On October 19, the Supreme Court of Canada released the decisions in Canada Trustco Mortgage Company v The Queen 2005 SCC 54, and Kaulius et al v The Queen 2005 SCC 55. Both cases were heard concurrently by that court on March 8 2005 and are the first examination by the court of the statutory general anti-avoidance rule (GAAR) in section 245 of the Income Tax Act (Canada) (Tax Act). The long delay in releasing the judgments had led to much speculation in the Canadian tax community that the court may be seriously divided on the outcome. In the result, however, both appeals were dismissed unanimously on the basis that the original trial decisions should be upheld. In each case, the trial decision had also been upheld by the Federal Court of Appeal, though on slightly different grounds. The more interesting aspect of the decisions, however, lies not in the narrow result but in the interpretive approach adopted by the court and the guidance offered to the Tax Court of Canada and Federal Court of Appeal for future GAAR cases.
Canada Trustco case
The Canada Trustco case involved a cross-border sale-leaseback of US-based trucking equipment (trailers), and a claim for capital cost allowance (CCA) by Canada Trustco Mortgage Company (CTMC), the Canadian purchaser/lessor of the trailers. The transactions involved are described very succinctly in the Supreme Court reasons as follows:
Briefly stated, on December 17, 1996, [CTMC], with the use of its own money and a loan of approximately $100 million from the Royal Bank of Canada (RBC), purchased trailers from Transamerica Leasing Inc. (TLI) at fair market value of $120 million. CTMC leased the trailers to Maple Assets Investments Limited (MAIL) who in turn subleased them to TLI, the original owner. TLI then prepaid all amounts due to MAIL under the sublease. MAIL placed on deposit an amount equal to the loan for purposes of making the lease payments and a bond was pledged as security to guarantee a purchase option payment to CTMC at the end of the lease. These transactions allowed CTMC to substantially minimize its financial risk.
Diagram 1 illustrates the same day circular flow of funds and contracts which occurred on the facts of the case.
Diagram 1: Flow of funds and contracts in Canada Trustco case |
The taxpayer, CTMC, used the CCA which it claimed on the trailers to shelter other taxable lease income and, therefore, to defer taxes to the extent of the CCA deductions. Additional tax would be imposed subsequently on "recapture" of CCA into income when the trailers were disposed of at the end of the lease in excess of the amount claimed as CCA. The involvement of MAIL, an offshore entity in a tax shelter jurisdiction, permitted the same day defeasance of the sublease from MAIL to TLI, without an income inclusion for that defeasance being recognized by CTMC. The Crown argued that the up-front defeasance of the sublease should reduce CTMC's "cost" in the trailers to nil under the GAAR since CTMC had no economic risk in the trailers following the defeasance. In short, the Supreme Court upheld the finding of the trial judge that the scheme of the CCA regime in the Tax Act is based upon a deduction for legal cost and not cost as determined by economic risk:
"Cost" in the context of CCA is a well-understood legal concept. It has been carefully defined by the Act and the jurisprudence. Like the Tax Court judge, we see nothing in the GAAR or the object of the CCA provisions that permits us to rewrite them to interpret "cost" to mean "amount economically at risk" in the applicable provisions. To do so would be to invite inconsistent results. The result would vary with the degree of risk in each case. This would offend the goal of the Act to provide sufficient certainty and predictability to permit taxpayers to intelligently order their affairs. For all these reasons, we agree with the Tax Court judge's conclusion that the "cost" was $120 million, not zero as argued by the [Crown].
Kaulius case
The Kaulius case involved the transfer of Canadian business income losses to unrelated persons through the use of a partnership. The interpretive issue under the GAAR turned on the interrelationship between the rules in the Tax Act aimed at restricting the transfer of losses to arm's-length persons through corporations and the rules relating to the taxation of partnerships. Once again, the Supreme Court distilled the essential facts into a succinct description:
As a result of a series of transactions, the [taxpayers] lowered their incomes by deducting losses from the sale of mortgaged properties originally belonging to Standard Trust Company (STC). The overall arrangement involved three stages. At the first stage, STC transferred a portfolio of mortgages with unrealized losses to a non-arm's length partnership, Partnership A, thereby acquiring a 99 percent interest in it. At the second stage, STC relied on s. 18(13) to transfer the unrealized losses to Partnership A and then sold its 99 percent interest in it to an arm's length party. At the third stage, Partnership B was formed to acquire the 99 percent interest in Partnership A. The [taxpayers] joined Partnership B and were thus able to claim their proportionate shares of the losses from the eventual sale or write-down of the mortgaged properties. In this way, STC's losses were transferred through s. 18(13) and the partnership vehicle to arm's length taxpayers who offset them against their own incomes, while STC recovered a portion of the losses associated with the defaulted mortgages.
The Supreme Court held that section 18(13) of the Tax Act, the rule which permitted the transfer of the losses from STC to Partnership A was intended as a stop-loss rule. The rule was intended to prevent a taxpayer who carries on a business of lending money from realizing a superficial loss, and was not intended to be used to facilitate the transfer of losses to arm's-length persons. The court concluded that:
Section 18(13) preserves and transfers a loss under the assumption that it will be realized by a taxpayer who does not deal at arm's length with the transferor. Parliament could not have intended that the combined effect of the partnership rules and s. 18(13) would preserve and transfer a loss to be realized by a taxpayer who deals at arm's length with the transferor. To use, as here, these provisions to preserve and sell an unrealized loss to an arm's length party results in abusive tax avoidance under s. 245(4).
Diagram 2: The transaction in Kaulius |
Guidance on interpretive approach
The three "steps" for the application of GAAR
In the Canada Trustco decision, the Supreme Court provided substantial general guidance on the operation and application of the GAAR. The court noted that the application of the GAAR involves a three step analysis. This analysis is illustrated in diagram 3.
Diagram 3: Three-step analysis |
Only if the third question in diagram 3 is answered in the affirmative (with the taxpayer having the benefit of the doubt if there is no clear answer) will the GAAR apply to allow Canada Revenue Agency to "redetermine" the tax consequences as is reasonable in the circumstances.
In each case the taxpayer had effectively conceded the presence of an "avoidance transaction" (that is, a transaction which was arranged primarily to obtain the tax benefit), and therefore the first two questions were not in issue. Nevertheless, the court discussed the first two stages of the GAAR analysis and used that discussion to demonstrate the limited scope of the GAAR and the fact that parliament intends taxpayers to take full advantage of provisions of the Tax Act that confer tax benefits except in cases of "abusive" tax avoidance. The court stated:
Despite Parliament's intention to address abusive tax avoidance by enacting the GAAR, Parliament nonetheless intended to preserve predictability, certainty and fairness in Canadian tax law. Parliament intends taxpayers to take full advantage of the provisions of the Income Tax Act that confer tax benefits. Indeed, achieving the various policies that the Income Tax Act seeks to promote is dependent on taxpayers doing so.
The court further described the principle that taxpayers may structure their affairs so as to minimize tax as a "basic tenet of tax law" and opined that, where parliament has specified precisely what conditions must be satisfied to achieve a particular result, parliament intends that taxpayers rely on such provisions to achieve the result they prescribe.
Textual, contextual and purposive interpretation
The final stage of the GAAR analysis in section 245(4), which was at issue in each of the cases, "draws a line between legitimate tax minimization and abusive tax avoidance." In the words of the court in Canada Trustco, "[t]he line is far from bright". The court commenced its examination of the distinction with the proposition that in statutory interpretation in general there is but one principle:
It has been long established as a matter of statutory interpretation that "the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act, and the intention of Parliament": see 65302 British Columbia Ltd. v. Canada, [1999] 3 S.C.R. 804, at para. 50. The interpretation of a statutory 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.
Apart from the new label of "textual, contextual and purposive" there is nothing novel in the Supreme Court's statement of the well-established test in Canada for the interpretation of statutes, including the Tax Act. The court stated that in the Tax Act, other than the GAAR provision, "the particularity and detail of many tax provisions have often led to an emphasis on textual interpretation", an emphasis which is thought to provide predictability.
What is new is the recognition by the court that, where GAAR is at issue, the traditional focus on the text of the relevant provisions shifts from the textual towards a more contextual and purposive approach. The Canada Revenue Agency will take considerable comfort that the court expressly recognizes an obligation under the final step in the GAAR to determine the intent of parliament having regard to the text, its context, and other indicators of legislative purpose. As if to emphasize the point, the court in Kaulius implicitly accepted that the section at issue in that case (section 18(13)) applied textually to permit a transfer of losses, but sharply rejected this literal interpretation as dispositive of the GAAR inquiry:
The [taxpayers'] submission that nothing in s. 18(13) limits subsequent dispositions of the property to arm's-length parties depends on a literal interpretation of the section and fails to address the main inquiry under the GAAR, which rests on a contextual and purposive interpretation of the provisions at issue.
The two-part inquiry under section 245(4)
Founded upon its comments on interpretive principles, the court held that section 245(4) imposes a two-part inquiry. First, the trial court must conduct a unified "textual, contextual and purposive" analysis of the provisions giving rise to the tax benefit 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 Tax Act that confer the tax benefit, read in the context of the whole Tax Act. Second, the trial court must examine the factual context of the case to determine whether the avoidance transaction defeated or frustrated the object, spirit or purpose of the provisions at issue.
David Spiro: new label of "textual, |
The unified analysis of the provisions of the Tax Act
Having set out the two-part inquiry, the court addressed the debate about "misuse" and "abuse" which arose from the different English and French versions of section 245(4). The court noted that uncertainty had arisen from the apparently disjunctive English version ("misuse of the provisions of this Act" or "abuse having regard to the provisions of this Act ... read as a whole") and the non-disjunctive French version ("d'abus dans l'application des dispositions de la présente loi lue dans son ensemble").
In Canada Trustco, the court concluded that parliament could not have intended this to require a two-step approach (one for misuse and the other for abuse) "which on its face raises the impossible question of how one can abuse the Act as a whole without misusing any of its provisions." The court adopted the comments of Justice Miller, the Tax Court judge in that case, that
[i]n effect, the analysis of the misuse of the provisions and the analysis of the abuse having regard to the provisions of the Act read as a whole are inseparable.
In Canada Trustco, the court clearly put the onus upon the Crown to establish that the avoidance transaction frustrates the purpose for which the tax benefit was intended to be conferred:
The taxpayer, once he or she has shown compliance with the wording of a provision, should not be required to disprove that he or she has thereby violated the object, spirit or purpose of the provision. It is for the Minister who seeks to rely on the GAAR to identify the object, spirit or purpose of the provisions that are claimed to have been frustrated or defeated, when the provisions of the Act are interpreted in a textual, contextual and purposive manner. The Minister is in a better position than the taxpayer to make submissions on legislative intent with a view to interpreting the provisions harmoniously within the broader statutory scheme that is relevant to the transaction at issue.
Furthermore, the court held that the search for policy is essentially confined to the four corners of the Tax Act together with "permissible extrinsic aids", a phrase on which the court did not elaborate. The policy inquiry must therefore be grounded in the interpretation of the specific provisions at issue, undertaken in light of the context of those provisions in the Tax Act and their purpose. The court noted that a broader search for some "overarching policy" which would override the wording of the provisions of the Tax Act would inappropriately place the formulation of taxation policy in the hands of the judiciary and concluded that:
Notwithstanding the interpretative challenges that the GAAR presents, we cannot find a basis for concluding that such a marked departure from judicial and interpretative norms was Parliament's intent.
The point that tax policy is to be found within the Tax Act itself is illustrated by the result in Canada Trustco where the notion of "economic cost", which was alleged by the Crown to constitute an overarching principle, was found inapplicable on the basis that the relevant provisions did not reflect any such principle. The court stated:
A transaction may be considered to be "artificial" or to "lack substance" with respect to specific provisions of the Income Tax Act, if allowing a tax benefit would not be consistent with the object, spirit or purpose of those provisions. We should reject any analysis under subsection 245(A) 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 court went on to say that the "economic substance" of a transaction "has little meaning in isolation from the proper interpretation of specific provisions of the Act". The court found that the Crown's "submissions on [economic cost] amount to a narrow consideration of the "economic substance" of the transaction, viewed in isolation from a textual, contextual and purposive interpretation of the CCA provisions."
What constitutes abusive tax avoidance?
The Supreme Court explained that abusive tax avoidance exists 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 relied upon to confer the tax benefit, or are wholly dissimilar to the relationships or transactions that are contemplated by the provisions. The Court identified three specific situations in which tax avoidance will be considered abusive for the purposes of subsection 245(4) of the GAAR:
where a taxpayer relies on specific provisions of the Tax Act in order to achieve an outcome that those provisions seek to prevent;
where a transaction defeats the underlying rationale of the provisions that are relied upon; or
where an arrangement circumvents the application of certain provisions, such as specific anti-avoidance rules, in a manner that frustrates or defeats the object, spirit or purpose of those provisions.
In Kaulius, the court found that the second of these instances of abusive tax avoidance applied. In the court's view "...to allow the [taxpayers] to claim the losses in the present appeal would defeat the purposes of s. 18(13) and the partnership provisions...". For further emphasis of the point, the court also made a blunt finding that the only reasonable conclusion is that the transaction frustrated the purpose of parliament:
The abusive nature of the transactions is confirmed by the vacuity and artificiality of the non-arm's length aspect of the initial relationship between Partnership A and STC. A purposive interpretation of the interplay between s. 18(13) and s. 96(1) indicates that they allow the preservation and sharing of losses on the basis of shared control of the assets in a common business activity. In this case, the absence of such a basis leads to an inference of abuse. ... The only reasonable conclusion is that the series of transactions frustrated Parliament's purpose of confining the transfer of losses such as these to a non-arm's length partnership.
Edward Rowe: focus on the text of the relevant provisions shifts from the textual towards a more contextual and |
Deference to the Tax Court judge
One of the more remarkable points of guidance provided by the Supreme Court in these GAAR decisions is that the appellate courts should be extremely reluctant to interfere with the decision of the trial judge at the Tax Court of Canada. This point is underscored by the unqualified acceptance of the Tax Court decisions in the two cases on appeal. The Supreme Court held that where the Tax Court judge has proceeded on a proper construction of the provisions of the Tax Act and on findings supported by the evidence, his or her conclusion with respect to abusive tax avoidance is not to be interfered with by an appellate court except in the case of palpable and overriding error. This high threshold upon an appellant (whether Crown or taxpayer) to establish "palpable and overriding error" is the usual test for dislodging findings of fact. It is, however, unusual to apply so significant a burden to the policy analysis which the court itself characterizes a "mixed question of fact and law".
The court's deference to the findings of the trial judge may reflect a view that determinations under the Tax Act are best left to the specialist Tax Court of Canada rather than to the generalist appeal courts. Alternatively, this may simply be a reflection of the fact that GAAR cases are by their nature extremely fact sensitive and that the outcome of the policy debate is largely predicated on the findings of fact themselves. The fact-sensitive nature of GAAR cases was highlighted in the oral hearing of Canada Trustco where Crown counsel spent over half his allotted time attacking, and the taxpayer's counsel spent over half his allotted time defending, the factual findings of the Tax Court judge.
Does the Supreme Court test clarify the law?
Before the oral hearing of the two GAAR cases at the Supreme Court, the conventional wisdom was that the court would uphold the decisions of the Federal Court of Appeal which had themselves upheld the Tax Court decisions with limited comment. However, the recent dissent by Justices LeBel and Bastarache of that court in The Queen v Singleton 2001 SCC 61 which made the case for a departure from the strict textual interpretive approach outlined in the 1999 decision of that court in Shell Canada Ltd v The Queen 99 DTC 5669 (SCC) (a case which itself expressly carved out the GAAR from that approach), made that result uncertain. The comments of those judges and other members of the Supreme Court during the oral hearings and, most particularly, the lengthy delay in the release of the judgments, led to much post-hearing speculation that the court's view may be far from unanimous. In the result, the court did decide to uphold the Tax Court decisions on a basis only slightly different from the route followed by the Federal Court of Appeal.
The Supreme Court has managed to fashion a compromise which has enabled the court to speak with a unified voice, by including language which may appeal to persons on either side of the interpretive debate. In future cases, the Crown will rely upon the affirmation of a purposive approach under the GAAR, while the taxpayer will cite those passages which seek to preserve the right to legitimate tax minimization. A Tax Court judge will be presented with a tremendous amount of latitude in future cases, both from the inclusive language of the tests which start from the proposition that "the line is not bright", and from the fact that the determinations at trial are not be interfered with save for "palpable and overriding error". As a result, it is only the subsequent decisions of the Tax Court (and the review of those decisions by the Federal Court of Appeal within the limits of the Supreme Court's test) which will determine with some finality whether the Supreme Court's elucidation of the GAAR test will provide certain or predictable results.
David Spiro (david.spiro@blakes.com) is a partner in the Toronto office of Blake, Cassels & Graydon
Edward Rowe (edward.rowe@blakes.com) is a partner in the Calgary office of the same firm
