RECENT TAX AVOIDANCE JURISPRUDENCE

RECENT TAX AVOIDANCE JURISPRUDENCE Prepared for: 2014 CPTS Annual Conference Christopher J. Montes Felesky Flynn LLP June 4, 2014

AGENDA Pièces Automobiles Lecavalier (debt forgiveness/parking) Lehigh Cement (para. 95(6)(b)) McKesson (transfer pricing) Devon Canada (successor rules) D & D Livestock (s. 55(2)) Swirsky (interest deductibility) Conclusions Page 2

Pièces Automobiles Lecavalier Inc. 2013 TCC 310 Ford US owned shares of Greenleaf and debt owing from Greenleaf with a principal amount of $24 million Total value of shares and debt was $9 million Ford US wanted to sell its Greenleaf shares to realize a capital loss for US tax purposes Ford US subscribed for $15 million of Greenleaf shares and Greenleaf used the proceeds to repay a portion of the debt and accrued interest Purchaser bought the shares of Greenleaf from Ford US for $1 and bought $9 million of debt owing by Greenleaf (greater than 80% of the principal amount so not a specified obligation or parked obligation ) Page 3

Pièces Automobiles Lecavalier Inc. Page 4

Pièces Automobiles Lecavalier Inc. Both Greenleaf and the purchaser were predecessors of the appellant Minister reassessed the appellant under GAAR Treated $15 million as forgiven debt subject to s. 80 reduction of tax attributes and income inclusion Page 5

Pièces Automobiles Lecavalier Inc. TCC HELD: Appeal dismissed; GAAR applies Tax benefit: The appellant admitted that the non-application of s. 80 was a tax benefit Avoidance transaction: Appellant argued that the debt clean-up transactions and subsequent purchase of Greenleaf shares were not part of the same series because the former transactions were imposed by Ford US; Court was not convinced that they were imposed by Ford US Appellant argued that the transactions were carried out for bona fide purposes US tax considerations and considerations applicable to Ford US; Court was not convinced as they failed to call any US tax expert or representative from Ford US, but the Court acknowledged that seeking to reduce foreign tax is a bona fide purpose The debt clean-up transactions were avoidance transactions Page 6

Pièces Automobiles Lecavalier Inc. Misuse or abuse: Minister argued that s. 80, the debt parking rules, and para. 80(2)(g) in particular were abused Appellant argued: s. 80 is a detailed provision that simply did not apply s. 80 is intended to offset the increase in economic power and possibility of a bad debt deduction when a debt is forgiven the second purpose is not relevant here Same as capitalizing company with equity from the start Appellant did not make submissions on s. 80.01 or para. 80(2)(g) Page 7

Pièces Automobiles Lecavalier Inc. s. 80: Debtor realizes an economic gain when debt is forgiven tax cost /income should be adjusted Bad debt deduction provisions not part of scheme s. 80.01(6), (7) and (8) Deem certain situations that effectively are debt forgiveness, but would not otherwise be caught by s. 80, to be within the scope of s. 80 De minimis exception if debt acquired for > 80% of principal amount Para. 80(2)(g) is intended to prevent a taxpayer from converting a debt into shares of lesser value Page 8

Pièces Automobiles Lecavalier Inc. TCC HELD: Appellant circumvented application of s. 80 and s. 80.01 in an abusive manner It was relieved of an obligation to pay $15 million, but maintained associated tax cost and expenditures Alternatively, the appellant misused para. 80(2)(g) by proceeding in two steps rather than just converting debt to shares Page 9

Pièces Automobiles Lecavalier Inc. Recommendations: Consider method of financing carefully when advancing funds within a corporate group Ensure debt clean-up transactions have a bona fide business purpose Page 10

Lehigh Cement Ltd. 2013 TCC 176 / 2014 FCA 103 Double dip structure into the US Canadian parent borrowed money from arm s length bank Canadian parent set up a US LLC and contributed borrowed money to US LLC for an equity interest US LLC loaned money to a US corporation on an interest-bearing basis Interest income of US LLC deemed active business income under Canadian foreign affiliate/fapi rules US LLC paid dividends to Canadian parent Page 11

Lehigh Cement Ltd. Page 12

Lehigh Cement Ltd. US interest deduction; Canadian interest deduction; no net Canadian income inclusion double dip Minister reassessed on the basis that para. 95(6)(b) applied because the purpose of the acquisition of US LLC shares was the reduction of Canadian tax US LLC not a foreign affiliate of Canadian parent US LLC dividends not deductible under para. 113(1)(a) Page 13

Lehigh Cement Ltd. Para. 95(6)(b): where a person or partnership acquires or disposes of shares of the capital stock of a corporation or interests in a partnership, either directly or indirectly, and it can reasonably be considered that the principal purpose for the acquisition or disposition is to permit a person to avoid, reduce or defer the payment of tax, that acquisition or disposition is deemed not to have taken place... Page 14

Lehigh Cement Ltd. Appellant argued: Para. 95(6)(b) is intended only to prevent the manipulation of foreign affiliate or controlled foreign affiliate status Otherwise it would be like a mini-gaar with no misuse or abuse exception Consider limited consequences if the provision applies Para. 95(6)(b) only applies where the purpose of the acquisition or disposition of shares (as opposed to the series of transactions) is to avoid or reduce tax Here, the main purpose of acquisition of US LLC shares was to reduce US tax; the Canadian tax benefits would have been the same if the appellant subscribed for shares of the US corporation directly (interest deductibility and the deduction of exempt surplus dividends) Page 15

Lehigh Cement Ltd. Crown argued: The Canadian tax benefit exceeded the expected return on the US LLC shares A direct subscription for shares in the US corporation was not possible because it would have violated a banking covenant and it would have been impossible to pay dividends from the US corporation Page 16

Lehigh Cement Ltd. TCC HELD: Appeal allowed; s. 95(6) does not apply Only the purpose of the acquisition or disposition of shares is material the words of the provision are clear However, this is a question of fact to be determined based on all circumstances, which could include the purpose of the series of transactions of which the acquisition or disposition forms a part Para. 95(6)(b) not limited to preventing manipulations of foreign affiliate or controlled foreign affiliate status Page 17

Lehigh Cement Ltd. Determining tax that would otherwise be payable Different from a tax benefit in s. 245 (not following Univar Canada Ltd., 2005 TCC 723) Must compare to an alternative arrangement: where the relevant acquisition or disposition has not occurred, and that might reasonably have been carried out by the taxpayer Page 18

Lehigh Cement Ltd. Here, the appropriate alternative arrangement is a direct subscription for shares of the US corporation Because the Canadian tax results would have been the same under that alternative arrangement, no Canadian tax was avoided The principal purpose of the acquisition of US LLC shares was to avoid US tax, not Canadian tax Page 19

Lehigh Cement Ltd. FCA affirmed the TCC s decision, but for different reasons s. 95(6) only applies to prevent a manipulation of foreign affiliate / controlled foreign affiliate / related corporation status, not to prevent other tax benefits arising from the series The words of para. 95(6)(b) are clear and do not refer to series of transactions like other anti-avoidance provisions Para. 95(6)(b) is in the foreign affiliate section of the Act (Subdivision i of Division B of Part I), not with general provisions dealing with tax avoidance (Part XVI) If s. 95(6) was intended to be so broad, certain other amendments to the Act would not make sense The Crown s interpretation of para. 95(6)(b) would give the CRA an undesirable amount of discretion Page 20

Lehigh Cement Ltd. Paragraphs 62-64, per Stratas J.A.: [T]he Crown seems to believe that the paragraph can be used even if the non-resident corporation has obtained foreign affiliate status without any artificial manipulation of share ownership. At the same time, however, the Crown does not take the view that whenever paragraph 95(6)(b) can be applied, it will. Rather, the Crown says that paragraph 95(6)(b) will be applied only where the tax avoidance is unacceptable. Unacceptability is in the eye of the beholder. It can shift depending on one's subjective judgment and mood at the time. Using it, as the Crown suggests, to restrain the indiscriminate use of paragraph 95(6)(b) creates the spectre of similarly-situated taxpayers being treated differently for no objective reason. This would violate the principle that, absent clear legislative wording, the same legal principles should apply to all taxpayers Page 21

Lehigh Cement Ltd. Paragraphs 66-67, per Stratas J.A.: A standard of unacceptability, even if it were open to us to invent it and insert it into paragraph 95(6)(b), is in itself unacceptable, as I have explained. Absent clear wording, I would be loath to interpret paragraph 95(6)(b) in a way that gives the Minister such a broad and ill-defined discretion a standardless sweep as to whether or not a tax is owing, limited only by her view of unacceptability. It would be contrary to fundamental principle. It would also promote arbitrary application, the bane of consistency, predictability and fairness. Page 22

Lehigh Cement Ltd. The principal purpose of an acquisition or disposition of shares is a question of fact to be determined based on all relevant circumstances, which could include the purpose of the series But the Minister cannot look at the series of transactions in determining a tax avoidance purpose that is not the target of para. 95(6)(b) Here, the purpose of the acquisition was not to manipulate foreign affiliate status therefore, the TCC correctly concluded that para. 95(6)(b) does not apply Page 23

Lehigh Cement Ltd. Comments: This decision should significantly reduce uncertainty regarding the scope of para. 95(6)(b) It provides greater certainty in transactions where a Canadian corporation borrows funds and invests those funds, directly or indirectly, in shares of a foreign affiliate (e.g., double dips) Page 24

McKesson Canada Corp. 2014 TCC 404 McKesson Canada was part of a large multinational group McKesson Canada had significant receivables which were managed by its own credit department Luxembourg parent purchased McKesson Canada s receivables at a discount and paid McKesson Canada to continue to manage them Page 25

McKesson Canada Corp. McKesson Canada s receivables had a historical collection rate of 99.96% and were outstanding for approx. 32 days on average Receivables Sales Agreement Five-year revolving facility Discount rate of 2.206% (which resulted in McKesson Canada incurring losses in the relevant years) Servicing Agreement Flat fee paid periodically Page 26

McKesson Canada Corp. CRA reassessed under paras. 247(2)(a) and (c) to reduce the discount under the Receivables Sales Agreement to 1.013% No transfer pricing penalty was assessed Page 27

McKesson Canada Corp. TD Securities provided a report on the calculation of the discount rate at the time the transactions first were entered into Boyle J. went through it in detail and criticized it extensively, especially the assumptions made Boyle J. described it as an advocacy piece Page 28

McKesson Canada Corp. A major accounting firm prepared a transfer pricing report when the CRA reviewed the transactions Boyle J. went through it in detail and criticized it extensively, especially the assumptions made Boyle J. described it as primarily a piece of advocacy work, perhaps largely made as instructed (para. 202) Page 29

McKesson Canada Corp. Appellant had two expert witnesses; the Crown had three expert witnesses Court went through each expert s report in detail, assessing the reliability of each one and considering the weight to be given to each one Page 30

McKesson Canada Corp. TCC HELD: Appeal dismissed Boyle J. found that the discount rate was not what arm s length parties would have agreed to Boyle J. applied the principles from GlaxoSmithKline (2012 SCC 52), even though it was decided under former s. 69(2) he found that the wording of s. 247(2) was not inconsistent Page 31

McKesson Canada Corp. Boyle J. determined his own range based on his evaluation of expert evidence 0.959% to 1.17% The Minister s assumption that the discount rate between arm s length parties would have been no greater than 1.0127% was not demolished Boyle J. stated that it was not appropriate for a court to reassess at high end of range this would reward overreaching taxpayers and encourage frequent use of the courts Page 32

McKesson Canada Corp. Timing of Part XIII Assessment McKesson Canada was assessed for its failure to withhold on the deemed dividend to its Luxembourg parent under s. 214(3) The transfer pricing reassessment of McKesson Canada was issued on March 25, 2008 (within 5 years of end of relevant tax year) The Part XIII withholding tax reassessment was issued on April 15, 2008 (not within 5 years of end of relevant tax year) Page 33

McKesson Canada Corp. Article 9 of the Canada-Luxembourg Treaty 1. Where an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, and conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any income which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the income of that enterprise and taxed accordingly. 3. A Contracting State shall not change the income of an enterprise in the circumstances referred to in paragraph 1 after the expiry of the time limits provided in its national laws and, in any case, after five years from the end of the year in which the income which would be subject to such change would, but for the conditions referred to in paragraph 1, have accrued to that enterprise. Page 34

McKesson Canada Corp. TCC HELD: Art. 9(3) of the Canada-Luxembourg Treaty does not apply to prohibit secondary transfer pricing adjustments The assessment under s. 215(6) is not an adjustment to the Luxembourg parent s income and an assessment of tax against the Luxembourg parent; therefore, art. 9(1) and 9(3) do not apply The reduced discount would not have resulted in income to the Luxembourg parent This result is consistent with the purpose of the treaty because no double tax resulted (no material amount of tax was paid in Luxembourg) Page 35

McKesson Canada Corp. Comments/recommendations: This case is being appealed to the FCA Engage properly qualified transfer pricing experts Review transfer pricing reports in detail before the transactions are put in place; question the assumptions Keep in mind that transfer pricing litigation can be a long, arduous and uncertain process Page 36

Devon Canada Corp. 2013 TCC 415 Parent of Home Oil was acquired by Devon Prior to acquisition of control, Home Oil owned resource properties through Anderson Partnership After acquisition of control, Anderson Partnership transferred its resource properties to a subsidiary partnership, Devon Canada Partnership Page 37

Devon Canada Corp. Page 38

Devon Canada Corp. Home Oil was amalgamated and continued as Devon Canada Corp. Minister reassessed Devon Canada Corp. to deny its claim for successor deductions in respect of the transferred resource properties Minister s position was that para. 66.7(10)(j) ceased to apply after the properties were transferred to a lower tier partnership Page 39

Devon Canada Corp. The successor rules contain elective rules that allow a corporation which acquires all or substantially all of the resource properties of a vendor to claim the unused resource expenditures of the vendor against production income or proceeds from the properties These rules are deemed to apply upon an acquisition of control Page 40

Devon Canada Corp. Successored resource expenditures are only deductible against income that can reasonably be regarded as attributable to production from the relevant properties In 1987, Parliament introduced deeming rules in para. 66.7(10)(j) to clarify that a corporation that was a member of a partnership that owned a Canadian resource property could deduct successored resource expenses against income from that property after an acquisition of control of the corporation Page 41

Devon Canada Corp. TCC HELD: Appeal allowed; successor deductions allowed Reframed question: whether a corporation can continue to deduct successored resource expenses against income from a resource property that has been transferred from a partnership of which it is a direct member to a subsidiary partnership following an acquisition of control. (para. 23) Page 42

Devon Canada Corp. Hogan J. rejected the Crown s argument that successored resource expenses expire if properties are transferred in a way that does not trigger the application of the successor rules Home Oil was deemed by subpara. 66.7(10)(j)(i) to have acquired its share of the properties owned by Anderson Partnership immediately before the acquisition of control; there was no subsequent event to terminate this status Page 43

Devon Canada Corp. Income earned through the subsidiary partnership can reasonably be regarded as being attributable to production from the resource properties Considered case law in s. 55(2) context on the meaning of reasonably be attributed fair and moderate allocation of the amount Considered CRA document regarding meaning of can reasonably be considered to relate if connection is easily discernable Page 44

Devon Canada Corp. At common law, partners own the property of a partnership s. 96(1) preserves source of partnership income in partners hands Tiered partnerships source and location of income preserved until allocated to corporate or individual partners see Fredette, [2001] 3 C.T.C. 2468 s. 102(2) In this subdivision, a reference to a person or a taxpayer who is a member of a particular partnership shall include a reference to another partnership that is a member of the particular partnership. Home Oil ultimately pays tax on the income from these properties Page 45

Devon Canada Corp. Para. 66.7(10)(j) was introduced to ensure successor deductions would be available to corporate partners of partnerships that held resource properties at the time of an acquisition of control To deny the deduction in this circumstance would be contrary to that purpose Successored resource expenses then would be stranded; several other provisions are designed to prevent this from happening Page 46

Devon Canada Corp. Comments: Clearly the correct policy result Contrast to D&D Livestock (discussed below) Page 47

D & D Livestock Ltd. 2013 TCC 318 Safe income of Parent was $1.5 million, made up of $976K of its own income and $517K of its Subsidiary s income Parent declared and paid a stock dividend ( First Dividend ) of $1.47 million which was reasonably attributable to safe income of Parent Parent rolled shares of Subsidiary to Newco Newco declared and paid a stock dividend to Parent ( Second Dividend ) of $517K (in several parts, under para. 55(5)(f)) Page 48

D & D Livestock Ltd. Page 49

D & D Livestock Ltd. Issue: Did Parent s payment of the First Dividend reduce the safe income of Subsidiary (and Newco), such that the Second Dividend was subject to s. 55(2)? The Minister reassessed under s. 55(2) The appellant admitted that there was a duplicate use of safe income in this case, but argued that the Act mandated that result Page 50

D & D Livestock Ltd. TCC HELD: Appeal allowed; Second Dividend was reasonably attributable to safe income of Newco Graham J. acknowledged that s. 55(2) is a specific anti-avoidance provision directed against capital gains stripping and that the appellant had engaged in capital gains stripping However, s. 55(2) should be interpreted based on its words; words are clear Capital gain was attributable to Newco s/subsidiary s income, not anything else GAAR was not argued Page 51

Swirsky 2013 TCC 73 / 2014 FCA 36 Husband and wife owned shares of a family corporation (Torgan) Corporation was a participant in a project that got into serious financial trouble; husband and other participant had provided personal guarantees on loans Husband transferred shares of corporation to his wife for creditorproofing reasons in 1991, 1993 and 1995 Wife borrowed from lender to fund each purchase; interest and carrying costs attributed back to husband to create a loss Husband used proceeds to repay shareholder loans; corporation used those funds to purchase a GIC, which it assigned to the lender Lender applied the interest from GIC against interest on loan Corporation guaranteed loan and actually paid residual interest; charged to husband s shareholder loan account (allegedly in error) Page 52

Swirsky Page 53

Swirsky Corporation did not have a history of paying dividends when shares were acquired by wife Family usually took money out of the corporation by way of shareholder loans and bonuses The corporation did not have a dividend policy A $2.5 million capital dividend was paid in 1999; a $1.6 million dividend was paid in 2003; dividends were also paid in 2004 and 2005 Page 54

Swirsky Minister reassessed to disallow husband s attributed losses from the deduction of interest and carrying charges on the basis that: Wife was not entitled to deduct interest and carrying charges because the loan proceeds were not used for an income-earning purpose s. 74.5(11) applied GAAR applied Page 55

Swirsky TCC HELD: Appeal dismissed; interest and carrying charges were not deductible There was no intention to acquire the shares for the purpose of earning dividend income income-earning potential was not even considered No history of paying dividends at time of share transfers; this continued for some time after the share transfers Share transfers were for creditor-proofing wife expected to return the shares after the corporation s financial difficulty passed (and later she did transfer the shares back) Wife did not have to pay interest or carrying charges herself, so she likely was not concerned with income-earning potential Page 56

Swirsky s. 74.5(11) does not apply (obiter) One of the main reasons for the transfers was not to reduce tax The main reasons were creditor-proofing and to pay off husband s shareholder loans GAAR does not apply (obiter) Tax benefit Crown has the onus because it first invoked GAAR at the confirmation stage No avoidance transaction purpose was for creditorproofing But otherwise transactions similar to Lipson, 2009 SCC 1 Page 57

Swirsky FCA affirmed TCC s decision: Interest and carrying charges were not deductible TCC looked at objective and subjective manifestations of purpose to determine whether wife acquired shares for an income-earning purpose Minister abandoned s. 74.5(11) argument at the FCA Dawson J.A. declined to comment on GAAR and specifically on Paris J. s comment with respect to onus in proving the alleged tax benefit Page 58

Swirsky Comments/recommendations: Potentially applicable in standard commercial situations Inconsistent with CRA policy? To minimize risk on interest deductibility, ensure that: dividends are paid on the shares acquired with loan proceeds there is a dividend policy consideration is given to whether income will be earned from the investment Page 59

Conclusions It is difficult to predict what the CRA will challenge and take to court Tax litigation is an uncertain process, particularly when dealing with broadly phrased anti-avoidance rules purpose tests reasonability standards arm s length comparisons comparisons to alternate arrangements misuse or abuse test in the GAAR These concepts are used throughout the Act; growing body of jurisprudence is providing some greater clarity and definition Page 60