Understanding avoidance: GAAR changes and challenges impact taxpayers doing business internationally. Unfortunately, the new landscape has yet to be defined.
Two significant developments have recently occurred that affect this much-disliked rule. First, the federal government broadened the application of GAAR in the March 2004 federal budget. Secondly, for the first time since its introduction, the Supreme Court of Canada will be hearing appeal cases related to GAAR. Both developments could have wide-reaching effects on organizations and individuals that conduct cross-border business.
Canadian tax law adopted GAAR in 1988. The government's view is that GAAR is intended to prevent abusive or artificial avoidance schemes, without interfering with legitimate commercial transactions. It does so by giving Canadian tax authorities the ability to deny any tax benefit obtained as a result of a particular offensive avoidance transaction or series of transactions.
But the courts have been reluctant to apply GAAR and have usually viewed the Canada Revenue Agency's (CRA) application of GAAR as highly subjective. The CRA has always held the view that GAAR could also apply to the wording in Canada's bilateral tax treaties, the regulations to the Income Tax Act and the Income Tax Application Rules. The courts have disagreed and, in one case, decided that GAAR did not apply to the regulations. The reason why the CRA wants to apply GAAR to bilateral tax treaties is to circumvent what is colloquially referred to as "treaty shopping." Many modern tax treaties contain treaty shopping language, but, with one fell swoop, the CRA would like to skip having to insert this into all of its existing treaties.
Most experts in the Canadian tax community, however, disagree with the CRA's stance, noting that the wording in Canadian law states that GAAR can only apply when there has been a misuse or abuse of the provisions of the Canadian Income Tax Act. Since a bilateral tax treaty is not part of this Act (nor are the regulations, nor are the Income Tax Application Rules), it was difficult to understand the CRA's position. Faced with this conflict, the federal government acted in the 2004 federal budget released on March 23 of that year.
Widening the scope
The proposal to amend GAAR is included in the Notice of Ways and Means Motion to Amend the Income Tax Act, Resolution 18. The government proposes to amend section 245 of the Act to expand the range of transactions to which GAAR may apply.
Moreover, the government proposes that this change will be retroactive to 1988, the year that GAAR was enacted. In effect, this would replace the text of the law as originally enacted with something different, grandfathered back to the original enactment. While any retroactive taxation change is problematic, it is particularly so in the case of GAAR because it is a unique provision that applies to a broad range of circumstances and can have a broad range of consequences. The government's proposed changes could cause far-reaching implications for not only Canadian taxpayers, but also for foreign enterprises as well as for Canada's international obligations under its bilateral tax treaties.
At the same time as this pre-emptive strike is unfolding, the Supreme Court has, for the first time, agreed to hear two cases on GAAR. Until now, the courts have held that for GAAR to apply to a transaction, or a series of transactions, the following conditions must be met.
* The transaction(s) in question must result in a tax benefit to the taxpayer.
* The primary purpose of the transaction(s) is to obtain the tax benefit.
* There has been a misuse or abuse of one or more provisions of the Canadian Income Tax Act.
Since the CRA would not be challenging a tax plan if there were no tax benefit, the key tests are whether the primary purpose of the plan is to obtain a tax benefit and whether there has been a misuse or abuse of a provision of the Act. The Canadian courts have held that if the primary purpose of a transaction(s) is a business purpose and not to obtain a tax benefit, then GAAR cannot apply. Therefore, as long as a taxpayer can justify the transactions from a business perspective, they should be safe from GAAR.
Even if the primary purpose of the transaction(s) is to obtain a tax benefit, there still must be a misuse or abuse of a provision of the Canadian Income Tax Act. The courts have held that for there to be a misuse or abuse, there must be a clear and unambiguous policy intent with respect to the specific provisions that have been abused.
Appeals under consideration
While this framework has now been applied in many cases, the Supreme Court of Canada has not yet had its say--although it soon will. On June 24, 2004, the Supreme Court granted leave to appeal in two recent GAAR cases: one in which the CRA was successful and one in which the taxpayer was successful.
In Kaulius v The Queen, 2003 DTC 5644 (FCA), the taxpayers acquired interests in a partnership to access partnership losses. These were denied by the CRA on the basis of GAAR. The Federal Court of Appeal held that there was a general policy in the Income Tax Act against the transfer of losses between arm's length taxpayers such that the taxpayers' transactions resulted in an abuse relative to the provisions of the Act. The appeal to the Supreme Court focuses on certain "clear and unambiguous" policies in the Act for the purposes of applying GAAR.
In Canada Trustco Mortgage Company v The Queen, 2004 DTC 6119 (FCA), the taxpayer purchased certain equipment that was leased back to the vendor. These lease financing transactions were structured such that the taxpayer bore little "economic risk" in the purchase price of the equipment. The CRA denied the taxpayer's capital cost allowance deduction of the leased equipment on the basis that it did not incur any "cost" to acquire the equipment since the taxpayer bore no economic risk for the purchase price.
The Federal Court of Appeal found that GAAR did not apply in this case since there was no clear and unambiguous policy that capital cost allowance could only be claimed on economic cost (versus legal cost) incurred to acquire an asset. The appeal to the Supreme Court relates to the issue of whether the Federal Court of Appeal erred in failing to consider the substance of the transactions in determining whether GAAR applied, or whether the Court erred in holding that there was no misuse or abuse.
While no one can predict how the Supreme Court will rule in these cases, taxpayers and tax professionals alike can only hope that the decisions will clarify how the CRA may apply GAAR. The prevailing belief in the tax community is that the jurisprudence to date may have gutted the application of GAAR. The Supreme Court will be the government's last kick at the can to restore the spectre of the provision. The recent replacement of Justice Iaccobucci on the court may bode well for the government, since the new judges are not considered "taxpayer friendly."
Stan Zinman (email@example.com) is a partner of BDO Dunwoody LLP.