What is clear in the caselaw is that the Duke of Westminster principle still holds in Canadian tax law (see: Canada Trustco Mortgage Company v. Her Majesty the Queen, 2005 SCC 54). What is unclear, however, is how, when, and to what degree the GAAR attenuates this principle. Recently, the Supreme Court of Canada (SCC) explored this tension in Copthorne Holdings Ltd. v. Canada, 2011 SCC 63, refining the interpretive approach to GAAR but at the same time affirming the inescapable truth that “it is relatively straightforward to set out the GAAR scheme. It is much more difficult to apply it.”

The case involved a group of Canadian and non-resident companies controlled by Li Ka-Shing and his son, Victor Li. Through a series of transactions, two Canadian corporations within this group that had previously been parent and subsidiary became “sister” corporations, or corporations owned directly by the same non-resident shareholder. The nature of the amalgamation becomes relevant because of the tax treatment of paid-up capital (PUC), the capital invested in a class of shares of a corporation by its shareholders. When that class of shares is redeemed by the corporation, the amount paid to shareholders includes an amount which is simply the return of capital (i.e. after-tax dollars invested in a corporation). This amount is not included in income as it has already been taxed. If the amount paid to shareholders exceeds the PUC (i.e. the amount invested), the excess amount is included in income as a dividend. It is in the interest of taxpayers, therefore, to structure their affairs so as to maximize the proportion of the payment which is attributable to PUC and thereby minimize the amount that is deemed to be a taxable dividend. This is exactly what Li Ka-Shing tried to do.

When corporations amalgamate, the general rule is that the PUC of the shares of both amalgamating corporations are aggregated to form the PUC of the new corporation. This does not apply, however, to an amalgamation involving a parent and subsidiary company (i.e. a vertical amalgamation). Upon amalgamation, the PUC of the shares of the subsidiary corporation owned by the parent company are cancelled to prevent the artificial inflation of PUC for tax purposes. Had the two Li companies remained as parent and subsidiary, the PUC of the shares of the subsidiary would have been cancelled on amalgamation. Since the two corporations had become sister corporations, the PUC was not cancelled and the amalgamated corporation proceeded to redeem a large portion of its shares to the non-resident shareholder.

The payment was treated by the taxpayer as a return of capital and thus not taxable income. Despite the fact that there is no specific provision in the Act requiring inclusion of the payment in income, the Minister of National Revenue deemed the transactions abusive within the meaning of GAAR and concluded that a deemed dividend arose on the redemption of the shares amounting to $58,325,223. The re-assessment was upheld by the Tax Court and the Federal Court of Appeal.

At the SCC, Rothstein J. affirmed the analytic framework for applying the GAAR set out in Canada Trustco Mortgage. Courts must ask three questions: (1) was there a tax benefit? (2) was the transaction giving rise to the tax benefit an avoidance transaction? (3) was the avoidance transactions giving rise to the tax benefit abusive? What is unusual about the GAAR is that while a taxpayer’s transactions will be in compliance with the text of the relevant provisions of the Act, they may contravene their object, spirit, or purpose. Thus, unlike traditional statutory interpretation which draws on the spirit of legislative provisions in order to make clear the meaning of the text, the GAAR interpretive approach requires courts to enforce not only the text of the Act but also the underlying rationale as it may extend beyond the text.

In other words, the GAAR, by definition, constitutes a legislative override of a canon of statutory interpretation often invoked by courts in deciding tax cases: if the legislature had intended to include something in a statutory provision, it would have done so and it is not for courts to judicially supplement the legislative process. In the context of GAAR, the starting premise of judicial analysis is that the rationale of a provision will not always be exhausted by the precise words of a statute.

In applying the three-part test outlined above, the SCC found that the transactions resulted in a tax benefit. While Rothstein J. accepted that the transactions were necessary to achieve a number of beneficial outcomes sought (e.g. simplification of the corporate structure and the ability to shelter anticipated gains with losses within the amalgamating corporations), the decision to opt for a horizontal instead of a vertical amalgamation produced a discernable benefit to the taxpayer.

Second, the SCC found that the transaction giving rise to the tax benefit was an avoidance transaction since it was part of the same series of transactions as the prior amalgamation and a vertical amalgamation would have resulted in the same non-tax benefits as the horizontal amalgamation undertaken by the taxpayers.

Finally, the transaction giving rise to the tax benefit was abusive. Generally, the SCC held that the case for abusive tax avoidance will be made out where: (1) the transaction achieves an outcome the statutory provision was intended to prevent; (2) the transaction defeats the underlying rationale of the provision; or (3) the transaction circumvents the provision in a manner that frustrates or defeats its object, spirit, or purpose. Rothstein J. found that the purpose of the provision was to preclude corporations from preserving PUC of the shares of a subsidiary corporation on amalgamation with the parent corporation as that PUC reflects the investment of the same tax-paid dollars in the subsidiary as in the parent corporation. Copthorne’s transactions, therefore, contravened this purpose.

Implications: Certainty, Flexibility, and the “Damoclesian Menace of the GAAR”?

A corollary of vesting courts with the power to enforce not only the statutory text of the Act but also its underlying rationale is a requirement that courts look deeper into corporate transactions and assess their economic realities. Traditionally, the common law approach of the courts has been to accept the legal characterization of transactions despite their economic realities if there is no “sham” or “window dressing.” Thus, what is most significant about GAAR is not so much the requirement that courts elucidate the spirit, object, or purpose of statutory provisions and give them concrete weight, but the corresponding obligation on courts to depart from their usual hesitancy to inquire into the economic realities of transactions. Through the GAAR, the legislature recalibrates the traditional judicial balance struck between individual liberty and equity.

The outcome of the decision is consistent with several underlying principles of the tax regime, particularly the need to tax people on their ability to pay and the use of the tax system to achieve horizontal and vertical equity. One of Copthorne’s arguments was that the current approach to the GAAR, in affording a great deal of leeway and flexibility for reassessments in light of the rationale of provisions, undermines another important goal of the tax system: certainty and predictability. Copthorne argued that upholding the Tax Court’s decision amounts to subjecting taxpayers to the “Damoclesian menace of the GAAR.”

The SCC was satisfied that there are adequate safeguards embedded in the analytic framework set out for GAAR to manage effectively the inevitably greater uncertainty. The Court pointed out that GAAR should only be turned to as a last resort and that in order for it to be triggered, there must be an avoidance transaction resulting in a tax benefit. It also highlighted the fact that if a transaction had a secondary tax benefit purpose, it would not engage the GAAR. Furthermore, the imposition of the burden on the Minister “who wishes to overcome the countervailing obligations of consistency and predictability to demonstrate clearly the abuse he alleges” protects taxpayers from the ‘menace’ of the GAAR.

Despite these safeguards, however, in the end the inescapable truth remains: it is relatively straightforward to set out the GAAR scheme. It is much more difficult to apply it.

As a member of the Obejiwan First Nation (as defined by the Indian Act R.S.C. 1985, c.I-5), living on a reserve in Quebec, many of Mr. Dubé’s sources of income are exempt from federal and provincial taxation schemes. He makes a living offering transportation services, including transporting reserve residents to the nearest city for medical care. There is no bank on his reserve, so in order to maintain his practice of banking within the Native community, he drives to the Caisse populaire Desjardins de Pointe-Bleue (the “Caisse”) on the Mashteuiatsh Reserve, some 300km away.

The issue deliberated is whether the appellant’s investment income, garnered from his dealings with the Caisse, is to be considered “situated on the reserve” and therefore exempt from taxation pursuant to Para. 8(1)(a) of the Income Tax Act and s. 87 of the Indian Act.

Dubé v. R. is an appeal from the decision of Nadon, J.A. and the concurring reasons of Pelletier and Blais JJ of the Federal Court of Appeal, which itself was appeal from the Tax Court of Canada.

Banking On a Reserve

The appellant has been a member of the Obedjiwan First Nation since birth, and spends at least every weekend on the Reserve. The customers at the Caisse where he banks are also mostly Native peoples. The Caisse deposits 25% of their customer’s reserves into the Federation des caisses populaires Desjardins  (the “Federation”) which makes investments in both investment and liquidity funds that are in turn invested in the economic mainstream. The remainder of the deposits are lent to members of the Caisse, both on and off the reserve.

Between 1997 and 2002, Mr. Dubé earned close to $300, 000 from his investments with Caisse. He included this in his taxable income, and then deducted it. When he was assessed in 2002, the Minister of Finance disallowed Mr. Dubé’s deductions from this source of income. In addition, late penalties were applied. The appellant now finds himself owing a large sum to the Canada Revenue Agency because of contrary interpretations of the relevant statutory provisions. Members of First Nations communities are eagerly anticipating the SCC’s decision for some clarity in the tax laws that apply to them, so they can plan their finances accordingly.

Not Very Taxing

In order for the Indian Act to apply and the income be exempt from taxation, three elements must be satisfied:

1.     The taxpayer is an Indian as defined by the Indian Act

2.     Having possession of personal property

3.     Which is situated on a reserve.

Justice Angers of the Tax Court highlighted that in Recalma v. Canada (1998), the Court restated the principles enunciated in Williams v. Canada (1992) that identified the four connecting factors used to determine the where (“situs” ) of the earned income. They are:

1.     The investment income’s connection to the reserve

2.     The benefit of the investment to the traditional Native way of life

3.     The potential danger of the erosion of Native property

4.     The extent to which the investment income may be considered as being derived from economic mainstream activity.

It’s easy to identify several connecting factors between the appellant’s investment income and the reserve: Mr. Dubé’s place of residence, the source of the capital, the location of the Caisse and the place where the investment income was paid. Angers J nevertheless found that the fourth factor was the most significant area of analysis, and found that the Federation’s investments were integrated with the economic mainstream and thus not closely connected to the reserve.

Capital Pains

In his appeal, Mr Dubé submitted to the FCA that the Tax Court judge erred in finding that the investment income was situated off the reserve. He submitted that according to Recalma, funds invested in banking institutions may be exempt from taxation if the funds are used exclusively for Native development. To this end, he pointed out that the Caisse in question is directly involved in Native economic development through its loans to natives on the reserve.

The appellant also alleged that the judge erred in neglecting to assess the danger of “erosion to Native property” presented by the taxation of investment income. The judge found that there was no danger to his initial investment, but the analysis falls short of addressing whether Aboriginals have the right to protect their capital property from the erosion of inflation through capital investments.

Since the Industrial Revolution, modern capitalist economies have thrived through the accumulation of returns on investment capital. By choosing to tax this particular form of income, it could be argued that the government is choking Native benefits by imposing taxes on the very method that could be used to end the abject poverty that has plagued many reserves. This is not to say that allowing the interest income to be non-taxable would have this effect, or that disallowing it would preclude it. It is to say that it may seem counter-intuitive to some that economically successful Natives would be taxed where it hurts most, while most Natives on reserves, who earn less than the lowest tax bracket, are “exempt” from a taxation system that would hardly tax them anyway.

The purpose of the tax exemptions is articulated nicely in an older SCC decision:

Justice LaForest in Mitchell v. Peguis Indian Band [1990] noted that

“…The exemptions from taxation…have historically protected the ability of the Indians to benefit from [their] property  [by guarding] against the possibility that one branch of government, through the imposition of taxes, could erode the full measure of the benefits given by that branch of government entrusted with the supervision of Indian affairs.” [para 86].

In Williams, Justice Gonthier referred to the choice that Natives have as to how to organize their financial affairs: if it’s off the reserve, it is open to taxation but is also “more fully available for commercial purposes in society.” (para 18).

He also noted that each case had to have its facts specifically turned over the four connecting factors, and therefore that this issue had to be approached on a case by case basis.

Nadon J.A. relies almost exclusively on the final connecting factor from Williams, deciding that, “if all or part of the funds were invested in the general mainstream of the economy, the exemption from taxation provided at Para 87(1)(b) of the Indian Act cannot apply.”

The intention of the Indian Act, he notes, is not to allow First Nations peoples to acquire and negotiate for property that is situated outside of a reserve on better terms than other Canadians.

As Pelletier remarks in his concurring reasons, “While the sources of the capital put on the market are local and the projects in which that capital is invested are local, the fact remains that the market itself is global.” (para 4, emphasis my own).

Tax, Tax, Tax…Exemption!

There’s something missing from the Federal Court’s decision which I hope is addressed in the Supreme Court’s rendering: coaxing lucrative returns on capital investments is no longer reserved for the super-elite.

On the one hand, if it looks like the funds from the gains on capital invested are going to be reinvested in the reserves, then allowing them to be tax-free could be a huge windfall for traditionally impoverished and neglected communities. It could be the ultimate self-help system. Or, the tax-free nature of returns could be used to profit only the wealthy elite and further entrench economic disparity on those reserves.

One thing is certain: the taxation exemptions that currently exist should not be used by unscrupulous business people who happen to have Indian status, and who are going to capitalize on this benefit, that is intended for communities, for their own private gain.

I would suggest, however, that there is another issue at play. Not only is there no bank on the appellant’s reserve, but there may be very little in the way of investment opportunities. It seems like Mr. Dubé has done his best to direct his energies and investments into preserving the way of life he so cherishes.  If the Supreme Court chooses to limit his and others’ tax-free investments to activities that are not part of “the global economy,” then the entrenched and systemic poverty that affects many Aboriginal communities may continue unabated.

The Tax Court of Canada considered two main issues: whether the trust was valid and if the General Anti-Avoidance Rule (“GARR”) was applicable to deny the transactions and related tax savings. Sona Dhawan discussed the Tax Court decision in an earlier post. This post will focus on the validity of the trust and the appeal court’s reversal of the lower court’s finding that the arrangement was not a sham.

Background and Facts

Mr. Antle transferred shares that had accumulated a capital gain to a spousal trust set up in Barbados. The trust then sold the property to his wife who then sold the property to an arm’s length third-party. The proceeds from the sale were put back into the trust and the wife received them as a beneficiary. Barbados has zero capital gains tax, therefore the wife’s beneficial interest from the ultimate disposition of securities was tax-free.

As a result, the taxpayer saved approximately $1,299,821. Normally, if he had sold his shares to a third-party in Canada he would have been liable for tax on the accumulated capital gain. The Minister of National Revenue (“Minister”) reassessed Mr. Antle and included these gains as taxable capital gains. (It is not uncommon in these types of transactions for the tax savings to be divided between the taxpayer and the legal professionals who implemented the strategy.)

The Three Certainties

The first problem for the taxpayer was the creation of the trust. For a trust to be valid it must exhibit the three certainties: certainty of intention, certainty of subject matter, and the certainty of objects. For example, regarding certainty of intention, Mr. Antle argued that determining intention was not a subjective process but merely an objective evaluation of the text of the trust agreement. In other words, if the trust document itself indicated an intention to create a trust, the surrounding circumstances did not matter. Hence, if from reading the trust document it was clear that the trust had been set up to hold property for the eventual beneficiary, Mrs. Antle, then the certainty of intention requirement was met.

However, C. Miller J. of the Tax Court agreed with the Minister, concluding that there was no certainty of intention to create a trust; rather it was merely “a conduit to avoid tax”. The Justice concluded that determining intention is not solely an exercise in interpreting the written words of the trust agreement. He agreed with the Minister’s contention that “the language of the [trust] is insufficient if it does not accord with Mr. Antle’s actions.” According to C. Miller J.: “the inevitable conclusion [is] that Mr. Antle did not truly intend to settle shares in trust with Mr. Truss. He simply signed documents on the advice of his professional advisers with the expectation the result would avoid tax in Canada.”

On appeal, Antle again argued that to look beyond the wording of the trust agreement to determine whether certainty of intention existed was an error in law. This argument was also rejected by the Federal Court of Appeal, which affirmed that contextual considerations are relevant, making it necessary to look at the actions that accord with the trust agreement.

The Trust was a Sham

One of the more interesting conclusions of the Tax Court judge in Antle 2009 was the ruling that the trust was not a sham. Even though this issue did not affect the outcome of the appeal, it is notable that the Court of Appeal felt it necessary to correct the error in law.

A sham trust is a trust, validly constituted or not, where the terms of the trust are meant to deceive. In Snook v. London West Riding Investments, [1967] 2 QB 786, Lord Diplock considered the term “sham”, stating:

it means acts done or documents executed by the parties to the “sham” which are intended by them, to give to third parties or the Court, the appearance of creating between the parties, legal rights and obligations different from the actual legal rights and obligations (if any), which the parties intend to create… [T]hat for acts or documents to be a “sham”, with whatever legal consequences follow from this, all the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating. No unexpressed intentions of a “shammer” affect the rights of a party whom he deceived.

Canadian jurisprudence adds that in order for a trust to be a sham, the settlor and trustee must both be of the same intent—that is to deceive or misrepresent the actual transaction.

The Tax Court of Canada undertook a nuanced determination of whether the trust was a sham, looking for proof of the intentions of those involved. The Federal Court of Appeal was much more succinct, stating:

the Tax Court judge misconstrued the notion of intentional deception in the context of a sham. The required intent or state of mind is not equivalent to mens rea and need not go so far as to give rise to what is known at common law as the tort of deceit. It suffices that parties to a transaction present it as being different from what they know it to be…[B]oth the appellant and the trustee gave a false impression of the rights and obligations created between them. Nothing more was required in order to hold that the Trust was a sham.

Conclusion

The Federal Court of Appeal may have been issuing a warning to those who structure tax avoidance transactions using trusts, and in particular offshore trusts. For one, they affirmed that determining certainty of intention required contextual considerations; the taxpayer is not able to rely solely on the wording of the trust agreement in order to prove that certainty of intention exists. If the property was, as according to the agreement, to be held in trust for the beneficiary, then that is what must occur.

Again, the intention referred to by Lord Diplock “is not equivalent to mens rea“. A trust is a sham if “parties to a transaction present it as being different from what they know it to be…” Nothing more is required. This effectively makes the Minister’s job much easier. A valid trust must be a valid trust, there may be no way around it.

But what happens when the garnished account is a trust account belonging to a lawyer who has an outstanding personal tax debt of over $300,000? Well, things get complicated as we have found out after the SCC granted leave to appeal of the decision of the Federal Court of Appeal in Canada Trustco Mortgage Company v. Canada, 2009 FCA 267. Without providing reasons, the appeal court upheld the tax Court of Canada’s ruling in Canada Trustco Mortgage Company v. The Queen, 2008 TCC 482, which essentially approved the Minister’s garnishment. The appeal is scheduled to be heard by Canada`s top court in early December.

Garnishment Pursuant to the Federal Income Tax Act

Under ss. 224(1) of the Federal Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (“ITA”) the Minister has the authority to compel a person “liable to make a payment” to the tax debtor to pay the Minister instead. Subsection 224(1) states:

Where the Minister has knowledge or suspects that a person is, or will be within one year, liable to make a payment to another person who is liable to make a payment under this Act (in this subsection and subsections (1.1) and (3) referred to as the “tax debtor”), the Minister may in writing require the person to pay forthwith, where the moneys are immediately payable, and in any other case as and when the moneys become payable, the moneys otherwise payable to the tax debtor in whole or in part to the Receiver General on account of the tax debtor’s liability under this Act. [emphasis added]

Under ss. 224(4) a penalty is imposed for non-compliance with the requirement to pay dictated by s. 224(1).

In Canada v. National Trust Co., [1998] 4 C.T.C. 26, [National Trust] it was ruled that the following conditions must be met in order for the Minister to have the authority to issue a requirement to pay:

(a) the Minister has knowledge or a suspicion,

(b) a person is or will be within 90 days liable to make a payment to a tax debtor, and

(c) the amount must be payable immediately or in the future.

In the same decision, the Federal Court of Appeal concluded that the word “liable” denoted “the fact that a person is responsible at law…” and also rejected the lower court’s limitation of “the phrase “”liable to make a payment”" only to situations where a debtor creditor relationship exists.” (In National Trust, the Minister was successful in garnishing an investment account belonging to an indebted taxpayer.)

At issue in the present case was whether Canada Trust was “liable to make a payment” to the lawyer, Mr. McLeod, and “if money was payable to Mr. McLeod in the relevant period.”

Is Withdrawing and then Depositing an Amount by Cheque a Demand for Payment?

The indebted lawyer, Mr. McLeod, withdrew funds from a trust account by cheque and deposited them into another of his accounts at Canada Trust. The issue before the courts was whether this transaction meant that Canada Trust was liable to pay Mr. McLeod. The Tax Court of Canada said yes. According to Justice L.M. Little, “because there was money deposited in the Trust Account, the obligation associated with a deposit makes the money payable on demand to the tax debtor.” As a result Canada Trust was required to remit those funds to the Minister.

At first, the resolution to this dispute appears pretty straightforward. When Mr. McLeod withdrew funds from the trust account by cheque, Canada Trust was liable to pay him that amount. However, Canada Trust is arguing that “[d]elivering a cheque for deposit…” into another account “is not a demand for payment”; only when Mr. McLeod cashed the cheque would a “demand for payment” have come into existence.

Canada Trust is relying on the technical procedure through which the bank processes a cheque. According to the appellant:

The Tax Debtor was not demanding repayment of the funds on deposit in the Trust Account when he delivered the Cheques for deposit into the Joint Account. In holding otherwise, the Tax Court departed from over 150 years of banking and bills of exchange law developed in the common law and under the Bills of Exchange Act.

(The factums from both parties are available here.)

For the purposes of ss. 224 the distinction between receiving the funds directly (in cash for instance), versus immediately depositing the cheque into another account, is not immediately clear to me. In fact, I agree with the Tax Court that the analysis should end at the moment the cheque was issued to Mr. McLeod. At that point the bank was “liable to make a payment” to him.

In actuality, the funds moved from the trust account to the joint account. The Tax Court concluded that this was not relevant. It did not matter where the money eventually went; it only mattered that the cheque represented a demand for payment. The description put forward by counsel for Canada Trust was that the funds moved from the trust account, to a Canada Trust account, and then to the joint account. And because the cheques were never cashed, Mr. McLeod was never paid, Canada Trust was never “liable to make a payment” to Mr. McLeod, and the garnishment provision of the ITA was never triggered. A very clever argument to be sure.

Conclusion

The SCC will have to decide if there is a distinction between Mr. McLeod being paid in cash versus him making a withdrawal by cheque from one account and then a deposit by the same cheque into another account. Will the SCC honor the technicality of the transaction or its effect?

Ultimately, the Minister appears to have a stronger case. Section 224 is triggered when “another person…is liable to make a payment” to Mr. McLeod. Certainly the bank was liable to pay Mr. McLeod the amount of the cheque once he withdrew from the trust account. I doubt the technical argument submitted by Canada Trust will succeed.

In this latest case, Heron Bay Investments Ltd. v. Her Majesty the Queen, 2010 FCA 203, the Federal Court of Appeal (reasons for judgment by Sharlow J.A.) ruled that the actions of Hogan J. in Heron Bay Investments Ltd. v. The Queen, 2009 TCC 337 gave rise to a reasonable apprehension of bias and breached “the rules of procedural fairness.” The case was sent back to the Tax Court for retrial by another judge.

Background and Facts

The Heron Bay Corporation is a member of the Conservancy Group of corporations, which includes Rosehue Downs Developments Inc., Burlmarie Developments Inc., Shellfran Investments Ltd., Marlo Developments Inc., and Viewmark Homes Ltd. The Rosehue and Burlmarie corporations entered into an agreement to purchase property from Runnymede Development Corporation Ltd., an arm’s length corporation. Marlo, along with Shelfran and Viewmark, entered into an agreement to purchase the property from Rosehue and Burlmarie. Viewmark borrowed from Heron Bay for the purchase.

For the 1995 tax year, Heron Bay deducted the amount of the loan to Viewmark. According to Heron Bay, the loan was doubtful because the value of the property interest bought by Viewmark was less than the purchase price, thus there was a reasonable doubt that it would be repaid.

For tax purposes, a doubtful loan is one that stands the chance of not being reimbursed in full. The deducted amount must be included as income in the following year. But, if  the loan is still doubtful at the end of the year a new deduction is allowed. This can be repeated until the debt is recovered or is no longer doubtful. At that point the deduction is included as income. (If the loan becomes bad or uncollectible it can be deducted per s. 20(1)(p)(ii) of the ITA).

Pursuant to s. 20(1)(l)(ii) of the ITA, the amount of a doubtful loan can only be deducted from income if certain conditions are realized. The criteria in the present case were as follows:

(1) in the year in which the deduction is claimed, the taxpayer’s ordinary business must include the lending of money;

(2) the loan in respect of which the deduction is claimed must be made in the ordinary course of the taxpayer’s money lending business; and

(3) the loan must be doubtful at the end of the year in which the deduction is claimed, meaning that there must be a reasonable doubt that it would be collected.

The Tax Court of Canada ruled that the first criterion under s. 20(1)(l)(ii) was met; the year in which the deduction was claimed the taxpayer’s ordinary course of business included the lending of money. However, criterion two and three were not fulfilled—the loan was not “made in the ordinary course of the taxpayer’s money lending business” and there was not a reasonable doubt that at the end of the relevant taxation year the loan would be repaid. Hence, the deduction was disallowed.

The Federal Court of Appeal

Before the Federal Court of Appeal, Heron Bay argued that Hogan J. of the Tax Court was “wrong in law” by finding that criterion 2 and 3 were not met. Also, Heron Bay maintained:

the judge deprived Heron Bay of procedural fairness by considering authorities not cited by either party without giving the parties an opportunity to make submissions on those authorities, considering issues not pleaded by either party without giving the parties an opportunity to make submissions on those issues, and intervening excessively in the examination of witnesses, giving rise to a reasonable apprehension of bias.

At trial, Hogan J. referenced authorities not referred to by Heron Bay or the Minister. For example, Canada Trustco Mortgage Co. v. Canada, [2005] 2 S.C.R. 601 was not cited in the reasons of Hogan J., but referred to in his deliberations. As well, Hogan J. considered journal articles and additional secondary sources not cited or referred to by Heron Bay or the Minister. Nevertheless, according to the Court of Appeal, this alone did not indicate a breach of procedural fairness:

The judge cannot be precluded from referring in his deliberations to cases that are not cited by a party and are not referred to in his reasons…Nor can the judge, when addressing a legal issue raised by a party, be precluded from referring to a case he considers relevant to that issue merely because the case was not cited by a party… As to the judge’s reliance on articles by learned authors, it seems to me that he has simply adopted from those articles excerpts (including case references) stating principles that the authors have derived from jurisprudence relevant to the issues raised in the appeal…

According to the Court of Appeal, a “breach of procedural fairness” might have occurred if Hogan. J had relied on the impugned authorities to introduce “a principle of law that was not raised by either party expressly or by necessary implication, or had taken the case on a substantially new and different analytical path.”

It was Hogan J.’s application of s. 69 of the ITA, without allowing Heron Bay to make relevant submissions, that the Court of Appeal ruled a breach of procedural fairness. Section 69(1)(a) states that the acquisition of anything from someone at non-arm’s length, at greater than the fair market value, is deemed for tax purposes to have been acquired at fair market value. The Federal Court of Appeal ruled that even though this reference to s. 69 was a breach of procedural fairness, it was obiter and did “not justify a retrial.”

In the end, a retrial was ordered due to concerns regarding the Tax Court judge’s excessive intervention in examinations and cross-examinations. Excessive intervention by a judge can warrant a new trial (see James v. Canada (2000), [2001] 1 C.T.C. 227 (F.C.A.); R. v. Brouillard, [1985] 1 S.C.R. 39).

According to the Court of Appeal, the Tax Court judge “seemed to fall into the habit of taking over the questioning.” Moreover, Hogan J., during the examination of one witness, “adopted a position in opposition to Heron Bay on a critical issue in the case, giving rise to a reasonable apprehension that the judge was not a fair and impartial arbiter.”

In the case of GlaxoSmithKline Inc. v. The Queen, 2008 TCC 324 [Glaxo I], the “reasonable in the circumstances” standard was applied to payments for a pharmaceutical product purchased by Glaxo Canada (“Glaxo”) from a non-arm’s length non-resident person, Adechsa SA (“Adechsa”), both members of the Glaxo Group of companies (“Glaxo Group”). The Minister and Tax Court of Canada agreed that the reasonable amount was the fair-market value of the pharmaceutical product.

However, according to the Federal Court of Appeal decision in Glaxosmithkline Inc. v. Canada, 2010 FCA 201 [Glaxo II], (reasons for judgement by Nadon J.A.) the failure of the Tax Court of Canada to “consider all relevant circumstances which an arm’s length purchaser would have had to consider…”, including a related licensing and purchasing agreement, was a legal error. Essentially, determining the price that is “reasonable in the circumstances” is a contextual process and not merely an exercise in determining the fair market value.

Legal Framework

Section 69(2) of the ITA states:

69. (2) Where a taxpayer has paid or agreed to pay to a non-resident person with whom the taxpayer was not dealing at arm’s length as price, rental, royalty or other payment for or for the use or reproduction of any property, or as consideration for the carriage of goods or passengers or for other services, an amount greater than the amount (in this subsection referred to as “the reasonable amount”) that would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm’s length, the reasonable amount shall, for the purpose of computing the taxpayer’s income under this Part, be deemed to have been the amount that was paid or is payable therefor.

Pursuant to this section, a payment to a non-arm’s length non-resident person has to be an amount not greater than what would be “reasonable in the circumstances” if the payment was made to an arm’s length person.

Background and Facts

For the four years at issue (1990-1993), Glaxo purchased the pharmaceutical ingredient ranitidine, which is marketed as Zantac, from Adechsa SA (“Adechsa”), a related non-resident company, for the price of between $1512 and $1651 per kilogram. In the same period, two generic Canadian pharmaceutical companies purchased the same product for much less—between $194 and $304 per kilogram.

The Minister reassessed Glaxo for the years 1990-1993 for overpaying for the drug randitine and as a result its income was increased to account for the difference between the price paid and what the Minister considered to be the amount “reasonable in the circumstances.”

In Glaxo I, Rip A.C.J. (now C.J.) of the TCC deemed the reasonable amount to be the fair market value of ranitidine, as substantiated by the prices paid by the generic companies. The excess amounts paid to Adechsa were deemed to be benefits, and pursuant to s. 56(2) of the ITA, subject to non-resident withholding tax.

When Determining the “Reasonable Amount” Under s. 69(2) Business Circumstances Must be Taken Into Account

The main issue in the present case was what considerations were to be taken in order to determine what was a “reasonable amount” pursuant to s. 69(2) of the ITA. According to the Court of Appeal, for s. 69(2) to take effect the following criteria must be met:

1. There must be a taxpayer (as defined in subsection 248(1);

2. who paid or agreed to pay;

3. to a non-resident;

4. with whom the taxpayer was not dealing at arm’s length;

5. an amount and as a price, rental, royalty or other payment for or for the use or reproduction of any property, or as consideration for the carriage of goods or passengers or for other services;

6. the amount must be “greater than the amount that would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm’s length”.

The Federal Court of Appeal was primarily concerned with criterion 6. Glaxo contended that the business circumstances surrounding the transactions should have been taken into account when determining the price that would have been “reasonable in the circumstances.” The company argued that s. 69(2) should not apply if it could be determined that any reasonable business person, in the same situation, yet dealing at arm’s length, would have paid the amount.

To buttress this argument, the company contended that related license and supply agreements, which in part required that Glaxo purchase the product from Adechsa, should be taken into consideration; to do otherwise would be “ignoring a crucial business circumstance.” In part, the agreements provided the Glaxo subsidiary with select intellectual property rights, including the use of the ranitidine patent and associated trademark, along with “other patented and trademarked products.”

Conclusion

In Glaxo I, the Tax Court rejected the impact of the agreements. In Glaxo II, the supply and license agreements were together held to potentially validate the price difference at issue. According to the Federal Court of Appeal, the Tax Court of Canada erred by misunderstanding the test for s. 69(2). Real world conditions must be taken into consideration, “including all relevant circumstances which an arm’s length purchaser would have had to consider…” As a result, the issue was returned to Rip C.J. of the Tax Court for a rehearing.

For the unfamiliar, the GAAR is a catch-all provision within s. 245 of the ITA that serves to limit abusive tax avoidance transactions that otherwise technically comply with respective provisions of the ITA. The SCC provided the application framework for the GAAR in Canada TrustCo Mortgage Co. v. Canada, [2005] S.C.R. 601, which was followed in the case of Lipson v. R., [2009] 1 S.C.R. 3 (discussed here).

This case is notable for two reasons. One, the Canada TrustCo precedent was adhered to, with passing reference to the Lipson decision. Second, it provides guidance regarding the burden of proving that an impugned transaction is antithetical to the purpose of the ITA provision relied upon.

The Legislative Framework

Pursuant to the decision in Canada TrustCo the application of GAAR is a three step process. First, it has to be determined if a tax benefit was realized as a result of the transaction or series of transactions at issue. This consideration involves ss. 245(1) and 245(2) of the ITA. Second, the transaction or series of transactions must have been arranged primarily to realize a tax benefit. In other words, were the transactions avoidance transactions under s. 245(3)? Finally, the transaction or series of transactions must be deemed an abuse of a relied upon provision of the ITA under s. 245(4). At this step, abuse is evident if the “object, spirit or purpose” of the provision is contradicted. The taxpayer carries the burden of disproving steps one and two, and the Crown must prove step three. The taxpayer is entitled to the benefit of the doubt.

In the present case, the Tax Court and Court of Appeal were unable to agree on the “object, spirit or purpose” of subparagraph 212(1)(b)(vii). Pursuant to s. 212(1)(b) interest paid by a resident of Canada to a non-resident is taxed as income from a Canadian source. There are multiple exceptions to the application of this provision and at issue in the present case was the exemption at s. 212(1)(b)(vii). According to this subparagraph, withholding tax is not required “on interest payable by a corporation resident in Canada to a non-resident.” However, this exemption only applies if the following qualifications are met:

- interest is payable by a corporation resident in Canada;
- payable to an arm’s length non-resident person; [the “arm’s length test”]
- evidence of the debt was issued by the corporation after 1975;
- the corporation is not obliged to pay more than 25% of the principal amount within 5 years from the date when the debt instrument was issued. [the “5 year test”]

The 25% rate is subject to any applicable international income tax conventions. In this case the rate was reduced to 15% pursuant to the Canada-Belgium Income Tax Convention (1976).

Background and Facts

Lehigh Cement Inc., a Canadian company, borrowed $140 million dollars from a group of Canadian banks. Lehigh was a member of a German group of corporations, the parent company being Heidelberger Zement (“HZ”). This group also included the foreign corporation CBR International Services S.A. (“International Services”), among others. Over the years the debt was sold and held by various members of the HZ group. The last member of the group to hold the debt was International Services. Pursuant to s. 212(1), as long as interest on the debt was being paid to a non-arm’s length non-resident corporation it was subject to withholding tax. To clarify, the Canadian company Lehigh, was paying interest to the foreign corporation International Services, and because both were members of the HZ group they did not deal at arm’s length. Thus, the exemption from withholding tax pursuant to s. 212(1)(b)(vii) did not apply.

Accordingly, Lehigh withheld the applicable tax for many years but eventually, as the company conceded, the debt was restructured to qualify for the s. 212(1)(b)(vii) exemption. International Services sold the right to the interest on the debt to a Belgian bank. A corporation within the HZ group received payments on the principal. Under additional terms of the restructuring, the arm’s length test and 5 year test were met. Now that Lehigh paid the interest on the debt to a non-resident corporation at arm’s length, the exemption under s. 212(1)(b)(vii) applied.

The Tax Court of Canada Rules against Lehigh

Before the Tax Court, the Crown argued that the aforementioned transaction was contrary to the GAAR because it did not meet the purpose of the ITA provision relied upon. Determining the purpose of a provision of the ITA for a GAAR analysis “should be discerned from its words, interpreted textually, contextually and purposively.” In the present case the Tax Court first referred to a paper delivered at a Canadian Tax Foundation conference in 2005 which in part read: “[t]he policy rationale behind the withholding tax exemption in subparagraph 212(1)(b)(vii) is to provide Canadian businesses with access to foreign capital markets for medium- and long-term debt.” The Tax Court also relied on additional third-party sources including an article from the Canadian Tax Journal that put forth similar rationale. It determined that this was sufficient evidence of the purpose of s. 212(1)(b)(vii).

According to the Tax Court, the purpose of s. 212(1)(b)(vii) is “to help Canadian corporations needing to borrow money by increasing their access to international capital markets. The exemption from withholding tax on arm’s length borrowing from foreign lenders makes such borrowing more competitive with domestic borrowing in Canada.” Furthermore, “the tax benefit applies only to the arm’s length borrowing of capital from a non-resident lender…” A transaction under s. 212(1)(b)(vii) has to be with a “certain commercial purpose…[Lehigh] did not borrow any money from [the Belgian Bank] or any other non-resident lender.” It merely sold the right to the interest to a foreign corporation at arm’s length. Hence, the provision was abused and both the avoidance transaction and resulting tax benefit were disallowed.

The Crown Fails to Meet its Burden

The main issue before the Federal Court of Appeal was the “object, spirit or purpose” of subparagraph 212(1)(b)(vii).The appeal court decided that the Crown did not meet its burden of proving the purpose of s. 212(1)(b)(vii).

Lehigh argued that it simply took advantage of the available exemption. All that was required was that the two tests under the provision (the 5 year test and arm’s length test) be met. According to Lehigh, the transaction did not violate the purpose of the two tests:

The 5 year test is intended to ensure that the debt is medium to long term debt…The arm’s length test is intended to ensure that the contractual conditions governing the debt, particularly the interest rate, fairly reflect the applicable market.

Of course, the preceding argument did not take into account the textual, contextual and purposive analysis mandated by the CanadaTrustCo decision regarding the application of the GAAR. The GAAR comes into play precisely when the statutory requirements are met but it is alleged that the provisions have been abused in order to realize a tax benefit.

The interest payments were to a foreign company at arm’s length. According to the Appeal court, the arm’s length test only had “to be met in respect of the relationship between the person required to pay the interest and the person entitled to be paid the interest.” Furthermore, the splitting of the interest from the principal was acceptable and common in commercial financing transactions. Finally, s. 212(1)(b)(vii) “is broad enough to include any interest payable by a corporation resident in Canada to a non-resident, no matter how the non-resident may have become entitled to receive that interest.”

The Appeal court ruled that the Crown did not meet its burden of proving the “object, spirit or purpose” of s. 212(1)(b)(vii). As a result, the Crown was not able to establish that the purpose had been defeated. If the Appeal court had agreed with the Tax Court’s determination of the purpose of s. 212(1)(b)(vii) surely that decision would have been upheld—Lehigh did not borrow from the Belgian bank, the loan interest and principal were split, and the right to the interest was sold to an arm’s length foreign entity. While technically legitimate, this was not within the purpose of s. 212(1)(b)(vii) as stated by the Tax Court.

The Crown’s “Shaky Foundation”

This decision suggests that when establishing the purpose of a provision of the ITA the burden on the Crown is relatively stringent. While the Tax Court accepted a single Parliamentary document and related journal and conference articles, the Court of Appeal decided that those documents did not sufficiently evidence the purpose of s. 212(1)(b)(vii).

Importantly, there was no case law presented to support the Crown’s position and nor was there mention of a Parliamentary record indicating the purpose of s. 212(1)(b)(vii), except for one Department of Finance publication from 1975. The publication in part stated: “[t]he proposed relief from withholding tax is intended to increase the flexibility of Canadian business to plan long-term debt financing and facilitate access to funds in international capital markets.” The Appeal court conceded that the “1975 budget paper says something about the history of subparagraph 212(10(b)(vii)” but ultimately that was not enough:

[I]t is fatal to the Crown’s misuse argument that it finds no support in any provision of the Income Tax Act, or in any jurisprudence or other authority saying or suggesting that the splitting of the interest and principal obligations of a debt have any income tax implications in relation to subparagraph 212(1)(b)(vii), or any analogous provision or relevant statutory scheme.

It may be comforting to some tax counsel to know that the burden of proving misuse or abuse under s. 245(4) remains relatively high. In the Lipson decisions, the SCC, the Federal Court of Appeal, and the Tax Court of Canada all referenced case law indicating the purpose of the provisions at issue. In the present case the Crown did not advance any case law to support its determination and the evidence it did present was inadequate. Ultimately, it appears that if a reassessment under GAAR is to be successful the Crown must provide evidence of the purpose of a provision of the ITA through supporting case law or a substantive Parliamentary record.

Tax Harmonization Leads to Disagreement

Prior to 2003, the City collected property taxes on all taxable immovables within its territory. Two other taxes that could be imposed on top of the general property tax included a surtax on non-residential immovables, and an occupancy tax on commercial and professional premises (“business tax”). When the City amalgamated the tax systems of local municipalities into one harmonized system in 2003, it abolished the business tax. The respondents, the Canadian Broadcasting Corporation (CBC) and the Montreal Port Authority (MPA), had been making PILTs corresponding to the property tax on the taxable value of their immovables in Montreal, but they had never paid the business tax. When the harmonization occurred, the City adjusted the tax rates to recover the loss of revenue from the abolition of the business tax. The effect was to increase the amount of PILTs paid by the respondents to the City. They refused to make the PILTs calculated according to the new tax rates for non-residential immovables.

The CBC and MPA exercised their purported discretion to determine the applicable tax rate in calculating their PILTs. Both engaged in creative calculating by reducing their PILTs by the amount equivalent to the increase in the property tax that was attributable to the abolition of the business tax. The CBC was more aggressive than its co-respondent with its additional argument that it should be allowed to recoup the amounts by which it claimed to have overpaid its PILTs to the City in the past. Its position was that the effect of abolishing the business tax should be applied retrospectively so that its PILTs would be considered to be overpaid by the amount of the business tax.

What is the Scope of Crown Corporations’ Discretion?

The crux of the decision written by LeBel J. came down to an interpretation of the scope of the discretion conferred upon Crown corporations in the definitions of “property value” and “effective rate” in the calculation of PILTs. Subsection 4(1) of the Act contains the basic formula for calculating a PILT, which is “the product of the effective rate applicable to the federal property in the taxation year and the property value of the property.” (Emphasis added). The respondents argued that both definitions gave them the discretion to determine the applicable tax rate. For convenience, the definitions are listed below:

effective rates means the rate of real property tax or frontage or area tax that, in the opinion of the Minister, would be applicable to any federal property if that property were taxable property;

property value means the value that, in the opinion of the Minister, would be attributable by an assessment authority to federal property…as the basis for computing the amount of any real property tax that would be applicable to that property if it were taxable property [.]

The SCC held that these provisions did confer discretion upon Crown corporations to determine the tax rate, but within certain limits. LeBel J. gave examples of circumstances in which this discretion was appropriately exercised, such as protecting federal government interests in the face of bad faith by municipal tax authorities. Discretion must be exercised in a manner consistent with the rule of law. LeBel J. wrote that the respondents “cannot base their calculations on a fictitious tax system they themselves have created arbitrarily. On the contrary, those calculations must be based on the tax system that actually exists at the place where the property in question is located.” In turn, neither Crown corporation could decrease the amount of their PILTs to account for the abolition of the business tax. Further, the CBC could not reach back in time and retrospectively apply the abolition of the business tax in order to claim that it overpaid its PILTs to the City.

The City of Montreal Sweeps the Floor with the CBC and MPA

The City’s success on all fronts marks a key victory for municipalities vis-a-vis Crown corporations beyond the specific facts of this case. Not only did the City manage to circumscribe the discretion of Crown corporations in determining their tax rates for calculating PILTs, it also managed to get away with indirectly imposing the business tax on them. Recall that the CBC and MPA did not pay the business tax prior to 2003. The effect of the harmonization was to increase the PILTs paid by both of them, which arguably constitutes indirect taxation on the basis of the business tax. The facts clearly showed that the City adjusted the tax rates to account for the loss of revenue arising out of the abolition of the business tax. However, LeBel J. found that Quebec municipal legislation allowed the City to impose variable-rate property taxes, and that the City was merely exercising that power. This element of the decision is disconcerting because it allowed the City to indirectly do what it could not do directly. Harmonizing the tax system is a worthy goal, but the City should not have been allowed to use its power in bad faith to increase the PILTs owed by the CBC and MPA. As mentioned earlier, Crown corporations are permitted to exercise their discretion in the face of bad faith by municipal tax authorities. LeBel J. specifically stated, “[M]anagers of federal property must retain some latitude so that they can react to protect federal government interests should municipalities use their taxing powers in bad faith to specifically target federal property.” Based on the legislative framework regarding PILTs, this elucidation of bad faith is rather narrow. Since the City technically has no legal right to the PILTs, it was arguably bad faith on its part to compel the respondents to pay PILTs at the higher tax rates. It difficult see how allowing the respondents to pay PILTs at the old tax rate would be  contrary to “fairness and equity” when the rise in the tax rate is due to the abolition of a tax that they did not previously pay. The primary concern with such a narrow elucidation of bad faith is that it could led to future manipulations of the tax rates in order to get Crown corporations to make greater PILTs. A municipality could disguise the manipulation by changing the tax rates across the board as was the case here. It is for that reason that this decision should be applied as narrowly as possible in the future.

Noted tax law scholar Vern Krishna related the gist of general anti-avoidance legislation at a recent lecture competition:

The law allows you to do something. You do it according to the law, and take advantage of the law, and then somebody says, “No… that was not very nice. You went too far.” And you say, “How far is ‘too far’?” And [they] say, “Well, we’ll tell you when we find out.” (Laughter.) But you say, “I need to know, because I need to plan in advance!” And they say, “No, you’ll find out in the fullness of time.” (Laughter.)

Thus, general fairness concerns of uncertainty, unpredictability, and retroactivity arise. Furthermore, having to do with but a property interest, general anti-avoidance legislation is not subject to Charter scrutiny under s. 7. As expected, the courts are left to divine the meaning of “misuse” and “abuse” under s. 245(4), demarcating the line between valid and non-valid arrangements of financial affairs.

This brings us to Copthorne Holdings Ltd. v. Canada, 2009 FCA 163, the latest tax avoidance case that the Supreme Court of Canada is set to hear. Granted leave to appeal on January 28, Copthorne Holdings concerns a series of avoidance transactions in the corporate context. Involved in a dizzying corporate web is a group of interrelated companies owned by the family of Hong Kong businessman Li Ka-Shing (“the Li group”). Unravelling this web, the pertinent facts, as best as I can understand, are as follows:

• 1991: The Li group invests $96.7m in its corporation, VHHC Investments Inc. (“VHHC Investments”). VHHC Investments invests $67.4m of that amount in a subsidiary, VHHC Holdings Ltd. (“VHHC Holdings”). At the end of the year, the issued shares of VHHC Investments and VHHC Holdings thus have paid-up capital (“PUC”) amounts of $96.7m and $67.4m respectively.

• 1992: VHHC Holdings is transferred from VHHC Investments to another Li group company, Copthorne Holdings Ltd. (“Copthorne I”). VHHC Holdings realizes a capital loss.

• 1993: The decision is made to amalgamate VHHC Holdings and Copthorne I. Since VHHC Holdings is Copthorne I’s subsidiary, such a vertical amalgamation would result in the intercorporate elimination of VHHC Holding’s PUC. VHHC Holdings is instead transferred to Copthorne I’s parent corporation for its nominal fair market value (“the 1993 Share Sale”), making VHHC Holdings and Copthorne I sister corporations prior to amalgamating to form Copthorne Holdings Ltd. (“Copthorne II”), thereby preserving VHHC Holdings’ $67.4m as part of Copthorne II’s aggregate PUC.

• 1994: In response to the announcement of proposals to amend foreign accrual property income (“FAPI”) provisions of the Income Tax Act, the Li group decides to undertake a corporate reorganization. Copthorne II as well as VHHC Investments are transferred to L.F. Investments (Barbados) Ltd. (“L.F. Investments”).

• 1995: Copthorne II and VHHC Investments are amalgamated to form Copthorne Holdings Ltd. (“Copthorne III”). Copthorne III’s PUC is roughly $164.1m, consisting of the $96.7m PUC of VHHC Investments and the preserved $67.4m of VHHC Holdings, the PUC of all other parties to these successive amalgamations being nominal. Following this amalgamation, Copthorne III redeems a number of shares from its parent, LF Investments (“the 1995 Redemption”). Since the redemption price of each share was equal to its PUC, the redemption did not give rise to taxable income in the form of a deemed dividend pursuant to s. 84(3) of the ITA. Accordingly, Copthorne III did not withhold or remit tax on behalf of L.F. Investments in respect of the redemption proceeds.

The Minister of Finance, applying the GAAR, determined that a deemed dividend had in fact arisen on the 1995 Redemption, for which withholding tax was due on the part of Copthorne III. The 1993 Share Sale was determined to be the avoidance transaction, though the tax benefit of it was not realized until the later 1995 Redemption. Since the GAAR applies not only to a “transaction” pursuant to s. 245(3)(a) but also to a “series of transactions” pursuant to s. 245(3)(b), the tax benefit that arose from 1993 Share Sale and 1995 Redemption was open to be denied if the two transactions were found to constitute a series thereof and furthermore were found to be abusive per the statute and related case law. The Tax Court of Canada, agreeing with the Minister’s tax assessment, explained the abusiveness of the transactions and the deemed dividend that should have otherwise arisen:

25     … [T]he calculation of PUC resulted in the very blatant advantage of a “double counting” in the amount of $67[.4m]. None of the provisions in the Act ever intended that an artificial inflation of PUC be preserved for a subsequent return of such an increase to shareholders on a tax-free basis. I am dealing with a total PUC of $164[.1m] belonging to Copthorne III … The origin of this amount is made up of $96[.7m] PUC originally belonging to VHHC Investments and $67[.4m] PUC belonging to Copthorne II. However the $67[.4m] is easily traced to the initial investment made by VHHC Investments in VHHC Holdings. This PUC was preserved by the 1993 Share Sale and maintained throughout the First and Second Amalgamations. This means that the $67[.4m] PUC is part and parcel of or is derived from the $96[.7m] PUC. To permit transactions that produce an aggregate of these two amounts creates a double counting of PUC in the amount of $67[.4m]. …

74     … When VHHC Investments is later amalgamated with Copthorne II, the underlying principles respecting the calculation of PUC are offended because approximately $67 million of PUC is essentially double counted in the PUC of the newly amalgamated corporation. It is this double counting that circumvents the proper application of the relevant provisions in a manner that frustrates and defeats the object, spirit and purpose of those provisions, which individually, together and when read in conjunction with other provisions in the Act, are meant to operate to prevent the artificial increase of PUC on amalgamation and its subsequent return to shareholders on a tax-free basis.

At issue on appeal to the Federal Court of Appeal was the precise definition of a “series of transactions”. Where s. 245(3)(b) makes “series['] of transactions” subject to the GAAR, s. 248(10) helps to set out and broaden the definition of a “series” beyond the common law definition: a “series [of transactions or events] shall be deemed to include any related transactions or events completed in contemplation of the series.”

The proper interpretation of s. 248(10), specifically the words “completed in contemplation of the series”, was the question of law on appeal. Justice Ryer, for the unanimous Federal Court of Appeal, reviewed the case law on which the Tax Court of Canada based its decision:

40     Subsection 248(10) was interpreted by Rothstein J.A. in [OSFC Holdings Ltd. v. Her Majesty the Queen, 2001 FCA 260 ("OSFC")] (at paragraph 36). There, he stated:

… Subsection 248(10) does not require that the related transaction be pre-ordained. Nor does it say when the related transaction must be completed. As long as the transaction has some connection with the common law series, it will, if it was completed in contemplation of the common law series, be included in the series by reason of the deeming effect of subsection 248(10). Whether the related transaction is completed in contemplation of the common law series requires an assessment of whether the parties to the transaction knew of the common law series, such that it could be said that they took it into account when deciding to complete the transaction. If so, the transaction can be said to be completed in contemplation of the common law series. [Emphasis added]

41     The Supreme Court of Canada approved and elaborated upon Justice Rothstein’s interpretation of subsection 248(10). At paragraph 26 of [Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54 ("Canada Trustco")], McLachlin C.J. and Major J. stated:

26     Section 248(10) extends the meaning of “series of transactions” to include “related transactions or events completed in contemplation of the series”. The Federal Court of Appeal held, at para. 36 of OSFC, that this occurs where the parties to the transaction “knew of the … series, such that it could be said that they took it into account when deciding to complete the transaction”. We would elaborate that “in contemplation” is read not in the sense of actual knowledge but in the broader sense of “because of” or “in relation to” the series. {…}

Copthorne Holding’s objection to the Tax Court’s ruling and argument before the Federal Court of Appeal:

43     The appellant contends that a close [causal] connection is required. … [T]he appellant argues that there is no causal connection between the [1993 Share Sale] and the 1995 Redemption, in the sense that the latter event was caused by the Proposed FAPI Amendments and therefore could not have been caused by the [1993 Share Sale] in which the PUC preservation transaction occurred. … [A]ny causal connection that might otherwise have existed between the [1993 Share Sale] and the 1995 Redemption was … broken by the Proposed FAPI Amendments.

44     In support of this … the appellant cites a passage from the decision of the Tax Court of Canada in MIL (Investments) S.A. v. The Queen, [2006] 5 C.T.C. 2552 (affirmed on other grounds, 2007 FCA 236). At paragraph 65 … Bell J. stated:

There must be a strong nexus between transactions in order for them to be included in a series of transactions. In broadening the word “contemplation” to be read in the sense of “because of” or “in relation to the series”, the Supreme Court cannot have meant mere possibility, which would include an extreme degree of remoteness. {…} [Emphasis added]

While agreeing that the Supreme Court of Canada’s broadening in Canada Trustco of “in contemplation” did not go so far as to mean “mere possibility”, Ryer J.A. rejected Bell J.’s stricter wording of “strong nexus”. This makes sense, as it would “require an even closer connection between the transaction and the series than was required under the interpretation offered Rothstein J.A. in OFSC.”

Following OFSC and Canada Trustco, and thus affirming the Tax Court in this regard, Ryer J.A. introduced the phrase “motivating factor”:

In my view, if a series is a motivating factor with respect to the completion of a subsequent transaction, the transaction can be said to have been completed “in contemplation of the series” and a direct causal relationship between the series and the transaction, as argued by the appellant, need not be established. In my opinion, this standard is reconcilable with the test as stated in OSFC and as broadened in Canada Trustco. [My underlining.]

Ryer J.A. affirmed the Tax Court’s application of OFSC and Canada Trustco to the facts and conclusion that “the 1995 Redemption formed part of [a s]eries [containing the 1993 Share Sale]“: “the conclusion that the PUC preservation that occurred in the [1993 Share Sale] was … a motivating factor in relation to the completion of the 1995 Redemption, is unassailable.”

In dismissing this appeal, the Federal Court of Appeal also affirmed the Tax Court of Canada’s finding of mixed law and fact that avoidance transactions of corporate PUC preservation, such as conducted here, are abusive within the meaning of the Act and the related case law, offending the principles respecting the calculation of PUC.

In closing, the Court will, having granted leave to appeal in Copthorne, at the very least have to abate whatever uncertainty there is in respect of the corporate tax consequences relating to amalgamations and paid-up capital. More importantly, the Court will have to settle any conflicting trends in the case law arising from a misinterpretation of its jurisprudence (i.e. Canada Trustco) with respect to the concept of a “series of transactions” as set out in the Income Tax Act. Furthermore, when the Court ultimately settles on an appropriate standard (whether familiar or novel), as part of defining that standard it will have to demonstrate and elaborate on what exactly qualifies that standard. Fairness concerns aside, such jurisprudential wrangling seems an inescapable part of the administrative and judicial burden imposed by general anti-avoidance legislation such as our s. 245.

The issue in C.P. Desjardins de Montmagny was determining the status of collected but unremitted GST and QST amounts where a business later filed for bankruptcy, and determining the priority as between the government, the trustee in bankruptcy, and secured creditors in claiming the amounts in question. Since the 1992 amendments to the Bankruptcy and Insolvency Act, R.S.C. 1985, c. B‑3, it is established law that any statutory deemed trust creating a superpriority for the Crown for amounts related to excise tax is extinguished as soon as the debtor files for bankruptcy. Tax authorities must be treated as an ordinary creditor. Thus the fact that the Quebec Superior Court found in favour of the Crown was surprising; all three judgments were overturned by the Quebec Court of Appeal and the appellate judgments were upheld by the Supreme Court in short order.

The appeal arose from three cases involving bankruptcies of a number of companies and problems related to unremitted GST and QST amounts. In all three cases, businesses filed for bankruptcy under the BIA while they had GST and QST amounts that had been collected but not yet remitted or collectible by the Crown. In two of the claims—Deputy Minister of Revenue of Quebec and Her Majesty the Queen in Right of Canada v. Caisse populaire Desjardins de Montmagny and Raymond Chabot Inc., in its Capacity as Trustee for the Bankruptcy of 9083‑4185 Québec inc., 2006 QCCS 2108, and Deputy Minister of Revenue of Quebec and Her Majesty the Queen in Right of Canada v. Raymond Chabot Inc. in its Capacity as Trustee for the Estate of the Debtor Consortium Promecan inc., 2006 QCCS 6370—the Quebec Deputy Minister of Revenue gave notice to the respective businesses’ trustee in bankruptcy of the Minister’s stance that the Crown “owned” the GST and QST amounts collected by the bankrupt business. In Deputy Minister of Revenue of Quebec and Her Majesty the Queen in Right of Canada v. National Bank of Canada, 2006 QCCS 2656, the National Bank of Canada had a security interest in the accounts of the bankrupt debtors, pursuant to the Bank Act, S.C. 1991, c. 46. However, the Deputy Minister of Revenue of Quebec claimed these amounts as GST and QST amounts collected by the bankrupt businesses on behalf of the Crown.

In all three cases, the Quebec Superior Court sided with the Crown, holding that the Crown owned the disputed GST and QST amounts. “In essence, the Superior Court judges held that the GST and QST amounts were not part of the bankrupt’s patrimony” (at para. 6).

The Quebec Court of Appeal overturned all three decisions, holding that the Deputy Minister of Quebec is an unsecured creditor under the BIA and must be treated as an ordinary creditor (« que le sous-ministre du Revenu du Québec, pour fins de réclamation sur TPS et TVQ s’il y a lieu, est un créancier ordinaire au sens de la Loi sur la faillite et l’insolvabilité et, qu’en conséquence, il n’a aucun droit sur les comptes à recevoir ou autres actifs de la débitrice », 9083-4185 Québec inc. (Syndic de), 2007 QCCA 1837 at para. 7).

Writing for a unanimous panel of seven justices, Justice LeBel dismissed the Crown’s appeal in a summary fashion (the judgment consists of 30 short paragraphs).

He clarified that under the BIA, any statutory deemed trust created in favour of the Crown is extinguished when the debtor files for bankruptcy (with the exception of the three employee source deductions expressly enumerated in subsection 67(3) of the BIA: income tax deductions under subsection 227(4) or (4.1) of the Income Tax Act; CPP contributions under subsection 23(3) of the Canada Pension Plan; and EI contributions under subsection 86(2) or (2.1) of the Employment Insurance Act. See Caisse populaire Desjardins de l’Est de Drummond v. Canada, 2009 SCC 2, and its analysis by TheCourt.ca).

Justice LeBel then addressed the Deputy Minister’s submission that the Crown “owns” the GST and QST amounts collected by a business. Essentially, the argument was that the GST and QST amounts collected by a business are never the property of the business itself but immediately become the property of the Crown upon collection. As such, upon bankruptcy, these sums do not form part of the bankrupt business’s patrimony to be apportioned amongst secured and unsecured creditors. Rather, the trustee is to hold these funds separately, and turn them over to the Crown as its mandatary.

This line of argumentation basically ends up with the same result that the government was aiming to overcome with the 1992 amendments to the BIA overriding of Crown statutory trusts under the BIA regime. At that time, subsection 67(2) was introduced, which reads:

(2) Subject to subsection (3), notwithstanding any provision in federal or provincial legislation that has the effect of deeming property to be held in trust for Her Majesty, property of a bankrupt shall not be regarded as held in trust for Her Majesty for the purpose of paragraph (1)(a) unless it would be so regarded in the absence of that statutory provision. [emphasis added]

As discussed in Justice LeBel’s decision, the aim of this and other amendments was to limit the priority given to the Crown in bankruptcy proceedings. The aim was to avoid a situation where the federal and provincial Crowns would clean up the bankrupt’s estate due to unremitted taxes, leaving nothing behind for the unsecured creditors. Rather, the Crown was to be considered an unsecured creditor on par with other unsecured creditors and compete for its claim. Conceding that the Crown does not have a superpriority trust in respect of excise tax amounts but then claiming that the Crown outright owns these amounts from the outset has the effect of a “super-superpriority.”

Justice LeBel rightly rejected this argument, finding that such a proposition would be contrary to a purposive and contextual reading of the BIA as well as the federal Excise Tax Act and Quebec Act respecting the Ministère du Revenu.