Of Gaps and the GAAR

Many tax planning transactions fall within the definition of “avoidance transaction” in subsection 245(3) of the Income Tax Act and as such are subject to review under the general anti-avoidance rule (GAAR). Equally, many of the transactions that are reviewed are found not to offend the GAAR on the basis that the planning involved does not result in a misuse of a section of the Act or an abuse of the provisions of the Act read as a whole. In its decisions on the GAAR the Supreme Court has made the point that the misuse and abuse analysis must start with an examination of the text, context and purpose of the tax provisions related to the transactions under review. Specifically, the GAAR is not to be applied on some general theory of improper tax avoidance premised on the notion that certain types of planning ‘are not to be allowed.’ In other words, to succeed with a GAAR challenge, the Canada Revenue Agency (CRA) must show in a specific way how a section was misused or the Act as a whole was abused. This puts the onus on the CRA to satisfy the court as to the intended purpose of the provision alleged to be misused, or of the more general statutory scheme involved.

It can be difficult for the CRA to meet this onus when a tax provision underlying the planning is not itself a specific anti-avoidance rule. In such a case, ‘using’ that provision for the specific purpose for which it was intended is not a misuse justifying the application of the GAAR. This sort of difficulty is illustrated by the recent Tax Court decision in MacDonald. The taxpayer in that case owned the shares of a professional corporation which he sold to a member of his extended family for a promissory note, on fair market value terms. Although this resulted in the realization of a capital gain, he had capital loss carryforwards available to offset the gain. The family member transferred the shares of the purchased company to his own holding company and caused the acquired company to pay a dividend to his Holdco. Holdco received the dividend free of tax and used it to fund the payment due to the taxpayer on the note.

The CRA saw the series of transactions as a dividend strip in which amounts that would have been taxed as dividends if paid in the first instance to the taxpayer, were instead received by the taxpayer as proceeds of sale of his shares, a capital gains transaction. They argued that this was an abuse of the provisions of the Act relating to the taxation of corporate distributions, pointing to the fact that the funds used to pay the promissory note were derived entirely from the taxpayer’s company. As such, the amounts should be taxed as dividends and not as capital gains.   The Tax Court disagreed and allowed the taxpayer’s appeal. In the court’s view, no provision of the Act had been misused, and there was no abuse of the Act as a whole.

It’s not hard to see why the CRA felt the need to try the GAAR in a case like this. Historically, attempts to convert dividends taxable at the general rate into  capital gains taxable at a preferred rate have been regarded as unacceptable dividend stripping. There is no section in the Act  that speaks specifically to the consequences of dividend stripping. It is not defined anywhere, and although it has a commonly understood meaning, it is not always clear when any particular ‘dividend strip’ ought to be subject to the GAAR as a matter of general tax policy.

This brings me to the observation that tax planning which falls in the gaps between specific anti-avoidance rules and the more general provisions of the Act may also escape the GAAR. Our courts have generally been reluctant to stretch the meaning of the non-avoidance provisions of the Act to catch aggressive planning. This follows the Supreme Court’s direction to root the GAAR analysis in the text, context and purpose of the relevant provisions. If the planning passes the TCP test, the odds are pretty good that a case can also be made against the application of the GAAR. The argument is that if the general provisions have been applied in accordance with their purpose, there is no room for the GAAR. If this identifies a gap in the general provisions, the remedy is an amendment to the Act, not the application of the GAAR. Even 20 plus years into the GAAR regime it is too early to say with confidence that the court will never use the GAAR to fill a perceived gap in the Act. But the jurisprudence to date supports the position that the CRA is more likely than not to fail with a GAAR assessment that attempts to do this.