Supreme Court of Canada upholds taxman’s GAAR crackdown on offensive corporate loss trading

By Cristin Schmitz

Last Updated: Friday, May 26, 2023 @ 7:00 PM

Law360 Canada (May 26, 2023, 5:20 PM EDT) -- Applying the Income Tax Act’s general anti-avoidance rule, the Supreme Court of Canada has ruled 7-1 that a corporate taxpayer engaged in abusive tax avoidance when it tried to monetize millions in unclaimed non-capital losses and tax credits, by carrying them over for use by a different business, via investment transactions that skirted the ITA’s s. 111(5) restriction on non-capital loss carryovers.

On May 26, the top court dismissed the appeal of Deans Knight Income Corporation from a unanimous 2021 Federal Court of Appeal ruling which upheld the Canada Revenue Agency’s (CRA) denial of nearly $65 million in non-capital losses and other tax credits that the company had claimed to reduce its tax liability in the years 2009 to 2012: Deans Knight Income Corp. v. Canada, 2023 SCC 16.

Justice Malcolm Rowe’s 141-paragraph majority judgment provides guidance on how to analyze and apply the GAAR, first adopted in 1988, which analysis involves a structured three‑step test asking whether: (1) there was a tax benefit; (2) the transaction giving rise to the tax benefit was an avoidance transaction; and (3) the avoidance transaction was abusive. 

Justice Malcolm Rowe

Justice Malcolm Rowe

His decision also marks the first time the top court has decided a case alleging abusive tax avoidance carried out by skirting the “acquisition of control” threshold for restricting non-capital loss carryovers under ITA s. 111(5).

Subsection 111(1)(a) of the ITA allows a taxpayer’s non-capital losses to be carried back three years or carried forward 20 years in order to offset income in those years. However, the ability to carry over losses is limited by s. 111(5) which indicates that when another entity acquires control of the taxpayer corporation, non-capital losses from before the acquisition of control cannot be carried over, unless the corporation continues the same or similar business that incurred the losses.

In 2007, Forbes Medi-Tech Inc. (which later became Deans Knight Income Corporation) was a financially struggling biotech business in B.C. that had built up about $90-million-worth of tax credits and unclaimed non-capital losses (i.e. its annual expenses exceeded annual income).     

Deans Knight did not have enough income against which to deduct its non-capital losses so in 2008 it entered into a complex investment agreement with the venture capital firm, Matco Capital Ltd. The investment agreement was careful not make Matco the majority shareholder as that would have triggered the s. 111(5) restriction on carrying over losses. However, the transaction’s effect was to give Matco major influence over Deans Knight’s business. Matco found a mutual fund management company to use Deans Knight as a corporate vehicle to raise money through an initial public offering. The money was used to change Deans Knight into an investment business — which was then able to make use of its non-capital losses to shelter most of the new business’s portfolio income and capital gains.

“The appellant sought to take advantage of the loss carryover rule in s.111(1)(a) without triggering the restriction in s.111(5),” Justice Rowe said. “Before this court, the parties accept that the appellant complied with the text of the Act. In other words, the parties agree that there was no ‘acquisition of control’ and that, therefore, the loss carryover restriction in s.111(5) did not apply.”

However, on appeal the issue was whether the appellant’s series of transactions aimed primarily at avoiding tax amounted to “abusive” tax avoidance, contrary to the GAAR.

“The transactions were abusive,” Justice Rowe held for the majority. “The object, spirit and purpose of s. 111(5) of the Act is to prevent corporations from being acquired by unrelated parties in order to deduct their unused losses against income from another business for the benefit of new shareholders. Through a complex series of transactions, the appellant underwent a fundamental transformation that achieved the outcome that Parliament sought to prevent, while narrowly circumventing the text of s. 111(5).”

Justice Rowe elaborated, “without triggering an ‘acquisition of control,’ Matco gained the power of a majority voting shareholder and fundamentally changed Deans Knight’s assets, liabilities, shareholders and business. This severed the continuity that is at the heart of the object, spirit and purpose of s.111(5). The result obtained by the transactions frustrated the rationale of s.111(5) and therefore constituted abuse.”

Justice Rowe noted that the transactions “resulted in Deans Knight’s near‑total transformation: it became a company with new assets and liabilities, new shareholders and a new business whose only link to its prior corporate life was the tax attributes. It was used as the vessel for an unrelated venture selected by Matco. Matco achieved the functional equivalent of an acquisition of control through the investment agreement, while circumventing s.111(5), because the transactions dismembered the rights and benefits that would normally flow from being a controlling shareholder.”

The transactions “allowed Matco to reap significant financial benefits, while depriving Newco, the majority voting shareholder on paper, of each of the core rights that it could ordinarily have exercised,” Justice Rowe wrote.

Justice Rowe remarked that until Parliament legislates otherwise,“de jure control remains the standard for the application of s.111(5)” — a standard that “appropriately recognizes that obtaining majority voting shares carries with it the ability to elect the board of directors and therefore to control the management of the affairs of the corporation.”

Here “Matco achieved the functional equivalent of such an acquisition of control through the Investment Agreement, while circumventing s. 111(5), because it used separate transactions to dismember the rights and benefits that would normally flow from being a controlling shareholder,” he said. “Several aspects of the transactions at issue demonstrate this functional equivalence, by which I mean that Matco achieved an outcome that Parliament sought to prevent without directly acquiring the rights that would have triggered s. 111(5).”

Justice Suzanne Côté

Justice Suzanne Côté

In her lone dissent, Justice Suzanne Côté agreed with the Tax Court judge below that the avoidance transactions which led to a tax benefit were not abusive as, in her view, they did not frustrate the rationale of s. 111(5).

“As de jure control is an essential element of the object, spirit and purpose of s. 111(5), the key question is whether Matco acquired de jure control of Deans Knight and the relationship between Matco and Deans Knight is the proper focus of the abuse analysis,” Justice Côté reasoned. “At no point did Matco own or have a right to own enough shares to reach a majority shareholder position,” she remarked. “Matco did not acquire Deans Knight in any practical sense. Matco was only a facilitator of the transactions and did not use Deans Knight’s non‑capital losses for its own benefit. The existence of abusive tax avoidance is, at best, unclear and the benefit of the doubt should go to the taxpayer,” she held.

Commenting on the threshold for “acquisition of control” which triggers the s. 111(5) limit on loss carryovers — which issue attracted the intervention of the Canadian Chamber of Commerce and the Tax Executives Institute Inc., Justice Côté argued that despite Parliament’s “unambiguous adoption of the de jure control” test (which generally involves acquiring sufficient share ownership to elect a majority of the board of directors) “the majority has opted for an ad hoc approach that expands the concept of control based on a wide array of operational factors.”

“This approach,” she warned, “invites the exercise of unbounded judicial discretion and will result in the loss‑trading restrictions in s. 111(5) being applied to transactions on a circumstantial basis.”

Calling the case at bar “of profound concern to Canadian taxpayers,” Justice Côté remarked that the GAAR “requires a careful balance between the interest of the taxpayer in minimizing his or her taxes through technically legitimate means and the legislative interest in ensuring the integrity of the income tax system.”

The majority’s approach to determining the object, spirit and purpose of s. 111(5) “fails to account for the central principle that the GAAR does not and cannot override Parliament’s specific intent regarding particular provisions of the Act,” Justice Côté wrote. “I am of the view that both my colleague Rowe J. and the Federal Court of Appeal have failed to apply the GAAR with due restraint.”

Barry Crump, Burnet, Duckworth & Palmer

Barry Crump, Burnet, Duckworth & Palmer

Co-counsel for the appellant Deans Knight Income Corp.,  Barry Crump and Heather DiGregorio of Calgary’s Burnet, Duckworth & Palmer, said “we are disappointed that the majority of the Supreme Court of Canada took an approach that makes the boundaries of the general anti-avoidance rule increasingly unclear and moves away from the principled approach first established in Canada Trustco in 2005.”

“As a result of this decision taxpayers now face a mountain of uncertainty in planning their affairs,” they suggested, echoing Justice Côté’s comment that the majority’s approach “ ‘introduces the novel and unprecedented concept of functional equivalence, which has no known boundaries’ and ‘invites the exercise of unbounded judicial discretion.’ ”

Canada Revenue Agency spokesperson, Sylvie Branch, told Law360 Canada the CRA “welcomes” the decision. “The CRA remains committed to combating tax avoidance which erodes Canada’s tax base and undermines the government’s ability to provide important benefits and services to Canadians,” she said by email.

Steve Suarez of Toronto’s Borden Ladner Gervais LLP, who with Laurie Goldbach and Elizabeth Egberts represented the intervener Canadian Chamber of Commerce, said the majority’s “functional equivalence” approach to the GAAR “is perhaps the only new principle coming out of the case, which the dissent expresses reservations over as having ‘no known boundaries.’ ”

Steve Suarez, Borden Ladner Gervais LLP

Steve Suarez, Borden Ladner Gervais LLP

“In that sense, the decision is something of a missed opportunity for the court to provide more guidance on how to determine the ‘object, spirit and purpose’ or ‘legislative rationale’ of provisions when conducting a GAAR analysis,” Suarez said, noting he was speaking for himself and not for the chamber.

“More generally, what is potentially troubling about this decision is that in determining the legislative rationale of the relevant provisions, the majority simply ignored all of the extrinsic evidence on the context and purpose of those provisions that didn’t agree with the result it reached, for example the subsequent legislative amendment, CRA advance tax rulings given, [and] statements made by government officials when GAAR was enacted, etc.,” he said. “Rather than addressing that contrary evidence and explaining why it was either incorrect, irrelevant or outweighed by other relevant extrinsic evidence, the majority simply ignored it, and instead adopted an overly broad view of the object, spirit and purpose of the loss utilization rules that does not sit well with the evidence on the context and purpose of these rules that was put forward. To that extent, the majority’s judgment potentially encourages the application of GAAR on a highly discretionary basis, without as much rigour and process as the business community would have hoped for.”

Suarez said it was “actually somewhat reassuring to see the majority base its decision on finding that ‘Matco achieved the functional equivalent of such [a de jure] acquisition of control’ in para. 128, thereby accepting the de jure control standard found in the text of s. 111(5) as the benchmark that constituted where Parliament had drawn the line for when a corporation’s losses should be restricted.”

“In so doing, the court rejected the Crown’s invitation to apply GAAR on the basis of some lesser degree of control, and significantly limited the precedential impact of the case,” he suggested. “It was also helpful that the court rejected the ‘actual control’ standard that the Federal Court of Appeal proposed (in paras. 114-115), which had significantly muddied the waters.”

Suarez added the court’s decision on the outcome was not “particularly surprising, as the taxpayer’s facts were close to the line and were always going to be a challenge to defend.”

He suggested, “the majority’s decision seems to ultimately boil down to, ‘this taxpayer on these facts achieved the functional equivalent of the very degree of control Parliament intended to trigger the loss utilization rules, albeit using different means than are applicable under the normal de jure control test set out in s. 111(5).’ ”

“If that’s so, which is ultimately a factual question confined to this taxpayer’s own specifics, that’s not an unreasonable conceptual approach to take as to when GAAR should apply,” Suarez said. “Although I’d have preferred Justice Côté’s approach, i.e. this taxpayer not only didn’t achieve a level of control equivalent to de jure control on the facts, but further whatever control it did achieve was through factors (i.e., contractual rights) that aren’t part of a de jure control analysis (i.e., voting rights attached to share ownership), and when considering what Parliament’s intent was in enacting these rules and what their object, spirit and purpose is, the courts should be limited to looking at not just the same level of control that de jure control provides but also the same factors and methods (i.e. voting rights) that the statutory de jure test uses, to truly respect Parliament’s intent,” Suarez said. “Reasonable people can differ as to the two approaches.”

Vern Krishna, University of Ottawa

Vern Krishna, University of Ottawa

University of Ottawa tax law professor Vern Krishna, also tax counsel with Chambers LLP and the author of the first text on the GAAR, agreed that the case’s outcome was not surprising. “The Federal Court of Appeal’s decision [below] was well-reasoned and the Supreme Court of Canada decision predictable,” he remarked. “Ultimately tax law is about balancing the interest of the state in revenue collection and the interest of taxpayers in income retention. As we move from the capitalist era of the Duke of Westminster [decision], which the House of Lords decided in 1936, towards a more regulatory state demanding increased revenues to fund public programs, tax law has had to adapt,” Krishna observed. “Hence, we see legislation, such as the loss carryover rules in s. 111(5), designed to safeguard revenue collection and, concurrently, anti-avoidance provisions to prevent taxpayers from undermining the integrity of the modern tax system.”

Krishna called Deans Knight “a significant shift away from the Duke of Westminster test, which said that a person could arrange their affairs to minimize taxes if they complied with the technical requirements of the tax statute. The Supreme Court repeats that the Duke of Westminster principle has ‘never been absolute’ and it is open to Parliament to derogate from it. Parliament has done so through the GAAR.”

Krishna said Justice Rowe’s judgment “articulates the abuse test clearly and in a comprehensive manner, which the tax bar should welcome. Those who rely solely on technical interpretations may be disappointed, as the decision once again clips the wings of the Duke of Westminster of an earlier era” making “tax planning somewhat more uncertain.”

Krishna said it’s important for tax practitioners to understand the ITA in the context of the statute’s underlying policies.

“People will have to first ensure they comply with the technical details of the statute, and then overview the arrangement to see that it does not amount to abusive tax avoidance,” he advised. “The essential issue to be answered by tax practitioners in each tax minimization arrangement is the interaction between specific statutory provisions used in transactions and the general anti-abuse doctrine inherent in GAAR.”

Nor is it enough to be “technically” correct in tax arrangements, Krishna added. “One must also ensure that the arrangement does not violate the fundamental purpose of specific anti-avoidance provisions built into the technical provisions.”

Photo of Justice Malcolm Rowe by Andrew Balfour Photography SCC Collection
Photo of Justice Suzanne Côté by Philippe Landreville Photography SCC Collection

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