Canada’s General Anti Avoidance Rule

- The Process -

July 2012

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Outline

• GARR, An Introduction

• Overview of GARR: Sections 245 (1) to 5

• Proposed GARR in India

• Court cases: Canada Trustco, Collins & Aikman and Lipson

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GARR: An Introduction

• The General Anti-Avoidance Rule (GAAR), set out in Section 245 of the Income Tax Act, was first introduced in 1988.

• It was intended to give the Canada Revenue Agency (“CRA”) broad powers to challenge perceived tax avoidance activities or abuses of the tax system in situations where no specific anti-avoidance measures existed.

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• The GAAR legislation provides that where a transaction or series of transactions achieves a reduction, avoidance or deferral of tax and the transactions or series of transactions are not primarily for bona fide purposes other than to obtain a tax benefit, the tax consequences of the transactions may be invalidated.

GARR: An Introduction

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Overview of GARR: Sections 245 (1) to 5

• The general anti-avoidance rule (“GAAR”) scheme is set out in ss. 245(1) to (5) of the Act and requires that three questions be decided:

(1) was there a tax benefit; (2) was the transaction giving rise to the tax

benefit an avoidance transaction; and(3) was the avoidance transaction giving rise to

the tax benefit abusive.

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Overview of GARR: Sections 245 (1) to 5

• A “tax benefit,” as defined in subsection 245(1), means a reduction, avoidance or deferral of tax or other amount payable under this Act or an increase in a refund of tax or other amount under this Act, and includes a reduction, avoidance or deferral of tax or other amount that would be payable under this Act but for a tax treaty or an increase in a refund of tax or other amount under this Act as a result of a tax treaty.

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Overview of GARR: Sections 245 (1) to 5

• An “avoidance transaction,” as defined in subsection 245(3), means any transaction (a) that, but for this section, would result, directly or indirectly, in a tax benefit, unless the transaction may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit;

• or (b) that is part of a series of transactions, which series, but for this section, would result, directly or indirectly, in a tax benefit, unless the transaction may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit.

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Overview of GARR: Sections 245 (1) to 5

• Under s. 245(3) of the Act, a transaction will be an avoidance transaction if it results in a tax benefit, and is not undertaken primarily for a bona fide non-tax purpose.

• An avoidance transaction may operate alone to produce a tax benefit, or may operate as part of a series of transactions to produce a tax benefit.

• The starting point of the common law test for whether a transaction is part of a series: Was “each transaction in the series is pre-ordained to produce a final result”?

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Overview of GARR: Sections 245 (1) to 5

• Under subsection 245(4), abusive tax avoidance exists where the impugned transaction(s) would result directly or indirectly in a misuse of the provisions of the Act or an abuse of the Act read as a whole.

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Overview of GARR: Sections 245 (1) to 5

• Section 245(5), without restricting the generality of s. 245(2), sets forth a scheme for determining the tax consequences of the application of that provision. Section 245(5) reads as follows:

Without restricting the generality of subsection (2), and notwithstanding any other enactment,

(a) any deduction, exemption or exclusion in computing income, taxable income, taxable income earned in Canada or tax payable or any part thereof may be allowed or disallowed in whole or in part,

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Overview of GARR: Sections 245 (1) to 5

(b) any such deduction, exemption or exclusion, any income, loss or other amount or part thereof may be allocated to any person,

(c) the nature of any payment or other amount may be recharacterized, and

(d) the tax effects that would otherwise result from the application of other provisions of this Act may be ignored, in determining the tax consequences to a person as is reasonable in the circumstances in order to deny a tax benefit that would, but for this section, result, directly or indirectly, from an avoidance transaction.

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Overview of GARR: Sections 245 (1) to 5

• The GAAR, which began to be considered by the lower level courts a few years ago, generally resulted in judgments in favor of the taxpayer, and seemed to put significant limitations on its use.

• Recently, however, the GAAR environment seems to have undergone a change since it was first considered by the Supreme Court in the Canada Trustco case.

• This change has not resulted in clarifying when the GAAR is applicable. Instead, as a result of conflicting court decisions, there is considerable confusion.

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Procedure for applying GAAR in India

Procedure for applying GAAR in India• It is our understanding that the power to invoke GAAR is

bestowed only upon the Commissioner of Income Tax (CIT).

• Power to call on for information• Required to follow the principles of natural justice before

declaring arrangement as impermissible avoidance arrangement

• He will determine the tax consequences of such impermissible avoidance arrangement and issue necessary directions to the Assessing Officer for making appropriate adjustments.

• The directions issued by him will be binding on the Assessing Officer.

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Procedure for applying GAAR in Canada

• Field office determines if transaction is subject to GARR

• Prepare report to head office • Head office tax officer determines if they agree with

field and whether GARR applies• If GARR applies, head office reports to the GARR

committee • GARR committee votes to determine whether GARR,

in fact, applies• Report sent to head office explaining explaining

position taken by the committee

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Court Cases (If time permits)

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Canada Trustco Mortgage Co. v. Canada, [2005] 2 S.C.R. 601

• McLachlin J. and Major J.: Appeal dismissed in favour of Taxpayer

• Series of transactions allowed Trustco to take advantage of over $31 million in CCA

• Detailed guide to GAAR analysis and application; broadens the definition of a series; provides guidance on the burden of proof.

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Canada Trustco Mortgage Co. v. Canada (cont’d)

• SCC: The first task is to interpret the provisions giving rise to the tax benefit to determine their object, spirit and purpose. The next task is to determine whether the transaction falls within or frustrates that purpose. The overall inquiry thus involves a mixed question of fact and law. The textual, contextual and purposive interpretation of specific provisions of the Income Tax Act is essentially a question of law but the application of these provisions to the facts of a case is necessarily fact-intensive.

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Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536

• Estey J.: Appeal from FCA allowed in favour of Taxpayer

• Rejection of “Business Purpose” test in Canadian tax law: contrary to legislative intent; general avoidance provision already exists and Act provides special voluntary deductions to encourage certain tax benefit transactions

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Stubart Investments Ltd. v. The Queen (cont’d)

• Clarification of “Sham” doctrine:

• Transaction or reorganization cannot be said to be a sham simply because it does not have a commercial purpose, is reversible or was undertaken by parties dealing at non-arm’s length

• Rather, a sham means that the legal consequences the transaction purports on its face do not actually exist

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OSFC Holdings Ltd. v. R., [2001] 4 C.T.C. 82 (F.C.A.)

• Rothstein J.: Appeal dismissed in favour of the Minister

• First FCA GAAR case

• Common law definition of series of transactions: each transaction in the series must be pre-ordained to produce the final result

• Statutory definition of series of transactions: 3 requirements: (1) a series within the common law meaning (2) a transaction related to that series (3) completion of the related transaction in contemplation of that series

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OSFC Holdings Ltd. v. R. (cont’d)

• Tax benefit and avoidance need not accrue to the same person, only same series

• S. 245(4) has 2 stages of analysis and a 2 part test (overruled by Canada Trustco)

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Canadian Pacific Ltd. v. R., [2002] 2 C.T.C. 197 (F.C.A.)

• Sexton J.: Appeal dismissed in favour of Taxpayer

• Issue: Whether a series of transactions undertaken for a single purpose may be compartmentalized to determine whether part of such a transaction constitutes an avoidance transaction in the sense that it is undertaken primarily or solely for a tax benefit?

• The Act requires regard for the purpose of the whole transaction. We cannot over-compartmentalize a commercially driven transaction which is structured tax favourably so as to deny the tax benefits under GAAR.

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Duncan v. R., [2002] 4 C.T.C. 1

• Noël J.: Appeal dismissed in favour of Minister

• FCA example of no bona fide commercial purpose

• Section 245(4) provides the courts with the ability to intervene where there has been a misuse of the provisions of the Act. In this case, the claiming of a transfer of the asset at book value, where its fair value was nominal was in clear violation to Parliament’s intent

• Parliament acted quickly to close loophole with subsequent enactment of ss. 96(8)

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Donohue Forest Products Inc. v. R., [2003] 3 C.T.C. 160

• Noël J.: Appeal dismissed in favour of Taxpayer

• First FCA case where Taxpayer admits avoidance and benefit but wins on lack of misuse or abuse of the Act (s. 245(4))

• Nothing to indicate that third party was not at arm’s length with the Respondent

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Imperial Oil Ltd. v. R., [2004] 2 C.T.C. 190

• Strayer J.: Appeal dismissed in favour of Taxpayer

• The loans made by Imperial to bank subsidiaries had a lower rate of return, than had it lent to the bank directly. However, once the tax advantage was included, the rate of return was better on the loans made to the bank subsidiaries

• No misuse or abuse even though transaction undertaken primarily for tax benefit within commercial context

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Imperial Oil Ltd. v. R. (cont’d)

• Since Imperial could have lent to bank at better rate of return, the loan had a bona fide commercial purpose. While these circumstances will result in an avoidance transaction, they will not necessarily be considered a misuse of the provision of the Act

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Mathew v. Canada, [2005] 2 S.C.R. 643

• McLachlin and Major: Appeal dismissed in favour of the Minister

• Released concurrently with Canada-Trustco but found that GAAR applies

• Court applied the analysis set out in Trustco

• Court found that it was not within the object, spirit and purpose of the provisions to allow for the sale of losses to arms length parties, and thus the transactions constituted abusive tax avoidance within the meaning of ss. 245(4)

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Univar Canada ltd. v. R., [2006] 1 C.T.C. 2308

• Bell J.: For the Taxpayer

• Only case decided on the basis that there was no tax benefit

• The Minister cannot recharacterize the transaction to make GAAR apply by creating a hypothetical scenario where UCan would have undertook transactions it never considered. The only basis for comparison in this case would have been never entering into the transaction at all

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R. v. MIL (Investments) S.A., [2006] 5 C.T.C. 2552

• Bell, J.: For the Taxpayer

• Application of GAAR to tax treaties (In 2005, Parliament amended s. 245 to specifically include treaties, and made this amendment retroactive effective Sept. 12, 1988)

• GAAR should be applied to Articles of a tax treaty in the same manner as to the Act

• Court seemed reluctant to find misuse where article individually negotiated

• “Treaty shopping” is not GAARable but may be a factor in finding abusive tax avoidance

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MacKay v. R., [2008] 4 C.T.C. 161

• Sharlow J.: Appeal allowed for the minister

• Only GAAR case reversed to date

• Must determine purpose of each step of a series of transactions. The conclusion that a series of transactions was undertaken primarily for bona fide non-tax purposes does not preclude a finding that the primary purpose of one or more steps within the series was to obtain a tax benefit

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MacKay v. R., (cont’d)

• Respondent failed to respond to Minister’s arguments on abusive tax avoidance, choosing instead to challenge only that the transaction was not a tax avoidance transaction. Sharlow J accepted the Minister’s ss. 245(4) arguments by “default” as he put it

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Short Summary: Lipson v. Canada, [2009] SCC 1

• LeBel J.: Appeal dismissed in favour of the Minister

• Applies GAAR to Singleton type interest deduction

• Using provisions of the Act to deduct interest on mortgage for family home is misuse

• Legitimate to look at purpose of the whole series in determining abuse of a transaction

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Copthorne Holdings Ltd. v. R., [2009] FCA 163

• Ryer J.: Appeal dismissed in favour of the Minister

• Examination of s. 248(10) series of transactions

• A tax benefit transaction carried out in contemplation of a previous series constituting an avoidance transaction forms part of that series

• Ryer J. concluded that the Share Sale was an abusive circumvention and avoidance of the requirement under the Act to eliminate the PUC of intercorporate shareholdings on amalgamations to avoid the duplication of the PUC

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Conclusion

• As one of the worlds fastest growing economies, India must increase foreign direct investment while protecting its tax base.

• Application of sound and practical transfer pricing regulations will serve reduce uncertainty surrounding transfer pricing between related parties which will serve to increase foreign direct investment.

• While India has attempted to make its transfer pricing legislation more progressive and transparent, more learning and awareness will be required to ensure that policies are enforced consistently.

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Conclusion

• Taxpayers must ensure that their transfer pricing documentation can hold up to the strict scrutiny of tax authorities.

• Many avenues are available to help corporations avoid double taxation.

• Legislation is rapidly changing, introducing new rules from which corporations can benefit.

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Thank You

www.taxand.com

Presenter:Dale HillPartner, Tax Services Tel: 613-786-0102E-mail: dale.hill@gowlings.com