Canada: The Line Is Far From Bright

The Supreme Court of Canada (SCC) yesterday released its decisions in Canada Trustco Mortgage Co. v. Canada ("Canada Trustco") and Mathew v. Canada ("Mathew"), the first two cases it has heard regarding the general anti-avoidance rule (GAAR) under the Income Tax Act. The facts in Mathew are for all practical purposes the same as those considered in OSFC Holdings Ltd. v. Canada ("OSFC"), a Federal Court of Appeal case previously considered to be the highest authority on the GAAR. The SCC unanimously dismissed both appeals; meaning Canada Trustco won and Mathew lost.

Canada Trustco won because (i) the Tax Court judge properly determined that the meaning of cost for purposes of capital cost allowance (CCA) was generally legal cost and not economic cost, and (ii) the Crown was unable to establish that the facts differed materially from a normal domestic sale-leaseback transaction. Mathew lost because (i) the Tax Court judge properly determined that the purpose of the specific provisions and the general policy of the Act is to prohibit the transfer of losses between taxpayers, and (ii) the Crown established that the only reasonable conclusion is that the transactions in question, if allowed to stand, would frustrate that policy.

Determining whether an abuse has occurred involves two steps. First, the Court must conduct a unified, textual, contextual and purposive analysis of the provisions giving rise to the tax benefit in order to determine why they were in place and why the benefit was conferred. This is a question of law. Second, as a question of fact, the Court must examine the factual context of the case in order to determine whether the avoidance transaction defeated or frustrated the object, spirit or purpose of the provisions in issue. If the existence of abusive tax avoidance is unclear, the benefit of the doubt goes to the taxpayer. Where, in cases such as these, the Tax Court has appropriately determined the purpose of the provisions under consideration, the Court's determination as to whether the case in question defeated or frustrated that purpose will not be overturned absent a palpable and overriding error.

The interpretation of a provision must be made according to a textual, contextual and purposive analysis to find a meaning that is harmonious with the Act as a whole. Even when the words of a provision are precise and unequivocal, although the ordinary meaning of the words will play a dominant role in the interpretive process, reference to the Act as a whole must be had before the apparently obvious interpretation can be confirmed.

Unless the taxpayer can meet the onus of establishing that either (i) there was not a tax benefit or (ii) there was not an avoidance transaction, the issue of abuse arises. The onus is then on the Crown to establish that the only reasonable conclusion is that the impugned transactions are an abuse of the Act.

Although the Court commented that permissible extrinsic aids may be used in determining the object, spirit and purpose of the provisions of the Act, they gave no specific guidance as to what aids might be permissible. The Court relied on the explanatory notes issued when the GAAR was added to the Act and on commentators. However, the Court also made it very clear that Courts can not search for an overriding policy of the Act that is not based on a unified, textual, contextual and purposive interpretation of the specific provisions in issue.

The analysis of the misuse of a provision of the Act and of the abuse of the Act read as a whole are inseparable. The interpretation of specific provisions of the Act can not be separated from contextual considerations arising from other provisions.

The SCC endorsed the tests for a series of transactions, as adopted by the House of Lords in Craven v. White and Ramsey, as involving a number of transactions that are "pre-ordained in order to produce a given result" with "no practical likelihood that the pre-planned events would not take place in the order ordained". The Court then turned to the extended meaning of a series of transactions contained in subsection 248(10) as including transactions or events completed in contemplation of the series. In this regard, the Court held that "in contemplation of" is to be read in the broad sense of "because of" or "in relation to" the series. The phrase can be applied to events either before or after the basic avoidance transaction.

If any 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.

The GAAR does not apply to a transaction that "may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit". These words contemplate an objective assessment of the relevant importance of the driving forces of the transaction. The Tax Court judge must weigh the evidence to determine whether it is reasonable to conclude that the transaction was not undertaken or arranged primarily for a non-tax purpose. The determination invokes reasonableness, suggesting that the possibility of different interpretations of the events must be objectively considered.

While the "economic substance" of a transaction may be relevant at various stages of the GAAR analysis, this expression has little meaning in isolation from the proper interpretation of the specific provisions of the Act. That is, the economic substance must be considered in relation to the proper interpretation of the specific provisions that are relied upon for the tax benefit.

In 1996 Canada Trustco entered into a transaction where it paid $120 million, the majority of which was borrowed, to purchase a fleet of trailers from Transamerica Leasing Inc. ("TLI"). The equipment was then leased to a second company which, in turn, sub-leased the equipment to TLI. TLI prepaid a significant amount of its lease obligations, which was then applied against the outstanding loan.

Canada Trustco claimed capital cost allowance ("CCA") in the amount of approximately $31 million in 1997, and $67 million in subsequent years. The Minister reassessed the taxpayer by applying the GAAR to deny the CCA claim. The crux of the Minister's argument was that it is the object and spirit of the CCA regime and of the Income Tax Act (the "Act") as a whole to permit CCA on the "real" or "economic" cost of depreciable property, not on the "legal" cost, the purchase price paid by Canada Trustco in this case. The Minister argued that the fact that TLI prepaid a significant amount of its obligations, which were applied to the outstanding loan, caused the transaction to effectively have no real cost, and that Canada Trustco was claiming CCA tax deductions despite this. As a result, the Minister argued that the legislative intent to limit CCA deductions to actual costs was ignored.

The trial judge, in reaching his decision, followed the process laid out in the Court of Appeal's decision in OSFC. The trial judge concluded that the GAAR was not applicable as the transaction was consistent with the object and spirit of the relevant provisions of the Act, and was not abusive. The trial judge also found that the transactions were in all material respects a commercially normal and legitimate sale-leaseback transaction.

The Federal Court of Appeal dismissed the Crown's appeal, in which the Crown argued that the Tax Court judge made a reviewable error when he concluded that the transactions in this case did not constitute a misuse of a provision of the Act or an abuse of the CCA scheme as a whole. The Court concluded that the Crown had not been able to point to "any source" that suggested that the transaction in issue constituted abusive tax avoidance.

The CCA provisions use "cost" in the well-established sense of the amount paid to acquire the assets. Contextually, other provisions of the Act support this interpretation. The purpose of allowing CCA based on legal cost emerges clearly from the scheme of the CCA provisions within the Act as a whole. The applicable CCA provisions of the Act do not refer to economic risk. Where Parliament wanted to introduce economic risk into the meaning of cost related to the CCA provisions it did so expressly. The Tax Court judge, after considering all the circumstances, found the transaction was not so dissimilar from an ordinary sale-leaseback to take it outside the object, spirit or purpose of the relevant provisions. These conclusions on matters of fact should not be displaced unless there is a palpable and overriding error. The SCC may have been influenced by the fact that Canada Trustco received a deferral of tax, but not an absolute tax savings.

Standard Trust Company ("Standard") lent money on the security of mortgages on real property. Upon becoming insolvent in 1991, the Ontario Court of Justice (General Division) ordered that Standard be wound-up and appointed a liquidator for the company. To maximize the recovery from the disposition of Standard's assets, a series of transactions using two partnerships took place which, through the operation of subsection 18(13) of the Act and the partnership rules in section 96 of the Act, allowed the taxpayers to use the losses that had accrued on a portfolio of Standard's mortgages.

The taxpayers deducted their share of the losses incurred by the partnership in computing their taxable income. Relying on the GAAR, the Minister disallowed the deduction. Previously, in OSFC, the Federal Court of Appeal determined that there was a clear policy in the Act providing that losses cannot generally be transferred from one party to another.

In reaching its decision, the trial judge applied the principles established in OSFC. The trial judge held that the transactions were a series of avoidance transactions that conferred a tax benefit on the taxpayers. He also found that the transactions were an abuse of the Act as a whole, agreeing with the conclusion in OSFC that there was a clear policy against transferring losses from one taxpayer to another. As a result, the trial judge determined that the Minister properly applied the GAAR.

At the Federal Court of Appeal, the taxpayers argued that the subsection 245(4) abuse analysis relied on in OSFC was incorrect. The Federal Court of Appeal concluded that it was only in exceptional circumstances that it could overrule its own prior decision.

Interpreted textually, contextually and purposively, subsection 18(13) and section 96 of the Act do not permit arm's length parties to purchase the tax losses preserved by subsection 18(13) and claim them as their own. The purpose of subsection 18(13) is to transfer a loss to a non-arm's length party in order to prevent the transferor from realizing a superficial loss. The purpose of the broad treatment of loss sharing between partners is to promote an organizational structure that allows partners to carry on business in common. Parliament could not have intended that the combined effect of the partnership rules and subsection 18(13) would preserve and transfer a loss to be realized by a taxpayer who deals at arm's length with the original transferor. This was essentially a series of transactions aimed at transferring unrealized losses from one arm's length taxpayer to another. General policy against the transfer of losses between taxpayers is but one consideration to be taken into account in determining Parliament's intent with respect to subsection 18(13) and section 96. To allow a new arm's length partner to buy into the transferee partnership and to benefit from the loss would violate the fundamental premise underlying subsection 18(13) that the loss is preserved because it essentially remains in the transferor's control. Absent a non-arm's length relationship between the transferor and transferee there is no reason for the provision to apply. Therefore, the only reasonable conclusion is that the series of transactions, on which the appellants rely for the tax benefits they claim, result in abusive tax avoidance when subsection 18(13) and section 96 are interpreted purposively, in the context of the Act as a whole.

In Shell the SCC stated that, "absent a specific provision to the contrary, (emphasis added) it is not the courts' role to prevent taxpayers from relying on the sophisticated structure of their transactions, arranged in such a way that the particular provisions of the Act are met, on the basis that it would be inequitable to those taxpayers who have not chosen to structure their transactions that way. This approach had previously been adopted by the SCC in Duha Printers and Neuman. Unless the Act provides otherwise, a taxpayer is entitled to be taxed based on what it actually did, not based on what it could have done, and certainly not based on what a less sophisticated taxpayer might have done."

In Canada Trustco the SCC stated "the Act remains an instrument dominated by explicit provisions dictating specific consequences, inviting a largely textual interpretation. Onto this compendium of detailed stipulations, Parliament has engrafted quite a different sort of provision, the GAAR. This is a broadly drafted provision, intended to negate arrangements that would be permissible under a literal interpretation of other provisions of the Act, on the basis that they amount to abusive tax avoidance. To the extent that the GAAR constitutes a "provision to the contrary" as discussed in Shell, the Duke of Westminster principle and the emphasis on textual interpretation may be attenuated. The Court must to the extent possible contemporaneously give effect to both the GAAR and the other provisions of the Act relevant to a particular transaction."

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