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TaxMatters@EY - December 2012 - FCA rules that GAAR applies to loss generator transactions - EY - Canada

TaxMatters@EY - December 2012

FCA rules that GAAR applies to loss generator transactions

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Triad Gestco Ltd. v Her Majesty the Queen (2012 FCA 258)
1207192 Ontario Limited v The Queen (2012 FCA 259)
The Queen v Global Equity Fund (2012 FCA 272)
Jennifer Smith, Ottawa

In three recent cases before the Federal Court of Appeal (FCA) dealing with loss generator transactions, the court ruled in favour of the Canada Revenue Agency (CRA) against the taxpayers.

In Triad Gestco, 1207192 Ontario Limited and Global Equity Fund, the FCA found that the realization of an artificial loss on the transfer of shares to a trust was abusive tax avoidance. It was the artificiality of the losses in these cases that the FCA appeared to find offensive, as opposed to the realization of losses within the same economic group.

Facts

Both Triad Gestco and 1207192 Ontario involved the realization of artificial capital losses and involved the following steps:

  • The taxpayer realized a substantial capital gain on the disposition of certain property.
  • The taxpayer transferred property to its wholly owned subsidiary corporation in exchange for common shares of the subsidiary. The value of the transferred property and the subscription price were approximately equal to the capital gain the taxpayer previously realized.
  • The subsidiary declared a stock dividend on the common shares that was payable in preferred shares with a redemption amount equal to the value of the property originally transferred to the subsidiary.
  • The effect of the stock dividend was to shift all of the value of the common shares of the subsidiary to the preferred shares, resulting in the common shares having a nominal value.
  • The taxpayer then sold the common shares to a trust and used the resulting capital loss to offset the previously realized capital gain.

In both cases, the purchaser of the subsidiary’s common shares was a trust established for the benefit of the controlling shareholder of the taxpayer (or his family).

The Global Equity case involved similar facts, but the loss was claimed as a business loss rather than a capital loss.

In all three cases, the taxpayer was reassessed to deny the loss on the basis of the general anti-avoidance rule (GAAR) in section 245 of the Income Tax Act (the Act).

Tax Court decisions

The Tax Court of Canada upheld the reassessments in Triad Gestco and 1207192 Ontario. However, the “misuse or abuse” analysis in each case differed in some important respects.

In particular, in Triad Gestco, Justice Réal Favreau reviewed various stop-loss rules and the 2005 amendment to the definition of “affiliated person” in section 251.1 of the Act, extending its application to certain trusts, and applied the general anti-avoidance rule (GAAR) on the basis that “the recognition of artificial capital losses realized within the same economic unit is contrary to the object, spirit and purpose of these provisions” (paragraph 98).

In contrast, Justice Brent Paris in 1207192 Ontario expressly disagreed that the amendments to the definition of “affiliated person” were material in the determination of the policy underlying the stop-loss rules in effect for years prior to their enactment. Justice Paris, however, concluded that there was a policy in the Act against the deduction of artificial capital losses. He reviewed the history of the taxation of capital gains in the Act and concluded that the purpose of paragraph 38(b) is to recognize economic losses suffered by a taxpayer on the disposition of property.

In the Global Equity case, Justice Judith Woods found the series of transactions to be “vacuous,” but she was not persuaded by the Crown’s argument that there is a general policy in the Act against the deduction of artificially created business losses. Since the Crown failed in this regard, it was unnecessary for Justice Woods to consider whether the particular series of transactions in this case was in contravention of any such policy.

Federal Court of Appeal decisions

The FCA unanimously upheld the TCC’s two capital loss generator decisions in decisions written by Justice Marc Noël in Triad Gestco and by Justice Karen Sharlow in 1207192 Ontario. In reaching their conclusions, both judges approved of the approach Justice Paris had taken.

The Crown’s appeal in Global Equity was allowed.

Triad Gestco

The only issue on appeal was the application of the misuse or abuse test in subsection 245(4). The taxpayer argued that the loss should be recognized on the basis of the mechanical application of the relevant provisions.

The FCA disagreed, stating that the result would be “fundamentally counterintuitive,” since the capital gains system is understood to apply to real economic gains and losses (paragraph 41).

The taxpayer argued that the Act contemplates in some situations, such as those relating to the “change in use” rules (in subsection 45(1)) and the “flow-through share” rules (section 66.1), that capital gains or losses may be recognized despite the fact that there is no economic gain or loss.

Justice Noël noted that these and similar provisions are designed to accomplish specific policy objectives and do not detract from the general policy against the deduction of artificial losses.

However, he expressly disagreed with Justice Favreau’s finding that the transactions in issue also defeated the object, spirit and purpose of the stop-loss rule in subparagraph 40(2)(g)(i), and that this provision reveals the existence of a general policy against the deduction of capital losses on dispositions “within an economic unit.”

Instead, he agreed with Justice Paris’s reasoning in 1207192 Ontario that the fact that Parliament amended the definition of “affiliated persons” in 2005 to include certain trusts on a prospective basis could not be relied on to infer a policy that was in effect prior to the amendment. However, as noted, he also agreed with Justice Paris that there was a general policy in the Act against the deduction of artificial or “paper” capital losses such as those claimed by Triad Gestco Ltd. Therefore, the taxpayer’s appeal was dismissed.

1207192 Ontario Limited

The issues on appeal in this case were the existence of an avoidance transaction and the applicability of the misuse or abuse rule.

With respect to the avoidance transaction issue, Justice Paris had accepted that the principal objective of the series of transactions was to achieve creditor proofing. However, he found that several of the individual transactions had as their principal purpose the achievement of the capital loss, thus satisfying the avoidance transaction test.

The FCA held that Justice Paris had applied the correct test, citing its previous decision in MacKay (2008 FCA 105):

The existence of abona fide non-tax purpose for a series of transactions does not exclude the possibility that the primary purpose of one or more transactions within the series is to obtain a tax benefit (paragraph 25).

The taxpayer argued that Justice Paris had erred in reaching his conclusion on an objective basis, without taking into account the subjective creditor proofing motivation for the transactions.

Justice Sharlow did not accept this argument. She stated that Justice Paris had followed the correct approach by objectively ascertaining the purpose of each step by reference to its consequences rather than on the basis of the the major shareholder’s subjective motivation or his subjective understanding of what may have been required to achieve creditor protection.

The FCA dealt with the “misuse or abuse” issue in one brief paragraph, endorsed Justices Noël’s and Paris’s reasonsand dismissed the taxpayer’s appeal.

Global Equity

The primary issue in this case was whether the Crown could raise new arguments that neither it nor the Minister had used at the TCC. The main new argument was that the loss in question was a capital loss rather than a business loss.

Justice Robert Mainville held that allowing the Crown to introduce the alternative capital loss arguments in this case would prejudice the taxpayer. The arguments involved issues of mixed fact and law, and had the Minister or the Crown initially made them, the taxpayer might have adduced relevant evidence to counter them at the TCC. Therefore, the FCA did not allow the Crown to raise these arguments. However, the Crown was successful in convincing the FCA to overturn the TCC’s decision on the issue of abusive tax avoidance.

The taxpayer relied on sections 3, 4, 9 and 111 of the Act to obtain the tax benefit. The Crown argued at the FCA that the object, spirit or purpose of these provisions is relevant to establish abusive tax avoidance, and was able to convince the Court that the fundamental rationale underlying these provisions is that business losses must be grounded in some form of economic or business reality.

The FCA agreed with the Crown that the transactions at issue in this case were “vacuous” and “highly artificial,” and therefore constituted abusive tax avoidance.

The Crown’s appeal was allowed, but the taxpayer was granted costs because of the manner in which the Crown had argued the case, changing its approach numerous times, resulting in significant litigation costs to the taxpayer.

Conclusion

These are the first cases to deal with the loss generator schemes, which have been around since the 1990s. There are several important principles that can be drawn from them:

  • With respect to determining whether a transaction is an “avoidance transaction,” the FCA confirmed once again that the existence of a bona fide non-tax purpose for a series of transactions does not exclude the possibility that the primary purpose of one or more transactions within the series is to obtain a tax benefit.
  • The court should objectively ascertain the purpose of each step in the series by reference to its consequences, rather than on the basis of the taxpayer’s subjective motivations.
  • With respect to the misuse or abuse test, it is the artificial creation of the capital loss that is abusive rather than the triggering of a loss through a transaction within the same economic unit.

It is yet to be seen whether any of these taxpayers will seek leave to appeal to the Supreme Court of Canada.


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