Canada's Supreme Court sets the standards for permissive tax avoidance.

• Author: Bernier, Jacques

Introduction

On October 19, 2005, the Supreme Court of Canada released its first judgments on the general anti-avoidance rule (GAAR) under section 245 of the Income Tax Act (Canada) (Act). The judgments, which emanate from a unanimous court, were rendered in the companion cases of Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54 (Trustco), and Mathew, et al. v. Canada, 2005 SCC 55 (formerly known as Kaulius, et al. v. The Queen) (Mathew). These judgments were much anticipated by tax executives and their advisers since more than 20 decisions from lower courts have been rendered since GAAR was introduced in 1988.

By way of background, the GAAR was introduced after the predecessor of the Canada Revenue Agency (CRA) lost an important battle before the Supreme Court in the tax avoidance area 21 years ago. In Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536 (Stubart), the Supreme Court held that the Act did not contain an inherent or implicit "business purpose test." With Stubart, the so-called Duke of Westminster principle was rejuvenated and taxpayers continued to be "entitled to order their affairs to pay the least amount of tax allowed by law." Generally speaking, this meant that the taxpayer could minimize or avoid tax by bringing itself within (or keeping itself outside) the specific wording of the Act. This generally led Canadian courts, including the Supreme Court, to favor a "literal interpretation or application" of the Act.

In 1988, the GAAR became part of the Act law and "superimposed a prohibition on abusive tax avoidance, with the effect that the literal application of provisions of the Act may be seen as abusive in light of their context and purpose." (1) In the Supreme Court's view, its task in the Trustco and Mathew appeals was "to unite these two approaches in a framework that reflects the intention of Parliament in enacting the GAAR and achieves consistent, predictable and fair results." (2)

Trustco and Mathew are good reads. A first review, however, will leave the tax professional wanting more. While the judgments contain certain unequivocal and helpful diktats, ultimately they fail to define precisely what constitutes permissible tax avoidance. It is only after several readings and discussions that the tax executive will have a good appreciation of the effect of the Trustco and Matthew decisions. This article is intended to facilitate such an appreciation.

Statutory Context

The provisions of the GAAR, as they applied to the Trustco and Matthew decisions, (3) read in part, as follows [paragraphing modified]:

245. (1) [Definitions] In this section, "tax benefit" 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] "transaction" includes an arrangement or event.

(2) [General Anti-Avoidance Provision.] Where a transaction is an avoidance transaction, the tax consequences to a person shall be determined as is reasonable in the circumstances in order to deny a tax benefit that, but for this section, would result, directly or indirectly, from that transaction or from a series of transactions that includes that transaction.

(3) [Avoidance Transaction.] An avoidance transaction 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.

(4) [Where subsection (2) does not apply.] For greater certainty, subsection (2) does not apply to a transaction where it may reasonably be considered that the transaction would not result directly or indirectly in a misuse of the provisions of this Act or an abuse having regard to the provisions of this Act, other than this section, read as a whole.

(5) [Determination of Tax Consequences.] Without restricting the generality of subsection (2), (a) any deduction 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, (b) any such deduction, 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.

248. (10) [Series of transactions] For the purposes of this Act, where there is a reference to a series of transactions or events, the series shall be deemed to include any related transactions or events completed in contemplation of the series.

The Transactions under Scrutiny

In Trustco, the transaction resembled a sale-leaseback transaction. Canada Trustco was a mortgage lender and lessor, and as part of its business, obtained revenues from leased assets. In 1996, it paid $120 million to acquire a fleet of trailers from a U.S.-based company, TLI. To make the purchase, Canada Trustco used $20 million of its own money and borrowed the rest from Royal Bank. Immediately after purchasing the trailers, Canada Trustco leased them to a U.K. company, MAIL, which in turn sub-leased them back to TLI, the original owner. TLI then pre-paid the $120 million due to MAIL under the sub-lease, and this amount was placed on deposit for purposes of making MAIL's lease payments to Canada Trustco. Canada Trustco then assigned to Royal Bank the rent payments owed to it by MAIL to retire the loan and it was agreed that Royal Bank would have no further recourse against Canada Trustco. Canada Trustco went on to claim capital cost allowance (CCA) on the trailers totaling $98 million, which exceeded its lease income on the deal and could therefore shelter other income.

In Mathew, the facts were simpler. In 1991, the Standard Trust Company (STC) was insolvent and a liquidator was appointed. The liquidator transferred a portfolio of STC's non-performing mortgages into a general partnership called STIL II. The mortgages had significant accrued but unrealized losses at the time of the transfer. Because STC did not deal at arm's length with STIL II at the time of the transfer (and for the 30 days following the transfer), former subsection 18(13) denied recognition of the loss on the transfer and preserved it in the hands of STIL II. The liquidator then sought purchasers for the partnership and, after 8 months, found them in the taxpayers. The taxpayers acquired an interest in a second general partnership, SRMP, that had been established to hold 76 percent of STIL II. Thereafter, in 1993, STIL II realized on the mortgages and recorded a business loss of $52 million, $40 million of which was allocated its majority partner (SRMP). The taxpayers, as partners in SRMP, then claimed their respective shares of SRMP's losses, which amounted to $10 million, and sought to apply it against their own incomes.

Procedural History

The Minister of National Revenue challenged the tax result in each case under the GAAR (and some other arguments) and reassessed accordingly. Practically speaking, this meant incremental tax and (non-deductible) interest in both cases. In Trustco, the court of first instance, the Tax Court of Canada, found in favor of the taxpayer on the basis that there was no "misuse or abuse" under subsection 245(4), and the Federal Court of Appeal dismissed the Minister's appeal. In Mathew, however, both the Tax Court and Federal Court of Appeal upheld the GAAR assessment on the grounds that the subject transaction constituted a "misuse or abuse" for purposes of the same provision.

Before the Supreme Court, the Minister's argued in Trustco that the transactions in issue were completely circular, involved no economic risk for the taxpayer, and were designed solely to achieve a manufactured CCA deduction. As such, they offended the general policy that only money actually spent to acquire depreciable property should be respected for purposes of the CCA rules. In Mathew, the Minister's primary argument was that arm's-length taxpayers ought not be able to acquire tax losses of others on the ground this was contrary to the general policy against loss trading in the Act. Also, the argument before the Supreme Court involved whether the preferred approach developed to date by the lower courts was the correct one. In particular, in OSFC Holdings Ltd. v. Canada, [2002] 2 F.C. 288, 2001 FCA 260, a case involving essentially the same transactions as in Mathew, two of the three justices of the Federal Court of Appeal interpreted the phrase "misuse or abuse" in subsection 245(4) disjointedly and determined that it mandated a two-step enquiry to determine whether it applied. According to that approach, the first...