On October 19, 2005, the Supreme Court of Canada released its first two judgments on the general anti-avoidance rule (or "GAAR") under section 245 of the Income Tax Act (Canada) (the "Act"), Mathew et al. v. The Queen and Canada Trustco v. The Queen. In doing so, the Court unanimously concluded that the GAAR will apply only where it is not reasonable to consider that the tax benefit t obtained is within the "object, spirit or purpose" of the provisions of the Act when interpreted "textually, contextually and purposively". After more than 20 prior decisions from the lower courts on the GAAR, it was hoped that these two cases would clarify where permissible tax planning slips into abusive tax avoidance. While the line between the two remains elusive, the Court did offer some helpful guidance on where it might begin and, perhaps more importantly, where GAAR has no place.
Factually, the Mathew and Canada Trustco cases arise from transactions entered into in the 1990s. However, the fundamental issue raised by these cases stretches back 70 years to a well-known case involving a wealthy duke and his domestic staff called Inland Revenue Commissioners v. Duke of Westminster. In that case, the Duke had been paying non-deductible wages to his household employees for several years when he happened upon the idea of paying them (fully deductible) "annuity payments" instead. He then sought to deduct the payments from his income; revenue authorities said in substances these were wages.
In words that have resonated since they were written in 1935, the Court held that "[e]very man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be". The fundamental principle that taxpayers are entitled to order their affairs to pay the least amount of tax allowed by law was thus born.
In the intervening years, the Supreme Court of Canada has consistently reaffirmed the Duke of Westminster principle. However, when the general anti-avoidance rule was introduced into the Act in 1988, the question was naturally asked: Is this the end of the line for the Duke?
In the first case, Mathew et al. v. The Queen (also known as Kaulius v. The Queen), the facts were relatively straightforward. 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% of STIL II. Thereafter, in 1993, STIL II realized on the mortgages and recorded a business loss of $52 million, most of which was allocated to its majority partner, SRMP. The taxpayers, as partners in SRMP, then claimed their respective shares of SRMP's losses in computing their own incomes.
The Minister of National Revenue applied the GAAR to disallow the taxpayers' losses, as the Act's general policy was against loss trading.
The facts in the second case, Canada Trustco Mortgage Company v. The Queen, were more complex but ultimately 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 $22 million of its own money and borrowed the rest on a limited-recourse secured basis from the Royal Bank of Canada. 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 $116 million due to MAIL under the sub-lease, and this amount was placed on deposit under an arrangement that funded and secured MAIL's obligation to make future lease payments to Canada Trustco. Canada Trustco then assigned to Royal Bank the rent payments owed to it by MAIL as security for the loan made by Royal Bank. Canada Trustco went on to claim capital cost allowance (or CCA) on the trailers totalling $98 million, which was available to it to shelter income from other sources.
The Minister disallowed Canada Trustco's CCA claim, relying on the GAAR and other arguments, alleging the transactions were completely circular, involved no economic risk to Canada Trustco and were designed solely to achieve a manufactured CCA deduction.
The Supreme Court confirmed that for GAAR to apply, three requirements must be met:
The burden is on the taxpayer to refute requirements (1) and (2), but the Minister has the onus of establishing point (3). If unclear, the benefit of the doubt should go to the taxpayer.
In both cases, the Supreme Court found that the first requirement was easily met, allowing a low threshold for the existence of a "tax benefit". The magnitude of the "tax benefit" was irrelevant. The sole question was "whether the taxpayer reduced, avoided or deferred tax payable under the Act".
The Supreme Court also found the second requirement was met on the facts. Whether a particular transaction was an "avoidance transaction" depended on "an objective assessment of the relative importance of the driving forces of the transaction". Even if one transaction in a series is an "avoidance transaction", the tax benefit may be denied by GAAR.
The third requirement—the so-called "misuse and abuse" test—is normally the most significant, and has "given rise to the most difficulty in the interpretation and application of the GAAR". The questions whether there has been a "misuse" of a provision of the Act and whether there has been an "abuse" of the Act read as a whole are inseparable and the Supreme Court distilled the question down to whether there has been "abusive tax avoidance". This determination involves two steps:
Applying these tests, the Supreme Court upheld the lower courts' findings that the transactions in Mathew were abusive, while those in Canada Trustco were not.
In Mathew, the clear purpose of former subsection 18(13) was to prevent a taxpayer who is in the business of lending money from claiming a loss upon a non-arm's-length transfer of a mortgage. This loss was preserved in the hands of the transferee only "because of its special relationship with the transferee partnership". Accordingly, to allow a new, arm's-length partner to buy into the transferee partnership and benefit from these losses "would violate the fundamental premise underlying s. 18(13) that the loss is preserved because it essentially remains in the transferor's control". Therefore, to allow the new partners to benefit from the loss "would contradict the main purpose of s. 18(13) and the premise on which it operates".
In contrast, the facts in Canada Trustco did not demonstrate abusive tax avoidance because the scheme of the CCA rules in the Act was premised upon "legal cost" (rather than "real cost" or "economic cost") and that is precisely what was used to determine the taxpayer's CCA. The Court held:
Textually, the CCA provisions use "cost" in the well established sense of the amount paid to acquire the assets. Contextually, other provisions of the Act support this interpretation. Finally, the purpose of the CCA provisions of the Act, as applied to sale-leaseback transactions, was, as found by the Tax Court judge, to permit deduction of CCA based on the cost of the assets acquired. This purpose emerges clearly from the scheme of the CCA provisions within the Act as a whole.
Some commentators have already suggested that the only real certainty here is that one taxpayer won and the other lost. In our view, however, there is more:
1) Economic Substance — Economic substance was at the heart of the Minister's argument in Canada Trustco. While economic substance "may be relevant" in analyzing a transaction, the concept "has little meaning in isolation from the proper interpretation of specific provisions in the Act". The Court rejected any notion that the GAAR itself imposed an economic substance test that could be used to override specific provisions of the Act that did not.
2) Certainty, Predictability & the Role of the Courts — The Court reiterated (a) the importance of certainty and predictability in tax laws so taxpayers can order their affairs intelligently, and (b) courts are not the proper place for formulating fiscal policy. While some commentators say the first goal is merely one of many (such as fairness, neutrality, and raising revenue) and the second concern is overblown, the Court's strong support for these principles in the context of the GAAR is welcome.
3) Minister's Burden to Establish Clear Misuse & Abuse — The Court specifically endorsed the twin propositions that GAAR can only be applied "when the abusive nature of the transaction is clear" and that the burden is on the Minister to establish that the transaction frustrates the "object, spirit or purpose" of a particular provision of the Act. This reaffirms the extraordinary nature of section 245. In cases of doubt, the benefit should go to the taxpayer.
As usual, the real effect of these judgments will not be known for some time. However, the Supreme Court has given us a considered answer to our initial question: The Duke still lives, but he doesn't walk with quite the same object, spirit or purpose as before.