In Triad Gestco Ltd v The Queen and 1207192 Ontario Limited v The Queen, each taxpayer realised a capital gain and entered into transactions to generate an offsetting allowable capital loss. This was done via a process referred to as a value shift. In Global Equity Fund v The Queen, the issue regarded an income loss, rather than a capital loss, though the same principles applied.
The taxpayer subscribed for common shares of a subsidiary for cash, and the subsidiary then declared a preferred share stock dividend with a redemption value equal to the cash subscription. In this way, the subscription value was shifted onto the preferred shares and the taxpayer was left with worthless common shares with a tax cost equivalent to the subscription value.
The next stage of the transaction involved the taxpayer selling the shares to a non-affiliated trust. This meant the taxpayer had realised a loss on the shares equal to the subscription value.
But the FCA ruled that loss provisions are intended to provide relief to offset a gain only when the taxpayer incurred an economic loss when disposing of an asset. The Court ruled that in these instances the taxpayers suffered only a paper loss, not an economic loss, following the value shift.
Advisers are not surprised by the court’s decisions.
“The FCA’s endorsement of the application of GAAR against so-called value shifts in the trilogy was not altogether surprising,” said Brandon Siegal, of McCarthy Tetrault. “Despite public statements to the contrary, the GAAR has been described by some – including the former Chief Justice of the Tax Court of Canada – as a judicial smell test and in this instance the highly artificial nature of the scheme understandably set off the court’s olfactory sense.”
Mark Meredith, of KPMG, agrees, saying that while the courts formally acknowledge the concern that the determination of abuse under GAAR must not be reduced to a smell test, it is apparent that “a high level of artificiality or contrivance may still tweak the judicial nose”.
“The trilogy of FCA decisions all proceed on much the same basis – they look at our very general capital loss recognition rules, and glean an underlying statutory scheme requiring such tax losses reflect an economic loss,” added Meredith.
Paper loss only
As this wasn’t the case, and no economic loss was suffered by the taxpayers, the judges delivered verdicts reflecting the fact that the value-shift transactions were lacking in economic substance.
“The apparent artificiality of the transactions in issue clearly played against the taxpayer, leading one decision to criticise the transactions for their ‘vacuity’,” said Meredith.
Siegal notes the “charged language” of Justice Mainville in Tuesday’s decision in the Global Equity Fund case in particular.
“The application of the smell test is most evident in the recently released Global Equity Fund decision,” he said. “Justice Mainville, notably the only judge on the panel for all three appeals, used charged language to describe the creation of the losses as being ‘pulled out of thin air’ like the proverbial rabbit out of the magician’s hat and the transactions as being ‘nothing more than a paper shuffle’.”
Implications
Siegal said the cases serve as an excellent reminder of the power and applicability of the GAAR, as GAAR can be applied even when a scheme is “technically perfect under the Income Tax Act”.
“When planning it is important to consider not only the technical merits of a given transaction but also the optics,” he said. “As such we provide to clients, in addition to an analysis on the legal correctness of the various planning options, our advice as to how those options will be perceived by the Canada Revenue Agency and the courts.”
Taxpayers are becoming increasingly aware of the reputational implications of tax planning strategies, and the perception that companies should comply with the spirit, and not merely the letter, of the law.
“We are increasingly fielding requests from our clients to assist them with reputational risk considerations associated with tax planning,” added Siegal.
The judgments in these three cases could prove problematic, however. Meredith says the decisions may conflict with previous court rulings.
“In all three judgments, the court found a statutory scheme that required ‘an air of economic or business reality’. This is somewhat challenging,” he said. “In Shell Canada not many years ago, the Supreme Court of Canada rejected economic substance as a basis for taxation in Canada. In these cases, the FCA appears to have reached a contrary view, at least in the GAAR context. It would be very interesting to see what the Supreme Court of Canada would have to say about how economic substance has been applied in these cases.”
“Unfortunately, these decisions leave taxpayers on a one-way street: losses may be denied by GAAR if they lack economic substance, but realised gains lacking economic substance will presumably still be taxed,” added Meredith.
Though the taxpayers could seek leave to appeal to the Supreme Court of Canada, Siegal believes that course of action is unlikely.
“I predict we won’t see any further litigation in these appeals. In its most recent GAAR decisions the Supreme Court has shown significant deference to the lower courts. The consistent decisions in the trilogy were written unanimously by three different judges of the FCA,” he said, adding there is nothing to suggest an appeal on the issue of value shifts is of significant national importance to warrant a hearing before the highest court.
“In any event, it would be unlikely that the Supreme Court of Canada would agree to hear another GAAR case so soon after Copthorne [December 2011],” added Siegal.
Legislative consequences
Despite employing the “charged language” Siegal refers to, the court did not apply the doctrine of sham to invalidate the artificial transactions. This, Siegal feels, could have a serious impact, particularly in the context of the Global Equity Fund decision.
“Instead [of applying the doctrine of sham], the court considered there was ‘no air of economic or business reality associated with the loss’. There is currently no economic reality test in Canada in any section of the Act, including the GAAR,” said Siegal. “Whether that comment was included by Justice Mainville in obiter to describe the factual circumstances of the Global Equity Fund case or was explicitly intended to create a new test for the application of the GAAR going forward remains to be seen.”
