovery processSchiesser – RRSP strips – discovery process – case managementSSI Investments – alleged abuse of 97(2) rollover on sale of assets to income trust structure – discovery process

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GAAR Cases in Tax Court Process (cont’d)

Walsh – TCC (was scheduled for May 4 – 7/10 but discontinued) – departure tradeSwirsky – TCC – interest deductibility/reverse attribution – scheduled for June 1/11GTE Venezuela – alleged surplus PUC stripping following sale of foreign holding company to Canadian OPCO – discovery process6024530 Canada Inc. – Brazilian tax sparing –discovery process

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Some GAAR Areas Under Review

Leveraged donationsRRSP stripsTax attributes/value shifts/artificial capital lossesForeign tax credits and foreign accrual tax usageProvincial tax arrangements (Québec trusts, Ontario NRO, Québec year ends)Brazilian tax sparing

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Some GAAR Areas Under Review (cont’d)

Tax deferrals using partnerships88(1)(d) bumps – package and bump transactions“Profitco” transactions - partnership income allocated from a partnership with profit sheltered by deductions/losses of a party who acquires the partnership interest before year end

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Provincial GAAR Assessments

Provincial income tax legislation in each province contains a GAARThe scope of these provisions is quite broad and might be challenged as unconstitutional Two cases have been decided (OGT Holdingsand Husky Energy)OGT was unsuccessful in QCCA

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Husky (Alta Q.B.) – April 2011

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CFS I

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Results for CFS I

Subsidiaries claimed interest expense under ITA 20(1)(c) and ACTAOperations claimed ITA 112(1) deduction for dividendsCentral reported interest income under ITAand OCTA but not taxable under OCTA only ITA 12(1)(c)West reported interest income and deducted interest expense

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CFS II

(8) Payment of Dividend

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Results for CFS II

Operations paid interest to Brae Pacific and deducted under ITA and ACTABrae Pacific had interest expense and interest incomeBrae Finance had interest income but was only liable for tax under ITA 12(1)(c) and not OCTAHusky Energy claimed ITA 112(1) intercorp dividend deduction for dividends paid

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Alberta Reassessments

Denied 112(1) deductions to Husky Energy and OperationsDenied interest expense to Subsidiaries and Operations and treated Operations as having received interest income under CFS I

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Issues

Denial of interest expense to Operations to redeem shares in light of Trans-Prairie decision? (Technical Issue)Does Alberta GAAR override ITA and ACTA so that:

Operations gets tax on interest income under CFS I;Operations and subsidiaries get no interest deduction; and 112(1) dividend deduction is denied

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Decision

Taxpayer winsApproval of “certainty” principle in Shell, Trans-Prairie, SingletonReview of GAAR principles and Lipson

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Decision – Technical Issue

Trans-Prairie complete answer$ used to earn incomeNothing in 20(1)(c) requires an increase in capital

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Decision – GAAR (Abuse Only)

No abuse of 20(1)(c)Not abusive for corporations to reorganize and refinanceNot chained to “Alberta”Lipson and Trustco principles helpSingleton principle of “legal relations” help taxpayer

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Decision – GAAR (abuse only)

No abuse of 112(1)No need for income to be taxed for 112(1) to applyNon-Purpose of 112(1) – to ensure income taxed at least onceNo circumvention of ITA 12(1)(c) by Operations in CFS I

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Decision – GAAR (abuse only) (cont’d)

No recharacterization of interest to dividends in order to apply GAAROK to rely on difference in provincial taxing policyNothing unfair in Husky’s refinancing if fairness is an important measure of abuse (Lipson – LeBel)

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The Future – Predictions About GAAR in Practice

Harder to give opinions and advice?Harder to predict results?More or less GAAR litigation?Prospect of legislative overrides (e.g. March/11)

Amendments to/creation of specific anti-avoidance ruleschanges to GAAR

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Predictions About GAAR in Practice (cont’d)

Pursuit of retail strategies (RRSP strips, Barbados trusts, leveraged donations)More litigation on specific anti-avoidance rulesGAAR just one toolGAAR has two defences – why use it?

Other specific rules have fewer defences (e.g. 247(2)(b), 95(6))

The cases will turn on the facts as well as the law

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Predictions About GAAR in Practice (cont’d)

Documenting why transactions are done is importantImportant to have available personnel to talk about why a transaction was doneConcessions on “avoidance transactions” may not always be appropriate

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Predictions About GAAR in Practice (cont’d)

How will the changing judicial landscape and the composition of the Courts (TCC, FCA, SCC) affect the interpretation of GAAR? What you do now will be litigated years from now when judicial attitudes may have shifted!!