Bad News for Aggressive Taxpayers: Canada Revenue Agency Wins Another GAAR Case
On December 16, 2011, the Supreme Court of Canada (SCC) released its decision in Copthorne Holdings Ltd.1 unanimously dismissing the taxpayer’s appeal. The following article was the subject of an e-Alert published on December 19.
This was the fourth appeal heard by the SCC relating to section 245 of the Income Tax Act (Canada)(ITA), a provision more commonly known as the general anti-avoidance rule (GAAR). This decision will be of particular interest internationally as it involved a challenge to tax planning by a non-resident of Canada to repatriate funds from Canada on a basis free from Canadian tax.
When the SCC last considered the GAAR two years ago in Lipson,2 there was a surprising division amongst the bench, with three separate sets of reasons being issued. It was heavily speculated that the 11-month delay in issuing this decision was the result of a similar divide. This was not the case. Those looking for a radical debate on the future of the GAAR will be disappointed in the reasons of Justice Rothstein (for the Court), finding only a well-written analysis following the framework previously set out in Canada Trustco.3
Perhaps the only remarkable part of the decision was that the SCC granted leave at all. The reasons of Justice Rothstein differ only slightly from Justice Ryer’s reasons, for a unanimous Federal Court of Appeal panel, and the trial level reasons of Justice Campbell. Despite the agreement of 13 separate judges as to the application of the GAAR under these facts, Justice Rothstein’s reasons do provide some helpful clarity for the GAAR going forward.
The facts in the Copthorne appeal are complex. Fundamentally, there were two issues in the case: (1) was a share redemption part of the same series of transactions as an earlier transfer of shares of a subsidiary and subsequent "horizontal" amalgamation which allowed "paid-up capital" (PUC) to be preserved which would have been lost on a "vertical" amalgamation of the subsidiary with its parent; and (2) if so, whether the preservation of PUC by implementing a horizontal amalgamation rather than a vertical amalgamation gave rise to an abusive tax benefit caught by the GAAR. In brief, PUC is an amount that can generally be distributed by a corporation to its shareholders without giving rise to a deemed dividend. In the case of a non-resident shareholder as in Copthorne, a deemed dividend would be subject to Canadian non-resident withholding tax. Thus, a successful preservation of PUC would eliminate Canadian tax on the repatriation of funds in an amount equal to such PUC.
The key transactions can be simplified as:
- The Li family incorporated Investments in Canada in 1989. The family made significant equity injections so that by the end of 1991 the PUC of the shares of Investments was about $97 million.
- Investments used the funds to capitalize a Canadian subsidiary, Holdings. The PUC of the shares of Holdings was about $67 million by the end of 1991. Holdings made a share investment with the funds, which subsequently declined to a nominal value.
- Copthorne I was a wholly-owned Canadian subsidiary of a Netherlands corporation, indirectly owned by the Li family. Its issued shares had PUC of $1 when established in 1981.
- In 1992, Investments sold Holdings to Copthorne I for $1,000, being its value at that time, as part of a loss consolidation strategy.
- In 1993, the Li family decided to amalgamate Holdings, Copthorne I and two other corporations to simplify the corporate group and to consolidate income and losses of the amalgamating corporations. If the amalgamation of Holdings and Copthorne were achieved by way of a vertical amalgamation of Copthorne, the parent, with Holdings, the subsidiary, the PUC of the amalgamated corporation would have been equal to the PUC of Copthorne (i.e., $1) by reason of the application of subsection 87(3) of the ITA. Instead, Holdings was sold to the Netherlands parent of Copthorne I for $1,000 (1993 Sale).
- Holdings and Copthorne, now "sister" corporations, amalgamated to form Copthorne II and the PUC of Copthorne II was determined by adding the PUC of the amalgamating corporations, including the $67 million of PUC of Holdings (1994 Amalgamation).
- The 1993 Sale and the 1994 Amalgamation were part of a series of transactions (1993 Series) designed to offset capital losses against capital gains within the Li family group of Canadian corporations.
- In 1995, a series of further restructurings (1995 Series) was undertaken by the Li family to avoid the adverse effect of amendments to the foreign accrual property income regime on its investments.
- A preliminary step in the 1995 Series was the acquisition by a related Barbados corporation of all the shares of Copthorne II and Investments from their Netherlands parent. The capital gain on this sale was not taxable in Canada by virtue of the Canada-Netherlands tax treaty.
- Effective January 1, 1995, Copthorne II amalgamated with its sister corporation, Investments, and two other corporations in Canada to form Copthorne III. As a result, the Barbados corporation received shares of Copthorne III that had a combined PUC of $164 million, essentially representing the total PUC of the shares of Investments, Holdings and Copthorne I.
- Immediately after the amalgamation, Copthorne III redeemed certain of its shares having a PUC of $142 million held by a related Barbados corporation for $142 million. If the PUC of the shares had not been equal to their redemption amount, a deemed dividend would have arisen to the extent of any PUC deficiency, which would have been subject to 25% withholding tax, reduced to 15% under the Canada-Barbados tax treaty.
The Minister of National Revenue assessed Copthorne, applying GAAR to deny the preservation of the PUC of the shares of Holdings throughout the subsequent amalgamations. The Minister applied the GAAR on the basis that the 1993 Sale was an abusive avoidance transaction and that the PUC of the shares of Holdings should have been reduced to nil upon its amalgamation with its (former) parent Copthorne I. The reduced PUC would have resulted in a deemed dividend in the amount of $58 million on the redemption by Copthorne III of its shares.
The SCC Decision
Series of Transactions: It’s (Still) Okay to Look Back
Subsection 248(10) of the ITA provides that, where there is a reference to a series of transactions or events, the series is deemed to include "any related transactions or events completed in contemplation of the series."
In arguably the most interesting portion of the reasons, the SCC determined once and for all that subsection 248(10) allows for both a prospective (i.e., looking forward) and retrospective (i.e., looking backward) connection between a transaction and a common law series. Justice Rothstein was clear to note that the same determination had been made in Canada Trustco and that there was no basis for the Court to reverse its own recent decision.
Another clarification was made regarding the threshold required to connect a transaction with a series. At the trial level, Justice Campbell applied the reasoning from MIL Investments4 to search for, and find, a "strong nexus" between the share redemption by Copthorne III and the 1993 Series. Justice Rothstein clarified that the test does not require a "strong nexus" but does require more than a "mere possibility" or an "extreme degree of remoteness." Guidance was given that the length of time between transactions could be a relevant consideration.
The SCC agreed the trial judge made no palpable or overriding error in determining that the 1993 Series and the 1995 Series (including the share redemption) were sufficiently connected.
Having established that each transaction in the 1993 Series and the 1995 Series was part of one series of transactions, the next issue was whether the GAAR applied.
The GAAR provides that, if a transaction is an "avoidance transaction," the tax consequences will be determined as is reasonable in the circumstances in order to deny a "tax benefit" that would otherwise result from the transaction or the series of transactions of which it is a part.
However, the GAAR may only be applied if it may reasonably be considered that the avoidance transaction (i) would, if the ITA were read without reference to the GAAR, result in a misuse of, inter alia, the provisions of the ITA or the Regulations or a tax treaty; or (ii) would result directly or indirectly in an abuse having regard to those provisions, other than the GAAR, read as a whole.
(i) Tax Benefit
In a theme consistent with Canada Trustco, Justice Rothstein highlighted the difficult evidentiary burden placed on taxpayers to refute the Minister’s assumption of a tax benefit. Great deference is to be given to the trial judge, as a finding of fact on a tax benefit is only to be overturned when a palpable and overriding error can be established.
A tax benefit can be established by comparison with an alternative arrangement. In this instance, the SCC found that the trial judge made no error in comparing the 1993 Sale and 1994 Amalgamation with the ‘simpler course of action’ of amalgamating Holdings vertically with its parent Copthorne I. The tax benefit was the difference between the share redemption being tax-free rather than giving rise to a deemed dividend in the amount of $58 million.
(ii) Avoidance Transaction
The taxpayer argued that the true purpose of the 1993 Series was not to obtain a tax benefit but to simplify the corporate structure and implement a loss utilization scheme. However, the SCC found no error in the trial judge’s finding that the 1993 Sale to convert Holdings from a subsidiary of Copthorne I into a sister corporation was not necessary to achieve the stated goals. The addition of the 1993 Sale was for no other purpose than to preserve the $67 million of PUC, and therefore, was an avoidance transaction that was part of a series of transactions which resulted in a tax benefit.
(iii) Abusive Transaction
The GAAR is a provision of last resort and before being applied to deny a tax benefit a court must conduct an objective, thorough and step-by-step analysis. After concisely summarizing the facts and his analysis on the existence of a tax benefit and an avoidance transaction, Justice Rothstein focused on the question whether there was an abusive transaction. The majority of his lengthy reasons provide a template for the type of detailed analysis that is expected in a GAAR appeal.
Throughout the analysis are a number of clarifying statements. Practitioners will no doubt rejoice in the obligatory affirmation that the Duke of Westminster5 is alive, along with the memorable phrase that ‘moral opprobrium’ of creative tax planning is inappropriate. It is acknowledged there is no general principle against corporate reorganizations and that tax motivated reorganizations will only be subject to the GAAR where there is a finding of abuse. The oft-asked question as to whether there is any difference between a "misuse" and an "abuse" of the ITA is conclusively answered in the negative.
As noted above, the GAAR will only apply if a transaction results in a misuse or abuse of a particular provision. The object, spirit or purpose of a particular provision is to be identified by applying the same interpretive approach employed in all questions of statutory interpretation – a "unified textual, contextual and purposive approach." Justice Rothstein noted that while the approach is the same as in all statutory interpretation, the goal of the GAAR analysis is to determine a different aspect of the statute than in other cases. In a traditional approach, the Court applies the textual, contextual and purposive analysis to determine what the words of the statute mean. In a GAAR analysis the textual, contextual and purposive analysis is employed to determine the object, spirit or purpose of a provision. He notes that the meaning of the words of the statute may be clear enough but the search is for the rationale that underlies the words that may not be captured by the bare meaning of the words themselves. Determining the rationale of the relevant provisions of a statute such as the ITA, however, "should not be conflated with a value judgment of what is right or wrong nor with theories about what tax law ought to be or ought to do."
We are reminded that GAAR is to be invoked only when the Minister concedes that the words of the statute do not cover the transactions at issue. Accordingly, if the court’s analysis were to look solely at the text of the ITA, the GAAR would be rendered meaningless.
In looking beyond the text for the underlying purpose of subsection 87(3) of the ITA, Justice Rothstein referred to some secondary sources as contemplated by Canada Trustco but ultimately determined the policy through analysis of the provisions at issue. Indeed, rather than a theoretical discussion about whether tax was improperly minimized or the purpose of the overall PUC regime, the focus was on whether subsection 87(3) was abused. By showing that the 1993 Series including the 1993 Sale were designed to circumvent subsection 87(3) by turning a vertical amalgamation into a horizontal one, it was evident to Justice Rothstein that the statutory intention for PUC to be reduced had been defeated.
Going forward, taxpayers can expect future GAAR appeals to be similarly focused with an emphasis on the specific provisions of the ITA, the regulations or a tax treaty. Arguably, the unanimous reasons of 13 separate judges who considered the Copthorne appeal may signal that finally, as stated in Canada Trustco, the goals of predictability and consistency in GAAR analysis may be possible.
1 2011 SCC 63.
2 2009 SCC 1.
3 2005 SCC 54.
4 2006 TCC 460.
5  A.C. 1.