TAXPAYERS, PUT UP YOUR DUKE(S) : SCC SPEAKS ON GAAR

OCTOBER 20, 2005 TAXPAYERS, PUT UP YOUR DUKE(S) : SCC SPEAKS ON GAAR On October 19, 2005, the Supreme Court of Canada ( SCC ) released two muchanticipated decisions considering the general anti-avoidance rule ( GAAR ) under the Income Tax Act (Canada). In Her Majesty the Queen v. Canada Trustco Mortgage Company and Eugene Kaulius, et al. v. Her Majesty the Queen, the SCC ruled that the GAAR will not apply to deny a tax benefit where it may reasonably be considered that the transactions were carried out in a manner consistent with the object, spirit or purpose of the provisions of the Tax Act, as interpreted textually, contextually and purposively. In Canada Trustco, a unanimous panel of SCC judges enumerated the following seven guiding principles in determining the applicability of the GAAR: TAX LAW BULLETIN 1. Three requirements must be established to permit application of the GAAR: (1) A tax benefit resulting from a transaction or part of a series of transactions; (2) The transaction is an avoidance transaction in that it cannot be said to have been reasonably undertaken or arranged primarily for a bona fide purpose other than to obtain a tax benefit; and (3) There was abusive tax avoidance in that it cannot be reasonably concluded that a tax benefit would be consistent with the object, spirit or purpose of the provisions relied upon by the taxpayer. 2. The burden is on the taxpayer to refute (1) and (2), and on the Minister to establish (3). 3. If the existence of abusive tax avoidance is unclear, the benefit of the doubt goes to the taxpayer. 4. The courts proceed by conducting a unified textual, contextual and purposive analysis of the provisions giving rise to the tax benefit in order to determine why they were put in place and why the benefit was conferred. The goal is to arrive at a purposive interpretation that is harmonious with the provisions of the Act that confer the tax benefit, read in the context of the whole Act. 5. Whether the transactions were motivated by any economic, commercial, family or other non-tax purpose may form part of the factual context that the courts may consider in the analysis of abusive tax avoidance. However, any finding in this respect would form only one part of the underlying facts of a case, and would be insufficient by itself to establish abusive tax avoidance. The central issue is the proper interpretation of the relevant provisions in light of their context and purpose. www.blgcanada.com w BORDEN LADNER GERVAIS LLP

6. Abusive tax avoidance may be found where the relationships and transactions as expressed in the relevant documentation lack a proper basis relative to the object, spirit or purpose of the provisions that are purported to confer the tax benefit, or where they are wholly dissimilar to the relationships or transactions that are contemplated by the provisions. 7. Where the Tax Court judge has proceeded on a proper construction of the provisions of the Income Tax Act and on findings supported by the evidence, appellate tribunals should not interfere, absent a palpable and overriding error. The SCC pointed to a single overarching policy of Canadian income tax law in formulating these conclusions: the provisions of the Tax Act must be interpreted in a way that achieves consistency, predictability and fairness so that taxpayers may manage their affairs intelligently. The Decision in Canada Trustco The facts in Canada Trustco are detailed and complex. Canada Trust Mortgage Company ( CTMC ), which carries on business as a mortgage lender and obtains large revenues from leased assets, purchased a number of trailers which it then circuitously leased back to the vendor in order to offset revenue from its leased assets by claiming a substantial capital cost allowance ( CCA ) on the trailers. The Minister of National Revenue ( Minister ) reassessed CTMC and disallowed the CCA claim. The Tax Court of Canada ( TCC ) set aside the Minister s decision on the basis that the transaction fell within the spirit and purpose of the CCA provisions of the Tax Act and concluded that the GAAR did not apply to deny the tax benefit. The Federal Court of Appeal ( FCA ) affirmed the TCC s decision. A unanimous panel of SCC judges dismissed the Crown s appeal and determined that the GAAR did not apply. Particularly noteworthy is that the SCC chose not to follow the FCA s GAAR methodology in OSFC Holdings Ltd. v. R., wherein the majority of the FCA suggested that whether a misuse or abuse has occurred would have to be established with reference to the clear and unambiguous policy underlying the particular provision(s) used or the Tax Act read as a whole, as the case may be. The SCC concluded, however, as noted above, that a court should have regard only to the proper interpretation of the relevant provisions in light of their context and purpose. McLachlin C.J. and Major J. wrote: There is but one principle of interpretation: to determine the intent of the legislator having regard to the text, its context, and other indicators of legislative purpose. The policy analysis proposed as a second step by the Federal Court of Appeal in OSFC is properly incorporated into a unified, textual, contextual, and purposive approach to interpreting the specific provisions that give rise to the tax benefit. Accordingly, the SCC established a new two-part inquiry for subsection 245(4). First, one must determine the object, spirit or purpose of the relevant provision(s), having regard to the scheme of the Tax Act and permissible extrinsic aids. Second, the court must examine the factual context of the particular case in order to determine whether the avoidance transaction defeated or frustrated the object, spirit or purpose of the provision(s) at issue. The burden rests with the Minister to establish that there is abusive tax avoidance, which, according to the SCC, means that it cannot be reasonably concluded that a particular tax benefit would be consistent with the object, spirit or purpose of the provisions relied upon by the taxpayer. 2 BORDEN LADNER GERVAIS LLP

There had been considerable debate amongst academics and tax practitioners as to whether courts should look to the economic substance of transactions in assessing the applicability of the GAAR. The SCC stated unequivocally that economic substance may be viewed as a single factor only, and is not determinative of whether the GAAR should apply. Accordingly, the economic substance or reality of a transaction is not dispositive of the issue. Rather, any economic substance must be considered in relation to the proper interpretation of the specific provisions that are relied upon for the tax benefit. In this respect, McLachlin C.J. and Major J. wrote: we should reject any analysis under s. 245(4) that depends entirely on substance viewed in isolation from the proper interpretation of specific provisions of the Income Tax Act or the relevant factual context of a case. The Crown also argued that CTMC s cost amount for CCA purposes should be reduced to nil to reflect the fact that CTMC had no economic risk. The SCC quickly disposed of this submission and stated that where Parliament wanted to introduce economic risk into the meaning of cost in relation to the CCA provisions, it did so expressly, as, for instance, in subsections 13(7.1) and 13(7.2). The SCC said that to override the CCA provisions because of the absence of real financial risk or economic cost would distort the purpose of the CCA provisions. The Decision in Kaulius In Kaulius, the liquidator of Standard Trust Company ( STC ), which carries on business as a mortgage lender, implemented a three-staged tax-driven arrangement devised to realize maximum returns on the disposal of certain assets of STC: (i) STC transferred a portfolio of mortgages with unrealized losses to a non-arm s length partnership, (ii) STC sold its interest in the partnership to an arm s length party, and (iii) a second partnership, of which the taxpayers, Kaulius et al., were limited partners acquired an interest in the first partnership. Relying on a combination of subsection 18(13) and the partnership regime of the Tax Act, Kaulius et al. deducted over $10 million of STC s losses against their own income. The Minister reassessed Kaulius et al., applied the GAAR and disallowed the deductions. Both the TCC and FCA upheld the Minister s decision. The only issue on appeal to the SCC was whether the transactions were abusive under subsection 245(4). A unanimous panel of SCC judges dismissed Kaulius et al. s appeal and found that the Minister properly disallowed the deductions. The SCC turned to its own decision in Canada Trustco for the principles to be applied in determining whether the GAAR should be applied. The SCC reiterated its instructions that courts must take a textual, contextual and purposive approach to interpretation. In this regard, the SCC offers the following instruction: While it is useful to consider the three elements of statutory interpretation separately to ensure each has received its due, they inevitably intertwine. For example, statutory context involves consideration of the purposes and policy of the provisions examined. And while factors indicating legislative purpose are usefully examined individually, legislative purpose is at the same time the ultimate issue what the legislator intended. The SCC went on to examine the context and purpose of subsection 18(13) and section 96 and determined that the combined effect of the provisions is such that they do not allow taxpayers to preserve and transfer unrealized losses to arm s length parties. The SCC placed significant emphasis on the fact that subsection 18(13) relies on the premise that the partners in the transferee partnership pursue a business activity in common other than to transfer losses and that the partnership and transferor deal in a non-arm s length relationship. Accordingly, the SCC ruled that allowing Kaulius et al. to claim the losses would defeat the purposes of BORDEN LADNER GERVAIS LLP 3

subsection 18(13) and the partnership provisions since, interpreted textually, contextually and purposively, s. 18(13) and s. 96 do not permit arm s length parties to purchase tax losses preserved by s. 18(13) and claim them as their own. Ultimately, the SCC found that the absence of a common business activity between STC and the Partnership led to an inference of abuse and the only reasonable conclusion was that the series of transactions frustrated Parliament s purpose of confining the transfer of losses. Conclusions and Implications By dismissing the Crown s appeal in Canada Trustco and dismissing the taxpayer s appeal in Kaulius, the SCC has signalled that the GAAR is alive and well. These judgments do not, however, provide any more finality on the operation of the GAAR than did the FCA in OSFC Holdings. The implications of these judgments for taxpayers, the Canada Revenue Agency ( CRA ) and the Crown will be the subject of much analysis and discussion. The following five implications immediately come to mind. First, while the economic substance or reality of transactions is not determinative of whether the GAAR applies, economic substance or reality may be assessed and considered for the purposes of determining whether a particular avoidance transaction is abusive. Second, CRA might take the view that the principle established in the Duke of Westminster case, namely that taxpayers are entitled to arrange their affairs to minimize the amount of tax payable, has been attenuated. Third, the SCC proclaimed in Canada Trustco that to require courts to search for some overarching policy and then to use the policy to override the wording of the provisions of the Tax Act would inappropriately place the formulation of taxation policy in the hands of the judiciary. The decision in Kaulius, however, shows that the CRA (and a court) has considerable scope for creativity in developing the purpose of the relevant provision(s) against which the facts will be considered and examined. For instance, the SCC found a general policy in the Tax Act restricting the transfer of unrealized losses between arm s length parties and read that restriction into section 96. Fourth, the SCC has stated clearly that the Minister has the burden of establishing abusive tax avoidance. The court, however, is no longer required to be satisfied of a clear and unambiguous policy underlying the relevant provision(s) or the Tax Act read as a whole. Query whether the net effect will actually favour the Minister. Finally, the SCC has said that where the trial judge has proceeded on a proper construction of the provisions of the Tax Act and on findings supported by the evidence, appellate tribunals should not interfere, absent a palpable and overriding error. Accordingly, taxpayers must put their best foot forward in the TCC. 4 BORDEN LADNER GERVAIS LLP

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