Federal Court of Appeal Quashes GAAR Assessment by the CRA
In 3295940 Canada Inc. v The King, A-201-22, the Federal Court of Appeal (the "FCA") overturned the CRA's GAAR abuse analysis on the basis that similar economic result can be reached by alternative transactions. This decision is significant in two aspects. First, it clarified that a series of transactions must be viewed as a whole when conducting abuse analysis under the GAAR. Second, it illustrates the necessity to consider relevant alternative transactions in the avoidance assessment.
Taxpayer Initiated Transactions to Lower Capital Gains Tax
The taxpayer appealed this decision from the Tax Court of Canada, which upheld the CRA's reassessment that the appellant and a corporation wholly owned by the appellant, MCo, had implemented a chain of transactions that resulted in a $31.5M reduction in the taxpayer's capital gains, effectively constituting a violation of the GAAR.
The taxpayer attempted to sell his minority stake in a pharmaceutical company to Novartis. The knowledgeable Canadian tax attorney for the taxpayer preferred to structure this sale by instructing MCo to initiate a series of transactions to lower the total tax liability since his shares in MCo had a lower adjusted cost base.
This chain of transactions aimed to achieve similar tax consequences to selling the taxpayer's shares directly, as the taxpayer's tax cost was much lower. The transactions can be summarized in the following steps:
- MCo exchanged its shares held by the appellant for preferred Class D shares with an adjusted cost base ("ACB") of $31.5M.
- MCo transferred the Class D shares to a newly created subsidiary (4244) in exchange for Class D shares of 4244 with the same ACB.
- The taxpayer transferred its Holdco shares, worth $88.5M, to 4244 and received 57 million Class D shares and 31.5 million common shares from 4244. The appellant elected to realize a capital gain of $53 million on the transfer.
- The taxpayer redeemed 4244's Class D shares for a promissory note of $31.5M, resulting in a deemed dividend for that amount. The taxpayer paid this to 4244 as a capital dividend. 4244 redeemed the taxpayer common shares, also for a promissory note of $31.5M. This transaction deemed the taxpayer to have received a dividend of $31.5 million, which 4244 elected to be a capital dividend. 3295 and 4244 offset the two promissory notes.
- MCo transferred its 4244 Class D shares to the appellant. The taxpayer sold all of its shares in 4244 to Novartis for $88.5M. The taxpayer realized no additional capital gain.
The CRA reassessed the taxpayer and added a capital gain of $31.5 million to the taxpayer's income, reasoning that this $31.5 million would have been realized by MCo if it had directly sold its shares to Novartis.
The Appellant's Arguments Before the Federal Court of Appeal
The taxpayer appealed to the FCA. On the appeal, the issue was whether the Tax Court of Canada erred in holding that the series of transactions was abusive. The taxpayer argued that it was not, because of the availability of alternative transactions which would have resulted in less tax liability. The Tax Court rejected this argument.
Federal Court's Decision: Analysis of GAAR as a Whole and the Mandatory Consideration of Alternative Transactions
The FCA allowed the appeal and accepted the submissions made by the expert Canadian tax litigation lawyer acting for the taxpayer. The FCA held that the Tax Court erred in two ways.
First, the Tax Court failed to consider and analyze the series of transactions as an entirety. In reaching its conclusion, the Tax Court overly relied on the cross-redemption capital dividend, as only one step in the series. However, when taking all the steps into consideration, the Tax Court should have reached the decision that the overall result did not reduce the taxpayer's capital gain since the ultimate capital gains realized is approximately the same as the gain would have been realized if MCo sold its shares directly to the purchaser. Hence, there is no abuse of s. 55(2) of the Act.
Second, the Tax Court erred in refusing to consider the alternative transactions proposed by the taxpayer's Canadian tax litigation lawyer. In this case, the alternative transactions are relevant to the abuse analysis in three aspects. The alternative transactions had a high degree of commercial and economic similarity to the series at issue; they generated tax consequences approximately as favorable as the series at issue; they were not abusive of the GAAR. In conclusion, the FCA was satisfied that the overall result of the tax planning was consistent with the object, spirit and purpose of the capital gains regime provided by the Act. Hence, there was no violation of the GAAR.
There are two major takeaways from this decision for both tax planners and the lower courts. In conducting an abuse analysis under the GAAR, a court should not unduly focus on one step in a series of transactions. Instead, the entire chain must be viewed as a whole to assess whether the overall result of tax consequences constitutes abusive planning. Moreover, this decision also confirmed the necessity to consider the alternative transactions, provided that they are relevant to the analysis, especially when they share commercial and economic similarities with the series at issue, generate similar tax consequences, and are not abusive.
Pro Tax Tips From Canadian Tax Litigation Lawyer
When tax authorities assess whether a tax scheme is abusive under the General Anti-Avoidance Rule (GAAR), they won't focus on isolated steps within the transaction series. Therefore, when carrying out tax planning make sure that your Canadian tax lawyer structures your transactions with legitimate commercial purposes in mind.
Also, since the courts will consider alternative transactions in the abusive analysis, taxpayers should be prepared to demonstrate that their chosen transaction structure is not the only way to achieve the desired commercial outcome. Explore and document by way of a memorandum from an expert Canadian tax lawyer, alternative approaches with similar economic benefits but a legitimate business purpose. This can help strengthen your case if your tax planning is ever challenged.
If you are uncertain how this new case will affect you or your business, you should engage with one of our expert Canadian income tax lawyers who can provide legal advice and assist you with fighting unreasonable CRA decisions.
FAQs:
How are the Capital Gains Taxed?
A capital gain occurs upon the disposition of a capital property sometime during the taxation year for an amount greater than the cost of the property. Under the Canadian Income Tax Act, capital gains are taxed at 50%, meaning that only 50% of your capital gains are subject to taxation. This rate is highly preferential when compared to other forms of taxation. However, the 2024 federal budget proposed to increase the capital gains inclusion rate for individuals, trusts, and corporations, effective June 25, 2024.
What is an Abusive Transaction? How does the General Anti-Avoidance Rule work?
An "abusive transaction" refers to a transaction or a series of transactions that comply with the literal wording of the Canadian Income Tax Act but violate the spirit and intent of the law. It tends to capture transactions that are manipulated by taxpayers to obtain a tax benefit. Whether a transaction amounts to "abusive" is a highly discretionary decision made by the CRA. Once the CRA finds a transaction to be abusive, the consequences may vary for the taxpayer as it often involves a denial of the tax benefit while certain penalties may apply.
How Should I Structure My Transaction to Avoid Being Characterized as "Abusive"?
The CRA has broad discretionary power to designate a transaction as abusive. There are a series of the steps you can take to fight the CRA decision, including filing a formal objection and appealing to the Tax Court of Canada. Taxpayers can take certain precautionary measures beforehand to lower the chance of having a transaction being characterized as abusive. For example, you could demonstrate that your chosen tax planning approach is not the only way to achieve the preferred tax benefit. Documenting alternative strategies with similar benefits but a legitimate business purpose will make your case stronger if ever challenged.
Disclaimer: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.