Supreme Court Rules in GAAR Case

On December 16, 2011 the Supreme Court of Canada released its decision in Copthorne, its fourth judgment considering the scope of the general anti-avoidance rule (GAAR) in section 245 of the Income Tax Act (Canada) (the Act).

In a unanimous 9-0 judgment, the Court upheld the Canada Revenue Agency’s (CRA) reassessment of Copthorne. As a result, Copthorne was liable to pay withholding tax on $67M of redemption proceeds that were recharacterized by the GAAR as a deemed dividend paid to a non-resident shareholder.

The facts of the case are complex, but boiled down to its essence, the case is about a corporate reorganization that resulted in the duplication of paid-up capital (PUC). PUC can be used to return funds tax-free to a shareholder.

More specifically, non-resident shareholders invested $96M by way of share subscription in a Canadian holding corporation (Holdco) in the late 1980s. The holding corporation, in turn, invested $67M of that $96M in a wholly-owned subsidiary (Subco), again by way of share subscription. This gave rise to $67M of paid-up capital (PUC) on Holdco’s shares of Subco.

Subco incurred capital losses on its investments. Copthorne, another corporation corporate group, had realized gains. In order to allow Copthorne to shelter its gains with Subco’s losses, Holdco sold its shares of Subco to Copthorne. Subco then sold its losing investments to Copthorne and Copthorne then sold those investments in a manner that allowed Copthorne to recognize the capital loss.

In 1993 the group decided to amalgamate Copthorne and Subco. At this time, Subco was a wholly-owned subsidiary of Copthorne. On the amalgamation of a parent corporation and its wholly-owned subsidiary (i.e., a vertical amalgamation), the shares of the subsidiary are cancelled and the PUC of the subsidiary’s shares disappears under subsection 87(3) of the Act. Rather than endure this result, Copthorne instead sold its shares of Subco to Copthorne’s parent corporation. At this point, Copthorne and Subco were sister corporations. They amalgamated, resulting in the aggregation of the PUC on their shares, instead of having Subco’s shares (with $67M in PUC) cancelled. In essence, the transaction was structured such that a horizontal amalgamation could be undertaken (which preserved PUC) rather than a vertical amalgamation (which would not).

Still later, the group redeemed some of the amalgamated Copthorne’s shares held by a corporation resident in the Netherlands. With the preserved PUC, no deemed dividend arose on the share redemption (in the absence of GAAR) and thus no withholding tax applied.

The CRA challenged this result, asserting that subsection 87(3) had been circumvented in a manner such that the GAAR ought to apply: (1) there was a tax benefit in the form of a share redemption utilizing the preserved PUC; (2) Copthorne’s sale of Subco’s shares to Copthorne’s parent, resulting in Subco and Copthorne becoming sister corporations, was an avoidance transaction and was part of a series of transactions giving rise to the tax benefit; and (3) the avoidance transaction giving rise to the tax benefit was abusive.

The Supreme Court agreed that the GAAR was engaged in this case, and made the following observations:

1. The Court was asked to reconsider its earlier position on what constitutes a “series of transactions” as expanded by subsection 248(10) of the Act. That is, although the share redemption was not specifically in Copthorne’s mind at the time of the amalgamation, was the subsequent share redemption done “in contemplation of” the prior PUC-preserving amalgamation?Subsection 248(10) provides that a series of transactions includes any related transactions completed “in contemplation of” a series. Here, the parties agreed that the transactions up to and including the PUC-preserving amalgamation was itself a series. The CRA, however, alleged that the subsequent share redemption utilizing the preserved PUC (i.e., the transaction giving rise to the tax benefit) was part of the same series because it was done “in contemplation of” the earlier amalgamation.In Canada Trustco, the Supreme Court held, after a cursory analysis and in reliance on a statement by Professor Duff, that later transactions can indeed be completed “in contemplation of” earlier transactions. However, Professor Duff had since changed his view and in a 2007 article stated:
   
   Although the conclusion that related transactions can occur “either before or after” an avoidance transaction is likely to accord with legislative intent, it is not obvious that this interpretation is consistent with the text of subsection 248(10), which might more reasonably be interpreted to include only related transactions completed prior to an ordinary series of transactions but not related transactions completed after the series. (emphasis added)

   However, the Court was not swayed by Professor Duff’s change of mind and held that subsequent transactions can be completed “in contemplation of” earlier transactions. The Court also noted that its decision in Canada Trustco was recent, and unless there were substantial reasons to believe that it was wrongly decided, it should stand. The endorsement of the Court’s seminal decision in Canada Trustco is prevalent throughout the decision.

2. With respect to the question of whether there was an “avoidance transaction”, the Court reiterated the test it established in Canada Trustco that the determination of whether a transaction is undertaken primarily for a non-tax purpose is to be “objectively considered, and must be based on all of the evidence available to the court.” The taxpayer argued that the transactions were undertaken for the purposes of simplifying the corporate group and using the losses “within the four corners of the amalgamated companies”. The Court objectively considered this explanation and rejected it, concluding that the explanation did not explain the sale that facilitated the horizontal amalgamation. As explained by the Court, “As the Tax Court judge found, the share introduced an additional step into a process of simplification and consolidation. A vertical amalgamation would have resulted in the same simplification and consolidation.” In essence, the Court compared the series of transactions to an alternative series (which achieved the same commercial result without the tax benefit) and found that the difference between the two could only be explained by tax motivation on the part of the taxpayer.

3. The Court covered little new ground in determining whether there has been abusive tax avoidance. The Court reiterated the approach it took in Canada Trustco, stating that the GAAR is a provision of last resort to be applied only when the abusive nature of the transactions is clear. In order to determine whether there has been abusive tax avoidance, one must first determine the object, spirit or purpose of the provision(s) that are relied on for the tax benefit, in the same manner as any other statutory interpretation question – namely, by reference to the text, context and purpose of the provision(s) in issue. Then, having determined the object, spirit or purpose, abusive tax avoidance will be established (1) where the transaction achieves an outcome the statutory provision was intended to prevent; (2) where the transaction defeats the underlying rationale of the provision; or (3) where the transaction circumvents the provision in a manner that frustrates or defeats its object, spirit or purpose.

4. Importantly, the Court stated: “[h]owever, determining the rationale of the relevant provisions of the Act should not be conflated with a value judgment of what is right or wrong nor with theories about what tax law ought to be or ought to do.”

5. Similarly, the Court refused to base its finding of abusive tax avoidance on some general policy within the Act against “surplus-stripping”. The abuse found to exist here was based on an examination of the PUC sections of the Act, not on some general policy.

In the end, the Court was swayed by what it viewed as a double-counting of PUC through a transaction that “artificially” preserved $67M in PUC. The Court did not say that double-counting would always be abusive – “this outcome may not be foreclosed in some circumstances” – but offered little more in the way of guidance.

Overall, the decision in Copthorne, while not providing certainty in the application of the GAAR, does clarify its application in some important respects and confirms the basic interpretive approach first laid down by the Supreme Court in its 2005 decision in Canada Trustco.

Prepared by: David Davies , Matthew Williams